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February 2, 2009

Stimulus Offers Too Little Bang for Bucks

But it may be mostly hype. For starters, $4.5 billion is a pittance. An industry study in 2004 -- surely outdated -- put the price tag of modernizing the grid at $165 billion. More important, says a report from J.P. Morgan, the "smart grid" isn't mainly a matter of building new transmission lines or installing new meters. It's more "communications and information processing technology" that allows for more efficient transportation and use of power.

"The smart grid, while a great idea, is basically a software project," says economist Marc Levinson of J.P. Morgan. "The reason utilities aren't pushing it faster is not lack of money or will, but because there are lots of technical issues and also important compatibility problems so that the various companies' grids can communicate freely with one another."

As it turns out, President Obama didn't make the tough choices on the stimulus package. He could have either used the program mainly (a) to bolster the economy or (b) to advance a larger political agenda, from energy efficiency to school renovation. But Obama wanted both, and, superficially, the two can be portrayed as an enlightened partnership.

"This is not just a short-term program to boost employment," Obama said recently. "It's one that will invest in our most important priorities like energy and education, health care, and a new infrastructure that are necessary to keep us strong and competitive in the 21st century."

In its releases, the White House gushes superlatives. The stimulus program, says one fact sheet, "launches the most ambitious school modernization program on record," "computerizes every American's health record in five years" and "undertakes the largest weatherization" -- insulation -- "program in history." What a bonanza of good stuff!

Unfortunately, investing in tomorrow won't automatically stimulate the economy today. The $819 billion program passed by the House would only slowly provide stimulus. The Congressional Budget Office estimates that in fiscal 2009 (through this September) about 21 percent of the new spending and tax cuts would flow to the economy. For 2010, the estimate is an additional 44 percent. The total of 65 percent means that, by the CBO's estimate, about a third of the $819 billion package would be spent after fiscal 2010. That falls far short of Obama's stated goal of 75 percent in the first 18 months.

One reason is that some of Obama's "investments" won't occur quickly. The "smart grid" would be one. Or take the $39 billion in the House bill for added highway and transit construction. That's nearly double existing funding levels. When queried, state officials worried about how fast they could "adjust their contracting procedures" for such a big increase, reports the CBO. As stimulus, the better course would simply be to give more money to states and localities -- and order them to spend it. Most would plug deficits, avoiding program cuts and layoffs.

What's also sacrificed are measures that, though lacking in long-term benefits, might help the economy now. A $7,500 tax credit for any home buyer in the next year (and not just first-time buyers, as is now in the bill) might reduce bloated housing inventories. Similarly, a temporary $1,500 credit for car or truck purchases might revive sales, down a third from 2007 levels. Normally, these targeted incentives would be unjustified; today, they may be necessary expedients.

The decision by Obama and Democratic congressional leaders to load the stimulus with so many partisan projects is politically shrewd and economically suspect. The president's claims of bipartisanship were mostly a sham, as he skillfully maneuvered Republicans into a no-win position: Either support a Democratic program, or oppose it -- and seem passive and uncaring.

But the result is that the stimulus, as an act of economic policy, is hobbled. A package so large can be defended only because the economy is so weak -- and seems to be getting weaker by the moment. The central purpose is simple: halt downward momentum. Perhaps some of the out-year spending might ultimately prove useful. But the immediate need is for the stimulus package to stimulate -- now. It needs to be front-loaded; it isn't.

Obama's political strategy fails to address adequately the economy's present needs while also worsening the long-term budget outlook. Some of his "temporary" spending increases in practice will almost certainly become permanent. There were tough choices to be made -- and Obama ducked them.

Bonus Fight Ushers In Post-Bailout Capitalism

"There will be time for them to make profits," he said Thursday with Treasury Secretary Tim Geithner by his side. "And there will be time for them to get bonuses. Now's not that time. And that's the message that I intend to send directly to them, I expect Secretary Geithner to send to them."

Vice President Joe Biden was even more pointed: "I'd like to throw these guys in the brig," he said.

Democratic Sen. Chris Dodd had this to say to those executives who take home big bonuses: "If you do it, I'm going to bring you before the (Senate Banking) Committee."

Perhaps the ire is deserved. It's hard to defend Wall Street executives' pay. Last year, the Dow closed off 34%, its third-biggest loss ever, as trillions in wealth evaporated. And financial companies lost nearly $50 billion for their shareholders.

Yet executives gave themselves hefty bonuses, claiming they had to do so in order to keep talented people.

Maybe so. But it's sad this should even be a part of our daily discussion, and it only shows just how twisted things have become in our once-capitalist system. In the brave new world of post-bailout economics, politicians — not the marketplace — decide what it's appropriate to pay executives.

At one time, businesses competed intensely, and success or lack of same guided what executives would earn. But no more.

Today, with hundreds of billions of dollars flowing from public coffers into the private financial sector to prop up failing companies, politicians feel quite within their rights to harangue, cajole, even threaten those who take their money.

This is one of the unforeseen consequences economists warn about. Executives who thought they'd get access to Uncle Sam's wallet without strings attached now find they're beholden to elected officials — not the market.

It would be far healthier for the economy if it was the companies themselves, operating within market-imposed discipline and under the watchful eye of shareholders, that decided how executives were compensated.

Sadly, Wall Street today seems to suffer from what economists call an "agency problem." In a healthy company, managers and execs work for the shareholders. But after a government bailout, taxpayers — that is, politicians — are boss.

And, as always, this leaves a lot of room for politicians to demagogue the issue, always on behalf of "the taxpayers."

That's what's happening now in Washington, and it isn't healthy. However outraged you might be at the executives' $18 billion in bonuses, that pales in comparison to Congress' pork-filled, 680-page, $825-billion stimulus bill.

As the bill moves toward law, polls show voters are having second thoughts about the whole thing. Mainly, they don't like the waste — or the fact that only about 10% to 15% of the spending can even remotely be called "stimulus."

Does this explain why politicians have suddenly gone into such high dudgeon over executive bonuses? After all, if you were about to misspend hundreds of billions in taxpayer money, wouldn't you want a scapegoat too?

Don't Give Up On Investing In This Market

The markets offer great potential for generating consistent returns and long term wealth. However, the markets aren't the "get rich quick" vehicle some make them out to be. It can be fun, fulfilling and profitable, but you need to spend the time it takes to learn what you need to know. Luckily, you can find those things on this site.

You should follow general economic news and learn Econ basics
As I mentioned before, investing requires time and effort. Part of the regular process is reading economic news and following general trends. And we're not talking about watching your favorite TV news channel. The economic illiteracy of talking heads and politicians is astounding. Don't listen to them. Find some quality, unbiased news sources you can scour every day.

Many sites will bring daily headlines together for you to make keeping up easy. You can use finance.google.com to set up alerts, or as a place where many sources are displayed on one page. RealClearMarkets.com is another. Find a few sources and sites you trust and enjoy.

As you do this, not only will you find great insights which influence your trading strategies, but you’ll also learn to get a “feel” for the market and you’ll be able to spot trends that may help or hurt your investments.

On this site we’ll constantly add education-focused articles that also touch on the condition of the markets and the economy, so you’ll want to make sure you visit daily.

It takes time and ongoing education – "Minutes a day" is a myth
Unless you plan to be a strict buy-and-hold investor, managing your investments is not something that can be done in a couple minutes a day; especially while you're getting started. There is a lifetime of learning in investing, and managing a portfolio that's profitable takes time as you learn to find trades, manage risk and diversify.

There are thousands of personality types and tastes, and there are investment styles to match each one. There are also varying amounts of time and energy commitments for each. Part of the process of getting started is determining how much time you want to put in to your investing and developing a strategy to fit that level of commitment. If you don't have the time or desire, learn the basics in our Stocks Essentials Course and find a good broker to manage your investments for you. If you have the time and catch the bug investing on your own can be a fun and gratifying process.

Don’t buy anything until you’ve practiced paper-trading
If you were offered a chance to shoot a free-throw shot at half-time of a basketball game to win $50,000 would you practice before the big shot? Of course you would. Why then would you risk your retirement or savings by investing immediately without practicing first? Hopefully you wouldn’t.

There are many great paper/practice trading platforms out there offered by good brokers. Take advantage of them. Take the courses on this site and before you trade a single stock, make sure you’ve practiced – and profited in your practice.

Short-term investing is very difficult to profit from. Think long-term
Short term retail investors lose money. It’s that simple. There may be a few who fully immerse themselves in trading and sweat out a profit, but the numbers overwhelmingly indicate that individual traders whose focus is short-term will eventually lose their money.

We advocate your portfolio be primarily focused on mid- and long-term investments. Don’t confuse long-term with buy-and-hold. They are very different. Smart long-term investing is still an active process requiring good timing, risk management, diversification and analysis.

But long-term retail investors have proven that’s where the profits are. Smaller transaction costs, lower volatility and reduced time managing positions make long-term investing smarter – if not necessarily glamorous.

Everyone wants to hit the home-run. Buy the stock that goes from $4 to $40 in 30 days. But those are very few and far-between, and traders looking for those usually strike out.

You MUST develop an overall strategy with guidelines you stick to
Retail traders are notorious for jumping into the market head first as they focus all their attention on finding and buying stocks. What they fail to do is properly educate themselves and learn to build a strategy to manage risk.

Investing is no different than any other part of life. Sure, it’s clichéd, but: If you fail to plan, you plan to fail. A few years ago, the US Olympic basketball team was comprised of professional basketball players whose combined talent had never been matched. They subsequently went into the Olympics and lost to teams with inferior talent.

Why? The planning was poor, and the pieces didn’t work right together. You may pick great stocks, but without proper entry points, exits, stop-losses and consistent position sizing those great stocks may yield a loss.

Part of educating yourself is learning what you need to know and building rules for an overall portfolio strategy that you stick to. Inside that overall strategy you may have allocations which require their own unique rules for more conservative or more aggressive trading strategies, and that’s a fine diversification model. And you may even have to modify your rules over time. But consistency is key and lack of it is catastrophic to a portfolio.

Learn, trade, profit and have fun!

In the end, only you can determine whether you have the time and/or desire to manage your own investments. There are plenty of good brokers who, for a price, will do it for you.

But if you take the time to learn you’ll quickly find the market is wide open for the individual investor. Nobody will put more time and concern into your investments than you and with the right approach, you can make strong returns year after year. And you’ll have a lot of fun doing it!

Originally publushed at LearningMarkets. Learn more now by checking out our Investing Guides.

Depression Economics: Four Options

But sane people would rather avoid inflation. It is a very dangerous expedient, one that undermines standards of value, renders economic calculation virtually impossible, and redistributes wealth at random. As John Maynard Keynes put it, 'there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose...'

But governments will resort to inflation before they will allow another Great Depression. We just would very much rather not go there, if there is any alternative way to restore employment and production.

The standard way to fight incipient depressions is through monetary policy. When employment and output threaten to decline, the central bank buys up government bonds for immediate cash, thus shortening the duration of the safe assets that investors hold. With fewer safe, money-yielding assets in the financial market, the price of safe wealth rises. This makes it more worthwhile for businesses to invest in expanding their capacity, thus trading away cash they could distribute to their shareholders today for a better market position that will allow them to reward their shareholders in the future. This boost in future-oriented spending today pulls people out of unemployment and pushes up capacity utilisation.

The problem with monetary policy is that, in responding to today's crisis, the world's central banks have bought so many safe government bonds for so much cash that the price of safe wealth in the near future is absolutely flat - the nominal interest rate on government securities is zero. Monetary policy cannot make safe wealth in the future any more valuable. And this is too bad, for if we could prevent a depression with monetary policy alone, we would do so, as it is the policy tool for macroeconomic stabilisation that we know best and that carries the least risk of disruptive side effects.

The third tool is credit policy. We would like to boost spending immediately by getting businesses to invest not only in projects that trade safe cash now for safe profits in the future, but also in those that are risky or uncertain. But few businesses are currently able to raise money to do so.

Risky projects are at a steep discount today, because the private-sector financial market's risk tolerance has collapsed. No one is willing to buy assets and take on additional uncertainty, because everyone fears that somebody else knows more than they do - namely, that anyone would be a fool to buy. Although the world's central banks and finance ministries have been devising many ingenious and innovative policies to stimulate credit, so far they have not had much success.

This brings us to the fourth tool: fiscal policy. Have the government borrow and spend, thereby pulling people out of unemployment and pushing up capacity utilisation to normal levels. There are drawbacks: the subsequent dead-weight loss of financing all the extra government debt that has been incurred, and the fear that too rapid a run-up in debt may discourage private investors from building physical assets, which form the tax base for future governments that will have to amortise the extra debt.

But when you have only two tools left, neither of which is perfect for the job - credit policy and fiscal policy - the rational thing is to try both, at the same time. That is what the Obama administration in the United States and other governments are attempting to do right now.

Brad DeLong is professor of economics at the University of California at Berkeley.

When the Old Bad Becomes the New Good

Is Congress really considering leveraging its decades of experience running Bad pension programs like Social Security, Bad health insurance plans like Medicare, Bad Government Sponsored Entities like Fannie Mae and Freddie Mac, and Bad regulatory agencies like the SEC? Are they going to crown these achievements by chartering a Bad National Bank to aggregate the nation’s Bad loans where they can be managed under Bad accounting rules unavailable to Bad Wall Street miscreants?

Maybe so. Our tribal elders don’t appear sated propping up Bad brokerage firms, Bad car companies, and Bad homeowners. A Greek chorus of Bad economists is emboldening them to get Bad to the bone.

Are you amused or frightened that our political overlords are so comfortable in their sinecures that they no longer need to use misleading euphemisms and can actually call things what they are?

FDR used hard times to give us The New Deal. As this $900 million dollar accretion rolls down Capitol Hill, brace yourself for what history may one day call The Bad Deal.

Can this possibly be the victory that Progressives worked so long and hard to achieve?

Are We the People so flummoxed by the relentless only-the-government-can-save-us-now media campaign that we’re going to stand mute as this slow-motion train wreck unfolds?
You betcha! What the hell, if the Age of America is over let’s go out with a bang!

If Congress has the genuine honesty to label its handiwork Bad, let’s face our own shameful truths. The jig may be up but with a little ingenuity we Baby Boomers can probably keep the party going long enough to slip these mortal coils before the bills comes due.

Is there any doubt that tax-dodging sharpies at Treasury will successfully recruit the Chinese Communist Party to underwrite The Bad Deal? What else are these born-again Commies going to do with the trillions of dollars they’re sitting on, build a Navy so they can come over here and beat up their best customer?

After decades cringing in poverty, the Chinese people rose up to work their butts off filling the shelves at Wal-Mart. They did this because their dear leaders promise that, one day, they will live like Americans. And how will these laborers, whose wages and working conditions right-minded people fret loudly about, be compensated for their efforts? With Congressional IOUs!

Tell me again who the suckers are?

When it comes time to redeem these IOUs, our Chinese brethren are in for a surprise. A decade of double digit inflation is the mother of all debt relievers. While we’re at it, we’ll see who gets the last laugh after we’re done fleecing the oil sheiks out of their sovereign wealth funds. The inflationary debacle lurking around the corner will be a lesson in monetary policy they’ll never forget, even if we have.

There was once a workers paradise where comrades living in economic equality lamented "We pretend to work and they pretend to pay us." Was the former KGB agent being sardonic when he opined at Davos that "The entire economic growth system, where one regional center prints money without respite and consumes material wealth while another regional center manufactures inexpensive goods … has suffered a major setback?"

Not yet, Bucko! Because the manufacturing center of which you speak is tightly controlled by the same sort of single-party central planners that are rapidly being installed here in the U.S. The music won't stop until the Chinese people throw the bums out in the same way we ushered ours in.

Wouldn’t it be ironic if Bad debt ultimately brings democracy to China?

So go ahead, pass out subsidies to build new houses even though we have a glut of empty old ones. Re-engineer the Detroit car companies to build politically correct vehicles no one wants to buy. Roll out giant environmental make-work programs that make no economic sense. The Bad bank stands ready to lend you Bad money provided by Bad Chinese despots flogging their Badly overworked citizens on behalf of Bad U.S. consumers whose own Bad government will spend any sum to put off Bad times.

The recently rehabilitated Lord Keynes once responded to critics with the retort “In the long run, we are all dead.” True. But not before we Baby Boomers and our duly elected representatives finish sucking the financial marrow out of every credulous rube and unborn child we can find, both here and around the world.

Imagine how long Bernie Madoff could have kept the game going if he had his own money-printing press.

The Stimulus Plan Must Be Stopped

Clinton economic adviser Alice Rivlin made the same point in testimony before the House Budget Committee. Her message: Divide up the package and slow down the process.

And Sen. Richard Shelby told CNBC that Washington should "shelve the stimulus package" and instead attack the banking and credit problem first -- probably with a government-sponsored bad bank that would relieve financial institutions from their toxic-asset problem. Mr. Shelby believes the credit crunch remains the biggest obstacle to economic recovery.

Later in the day when I interviewed Senate Republican leader Mitch McConnell, he agreed with Shelby that the stimulus plan should be shelved. For the first time -- as far as I know -- McConnell pledged to vote no on the package. Instead he wants larger tax cuts and smaller spending. McConnell might be willing to change his mind if the package changes, but he told me he didn’t expect that to happen.

And in what may prove to be the biggest stimulus-package hurdle of all, news reports suggest that Team Obama is contemplating as much as $2 trillion in TARP additions to rescue the banking system in one form or another. That would be $2 trillion on top of the nearly $1 trillion stimulus package.

Government spending, deficits, and debt creation of this magnitude is simply unheard of. So the added TARP money will surely imperil the entire stimulus package as taxpayers around the country begin to digest the enormity of these proposed government actions. Financing of this type would not only destroy the U.S. fiscal position for years to come, it could destroy the dollar in the process. What’s more, the likelihood of massive tax increases -- which at some point will become front and center in this gargantuan funding operation -- would doom the economy for decades.

By the way, Scott Rasmussen’s latest poll shows that already -- before the new TARP money is included -- public support for the humongous stimulus package has dropped to 42 percent.

It remains to be seen whether Republicans can in fact stop the stimulus package, but that certainly would be a very good idea. The long-run financial consequences will certainly force higher future tax rates -- a prosperity killer feared by Arthur Laffer. And while all the social spending gets baked into the long-run budget baseline, the short-run implications of the plan have little economic-growth potential.

Meanwhile, there’s no shortage of alternative tax proposals that would truly re-ignite the economy. Former Ronald Reagan and George W. Bush economist Larry Lindsey criticized the Democrat package in last Wednesday's Wall Street Journal, describing it as "heavily weighted toward direct government spending, transfers to state and local governments, and tax changes that have virtually no effect on marginal tax rates." Instead, Lindsey proposes a big payroll tax cut that would slice three points off the rate for both employer and employee.

Rush Limbaugh also made an appearance in the Journal. He has a clever idea to give Obama 54 percent of the $900 billion package -- equating that amount to the new president’s electoral majority -- while 46 percent, which was John McCain’s electoral tally, would go to a plan that would halve the U.S. corporate tax rate and provide a capital-gains tax holiday for one year, after which the investment tax would drop to 10 percent.

It was Sen. John McCain on Fox News last Sunday who started the stimulus revolt when he said he couldn’t support the package and called for less spending along with a large corporate tax cut. Over in the House, Republican leaders John Boehner and Eric Cantor have successfully launched an opposition drumbeat by attacking congressional Democrats rather than directly hitting President Obama. Now all eyes will turn to Republican Senate leader Mitch McConnell to see if he can keep up this drumbeat.

Will commonsense Americans really support a massive overdose of government run amok? I seriously doubt it. This whole story has to be completely rethought.

February 3, 2009

The Case for a Fiscal Stimulus

Of course, some government spending is desirable or necessary. But an increase in government outlays often means wasteful spending that produces less value than consumers would get from those same dollars.

Now, however, increased government spending and the resulting rise in the fiscal deficit are being justified as necessary to deal with the economic downturn – a sharp change from the reliance on monetary policy that was used to deal with previous recessions. Countercyclical fiscal policy had been largely discredited because of the delays involved in implementing fiscal changes and households’ weak response to temporary tax cuts. By contrast, the central bank could lower interest rates rapidly, which worked to raise household and business spending through a variety of channels.

Nevertheless, I support the use of fiscal stimulus in the US, because the current recession is much deeper than and different from previous downturns. Even with successful countercyclical policy, this recession is likely to last longer and be more damaging than any since the depression of the 1930’s.

The 40% decline in the US stock market and the dramatic fall in house prices have reduced American households’ wealth by more than $10 trillion, which is likely to reduce annual consumer spending by more than $400 billion. And the collapse of housing starts has lowered construction spending by another $200 billion. This $600 billion fall in demand is more than 3% of GDP. If not reversed, it will cause further cuts in production, employment, and earnings, leading to further reductions in consumer spending.

The usual monetary-policy response of lowering interest rates is unable to reverse this sharp drop in demand. The dysfunctional credit markets caused by the uncertain value of asset-backed securities means that banks and other financial institutions are unable to raise funds and are unwilling to lend. As a result, the central bank’s lower interest rates do not translate into increased spending on interest-sensitive investment and consumption.

So there is no alternative to fiscal policy if we want to reverse the current downturn. The resulting increase in the national debt is the price that we and future generations will pay for the mistakes that created the current economic situation. Those mistakes led to an underpricing of risk and the resulting increase in excessive leverage.

There are many reasons for the underpricing of risk and the rise in leverage. The exceptionally easy monetary policy at the start of the decade contributed to financial investors’ willingness to buy low-quality financial assets in order to get higher yield and to an explosive rise in house prices. The rating agencies miscalculated the value of asset-backed securities.

The increase in leverage was driven in part by government policies aimed at expanding home ownership among lower-income groups that have proven unable to afford that life style. Banking supervisors did not deal with many institutions’ low levels of capital and poor asset quality. A major challenge for the future is to fix the institutional policies that led to these problems.

The new Obama administration and the Congress are still working out the structure of the fiscal stimulus for the US. Although I support the need for a large fiscal package, I disagree with many of the specific features of the plans now under consideration.

Regardless of what is done to provide a fiscal stimulus, governments around the world must act to fix dysfunctional credit markets. Otherwise, credit will not flow and growth will not resume. In the US, reviving the credit markets requires stopping the mortgage defaults driven by negative equity. The US Treasury Department wasted valuable time in 2008 by not using the funds provided by Congress to deal with those housing-market problems. There is hope that the Congress and the new administration will now address that issue.

When the recession is over, the US and virtually every other country will have substantially higher debt-to-GDP ratios. At that point, it will be important to develop policies to reduce gradually the relative level of government spending in order to shift to fiscal surpluses and reduce the debt burden.

Martin Feldstein, a professor of economics at Harvard, was formerly Chairman of President Ronald Reagan’s Council of Economic Advisors and President of the National Bureau for Economic Research.

The Case for a Fiscal Stimulus

Of course, some government spending is desirable or necessary. But an increase in government outlays often means wasteful spending that produces less value than consumers would get from those same dollars.

Now, however, increased government spending and the resulting rise in the fiscal deficit are being justified as necessary to deal with the economic downturn – a sharp change from the reliance on monetary policy that was used to deal with previous recessions. Countercyclical fiscal policy had been largely discredited because of the delays involved in implementing fiscal changes and households’ weak response to temporary tax cuts. By contrast, the central bank could lower interest rates rapidly, which worked to raise household and business spending through a variety of channels.

Nevertheless, I support the use of fiscal stimulus in the U.S., because the current recession is much deeper than and different from previous downturns. Even with successful countercyclical policy, this recession is likely to last longer and be more damaging than any since the depression of the 1930’s.

The 40% decline in the U.S. stock market and the dramatic fall in house prices have reduced American households’ wealth by more than $10 trillion, which is likely to reduce annual consumer spending by more than $400 billion. And the collapse of housing starts has lowered construction spending by another $200 billion. This $600 billion fall in demand is more than 3% of GDP. If not reversed, it will cause further cuts in production, employment, and earnings, leading to further reductions in consumer spending.

The usual monetary-policy response of lowering interest rates is unable to reverse this sharp drop in demand. The dysfunctional credit markets caused by the uncertain value of asset-backed securities means that banks and other financial institutions are unable to raise funds and are unwilling to lend. As a result, the central bank’s lower interest rates do not translate into increased spending on interest-sensitive investment and consumption.

So there is no alternative to fiscal policy if we want to reverse the current downturn. The resulting increase in the national debt is the price that we and future generations will pay for the mistakes that created the current economic situation. Those mistakes led to an underpricing of risk and the resulting increase in excessive leverage.

There are many reasons for the underpricing of risk and the rise in leverage. The exceptionally easy monetary policy at the start of the decade contributed to financial investors’ willingness to buy low-quality financial assets in order to get higher yield and to an explosive rise in house prices. The rating agencies miscalculated the value of asset-backed securities.

The increase in leverage was driven in part by government policies aimed at expanding home ownership among lower-income groups that have proven unable to afford that life style. Banking supervisors did not deal with many institutions’ low levels of capital and poor asset quality. A major challenge for the future is to fix the institutional policies that led to these problems.

The new Obama administration and the Congress are still working out the structure of the fiscal stimulus for the U.S. Although I support the need for a large fiscal package, I disagree with many of the specific features of the plans now under consideration.

Regardless of what is done to provide a fiscal stimulus, governments around the world must act to fix dysfunctional credit markets. Otherwise, credit will not flow and growth will not resume. In the U.S., reviving the credit markets requires stopping the mortgage defaults driven by negative equity. The U.S. Treasury Department wasted valuable time in 2008 by not using the funds provided by Congress to deal with those housing-market problems. There is hope that the Congress and the new administration will now address that issue.

When the recession is over, the U.S. and virtually every other country will have substantially higher debt-to-GDP ratios. At that point, it will be important to develop policies to reduce gradually the relative level of government spending in order to shift to fiscal surpluses and reduce the debt burden.

Martin Feldstein, a professor of economics at Harvard, was formerly Chairman of President Ronald Reagan’s Council of Economic Advisors and President of the National Bureau for Economic Research.

Obama Is Authoring Liberalism's Capitulation

So while President Obama is not presently seeking the implementation of Soviet-style economic cures for the U.S. economy, his economic agenda very much embraces the kind of modern American liberalism that voters have regularly shown great disdain for. Popular history will surely suggest Obama’s predecessor in the White House failed for being overly reliant on free markets, but more realistic accounts will show that President Bush’s many economic failings were the result of a movement away from market-driven economic growth in favor of soft liberalism.

Indeed, from his zestful signing of Sarbanes-Oxley to massive spending and dollar debasement (both served as taxes on income and wealth) to his administration’s eager intrusions into the private marketplace via TARP, Bush’s presidency by any rational measure was highly “liberal” if we go by the American definition of a word that is used to describe free-marketeers elsewhere in the world. Bush’s leftward lurch revealed itself in his approval ratings, and even more clearly in stock-market indices. The S&P 500 declined 36 percent on Bush’s watch; the bear market he oversaw strong evidence that the great voting booth we call the stock market in no way countenanced his largely anti-market presidency.

Market indices take on special importance given their direction since voters went to the polls in November. While stocks have traditionally rallied post-election, in Obama’s case they’ve declined. The S&P 500 fell 11 percent in the month of January alone, and since November 4th the S&P is down 18 percent.

Some would reply that Obama inherited an unfortunate economic situation, but President Clinton arguably did too, yet the S&P rose 5 percent over the same timeframe used for Obama. More broadly, Clinton crossed the aisle on Nafta and welfare reform, signed a capital gains cut, hired Treasury secretaries after Lloyd Bentsen who regularly communicated to the markets the importance of a strong dollar, plus he matched his rhetoric about the era of big government being over with reduced spending. Clinton’s various rightward lurches in many ways embodied true change, and were cheered by the stock market as evidenced by the S&P’s 208 percent rise on his watch.

Returning to Obama and stock markets, rather than a barometer of the here and now, markets discount the future, and the present message from investors is one strongly suggesting that Obama’s economic solutions are not up to the task of righting our listing economy. Markets seem to fear that Obama is of the mind to expand on the various economic mistakes made by his predecessor.

Indeed, where Bush signed Sarbanes-Oxley to allegedly root out “executive malfeasance”, Obama has made Wall Street a top enemy with his critique of a bonus pool that is actually down 40 percent from the previous year. When we consider that nearly all of the finance meant to help existing and future businesses grow has a Wall Street origin, Obama’s bashing of the providers of finance is perhaps good political theater, but chilling rhetoric nonetheless.

On the trade front, the Bush administration gave us steel, softwood lumber and shrimp tariffs along with an aggressively negative stance vis-à-vis China. In Obama’s case, the supposed agent of change has allowed the Pelosi Congress to insert “Buy America” provisions into his economic recovery bill (wasn’t Rahm Emanuel appointed chief of staff to keep extremist Democrats in line?), plus his newly appointed man at Treasury chose to one-up the Bushies in terms of anti-China rhetoric that has resulted in an impressive decline by the dollar versus gold. Much like Bush, it appears Obama cares not a whit about the dollar.

And just as Bush presided over nosebleed levels of spending, including massive outlays to fund the disaster that is TARP, Obama has promised more in the way of trillion dollar deficits that will create work disincentives, along with an expanded TARP the price tag of which some say will approach $2 trillion. Far from fostering “change”, Obama’s moves so far suggest that he is eagerly trying to be FDR to Bush’s Herbert Hoover.

If there’s a silver lining here, it has to do with the truth offered by the stock market. With shares continuing to fall in response to an economic plan that will shrink the economy, we’re seeing with great clarity that investors don’t buy liberal left solutions no matter the person in charge. As smooth and charismatic as Obama may be, unless he gets the policies right, his presidency will fail in much the same way that George W. Bush’s did. Rich Karlgaard of Forbes has already pointed out that Obama’s approval rating is down from 72 to 58 percent, and if he continues to embrace liberalism’s discredited policies of the past, his descent will continue.

