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March 2, 2009

Americans Are Angry and Divided

The latest deception is the current economic crisis which Rahm Emmanuel has assured us won't be wasted by the new Obama administration. The crisis is being sold as the failure of capitalism so that the captains of the ship of state can accrue more power at the expense of those of us confined to steerage. The crisis is more accurately described as a failure of the fascistic marriage of corporate and political power, but we are asked to ignore the truth hidden behind a curtain of legislation and campaign contributions. We are told to ignore a Federal Reserve system set up by bankers for the benefit of bankers and politicians. We are told that trillions of our dollars must be "invested" to save a system that is as harmful to our values as it is beneficial to those who lack them.

The sources of the economic crisis are the deception of a fiat currency that distorts the price signals that a market system requires to function properly, and a culture of political corruption disguised as altruism. When our money's value is based on nothing but trust of politicians, is it any wonder that its value has plummeted? When politicians tell us that deficits don't matter, is it any wonder that we incur heavy debts? When the Federal Reserve, in the course of its history, destroys 90% of our money's purchasing power, is it any wonder that we value consumption over saving and investment? When government demonizes corporations and confiscates the rewards of success, is it any wonder that there is a reluctance to invest? This is not a failure of the market; this is the revenge of the market which can be restrained by the leash of central banking for only so long.

The market demands that borrowers be creditworthy despite the wishes of community organizers who use extortion to shackle the poor in the bonds of debt thereby ensuring the employment of future community organizers. The market demands that the supply of houses match the real demand for shelter rather than the artificial demand of speculators enabled by the easy money policies of the Federal Reserve. The market demands that we ultimately must produce sufficient goods to pay for those we wish to consume. The market demands that assets be valued based on a rational appraisal of future cash flow rather than the overly optimistic assumptions of computer models designed by rocket scientists who would have served society better by sticking to rockets. And can we blame the rocket scientists for succumbing to the siren song of Wall Street when the Federal Reserve conjures money from thin air and makes the alchemy of modern finance more profitable than the design and production of real goods?

Our leaders are now working feverishly to construct a "recovery" plan that is built on the sands of further deception. We are expected to believe that the path to redemption can be softened by enacting policies that perpetuate the very causes of the present crisis. If our economy is functioning poorly because we have borrowed and spent too much, how can recovery be manufactured by the borrowing and spending of the political elite? The implied message is that they know better than us how to spend our future earnings, that they are wiser than the collective wisdom of the citizens they presume to rule.

Just as the outgoing Bush team assured us that economic growth could only be secured by acceding to the demands of their campaign contributors, now the Obama team assures us of the same. They assure us that growth can be attained through the payment of indulgences to the Cardinals of the environmental movement, if we only ignore the loss of productivity created by investing scarce capital in inefficient energy sources and the jobs lost in the efficient, if less environmentally holy, extraction of carbon energy. They assure us that we can create jobs by building roads and bridges that will require the use of the expensive energy they intend to impose. They assure us that we can create jobs and improve our schools by repairing the buildings if we only ignore the mediocrity of the results produced by the teachers and administrators who occupy them. They assure us that we can make the American auto companies competitive by loaning them money we don't have so they can retool to make cars we don't need, don't want and can't afford.

As GDP recovers over the next few months it will not be because of this "stimulus" plan, but rather in spite of it. The Federal Reserve has expanded the monetary base in an attempt to avoid the non existent threat of deflation and while that might create the appearance of economic activity, it shouldn’t be confused with productive activity. Inflation is a monetary phenomenon and has long been with us notwithstanding government measures of same that lull only the obtuse into assuming it's quiescent. Further dollar debasement wrought by an over-aggressive Fed and a Treasury seeking to compound the monetary errors of Bush's Treasury heads will only make what was and is a bad problem, worse. The lessons of the 1970s, which we apparently need to learn anew, are being ignored for political expediency. The debt financed government stimulus will add to the inflationary pressures and the net result of all the government intervention will be a larger government share of the economy and a reduction in wealth for US citizens. While the politicians will publicly lament the consequences, they will have accomplished their goal of consolidating their power.

