The Great Divergence

[kandrathe]

What is "phantom capital"? Even the most faulty arbitrage models are methods of finding prices, and on the basis of those prices, making trades. That means buying and selling things, even if those things are debts, options, futures, etc. Those things have specific meanings traceable back to the bread and butter commodities, even if their relationship is somewhat abstract. There is no "phantom" here - actual value is involved, however much it may stand at arm's length. Starting up the process with "no capital" involves shorting, and shorting involves credit - a type of capital.

I don't think the balloon problems stem from the people who engage in arbitrage. They tend to do as you say, and really do know what they are buying and the risks involved.

I'd focus on something tangible that balloons, such as housing.

Real-estate tends to be prone to malinvestment. According to David Wheelock (St. Louis Fed) the same reckless bubble in real-estate precipitated the crash in 1929. Generally, the number of dwellings plus rental properties should correlate to the number of people inhabiting the general area. When shortages occur, the prices tend to rise and building booms since those with land bought cheap can now build a bunch of houses and make a tremendous profit. However, the side effect is that all home values rise giving everyone the feeling that they have more wealth. Where I live, the home values nearly doubled from 2000 to 2007 (as well as the property taxes). The Las Vegas area had the biggest growth boom during this period (both in housing and jobs), and I don't think it is unrelated that their foreclosure rates (1 in 86), and unemployment rates (U6 as high as 25%, now around 21.5%) are the highest in the nation (on par with those during the Great Depression). The correction is occurring the strongest where "malinvestment" was at it's worst.

There is your phantom money. How could homes suddenly be worth double in such a short time. Prices become ludicrous (just as I explained about Google before they had an income strategy). People took larger and larger risks, and then couple that with relaxing banking standards where lenders also took bigger and bigger risks in lending their money to people that may never pay it back. Or, perhaps the issue lies with greedy loan originators that deceptively package loans, and then sell them off wrapped up as mortgaged backed securities. As we discovered during the congressional hearings, many of the Wallstreet insiders knew what was going on (borderline fraud), but they viewed it as an opportunity to make money by betting against their own employers, or company.

Obviously, the assets were eventually packed to be worth a couple trillion or so more than they were actually worth. When the balloon popped, the contraction over-corrected due to the uncertainty of just which loans would be considered malinvestment. This also froze the credit market, since suddenly nearly everyone in the financial world had over leveraged their borrowing, compared to their *actual* reserves. Housing still has not found its true price (again similar to the 1930's), since it is politically distasteful to force millions of people (weighted against the working poor, and minorities) out of homes for which they cannot afford to make payments.

What Would Milton Friedman Say?

I found the statement by Thomas Macurdy at end of that article prophetic, written the October before Obama won the election. "If this election goes the way it looks as though it's going to go, then the political system is about to get a major overcorrection to the left. And that means the American people are about to get an extreme illustration of just how badly government intervention screws stuff up. If Milton were here, he'd tell us to remember what happened during the Clinton administration. After just two years, the Republicans ended up in control of both houses of Congress."

Now all we need is a trade war with China to bring about the neo Smoot-Hawley.