Liberalism of the American variety, much like communism, contradicts human nature. So while Obama’s acceptance of the policies of decline must be resisted, there’s hopefully comfort in the knowledge that liberalism’s implementation will be its undoing. In short, the more Obama moves leftward, the quicker he’ll author liberalism’s happy capitulation. If so, prosperity post-Obama is on the way.

Economic Enemies of the State

For example, when President Ronald Reagan in his first inaugural address said: “In this present crisis, government is not the solution to our problem; government is the problem,” he foreshadowed the coming reduction in the burden of government and an increase in the liberty of the American people. This fundamental shift in the relationship between the Federal government and the American people led to one of the longest periods of prosperity and wealth creation in American history.

Two such statements by those now in power point with equal clarity toward a significant increase in the burden of government on the American people and a concurrent loss of liberty. The implications for the longer-term outlook are as dire today as they were positive in the aftermath of Reagan’s words in 1980.

The first, Barack Obama telling “Joe the Plumber” during the Presidential campaign: “I think when you spread the wealth around, it’s good for everybody,” reveals a worldview that justifies taking money from some individuals and families and giving it to other individuals and families in the name of the “common good”.

The second came when House Speaker Nancy Pelosi revealed a complimentary element that is at the core of the liberal view of the relationship between the individual and the state. In response to a question by George Stephanopoulos on the January 25th “This Week,” she defended the proposal to spend hundreds of millions of dollars on family planning services by saying: “Well, the family planning services reduce cost. They reduce cost. The states are in terrible fiscal budget crises now and part of what we do for children’s health, education and some of those elements are to help the states meet their financial needs. One of those – one of the initiatives you mentioned, the contraception, will reduce costs of the states and to the federal government.” (emphasis added)

In other words, children in poor families are “costs” to the state, and more should be done to limit their number – to keep them from being born. They are not potential doctors, or scientists, or entrepreneurs or future loving fathers and mothers. No, they are a part of the “terrible fiscal budget crises”; they are a drain on society, an inconvenient reminder that the grandiose promises of the welfare state are creating an ever-greater burden on the productive middle class.

As a result, it is appropriate for the federal government to put the American people hundreds of millions of dollars further in debt and to use that money to attempt to keep poor people from having children. These babies, it seems, are enemies of the state.

The views expressed by President Obama and Speaker Pelosi are common to those who believe that the chosen elite – the royal blood of the middle ages, the totalitarian leaders of the 20th century, or today’s professional politicians and bureaucrats – have the right to fashion society, not through persuasion and political discourse, but through the exercise of the power of the state. As revealed in their statements, human beings exist either to produce the wealth that those in power can give to their chosen constituents who, in turn, are expected keep them in power, or they are costs, and therefore, within the limits society finds tolerable, should be eliminated.

Such views do not auger well for the longer-term outlook for the economy or financial markets.

February 4, 2009

Government: The One Price That's Still Rising

Nor are we alone by any means. California legislators are haggling over exactly which taxes to increase--contemplating surcharges to their income tax (already one of the nation’s highest) and a sales tax hike. New York Gov. David Paterson proposed a mind-boggling 88 new or higher fees and taxes in his budget, including a so-called ‘obesity tax’ on soft drinks, an ‘Ipod tax’ on music downloads, and new or higher taxes on movie tickets, beer and wine, taxi rides, and massages. Other states are mulling over new or higher taxes on sodas, snacks, alcohol and, of course, cigarettes, although “butt” taxes are already so high in many states that we’ve probably entered the realm of diminishing returns. Many of these tax proposals come on top of increases last year.

As private sector workers battle joblessness, pay cuts and longer work hours, it seems particularly nasty that the one cost that is most difficult for them to escape, the cost of government, is going up steadily. Just about the only ways to ameliorate rising property taxes, for instance, are through laborious and uncertain challenges to your home’s assessment, or by moving. There’s no doubt that people do plenty of the latter, considering that the places with the steepest tax burdens also have the highest rates of outmigration. But trying to sell your home and finding a job elsewhere in an environment of rising unemployment and collapsing housing prices hardly seems like a sound strategy right now.

People will also avoid higher consumption taxes by consuming less, one reason why projections of how much a new tax will raise often overestimate actual collections. Still, the resulting shortfalls often prompt governments to raise other taxes, trapping residents in an upward spiral of taxation.

Local newspapers are now assuring residents that Washington is coming to their aid with a stimulus package that directs billions of dollars to the states. But much of this money is for specific programs, which will limit how states can use it and hence won’t offset tax shortfalls. The Milwaukee Journal Sentinel reported that the local school board there, for instance, stands to gain $88 million in school construction money it largely doesn’t need because enrollment is declining and 15 school buildings are already empty.

Moreover, you can be sure that as states ramp up new programs with some of this designated federal money, local taxpayers will be left with the tab when the stimulus package disappears. Two years from now those same local newspapers that today are telling residents that help is on the way will be filled with gloomy stories about programs that will vanish unless the state steps in to replace federal funds. Any taxpayer who has lived through a few economic downturns knows that federal aid is largely a chimera.

Although the stimulus package also contains what’s described as significant tax cuts that presumably would offset some of the local tax increases, most of this is in the form of narrow credits that many taxpayers either can’t take advantage of or will fail to tap into because these credits tend to be obscure and complicated. In any case, tax credits hardly produce the kind of relief that comes from finding extra money in your paycheck every week.

It’s not hard to see why the price of government is rising. In the midst of the sharp downturn of the private economy starting early last year, many local politicians let their budgets and workforces continue to increase. In October I observed that state and local public sector jobs were still growing—the 11th increase in 12 months. Even as the private economy contracted by some 750,000 jobs, government added 200,000 positions in that time. Today, although the overall unemployment rate is about 7.1 percent, it’s 2.3 percent in the public sector.

Now, faced with steep shortfalls, politicians are playing their usual budgetary games. In their book The Price of Government, David Osborne and Peter Hutchinson observe that state and local politicians typically rig local fiscal debates by focusing on the small percent of a budget that has to be cut in tough times. That turns budget discussions into a form of horse trading in which advocates and favored constituencies work to preserve their jobs and programs, regardless of whether they are effective or whether citizens really value them. Good governments, by contrast, (and there are vanishingly few), start with how much money they presume will be available to spend and ask, how can we best serve our citizens and accomplish what they most want us to accomplish with this money?

To govern this way, however, requires that local leaders take on the advocacy groups—from public employee unions to social service agencies to private contractors living off public works—who frame even the smallest cuts in apocalyptic terms. Not only have these groups grown ever more powerful and savvy as lobbyists for their interests, but many of our state and local legislatures are now filled with representatives of these constituencies. Their ascendance represents the triumph of the tax-eaters over taxpayers. Where they rule, the pain for taxpayers is especially acute and the economic fundamentals are often the weakest.

What J.M. Keynes Should Have Said

For more than seventy years, policy makers have used Keynesian monetary and fiscal policies to control recessions (Keynes 1936). Although these policies are widely perceived to have been successful in stabilising the business cycle, academics gave up on Keynesian theory in the 1970s. The appearance of stagflation led to the adoption of the Phelps-Friedman hypothesis of a natural rate of unemployment, and it caused academics to abandon the Keynesian idea of many steady-state unemployment equilibria (Cross 1995). Mainstream economists adopted an approach in which temporary deviations from the natural rate of unemployment are caused by “sticky prices”.

In a forthcoming book (Farmer 2009), I propose a new paradigm that reconciles Keynesian economics with general equilibrium theory. Unlike existing interpretations of Keynes’ General Theory, my approach does not rely on sticky prices and does not carry the implication that the economy, if left to itself, will return to full employment. The theory implies instead that any level of unemployment can coincide with any rate of inflation.

I will make three related points. First, due to missing markets, labour market clearing may occur at many different unemployment rates, all of which are consistent with steady state equilibrium. Second, aggregate demand determines which of these equilibria will occur. Third, aggregate demand depends not on income, as asserted by simple Keynesian theories, but on wealth. My argument leads me to advocate a different policy from the trillion dollar bailout currently on the table. I argue instead for direct control of the stock market through Fed intervention in a market for indexed securities.

The labor market

Finding a job is not costless; it requires resources to match a worker with a vacancy. Search theorists (Pissarides 2000) define a search technology to be a process that takes the search time of a worker and the search time of a corporate recruiter as inputs. By embedding this technology into an otherwise standard general equilibrium model, one can arrive at a workable definition of the natural rate of unemployment – the unemployment rate that would be chosen by a social planner in this expanded general equilibrium environment.
To produce a commodity, competitive equilibrium directs firms to use the right mix of labour and capital through adjustments in the wage-rental ratio. But to produce a match between a worker and a vacancy, the corresponding price signals are missing. We do not observe markets for the search effort of unemployed workers or corporate recruiters, and there are no market prices to direct participants to use the correct mix of vacancies and unemployed workers to fill a given number of jobs.

Standard search theorists have proposed many different mechanisms that might substitute for the lack of prices and restore the uniqueness and optimality of equilibrium in a search economy. I believe that these mechanisms are not present in practice and that the multiplicity of equilibria that follows as a consequence is a real world phenomenon with the following important implication.

In high-employment equilibria, firms devote a high percentage of resources to searching for a small number of unemployed workers. In low-employment equilibria, firms devote a small percentage of resources to searching for a large number of unemployed workers. The absence of input markets allows there to be a continuum of equilibria, each one associated with a different ratio of vacancies to unemployment and all of them consistent with zero profits through adjustment of the wage.

The stock market

US households own roughly two times US GDP ($28 trillion) in the form of houses and three times GDP ($42 trillion) in the form of factories and machines. In classical theory, the value of tangible assets is equal to the present value of future rents and dividend payments, and these payments are pinned down by fundamentals – preferences, endowments, and technology.

There is an alternative theory of asset prices put forward in Keynes’ General Theory – asset values are based on confidence. According to the confidence hypothesis, stock market participants value assets based on their perceptions of how others will value them in the future. House prices and stock prices have fallen dramatically in the last fifteen months, and some observers are puzzled that private banks are not lending to each other or to corporations and firms. There is no need for puzzlement. Liquidity is frozen because market participants are concerned that the economy is moving to a low-employment equilibrium and that asset prices will fall further. If this belief is fulfilled, the US banking system will prove not just to be illiquid – it will prove to be insolvent.

According to the confidence hypothesis, there is a connection between the stock market and dividends but the direction of causation is not the one stressed by classical economics. Confidence is an independent causal factor. If confidence is low – the private sector places a low value on existing buildings and machines. Low confidence induces low wealth. Low wealth causes low aggregate demand, and low aggregate demand induces a high-unemployment equilibrium in which the lack of confidence becomes self-fulfilling.

A policy proposal

Since WWII, the US Federal Reserve has stimulated the economy by lowering the interest rate during recessions and allowing it to rise again during expansions. At the end of each recession, the economy begins a new expansion, but there is no tendency for unemployment to return to a time-invariant natural rate. Defenders of the natural rate hypothesis argue that the natural rate itself is time varying but there is, to my knowledge, no theory that can explain this variation as a function of a small number of observable variables.

In Farmer (2008a, 2009) I develop a new paradigm. I argue that the unemployment rate returns to a level that depends on wealth and, just as there are many equilibrium unemployment rates, so there are many equilibrium values for the prices of assets. This theory underlies my recent articles (2008, 2009) in the Financial Times in which I suggest that the Fed intervene directly in an index of stocks to maintain confidence in the markets. In recent years the Fed has used one instrument – the fed funds rate – to control two targets: inflation and unemployment. I argue that the Fed should add a second instrument – the rate of growth of the price of a stock market index. Here is how this would work.

First, establish a market in an index of all publicly traded common stocks. The weights of the individual securities would be set in proportion to market capitalisation and could be adjusted regularly as new firms enter and old firms exit.

Second, create a privately owned holding company that holds a basket of securities and that issues liabilities in the index. The creation of a privately owned company of this kind would allow the Fed directly to trade the index without owning shares in the underlying corporations.

Third, direct the Fed to purchase a block of shares in the index, financed by a mix of money and three month debt liabilities, guaranteed by the Treasury.
Fourth, announce a price path for the index to be reset at each meeting of the open market committee and stand ready to buy and sell the index at the announced price. One policy might be to set the fed funds rate according to an announced inflation target and to set the price path for the index to achieve an announced unemployment target. The fed funds rate and the index would be chosen independently and their values set by manipulating both the level and the composition of the Fed’s balance sheet.

Possible objections

Some will argue that the government cannot predict bubbles and crashes any better than private markets. But in practice we do have some information about bubbles and impending crashes, and this information is shared by the government and the private sector. Private individuals cannot make money by betting against the market because any one individual is too small to buck the trend. When the herd stampedes, it is best to get out of the way. The government is the only agent large enough to stop the stampede and restore optimality.

Some will argue that my plan represents a step on the slippery slope to socialism. Not so – I am arguing for no more than an extension of an already accepted role for the central bank. Just as the Fed already sets one price (the fed funds rate) to control inflation so it should set a second price (a stock market index) to control unemployment. Unlike the fiscal bailout currently under consideration, my plan involves no extension of the size of government. It puts spending power back where it belongs – in the hands of households.

Capitalism is the single greatest engine of growth ever devised and the free market allocation of capital is superior to any other system known to humanity. If the big three auto makers cannot produce cars that people want to buy – let them fail. If Lehman Brothers made bad investments – let it sink. But do not let every manufacturing firm and every bank fail at the same time as a result of speculative movements in markets that serve no social purpose.


Cross, Rod (ed) The Natural Rate of Unemployment: Reflections on 25 Years of the Hypothesis, 1995.
Farmer, Roger E. A. “The Great Depression” manuscript, UCLA, November 2008a.
Farmer, Roger E. A. (2008b) “How to Prevent the Great Depression of 2009” Financial Times Economists Forum., December 30th.
Farmer, Roger E. A. (2009) “A New Monetary Policy for the 21st Century” Financial Times Economists Forum., January 11th.
Farmer, Roger E. A. Expectations Employment and Prices Forthcoming, 2009.
Keynes, John Maynard. The General Theory of Employment, Interest and Money, Macmillan Cambridge University Press, 1936.
Pissarides, Christopher. Equilibrium Unemployment Theory. MIT Press, 2000.

Roger Farmer is professor of economics at UCLA.

Don't We Have Enough Bad Banks?

At what price will the assets be hived off, sold to the Fed, or put into a “bad bank?” The SUPER-SIV idea, originally proposed in late 2007 by Citibank, J.P. Morgan and Bank of America, and meant to be a private sector solution, went nowhere because nobody could agree on price. Paulson’s plan from last summer went nowhere because, for all the wisdom at Treasury and the Fed, nobody could square the competing objectives between keeping the taxpayer safe (READ, DON’T OVERPAY!) and providing meaningful help to the banks (READ, OVERPAY!).

Paulson should be commended for at least digging in on this point of not having the taxpayers overpay for junk, but he loses points on naïvete in that he never took the thought experiment to its natural conclusion. To wit, there is no price that can both help the banks and protect taxpayers.

It now appears that, with the economic news cascading downward every day, the banks could be about to win this game of chicken. The latest proposal being floated from the Obama administration is to create an FDIC run bad bank that will take “toxic” assets off of bank balance sheets. The question of what price remains unresolved. Market prices? Model prices? Made up prices?

Treasury Secretary Geithner told the Senate Finance Committee “I think you need to look at a mix of those types of measures,” conceding that “they all have limitations.” [Comptroller of the Currency John Dugan agrees, telling Bloomberg one of the “real key issues” will be “which assets to take from open institutions and how much you pay for them.”] Hold on a minute! We’ve been working on this for 6 months, and we’re no closer to a solution?

The gambit of the bankers seems clear enough: eventually the public and the government will be so spooked that the nice sentiment of protecting the taxpayer will be cast aside. With the latest proposal, nobody seems to be making so much fuss about the quaint idea of “protecting the taxpayer.”

Before hooking taxpayers for these rotten loans, officials have a responsibility to consider carefully whether or not it will do any good. The premise has been that the banks are viable and should be saved, and once they don’t have the capital adequacy problems the bad assets have created, they will get back to the business of lending. That is, apart from the bad assets, they are “otherwise healthy.” Everything depends on this being true. It is almost certainly false.

To understand why it is false requires understanding how banks work at the micro level. It requires understanding the mindset of the folks sitting in a room, a credit committee, deciding whether or not to accept the risk posed by a particular transaction. It is difficult for policymakers to understand the dynamic that drives the credit-making process within these large banks. Over the past 20 years I worked for two institutions that together have racked up nearly $100 billion in losses due to bad bets on structured products. The sad truth is that these institutions are irredeemable; money spent shoring up their capital is money, if not completely wasted, then certainly inefficiently spent.

These banks are made up of individuals who made disastrous bets and crippled their institutions. Their stocks and net worth have been decimated, their friends have been fired, and worse, their bonuses have been reduced. They are shell-shocked, risk averse, and for those that remain, the vow of “never again” becomes the new culture. So, like all things cyclical, they go from taking foolish risks to taking no risks.

Remember that in the beginning of the crisis it was the subprime mortgage assets causing all the trouble. Then it gravitated outward to LBO loans and other institutional credits. Now consumer lending is causing the headaches. These institutions are not “otherwise healthy.” They are “otherwise troubled” not least because of more bad assets that may not be on the radar screen now, but because the individuals running these banks cannot easily recover from this horrible experience. Apologies to the Joker, but for the big lenders, the credit crisis has “changed things… forever.”

What then to do? If the big banks cannot be saved, money spent pumping up their capital, or purchasing their bad assets at inflated prices, will never trickle down into new lending. Nor will it stave off “systemic collapse”, the great bogeyman of our time. This was the AIG con job. If AIG failed, the reasoning went, many of its creditors would become insolvent. But if in the summer of ’08 AIG was insolvent, then some of its creditors were similarly insolvent. Maybe Goldman Sachs, maybe Morgan Stanley. The over $150 billion spent to save AIG in order to avoid systemic collapse looks like a more dubious investment every day.

Goldman has denied having materially unhedged exposure to AIG. The NY State Insurance Commissioner pointed out, correctly I believe, that the life and annuity subsidiaries of AIG are adequately capitalized to meet their obligations. What good then has come of this investment? The rest of the TARP funds look similarly questionable.

Readers might also visit Wells Fargo’s web page where one sees an advertised 30-year, fixed rate of 5.5%. This is within 1% of the lows for the past 40 years. So it is tempting to ask, in the face of these very reasonable rates, what credit crisis? But the Obama administration clearly feels both the need and a mandate to do something big, and a big, bad bank starts to looks inevitable. Before heading down this path, we might consider an alternative, equally large but perhaps less profligate.

Indeed, one possibility has been overlooked. Instead of creating yet another bad bank, or keeping alive the walking wounded, why not create a good bank? Treasury and the Fed could take one of the many trillions sloshing around the various bailout schemes and create a federally chartered, taxpayer-owned lending institution that would ensure that some basic level of credit products are available. A trillion dollars goes a long way. With a 10% capital-to-assets ratio this institution would have a lending capacity of two-thirds of US GDP.

Policymakers can then decide what credit products this bank will make available. They could start with 30-year, fixed rate, 20%-down owner-occupied mortgages. Student loans to accredited colleges might be next. Perhaps the commercial paper of investment grade corporations. Loans to Vegas croupiers-turned-real-estate-moguls, private label credit card securitizations, and 10-year auto loans for cars that last 6 years? Save those for the next cycle.

February 5, 2009

To Ease the Credit Crunch, Let It Be

So in periods when gasoline is in short supply, the natural spike in its price is the happy market signal that scarcity will eventually be relieved with new supply. The spike or fuel "crunch" serves as an incentive for producers to bring new fuel to the market. If price increases are not allowed by bureaucrats, continued scarcity is a certainty.

The notion of price controls is critical at present given the seemingly bipartisan view that the federal government must use resources taken from the private sector to ease what many deem a “credit crunch.” The view held by many is that our federal minders must “normalize” credit markets in order to insure that businesses are able to access capital to fund their operations and growth. So if we ignore the obvious contradiction suggesting capital expropriated from the private sector by the federal government can somehow be used to fix the economy from which it was taken, we can then ask if these activities aren’t bringing major harm in the way that simple price controls do. Logic says they are.

First off, there’s no way the federal government can “normalize” any market, let alone our credit markets. When the cost of credit rises, that is the market for credit; meaning efforts to normalize natural market prices are in fact distorting the very price signals that tell those with capital where to invest most profitably. Future credit scarcity is also a certainty given the reality that those with money to invest have no incentive to offer up capital in markets where rates are being unnaturally held down by federal bureaucrats.

And as the present credit situation is deemed crisis-like by many, the same scenario as the one with regard to gasoline in hurricane season applies. Just as rules against price gouging by gas-station owners mean that those with access to gasoline will irrationally consume it at the expense of others, so do government attempts to fix the credit markets insure irrational consumption of capital.

Indeed, if capital is made abnormally cheap in times of crisis, those able to access it have no incentive to be circumspect in their borrowing. Rather than more aggressively selling off inventory or collecting on dated accounts receivable, those with the best pipeline to cheap money have the incentive to borrow as much as possible. This insures that many businesses will go without capital due to artificially low rates.

When we bring entrepreneurs into the equation, by virtue of them pursuing disruptive concepts (Silicon Valley is littered with venture capital firms that turned down Google’s request for funds) that may at first glance seem far-fetched, it’s tautological to say that they must routinely borrow at relatively high rates in order to implement the very ideas that change the commercial structure. But when available capital is being aggressively borrowed by established businesses, entrepreneurs must to some degree go without.

And for the businesses able to borrow at artificially low rates, the government is creating a scenario whereby it’s easier for the big to survive at the expense of the small and unformed. This works at cross-purposes with governmental initiatives in favor of helping the little guy, not to mention job growth given the consensus that small businesses are in aggregate the greatest job producers in our economy.

Worse, and particularly in times of crisis, when governments foster artificially low rates, they are subsidizing the “zombie” businesses that hog limited capital, and as such, slow economic growth. Better it would be if costs of money were left untouched by Washington. If this means that certain large, struggling businesses go bankrupt, we shouldn’t fret. Rather than vanish, the beauty of credit crunches when it comes to economic growth is that poorly run firms are blessed with new management more able to raise money in order to buy the firms poorly managed.

The above is very important. Indeed, contrary to all the apocalyptic talk about the economy collapsing if certain large firms aren’t saved, the simple truth is that if the federal government stands aside, all the human and physical capital that made once prominent businesses flush would still exist. The only difference would be in terms of new owners making work that which the previous owners could not.

So when we consider what is deemed a credit crunch, government attempts to fix the latter are every bit as impoverishing as similar efforts to fix rising gasoline prices. In the end, artificial controls lead to scarcity and less capital for all.

The better solution for tight credit is acknowledgement that tight credit itself is the path to more easy access to capital. When the price of any good is high, that’s the signal to producers and investors that there’s an unmet market need that will be rewarded with high returns. Just like the gasoline example, abnormally expensive credit is the flashing market signal telling us that if left alone, new sources of credit will soon enough come online.

Ultimately there’s no capital without risk, and when governments seek to normalize the cost of the former, they foster misallocations followed by capital scarcity. In short, the solution to the credit crunch is to let it be.

First, Do No Harm

Buy American. By inserting protectionist provisions that require some goods (such as steel, cement, and textiles) financed by the stimulus bill to be made in America, Congress is risking a trade war with important trading partners. It would reduce exports, potentially destroying millions of well-paid American jobs.

Although President Obama said on February 3, “I think we need to make sure that any provisions that are in there are not going to trigger a trade war,” he did not categorically rule out all Buy American provisions.

Cuts in Defense Spending. At the same time Congress is trying to revive the economy by expanding domestic spending, the Pentagon is reportedly facing budget cuts next year. But with President Obama promising to deploy more troops to Afghanistan, America needs more defense spending, not less.

America needs to purchase more weapons, ordnance, vehicles, and body armor so that our troops have the best equipment possible—and enough of it. Defense supplies are generally made in America, and production employs Americans with a wide range of skills. Moreover, America should increase regular forces by 100,000 and hire 100,000 more civilians to support them. This would enable the Pentagon to bring home reserve and National Guard troops, some of whom have been deployed for six to nine months or longer.

Nationalizing the health system. With little debate and no hearings, Congress is expanding state reimbursement for some government health insurance originally designed to help low-income Americans to those who are middle- or upper-income. That would make government a competitor to private insurance plans, threatening their existence, according to Grace Marie Turner of the widely-respected Galen Institute. It would also expand entitlements and raise future spending.

The Children’s Health Insurance Program, signed into law on February 4 by President Obama, changes eligibility from 200% of the poverty line, or about $44,000 for a family of four, to 300% ($66,000), or even 400% ($88,000), well above household median income of $50,000. In addition, under the stimulus bill, all unemployed workers, regardless of income or wealth, would qualify for Medicaid payments from states, fully reimbursed by the federal government.

Allowing states to set emissions standards. As though a 27-year low in auto sales wasn’t enough, under a new directive from President Obama states will be free to set their own auto emissions and fuel efficiency standards. California and 13 other states are interested in adopting standards that are stricter than federal law. This would complicate engineering and production, raise costs, and send the industry into an even greater decline.

Since California is America’s largest car market, companies will have to make lighter, more fuel-efficient cars that consumers might not want to purchase. Domestic companies will be particularly hard-hit because they make larger cars. At the same time as Congress is bailing out Detroit with loans and considering tax deductions for purchases of new cars and trucks, the Big Three will be forced to make small cars, which is not their comparative advantage. More red ink for the auto industry, and more layoffs across America.

Employee Free Choice Act. This bill, which passed the House in the 110th Congress and which congressional leaders may bring up again this week, has nothing to do with employee free choice other than to deprive workers of it. This misnamed bill would change the law to allow workplaces to be unionized without secret ballots. A workplace could be unionized if a majority of workers sign an open card in favor of unionization — a process known as "card check," exposing workers to union intimidation.

One of the bill’s House sponsors was House Committee on Education and Labor Chairman George Miller. In 2001 he and five colleagues wrote to the state arbitration board of Puebla, Mexico, saying, "we feel that the secret ballot is absolutely necessary in order to ensure that workers are not intimidated into voting for a union they might not otherwise choose." If Mexicans deserve a secret ballot, so do Americans.

States where employees do not have to join a union in order to work have lower average unemployment rates than other states, so it would not be surprising if increased unionization would raise unemployment rates.

As well as protectionism, cuts in defense spending, nationalization of key industries, unionization by intimidation, and arbitrary environmental standards, the economic stimulus bill would open the floodgates of deficit spending. The ensuing debt would burden Americans far into the future.

No wonder consumers are scared, financial markets are tumbling, and unemployment continues to rise. Democrats, who control the White House and Congress, would be wise to avoid further economic damage.

February 9, 2009

If Banks Aren't Revived, Economy Will Stay Down

Here's how the vicious circle works.

With the economy weakening, more loans go into default. Distressed households and businesses can't meet payments. Diane Vazza of Standard & Poor's predicts that the default rate on low-grade corporate bonds will reach a record 13.9 percent in 2009 -- up from only 1 percent just two years ago. Firms that took on heavy debts in "private equity" buyouts seem highly vulnerable.

Growing losses then make investors even more leery of risk. They further curb commitments. The consequences are global. Money flows into developing countries have collapsed. In 2009, they may be down 82 percent from 2007, forecasts the Institute of International Finance. Companies in these countries (Brazil, India and others) have $100 billion of maturing debts in the first half of 2009. The IIF worries that much of this debt won't be refinanced. Scarce credit spreads the global slump.

So, we've gone from too much credit to too little. Contrary to popular wisdom, banks -- institutions that take deposits -- aren't the main problem. In December, total U.S. bank credit stood at $9.95 trillion, up 8 percent from a year earlier, reports the Federal Reserve. Business, consumer and real estate loans all increased. True, lending was down 4.7 percent from the monthly peak in October. But considering there's a recession, when people borrow less and banks toughen lending standards, the drop hasn't been disastrous.

The real collapse has occurred in securities markets. Since the 1980s, many debts (mortgages, credit card debts) have been "securitized" into bonds and sold to investors -- pension funds, mutual funds, banks and others. Here, credit flows have vaporized, reports Thomson Financial. In 2007, securitized auto loans totaled $73 billion; in 2008, they were $36 billion. In 2007, securitized commercial mortgages for office buildings and other projects totaled $246 billion; in 2008, $16 billion. These declines were typical.

Given the previous lax mortgage lending, some retrenchment was inevitable. But what started as a reasonable reaction to the housing bubble has become a broad rejection of securitized lending. Terrified creditors prefer to buy "safe" U.S. Treasury securities. The low rates on Treasuries (0.5 percent on one-year bills) measure this risk aversion.

Somehow, the void left by shrinking securitization must be filled. There are three possibilities: (a) securitization revives spontaneously -- investors again buy bonds backed by mortgages and other loans; (b) commercial banks or other financial institutions replace securitization by expanding their lending; or (c) the government substitutes its lending for private lending. Until now, it's been mostly (c).

The Treasury and Federal Reserve, through various lending programs, are funneling funds to mortgages, student loans, small-business loans and even foreign governments. But a permanent expansion of government's lending role raises practical and philosophical issues. It might politicize lending decisions, involve huge increases in federal debt and pose long-term inflation dangers.

As proposed by President Bush, the $700 billion Troubled Assets Relief Program (TARP) aimed to rehabilitate the private credit system. The Treasury would buy some of banks' bad loans. Thus strengthened, banks could increase lending and offset dwindling securitization. But the Bush gambit failed. The Treasury changed course. It injected capital directly into banks after deciding that it was too difficult to put a price on the banks' bad loans. Unfortunately, banks remain reluctant to lend because they still have lots of bad loans on their books.

Now the Obama administration is crafting proposals to encourage lending. It's a genuinely hard problem. There will be ferocious debate. Will the plan work? Is the cost too high -- or too low? What conditions should be imposed on banks receiving aid? But we should resist turning the debate into a morality play about whether bankers deserve to be rescued. Probably they don't. Even though beating up on them may be politically satisfying, it's beside the point. If the financial sector isn't revived, the economy will stay depressed.