The public needs to see through these deceptions. The Federal Reserve cannot create prosperity by printing more money. Politicians cannot create growth by spending it. The factions who now dictate policy are not interested in our welfare but their own. The media is not unbiased but rather are purveyors of propaganda for their ideological sponsors. The answers to our problems are not to be found in Washington, D.C., but in our own abilities and actions. This country was founded by men who understood the evil that comes from excessive political power and designed a system to ensure it was limited. That system has now been perverted to serve the aims of the very people it was designed to shackle. It is time for us to recognize that fact and start acting to reverse the damage.

It is time for Republicans and Democrats, liberals and conservatives, Christians and atheists to put aside the petty squabbles that the political elite use to distract us. It is time to send a message. It is time for a cleansing. Throw them all out. Vote against every incumbent from local to state to federal. It is time for a fresh start.

Californian Democracy: Paving the Road to Ruin

Large enough to be a country in its own right, blessed with an abundance of natural resources, powered by a diversity of industries, home to some of the world’s top universities, and incubator of a storied entrepreneurial culture that is the envy of the world, California has all the resources any body politic could ask for.

So, what hath The People wrought?

The People have been living large, awarding themselves a 50% increase in the state budget over the past seven years. In order to pay for this cornucopia of largesse, personal and corporate income tax rates are among the highest in the country. The sales tax is on its way past 10%.

How has this worked out?

California is staring at a $42 billion state budget hole – the largest of any state shortfall in the nation’s history. The People have defaulted on more mortgages than the citizens of any other state. California’s general obligation bonds are rated lowest in the land, lower than even postdiluvian Louisiana, making it increasingly difficult and expensive for The People to borrow money. Unemployment is ten percent, and rising fast. One of four of The People’s children are dropping out of school. The list of broad-based dysfunction grows daily as the state teeters on the edge of bankruptcy.

Is it a surprise that citizens and business have begun fleeing? California lost more people to out-migration in 2008 than any other state, according to U.S. Census estimates. 2009 is shaping up to be even worse. The People are voting, all right. With their feet.

If you enjoyed watching billions get ineffectively squandered bailing out incompetent bankers and zombie car companies, you’ll love watching what’s left of your tax dollars get shipped off to California.

Despite the governator’s road-to-Damascus centrist conversion, California’s blue and red tribes remain locked at each other’s throats. Each claims that giving in to the other would precipitate disaster, as if disaster hasn’t already struck. So what is the classic Californian remedy for this gridlock? Lawyers are busy dismantling the last vestige of legislative checks and balances, which is the requirement that state budget bills achieve a two-thirds majority in order to pass. Apparently, The People want more power. Damn the minority, full speed ahead!

Can you imagine how California’s woes would be compounded if politicians in Sacramento had the power to issue their own currency? How long do you think it would be before the Sunshine State started to look like Bolivia?

Californians upset with the cultural backwardness of less enlightened Americans used to threaten secession. Sounds good to me; don’t let the door hit you in the keister.

Could California’s nightmare presage what the rest of us might expect as we empower our federal government to do “whatever it takes” to “fix the economy,” as if it were a broken watch?

As Congress doles out billions to anyone willing to prostrate themselves at the Capitol steps, are you surprised that those remaining productive elements of society hunker down in fear, not knowing what fresh outrages tomorrow might bring? What will stop ever more resources from being shifted into the public sector as The People shout down the minority, whose prior contributions to the mess have rendered them as impotent as they are intellectually bankrupt?

Could it be time to pause a moment and reflect on what we are doing to ourselves or are we happy behaving like a man with a raging fever who bursts into a pharmacy and starts randomly ripping open bottles of medicine, swallowing whatever pills he can get his hands on hoping that something – anything – might work?

Restarting the engine of our economy will take more than asking The People which tribe to let run amok. The illusion that either has the solution is the source of the problem.

