Economic Crisis: A Look Ahead

0:00I am Dr. Grimm in spite of that okay yeah I'm sitting and I'm formulating you know many things in my head I listen to you know some very talented individuals and folks that have perhaps in some cases decades more experience than I and at capital markets, although I have my share of experiences there. But I'm sitting there thinking in the context of, you ever see the people that wear those little arm bands, WWJD, what would Jesus do, and I'm starting to think, what would WWMS or something, what would Mises say, or what would Rothbard say or something, and this might be, to put things on a more uplifting note, a great opportunity, maybe we should all be jumping for joy right now.

0:56because everything that we fought and preached about in terms of economic theory and our perspective of the world and what's truth versus what's not has basically been vindicated. We're starting to be taken a little more seriously I believe. Okay, and I know for me personally, I've had many great teaching moments, you know, based on what's happened over the last year and a half in the classroom. So, you know, maybe this isn't such a pessimistic time for us. Maybe we should be somewhat surreally optimistic.

1:43I'm optimistic that this is what it took, this is what it took to wake people up. I don't know if we're at the bottom yet, maybe halfway there, maybe two-thirds, who knows? The future is very hard to predict. I know from my background, my background is finance. These guys are the economists. Okay, I know a little bit of economists, just enough to get me in trouble, okay, you know, it was fortunate enough to actually get a good introduction to business cycle theory through readings and Mises, okay, but aside from that, when I'm looking at, you know, I've been taking a look at the past, I've been going back and blowing the dust off of some of my textbooks and risk management, Okay, and you know, we know about the assistances of the central bank, you know, and money expansion and credit expansion, and I've actually worked on a paper that's under review right now that explains somewhat of how the credit expansion affects businesses simultaneously.

3:00But aside from that, I've looked at the influence of financial modeling, we talk about banks and their capital, We also have to look at the regulations that were imposed to deem what is sound capital. The answer from regulators and fully embraced by practitioners as well is value at risk. Okay, so we're employing models and this was actually a result officially of I believe an amendment to the Basel Amendment, BIS 98, where they said that you need to come in and stress test the risk of your portfolios if you're in banking, okay, to make sure that the system is sound, that you can weather a downturn.

4:09Alright, so here you have an imposition of a technique that's based on the assumption of, for lack of a better description, normality in terms of returns, return distributions. Now anybody who's studied markets knows that return distributions are not normally distributed. Cauchy, Leptokurtic, they have fat tails, and what fat tails means is that the very bad things in the extremes happen much more frequently than what we think according to the normal bell-shaped curve. Okay, so we have a banking system that was built on its false premise that everything's fine, that we have enough capital to cover X amount of disintegration in our loan portfolios or whatever assets we're holding.

5:06And the whole thing was based on a fallacy as a myth. And I guess what's troubling to me now is that the banks are being told now to come in and restress tests. tests their portfolios again. I'm not even fully aware of what the mandates are at this point in time. When you think about recovery, for a while there's a smidgen optimistic because you have some entrepreneurs out there that are starting new banking institutions, just starting right from the ground up. Okay, but yet you still have this auspice of these federal regulators that come in and say well you still have to, you know, have a capital test within certain modeling constraints.

5:58One of the problems we've seen in banking in terms of value at risk is that when things start to get wild in the markets, banks have to parse off their assets. And in doing so, you start to see a sell-off in the markets. They have to raise capital. Capital. And this in itself starts to perpetuate because the value at risk models start to go wild again and you start to see these downward spirals going down, down, down, down, is reflected in security market prices. So that's very troubling. And once again, where's the seed of it all? Regulation.

6:47So I've gone back many times and looked and tried to pinpoint, when did this crisis start, when did the seed start? In almost every instance there was some kind of a change in regulation that sort of sowed the seed of what you see culminating today. I think I'll leave it at that for now. We'll go to the next one.