Job Indices Down, Stock Markets Up?

Mustard seeds planted a while back are now pointing to economic recovery. The huge energy tax cut is one such mustard seed. The related inflation collapse is another. By the way, in Friday’s jobs report, wages rose again, and now stand nearly 4 percent higher than a year ago. With zero inflation, that’s a real increase in worker purchasing power for the 92.4 percent, or 135 million workers, still employed.

Then, of course, the Federal Reserve has been pumping in money to offset credit and asset deflation. The old Milton Friedman M2 money measure has grown by $590 billion since early September for a 20 percent annual rate of increase.

In the short-run, as money rises and GDP declines during a recession, the turnover (or velocity) of money plunges. But the use of money eventually picks up, which means all that new M2 growth is going to stimulate the economy this year -- and by a whole lot more than the goofy stimulus bill now before Congress.

Monetary lags are long and variable. But the money supply historically kicks in somewhere between six and 12 months. Through January we’ve had five months of money stimulus. So stocks may now be telling us that the gloom-and-doom crowd -- and its pessimistic economic prognostications that cover all of 2009 and in some cases 2010 -- is about to be proven wrong.

The commodity markets -- among the first asset sectors to respond to money stimulus -- are stabilizing. Broad commodity indexes are 6 percent or so above their lows. Ditto for energy. The Baltic Dry Index, which measures shipping volume around the world (those commodities are in the cargoes), has mounted a big rally, up almost 100 percent off its bottom. Gold is up more than 20 percent. (Investors call this the “reflation” trade.) And long-term Treasury rates have moved from 2 percent to around 3 percent in the 10-year market, another sign that the future economy will be stronger than the past.

There’s also hope for the hard-hit financial sector. A new bank-rescue plan to be announced Monday will probably guarantee a bunch of toxic assets. At the same time, the Fed is stepping up its efforts to refinance asset-backed bonds for banks, consumer-finance companies, and hedge funds in the secondary markets.

And while the quantity of money is rising significantly, the quality of credit is improving, too. All the credit-fear indicators -- from LIBOR all the way out to corporate-bond spreads -- have declined substantially.

Meanwhile, Bank of America CEO Ken Lewis told CNBC on Friday that he can get out from under TARP in three years. There will be no nationalization. Lewis also said his firm’s acquisition of Merrill Lynch will be successfully executed over time. So it’s no surprise that bank stocks were one of the leaders in Friday’s huge rally.

With all the fiscal mania and Keynesian government-spending-multiplier talk in Washington these days, most folks have forgotten Milton Friedman’s dictum that money matters. Indeed, money growth could well produce the biggest economic surprise this year. And as Art Laffer has taught us all, taxes also matter -- a lot. In fact, the only real stimulative part of the behemoth stimulus package is the simple fact that marginal tax rates will not be raised.

So cheaper energy, bundles of new money creation, zero inflation, and no tax hikes could very well combine to produce a stronger economy as the year progresses -- to the great surprise of the majority of economic pundits. That may well be the message of Friday’s stock market rally, which shrugged off yesterday’s painful slide in jobs.

February 10, 2009

Buy American, Buy Depression

Last week, leaders from Canada, Brazil, China, the U.K., India, Mexico, Germany and the Czech Republic, among others, spoke out against such "Buy American" provisions as protectionist. Some threatened retaliation.

The most assertive voice came from the European Union, our top overseas market, which last year engaged in two-way trade with the U.S. totaling $709 billion.

EU ambassador to the U.S. John Bruton warned Congress that the "Buy American" provisions will damage the U.S. as well as world trade by building protectionist sentiment around the world.

Even a watered-down provision "Buy American" provision passed "in a manner consistent with U.S. obligations under international agreements" is still bad news, Bruton said. It may not violate treaties, he said, but it's protectionism just the same.

We may have our differences with Europe about its lumbering statism and political correctness, but it's worth remembering the trade wars that presaged World War II and the core premise of the EU itself — a trading bloc of free nations designed to ensure continental peace.

Now, with a global crisis on, "we are all in this together," Bruton told IBD in a recent interview to make the EU's case. Even if the "Buy American" provision breaches no U.S. treaty obligation, as the Senate insists, Bruton said it still breaks a vow the U.S. made at the G-20 summit last November, in the early stages of the economic crisis.

All the large developed and emerging economic powers agreed to introduce no protectionist measures, he said.

But "Buy American" violates that. "To introduce this in a high-profile stimulus bill sends out a message that the U.S. doesn't see this crisis as a global problem but only an American problem that can be solved by American legislation."

"This is a global crisis we are facing," Bruton said. "We need to tackle this globally."

Retaliation would be the first problem, but not the last. "I suppose if the U.S. did breach its international obligations, there would be retaliation," he said. "But that doesn't mean this doesn't do a whole lot of damage."

Bruton said the stimulus bill is being closely watched and will send a global message. U.S. leadership would not be enhanced, he said, noting that another G-20 meeting is set for April, where the U.S. presumably would have to explain itself.

"I think this is a mistake for the signal it sends to the rest of the world," Bruton said.

After all, two can play the protectionist game. Europe was somewhat shielded from the move because it had signed a "Government Procurement Agreement" with the U.S. But in areas of the economy where that didn't hold sway, retaliation could be possible.

That would be terrible for U.S. companies, he said. They could be shut out of contracts they might otherwise win.

"The EU market for government contracts is one of the most open in the world, and many American companies bid successfully for public sector contracts," he said. "The risk is that if America becomes more closed, the only way to persuade it otherwise is to retaliate, which, in the short run, imposes costs."

Meanwhile, emerging countries such as Brazil and India "are not party to agreements," Bruton said, "so the full rigor of (the Buy American rule) would apply to them."

Besides, he said, "We already have had 'Buy American' provisions in effect since the 1930s, so why are they not adequate now? The legislation was signed by Herbert Hoover, and it didn't do much."

Even from the U.S. point of view, protectionism would bring less bang for the buck, Bruton said. If the U.S. wants to build new bridges, or invest more in information technology, or build schools, it will cost more if you limit the potential suppliers through protectionism than if you throw the process open to bidders around the world.

This is in no one's interest, said Bruton. "One would end up with less stimulus per dollar on a global basis."

And it would also mean more bureaucracy, he warned.

"If you have to buy American, you have to verify where products come from," he said. "So a lot of money would be wasted in paperwork to comply with the provisions, and that's not what we want at a time of urgency."

It's true the EU has its own list of protectionist policies. But Bruton's right about one thing: as we found in 1930, after the Smoot-Hawley tariffs were imposed, more protectionism is the last thing the world needs.

When Insurance Fraud Becomes Public Policy

After-the-fact fraud is easy to spot but hard to redress. If your house burns down and you discover that your insurance company absconded with your money, is there any doubt you’ve been defrauded? By that point, though, there’s not much you can do.

That’s why regulators are empowered to ferret out fraud before-the-fact, aiming to protect consumers from companies whose assets are insufficient to cover their liabilities. As a result, well run insurance companies tend to be large, profitable, and long-lived. It’s ultimately what makes their promises worth something. Would you buy insurance from Vinnie the Bookie?

Despite the whining, insurance companies secretly love regulation. Being large, profitable, and long lived they can “invest” in politicians. In return, politicians deliver a controlled market relatively free of price competition, protected from new entrants, and amendable to profits that yield campaign contributions year after year. These politicians also have the power to make laws that force consumers to buy insurance. If you’re an insurance company CEO, what’s not to like?

Nothing. Until politicians get into the business for themselves.

Like lottery tickets, most customers who buy insurance never get anything tangible in return. (Dang, I didn’t smash my car!) When you buy something and get nothing in return, do you feel cheated? When a politician invites you to vote for lower insurance rates, do you find it hard to resist? Who doesn’t want lower prices?

Insurance companies forgo profits lost under price controls and make it up with profits gained under protection from competition. As long as all their customers don’t all die or get in car accidents at the same time, the political pendulum swings seeking equilibrium.

But the game becomes unstable when massive amounts of correlated risks need to be insured. Floods, earthquakes, and hurricanes may be unpredictable in the short term but insurance companies have learned to manage risk long-term by hoarding profits during good times to cover payouts during bad. These profits get plowed into massive portfolios of financial assets waiting for The Big One. Insurers also balance risk by selling some to global re-insurance companies.

Most importantly, insurers are happy to charge customers higher rates when they build papier-mâché houses on sand dunes, McMansions on flood plains, or condos on earthquake faults. By building risk into the cost of a house, fewer houses get built in high-risk zones, innovative building techniques get developed that help houses withstand The Big One, and ecologically sensitive land becomes less attractive for development.

Until unconstrained democracy enters the picture. Why pay more when you can vote to pay less?

Because “long term” to a politician means “until the next election,” beating down insurance companies’ unfair rates and excess profits is a perennial vote getter. Even when insurers flee the state, as State Farm recently did in Florida joining Prudential, Allstate and Nationwide, the legislature can whip up a government run insurance company. Give it a catchy name like the Citizens Property Insurance Corporation, charge the lowest rates in town, throw all accounting rules out the window, and before you know it Vinnie the Bookie is insuring every home in the State.

Can’t get a commercial re-insurer to buy any of the underpriced risk on those papier-mâché houses? No problem! Create a government re-insurance entity and name it the Florida Hurricane Catastrophe Fund. Fill it up with IOUs financed by bonds that obscure the tax impact and let the good times roll.

Potential liabilities of CPIC and FHCF exceed assets by over $400 billion dollars, and growing. Under commercial regulations and accounting standards, these Government Sponsored Entities would be declared insolvent and their officers would be indicted for fraud. But with the fox guarding the henhouse, fraud will only be “discovered” after the next big hurricane blows through. Similar follies are unfolding in earthquake land.

Are Florida homeowners worried that their home-grown Vinnie might not be there when the bills come due? Are they begging State Farm, Prudential, Allstate, and Nationwide to come back, even if it means paying higher rates? Are they thinking twice before they build more papier-mâché houses on sand dunes? Is the governor in charge of this mess the least bit concerned?

“Floridians will be much better off without them’’ bellows said governor. Asked if State Farm was playing chicken when they asked for, and were denied, a rate increase, he replied: “I don’t really know, and I don’t really care.’’

Isn’t that a fitting motto for unfettered, know-nothing democracy – bound by no limits and bowing to no constitutional constraints? “I don’t really know, and I don’t really care.’’

Sovereign states can’t go bankrupt, right? There will always be a taxpayer somewhere who can be forced to bail them out. If not their own state’s taxpayers, then - even better - someone else’s! After all, Florida is a swing state representing 27 electoral votes. What creature of Washington will ever give Florida voters what they deserve, which is nothing, when their houses blow down and their politicians-cum-bookies cry, “We didn’t know!”

When Left Alone, Economies Never Fall Into Recession

But since Obama is stridently of the view that the world’s richest and most innovative economy can’t grow without federal assistance, a thought experiment is in order. What if Congress and the Obama administration took a six-month vacation and simply did nothing?

This would surely bother some Republicans who strongly feel that tax cuts are the tonic for what ails us. The notion is an appealing one given that taxes are merely a price put on work effort. At the same time, the U.S. economy has grown smartly with marginal rates much higher than they are at present, so to suggest that more tax cuts make keeping Congress in business a necessity seems a bit dramatic.

Furthermore, a do-nothing, vacationing Congress also could not raise taxes. So while work penalties wouldn’t fall, the cost of work also wouldn’t rise. This certainty in and of itself would be a big boost to future economic activity.

Republicans also seek to pass a measure that would reduce mortgage lending rates alongside a tax deduction on home purchases. For this alone a Congress on vacation would be a huge improvement. Indeed, home ownership is already heavily subsidized, and more federal help would simply drive more money into property, and away from the entrepreneurial economy. It would also lock even more Americans into specific regions of the country at a time when worker mobility is essential for a resumption of growth.

Democrats seek an extension of unemployment benefits, but if Congress weren’t in session, an impoverishing change like this couldn’t pass. Non-passage would offer the economy a huge economic boost owing to the economic reality that jobless benefits make it easier for workers on the sidelines to avoid looking for work altogether. Productive work effort once again is economic growth, so a reduction in the subsidies that allow Americans not to work would be hugely stimulative.

There would also be no trillion dollar stimulus package. It can’t be stressed enough that as the government creates no wealth, any efforts by it to stimulate certain aspects of the U.S. economy mean that it is depressing other parts. Rather than taxing or borrowing a trillion dollars and reducing U.S. wages in the process, there would be an extra trillion dollars in private hands that entrepreneurs and business could bid for in order to create real wealth that would not be distributed by our vacationing legislators.

The “Buy America” provision in the stimulus bill which has attracted support from both parties, but that properly scares investors to death, would die a quick death. Subsidies are merely tariffs by a different name, and as they’re at their core a tax on work, another governmental barrier to true productivity would fall by the wayside.

The disaster that is TARP would be put on hold, meaning the gun-shy zombie banks in our midst would fail only to be purchased by new owners whose future lending decisions would not be compromised by the stupendous lending failures of the past. In one fell swoop, our flagging banking system would achieve renewed health absent Washington meddling that has greatly weakened it.

And with our federal minders not seeking to create disorder through greater controls on lending rates, new capital would reach the loan markets thanks to the intrepid among us eagerly taking advantage of high rates of return wrought by what some deem a “credit crunch.” A slumbering Washington would translate to a boost in business confidence such that lenders would more likely be paid back thanks to a better business environment all around. Successful loans at high rates for first movers would create a natural loan environment that would ultimately attract more profit-seeking capital, thus bringing down interest rates in the process.

As for the dollar, with Treasury Secretary Tim Geithner hopefully well out of pocket, he could no longer make irresponsible comments about China that have proven time and again so bad for the greenback. Absent devaluationist commentary from Geithner, investors might comfortably bid up the dollar such that it would move out of inflationary territory. This would offer the economy a huge boost in that a stronger currency would reorient investment away from hard assets, and back into the wage/entrepreneurial economy.

So President Obama says we face catastrophe absent help from Washington? Far from it. Economies once again never fall into recession; instead they are pushed into slowdowns by governments that create wedges between work and reward. In short, the single best tonic for our economy is not tax cuts or tax increases, not housing or unemployment subsidies, not heavy spending or China jawboning, but a far humbler Washington that simply does nothing. Left alone, there’s nothing individuals working free of government oversight can’t achieve. The answer to our economic ills is for Washington to simply leave us alone.

February 11, 2009

Housing Won't Lead Us Out of Recession

Although somewhat different, both proposals reflect an underlying assumption common among politicians that housing drives the American economy and therefore must be supported by government intervention, an idea that is at best a distraction, but at worst a prescription for policy nightmares. In good times, government looks for ways to sustain house buying even as prices rise, which often contributes to bubbles and foreclosure crises. And in difficult times the “support housing at all costs” mentality produces bailout ideas that are costly and ineffective—not exactly the fundamentals of good government policy making.

Far from leading the way, the housing market often trails in an economic recovery. In a recent paper, economists Carmen Reinhart and Kenneth Rogoff looked at 18 major, recession-inducing financial crises around the world dating back to the Great Depression and found that typically housing is not the first but the last major indicator to recover in such sharp downturns. On average, housing prices declined 35.5 percent in these crises and took six years to bounce back. By contrast, gross domestic product snapped back in less than two years, followed by equity markets and unemployment.

The Great Depression, characterized not only by high unemployment and sharply contracting output, but by a massive housing foreclosure crisis, is a good example of how little impact massive government intervention has on housing during a downturn. The housing market back then was ripe for a fall. Production of new units had soared from about 250,000 a year in the early 1920s to 600,000 annually by the end of the decade. Banks had more than doubled their outstanding mortgage debt in the 1920s, and within 10 years the number of households that owned their homes had increased a whopping 30 percent.

Soon after the stock market’s crash in October of 1929, the housing market began to collapse in a manner that recalls today’s meltdown. As panicked depositors withdrew their money from banks, lenders stopped making mortgages, and homeowners, who in those days typically had short-term mortgages which needed to be refinanced several times before they could be paid off, suddenly couldn’t find new loans and started defaulting rapidly. Lacking new financing, by 1933 some 1,000 homes a day nationwide were going into foreclosure.

State and federal government employed a variety of aid plans to bolster prices and stop the failures, including foreclosure moratoriums that largely proved to be ineffective because they did nothing to solve the system’s fundamental problems. The most important bailout effort was the Home Owners Loan Corporation (HOLC), created in 1933 to buy troubled mortgages from banks and then allow homeowners to refinance these loans on more affordable terms with the government. HOLC was supposed to free banks to lend again because it purchased their bad mortgages. But although HOLC bought and refinanced about one million mortgages, total mortgage lending and production of new housing stayed absolutely flat for the rest of the decade because the country’s underlying economic fundamentals were so poor that there was little demand for new home lending. What ultimately revived the housing market was not HOLC’s bad mortgage buying program but the nation’s broader economic recovery after World War II.

The government’s housing interventions are generally even more troubling during good times because they help create bubbles and new foreclosure problems. After World War II, pent up housing demand sparked an explosion of new building and home buying. During that time the federal government’s G.I. bill provided returning soldiers with the opportunity to buy homes with mortgages subsidized by the Veterans Administration, while the Federal Housing Administration also backed loans to spur lending. By 1949, 40 percent of all new mortgages were government-backed.

But as the housing boom continued into the 1950s and prices started rising beyond the reach of a new generation of would-be homeowners, the federal government came under pressure to loosen its credit standards. Washington began requiring smaller down payments, so that by the early 1960s government–subsidized loans for more than 90 percent of the value of a home were typical. At the same time, the government loosened income ratios, that is, the ratio of a borrower’s income to housing payments, and began stretching out the terms of loans to longer periods.

The looser standards provoked rising delinquency rates and loan failures. The foreclosure rate on FHA loans spiked nearly five fold during the 1950s, while the failure rate on VA mortgages doubled. By the early 1960s, FHA loans were four times more likely to default than conventional loans and VA mortgages were more than twice as likely to default. In all, government-subsidized mortgages performed much worse during the recession of the early 1960s than did conventional mortgages, whose lenders had not reduced their underwriting standards.

This cycle has played itself out several times in the ensuing decades, to progressively more disastrous consequences. But we’re obviously not cured of our fascination with housing stimulus yet, even though it’s clear that the economic fundamentals don’t augur well for a current housing revival led by tax credits or interest rate cuts.

The Democrats’ plan to provide home buyers with a generaous tax credit is more likely to be used by people who would be purchasing homes anyway, producing a steep hit on the Treasury without much additional buying. And Harvard economist Ed Glaeser estimates that the Republican interest-rate plan would only result in enough new purchases to boost home prices by only about six percent, hardly enough to revive this a market. But more important, as Glaeser notes, lenders have only recently ‘recovered their sanity’ after the mortgage lending sprees of the last few years, and the last thing we want government to do is encourage them to go on a new lender bender.

Now if only our politicians would recover their sanity when it comes to the nation’s housing market.

Let Big Banks Fail, but Save Finance

The populist view has a populist appeal, and this is perhaps why the government is struggling with all the different manifestations of socializing the risk. The “bad bank” seems to have lost momentum after the congressional watchdog panel overseeing TARP released a report showing that Treasury’s last foray into the toxic asset buying business quickly turned $254 billion into $176 billion.

So, rather than buy the assets, the latest idea is to “guarantee” them, in an attempt to lure private investors into a “Public-Private Investment Fund.” We are all Credit Default Swap traders now! For a credit default swap is precisely what an asset guarantee is. And the next Nobel Prize in economics awaits the clever economist who can figure how to price a guarantee without pricing the underlying asset. Save the effort, it cannot be done. Figuring out the pricing of guarantees is no less vexing than pricing and then buying bad assets. It’s simply sounds like less of a taxpayer rip-off.

Of course, what the populist argument misses is the systemic collapse that would be risked by letting these large banks fail. The world economy, and the global financial system, is so intricately and massively interconnected that if one, let alone 10, of the big banks were to fail, the domino effect would crush the global economy. This may not be true, but even a small chance against such a massive risk makes the outcome so unthinkable that nobody will seriously consider it.

The big banks kind of have us where they want us, don’t they? If we allow the free market to punish them, we all go down together. It’s a form of financial mutually assured destruction. And we thought they were stupid for buying all those super-senior tranches of subprime CDOs.

Ideally there would be a way to allow market discipline for those who took bad risks without destroying what is left of the financial system. There is.

Consider what a fortunate thing it is to have so much of the current bad assets concentrated in so few hands. In a country with 10,000 banks, it is likely that a large percentage of the truly toxic assets are in the hands of a dozen or so players. As we saw with the subprime losses, of the first half trillion dollars, U.S. banks made up about half the total. Of that half, 10 institutions made up for 90% of the losses. If you go through the list of big losers, what strikes one is the top-heaviness of the list. In another stroke of luck, from the taxpayers’ perspective, 4 of the top ten, and 15 of the top 25, are not even U.S. institutions.

The Financial Stability Fund that Geithner unveiled yesterday would be targeted at the weakest players. Those banks that stress testing reveal are most in need of capital. This approach is exactly wrong. Perversely, Geithner vows to avoid the mistakes of Japan in the 1990s. But propping up bad banks is precisely what Japan did.

We don’t need to inject still more capital into weak banks in order to avoid systemic collapse. There is a solution to the dilemma of contagion. A remedy that does not involve buying the bad assets, or guarantying the bad assets, or guarantying the bad debt of the owners of the bad assets, or buying preferred shares in the owners of the bad assets… And the solution might be inexpensive.

Start by identifying the basket cases, the 8 or 10 or 12 that the FDIC must surely know are insolvent. Together they hold a bulk of the losses already realized and, presumably, yet to come. Announce they will no longer be the beneficiaries of any further government assistance. It is possible that they will all fail in short order. But the system need not collapse.

The government will effectively put these institutions into receivership. Equity holders and preferred stockholders will likely get nothing (including, alas, we taxpayers who own what Henry Paulson purchased for us). Importantly, bondholders will also suffer, and receive only what’s left in the final bankruptcy. Here the 8 cent recovery on Lehman unsecured debt is somewhat frightening, but bondholders are presumably sophisticated and any fixed income fund that still has more than 20% in financials is either crazy or PIMCO.

Systemic collapse can be avoided because the government will simultaneously announce two important measures. First, and least controversially, depositors of all forms, shapes and sizes will be promptly and unconditionally guaranteed by the US government. This seems to require little justification.

Second, all counterparties of failed banks will now face the US government on the other side of their trades. That is, the U.S. will guarantee repurchase agreements, derivative transactions and other counterparty claims of anybody, foreign or domestic, that has a transaction on with these banks. Systemic collapse avoided.

Clearly, we are dealing a windfall to some institutions that should perhaps be punished for not doing their homework before, for instance, entering into a long dated FX swap with Citibank. But not doing so really would risk systemic collapse. When AIG was saved, it was not, we hope, simply to save Goldman Sachs and Morgan Stanley. Systemic collapse is a domino effect primarily transferred through derivative transactions. The numbers are indeed staggering; the OCC reports over $182 trillion in outstanding notional amounts as of last June. And there exists the possibility that the failure of a dozen large players would take us back to the financial Stone Age.

Even well managed community banks, thrifts and municipalities have interest rate swaps on with the big banks. The municipality that hedged its interest rate risk with Citibank thinking it faced an entity one notch below AAA should not be punished.

The second reason the plan is viable is cost. There is no way to know how much more we will spend buying or guaranteeing bad assets. If Roubini’s number is correct, we are in the early stages of this game of letting good money chase after bad. If we are to dole out these funds $350 billion at a time, we could be playing for a long time and still have insolvent banks.

It is difficult but not impossible to figure out what such an overarching guarantee of counterparty claims might cost. But it may not be that expensive for the government to step into this role. Importantly, while the banks do not know, or pretend not to know, the value of their toxic assets, they know exactly what their counterparty claims are, to the penny. This information is routinely shared with regulators now. If by some stroke of bad luck these big banks are all off sides and under-collateralized in their derivative claims, the plan can be quietly abandoned.

But it is unlikely to be terribly expensive because generally the big banks do a reasonably good job of managing both net market risks and counterparty risks. So if Citibank has a bunch of counterparty trades on with small, shaky institutions, it probably has sufficient collateral against the trades. One might discover also that the bulk of the derivative transactions outstanding are among the banks on the hit list. Indeed according to the OCC the five biggest banks represent about 90% of net industry credit exposure. This would be a good thing, because derivatives are after all zero sum transactions. Theoretically, the taxpayer has a decent chance of coming out flat.

Over the summer there was some silly talk about how the taxpayer might actually make a profit on Paulson’s investments. After all, Warren Buffet was buying the same types of preferred shares. That argument was and remains nonsense. Last week’s revelations that Treasury seems to have quickly lost $78 billion should silence the optimists. It’s time to cut losses.

At the very least we need to recognize the inefficiency of addressing the crisis from the asset side. Trying to fix this problem by inflating assets is either futile or extremely expensive. The assets do need not to be propped up, but quickly written down. If we can do it while protecting the financial system, why would we delay?

Is Tim Geithner Ready for Prime Time?

You can say a lot of things about President George W. Bush’s big-government mistakes. But blaming the Bush tax cuts for the credit-crunched downturn is utter nonsense. It’s ideological politics at its worst. (It’s worth noting that while Obama was trashing supply-siders on Monday night, Scott Rasmussen’s latest poll showed 62 percent of U.S. voters wanting the stimulus plan to include more tax cuts and less government spending.)

Later in the news conference, Obama acknowledged how businesses that suddenly couldn’t get credit pulled back on their investment and laid off workers -- workers who then cut back on their spending. That -- along with the Fed’s stop-and-go monetary policy and a huge oil shock -- is much closer to the true cause of this recession.

This is all most strange. Obama’s attack on supply-side economics would rule out the successful Kennedy-Johnson tax cuts that spurred growth in the 1960s and the Reagan tax cuts that ignited growth in the 1980s. Even Bill Clinton cut the capital-gains tax. And George W. Bush’s tax cuts helped generate a six-year economic expansion before the oil shock and credit crunch took hold.

On Tuesday morning, stocks opened down about 75 points in the wake of Obama’s pessimism. But stocks really started to tumble when Tim Geithner stepped to the microphone. He totally bombed in his debut.

Geithner had no real plan to deal with the problem of unmarketable toxic assets on bank balance sheets. He offered no new architectural structure, no good way to remove the toxic assets, no clear pricing or funding proposals, and no meat on the bones.

According to Merriam-Webster, a “plan” is “a detailed formulation of a program of action; a method for achieving an end.” But Mr. Geithner had none of this. As a result, stocks plunged about 250 points. Prominent investment strategist Ed Yardeni described Geithner as an empty suit with an empty plan.

A week earlier, ace CNBC reporter Charlie Gasparino scooped the speech by chronicling how Wall Streeters advising the Obama administration talked Geithner out of a government-backed “bad bank” that would somehow buy toxic assets to be either worked out profitably or resold to private investors. These were the same “greedy” executives that Obama and Geithner had been trashing. So now Geithner talks vaguely about some sort of public/private investment fund that will use government capital and provide financing for private investors, who are then supposed to buy toxic assets.

Nobody on Wall Street is buying it right now. Geithner said the fund might cost $1 trillion, but there’s no “there” there. No wonder bank stocks dropped 12 percent on Tuesday.

By the way, Geithner did not offer any regulatory accounting relief, such as putting an end to the disastrous mark-to-market rule that has wrecked bank capital and is one of the root causes of the whole financial problem.

Geithner did talk about an expansion of the Fed’s Term Asset-Backed Lending Facility, or TALF, to help finance consumer-loan securitization packages that provide upwards of 40 percent of all consumer and small-business lending. This might work, but again there were no details. And the Fed has yet to start its TALF operation.

Finally, Geithner talked about a comprehensive $50 billion housing-and-mortgage modification plan. But once again, no details -- especially on the controversial issue of having bankruptcy judges determine home-loan interest rates and lending totals without bank recourse to contractual obligations.

One positive comes from a New York Times story claiming that Geithner beat back Obama’s political advisers who want to nationalize big banks, fire senior bank executives, and establish heavy government controls over bank operations. But at the end of the day the absence of any clarity or pragmatic details from Mr. Geithner left stock markets sadder and poorer for the effort.

Geithner would have been better off not giving a speech until he could put real meat on the bones. What he pulled Tuesday was a classic rookie move that will further erode the public’s trust in his capabilities. Following the controversy over his late payment of taxes, this bank-plan blunder could be another nail in his coffin. Apparently, Tim Geithner is not yet ready for prime time.

February 12, 2009

Coming Soon--Capitalism 3.0

Capitalism is in the throes of its most severe crisis in many decades. A combination of deep recession, global economic dislocations, and effective nationalization of large swathes of the financial sector in the world’s advanced economies has deeply unsettled the balance between markets and states. Where the new balance will be struck is anybody’s guess.

Those who predict capitalism’s demise have to contend with one important historical fact: capitalism has an almost unlimited capacity to reinvent itself. Indeed, its malleability is the reason it has overcome periodic crises over the centuries and outlived critics from Karl Marx on. The real question is not whether capitalism can survive — it can — but whether world leaders will demonstrate the leadership needed to take it to its next phase as we emerge from our current predicament.

Capitalism has no equal when it comes to unleashing the collective economic energies of human societies. That is why all prosperous societies are capitalistic in the broad sense of the term: they are organized around private property and allow markets to play a large role in allocating resources and determining economic rewards. The catch is that neither property rights nor markets can function on their own. They require other social institutions to support them.

So property rights rely on courts and legal enforcement, and markets depend on regulators to rein in abuse and fix market failures. At the political level, capitalism requires compensation and transfer mechanisms to render its outcomes acceptable. As the current crisis has demonstrated yet again, capitalism needs stabilizing arrangements such as a lender of last resort and counter-cyclical fiscal policy. In other words, capitalism is not self-creating, self-sustaining, self-regulating, or self-stabilizing.