Please, put the circus on hold and let’s turn off the TVs and get back to work. We can bake our own bread.

Treasury's Flawed Plan for Citigroup

As housing prices fall, mortgage losses mount and could easily reach another $1 trillion. Moreover, banks face similar losses on credit cards, auto loans and other questionable loans written during the Great Age of Excess—a.k.a. the second term of George W. Bush.

Banks must cover those losses by taking charges against their capital, and could deplete their capital and become insolvent. The Treasury's approach is to boost their capital by purchasing preferred shares from the banks through the TARP. Essentially, the Treasury is selling $750 billion in bonds, and using those funds to purchase dividend paying preferred shares in Citigroup, other commerical banks, large Wall Street securities dealers, and other financial service firms like AIG.

As housing prices fall, and projected defaults and losses rise, the values of CDOs held by banks fall too. Housing prices are down by 27 percent since August 2006, and the pace of the decline is accelerating. Prices could easily fall another 15 to 25 percent.

Already, about $400 billion in TARP funds are committed, and with housing prices dropping faster than Galileo’s rock, the remaining $350 billion will not be enough.

The Treasury is performing stress tests on the 19 largest banks to determine whether their common share equity could cover losses under various scenarios. Citigroup and others will likely come up short if Treasury is honest about how much housing prices could fall.

Bankers usually include preferred shares and other assets when measuring capital adequacy against prospective losses, and by those measures, Citigroup and others remain well capitalized - at least for now. Treasury has offered banks the option of converting its preferred shares to common stock, thus eliminating the 5 percent dividend on those shares but significantly diluting private shareholder equity.

At Citigroup, Treasury is offering to convert $25 billion of preferred shares to common stock; assuming Citigroup suspends dividends to most private preferred shareholders and significant numbers convert to common shares.

Faced with the choice between preferred shares that pay nothing, and high risk common shares worth close to but a bit more than nothing, most are expected to take the plunge.

Together, these ploys essentially confiscate private equity—a government taking in the meanest sense.

Washington’s stress tests and the sacking of Citigroup are motivating general fear among investors, and are driving prices for common stock of most banks into a race to zero. Coupled with the need for much more government funds as housing prices fall, this makes the U.S. government the inevitable controlling shareholder of the nation’s largest banks.

Comrade Stalin was not nearly as stealth.

No solution to preserve private banking can be found without halting the freefall in housing prices. That will require an aggregator or bad bank to purchase about $2 trillion in mortgage-backed securities at current mark-to-market values on the banks books. It could be capitalized with $250 billion in TARP funds, $250 billion in share sales to private shares, and $1 trillion in bonds. Banks and others could be paid for securities with 75 percent in cash and 25 percent in aggregator bank shares.

Performing triage—leaving alone mortgages that will be repaid, reworking those that could be repaid with some adjustments in principal and interest terms, and foreclosing on the rest—the aggregator banks could fix the number of foreclosures and limit the fall in housing prices. As many mortgages would be saved, the aggregator bank, like its predecessor the Savings and Loan Crisis Resolution Trust, would likely earn a profit for investors.

The banks, though not free of their other loan problems, would be strong enough to raise new capital, buy back the government’s preferred shares, reform management and lending practices, and contribute to, rather than retard, economic recovery.

Secretary Geithner has other plans few can understand, and whose motivations only the Gods above Mount Olympus can divine.

March 3, 2009

Obama's 'Change' Is Capital On Strike

This is both highly significant and dangerous. Capital, bluntly put, has gone on strike. Those who own wealth are pushing it to the sidelines, as a young and inexperienced president tries to jam through the most sweeping economic changes in over 70 years.

The prospect of these changes becoming law has already radically altered our nation's economy. Entrepreneurs and CEOs who once created new products, new services, jobs and trillions in wealth for America's workers and retirees now find themselves vilified and punished for their success.

