I think it’s very simple.

They know something bad is going to happen. It could be a deflationary recession, it could be out of control inflation. In a world awash in liquidity and debt, in which the US Fed has limited effective control over the quantity of money and the quality of claims, either possibility is plausible.

The Fed doesn’t want to be blamed. Feds are historically blamed first for pushing interest rates too high (causing a deflationary recession), and second for letting inflation get out of hand. So, the Fed’s first priority is not being blamed for acting too aggressively and causing a recession. They can avoid blame by pausing the rate hike cycle, if it seems decent to do so, or by moving 25 bp per meeting, if inflation numbers run high. That “measured pace” is now a kind of default, not a blame magnet, and anyway, it’s a Greenspan Fed strategy, so if contiguous 25 bp moves precede a recession, most of the blame goes to Bernanke’s predecessor. But the Fed also doesn’t want to be blamed for failing at its core mission of keeping inflation under control. So, in “jaw-jaw” mode — speeches, informal comments, etc. — Fed officials come off as hawkish, hoping to maintain their credibility as inflation fighters, and thereby reduce self-fulfilling expectations of increased inflation.

This is a fairly optimal strategy for avoiding blame. If a recession hits, blaming the Fed for being too aggressive will have limited traction. After all, the Fed only continued its predecessors policy of gently tightening, and only when inflation numbers clearly forced continued tightening. Blaming the Fed because Bernanke talked about inflation numbers exceeding his comfort levels in some speech is not going to take. The formal record will be one of very measured interest rate rises, and very moderate statements and minutes. If there’s a recession, it won’t be the Fed’s fault. If inflation continues to pick-up, the Fed can try to maintain its credibility by talking tough and continuing the 25 bp hikes. If the Fed really is “behind the curve” on inflation, and prices accelerate, eventually they might be blamed. But that involves incremental and subtle attributions of blame. They can always, actually “shock the market”, if things get out of hand and the blame for inflationary pressires gets palpable. But much better to threaten to do something radical (deniably, through third parties and rumors) than to take the risk of actually doing something, until something absolutely must be done, and the risk of serious blame can no longer be avoided.

I do think some kind of bad economic period is inevitable, though whether it looks like recession or stagflation or just modest inflation and sluggish real growth is uncertain. I’m not sure that I blame the Fed for avoiding blame. But I do blame the Greenspan Fed, and current administration, and the ossification of economic ideas into stale ideologies over a longer period of time, for getting the US economy into an obvious, big mess, while the best and brightest debated whether a garbage dump wasn’t the optimal outcome if something resembling a market happened to produce it.

Traded financial derivatives, it is often claimed, permit markets to find the “least cost bearer of risk”. But if this is true, what exactly does it mean? Who are the least cost bearers of risk? Highly diversified investors with very strong balance sheets? It’d be natural to think so. But think again. Perhaps the least cost bearers of risk are aggressivley speculative investment funds intentionally leveraged to the point where the potential upside is very large, and the corresponding downside triggers bankruptcy.

Recall that any leveraged, limited-liability entity can be understood as a call option. If a business owes the bank $1M, but its assets — including the present value of expected future profits — are worth less than that $1M, it can declare bankruptcy. Its owners hand over all assets to the bank, and walk away without paying off the loan. On the other hand, if equityholders believe the business is worth more than a million, they pay off the bank, or rollover the loan, depending on the operation’s current liquidity and available investment opportunities. Thus, the value of this entity to equityholders can be described by the red curve below.

Investments whose returns are like options have an unusual property. Usually, investors hope to minimize risk and maximize returns in their investment choices. But the expected return of an option increases with the risk (or volatility) of the underlying asset. Consider the case of an idealized entity operating entirely on borrowed cash. It holds $1M in assets, all borrowed, no owners equity. On the graph above, it sits at the point where the dotted line intersects with the red line. Suppose equityholders had a choice, hold the million dollars cash, or flip a coin in a bet that either doubles their money or loses it all. An unleveraged, risk-averse investor always prefers sure cash to a fair coin-flip. But a very leveraged investor who has the option of shifting costs to the lender, takes the coin-flip. If she loses the flip, she loses nothing, the lender takes the cost. If she wins, she’s turned other peoples’ money into a cool million for herself.

A 100% leveraged entity is a zero-cost bearer of risk. The downside of any potential investment is immaterial. Only the probability-weighted magnitude of the expected upside matters. A 100% leveraged entity prefers volatility to safety, even if the “average” outcome of a gamble is not particularly good. Even if the coin in the previous example were rigged so that the fund loses 2 out of 3 flips, equityholders still prefer to play than to hold cash. Since creditors bear the losses, the only cost to a bad gamble is the opportunity cost of better gambles that might otherwise have been undertaken.