The history of capitalism has been a process of learning and re-learning these lessons. Adam Smith’s idealized market society required little more than a “night-watchman state.” All that governments needed to do to ensure the division of labour was to enforce property rights, keep the peace, and collect a few taxes to pay for a limited range of public goods.

Through the early part of the twentieth century, capitalism was governed by a narrow vision of the public institutions needed to uphold it. In practice, the state’s reach often went beyond this conception (as, say, in the case of Bismarck’s introduction of old-age pensions in Germany in 1889). But governments continued to see their economic roles in restricted terms.

This began to change as societies became more democratic and labour unions and other groups mobilized against capitalism’s perceived abuses. Anti-trust policies were spearheaded in the Unites States. The usefulness of activist monetary and fiscal policies became widely accepted in the aftermath of the Great Depression.

The share of public spending in national income rose rapidly in today’s industrialized countries, from below 10 per cent on average at the end of the nineteenth century to more than 20 per cent just before World War II. And, in the wake of WWII, most countries erected elaborate social-welfare states in which the public sector expanded to more than 40 per cent of national income on average.

This “mixed-economy” model was the crowning achievement of the twentieth century. The new balance that it established between state and market set the stage for an unprecedented period of social cohesion, stability and prosperity in the advanced economies that lasted until the mid-1970s.

This model became frayed from the 1980s on, and now appears to have broken down. The reason can be expressed in one word: globalization.

The postwar mixed economy was built for and operated at the level of nation-states, and required keeping the international economy at bay. The Bretton Woods-GATT regime entailed a “shallow” form of international economic integration that implied controls on international capital flows, which Keynes and his contemporaries had viewed as crucial for domestic economic management. Countries were required to undertake only limited trade liberalization, with plenty of exceptions for socially sensitive sectors (agriculture, textiles, services). This left them free to build their own versions of national capitalism, as long as they obeyed a few simple international rules.

The current crisis shows how far we have come from that model. Financial globalization, in particular, played havoc with the old rules. When Chinese-style capitalism met American-style capitalism, with few safety valves in place, it gave rise to an explosive mix. There were no protective mechanisms to prevent a global liquidity glut from developing, and then, in combination with US regulatory failings, from producing a spectacular housing boom and crash. Nor were there any international roadblocks to prevent the crisis from spreading from its epicentre.

The lesson is not that capitalism is dead. It is that we need to reinvent it for a new century in which the forces of economic globalization are much more powerful than before. Just as Smith’s minimal capitalism was transformed into Keynes’ mixed economy, we need to contemplate a transition from the national version of the mixed economy to its global counterpart.

This means imagining a better balance between markets and their supporting institutions at the global level. Sometimes, this will require extending institutions outward from nation states and strengthening global governance. At other times, it will mean preventing markets from expanding beyond the reach of institutions that must remain national. The right approach will differ across country groupings and among issue areas.

Designing the next capitalism will not be easy. But we do have history on our side: capitalism’s saving grace is that it is almost infinitely malleable.

Dani Rodrik is professor of political economy at Harvard University’s John F Kennedy School of Government.

The Financial Instability Plan

With good reason. It’s not just that the amount of money is troubling. The markets were also distressed by lack of detail, especially on how to take so-called toxic assets—loans with diminished and uncertain value—off banks’ books. Last fall the difficulties of pricing toxic assets caused the Bush administration to switch to infusions of fresh capital by purchasing banks’ preferred stock.

Charles Calomiris, business professor at Columbia University, told me that “the new Treasury approach is designed to take little risk, economically or politically, but to pretend that it is doing something. The market saw right through it.” Last month Calomiris laid out sound principles for a financial stability package, including the following:

Not all banks are the same, and not all should be saved. If a bank is in severe financial difficulty, the government shouldn’t try to prop it up with additional capital or enhanced asset insurance. Better-performing banks should be rewarded.

The government helps those who help themselves. A bank should only be permitted to participate in the bailout program if it can raise some capital on its own.

No dividend payouts. Banks receiving government help should not be allowed to pay dividends, because they deplete capital and prevent recapitalization.

So far Geithner and the administration do not appear to have consulted Professor Calomiris, much less Congress. Geithner and an assortment of government agencies instead have embarked on a journey to save the American economy all by themselves with no principles, no standards, and no details.

Last October, after much debate, Congress allocated $700 billion to the Troubled Asset Relief Program, after then-Treasury Secretary Paulson said, “The financial security of all Americans — their retirement savings, their home values, their ability to borrow for college, and the opportunities for more and higher-paying jobs — depends on our ability to restore our financial institutions to a sound footing.” But TARP, with roughly half the $700 billion disbursed, has not yet delivered on its promises.

Then, on February 10, it was déjà vu all over again, except to the tune of $2 trillion, as Geithner declared, “Our plan will help restart the flow of credit, clean up and strengthen our banks, and provide critical aid for homeowners and for small businesses.” He didn’t say how long it would take—because no one knows.

The Geithner plan is another version of TARP, but with more bells and whistles. Banks would undergo a “stress test,” an intensive audit, to measure their capabilities. A Public-Private Investment Fund would purchase troubled assets and provide additional funding to reach the $1 trillion level, although how private investment is to be mobilized was unclear. In addition, Treasury will use $100 billion to leverage up to $1 trillion in lending from the Federal Reserve.

The idea behind TARP was not new. Similar programs had successfully been put in place in the Asian banking crisis of the late 1990s. A government agency, a so-called “bad bank,” would buy the toxic assets, paying for them with fresh capital so that the banks could continue to function.

By definition, if the government is purchasing distressed assets it is paying more than the "market price," more than a private buyer would pay.

Geithner might be better off just admitting that these assets will have to be purchased by the Treasury at prices higher than market, and going before Congress and the American people to make his case. He could say up front that this will be expensive, but that this course of action will allow banks to clear underperforming assets off their balance sheet, thereby enabling banks to start lending again. In turn, with revived credit markets, the economy can grow.

Why, with the economy contracting and losing over half a million jobs a month, is the administration taking special pains over banks? This question is said to rankle Main Street.

The answer is that banks are essential to commerce. Businesses run in part on revolving credit—to carry inventories, to smooth out seasonal dips in revenue, to pay for construction, to finance consumer credit cards.

The implicit reason message from Geithner is: “Trust us, we know what we are doing.” Yet he repeatedly undermined that message by stating that all of this is uncharted territory and that mistakes would certainly be made. Neither the message nor the messenger reassures financial markets. Quite the opposite.

Tim Geithner Offers Paralysis, Not Solutions

After acknowledging that Americans had “lost faith” in an economic rescue plan that he was a principle architect of, Geithner added understatement in suggesting that there exists a great deal of “public distrust” when it comes to “taxpayer money being provided to the same institutions that helped cause the crisis.” But with successful political types nothing if not self-unaware, Geithner proceeded with a straight face to pitch a plan whereby $2 trillion more will be spent to prop up the same institutions that caused the crisis.

For the uninitiated, Geithner plans to put a bull's eye on the healthy banks in this country that will have to continue to compete with banks inneficiently backstopped by taxpayers. That Japan tried this and failed impressively doesn't seem to bother him one bit.

First up is what Geithner terms a “Public-Private Investment Fund” in which (try not to laugh) private investors will be asked to buy “toxic” assets alongside the federal government from the ailing banks. This is a variation of the ‘bad bank’ scenario, but it’s really no different.

The problems here are many, but assuming a natural bidding process, how is it that private investors with limited resources could outbid that which can tax unlimited funds from the productive sector while investing absent the pressure of achieving positive returns? Assuming the impossible, as in a natural market created unnaturally, what’s certain is that the very purchase of these down-and-out assets would immediately make the banks selling them insolvent.

Since the above isn’t in the cards, there will be a premium put on assets in order to reflate the banks. In that case, what we have is the ‘bad bank’ scenario all over again and the buyers will be the same hapless taxpayers who didn’t countenance TARP 1 to begin with. The “Private” in the Public-Private Investment Fund will merely be window-dressing meant to mask the banking industry’s swallowing by the federal government. A sector already in thrall to the government will be even more under its thumb, and bank loans will more and more be a right rather than a privilege for those possessing good credit.

Of course there will also be direct capital injections into banks with the $350 billion in TARP funds left over from the Bush administration. Simplified, the very cash injections that occurred in concert with a freefall in bank shares will be tried again. With politicians, past failure is rarely a deterrent when there’s money to spend.

What’s not been acknowledged is the simple truth that the minute any business, including a bank, takes federal money, it is effectively dead. That is so because with government investment never passive, once a company crosses this line, it is no longer in business for profit. Still, politicians love to spend money and they can at least say they’re “doing something” with money not theirs.

And if future Social Security recipients constitute the third rail of politics, homeowners have joined them on what is an increasingly crowded rail groaning under the weight of various sacred political cows. $50 billion will be spent to assist struggling homeowners with their mortgages, so while one part of Geithner’s plan seeks to address toxic mortgage assets, another will make them more toxic given market knowledge that contracts between borrower and lender will soon be rewritten.

Worse, with it uncertain as to which homeowners will benefit from the latest taxpayer-sponsored mulligan, it can be assumed that many homeowners will go non-current on their mortgage payments in the hope that they’ll luck into their own personal bailout. Much as the government has bailed out GM and Chrysler only to demand that they build cars no one wants, the Geithner plan seeks to address the toxic assets on bank balance sheets all the while making them even less desirable.

The Federal Reserve couldn’t be left out, and given its unique ability to increase its cash on hand with a click of a computer mouse, the Fed will buy up as much as $1 trillion in student loans, car loans and credit card debt. Translated, with many businesses struggling to access capital amid what some deem a credit crunch, the Fed will help push even more credit into the hands of already strapped borrowers such that access to capital for businesses with designs on growth will be even more of a distant object. Adam Smith must be spinning.

And perhaps looking to hedge his credibility with regard to a plan that would make even the greatest optimist incredulous, Geithner explained that amid its staggered implementation, “We will have to adapt it as conditions change” and “We will have to try things we’ve never tried before.” Unsurprisingly, stocks cascaded downward after his press conference. Indeed, not only will the Geithner plan not work, but it will also be ever changing; meaning the intrepid investors lying in wait to start buying once the government stops distorting now have another variable to price called uncertainty.

Going back to the fall, a purely conjectural concept termed “systemic risk” was trotted out with great frequency to justify the bank bailouts. Looked at in the present, could systemic risk have possibly been worse than the emasculation of our banking system that continues unabated?

It would be hard to imagine an affirmative answer to the above. Instead, we have to conclude that an historical mistake was made in which supposedly free-market adherents gave up what they incorrectly deemed a little bit of market freedom in return for the false and oxymoronic God of government security. John Stuart Mill said paralysis is the certain result when governments offer cheap sustenance, and economic paralysis is what Geithner is delivering.

February 14, 2009

Japan's 'Lost Decade' Argues Against Obama's Policies

Japan’s problem in the 1990s was a deflationary recession – the worst such in modern history – caused by a hyper-strong currency and tax increases.

The trouble began in the mid 1980s when the yen began a sustained rise, climbing against the dollar from ¥240/dollar to ¥120/dollar by the late 1980s and rising to ¥60,000/oz. of gold, according to Nathan Lewis’s book, “Gold: The Once and Future Money.”

Asset prices, especially land, rose during the late 1980s due to tax cuts, falling interest rates, and a demographic shift that drove up urban real estate prices. Faced with rising asset prices, in the early 1990s the Bank of Japan (BOJ) – oblivious to the deflationary gold signal – made a disastrous misdiagnosis, assuming there was an asset bubble that needed popping.

The BOJ decided to strengthen the yen further via tight money, a policy applauded by the U.S. Treasury which believed a stronger yen would improve the U.S. trade deficit. The BOJ pushed the yen higher – reaching an eye-popping ¥80/dollar, or ¥32,000/oz. of gold in 1995, essentially doubling the yen’s value in five years.

This monetary deflation was compounded by a series of tax hikes meant to reduce asset values. This policy mix, a reversal of the classical sound money/low tax policies that made Japan an economic miracle, hammered the economy into deep recession.

During this period, the Japanese government engaged in numerous, mammoth infrastructure spending projects, meant to increase “aggregate demand.” The result was a nation of bridges to nowhere and empty superhighways, as The New York Times reported recently. A telling quote: “Economists tend to divide into two camps on the question of Japan’s infrastructure spending: those, many of them Americans like [Treasury Secretary Tim] Geithner, who think it did not go far enough; and those, many of them Japanese, who think it was a colossal waste.” That is, citizens who actually lived through it think the spending was ineffective, but outside theorists like Geithner know better. Meanwhile, the ‘90s stimuli quadrupled Japan’s national debt, driving it to more than 180 percent of GDP.

Stateside, the current $820 billion spending package – on top of the $1 trillion existing national debt, plus the billions combined from what has been spent from the TARP, last year’s stimulus, and Geithner’s just-unveiled financial plan – will push U.S. debt in a similar direction.

As for Japan, it remained in deflation until the BOJ abandoned its interest rate target – then set at zero – and went to “quantitative easing,” meaning directly increasing the monetary base. The deflation ended in 2001 and, aided by tax cuts, Japan’s economy revived.

The United States’ situation today is quite different. The greenback has steadily weakened for 8 years, plunging from around $250/oz. of gold in 2001 to about $900/oz. today. (The average gold price across the 1980s and ‘90s was $350/oz.) Today’s gold price indicates substantial dollar inflation is baked into the cake, though traditional indicators can take six years to register it.

Some analysts, including Steve Forbes, see the dollar’s fall as the impetus for capital sloshing into hard assets in recent years, causing massive over-investment in real estate, and price shocks in commodities such as oil and agriculture, which slowed economic growth. Combined with a substantial decline in international trade caused by see-sawing currencies, recession has taken hold and financial markets have ground to a halt.

Though today the U.S. faces a weak rather than a strong currency, the right policy mix should be similar to Japan’s eventual solution: a renewed commitment to sound currency followed by reduced tax rates, especially on capital. Massive spending will do little to stimulate, and may actually impede recovery.

February 17, 2009

We Already Live In a Protectionist World

Which is all very well -- except that there are many ways to pursue protectionist policies, and rest assured that every single one of them is being tried by someone, somewhere, right now. New tariffs are already in force, for example in Russia, where especially high ones have destroyed the previously thriving used-car import business (and thus inspired used-car salesmen to stage unusually violent protests). Rumors of more tariffs pending -- in Brazil, in the Philippines -- are haunting the steel industry trade press, too. Still, these are minor infractions. The real story, over the next several years, will be the spread of more carefully camouflaged protectionism: measures, some legal, some not, designed to help one nation's workers or companies at the expense of those next door.

These kinds of games are already being played stealthily in Europe, where, despite pious recitations by G-7 finance ministers -- and despite the free-trade rules that are supposed to be enforced by the European Union -- almost everyone is seeking to protect domestic industry. The French have not only thrown heavy subsidies at their automobile industry, they have made it crystal clear that the money is to be spent in France. "If we are to give financial assistance to the auto industry, we don't want to see another factory being moved to the Czech Republic," declared President Nicolas Sarkozy, failing to note that the Czechs and the French theoretically belong to the same free-trade zone, with open borders. Meanwhile, the Slovaks, who live in the same free-trade zone, have declared that if the French try anything funny with Slovakia, they're going to send Gaz de France packing.

The Germans, whose economy depends heavily on exports, often object to all of this -- but they are quietly playing a subtler game, offering special loans to German companies, for example, through German banks which the German government now partly owns. The Spanish have also joined in, with subsidies for Spanish companies, as have the Swedes. Both, like the United States, started with the automobile industry -- but if cars, why not other industries, too? Some British banks, meanwhile, have quietly told their employees not to invest abroad.

Whatever the finance ministers might say, all of these measures are, of course, extremely popular, and political parties of all stripes have capitalized on them wherever possible. The U.S. Congress put its nonsensical "Buy American . . . as long as no trade laws are broken" clause into the stimulus bill, thus guaranteeing that every infrastructure investment will be accompanied by a flood of extra paperwork. A Spanish minister has called on his nation to "Buy Spanish." In England the most popular strike slogan is "British jobs for British workers." Expect more than one political leader, on more than one continent, to rise to power in the next few years riding a wave of protectionist sentiment.

But this should surprise no one; after all, Smoot-Hawley was popular, too. At the time of its passage, more than 1,000 economists of all ideologies signed a petition against it. Since then, historians have reckoned that it reinforced the global slump: Between 1929 and 1934, world trade declined by 66 percent. Still, the politicians of the 1930s knew which way the popular winds were blowing -- and those of the present know, too. There is no need to hold any further G-7 meetings to warn against the perils of a protectionist world: We're living in one already.

Why a Commerce Job Goes Unfilled

That's a shame, because a stimulus promises to create 3 million jobs at best, and currently 11.6 million people don't have work. Only the private sector can pick up the slack.

At least a dozen candidates turned the prestigious commerce secretary's post down before President Obama came up with Gregg, after assuring him that the Democratic governor in his home state would appoint a Republican to take his seat. Obama even joked about the difficulty of "finding a commerce secretary" to the media.

But the real reason why Gregg pulled out is probably that he found there isn't any real place for commerce in the new administration. With President Obama saying things like "only government" can save the economy, Gregg learned quickly he was unlikely to have any power or influence on behalf of the private sector.

The decision to remove the 2010 Census from the Commerce Department and give it to White House political operatives was a strong vote of no confidence in Gregg.

It wasn't the only signal. On the day Gregg quit, White House Press Secretary Robert Gibbs declared the Colombia free-trade agreement was dead, too. "I think the concerns that (President Obama) and others have are still valid around that trade agreement," Semana, a Colombian publication, quoted Gibbs as saying.

With the Census gone before he'd even started, and no new export markets to bring to U.S. firms as commerce chief, it's a fair bet that anything Gregg did was likely to be ignored in Obama's administration.

That's why the Obama administration needs to rethink its exclusive focus on government spending as the basis for its administration, and start making the private sector a focus instead.

The current approach has been to use business and bipartisan Republicans like Gregg as window dressing. But no one's fooled.

The chief executive officer of Caterpillar, for one, wasn't.

On the day Gregg made his surprise exit, President Obama made a showy appearance at Caterpillar's big plant in East Peoria, Ill., telling embattled workers who'd just endured 22,000 layoffs a week earlier that the chief executive would hire back some with the passage of Congress' $787 billion stimulus package.

Asked about it later by ABC News, Caterpillar CEO Jim Owens denied Obama's claim. "The truth is we're going to have more layoffs before we start hiring again," Owens said. "It is going to take some time before that stimulus bill" means rehiring.

That's because the stimulus isn't what the administration and Congress say it is. A look at what Caterpillar and others like it really want is precisely what is being run roughshod over by special interests in the White House right now.

Caterpillar is vocal about wanting Colombia free trade which would give it another market to sell in during a downturn. It also wants the "Buy American" provisions in the stimulus bill gone, because they could destroy Caterpillar's years of market-building overseas as foreign retaliatory measures kick in.

Caterpillar, like many American companies, exports much of its giant machinery overseas, 63% in Cat's case. The U.S. in 2008 exported $1.84 trillion in goods and services, more than any other country, so any trade war shutting overseas markets will hit us hard.

But Congress paid little heed to that in its $787 billion stimulus bill passed Friday. Sure, it paid lip service to not letting "Buy American" violate existing international treaties. But it still left the measures in, leaving the potential loss of gigantic markets where there are no relevant treaties, real. Among these are China, which needs $200 billion in infrastructure spending through 2030, according to a CG/LA Infrastructure study.

If it retaliates, "Buy American" may turn into "Bye, American."

And that's just one market. In reality, access to the $996 billion global infrastructure market will disappear in a trade war, all in exchange for access to $43 billion in federal stimulus spending on infrastructure — not a good swap. No wonder Caterpillar's chief couldn't tell reporters he'd be back to hiring with the passage of the stimulus.

Gregg made a principled move in leaving because he couldn't be effective. In reality, no one can. Private businesses are critical to economic recovery, but Congress and the administration are focused on government solutions.

Tax cuts, open markets and favorable investment conditions are getting the short shrift. Obama should realize now that a friendlier business climate is as badly needed as a new commerce secretary.

Mean Reversion May Be Longer Than Your Life

We believe that investors should focus on an absolute return instead of a relative return. We know we are attacking the long-held industry foundations of buy and hold, historical asset class returns and relative results. Some may even criticize that switching now from a relative return to an absolute return strategy may look like a case of putting your money where it should have been. Such a switch now would only be a mistake if we were returning to a period of stock market friendly policies that produced immediate high returns on risk capital.

On the contrary, the mood of the country and government has turned hostile towards wealth. The focus has shifted to spreading the current wealth around rather than producing more of it. Perhaps the year '08 compared to '80 is not merely the numerical opposite but the policy opposite. If we are in a period of sustained hostility to capital, it is important to break out of our automatic assumptions, biases and prejudices about investing.

We must start from the basis of preserving and protecting capital. That means starting with an assumption of fully investing in risk free assets rather than more risky assets like equities. Markets are not living things. They do not know they are oversold, undervalued or making a triple bottom reverse head and shoulders pattern. Instead, market prices are footprints of government policy. If we are not satisfied with merely “hoping” that markets bounce back, then we must construct an investing framework to both preserve and grow capital based on policy. This is where investing with an absolute return framework across multiple asset classes, not just equities, can produce superior results. It not only changes the way investors construct portfolios, but it fundamentally changes one’s thinking and orientation to the world. It changes the observer you are.

What is wrong with relative results?

Constructing portfolios and measuring performance in a relative results game is dangerous. It forces managers to “play” to lose less than their benchmark. In a year like 2008, a manager who loses “merely” a third of your money is a hero for beating the S&P benchmark by 400 basis points. In fact, managers who beat relative benchmarks by as little as 200 basis points a year become investment gurus. According to Morningstar figures, any diversified equity mutual fund that lost a “mere” 27% in 2008 ranked in the top 5% of all funds. Even with the benchmark suffering as it did, more than 60% of all funds did worse than the S&P 500. This whole idea of relative performance and playing to “lose less” is a fool’s game. In the end, no manager should ever be praised for losing a third of his client’s money. So then, how do we think about and measure an investment strategy?

An absolute return strategy

In a relative game, the default way of investing is to be fully invested in the benchmark. Managers depart from that fully invested posture at their own peril, running the risk of being “different” from the market. A relative game measures how well the manager does, but investors really should measure and reward their managers for how well the money does. To do this, investors should change their focus to an absolute return. In an absolute game the default is 100% invested in some positive, risk free rate of return as opposed to being 100% invested in the risky market benchmark. Since anyone can earn the risk free rate, or Treasury bill yield, that becomes the minimum hurdle rate any capital must earn. An investment in Treasuries would have no years of decline, have no default risk, provide instant liquidity, be subject to taxation, and be eroded by inflation.

Taking the T-bill return as the minimum, let’s examine how one’s money would have done returning the T-bill rate plus 100 and 200 basis points. The results are most surprising. As you see in the attached chart, except in those rare and wonderful decades when great policy collides with low market valuations (1980’s), T-bills plus 100-200 basis points does very well. In the 1980’s, a period of “as good as it gets" pro-growth policies for stocks, an investment in the S&P 500 returned 404% (17.5% annualized) while an investment in T-bills returned 133% (8.8% annualized). A manager who earned T-bills plus 2, and this is very hard to do, returned 179% (10.8% annualized).

So even if you failed to invest in the S&P during one of the best decades ever for stocks, you would have still more than doubled your money with a T-Bill return. Now let’s look at a period of bad policy and down markets, opposite the 1980’s. From 2000 to 2008 an investment in the S&P lost 31.5% (-4.1% annualized). An investment in T-bills returned 30% (3% annualized), and an investment in T-bills plus 2 returned 54.6% (5% annualized). Combining these two periods into a sample set of a great policy period and a bad policy period, the results are shocking. An investment made in the S&P 500 returned 245% (6.7% annualized) while an investment in T-bills plus 2 returned 331% (8% annualized).

How do we construct an absolute portfolio?

An absolute portfolio begins fully invested in Treasury bills as the default, rather than being fully invested in the S&P 500 as the default. From there, our investment process considers five other asset classes for investment: U.S. Equities, Fixed Income, Foreign Equities, Real Estate and Commodities. These asset classes compete to pull investment capital away from risk free Treasuries. Our process implements a top down, macro view focusing on government policy and economics to continually assess where investment capital will be treated best.

In normal times these asset classes will be somewhat uncorrelated and provide a high level of diversification. However, in a collapse year like 2008 the correlations will rise as wealth flees all asset classes. In those times, a rigid sell discipline is essential to force capital into T-bills and out of risky asset classes. Rigorously making assessments in each of the five asset classes broadens both our thinking and our sources of future return.

What is the right benchmark for an absolute return strategy?

When constructing a benchmark, there are two important areas of assessment: 1. How has your manager done? 2. How has your money done? These two are always in conflict. Managers are paid to beat the benchmark, which is not the same as dong well with the client’s money. Beating a relative benchmark is not good enough when you lose money on an absolute basis. Therefore, investors must change both the strategy and the benchmark. We think investors should use an absolute benchmark of T-bills plus 100-200 basis points.

One may think this is an easy benchmark to beat, but history would suggest otherwise. Importantly, it avoids the safe, almost cowardly, posture of hiding behind a relative number. Fundamentally, it means that if we lose money we cannot “blame” the market and smugly report that we “lost less.” We believe it is crucial to depart from this industry practice of hiding behind relative results. In doing so, we will achieve lower volatility while still producing strong returns.

Investors with a 50 -100 year time horizon may have long enough to wait for asset class returns to normalize around their historical averages. However, “mere mortals” with retirement looming should only focus on an absolute return for their capital. Although the market has returned 8% per year on average, there are rarely average years or average decades. Prosperity and equity friendly policies cluster. Returns may be mean reverting, but they are not random. Importantly, the time for mean reversion may be much longer than the rest of your life.

The market does not know it is seriously undervalued or that it fell 50% in the last fourteen months. It is not a living thing nor does it know that it “owes” you a double on your investment capital. The market is simply a mechanism that prices future cash flows, and those cash flows are dominated by government policy. Do not fight the effects of government policy. Assess those effects across multiple asset classes instead of just using the S&P 500. Invest capital in those asset classes that are helped by government policies. Concentrate on absolute, not relative, returns. In the end, an absolute return strategy reminds us not to lose money, and that must be the first priority of any wealth building strategy.

Will Compensation Controls Move Wall Street Overseas?

What’s scary is that with the federal government now more than a rent-seeking partner in our financial future, it’s easy to imagine how our Washington minders might seek to impose compensation controls on financial firms already weakened by TARP as though they “benefited” from it, but who wisely chose to refuse funds. Indeed, given the growing consensus among the chattering class that Wall Street compensation practices somehow led to the financial meltdown, what’s to keep Washington from changing compensation for all finance firms as a pre-emptive move with the taxpayer in mind? For the skeptics out there, how many predicted even a year ago that two major investment banks would vanish, followed by a $700B (and counting) bailout?

The problem for taxpayers is that since they’re now partners of sorts with Wall Street, it’s hard to imagine how their unwitting investment in same could aid their cause. Indeed, the value of Goldman Sachs, Morgan Stanley, Citi and others has very little to do with plant and equipment, and everything to do with the people who show up for work each day. Legendary investor Gordon Crawford once said he bet on employees riding up the elevator, and with Congress seeking to impose compensation limits, will future Wall Street employees be worth betting on?

The new rules become ever more obtuse when we consider those who benefited from an $18 billion dollar bonus pool in 2008. As anyone who has ever worked on Wall Street knows well, the employees that lose money are most often terminated quicker than the time it took to read this sentence. The remaining employees who benefited (remember, Morgan Stanley’s John Mack and Goldman’s Lloyd Blankfein did not take bonuses in ’08) were likely the ones who were actually profitable for the firm, but who saw their profits erased thanks to the mistakes of others.

For the federal government and an electorate seemingly out for blood to decry the process whereby a firm’s best and brightest are compensated at levels 40 percent below the previous year is the equivalent of cutting the pay of every New York Giant because Plaxico Burress shot himself and ruined the team’s Super Bowl chances. In truth, the remaining Wall Street employees were kept around most likely because they did not lose money for their respective firms.

Also lost in the Wall Street witch hunt is an issue that was very prominent in the minds of Republicans and Democrats not long ago. Specifically, in a Wall Street Journal op-ed from November of 2006, Senator Chuck Schumer (D- New York) and New York City Mayor Michael Bloomberg decried the fact that “In 2005 only one out of the top 24 IPOs was registered in the U.S., and four were registered in London.”

While Bloomberg and Schumer acknowledged that the happy process of globalization was a factor (they neglected, however, the falling dollar’s role in making investment in entrepreneurs less attractive) in the internationalization of public offerings, they added that unwieldy regulations and the difficulties that came with Sarbanes-Oxley’s passage in 2002 had made going public in the U.S. less appealing. In particular, they cited “auditing expenses for companies doing business in the U.S.[that] have grown far beyond anything Congress had anticipated”, along with “a worrisome trend of corporate leaders focusing inordinate time on compliance minutiae rather than innovative strategies for growth, for fear of facing personal financial penalties from overzealous regulators.”

Where finance is considered, the simple reality is that dollars are fungible, and just as a dollar is a dollar everywhere in the world, so is finance simply finance. Assuming creative accounting can’t help Wall Street firms get around the federal government’s latest attempt to curb pay, finance as we know it won’t disappear, but we shouldn’t be surprised if some of Wall Street moves to London, Shanghai and Tokyo in order to avoid excessive regulation in the United States. Such is the good and bad of globalization.

So while it’s hard to feel too sorry for certain financial firms that eagerly accepted federal aid, it’s not a reach to assume that the federal government will compound already evident weakness in the financial sector with rules certain to drive good financiers elsewhere, or finance overseas altogether. At this point all we can hope for is that having seen the horror that comes with federal largess up close, that financial firms with an eye on the future will follow the lead of Goldman Sachs and seek to pay every cent back to federal government in order to free themselves of rules that don’t reward enterprise, and that foretell their certain emasculation.