ABC News reported this week that many upper-income taxpayers already are planning to cut back on work and investments to stay under $250,000 in income — the point where Obama's punitive taxes kick in. No one wins from this, yet Obama seems oblivious.

This isn't the only warning sign. A new study asserts that some 100,000 highly educated, well-trained Indians now living in the U.S. will return home in the next few years. Ditto China.

Immigrant entrepreneurs are highly sensitive bellwethers of economic and social conditions. They know where the opportunities are — and where they aren't. They're voting with their feet.

The economy shrank 6.2% in the fourth quarter, worse than first expected. Home sales continue to fall, unemployment is rising sharply, and business investment is prostrate. Such an economy cries out for tax cuts, but we get none. Just punishment of those with wealth who might be able to pull us out of the slump.

An estimated $1.4 trillion in new taxes planned by the new administration over the next decade explicitly target the people President Teddy Roosevelt once derided as the "malefactors of great wealth" — those in the top 5% of the income spectrum. Yet, they're the ones who've made our economy the envy of the world.

By the way, under Obama's plan the rich won't pick up the whole tab. New energy taxes of $646 billion will hit the middle-class hard. Meanwhile, in just eight years, our national debt will double to $20 trillion, as nondefense federal spending jumps from the long-term average of 16.5% of GDP to above 23%.

You — or your children — face higher taxes for decades to come.

As our stock markets melt under a barrage of new taxes on incomes, estates, capital gains, dividends and energy, it's good to recall that more than 100 million people own stocks or mutual funds. And that the stock market is the main wealth- and growth-creating mechanism in our capitalist society.

But when taxes go up, regulations proliferate and the rule of law and private property protections are weakened, the economy will invariably suffer. This is a universal lesson of economic history, one we ignore at our peril. And yes, this is what's happening now.

No, we don't blame all our current ills on President Obama. He came in at a tough time, when many bad decisions had already been made. But he is responsible for what he's done since.

His stimulus package is little more than a down payment on a socialist economy. It raises taxes on the successful, brings back the welfare state, hands out favors and cash to friends of one political party, while imposing government control over the entire free market in ways that just a year ago would have seemed unimaginable.

March 4, 2009

Take It From An Old Socialist, Obama Isn't One

First, as we survey the political landscape, what's striking is the absence of advocates of socialism, at least as the term was understood by those who carried that banner during the capitalist crisis of the 1930s. Then, socialists and communists both spoke of nationalizing all major industries and abolishing private markets and the wage system. Today, it's impossible to find a left-leaning party anywhere that has such demands or entertains such fantasies. (Not even Hugo Chávez -- more an authoritarian populist than any kind of socialist -- says such things.)

Within the confines of socialist history, this means that the perspective of Eduard Bernstein -- the fin de siecle German socialist who argued that the immediate struggle to humanize capitalism through the instruments of democratic government was everything, and that the goal of supplanting capitalism altogether was meaningless -- has definitively prevailed. Within the confines of American history, this means that when New York's garment unions left the Socialist Party to endorse Franklin Roosevelt in 1936, they were charting the paradigmatic course for American socialists: into the Democratic Party to support not the abolition of capitalism but its regulation and democratization, and the creation of some areas of public life where the market does not rule.

But in the United States, conservatives have never bashed socialism because its specter was actually stalking America. Rather, they've wielded the cudgel against such progressive reforms as free universal education, the minimum wage or tighter financial regulations. Their signal success is to have kept the United States free from the taint of universal health care. The result: We have the world's highest health-care costs, borne by businesses and employees that cannot afford them; nearly 50 million Americans have no coverage; infant mortality rates are higher than those in 41 nations -- but at least (phew!) we don't have socialized medicine.

Give conservatives credit for their consistency: They attacked Roosevelt as a socialist as they are now attacking Obama, when in fact Obama, like Roosevelt before him, is engaged not in creating socialism but in rebooting a crashed capitalist system. The spending in Obama's stimulus plan isn't a socialist takeover. It's the only way to inject money into a system in which private-sector investment, consumption and exports -- the other three possible engines of growth -- are locked down. Investing more tax dollars in education and research and development is a way to use public funds to create a more competitive private sector. Keeping our banks from speculating madly with our money is a way to keep banking alive.