In the real world, very few entities get to borrow all their assets, hold all gains, but walk away from any losses by defaulting. It’s a great deal for the borrowers, but a crappy one for lenders, who strive to prevent these kinds of perverse incentives from arising. Lenders typically require borrowers to hold significant equity. A typical borrower sits at the intersection of the red and green lines. At this point on the curve, equityholders absorb most losses, as well as any gains on their investments, and the possibility that some of their losses will be borne by lenders if they lose absolutely everything is unlikely to be particularly relevant. Also, business bankruptcy often exacts nonmonetary costs that mitigate predatory behavior by borrowers. Controlling equityholders of failing businesses lose reputation, their jobs, see their friends lose jobs and retirement security, face lawsuits, etc. Finally, lenders often protect themselves with “covenants” that remove control from equityholders as the degree of business leverage increases, to prevent borrowers from taking big chances after they’ve borne great losses.

But, nevertheless, the world is a diverse place, with lots of different kinds of businesses and creditors. While very few entities enjoy 100% leverage, some businesses fall much closer than others to the dotted line on the graph above, some businesses have more non-monetary costs associated with bankruptcy than others, some businesses have more restrictive covenants than others. Leverage is no longer as simple a concept as funds borrowed from a diligent local bank. Bonds can be sold to the public, to naive foreign investors, to foreign central banks. In markets awash with liquidity, borrower reputation may substitute for balance sheet due-diligence in the decision to extend credit.

The trading of financial derivatives is supposed to transfer risk exposure to its least cost bearer. In light of the foregoing discussion, what might a least cost bearer look like? As we’ve seen, entities that are nearly completely leveraged, that fall near the dotted line on the graph above, face a low, or even negative, cost to bearing risk! This is counterintuitive, since these are the sorts of entities that face the greatest likelihood of bankruptcy. But that is exactly the point. Bankruptcy transfers the cost of risk gone bad to others. The least cost bearer of risk is an entity with few nonmonetary costs associated with failure, and a reputational or strategic capacity to take on leverage without surrending its ability to take risk. It should be no surprise to anyone following financial markets that this sounds a lot like a highly regarded hedge fund. Think Long-Term Capital Management.

The point of this essay is that LTCM-style meltdowns are not aberrations, but are a rational, structural consequences of a financial system in which the returns of some entities have high optionality, offering the possibility of high-returns for a low sums put at risk of total loss. LTCM should not be regarded as a failure or lapse of judgement on the part of its managers or investors. Its failure was a “normal accident”. Assuming independence of returns across investments, the rational investor should diversify her holdings among a very large number of funds with LTCM-style leverage and high appetites for risk, as these offer far superior return to risk than traditional investments. Many, perhaps most, of these investments would go south, and end up worthless. But the returns on the high-leverage, high-risk funds that succeed will much more than make up for these setbacks. On average, lenders bear most of the risks and equityholders enjoy most of the gains. It’s a good deal for investors.

If highly leveraged funds are good deals for investors, than hedge-fund managers ought to be competing to create them. (We’ve not touched on the much maligned “2 & 20” fee structure of many hedge funds. That adds additional optionality to hedge fund incentives, but it is only icing on the cake.) Funds should be competing to maximize their leverage without compromising their capacity to take-on risk, leap-frogging one another down the slope of a graph towards that dotted line. Speculative derivative positions often offer both risk and leverage in convenient packages whose “rocket-scienceness” helps to obscure both aspects, and make it possible for a fund to take on yet more.

Of course there is a problem here. Somebody ends up bearing all the risk that leveraged funds can write off via defaults. What is rational behavior for each individual fund or investor may turn out not to be so rational, if failures turn out to be correlated rather than mostly independent. If several funds default away large losses, the funds’ creditors may in turn default, wiping out other funds’ gains and increasing the likelihood of futher defaults. In a typical “tragedy of the commons”, rational behavior by investors and managers can lead to a systemic crisis.

What was that famous Adam Smith quote, the one that made the case for free trade better and more concisely than ever before, or ever since?

It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor.

What is prudence in the conduct of every private family, can scarcely be a folly in that of a kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.

But, you know, the “prudent master of a family” does not engage his tailor and buy his shoes on credit, for prolonged periods of time and with no forseeable means of repayment. Debt securities do not represent the produce of our industry. Sometimes the wisdom of crowds is not found in central-bank manipulated markets, but in the messy kinds of preferences expressed by voters in elections.

I’m all for free trade. But what many businesses and economists refer to as free trade, in this real world circa 2006, is not trade at all. Trade implies two parties exchanging value. I’m a long-time, knee-jerk anti-protectionist. But at this moment, I don’t know who to be more afraid of: US politicians catering to paleolithic economic xenophobia, or economists who’d describe as “free trade” the United States’ growing addiction to goods and services it cannot pay for and the nation’s ongoing, humiliating “soft default” on debts public and private via real depreciation of the dollar.

A man standing in line at a soup kitchen is involved in a voluntary transaction between two parties. He may think he’s outsmarted the guy with the ladle, working the system, getting something for nothing. But that man in line at the soup kitchen is neither admirable nor prudent, and it is that guy with the ladle who holds the power. The problem with a free lunch is that it may not be there tomorrow. And a free lunch, however long it lasts, is not free trade.

This rant was inspred by a post by the very excellent Mark Thoma.