February 18, 2009

The SEC Killed Wall Street On April 28, 2004

While regulatory frameworks often take decades to build, in this unusual case, one particular afternoon, on April 28, 2004, drastically changed the equation. The Securities and Exchange Commission agreed to allow the five major American investment banks to compute their capital adequacy requirements according to a revised methodology, hugely increasing their leverage In consequence, those five giants no longer exist in their former incarnations.

On that fateful day, the five SEC commissioners met for just under an hour at the SEC headquarters in F Street in Washington D.C. The Commission, one of the constellation of agencies that oversees the American financial industry, was established in 1933, to restore confidence in shattered financial markets. It now oversees securities firms, brokers, investment advisors and rating agencies. At the April 2004 meeting, the commissioners considered several proposals, including one to consolidate the supervision of broker dealers (who trade securities both for their own and their clients;’ accounts) along with that of their holding companies.

The broker dealers – Bear Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley and Lehman Brothers – were all keen to see their holding companies monitored by the SEC under a new Consolidated Supervised Entities (CSE) program. Their alternative would have been to submit to European regulation, because the EU had adopted a Financial Conglomerates Directive in 2002, which affected the Americans, who all had operations in London. The EU, would accept as another option equivalent foreign regulation. Yet since no other agency was regulating the American holding companies in 2004, that left a gap. Both sides needed one another: the SEC wanted to extend its purview, while the broker dealers required a new foster parent.

“The SEC thought that, with the added oversight of the holding companies, it could offer more effective protection,” says Lee Pickard, an attorney at Pickard and Djinis in Washington. “Yet it didn’t get enough for that oversight, and in return it gave up tremendous restraints.” As part of the deal, the broker dealers would enjoy a much more relaxed framework for maintaining their capital cushions. With looser capital requirements, they could reallocate those resources and use the leverage to generate additional profits.

During the 55-minute 2004 meeting, the commissioners questioned the SEC staff. They were concerned to be sure the agency had the requisite resources to monitor the holding companies under a new regime, and were assured that the SEC had access to the “best minds” and quantitative skills. An early warning system would also be imposed, whereby the participants must alert the Commission if capital limits were ever breached. Besides, the voluntary program would only be open to the largest institutions, commanding at least $5 billion in net capital. Those comments provoked a short discussion over the fairness of precluding smaller firms from joining the program. After a few collegiate chuckles, and a round of congratulations on everybody’s work, the Commission voted unanimously and the proposals passed.

As the theoretical quid pro quo, the former Net Capital Rule, devised in 1975, was replaced. How had it worked before, during the previous 29 years? Pickard, who was one of the original architects of that rule, recalls that banks rarely exceeded gross leverage over about 6% on his own watch at the SEC in the late 1970’s. In the following decades, leverage generally ranged around 12%, comfortably beneath the rule’s 15% ceiling. Under the old rule, broker dealers took precise, arithmetic charges, or “haircuts”, deducted from their net worth. For example, long government treasuries only lost 6%, while riskier equities lost 15%, and illiquid assets were 100% reduced.

After the 2004 revision, brokers were no longer constrained by any gross leverage limit. Instead, they could evaluate their assets according to their own internal models, in keeping with the principles of the Basel II accord, considered the cutting edge model for bank regulation. The danger lay in the nature of assets they held. “If they had mainly been invested in government securities, even 30 times leverage would not have been so risky,” says George Simon, an attorney at Foley & Lardner, who worked at the SEC from 1976 to 1981. “But the leverage became fatal, with small haircuts for particular securities, and with the risk of default inadequately addressed. As it turned out, triple A-rated received smaller haircuts than they deserved.”

Miscalculations were compounded, as banks gained a free hand to assess their own risk positions based on internal value-at-risk models. Now the fox was loose in the henhouse. The revised framework, which embraced the more “modern” principles of Basel II, both lowered the haircut percentages and allowed extra offsets for cross margining. Guy Erb of LECG pinpoints the internal portfolio modeling as the “common element,” with reliance on Basel II as a significant cause of the malfunctions.

Patrick Daugherty, a fellow partner at Foley & Lardner, and chief strategy partner at the firm’s business law development department, criticizes the weaknesses of the banks’ proprietary mathematical systems. For example, he points out, it may be harder to assess the market risk than the credit risk for distressed debt securities. “When many tranches of asset backed securities and whole mortgage loans are so thin, it’s difficult to gage the market risk. Since you don’t take 100% for illiquidity any more, you are allowed to place a value greater than zero, and the writedown may not be severe enough.”

Once more, we return to the climber who is scaling the building without the safety net. To what extent did the added leverage directly lead to the end of the five giant banks? Bear Stearns sold its decimated stock to JP Morgan in March, on September 15, Lehman Brothers filed for bankruptcy and Merrill Lynch sold itself to Bank of America, and on September 22 Goldman Sachs and Morgan Stanley converted themselves into commercial banks. “I’d call it res ipsa loquitur – in other words the thing speaks for itself,” Ritholtz comments. “It’s no coincidence that since the SEC created the exemption, all five are now gone.”

It is well understood that banking by its nature is a confidence game. The entire business of lending depends on ensuring that borrowers believe in both words and assets. Any business that is predicated on confidence must be certain nothing threatens that trust – such as levering up to over 30 times.

In a letter on March 20, 2008, SEC Chairman Cox wrote to Dr. Nout Wellink, Chairman of the Basel Committee on Banking Supervision, “…the fate of Bear Stearns was a result of a lack of confidence, not a lack of capital.” Consider, however, that a run on the bank would not have occurred if investors did not perceive the firm to be weak.

Banks finance themselves short term in the repo markets. When a bank’s capital comes under siege, lenders’ confidence declines fast. What happened in 2008 was that the investment banks lost their funding when the repos could no longer be rolled. Says Daugherty, “market downturns can quickly destabilize an institution with thirty to one leverage, and which relies on short term funding.”

Firms can fail fast, and it is not so easy to rebuild them by recapitalizing under extremely stressful scenarios. Last autumn, once-plentiful capital suddenly became scarce as credit conditions worsened across the world. Even sovereign wealth funds, formerly hungry to invest, drew in their horns. “Now it was harder to get the needed recapitalization, since so many entities were in the same spot,” says Erb.

There is ample blame to go around for the failed CSE program. Already, many salvos have been leveled at Christopher Cox, who in 2005 succeeded William Donaldson as SEC Chairman. Although the 2004 ruling was not during Cox’s tenure, critics have emphasized his pro-business, conservative leanings, and lambasted him for the insufficient oversight during the course of the program.

Cox himself admitted on September 26, 2008, that the CSE experiment had been “an utter failure”, as the SEC ended the program. Meanwhile, the remaining investment banks were flailing. The Chairman attributed the breakdown to the voluntary aspect of the arrangement, whereby the banks could opt in and out of supervision at will. He said, “The fact that the investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.” In ending the program, Cox was plainly stating that self regulation had fallen far short. “He was implicitly saying that the oversight of the regulators had failed,” says Daugherty.

Only two months earlier, in July, Cox had sounded considerably more positive and confident when he testified at a hearing of the House Committee on Financial Services. He acknowledged the importance of the “regular interaction of Commission staff with senior managers in the firms’ own control functions, including risk management, treasury, financial controllers and the internal auditor…” A month before that, Erik Sirri, director of Trading and Markets at the SEC, had outlined various steps the agency was taking in the wake of the Bear Stearns collapse, such as strengthened liquidity requirements and additional stress testing..

Despite such intentions, the SEC lacked the resources to perform the required surveillance. “That was a serious misjudgment. They had one small unit, whereas the banks had thousands of people on the other side,” Pickard says. The SEC allotted a mere three staffers to each CSE, hardly enough for the keen monitoring the Basel II framework would contemplate.

A glance back in history indicates that the SEC was not well prepared to oversee the banks’ entire investment portfolios. After Drexel Burnham Lambert – once the fifth largest American investment bank – filed for bankruptcy in 1990, Congress adopted risk assessment rules that permitted the SEC to look at the finances of broker dealers’ parent companies and material associated persons. Those rules required that parents and affiliates file limited financial statements. “And what did the SEC then do?” Simon asks. “It filed those statements carefully in a big file cabinet and did – absolutely nothing! If you are looking for signs that the SEC was not equipped to deal with comprehensive oversight, that should have been the first red flag.”

The reports were not even being filed in a timely manner. Since 2005, the SEC had established an electronic filing system, but as of August 2008, only 20 out of 146 firms were actually using it. The remainder still relied on old fashioned paper documents.
Paper was in theory becoming a relic of the past, but the financial industry looked to a future based on the rationality and objectivity of mathematical models. Even if investors did not trust, say, Bear Stearns, they still devoutly trusted Bear’s models. With the same fervor, the creed took hold that it would be in the interest of major firms to police themselves.

While the SEC cannot abjure responsibility, the entire CSE episode must be observed in the light of the laissez faire culture that held sway for decades in all developed financial markets. To put the free market ideology in context, after World War II both government involvement and bureaucracy galloped apace. It became increasingly complex, expensive and time consuming for businesses to maintain full regulatory compliance. That onus led to a legitimate move to reduce some of the burden of red tape. “The pendulum seems to have swung too far,” argues Ritholtz. There are good reasons for not allowing 5-year olds to cross the street alone. A couple may be run over, and Darwin suggests the rest may learn the hard way to manage. Perhaps free marketers left out the drastic part of the calculus, as the broker dealers got crushed.

Since Reagan’s presidency in the 1980’s, an almost theological faith in free market solutions developed, with the conviction that the government should refrain from intervention. Many still espouse it, despite last year’s upheavals. “We can only imagine there must be high levels of cognitive dissonance among libertarians right now,” Daugherty notes dryly.

Alan Greenspan, maestro among libertarians, had the grace to take some responsibility for an exuberant reliance on self-policing. Last October, he testified that he had “found a flaw in the model that I perceived is the critical functioning structure that defines how the world works.” Scott Mosley, owner of Mosley, an independent investment firm in Austin, Texas, sums up the mea culpa: “Couldn’t Greenspan just have said, ‘I was wrong’?” Mosley reinforces the theme that the underlying concept, which ran through decades, was to pare back the regulatory agencies until they were “basically neutered”, so they could not interfere with the market’s workings.

As a new administration rolls up its sleeves in Washington, it may inherit a rare opportunity, a blank check to rewrite regulation on a grand scale. The debate will be intense. Should the regulators be more robust? Should the SEC and other agencies be aggregated into a single structure? Where is the dividing line between regulation and oversight? Mosley believes that simply adding more rules may not be the answer, “but oversight and enforcement go a long way to preventing excesses.” He also suggests that regulators could benefit from “sitting side by side with traders and risk management experts.”

The quagmire will continue to bedevil the financial industry until the SEC revises its entire approach to risk. “The statute does need to be revised, but the agency also needs to take a different view of itself,” says Simon. In its entire history, the agency has never effectively enforced its mandate and ability to manage the risks of large firms with unregulated affiliates. At this juncture, financial institutions still have access to plenty of unregulated entities, where they can place securities and other instruments off balance sheet, which creates systemic risk. That potential for damage remains unaddressed. Simon warns that the problem will not go away, “until the SEC starts to look at firms on a more global basis.”

Feds Re-Impose Loan Standards They Helped Undermine

The movement to water down underwriting standards grew out of claims of some housing advocates and elected officials that mortgage lenders were ‘redlining,’ or avoiding, certain urban neighborhoods, and that these credit-starved areas were decaying from a lack of capital. When bankers countered that they received few credit-worthy applications based on their traditional underwriting criteria in many of these neighborhoods, regulators and housing advocates began to argue that there must be something wrong with the lending criteria, which needed to change.

One group that led the way was the Association of Community Organizations for Reform Now, or ACORN, which began protesting bank mergers and expansion requests in the mid-1980s under the Community Reinvestment Act. In 1986, ACORN threatened to oppose an acquisition by a Southern bank, Louisiana Bancshares, until the financial institution agreed to new “flexible credit and underwriting standards” for low-income borrowers, including agreeing to take into account on mortgage applications such income as public assistance and food stamps. ACORN also led a coalition of community groups that demanded industry-wide changes in lending standards for urban residents, including watering down minimum down-payment requirements. The community groups also attacked Fannie Mae as part of the problem with bank lending in certain areas because the giant, quasi government agency’s underwriters were “strictly by-the-book interpreters” of standards who turned down purchases of unconventional loans, which sent a message to banks that these loans were unsafe.

Under pressure from Washington, Fannie Mae and Freddie Mac agreed to begin purchasing mortgages under new, looser guidelines. Freddie Mac, for instance, made 28 changes to its underwriting standards, including approving low-income buyers without credit histories or with bad credit as long as they were current on rent and utilities payments--even though research had concluded that such buyers are more likely to default. Freddie Mac also said it would count income from seasonal jobs and public assistance toward income minimums, although such income (particularly seasonal work) was by definition not steady.

The giant agencies began several experimental lending programs based on watered-down standards. Freddie Mac began a program with Sears Mortgage Corporation to make mortgages to borrowers with an income-to-monthly payment ratio of 50 percent, at a time when most private mortgage companies aimed for a 28-to-33 percent ratio. The program also allowed borrowers with bad credit to win mortgage approval if they took credit counseling classes administered by local nonprofits like ACORN, although research would show that credit counseling classes have little impact on default rates.

These efforts gained the endorsement of some of our most authoritative federal institutions. Shortly after producing a controversial study in 1992 which asserted there was some evidence that lenders were intentionally avoiding minority neighborhoods, the Federal Reserve Bank of Boston produced a “guide” to equal opportunity lending in which it told mortgage makers that conventional underwriting standards were “unintentionally biased” because they didn’t take into account “the economic culture of urban, lower-income and nontraditional customers.” Among other things, the Boston Fed told lenders they should consider junking the industry's traditional “obligation ratios,” including the 28 percent income-to-payments ratio. The Fed noted in its guide that the “secondary market,” that is, those that purchased mortgages from banks, was willing to buy loans with higher ratios, thereby implying that others thought these loans a good bet, too. But at this point the secondary market for such loans consisted of Fannie Mae and Freddie Mac, which had both been cajoled into buying them by Washington.

Under pressure, these institutions accepted these new standards even though there were plenty of early warning signs as well as several decades worth of research which suggested that when banks departed too far from traditional underwriting criteria delinquencies and foreclosures rose sharply. For instance, a minority loan program put together by banks in Atlanta after a newspaper series accused local financial institutions of redlining quickly ran into predictable trouble. The program allowed loans with payments that were up to 50 percent of an applicant’s monthly income, and within a year, 10 percent of the loans were delinquent. Even worse, those who took out the loans fell deeper into other kinds of debt, defaulted on credit card payments and had goods they’d purchased on credit repossessed.

Meanwhile, a Freddie Mac program called Affordable Gold, which purchased loans from banks under looser underwriting standards, including loans which allowed a borrower to make a down payment with funds contributed from a third party like a government assistance program or a nonprofit, showed sharply higher default rates, up to four times higher than traditional underwriting standards.

Despite such evidence, over time these programs moved from the experimental stage to a large part of the marketplace because politicians in both parties made expanding the number of home owners in America a high priority, and the only way to keep doing that was to lend to people with increasingly riskier credit. Fannie Mae announced a $1 trillion commitment to purchase affordable housing loans in 1992, then in 1999 under pressure from the Clinton administration announced a new program to buy loans made to “borrowers with slightly impaired credit.” In 2005 Fannie Mae and Freddie Mac committed to another $1 trillion in affordable housing lending.

And as their loan pools grew, their credit standards deteriorated. In a recent Forbes article Peter Wallison of the American Enterprise Institute and Edward Pinto, former chief credit officer of Fannie Mae, point out that by 2001, 18 percent of Fannie Mae’s portfolio consisted of loans to people with credit scores below 680—the traditional definition of a loan to someone with riskier credit, who is also someone more likely to default.

Of course, with two huge federal agencies willing to purchase such loans, mortgage makers couldn’t churn them out fast enough, and private investors also began snapping up the loans in competition with Fannie and Freddie. Prof. Stan Liebowitz of the University of Texas uncovered a 1998 sales pitches by Bear Stearns, the leading private packager of mortgage-backed securities, in which a managing director of the firm assures banks in language remarkably similar to that used by government regulators that these loans were safer than traditionally thought and that investors were ready to buy them, if only banks would make more of them. “Do we automatically exclude or severely discount …loans with [poor credit scores]? Absolutely not,” the eager investment banker tells his audience. Bear Stearns, of course, was eventually sunk by such loans.

Today, housing advocates and ex-government regulators say federal programs were not the problem because many of the worst loans portfolios were created by non-bank lenders which are not even subject to the Community Reinvestment Act. But that’s an argument that ignores the much broader role that government played in watering down standards, including using pressure to force players across the industry to participate.

The Department of Housing and Urban Development under President Clinton, for instance, threatened to introduce legislation to make non-bank lenders, that is, mortgage finance companies, subject to CRA if these firms didn’t sign on to affordable lending goals. HUD even crafted an agreement with the Mortgage Bankers Association, the industry trade group, which pledged that the group’s members would aid in affordable housing goals. One of the first members of the MBA to take up the pledge was Countrywide, which pledged to introduce low-down payment loans with high income-to-payment ratios for low-income borrowers. Countrywide and its co-founder, Angelo Mozilo, ultimately became infamous as one of the first major mortgage lenders to melt down under the weight of its bad lending, but before it was notorious Countrywide was celebrated for its low-income efforts.

Today, the Obama administration acknowledges through its bailout program that those standards were unsafe. It’s a backhanded acknowledgement that comes only because bailout efforts up until now have largely failed except in cases where borrowers are given new mortgages written to reflect former underwriting standards, which in many cases can only be accomplished by simply forgiving a big chunk of the borrower’s debt. I suppose that’s about as far as we can expect government to go in admitting the mess it helped to make.

Obama's Stimulus Conceit Spooks Markets

Why the vote of no confidence by equity markets in the massive spending package?

The answer can be found in the following excerpt from President Barack Obama’s opening statement at his February 9th press conference:

“It is absolutely true that we can't depend on government alone to create jobs or economic growth. That is and must be the role of the private sector. But at this particular moment, with the private sector so weakened by this recession, the federal government is the only entity left with the resources to jolt our economy back into life. It is only government that can break the vicious cycle where lost jobs lead to people spending less money which leads to even more layoffs. (emphasis added) And breaking that cycle is exactly what the plan that's moving through Congress is designed to do.”

There are two fundamental flaws in the President’s statement, and they are at the root of the problems with his economic policies. The first is simply this: Contrary to the President’s statement, within the context of the spending bill, the federal government has no resources. The government is not drawing on accumulated savings or retained profits to fund its spending. It is not selling any of its vast land holdings to provide resources to fund increased transfer payments to individuals or corporations.

What the federal government does have is an extraordinarily good credit rating which allows it to borrow trillions of dollars at extremely low interest rates. But, unlike a corporation, which garners the resources to retire that debt by satisfying customers, every dollar the government is spending now will be extracted from tax paying businesses and workers when the loans come due. What the President fails to see is that for every dollar spent, a dollar is being taken from the productive sector. And therefore, Federal spending, per se, offers no net economic stimulus. This bill – Keynesian demand side stimulus on steroids – follows the failed policies of the FDR administration, which prolonged the Depression in the 1930s, and the Japanese bout of deficit spending, which produced the lost decade of the1990s, only more so.

The second flaw is the conceit that President Obama and his advisors can break the vicious (downward) cycle by spending other people’s money. To the extent the federal money is spent on needed highways and bridges, or other items that serve the public at large and thereby reduces the barriers to doing business, there is at least the prospect of additional economic activity.

However, most of the money in this bill will be given to individuals and corporations in the form of tax rebates or transfer payments and will do nothing to reduce the barriers to commerce. Think of it as paying individuals or companies to dig holes and fill them up again, but skipping all of the make-work. The investments in green technology and the like may be desirable from a policy perspective. But, they most likely have a negative return – otherwise, private capital would be forthcoming. Investments with negative returns squander capital and reduce economic activity by taking it away from more productive job creating opportunities.

Unlike voluntary exchanges, which have the promise of making both supplier and buyer better off, thereby increasing the wealth of the community, most of the spending mandated by this bill will be one-sided, involuntary exchanges, where the person actually paying the bill (future tax payer) is made worse off, even as those special interest groups favored with the Federal largesse are made better off. As a consequence, this bill will weaken the private sector even as it extends the heavy hand of government and protects the special interests who rely on taxpayer funding. And, that will prolong, not shorten, this cycle of economic weakness.

These are the reasons why this bill has made our society poorer, not richer as President Obama seems to believe. This week’s decline in the stock market is but the first write-down of the country’s wealth in recognition of this brutal fact.

February 19, 2009

GM & Chrysler Come Back to the Well Again...

No one took that requirement seriously, because no one believes for a second that President Obama will call in the loans, regardless of how preposterous the “viability plans” are. When former President Bush declared all the meaningful performance measures to be “targets” rather than requirements, it was easy to see how this was going to turn out.

In a development as predictable as Monday following Sunday, Detroit’s Teetering Two are bringing their plummeting sales figures back to Washington to ask that the $17.4 billion already committed to propping them up be boosted to $39 billion. What’s more, they have reached an agreement on “givebacks” with the United Auto Workers that leaves wages exactly where they are, continues to pay some laid off workers not to work and does nothing to settle the question of who will bankroll the Voluntary Employee Benefits Association, through which the UAW supposedly takes over retiree health care, albeit with money from GM that GM obviously does not have.

It gets worse. Much worse. Bondholders have balked at accepting GM and Chrysler stock in exchange for debt relief, apparently suspecting for some mysterious reason that the value of GM and Chrysler stock is less than robust.

And it gets worse still, though not unexpectedly, in the sense that sales have tanked even more seriously than last year.

GM, which said in November that it needed $12 billion in government aid to survive, then upped the amount to $18 billion in just two weeks, now says it actually needs $30 billion.

Try this: Go to your banker. Tell him your company is in financial distress and your sales are terrible. Ask to borrow some money. Go back two weeks later. Tell him you’re in even worse shape than you thought, so you’d like him to loan you even more money. Go back five weeks later . . .

Only the federal government would throw good money after bad to this level of insanity.

The fact that Chrysler now says it needs $5 billion to survive, whereas in December it said it would come back asking for no more than an additional $2 billion, almost seems like an afterthought. Even many auto industry apologists don’t pretend Chrysler is still viable, but Washington is famous for sneaking a little extra money into bills already larded up with waste.

This has to stop. But it won’t.

The UAW, the bondholders and – in all likelihood – company management have not produced a serious viability plan because there is no hammer forcing them to do so. Does anyone seriously believe the administration will reject this plan and force GM and Chrysler into Chapter 11? How would President Obama explain that $800 billion we don’t have is absolutely essential to save American jobs, but $30 billion to prop up an industry whose failure absolutely would create a job carnage is simply too expensive?

He can’t. GM and Chrysler could have turned in a cocktail napkin with “make gooder cars” written on it and Obama would have given them the money. The administration didn’t even decide until last week who was going to oversee the viability plans, which sent the unmistakable signal that there would be no oversight.

The establishment power structure in Michigan is once again gearing up to plead, cajole or guilt-trip Washington into handing over the money, and will once again breathe a huge sigh of relief when the money is handed over as per usual.

And Michigan’s entire economic structure will continue to rely on the outdated, dysfunctional business model of companies who can’t control their costs, can’t sell their products and can’t satisfy their creditors – but can’t be allowed to fail because we need them so very much.


Is the Stimulus Spending Just a Start?

He predicted that "once Congress passes this plan and I sign it into law, a new wave of innovation, activity and construction will be unleashed all across America."

Now with the $787 billion on the books — an amount greater than the entire federal budget in 1982 — the administration is suddenly in full expectation-lowering mode, throwing out strong hints that it may have to go back for second helpings in a matter of months.

"Signing Stimulus, Obama Doesn't Rule Out More," is how the New York Times put it. And, indeed, Obama sounded almost dour about the bill he had so aggressively pushed to get passed.

Gone was all the bold talk of unleashing innovation and activity. Now it's just "the beginning of what we need to do."

Obama deputies were even more downbeat. Last weekend, after the bill was safely through Congress, administration press secretary Robert Gibbs predicted that the "economy is going to get worse before it gets better."

Both he and senior adviser David Axelrod are now saying that the unemployment rate is likely to go as high as 10%, even with the stimulus.

This alone is a stunning admission, since just before the stimulus plan was signed into law, the Congressional Budget Office forecast unemployment would peak at about 9% — without passage of the gargantuan plan.

The shift in tone has been so sudden that even the mainstream press has noticed. On Tuesday, a reporter pointed out to Gibbs that the administration seemed to be taking "a wait-and-see kind of approach" to the stimulus, asking whether that suggests it will seek a second round of stimulus spending.

Gibbs' response: "There are no particular plans at this point for a second stimulus package at the moment. I wouldn't foreclose it."

So what can explain all this cold water? As we see it, there are four possibilities:

1. The administration discovered in the past couple of days that the economy is far worse that it thought. Unlikely, unless the economic team doesn't know what it's doing.

2. The administration has seen what it can get by scaring the public, so why not try it again? With much of its long-term spending agenda enacted, a few more months of catastrophe talk and it could even score nationalized health care. Maybe, but we hope that's far too Machiavellian for this crew.

3. The president and his team have spent so much time and energy talking down the economy that it can't seem to stop. As Obama might put it, "Old habits are hard to break." This is within the realm of the conceivable.

4. The most likely explanation: The administration is quietly coming to understand what critics of the bill knew all along. It spends huge sums of money, but does so in ways that will do little to stimulate the economy in the short term.

If true, it would amount to the most expensive learning curve in the history of mankind.

The Collapse of the Capitalist Consensus

And just as the richest in America are a moving target, so are the top companies. For evidence of this, all one would need do is take a Fortune 500 list from 1980, and compare it to the 1990 list, 2000 and the present.

Constant change is an exciting property of capitalism whereby new entrants frequently purchase the assets of past giants, only to manage them better. In much the same way, the human capital within our borders that is surely our best asset engages in constant reinvention in order to find the best ways to work profitably, and in doing so, fulfills the consumption needs of a productive population.

So while company failure and job losses have always been an unfortunate and painful part of the process, they have also been something that Americans have mostly accepted as the price of prosperity. And far from impoverishing us permanently, our economy has regularly rebounded from its mistakes. The logical reality is that when companies fail, their assets, both physical and human, don’t disappear. Instead, they’re snapped up by the intrepid among us, often at a bargain, and productive growth resumes.

Sadly, the at times rough hand of capitalism has taken a back seat over the last eleven months to the allegedly benevolent hand of the federal government. Rather than embrace the very uncertainty that has made us wealthy by any measure, Americans have accepted a newly muscular role from Washington meant to shield us from failure. But if history is any kind of indicator, that will surely be a deadening influence over time.

The broken consensus. To a high degree the capitalist consensus held until last spring. It was then that Bear Stearns, a fairly minor bulge bracket investment bank, ran into trouble. With its share price in freefall heading into the weekend, officials at Treasury and the Federal Reserve effectively blinked, and a forced marriage ensued in which J.P. Morgan purchased Bear for next to nothing in return for the Fed taking on the fallen investment bank’s “toxic assets.”

Even though Bear Stearns wasn’t a bank in the traditional sense, government involvement was defended by some as necessary to avert a collapse of the financial system. Myriad other financial institutions had exposure (“counterparty risk”) to trades entered into by Bear, and absent the infusion of government capital, our system of credit would supposedly have cascaded downward, Depression the certain result.

In a November 21 speech for the Cato Institute, Harvard professor Jeffrey Miron eagerly stated that the idea of counterparty risk is overdone. Miron noted that the only scholarly work on the subject was written by none other than our present Fed Chairman, Ben Bernanke, back in the early ’80s. Bernanke’s fears of a domino effect with regard to banks were then, and remain pure conjecture. And assuming the domino effect is real, when we consider how whole countries have bounced back from total economic and human destruction as a result of war, it seems a reach to assume that ours would fail to bounce back from the demise of one or many banks.

More broadly, it should be pointed out that every transaction irrespective of its business purpose involves counterparty risk. When businesses go under, counterparties are left short, but one or many failures rarely have any kind of lasting economic impact.

That is so because when businesses fail, they in no way disappear. Instead, an opportunity arises for competitors to quickly snap up market share, not to mention that capital previously misused by the failed business in question is quickly redirected to those with a stated objective to deploy it more wisely. No doubt the rise of the Big Three automakers in the early part of the 20th century put a lot of carriage companies out of business, but far from harming the economy, the aforementioned rise created new, and better opportunities for capital and individuals put out of work by natural economic change.

Had Bear simply been allowed to go under, there doubtless would have been turbulent markets, but it would be hard to presume any more turbulent than they’ve been since last spring. More important, had the Fed and Treasury simply stood aside, Bear’s failure would have been a certain signal to other teetering banks to either find new capital, or quickly find a buyer.

More important, and as we've seen very clearly since last spring, government aid meant to avoid "systemic risk" creates risks far worse for the banking system. Indeed, the acceptance of government aid, rather than a bank savior, is a death sentence for the weak and healthy alike.

Those that accept government money are no longer in business for profit, and worse, their existence is a cancer on the healthy firms in the banking system who must compete with financial institutions no longer serving profit-driven shareholders. Systemic risk was the excuse for shedding free-market principles, but the far more treacherous risk of government ownership was seemingly never considered by many.

Unemployment. Another argument underpinning the newly muscular economic role of the federal government involves jobs. The saying goes that absent federal funds to prop up failing companies, job loss would be substantial, and recession a certainty.