If Obama realizes his agenda, what emerges will be a more social, sustainable, competitive capitalism. His more intellectually honest and sentient conservative critics don't accuse him of Leninism but of making our form of capitalism more like Europe's. In fact, over the past quarter-century, Europe's capitalism became less regulated and more like ours, one reason Europe is tanking along with everyone else.

Take it from a democratic socialist: Laissez-faire American capitalism is about to be supplanted not by socialism but by a more regulated, viable capitalism. And the reason isn't that the woods are full of secret socialists who are only now outing themselves.

Judging by the failures of the great Wall Street investment houses and the worldwide crisis of commercial banks; the collapse of East Asian, German and American exports; the death rattle of the U.S. auto industry; the plunge of stock markets everywhere; the sickening rise in global joblessness; and the growing shakiness of governments in fledgling democracies that opened themselves to the world market -- judging by all these, a more social capitalism is on the horizon because the deregulated capitalism of the past 30 years has blown itself up, taking much of the known world with it.

So, for conservatives searching for the culprits behind this transformation of capitalism: Despite our best efforts, it wasn't Bernie and it wasn't me. It was your own damn system.

Obama Gives Us the Same Old New Deal

In fact, many economists agree that the New Deal was a formula for institutionalizing unemployment, not reducing it.

Seventy-five years later, with unemployment heading to 10%, government has prescribed a similar formula.

"We can only hope that the government's cure doesn't further sicken the patient," Johnson added.

The odds aren't good, though. FDR proved that we can't spend our way back to prosperity, and we certainly can't tax our way back. Yet Obama's long-term budget calls for massive new spending along with $1.4 trillion in net new taxes.

The president's insistence on soaking the rich in a severe downturn is also troubling. He may be dooming us to repeat FDR's mistakes.

Even Roosevelt's loyal Treasury secretary confessed that New Deal policies failed. By 1939, a frustrated Henry Morgenthau had concluded that massive tax-and-spend programs hadn't made a dent in structural unemployment, which was at 20%.

"We have tried spending money," Morgenthau lamented. "We are spending more than we have ever spent before and it does not work. We have just as much unemployment as when we started. . . . And an enormous debt to boot!"

Will Timothy Geithner be lamenting the same thing four years from now?

While Obama says he doesn't want to reprise FDR's policies, he sure is a big fan of them. In fact, in his 2006 memoir he explicitly said he wanted to resurrect them. And this was long before the recession.

"Today the social compact FDR helped construct is beginning to crumble," Obama wrote. He proposed an "alternative approach" to what he felt was the GOP's flint-hearted "ownership society." He offered a path that "recasts FDR's social compact to meet the needs of a new century."

Obama mistakenly credits FDR's policies — not World War II, and the reversal of many of FDR's policies — with the postwar economic boom.

Referring to globalization, he wrote: "The last time we faced an economic transformation as disruptive as the one we face today, FDR led the nation to a new social compact — a bargain between government, business and workers that resulted in widespread prosperity and economic security for more than 50 years."

Now he has a full-blown economic crisis to help justify returning to such a state (as his chief of staff says, never let a good crisis go to waste). The parallels between his policies and those of FDR are numerous — and ominous.

1. FDR raised the top marginal income-tax rate (to 79%, then again to 90%), discouraging entrepreneurs from investing and starting new businesses. Obama vows to hike income taxes (while limiting deductions) for couples and businesses earning more than $250,000.

Ronald Reagan, in contrast, incentivized entrepreneurs with tax cuts, and they led us out of the last recession that was this bad. (Interestingly, Reagan now ranks as the greatest president of all time, easily surpassing Roosevelt, who ranked fourth, according to a recent Gallup poll.)