This is certainly an intriguing thought, but then in any market economy jobs are constantly destroyed only for new ones to be created. If there’s any realistic driver of job growth, it has to do with labor supply; the more individuals looking for work, the more jobs created. And when we consider unemployment, it’s not so much the result of businesses not hiring as it has to do with the failure of individuals to supply their labor at the present market rate.

Of greater importance is that human capital is precious. Just as going-out-of-business sales at retail establishments attract all manner of buyers seeking value, layoffs, however painful they can be for the individual, create opportunities for rising businesses to hire workers that were previously too expensive. In that sense, layoffs are a rare growth opportunity for scarce human capital that suddenly becomes available at a lower rate.

But least spoken of is the likely response of those not laid off in an uncertain economic environment. When we consider that economic growth is always and everywhere the result of productive work effort, what better than a dicey job picture to scare those still employed into working much harder?

And in addition to extra work effort, an unfortunate job environment frequently makes the prodigal spender parsimonious. This is important considering that all profits result from past saving.

Looked at from an economic perspective, it’s fair to presume that one reason recessions are frequently short has to do with the fear that they engender, which makes us work harder, and save more. Our work grows the economy, and extra money saved is among other things lent to companies in need of capital in order to expand.

Stimulus. Due to the economic slowdown, there’s a misguided political consensus that the federal government must put money in peoples’ pockets so that they go out and spend. What’s shocking here is that the basic argument contradicts itself.

Governments can only spend to the extent that past economic productivity has created profits to tax. Bastiat used to say that we can’t profit from the same transaction twice, but in the bizarre world that is Washington, the basic laws of economics seemingly don’t matter.

In the real world they do, and with economic growth a function of productive work, it should be said that stimulus can only shrink the economy for the alleged beneficiary who works less thanks to the handout. And what about those taxed? If the productive see that their wealth will be handed to the indolent, don’t they have less reason to work too?

Lastly, it can’t be forgotten that government spending is a tax like anything else, and to the extent that governments spend, they are withholding capital from the laboring classes. So even if we ignore the enervating nature of handouts, it should be said that the check arriving in the mail from Uncle Sam is money that was previously withheld from the average paycheck.

A look into the future. As we try to figure out what our economy will look like in the future, there’s plenty of scope for worry. In addition to a growing deficit wrought by all manner of spending, probably the biggest challenge has to do with a business class that has forfeited a great deal of moral authority relative to the federal government.

While the U.S. economy has never in modern times been entirely free, companies could at least credibly say that federal bureaucrats should keep their distance when it comes to regulation. But thanks to the willingness of certain entities to accept funds from our minders in Washington, they’ll no longer be able to push back against the encroaching leviathan with as much vigor. Instead, thanks to the original sin that involved accepting handouts, our once vibrant commercial class will have to take the bad with the alleged good in the form of greater regulation.

That is unfortunate, because as John Stuart Mill also wrote, “The only insecurity which is altogether paralyzing to the active energies of producers, is that arising from the government, or from persons vested with its authority. Against all other depredators there is a hope of defending oneself.” Sadly, we’ve accepted the false God of government security, and with that we must now accept a certain level of paralysis that will enervate our entrepreneurial economy, and which will make us less prosperous as a result.

Interview with Black Rock's Bob Doll

KUDLOW: All right, look, there is an election every day in the stock market. Investors vote with their money, and they are voting thumbs down. And there may be some good things out there, I don’t want to lose sight of that later when we talk, but I got to ask you right off the top, what is your assessment of this current downturn threatening the bottom? It’s a worldwide event, it’s not just the USA. It’s global Bob.

DOLL: It’s all about credit. It’s all about people not being able to pay their debt and the economy imploding as a result of that as you know Larry. And we are at a point now where we are testing those bottoms. As you pointed out in the front of the show, the S&P is 5 percent off the bottom and the Nasdaq is 12 percent off the bottom. So there is some room here. Our guess is we are in a bottoming process that really started in October, and we’ve gone sideways now for a few months. This will take longer until all the things that we’ve been throwing at this – lower interest rates, credit relief, thawing of the bond market – takes some effect. It will take longer.

KUDLOW: Tremendous increase in the old Milton Friedman M2 money supply, $600 billion since early September as a result of the Fed’s buying assets and expanding their balance sheet and pouring liquidity into the economy. The Baltic Dry Index suggests that commodities shipping is picking up around the world. But Bob, you know I say this every morning, every evening, I go through this, I’m getting clobbered in this point of view and I want to ask you a general thought. Is this country and the rest of the world moving left? Is it departing from free market capitalism? Is it suggesting to investors that the solution to the recession may be worse than the recession?

DOLL: Sad but true, I’m afraid you’re right Larry. It’s curious that on a day we get this so-called stimulus package signed, the market thumbs its nose at that package. I heard your interview with Senator Corker and the whole business about working on writing checks for inefficient businesses in this country. We need to reward efficiency. We need to create some incentives so we can come out of the mess, not protect those areas that are already defensive.

KUDLOW: So when investors see the Sunday talk shows, where Republican Senator Lindsey Graham starts shifting toward President Obama and touts nationalizing banks – which I think probably had a lot to do with today’s action, financials were clobbered again today – when you read about bank nationalization, this is like the most anti-shareholder thing imaginable. What do you make of that? How big a factor was that today? How big a factor is this going to be?

DOLL: It is a big factor. Each time we have this collapse in financials, which has happened several times, it’s usually the same day that you hear the word nationalization used often. And as you pointed out, and I agree, we have to let some capacity go in many industries. We can’t keep all this capacity. For example, in the financial system some banks won’t be around. And to protect them is probably not a smart move. It’s throwing good money after bad.

KUDLOW: I mean when you look at the list today, it was all the pro-growth, so-called cyclical sectors that got killed right? Coal, energy transportation, construction, the semiconductors, metals, mining, machinery, commodities. The stuff that should be going up if we’re on the verge of an economic recovery is not going up. There’s a six to nine or twelve month lead, it’s not happening, despite the money supply growth, despite the credit thaw that you point out all the time and I try to. What’s the message here in the stock market? I don’t want to give up on it. I’m never going to give up on it.

DOLL: And I don’t want to either. You and I are both optimists.

KUDLOW: But it’s a gloomy picture. What do you do here now? What do you do Robert? Give people some wisdom.

DOLL: I think a couple of things. One, have some patience. The Fed did not get even with the curve I would argue until December when they went to the zero interest rate policy. I think that we also need to recognize that all the measures in place will take some time. The big decline in the price of oil did not happen that many months ago. These things take time before they have an effect on the economy.

We have argued that 740 to 840, the gap between the November 21 and the October 10 lows is an area to dollar cost average carefully, slowly but surely, into equities. We haven’t spent that much time there, most of this year we have been above that range. We’re back into it now. This is when the rubber meets the road. We would be dollar cost averaging back into risk assets.

KUDLOW: All right, well that’s a positive view, and I thank you. I just want to read out to evening viewers, the S&P 500 is still 5 percent above its November lows. The mid-cap 400 is much, much better, that’s still 16 percent above. The smaller cap 600 is 8 percent. The small-cap Wilshire 2000, that’s a good small cap index, that’s up 11 percent. And the broadest measure, the Wilshire 5000 is up 7 percent. So, apart from the emotion of a bad day, you could say we’re still okay, we’re holding that bottom. And those bottoms are important.

DOLL: We’d agree totally with that view. We think the average stock is doing better than some of the broad averages, especially the Dow. And as result of that, the market is repairing. It is forming a bottom. It won’t happen overnight. But we would argue the next noticeable move in equities will be to the upside.

KUDLOW: One other thing here. Look, the stimulus package looks like a big welfare and transfer payment. There’s some small stimulus for middle and lower income consumers. There’s nothing in there for investors. There’s nothing in there for producers. There’s nothing in there for capitalists, okay? But I want to ask you, let me come back to this, another competing theory—and I’m trying to get everybody to think about this—the money supply. Milton Friedman. All right? Keynes is dead. Friedman’s dead. But we’re going to debate Keynes versus Friedman. You know, fiscal, government spending and fine-tuning versus monetary growth. This is the biggest buildup in M2 I’ve ever seen Bob Doll. Isn’t that going to have some salutary effect on the economy? Shouldn’t stocks be sniffing that out?

DOLL: Absolutely. It is a positive. We need to stabilize the velocity of that money before we can get the positive out of the growth in the money supply

KUDLOW: So at the end of the day, this is either the greatest buying opportunity in 70 or 80 years, or, or, or what?

DOLL: Who knows what the next episode brings. We don’t want to look at the end of the world. I don’t think it’s coming any time soon.

KUDLOW: You know what? I think you’ve just got to bet on the country. You’ve got to bet on the country at times like this. I think that’s the right call. Robert Doll thank you ever so much.

DOLL: Thank you Larry.

Do You Know Where Your Food Comes From?

This year Congress has given the Agriculture Department $952 million to oversee meat, poultry and eggs, the one-fifth of America’s food supply by value that is based on animal products. The other four-fifths fall under the jurisdiction of the FDA, whose appropriation for food safety is only $538 million in a budget of $2.3 billion.

Our government does a thorough job of inspecting meat. The U.S. Department of Agriculture examines meat, poultry and eggs, produced both domestically and abroad, and USDA inspectors are in every American processing plant. Foreign companies which export to America adhere to USDA standards and are subject to periodic inspections.

Food that falls under the jurisdiction of the FDA is a different kettle of fish, so to speak. Not only is the FDA failing to oversee adequately its share of domestic food, but it is practically impossible now for it to guarantee the safety of foreign food imports.

Former FDA Deputy Commissioner William Hubbard, now of the Alliance for a Stronger FDA, testified before the Senate Committee on Agriculture earlier this month that FDA’s responsibilities have grown at the same time that its resources have diminished. In the 1970s FDA performed 35,000 inspections a year on the 70,000 food processing plants subject to regulation. Today, FDA conducts only 7,000 inspections a year, yet the number of plants has grown to 150,000.

The situation for inspection of imported food is worse. Last year, America imported about $18 billion of fruits and vegetables from other countries, more than twice as much as a decade earlier, and 67 percent more than five years ago. FDA inspects only a fraction of one percent of the 216,000 foreign facilities importing food into America.

Congress has not even given FDA authorization to block the entry of food from foreign firms that refuse to allow overseas inspection by FDA officials. Nor has it allowed FDA to require preventative controls to hinder terrorists or industrial saboteurs, such as locks on tankers carrying milk or trucks parked overnight at rest stops.

Perhaps this doesn’t matter. After all, companies that rely heavily on their brand names, such as McDonald’s and Coca Cola, already do a good job of inspecting their products. The discovery of a rodent’s tail in a can of Coke or a McDonald’s hamburger, for example, would do indescribable damage to the brand, and so companies have an incentive to put strong systems in place to preserve quality.

But other companies, such as the Peanut Corporation of America, aren’t sufficiently influenced by these incentives. And we’re living in a dangerous world, at war with terrorists who don’t stop at suicide bombings. Their idea of a good time might be to make Americans panic by trying to poison the food supply.

What can be done? Congress could give FDA more money and staff, as well as more authority to mandate measures to prevent contamination. If another $500 million were allocated to inspections, spending on food inspection would once more equal half FDA’s budget, the same as it was in the 1970s. The costs might be justified by American taxpayers and consumers who avoid illness and don’t miss work or school.

Another alternative is to authorize private companies to inspect food, like Underwriters Laboratories for electrical appliances or kosher inspections for food. UL sets standards, tests products, provides certification, and conducts follow-up tests for a wide range of products and services all over the world.

Food producers would apply to be certified by independent organizations, and FDA could monitor those organizations. In time, independent firms would develop their own brand recognition with the public for reliable certification of food products. Rather than inspecting food producers, FDA would check that the independent organizations were doing a good job.

A similar system has developed for kosher foods eaten by observant Jews. Rabbis inspect food production and grant producers the right to display a symbol to say that it is kosher. Various rabbinical groups have different reputations, and some Jews trust some kosher symbols more than others. The producer pays the rabbinical organization for the inspection, and the price of the food can be higher.

Contamination of food, whether deliberate or accidental, whether from peanut butter, spinach, or peppers, can be lethal and costly. We’ve just spent $787 billion on economic stimulus—surely we can spare a few million to make our food supply safer.

February 20, 2009

The Upside-Down Economics of Consumption

There has been less emphasis on what we, as individuals, should do. President Obama ducked the question at his news conference last week. But logic suggests that we should be gluing those credit cards back together. The government is actually going to pay us to buy a new house or car. Borrow and spend, borrow and spend is what got us into this mess. Apparently, borrow and spend will get us out of it.

It sounds too good to be true, but it is true. By now we all know about the "paradox of thrift": If everyone stops spending because times are bad, times get even worse. An economist writing in the New York Times the other day addressed the wonderfully inverted problem of people who feel guilty about not spending enough. His advice: Don't feel guilty about saving money, because it's the government's job, not yours, to make sure that we spend enough. But what if you don't feel guilty about reckless borrowing and spending? What if you actually enjoy it? This has been a more common attitude in recent years. Is it still okay? Or does the medicine have to taste bad to be any good?

And can we rely on the government to spend enough? This also seems like a wonderfully upside-down problem. The answer is, apparently not. We're going to need a second stimulus package, probably a third chapter of the bank bailout, more for the auto industry and others. It's all going to cost at least two or three trillion. If it works, it will be money well spent. If it doesn't work, that means we should have spent more.

Trouble is, money well spent is still money spent. The reasons that made it a bad idea to run up all that debt haven't disappeared just because something even worse came along. Almost no one in Washington is talking about this. Since 1981, Republicans have run up massive deficits and Democrats have discovered fiscal responsibility. Now they're all having too much fun reverting to type. Republicans reject the Keynesian premise that the money is being well spent because it is being spent. Too zen for them, or something. For some Democrats, meanwhile, the very fact that a program is costly has magically become an argument in its favor.

But even if the stimulus is a magnificent success, the money still has to be paid back. The plan of record apparently is that we keep borrowing, spending and stimulating, faster and faster, until suddenly, on some signal from heaven or Timothy Geithner, we all stop spending and start saving in recordbreaking amounts. Oh sure, that will work.

There is another way. If it's not the actual, secret plan, it will be an overwhelming temptation: Don't pay the money back. So far, even as one piggy bank after another astounds us with its emptiness, there have been only the faintest whispers about the possibility of an actual default by the U.S. government. Somewhat louder whispers can be heard, though, about the gradual default known as inflation. Just three or four years of currency erosion at, say, 10 percent a year would slice the real value of our debt -- public and private, U.S. bonds and jumbo mortgages -- in half.

Anyone who regards the prospect of double-digit inflation with insouciance is either too young to have lived through it the last time (the late 1970s) or too old to remember. Among other problems, inflation works only as a surprise or betrayal. It can never be part of any public, official plan. Plan for 10 percent inflation, and you'll get 20. Plan for 20 and you'll need a wheelbarrow to pay for your morning Starbucks. But if that's not the plan, what is?

Obama Subsidizes Bad-Mortgage Behavior

Reporting from the Chicago commodity pits, my CNBC colleague Rick Santelli unleashed a torrent of criticism over this scheme. Santelli said: “Government is promoting bad behavior . . . Do we really want to subsidize the losers’ mortgages? This is America! How many of you people want to pay for your neighbor’s mortgage? President Obama, are you listening? How about we all stop paying our mortgages! It’s a moral hazard.”

All this took place on the air to the cheers of traders. Santelli called for a new tea party in support of capitalism. He’s right.

Obama’s so-called mortgage-rescue plan amounts to $275 billion in new debt that will have little if any lasting impact on deeply corrected housing prices or the mortgage-default problem that stemmed from the insistence of government to throw home loans at lower-income people. A modest reduction in mortgage rates will have little impact on home prices, as Harvard professor Ed Glaser has shown. And by the way, re-default rates on modified mortgages have been running 50 to 60 percent. This is not going to change. So why should we throw more good money after bad?

Meanwhile, Wall Street is awakening to the disappointment that the securitized mortgages behind the toxic assets that have done so much damage to banks and the credit system are not being treated in the Obama program. The oversight is incredible. There are no safe-harbor provisions to protect mortgage servicers against lawsuits if agreements are broken. The ownership of these securitized mortgage pools is wide and far, spanning the globe. Breaking contracts is exceedingly difficult, especially without any legislated legal protection.

Of course, banks that have whole loans can choose to modify them if they want. And in some cases it’s much better to modify than foreclose. But 70 percent of this bank-owned paper is performing. It’s the securitizations that have clogged up the world credit system.

Then there’s the bankruptcy-judge cram-down, which would allow the courts to renegotiate interest rates and loan principal. This would abrogate private contracts and throw out the rule of law. Do we think future investors will put up mortgage capital if they fear judges will overturn the terms of contracts? Home-loan supplies will fall and mortgage rates will rise.

Then there’s Fannie and Freddie, the big winners here. Only their products are eligible for mortgage relief. Jumbo mortgages are not. Neither are private-label mortgages created by various non-bank lenders. Fan and Fred already run 48 percent of the mortgage market. Obama’s proposal would greatly enlarge that and move the mortgage system toward government nationalization.

What’s even more incredible is Team Obama’s stubborn refusal to have any faith in the free market. In some of the hardest hit areas of the country, markets are already solving the housing problem. Writing on his Carpe Diem blog, University of Michigan professor Mark Perry notes that while California home prices dropped 41 percent in 2008, home sales in the state jumped 85 percent. It now looks like 2008 sales for single-family houses will exceed levels reached in 2007.

What’s more, the unsold-inventory index for existing single-family detached homes in December 2008 was 5.6 months compared with 13.4 months for the year-ago period. And the median number of days it took to sell a single-family home dropped to 46.1 in December 2008 compared with 66.7 in December 2007. So inventories are dropping, the number of days to sell a home are falling, and sales are rising in the wake of lower prices.

If the government really wants to help, instead of bailing out irresponsible mortgage holders, it should support new and younger families who want to buy starter homes and begin to climb the ladder of prosperity.

All this is free-market economics 101. And I say, let free-markets work. Let’s remember that most folks -- even those with underwater mortgages, where the loan value is more than the home value -- do not walk away from their obligations. They don’t want to wreck their credit -- and their homes are their castles. That’s the American way.

But if we penalize the good guys and subsidize the bad ones, we are undermining the moral and economic fabric of this country.

The Market Is Shorting Obama's 'Stimulus'

The Bush Economy went up in smoke in September-October 2008. The financial meltdown hit Wall Street, devastating bank equities and laying waste to America’s 401-Ks. The Republican ticket, McCain-Palin, was a 50-50 bet on Sept. 15; by Oct. 15 it was a 5-1 long-shot. Voters saw the carnage: the Dow Jones Index lost 17% of its value from Sept. 2 through Nov. 3. In a flash, Americans lost years of toil, and Republicans the election. Decisively.

The election marked a turning point. Investors looked forward to the economic policies crafted by Democrats in Congress and the White House. More pointedly, they wanted decisive, well-crafted action on the banking crisis. Hence the Dow soared 6.5% Nov. 21 on news that Timothy Geithner, the highly-respected head of the New York Federal Reserve Bank, was Obama’s pick for Treasury Secretary.

Yet, from Nov. 4, 2008 through Feb. 12, 2009, the DJI overall fell 18% -- a larger drop than during the Sept-Oct plunge. In January, when the Obama plan, promising far greater deficits than the two much smaller “emergency stimulus” plans signed by Pres. George W. Bush in 2008, was unveiled, the market tanked – the worst January performance in 113 years.

More pointedly, key political victories for the Team Obama spending plan have not been viewed as buying opportunities on Wall Street. A string of negative market reactions began with the December 18 announcement of a stimulus bill of $700 billion (Dow down 2.5%), continued with the January 7 announcement that the actual plan would be “on the high side” (-2.7%) and continued with last week’s 61-36 Senate vote supporting the Administration’s fiscal plan. The White House victory and the new bank bail-out plan announced the following day by Treasury Secretary Geithner were met with a 5% wipe-out in the DJI, and a decline in Treasury bond yields, indicating a “flight to quality.”

There are many problems with Keynes’ “stagnationist thesis,” as Joseph Schumpeter called it, not the least of which is that it didn’t test so well when applied by New Dealers. U.S. unemployment was perniciously high throughout the 1930s, peaking at 25% in 1933 but still over 17% in 1939.

Many claim that World War II brought us out of the Great Depression, but the lesson to be learned is still being debated. Federal budget deficits soared (reaching 26.5 % of GDP in 1942 as calculated by Harvard economist Robert Barro), providing Keynesians an argument for spending as stimulus. But WWII also brought a profound shift in the New Deal’s regulatory policies. Attorney General Thurman Arnold’s vigorous campaign to break-up “the bottlenecks of business” in major industries like steel, chemicals and electrical equipment was shuttered, and America’s largest corporations enjoyed a respite from threats of dismemberment (Arnold was kicked upstairs to a judgeship). As Thomas K. McCraw writes in his superlative Schumpeter biography, “Under the life-and-death pressure of war mobilization… the Roosevelt Administration, which had been hostile toward alleged monopolies, now decided that big business must lead in the job that had to be done.”

The only thing guaranteed by the spending stimulus is more national debt. One stroke of the presidential pen has now increased it by $800 billion. Democrats recently screamed about W-era profligacy. On July 28, 2008, Sen. Kent Conrad (D-ND), Chair of the Senate Budget Committee declared, "If they gave out Olympic medals for fiscal irresponsibility, President Bush would take the gold, silver and bronze. With his eight years in office, he will have had the five highest deficits ever recorded. And the highest of those deficits is now projected to come in 2009, as he leaves office."

Kent Conrad was right. The projected 2009 deficit then stood at $482 billion. In January it was forecast by the Congressional Budget Office at $1.2 trillion. Pres. Obama’s new plan now ups that to $1.7 trillion. If W got the gold, the new Administration has landed the Platinum in just its qualifying heat.

If historic U.S. budget deficits are any indication, the economy is already “stimulated.” The predicted 2009 federal deficit stood at 8.3% of GDP before Obama’s package sent it to about 12%. This is a stunning level of debt, double the previous post WWII high when Reagan’s 1983 budget deficit amounted to 6% of GDP. That time around, the 10.8% unemployment rate, the worst since the Great Depression, was soon reversed.

Keynesians claim that the Reagan boom was an outcome of just this deficit strategy; for sake of argument, let us assume the Keynesian position. Reagan’s budget deficit, half the size of Obama’s as a fraction of GDP, was able to pull the economy out of an unemployment trough deeper than the 7.6% hole we’re in today.

How do economists know that, while a deficit amounting to 6% of GDP budget was sufficient to spur the economy back to health in 1983, it will take more than twice that federal borrowing to do the same now? They don’t. Economic models are all over the place in their projections. Indeed, Prof. Barro’s cutting edge analysis of fiscal policy finds no historical stimulus from peacetime deficits. Of course, we’ve never seen so massive a deficit – one that would bar the U.S. from membership in the European Union, on grounds that our government finances are a mess -- and so we lack empirical evidence to inform the precise experiment we’re running today.

We do, however, know the accounting trends: our government faces massive new spending increases as Baby Boomers retire and their Social Security and Medicare bills come due. Market investors are wary of new spending, guaranteeing either future tax increases or inflation, as a run-up to the demographically guaranteed spending spiral. The quest for “shovel-ready” projects makes one think, Where’s Senator Ted Stevens when we need him? In any event, this fiscal bridge to nowhere is not spurring markets.

Government deficits are nonetheless being sold as doctor’s orders, an elixir that – while it looks ugly and tastes bitter – will propel us back to economic health. Yet the best forecast currently on the table is the one made by investors risking their own money. They are shorting the “stimulus.”

Stress Testing Is What Got Us Here

For the uninitiated, stress testing is a process whereby banks calculate their capital adequacy at statistically unlikely but possible extremes. It has been done for decades at most banks. So it was odd to me, having worked at two large banks that employ thousands of quantitative analysts to do this “value at risk” analysis, to hear the Treasury Secretary talking about it like it was something he just thought up.

Worse, one would hope the man charged with fixing the crises would have some appreciation for what started it. And for this crisis, it is fair to say stress testing is what got us here.

Legions of quantitative analysts at the big banks stress test all forms of market risks: foreign exchange, interest rates, credit, volatility, etc. Most of them missed the current crisis because their work is backward looking. Stress testing involves looking at the volatility of assets and their correlations to determine a bank’s exposure to “worst case” moves. The most toxic assets the banks now own had shown very little volatility before they fell off a cliff. This is why the banks owned so much of them.

Stress testing for interest rates or foreign exchange is easily done because there are long and continuous time series of data. One can calculate all the statistical variables and the correlations among them. Banks do this well, which is why it rarely happens in modern banking, unless by fraud or error, that a large bank takes a big hit on generic market risks.

Enter the super-senior tranches of CDOs backed by subprime mortgages. All that was really known about these securities was that they were rated AAA and before the crises traded very close to par. The total history was about 3 years. Banks used ratings as a proxy for risk and got burned.

The problem was not one of insufficient testing but of insufficient imagination. The model might indicate that these AAA tranches should never move by more than a few points. Some banks took that as reason to buy tens of billions of dollars of them. Some who asked “What if?” have fared better.

Perhaps Geithner is naïve as to the role of stress testing in the crisis thus far, but as former head of the Federal Reserve Bank of New York, he should not be. What he proposes now is even more bizarre, using stress testing to determine capital needs. The assets that are most troublesome are also the ones most difficult to price, the so-called “toxic assets.” They cannot be priced, but Geithner somehow believes they can be stress tested?

Simplified, a stress test requires very good information about at least two things: the current price and the historical prices. Ideally one would know something about an asset’s correlation with other asset classes. We have none of the three.

Strangest of all was Geithner’s punchline: We will employ stress testing to determine which institutions are most in need of additional capital. And then what?

One might naively have thought that the reason for mentioning Japan in the 1990s was because Geithner had chosen some form of receivership for those revealed to have the weakest capital positions. Oddly, he proposes to give them the capital they need. In effect, do what Japan did and hope for a better outcome.

Some of the smartest minds on the planet have been noodling for 2 years on this banking crisis, and there are many ideas floating around. One might point out that the marketplace of ideas has been doing its job in thrashing around different alternatives. Not surprisingly, there is not a consensus on what to do next.

Then, in the middle of this maelstrom, the young new Treasury secretary tells the world that next Monday he’s going to announce a comprehensive plan to fix this whole thing. Check that. Tuesday.

It is not surprising that the market fell sharply after this underwhelming plan was announced. Part of the problem may be that Geithner’s plan showed a misunderstanding as to what caused the crises; but part of it may be that his remedy seems so unlikely to work. It’s a fair bet that those banks which stress testing shows need more capital will be the banks who have already taken the most from TARP. Geithner announced that to whom much has been given, even more will be given.

The plan does not seem serious because seriousness will require making choices about which banks to let fail. It may require admitting that those most in need of capital are most in need of shuttering. The approach of saving everybody cannot work. Even if stress testing could determine which are which, it would still take leadership to make the right choices.

February 23, 2009

One Pack of Losers Stimulating Another

Food stamps are sometimes characterized as a "social investment" helping the needy get through their troubles, perhaps allowing them to return to work. But if the same food is distributed to the same people by a church soup kitchen, wouldn’t you call it charity?

Congressmen and their court economists are in a lather worried that consumers will invest their savings during recessionary times instead of engaging in debt-besotted consumption. So they’re printing up a trillion dollars to "invest" in everything from shovel-ready infrastructure programs to politically favored science projects. The stated goal is “creating” jobs whose major benefit is turning investments directly into consumption. Never mind whether these jobs actually generate positive financial returns, the usual sign that more wealth is being created than destroyed.

Forget the scientific theories of long dead economists. Does Congress’s approach pass the sniff test?

I work in an industry, namely venture capital, charged with the task of making speculative investments. These investments never go to well-connected corporations that spend millions on lobbyists. They go to entrepreneurs and inventors seeking to upend the hegemony of these very corporations using the simple trick of doing a better job serving customers. We don't measure success by the number of jobs created, though create them we do. That’s because jobs are a cost not a benefit, a means to an end and never the end itself. In truth, we use our perch on the boards of the companies we invest in to hector CEOs to deliver as much progress as possible hiring as few people as they can. In our world, paying people to dig holes and fill them up again is not investment.

We persevere through good times and bad knowing that a significant number of our investments are going to fail. That's why we watch our companies like hawks, stepping in to make strategy and CEO changes designed to improve the odds of success while reluctantly shutting down companies that don't make the grade. We do this with keen attention largely because our own money is at risk alongside that of our investors. And contrary to the blather of pundits, it’s not venture capitalists that pick winners and losers. It’s Darwin.

Exactly how is Congress supposed to create economic growth “investing” someone else’s money in lobbyist-laden companies selected through political pull measuring success not by financial returns but by the number of jobs created? How are our sovereigns-of-subsidy likely to influence the behavior of CEOs who line up at their money trough? And what happens to such congressionally created jobs when Darwin renders an unfavorable judgment? This is bound to happen because, let’s face it; if getting this right were so easy venture capitalists wouldn’t be paid so much when it occasionally happens.

Some have suggested that public/private partnerships might inject enough discipline to resolve these conflicting goals. OK. Imagine sitting on the board of a company holding your CEO’s feet to the fire demanding that he hit his milestones using the smallest possible headcount while some government czar is insisting on just the opposite.

Another way of saying this is, how can we possibly succeed rebooting our economy if we conflate investment with consumption with charity?

Denigrate venture capitalists if you'd like but at least the losing investments we make are self correcting. Congress has a track record of investing in even more losers than we do, and on a scale unimaginable to those of us who actually pay attention to what happens to the money after it’s “invested.” When we make failed investments we take our lumps, learn from our mistakes, and move on. What does Congress usually do when failure becomes undeniable even to the most self-interested proponents?

It's been many years since I've worked in the engineering profession to which I was trained, but I do remember one thing. You can't solve a problem if you don't get the problem statement right. I have no magic plan to turn our slumping economy around. But investing someone else’s money in charitable consumption can't be a sustainable solution.

February 24, 2009

Obama's Stunted Economic Stimulus

His politics compromise the program's economics. Look at the numbers. The Congressional Budget Office (CBO) estimates that about $200 billion will be spent in 2011 or later -- after it would do the most good. For starters, there's $8 billion for high-speed rail. "Everyone is saying this is [for] high-speed rail between Los Angeles and Las Vegas -- I don't know," says Ray Scheppach, executive director of the National Governors Association. Whatever's done, the design and construction will occupy many years. It's not a quick stimulus.

Then there's $20.8 billion for improved health information technology -- more electronic records and the like. Probably most people regard this as desirable, but here, too, changes occur slowly. The CBO expects only 3 percent of the money ($595 million) to be spent in fiscal 2009 and 2010. The peak year of projected spending is 2014 at $14.2 billion.

Big projects take time. They're included in the stimulus because Obama and Democratic congressional leaders are using the legislation to advance many political priorities instead of just spurring the economy. At his news conference, Obama argued (inaccurately) that the two goals don't conflict. Consider, he said, the retrofitting of federal buildings to make them more energy efficient. "We're creating jobs immediately," he said.

Yes -- but not many. The stimulus package includes $5.5 billion for overhauling federal buildings. The CBO estimates that only 23 percent of that would be spent in 2009 and 2010.

Worse, the economic impact of the stimulus is already smaller than advertised. The package includes an obscure tax provision: a "patch" for the alternative minimum tax (AMT). This protects many middle-class Americans against higher taxes and, on paper, adds $85 billion of "stimulus" in 2009 and 2010. One problem: "It's not stimulus," says Len Burman of the nonpartisan Tax Policy Center. Congress was "going to do it anyway. They do it every year." Strip out the AMT patch, and the stimulus drops to about $700 billion, with almost 30 percent spent after 2010.

The purpose of the stimulus is to keep declines in one part of the economy from dragging down other sectors. The next big vulnerable sector seems to be state and local governments. Weakening tax payments create massive budget shortfalls. From now until the end of fiscal 2011, these may total $350 billion, says the Center on Budget and Policy Priorities (CBPP), a liberal advocacy group. Required to balance their budgets, states face huge pressures to cut spending and jobs or to raise taxes. All would worsen the recession and deepen pessimism.

Yet, the stimulus package offers only modest relief. Using funds from the stimulus, states might offset 40 percent of their looming deficits, says the CBPP's Nicholas Johnson. The effect on localities would probably be less. Congress might have done more by providing large, temporary block grants to states and localities and letting them decide how to spend the money. Instead, the stimulus provides most funds through specific programs. There's $90 billion more for Medicaid, $12 billion for special education, $2.8 billion for various policing programs. More power is being centralized in Washington.

No one knows the economic effects of all this; estimates vary. But Obama's political strategy stunts the impact from what it might have been. By using the stimulus for unrelated policy goals, spending will be delayed and diluted. There's another downside: "Temporary" spending increases for specific programs, as opposed to block grants, will be harder to undo, worsening the long-term budget outlook.

Politics cannot be removed from the political process. But here, partisan politics ran roughshod over pragmatic economic policy. Token concessions (including the AMT provision) to some Republicans weakened the package. Obama is gambling that his flawed stimulus will seem to work well enough that he'll receive credit for restarting the economy -- and not be blamed for engineering a colossal waste

'Buy American', But Only Our Debt?

So far, everything China has done that makes them able to buy U.S. bonds in large quantities has been demonized.

As Clinton coaxes China to buy more, Democrats back home, including U.S. Treasury Secretary Timothy Geithner, have blasted China for "currency manipulation." It sounds nefarious, but before 1973 all major countries did the same thing. Back then, we called them "fixed exchange rates."

The Chinese have also been targeted by Congress for trade "disruption" in no-longer competitive U.S. industries like textiles. They get the blame for outsourcing, too. On the diplomatic front, they've been denied a bilateral investment treaty by Democrats in Congress, something that could pave the way for a free-trade pact.

Meanwhile, Americans' free choice to buy Chinese goods has been maligned as U.S.-China trade hit a record $266 billion in 2008.

Now, there's the sour prospect of the stimulus itself, which no one protested more fervently than China. The congressional package contained a provision permitting purchase of only U.S.-made factory goods on all government public works projects. This specifically targets China, which stands to lose the most from this.

We've got news for Democrats and other protectionists: What China does to compete in the global economy enables our Congress to finance its own wasteful pork projects and wealth redistribution. It's called Treasury bond buying.

The Chinese, who have done so much since their economic opening in 1978, aren't just a top trading partner, they're also the chief financier of the U.S. deficit. Today, they hold more than $1 trillion in U.S. Treasury bonds and agency debt.

When the Chinese sell Americans their lawn mowers, microwave ovens, skis and designer purses, they don't bury their earnings in coffee cans. They put that cash into U.S. Treasury bonds.

This isn't a bad thing. It's how we get our dollars back when we trade. That China continues to buy our bonds is a vote of confidence in America's underlying stability and trade openness. Without these, they won't buy our bonds at all.

This highlights the basic problem we have: Congress spends too much, issues Treasuries to pay for them, and then expects our largest trading partner, China, to buy our bonds — even as Congress does everything it can to reduce trade with that country.

It's like killing the golden goose.

Fact is, our vast trade with China has some good side effects that draw little mention from Democrats. With the cash from those bonds buttressing our economy, the Chinese are effectively doing our saving for us and letting us consume more.

Meanwhile, China's low prices have helped to raise the standard of living of every American, especially the poor, who spend the greatest share of their income on basic consumer goods.

There are issues with China over trade that are legitimate. Unfortunately, a Democrat-led Congress seems intent on shrinking our trade with China, even if it means making it harder to finance Congress' own spending spree and raising the cost to taxpayers.

Their "Buy American" provisions mean the steel China might have sold at a competitive price to the U.S., for one, won't be sold here. That means China has fewer dollars to buy Treasury bonds.

Instead, the U.S. taxpayer will buy domestic steel at 25% above the most competitive overseas rate, and the U.S. government will get fewer buyers for its bonds.

If Congress gets its way, China's trade surplus with the U.S. will fall sharply. That means it will have less money to spend on our bonds at a time when many budget analysts expect our federal deficit to reach $1 trillion annually for the next decade or so.

Who'll buy all those bonds? Americans, who at least by official figures save about 3% of their incomes? Europeans, who are in even worse shape than we are? Oil-rich Mideast countries, which are suffering from the recent plunge in oil prices?

The fact is, there are many things to criticize China on, and we've done so repeatedly in the past. But asking China to buy our bonds without letting it sell goods is a dead end.

Cause for Optimism Amid Gloom

Despite the determined efforts of politicians to prevent the inevitable, our economy is undergoing a much needed reallocation of resources. The home construction industry is being reduced to its former position of relative unimportance. The financial sector, which had become much too titanic for its trousers, is being put on a forced diet. A stomach staple may yet be needed, but the slimming is well underway. We’ll be hearing more from our timid Treasury Secretary Tim Geithner this week about his plans for the banking sector, but the market waits for no man. The verdict on Citigroup and several other financial institutions has already been rendered; the only question at this point is whether they will get the death penalty or join the likes of AIG, Fannie Mae and Freddie Mac in the government gulag. Having watched Citigroup, and its predecessors, find its way into every financial debacle of the last three decades, I would prefer to put them out of our misery.

The housing market, which everyone believes must be healed before recovery can begin, is quietly healing itself. Home sales in California, the eye of the housing storm, are rising. Lower prices are attracting buyers at a rate 85% above last years pace. Indeed, even as the median price fell over 40%, the total dollar volume of sales in December was higher than the same month last year. Florida has seen existing home sales rise for four consecutive months, although the rise is more muted than California, up only 27% over last year in December. The government’s actions last week to limit foreclosures not only angers responsible homeowners, it slows the process of moving houses from those who can’t afford them to those who can.

The news of the credit markets’ death also seems to have been a bit premature. Those real estate sales in California and Florida weren’t all cash deals. While banks are certainly requiring more in the way of a downpayment and may actually call your employer to verify you are indeed gainfully employed, it is obvious that banks are lending. Contrary to news reports, banks are even extending financing for other consumer wants; consumer loans at commercial banks are still rising at a 10% rate. That doesn’t mean that lending as a whole is still rising; the securitization market is basically dead. As non-bank lending has withdrawn from the market, banks have stepped up to fill the void. The total volume of lending may not be where it was, but is that something that should be lamented by anyone other than the Wall Street firms who benefited from the easy profits in the boom years? I think not.

Leading economic indicators have risen two months in a row. Some have been quick to seize on the fact that the rising money supply is the biggest contributor to the rise. These pessimists assume that we are in a liquidity trap and that monetary policy has lost its effectiveness. If that is true then the rise in money supply means nothing and the LEI is rendered ineffective as an indicator, but based on the continued rise in bank lending, I remain unconvinced. Furthermore, in last month’s LEI report, five of the ten indicators were positive.

Productivity, which fell in the bad recession of 1981-82 and during the Great Depression, was up 3.2% in the fourth quarter. Incomes, adjusted for the recent deflation in the CPI, are rising. And while the Keynesians among us fret about the paradox of thrift, I find the rising savings rate comforting. Higher savings is exactly what we need to repair the damage done to our economy by excess consumption fueled by easy credit. And besides, retail sales were up in January.

Obviously, we are still in recession and there is more pain to come, but the gloomy mood that surrounds the Obama administration is either manufactured for some political purpose or completely unwarranted. The idea that only government can come to the rescue at this point is not only entirely too convenient for an administration determined not to waste a crisis, but also false. Whether one is speaking of the economic condition or the response to it, we are not experiencing unprecedented events right now.

In the panic of 1819, caused primarily by reckless lending and real estate speculation, Thomas Law advocated increasing the supply of money (from Murray Rothbard’s The Panic of 1819: Reactions and Policies which is available online at the Mises Institute):

“To Law, domestic manufactures were distressed from “the want of money, for the home manufactures cannot afford to sell on long credits. They must have quick returns to pay workmen. I know of manufactures which have stopped, not because they were undersold by foreign goods, but solely because they could not get money. Money is the means to pay workmen, to set up machinery….”.”

Law also expounds an early, cruder version of Keynes theory:

“Elaborating on the benefits from increased money, Law pointed to the great amount of internal improvements that could be effected with the new money. He decried the slow process of accumulating money for investments out of profits. After all, the benefit was derived simply from the money, so what difference would the origin of the money make? And it would be easy for the government to provide money, because the government “gives internal exchange value to anything it prefers”. All it needs to do , concluded Law, was spend five millions of newly issued currency per year on public works, and, in a pump priming effect, “the money thrown into circulating would, in the course of a year, enable individuals to make a number of improvements also.””

Maybe Mr. Keynes wasn’t the original thinker everyone makes him out to be. The debate also centered on whether relief should be provided to debtors:

“The moratoria were known as “stay laws” or “replevin laws”, which postponed execution of property when the debtor signed a pledge to make the payment at a certain date in the future. Minimum appraisal laws provided that no property could be sold for execution below a certain minimum price, the appraised value being generally set by a board of the debtors’ neighbors. Such laws had been an intermittent feature of American government since early colonial Virginia.”

Those on the other side of the debate employed arguments quite similar to the ones we see today:

“The report began with assurances that the committee was deeply sensitive to the prevailing financial embarrassments, and that they had given due weight to the numerous petitions for relief legislation. While the proposed legislation, however, would perhaps alleviate the condition of the debtors temporarily, it would, in the long run, make their distress worse…The Hopkinson Committee used a familiar medical analogy noting that “palliatives which may suspend the pain for a season, but do not remove the disease, are not restoratives of health; it is worse than useless to lessen the present pressure by means which will finally plunge us deeper in distress.” …The report remarked that suffering men were disposed to complain about their lot and look for rapid remedies rather than admit that the only cure was slow and gradual.”

This sounds remarkably similar to the debate which rages today. Then, as today, one side argued for monetary expansion, debt relief and public spending. The other side argued for sound money (gold standard),thrift and industry as well as limited government intervention:
“Time and the laws of trade will restore things to an equilibrium, if legislators do not rashly interfere to the natural course of events.” - The New York Evening Post

President Monroe basically ignored the depression, barely mentioning it in his annual addresses. Some states enacted debt relief measures and others enacted schemes to inflate the money supply (all of which failed), but basically the depression ran its course and ended by 1821.

The current crisis is not near the magnitude of some of the previous crises we’ve faced in the history of the US. We recovered from them all despite the ministrations of our perplexed pols. What stands out about the current difficulties is not its unique nature but how much it resembles all the others. The common characteristic of past crises is fairly easy to identify: overlending by banks for some speculative activity, although real estate is the most common. The overlending was generally a result of some type of monetary inflation. The Great Depression stands out for its length and the depth of political interference in the market processes.

While I don’t believe the current administration’s actions will be helpful in the recovery, neither do I believe they have taken action nearly as drastic as that taken by FDR and his brain trust. The economy, and the stock market, will recover from their current malaise. The healing is already underway and unless the administration further impedes the workings of the market, it will become more obvious over the coming months. It is time for the debate to shift to longer term concerns. Given the banking systems’s penchant for periodic self destruction, a rise in capital requirements would seem obvious. The tax code’s favorable treatment for real estate investment also needs review. Monetary policy, which is the real source of our troubles, needs to be reduced once again to the role it is best equipped to fulfill - preserving the purchasing power of our money.

I am optimistic about America. We are the most productive nation the world has ever seen and there is no reason we shouldn’t stay that way. We need to end the bickering and do the heavy lifting required for recovery. I have every confidence in the ability of the American people to do exactly that. The gloom and doom talk, especially by President Obama, needs to end.

A Dollar Saved Is Not a Dollar Hoarded

It is necessary to stress these facts because of the prevailing state of utter ignorance on the subject. Such ignorance is typified by a casual statement made in a recent New York Times news article. The statement was offered in the conviction that its truth was so well established as to be non-controversial. It claimed that “A dollar saved does not circulate through the economy and higher savings rates translate into fewer sales and lower revenue for struggling businesses.” (Jack Healy, “Consumers Are Saving More and Spending Less,” February 3, 2009, p. B3.)

The writer of the article apparently believes that houses and other expensive consumers’ goods are purchased out of the earnings of a single week or month, which is the normal range of time between paychecks. If that were the case, no savings would be necessary in order to purchase them. In fact, of course, the purchase of a house typically requires a sum equal to the purchaser’s entire income of three years or more; that of an automobile, the income of several months; and that of countless other goods, too large a fraction of the income of just one pay period to be affordable out of such limited funds.

In all such cases, a process of saving is essential for the purchase of consumers’ goods. The savings accumulated may be those of the purchaser himself, or they may be borrowed, or be partly the purchaser’s own and partly borrowed. But, in every case, savings are essential for the purchase of expensive consumers’ goods.

The Times reporter, and all of his colleagues, and the professors who supposedly educated him and his colleagues, all of whom spout such nonsense about saving, also do not know other, even more important facts abut saving. They do not know that saving is the precondition of retailers being able to buy goods from wholesalers, of wholesalers being able to buy goods from manufacturers, of manufacturers, and all other producers, being able to buy goods from their suppliers, and so on and on. It is also the precondition of sellers at any and all stages being able to pay wages.

Such expenditures must generally be made and paid for prior to the purchaser’s receipt of money from the sale of his own goods that will ultimately result. For example, automobile and steel companies cannot pay their workers and suppliers out of the receipts from the sale of the automobiles that will eventually come in as the result of using the labor and capital goods purchased. And even in the cases in which the payments to suppliers are made out of receipts from the sale of the resulting goods, the seller must abstain from consuming those funds, i.e., he must save them and use them to pay for the capital goods and labor he previously purchased.

In contrast, the Keynesian reporters and professors believe that sellers do nothing but consume or hoard cash. They are too dull to realize that if that were really the case, there would be no demand for anything but consumers’ goods. This becomes clear simply by following the pattern of the Keynesian textbooks in allegedly describing the process of spending.

Thus a consumer buys, say, $100 dollars worth of shirts in a department store; the owner of the department store, following his Keynesian “marginal propensity to consume” of .75, then buys $75 worth of food in a restaurant, and allegedly hoards the other $25 of his income; the owner of the restaurant then buys $56.25 (.75 x $75) worth of books, while allegedly hoarding the remaining $18.75 of his income; and so on and on. Now, unknown to the Keynesians, if such a sequence of spending actually took place, all that would exist is a sum of consumption expenditures and nothing else.

The fact is that most spending in the economic system rests on a foundation of saving. The seller of the shirts will likely save and productively expend $95 or more in buying replacement shirts and in paying his employees and making other purchases necessary for the conduct of his business, and perhaps only $5 on consumption. And so it will be for those who sell to him, or to the suppliers of his suppliers, or to the suppliers of those suppliers, and so on.

Any business income statement can provide a simple confirmation of such facts. The ratio of costs to sales revenues that can be derived from it, is an indicator of the ratio of the use of savings to make expenditures for labor and capital goods relative to sales revenues. For the costs it shows are a reflection of expenditures for labor and capital goods made in the past. The saving and productive expenditure out of current sales revenues will show up as costs in the future. The higher is the ratio of costs to sales, the higher is the degree of saving and productive expenditure relative to sales revenues. A firm with costs of $95 and sales revenues of $100 is a firm that can be understood as saving and productively expending $95 out of its $100 of sales revenues. This relationship applies throughout the economic system.

Bank Nationalization Is a Truly Awful Idea

Worse when it comes to banks, once under government control they either are forced to invest conservatively, in politicized ways, or in the case of the alleged beneficiaries of TARP funds, they’re required to engage in the very non-economic lending that made them insolvent to begin with. Institutions that have failed their investors, whether it be GM or Citigroup, should be allowed to fail so that they no longer waste human and financial capital that could otherwise be deployed profitably.

Of course some, including Greenspan and Roubini, argue that nationalization would be a clean process that would lead to a quick resale of these institutions by the government back to the private sector. It’s a nice thought, but judging by the slow and difficult de-nationalization of British firms that Nigel Lawson (the U.K.’s Chancellor of the Exchequer under Margaret Thatcher) oversaw in the ‘80s, it’s positively naïve to assume that de-nationalization would be simple here.

And as MIT professor Lester Thurow has observed, “Disinvestment is what our economy does worst. Instead of adopting public policies to speed up the process of disinvestment, we act to slow it down with protection and subsidies for the inefficient.” And assuming an efficient process of disinvestment, it’s charitably utopian to presume that our federal minders would ever again allow banks to control their own lending destiny. Banks would join utilities and other prosaic wards of the state as politicized entities offering non-economic loans that would do nothing for our economic health.

Nationalization advocates, including Roubini, point to Sweden’s successful bank nationalizations and subsequent disinvestment as a model that could be applied here. Nothing against Sweden, but when we consider the size of its banking system relative to ours, the nationalization of its banks is the equivalent of government officials in West Virginia taking over financial institutions there. Harmful to the economy for sure, but not relevant to ours or the world economy in any material way.

The above is true given the basic truth that money, like finance, is fungible. Dollars, yen and euros are the same everywhere, so if officials in Sweden or West Virginia were to take over the banks, companies and businesses within both could still find rational, profit-driven finance outside of their state-run banking systems.

The United States, however, is quite different. Were we to nationalize our sick banks, some of which list among the largest in the world, we would very quickly harm our banking system in total. Indeed, with capitalism and the health of banks very much reliant on the efficient deployment of capital to its highest use, banks backed by owners not motivated by profit would quickly prove cancer-like to the many healthy banks in our system.

Competing for loan opportunities against institutions being told to lend as though free money is an economic stimulant, the strong would quickly weaken alongside their federal competitors. In short, the world’s center of finance would soon enough morph into a favor factory along the lines of the crony banking system that helped take down Indonesia’s economy in the late ‘90s.

The logical reply to all of this is that finance is once again fungible, and if nationalization makes our banks irrelevant, U.S. firms could still look overseas for profit-driven capital. This is all true in that just as there’s no logical explanation for why we need U.S.-based energy sources, there’s nothing saying we must have U.S.-based sources of finance.

The problem with this assumption is that given the size of our banking system, its takeover by the government would have worldwide consequences. Indeed, government aid or nationalization is merely protectionism by another name, and with our banks greatly distorting the lending process, it’s not a reach to assume that foreign banks, seeking protection from U.S. loan practices, would follow our lead. Simplified, crony banking practices stateside would quickly prove virus-like and help to corrode lending standards worldwide as governments sought to protect their own champion banks.

The better answer is to simply let markets run their natural course. As recently as the ‘80s we heard with deafening regularity that the size of Japanese banks relative to ours was a certain signal of our economic decline. While this later proved demonstrably untrue, it’s an historical fact that when these Japanese banking behemoths lurched into insolvency, market-oriented thinkers in the U.S. correctly prescribed failure for those institutions as the surest way for Japan to resume its impressive economic growth.

So if Japan’s largest banks in the world were not too big to fail, it seems fanciful to presume that bank failure here would consign us to poverty. But what will impoverish us is if bipartisan hysteria leads us toward a process of bank nationalization that is almost certain to spread, and weaken institutions of finance worldwide.

Going back to last year, the purely conjectural notion of “too big to fail” entered the economic discussion in such a way that our economy has continued to weaken. The better answer is that our banks are far too important to be saved by Washington, so rather than continue down the impoverishing path of federal aid, the true solution involves letting the weak die so that existing and future banks can handle the deployment of capital in ways that their previous competitors failed to.

February 25, 2009

Should We Let California Go Bankrupt?

There’s good reason why most states won’t fall down the fiscal black hole where California now dwells. This is a state whose politicians, public sector unions and advocacy groups have been living in a fantasy world of overspending, investment-deadening taxation and job-killing regulation. Looking out over the state’s prospects and examining the budget deal that legislators have put together (jerry-rigged as it is with revenue gimmicks and unrealistic projections), the only question is who will be begging Washington for more money sooner, the banks, the auto companies or the Terminator?

The similarities between California and the auto companies are especially striking. Neither can afford their workforce. California schools pay their employees 35 percent more on average in wages and benefits than the national average (17 percent more when adjusted for the state’s higher standard of living), a significant bite because the state funds much of local education (to the tune of $42 billion last year). Benefits are a big part of these costs. A public employee in California with 30 years of service can already retire at 55 with more than half of his salary as pension, and public-safety workers can get 90 percent of their salary at age 50.

Another budget buster is California’s spending on social services, clocking in at about 70 percent more per capita than the national average. Leading the way is state spending on cash assistance programs (that is, welfare), where the state expends nearly three times more per resident than other states. There’s a good reason for this rich budget. California’s legislature has only reluctantly embraced federal welfare reform, and for years the state has had one of the worst records in moving people from welfare to work because state law limits the ability of welfare administrators to sanction those who refuse to participate in work programs.

The rich program of social service benefits is also burdensome because of the state’s large low-wage immigrant population. As Milton Friedman observed in the mid-1990s, you can’t have porous borders and a welfare state. The incentives are all wrong. California has become a case-study in that notion. A report by economists working for the National Academy of Sciences in the mid-1990s concluded that the average native-born California household paid about $1,100 in additional taxes because of government services used by immigrants whose own taxes don’t come close to covering their cost to society. It would be very interesting to see what the numbers are today.

But California doesn’t just have a spending problem. Increasingly it also has economic and revenue problems. Even as I write this other neighboring states are running ads in local newspapers inviting California businesses to move their headquarters out of the state. That’s advertising money well spent. A poll of business executives conducted last year by Development Counsellors International, which advises companies on where to locate their facilities, tabbed California as the worst state to do business in.

There are a host of reasons why California has become toxic to business, ranging from the highest personal income tax rate in the country (small business owners are especially hard hit by PITs), to an environmental regulatory regime that has made electricity so expensive businesses simply can’t compete in California. That is one reason why even California-based businesses are expanding elsewhere, from Google, which built a server farm in Oregon, to Intel, which opened a $3 billion factory for producing microprocessors outside of Phoenix.

In the race for the exits, residents are accompanying businesses. In just one decade California made a remarkable turnabout, going from a state with one of the highest levels of net in-migration to the state with the second highest level of domestic net out-migration. Typically people either head for the exits because they are seeking more economic opportunity or because they are being driven out by high housing costs. You get a little bit of both in California because the state’s zoning regulatory schemes keep housing production artificially low and housing prices high even in a mediocre economy.

As the economist Randall O’Toole points out in his study of housing restrictions, The Planning Penalty, “Thanks to a variety of land-use restrictions, California suffers from the least affordable housing in the nation.” The planning penalty, O’Toole estimates, adds from $70,000 to $230,000 to the cost of a home in the Central Valley, $300,000 to $400,000 in Southern California, and $400,000 to $850,000 in the San Francisco Bay area because in California, 95 percent of the population lives on just 5 percent of the land. “The problem is supply, not demand,” O’Toole observes. “Austin, Atlanta and Raleigh are growing faster than California cities, yet have maintained affordable housing.”

In the last decade, people tried to solve the problem of how to afford expensive housing in California with fancy mortgage products, one reason why the state topped the nation with 523,624 foreclosures last year.

California politicians have been expert at avoiding dealing with these problems. In 2003, enraged citizens recalled Gov. Gray Davis after he announced an impending $38 billion budget deficit. Arnold Schwarzenegger promised reform but delivered only a year of it. When tax revenues spiked in the national economic recovery that started in 2004, California politicians went on another spending spree, increasing expenditures by $34 billion, or 32 percent, in just four years before revenues slumped again.

Then the California legislature wrangled for eight months over the current budget mess, forcing the government to shut down road projects and delay tax refunds because the state needed the extra cash to service its debt. While California technically can’t file for bankruptcy, a default on its debt would have shut down financing options for Sacramento and its municipalities until the state agreed to lenders’ demands that it get its fiscal house in order. At least one of the state’s municipalities, Vallejo, has already filed for bankruptcy and other cities and towns were on the brink before the budget compromise.

California’s budget problems aren’t going away this time. There is no housing boom (or bubble) about to inflate, as it did in 2004, to help burnish the state’s economy, where the unemployment rate is now 9.3 percent, or two full percentage points above the national average. The current budget is only precariously balanced with revenue projections that the state probably won’t meet, and with fiscal gimmicks. And much of the federal stimulus money is geared to spending that increases the size of programs rather than fills in current deficits.

In other words, expect the Golden State to be in desperate need of a bailout soon, one that will certainly gain a receptive ear in the White House because Washington can’t conceive of our largest state defaulting on its debt, even though the prospect has now sunk California’s bond rating lower even than Louisiana’s.

But also expect Washington to take some heat if it simply bail outs out California, especially now that we have governors like Mark Sanford of South Carolina pointing out that the federal aid to states amounts to a subsidy by citizens of fiscally responsible governments to states where legislators have chucked responsibility out the window.

Back in the 1970s, New York City was on the verge of bankruptcy and despite a famous headline (Ford to City: Drop Dead), both the feds and New York State eventually bailed out Gotham, but under strict conditions. They imposed a financial control board which required demanding cuts to services, a new, more transparent budget process and several years of budgetary oversight. Maybe what Washington should impose on California will be a national version of a financial control board to shake some sense into state legislators.

Otherwise, we can always allow the state to default on debt and let its lenders start dictating the terms of California’s budget reforms. Go ahead, California, make my day.

Is Bank Nationalization Inevitable?

As housing prices fall, more homeowners with adjustable-rate-mortgages cannot refinance when their rates reset, and others, simply discouraged, default. Supply increases again, perpetuating the spiral of falling home values, mortgage defaults, and bank losses on mortgage-backed securities.

To cover losses, banks should raise new private capital by selling additional stock. But investors, seeing no end to falling home prices and bank losses, have pushed down share prices to levels making it impractical for banks to raise capital.

The TARP has aggravated the problem.

When first approved by Congress, Treasury was to buy mortgage-backed securities from the banks, but it ultimately determined it was not possible to assess their values. Instead, Treasury used TARP to inject capital into banks, purchasing warrants convertible to bank shares, and left banks to work out their problems.

As losses mounted, so did Treasury’s equity stake and involvement at Bank of America, Citigroup and several other banks. Many investors fear sweeping nationalization is inevitable, and have become even more reluctant to purchase bank stocks.

Those fears will continue until the mortgage-backed securities are removed from the banks’ balance sheets or their potential damage neutralized. However, Treasury Secretary Geithner’s proposal to create a public-private investment fund to value these assets and mitigate their consequences is vague and hauntingly reminiscent of the strategy the original TARP was forced to abandon.

As housing prices fall, the banks will have no place to go but the government for the capital to cover losses, and their ownership will pass into government hands; first Citigroup and then others.

Economists, whether employed by banks or the Treasury, cannot reasonably estimate the ultimate value of mortgage-backed securities and the losses banks will take until the number of defaults and foreclosures is known, and that is the trap that snares the market.

The number of foreclosures cannot be divined without knowing how far housing prices will fall, and the drop in housing values cannot be estimated without knowing the number of defaults and how many houses will be dumped onto the market.

A federally sponsored “bad bank,” or “aggregator bank” could purchase all of the mortgage backed securities from commercial banks at their current market-to-market values on the books of the banks. It could determine the number of defaults by performing triage on mortgages—deciding which homeowners if left alone will pay their mortgages, which if offered lower interest rates and moderate principal write downs could reasonably service new loans, and which must be left to fail.

Implementing those standards and necessary mortgage modifications across the entire market would, at once, limit the number of defaults and determine how much housing prices will ultimately fall. That is something the individual banks cannot accomplish acting independently.

The Bad Bank could be capitalized with $250 billion from the TARP, and it could raise additional capital by selling $250 billion in shares, and another $500 billion to $1 trillion by issuing bonds. The commercial banks could be paid for their securities with 25 percent in shares and the rest in cash.

By sweeping all the mortgage-backed securities off the books of the banks and limiting losses on those securities, the Bad Bank would earn money collecting payments on the majority of mortgages that ultimately pay out and sell off repossessed properties at a measured pace. Like the S&L era's Resolution Trust, and the Depression- era Home Owners’ Loan Corporation, it would likely make a profit.

Relieved of the mortgage backed securities, the banks would not be trouble free—they still have auto loans and credit card debt to repent. However, having huge deposits and vast networks of branches, they would be worth a lot to investors again, could raise new capital, repay their TARP contributions and write new mortgages.

The bankers could then go on their merry way, until a few decades hence, they once again determine their salaries should support the lifestyles of rock stars and create financial products to pay them.

My son plans to study finance. He can solve that crisis.

February 26, 2009

Aiding the Bottom 10%: A Recipe for Economic Decline

But most important for an economy very much reliant on the efficient deployment of what is precious human capital, it’s frequently the case among those made redundant that they were misapplying their talents. Layoffs and the feeling of failure they engender are remarkable for focusing the minds of those let go on the kind of work that best suits them, not to mention that while painful, failure is a wonderful teacher that focuses its beneficiaries on mistakes to avoid in the future.

Alcoholism and a drug arrest forced Dominic Dunne out of a cushy Hollywood life into a rented room lacking television and telephone at the Twin View Resorts in rural Oregon. Finished as a Hollywood movie producer, Dunne was in his fifties when he gambled on a career as a writer. Though his first script was roundly criticized, and his first book (The Winners) was a flop, Dunne wrote in his journal, "I have never believed in myself more than when I was writing my script. I was never happier with myself." With a burning desire to succeed while in possession of very few options, Dunne persisted and today is one of the best-known writers of criminal fiction in the world.

While coach of the Philadelphia Eagles, Buddy Ryan cut talented, but drug-abusing wide receiver Cris Carter. Happily, from the devastation of the waiver wire emerged one of the most productive receivers of the modern NFL era; Carter at present a strong future bet for the Hall of Fame. Salomon Brothers let millionaire partner Michael Bloomberg go in 1981, and thank goodness it did because freed of the firm’s bureaucracy, the well-to-do Bloomberg later emerged the billionaire head of an eponymous market-data firm whose terminals are a must-have among traders.

But with company layoffs on the rise, the federal government seeks to make them less frequent by offering tax cuts for the employers that choose to keep their worst employee matches and least productive on the payroll. And as has realistically been the case since the introduction of the income tax, the most economically productive workers are "rewarded" with tax penalties for being that way, while the least productive either pay little or no taxes, or are actually given rebates for not making a lot of money.

Moving to housing, the Obama administration plans to spend $275 billion in order to aid homebuyers who borrowed irrationally in order to buy that which they couldn’t afford. Proponents of the plan suggest that this will be economy enhancing, but in truth, efforts meant to cushion the failures of the bottom 10 percent of homebuyers will be economically retarding for turning the above-mentioned business logic on its head.

For one, it’s well known at this point that subsidization of mistaken investment insures more of the same, and in shielding the profligate from failure, the government shields them from lessons that will help them not to fail in the future. Failure is an excellent teacher, but those most in need of instruction will not be taught if the allegedly soft view of the housing problem prevails.

Less spoken of is the obvious problems that will result from keeping people in houses that in a free system, they couldn’t remain in. For one, it’s fair to presume that a certain portion of strapped homeowners live in parts of the country underperforming economically. In this case, measures taken to keep them tied to a specific location mean that they will be less able to chase economic opportunity that exists elsewhere. In this case, both the individual and the broader economy suffer thanks to housing serving as the proverbial ball-and-chain.

Of course, much ink has been spilled and many words have been spoken about how neighborhoods will be ruined if many of their residents are forced to foreclose. An interesting thought, but if we ignore how federalization of home ownership is blatantly unconstitutional, have our nannies in Washington ever stopped to consider how the saving of the irresponsible could similarly destroy neighborhoods? Indeed, have they considered how once peaceful neighborhoods could be balkanized between those current with their mortgages, and those not but who are being subsidized by their neighbors? Is it unrealistic to suggest that violence could break out, or that the responsible, so offended by their parasitical neighbors, might move elsewhere thus similarly destroying these neighborhoods in crisis?

Advocates of the Obama housing plan say with straight faces it’s not fair that buyers purchased houses that are in certain instances worth much less today. But if we apply the illogic of such reasoning to its logical conclusion in the business world, companies such as Webvan, eToys and theglobe.com would still be in business; wasting human and financial capital in ways that our economy would be even worse off. The reality is that investors in anything frequently find that what they’ve purchased is worth less, but far from a call for more government handouts, this is often a signal telling them to cease throwing good capital after bad. And these failures teach us what not to do in the future.

In the aftermath of the Korean War, North Korea imposed the notion of “songbun” on its citizenry. The poor and shiftless for being poor and shiftless had “good” songbun, and today they are the privileged class for having failed most impressively. The successful in North Korea were demonized for being that way, and today they are the bottom caste in a society that has committed economic suicide right before our eyes.

So while it’s surely a reach to suggest the U.S. is going the way of North Korea, it’s also true that bad policy has a way of slowly wrecking societies over time. At present, with the federal government creating incentives whereby companies will be rewarded by the tax code for not laying off unproductive employees, and just the same where irresponsible homebuyers are being sanctified for being irresponsible, the U.S. political class is imposing its own, minor form of songbun; these actions signaling our nation’s long-term economic decline.

So Much for Fiscal Responsibility

President Obama obviously thinks that it is, because he regards new spending as an investment in the future and his new taxes as inconsequential. “We have known for decades that our survival depends on finding new sources of energy. Yet we import more oil today than ever before.”

With regard to taxes, he said that “If your family earns less than $250,000 a year, you will not see your taxes increased a single dime. I repeat: not one single dime.”

But one reason that stock markets fell over the past month to levels not seen for a decade is that higher spending and taxes erode a country’s competitiveness by replacing efficient private investment with inefficient public projects. Investors know this, and flee.

It’s impossible to discuss all the president’s proposals, but let’s just look at energy. Mr. Obama wants more spending on alternative energy projects to achieve independence. Yet he wants to raise fees on carbon emissions that would fall most heavily on coal, our most important domestic source of energy for electricity generation.

We import more oil than ever before, but we have a larger economy and use less energy for each dollar of economic activity than we have in the past. We’ve made vast improvements since the 1970s when President Nixon first hoisted his “energy independence” banner.

Since then, all other presidents except President Reagan have endorsed the same goal, and we are still dependent on foreign oil. President Carter called energy independence “the moral equivalent of war” and set up the Department of Energy, which didn’t fix the problem. No one believed President George W. Bush when he said the United States could reduce gasoline use by 20% in ten years: consumption declined because of high oil prices and the recession.

At a time when oil prices in real terms have fallen to their lowest prices in over 10 years, and with the global economy in a recession, President Obama proposes to impose enormous costs on the American economy. Reducing imported oil and “harnessing the power of clean, renewable energy,” as the president put it, sounds simple. Why buy from abroad what we can make ourselves?

But such a transformation of technology is practically impossible and would be enormously expensive, which is why other presidents have failed. We would either need to produce vast quantities of alternative fuels for our cars, or move to electric vehicles. Both options result in higher costs and different forms of pollution.

As for electricity generation, wind and solar power, along with other renewables such as biomass and geothermal, account for 3% of our total power output and are unlikely to increase significantly.

We cannot expand our use of clean nuclear power beyond the current level of 19% for fear of accidents, controversy about where to dispose of spent fuel, delays in winning government licenses for new plants, and fear of litigation. It’s been over 30 years since the Nuclear Regulatory Commission has licensed a new nuclear power plant.

In the area of taxes, President Obama wants to put a “market-based cap on carbon pollution”—in other words, create a complex system of emissions allowances that companies could buy and sell, known as "cap-and-trade." This would essentially mean that energy-intensive companies would have to pay the government to emit carbon above a certain limit. Coal (a domestic energy source) and automobiles (the recipient of government largess) would be particularly hard-hit.

This tax would be passed on to consumers, even those earning under $250,000 per year, who use the companies’ products. Those companies that could switch from carbon-based energy to new forms would face higher prices for the new technology, prices that would also be passed on to consumers.

It makes no sense for America to regulate carbon and other greenhouse gases unless emerging industrial giants such as China and India do also because carbon emissions are a global problem. Without international cooperation, America would be raising costs on consumers in the middle of a recession—all for nothing.

With Americans losing confidence in the $3 trillion plus dollars in new government projects already announced, more spending and more taxes don’t add up to fiscal responsibility. They add up to a deeper recession.

It's Time to Consider the Cost of Regulation

The President praised the passage of the $787-billion stimulus bill—the largest spending bill in history. While a lot of that money will go back into the economy, it will do so according to decisions made by politicians and regulators. In other words, it’s all top down.

A better approach is to empower citizens and businesses—who pay the taxes, anyhow—to stimulate from the bottom up. Unfortunately, removing burdensome regulations on businesses, both large and small, hasn’t figured much into the economic recovery program thus far. But alternatives to “porkulus” and “bailout to nowhere” do exist.

Let’s call it “liberate to stimulate.” Such a campaign would include fiscal reforms (both taxing and spending), deregulatory stimulus, infrastructure investment liberalization, financial reforms that shift risk back on the institutions rather than on taxpayers, a regulatory reduction commission, and much more.

Starting from the basics of the free market, we can go a long way toward laying the right foundation for unimpeded economic recovery.

Consider regulation of business in America today. We’ve all heard of the trillions of dollars in new government spending. But the compliance costs generated by thousands of regulations pouring forth from over 50 departments, agencies and commissions impose another trillion-plus more, as CEI’s Ten Thousand Commandments survey shows.

Agency bureaucrats don’t answer to voters. Congress, although responsible for the underlying statutes that propel those agencies, can blame the agencies for regulatory excesses. That’s how we get “regulation without representation.”

Administrative reforms like cost-benefit analysis cannot tame the regulatory state as long as agencies themselves get to evaluate the benefits of their own rules, and as long as legislative constraints on the scope of the regulatory state remain weak.

Thus, reducing the scope of government control in the economy is the true end game. But until then, measures like a regulatory budget could promote accountability by limiting the amount of regulatory costs that agencies can impose on the private sector, and holding Congress responsible for those costs.

Of course, regulatory costs can never be precisely measured, so a budget could not achieve absolute precision. And enforcement will never be easy, since agencies will have incentives to overstate benefits and understate compliance costs. Still, regulatory budgeting could help restore congressional primacy in the legislative and rulemaking processes from which regulations spring.

As information—sorely lacking now—accumulates, Congress can begin to divide a “total” budget among agencies roughly in proportion to potential benefits, such as lives saved. Agencies’ incentives would be to rank hazards from most to least severe, and address them within their budget constraint. Unwise regulating could mean transfer of the squandered budgetary allocation to a “rival” agency, while Congress would weigh an agency’s claimed benefits against alternative means of protecting public health and safety.

A well designed regulatory budget should explicitly recognize that agencies’ basic impulse is to overstate the benefits of its activities, and therefore relieve agencies of benefit calculation responsibilities altogether.

Other ways to promote the success of a budget are to: start small, compile a periodic “report card” on the numbers and costs of regulations in each agency, establish a regulatory cost freeze, set up a Regulatory Reduction Commission to assemble a package of regulations to cut, and employ separate budgets for economic regulation and environmental/social regulation.

A regulatory budget will not magically reduce the current $1.3- trillion annual regulatory burden. But better information about the size and scope of the regulatory state will aid future economic stimulus efforts. And as Washington sets out on a massive growth spurt, any enhancement of congressional accountability and limitations on the delegation of regulatory power can only help.

February 27, 2009

The Ayn Rand Factor In the Santelli Revolt

But we will need more than just a political rebellion against the Obama administration and the Democratic Congress. We will need to engage in an ideological struggle, a battle of ideas. Columnist Monica Crowley named it best early last week when she called for a "21st century Boston Tea Party" and said that we needed a "second American revolution of ideas," "of getting back to the ideals of limited government, of constitutional parameters on government power, of individual liberty, and of the free market."

Yet we have to ask: where is the intellectual ammunition for this battle of ideas going to come from? It is important to remember that a Republican administration started us down this plunge into socialism. In praising Rick Santelli, Roger Kimball asks a very good question: "do we really need to go back to economic kindergarten and relearn" the lessons of the failure of statism and the superiority of capitalism? The answer is that we have to go back to basics because we never quite learned the fullest, deepest, philosophical reasons for the moral and practical superiority of capitalism.

Fortunately, we know where to find the free-market ideas we need, and this source is already indirectly driving the new taxpayer revolt. It's time to bring it fully out into the open.

In defending his stance against the bailouts, Rick Santelli referred to himself as an "Ayn Rander"—a reference to the great 20th-century novelist and philosopher Ayn Rand, who is most famous for her ideological defense of laissez-faire capitalism. Similar references seem to be lurking behind nearly every expression of resistance to big government. Rush Limbaugh—whose coining of the term "porkulus" helped galvanize the right's resistance to the so-called "stimulus" bill—has frequently recommended Ayn Rand's magnum opus Atlas Shrugged in recent months, as has conservative talk show host Glenn Beck.

In January, Stephen Moore caused a stir by arguing, in the Wall Street Journal, that the current crisis is turning Atlas Shrugged "from fiction to fact." And those who are warning that increased government restrictions will cause the nation's most productive workers to withdraw their talents have taken to calling this the "John Galt Effect," a reference to the hero—and the main plotline—of Atlas Shrugged.

It is no coincidence that the strongest resistance to a government takeover of the economy is coming from people influenced by Ayn Rand. She has long functioned as a stiffener of resolve and as the fountainhead of pro-free-market ideas.

I have written about this at greater length, but Ayn Rand's contribution to the philosophical defense of capitalism can be summed up in one central idea: individualism. Ayn Rand demonstrated that the ultimate source of all wealth—everything from steel mills to microchips—is the individual reasoning mind. Thus, a society that wants to prosper has to ask what is required by its thinkers and producers, the "prime movers" who originate and implement new ideas. And the first thing that is required for these thinkers to function is that they be free from coercive interference by bureaucrats, by blowhard legislators, or by federal "czars."

Ayn Rand was an individualist in the fullest sense: she regarded the unfettered individual, not just as a source of wealth, but also as an end in himself with the right to profit from and enjoy the wealth he creates, without being forced to sacrifice his happiness for the allegedly greater good of the collective. The issue, as she once put it, is not whether or not you give a dime to a beggar. The issue is whether you have a right to exist if you don't—and whether you have to buy your life, one dime at a time, from every moocher who comes along asking for a handout. She gave the clearest and most consistent "no" to that standard of morality, and the clearest and most consistent "yes" to the moral rights of the creators and producers.

There has been some recent crowing about how the current financial crisis has discredited Ayn Rand's defense of self-interest and the free market, as demonstrated by the defection of Alan Greenspan. In reality, the current financial crisis does not demonstrate the failure of Greenspan's alleged pro-free-market ideas, which he actually rejected decades ago; rather, it demonstrates the failure of his presumption that a talented "maestro" can orchestrate prosperity by setting himself up as the monetary central planner of the economy.

In fact, the current crisis has vindicated Ayn Rand's warnings. Haven't the financial markets collapsed every time a bureaucrat comes on TV to explain how he is planning to "rescue" them? And the policies of the current administration are about to prove Ayn Rand right once again, and perhaps more fully than ever before, by demonstrating what happens when we sacrifice more and more of the nation's productive minds to provide handouts for the beggars.

Far from facing growing rejection, Ayn Rand's ideas are the mostly unnamed fuel giving fire and confidence to people like Rick Santelli. Even if they don't fully accept Ayn Rand ideas, their encounter with her writings gives them the confidence to declare that they have earned their wealth and that they have a right to keep it and enjoy it.

That's the Ayn Rand factor we are observing now—and we need more of it.

If we're going to have an ideological Boston Tea Party, a declaration of independence from the whole theory behind state management of our lives and wealth, then Ayn Rand is the ideal philosophical hostess.

New Era, But Same Old Budget Story

The only tough thing about this budget is what it has in store for the most productive parts of the economy. Over the next 10 years, Obama seeks to impose tax hikes totaling a stunning $1.66 trillion on businesses and successful families.

The "rich" — those families earning $250,000 or more — would have to pay $954 billion more, thanks to Obama's plan to reimpose pre-Bush era tax rates, set a 20% rate on capital gains and add a limit on itemized deductions.

Businesses, meanwhile, would have to kick in an additional $645.7 billion through a cap-and-trade carbon tax the president hopes to get enacted allegedly to fight global warming.

Then there's the $353.5 billion raised through unspecified "other revenue changes and loophole closers." Given Obama's pledge not to raise taxes on the bottom 95% of taxpayers, that can only mean still more taxes for the "rich" and business owners.

Of course, Obama boasts that his plan also includes $940 billion in tax cuts. But much of this is actually in the form of checks written to people who don't pay income taxes to begin with — which is technically new spending, not a tax cut.

Meanwhile, the Obama budget clearly fails to live up to his goal of "honesty and accountability" in federal budgeting. Indeed, it's full of gimmicks designed to make it look much better than it is.


• Phony baseline spending forecasts. Obama's budget assumes that the government will continue to spend $170 billion a year on the Iraq War until the end of time. By cutting that number back, he magically credits himself a huge $1.49 trillion in savings over 10 years.

• Unreasonable assumptions: The budget counts on $316 billion in savings from Medicare, not through benefit cuts, but through efforts to promote "efficiency and accountability." History has shown that such promises are easy to make, but almost impossible to keep.

• Rosy economic scenarios: Budget forecasts are hugely dependent on underlying economic assumptions. And Obama's predictions assume that the economy will perform better over the next 10 years than the Congressional Budget Office or the Blue Chip Consensus predicts.

By 2013, for example, Obama says the GDP will be $700 billion bigger than the Blue Chip forecast, with unemployment, interest rates and inflation lower over the next four years. In the past, Democrats and the mainstream press routinely blasted GOP presidents for such sunny forecasts. Don't expect the same from them now.

• Spend now, save later: A subtler trick used by the administration is to front-load spending hikes while promising fiscal discipline later. In this case, Obama asks for an increase in discretionary spending of 6.5% this year, but then expects us to believe that he will hold spending hikes to 2% in the following years.

The president is right. This is certainly a new era. But somehow we doubt this is what voters had in mind when they voted for change last November.

Economic Debate: Laffer vs. Liesman

KUDLOW: What about this issue of the forthcoming Geithner plan? The public/private fund that is going to band together and purchase the toxic assets from the banks? Do you give that any credibility? Any efficacy? Will it do any good?

LAFFER: No, I don’t. I really don’t. I mean, everyone agrees with stress tests for banks. I mean that’s clear. But banks should do that on their own. And they should worry about their own capital functioning. That’s what they should do. It shouldn’t be a government function. And how does the government know what it’s going to be in unemployment rates, what the sensitivities are here? That’s something that, on the companies I’m on the boards of, we always do stress testing to see how we can handle bad times. But this is just government coming in and taking it all over. It’s outrageous.

KUDLOW: Steve Liesman, outrageous, that’s one of my favorite adjectives.

STEVE LIESMAN: Let me just say I share Arthur’s skepticism about the government’s ability to do anything here.

KUDLOW: Ohhhh…

LIESMAN: But Arthur…

: Yes Steve.

LIESMAN: You have $600 billion of excess reserves in the banking system, on the balance sheet of the Federal Reserve. It is not as if people are clamoring, and lining up out the door for private capital right now. I understand, over a long period of time, there’s a situation where the government could crowd out. But in times when you have the kind of slack we have in the economy, I think it’s sort of, at least conventional economic wisdom, that the government doesn’t crowd out when it invests at this time.

LAFFER: Well it’s conventional economics from this administration, Steve. But frankly that monetary base that they’ve increased by about 150 percent in the last six months is one of the most dangerous, outrageous things I’ve seen. It’s ten times the percentage increase ever before in the US. And banks are making loans. If you look at the M1 data Steve, you can see that bank loans are increasing. They’re increasing very rapidly…

KUDLOW: Across the board. Across the board…

LAFFER: Across the board. And over the last ten years…

LIESMAN: Art, Art, I am your student Art…

: Wait.

LIESMAN: There’s no velocity…

KUDLOW: It’s the breakdown in the securitized secondary markets Arthur.

: That’s what it is. That’s exactly what it is…

: The banks are actually doing their jobs. And oddly enough…

: But there’s no velocity Larry. That’s the thing. You can put out there a hundred trillion dollars, if there’s no velocity, there’s no inflationary effect.

LAFFER: But velocity comes later Steve, and then you’re going to get the inflation. The velocity will come.

: But you don’t have [velocity] now. Art, they can pull it back though at that point…

KUDLOW: Let’s talk about this. Hold on. Let me set the stage, this morning Arthur, this morning, on [CNBC’s] The Call with Melissa Francis and me, Steve Liesman and I had a little debate about inflation.

LAFFER: I heard.

KUDLOW: And the causes of inflation. Steve Liesman of course, is a great, famous Keynesian Phillips-curver. He believes that high unemployment reduces inflation, and low unemployment and strong economic growth raises inflation. On the other hand, I represented the monetary school, which says inflation is caused by too much money chasing too few goods. And Steve, as a throwaway said, with inflation and taxes, he’d like to discuss with Arthur Laffer. So I have delivered the aforementioned…

LAFFER: Well I love Steve Liesman, let me just tell you that Larry.

KUDLOW: Steve Liesman and Arthur Laffer. Arthur What is your response to Steve’s…

LIESMAN: He said he likes me Larry. You just talked right over that compliment.

KUDLOW: Actually, we love you. It’s not like, it’s love. It’s deep-seated love and I don’t even need a stress test to find this love.

LAFFER: The Fed can’t pirouette and do this sort of thing Larry. What they’ve done with the monetary base is they’ve set into motion an enormous inflationary pressure in the US economy. With the shrinking of the US economy, and it’s shrinking very rapidly, you not only have more money, but you also have fewer goods. That’s a classic double-whammy on inflation.

KUDLOW: Did you not hear that from me this morning, Mr. Liesman?

LIESMAN: I heard that from you.

KUDLOW: Did I say something that was almost virtually identical, even the same?

LIESMAN: You did. I do not buy the idea that capacity has been so diminished that we have a problem of too few goods. And Art, my whole point is this, is that, this idea of too much money? Absolutely. Doctrinaire. Doctrine. Absolutely. There must be a transmission mechanism. And when you have high unemployment, and you do not have the goods destruction, you maintain globalization, you maintain competition in the economy. Then you have no transmission mechanism for that inflation…

LAFFER: No, no. Steve, Steve. You’re missing one thing here, if I may interject.

LIESMAN: Okay, if it’s just one then I’m in good shape…

LAFFER: Unemployment has to do with the real wage in the system here. What we’re talking about is the price of goods, all goods, in terms of money. That has nothing to do with unemployment, except for the fact that you get fewer goods. And when you have more money and fewer goods, the amount of dollars per good goes up. It goes up because there are fewer goods and it goes up because there is more money. And the monetary base is the number you have to look at.

KUDLOW: All right, bottom line. Monetary base you have to look at.

LAFFER: That’s the one.

KUDLOW: And you should probably have a glance for the use of money from M1 and M2 Arthur, right?

LAFFER: That’s right.

KUDLOW: You buy that too. And by the way, more goods would be available to absorb the excess money. So more goods and more growth would be counter-inflationary. Is that right Art?

LAFFER: Yeah that’s exactly right. But then Larry…

: I agree with that.

LAFFER: But then Larry, the velocity of money is all of a sudden going to start rising…

LIESMAN: We should be so lucky…

LAFFER: Once you see your inflation starting Steve…

LIESMAN: We should be so lucky…

LAFFER: Then you’ll see the velocity soar and you’ll get [inaudible] hyper-inflation…

LIESMAN: Can we just admit that if the money sits on the balance sheet at the Fed, it is not at that moment inflationary?

LAFFER: It’s not sitting on the balance sheet at the Fed, and it is at that moment. That’s where money always sits. The question is how much money sits where and under what demand for money.

KUDLOW: All right, I’ve got to push down. I’ve got to push down. Last point. Steve Liesman wanted to know this morning Art, what is the highest marginal tax rate that would really do damage to the economy? And I want to raise this point, Mr. Obama last evening in his speech, reaffirmed his intention to roll back the Bush tax cuts. So the 33 percent tax rate goes to 36, and the 35 percent tax rate goes to 40. What we learned today Arthur is, he’s going to take steps before the Bush tax cuts expire in 2010. In his current budget, to be released tomorrow, he is going to lower the exemptions for the upper-end people. In other words, a 35 percent tax rate payer cannot deduct 35 percent, for example, of his mortgage interest. He’ll only be able to deduct 28 percent. He’ll only be able to deduct 28 percent from his charitable contributions. Art Laffer, will this hurt the economy? Just the beginning. The lower exemptions and ultimately the higher tax rates?

LAFFER: Well of course it will hurt the economy Larry. But I was watching Nancy Pelosi say that the real revenue raisers that they’re going to have to come to, and they will have to come to this, are the payroll taxes, consumption taxes, and low-income and middle-income income taxes. Sooner or later they’re going to go to that. And they’re going to go really hog wild on raising taxes. And they’re going to do it Steve, and it’s not going to be very far out in the future.

KUDLOW: All right Steve, last word, go ahead.

LIESMAN: I agree if that happens that’s terrible…

: Ask him your question.

LIESMAN: My only point Art that I had Art was this, is that there is no tailor rule for the great concept of the Laffer Curve. So my point is that it is impossible to know where we are on the Laffer Curve at any one point in time such that a 2 or 3 percent rise in the tax rate…

KUDLOW: Five percent, five percent.

: May have little effect or a huge effect.

LAFFER: That’s true, that’s true.

KUDLOW: All right Art, last word real quick.

: But so what? We’re not after which tax rates raise revenues, we’re after which tax rates hurt the economy, hurt output, hurt employment and cause inflation. And those tax rates are continuous across the whole range and they’re getting worse and worse and worse every day Steve. It’s frightening.

KUDLOW: All right, hang on. Thank you Steve Liesman. Well done. Art Laffer…

LIESMAN: Can I just thank you for the opportunity to talk to Art Laffer?

: Thanks Steve.

LIESMAN: Thank you Art.

KUDLOW: That was great stuff.

Go With Bankruptcy Over Nationalization

The complexity of big banks has been overemphasized. When we consider a large bank’s balance sheet, the parts that matter are not all that complicated. Imagine a big bank with $2.0 trillion in assets. It has suffered losses but still has $100 billion in equity. That leaves $1.9 trillion in debts, and of those maybe $500 million are deposits.

For those who deride “mark-to-market” accounting, consider the first question that this large balance sheet forces one to ask: How much are those assets really worth? It’s the first, last and only question. Of course we want to know the answer to that question. Mark-to-market is the only way to know.

Suppose the assets are worth 95 cents on the dollar, so the value of the assets is the same as the value of the liabilities. Then an investment of equity is a marginal investment, depending on how it is structured.

Suppose instead the assets are worth 80 cents on the dollar. Then there is a $400 million loss. The equity has some value, but it is really “option value,” which means it could have value if the assets improve. A government equity investment now looks like a bailout of the debt-holders, who would suffer a $300 million loss if the bank were liquidated.

Now, if the assets were worth 95 cents on the dollar, we wouldn’t be having a “banking crises.” So all we really need to know from Treasury Secretary Geithner’s proposed Stress Testing is if the assets are now worth considerably less than 95%. Let’s assume they are. In this case, the nationalization schemes currently being talked are debt-holder bailouts.

Why are these debt-holders being bailed out? In our hypothetical case the deposits are guaranteed so the $300 million loss must be borne by the other debt-holders, meaning their claims are now worth about 80% of par. Not great, but survivable.

Why is it better, either immediately or over time, to have the government rather than the debt-holders absorb these losses? There seem to be no good reasons. In fact, there are many good arguments for allowing the debt-holders to organize themselves as a class and control the fate of the insolvent bank.

First, they are sophisticated. Generally this debt is widely held among institutional investors who understand the credit markets very well. Who better to manage the “toxic assets” of a failed bank than professional bond fund managers?

Second, they are deep pocketed. They can absorb the losses because generally bond fund managers run balanced and diversified portfolios. A 20% loss on their big bank holdings should not wipe them out.

Third, they will do a better job maximizing the value of the assets than the government. This point should require little elaboration. Who would you hire to run a restructured Citibank, Bill Gross or Barney Frank? The debt-holder who just took a 20% haircut wants to preserve the value he still has, and hopes to get his 20% back and more. He will be profit-minded, not politically oriented.

As we see with all this distracting talk about bonus pools, if the government is in the bailout business, the average editorialist feels his or her input into Vikram Pandit’s compensation is entirely relevant. Debt-holders can quietly go about making decisions on how best to restructure the bank. They can decide on a purely rational basis whether to liquidate assets or hold them in hopes of improvement. Likewise, there is every reason to think that they will run the lending business to maximize their return, and this has a far better chance of creating value than a credit committee chaired by Christopher Dodd.

Finally, allowing the debt-holders to absorb the losses and then manage the failed enterprise avoids moral hazard and is perfectly fair. It avoids moral hazard because it restores debt-holders to their proper role as guardians of the banks’ asset quality. Because banks are so highly levered, and because management’s incentive schemes are often one-sided, it has traditionally been the debt-holders who guard against excess risk. Debt-holders are the real regulators. They were asleep at the switch and are both victims and culprits in the current mess.

But if the government were to bail out the debt-holders in the current crises, and return to them the par value of their securities, all hope for restoring a rational financial system would be lost. Temporary nationalization, as advocated by Greenspan, is the worst choice because it forever removes any incentive for debt-holders to check the excesses of bank management. For levered institutions like banks there could be no going back to a system where private capital-holders maintain vigilance over asset quality.

Bankruptcy where debt-holders take a haircut is fair because it is the one choice that does not deal anybody a free lunch. Equity-holders, preferred-stock holders, senior creditors and junior creditors will each get exactly what they bargained for when they invested in these banks.

About February 2009

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