2. FDR tried massive new government programs, and while they created jobs, they were largely make-work jobs that didn't last. And every dollar that went to create a federal job had to come from taxpayers who could have spent those dollars in the private sector. The programs also created a mammoth new bureaucracy that freighted the economy with even more inefficiencies.

For his part, Obama hopes to create 3.5 million jobs to build, among other things, "wind turbines and solar panels." He's betting that the industries of the future are green. But in his 2006 book, he bet wrong when he championed ethanol as the energy source of the future. So will his "green collar" jobs really be the jobs of the future, or just another boondoggle?

3. FDR re-regulated the economy, including the banking and finance industries, which are square in Obama's sights. Under FDR, the Federal Reserve let the money supply contract. He burdened businesses with onerous rules and price-support schemes and diminished competition across industries. The economy remained mired. Now Obama plans similar meddling.

4. FDR talked down free trade and talked up protectionism, which only hurt exports. Obama is singing the same tune for the benefit of the unions to whom he admits he's greatly indebted.

"I owe unions," he said in 2006. "When their leaders call, I do my best to call them back right away. I don't consider this corrupting in any way; I don't mind feeling obligated toward (them). . . . I got into politics to fight for these folks." That was back when he was a senator. Imagine the debt he owes unions now.

5. Obama, like FDR, wants to set wages. He wants to put in place federal rules that require businesses to pay above-market, union-level wages, meaning fewer jobs will be created.

"FDR understood that decent wages and benefits for workers could create the middle-class base of consumers that would stabilize the U.S. economy and drive its expansion," Obama wrote of his hero, failing to understand that wage mandates always cost jobs, and without jobs, consumers stop consuming.

6. FDR eventually employed Keynesian deficit spending. That didn't work either. It just piled up a massive debt that we had to inflate our way out of. When Obama is done with his own New Deal, we could find ourselves with a staggering $15 trillion gross national debt, which, combined with contracting GDP, could push the total debt burden well above 70% of GDP.

7. FDR created massive welfare programs without means-testing, and it just created a dole that prolonged unemployment. Obama is mandating that states dole out federal stimulus money based on census data alone. It's stealth welfare, just like his tax credits. Federal health care is next; in fact, Obama's budget proposes $1 trillion in new health and other entitlements.

The reason the New Deal didn't work was not that government didn't do enough, but that it did too much. The economic growth and job creation that this country so sorely needs now must ultimately come from the private sector.

The markets know this. That's why they're sending distress signals. The problem is, Obama's too busy plowing ahead with New Deal II to listen.

How Many Entrepreneurs Can Government Create?

Lately, America’s entrepreneurs are wondering just how dark the shadow will get for them. And the rest of us should wonder what kind of an impact our federal policies will have on entrepreneurial activity, and by extension on the economy in general.

There’s little doubt that the President was correct that entrepreneurs help drive our economy. Start-ups accounted for about 3 percent of all jobs in the U.S. economy annually from 1980 through 2005, according to new business dynamics research by the Bureau of Labor Statistics and the Kauffman Foundation. Given that annual job growth averaged 1.8 percent over that time, the net jobs added by new ventures proved vital to our economy’s advances.

Americans sense the importance of smaller firms, especially start-ups. In a Zogby poll last week, 63 percent of those sampled said they thought small business owners and entrepreneurs would lead us out of our current economic difficulties, compared to 31 percent who expressed confidence in our government leaders to find the answers to our economic problems, and 21 percent who thought executives of big businesses would show us the way to a new economic future.

But small firms can only lead the way if government does not inhibit them. A 2005 study by economists Donald Bruce and Tami Gurley, for instance, found a significant correlation between tax rates and entrepreneurial activity. Notably, the pair found that increases in tax rates on wages and entrepreneurial income (for example, income from a sole proprietorship or partnership) reduce the number of start-ups and hasten the number of entrepreneurs who give up their businesses, while tax cuts have the opposite effect, that is, they spur more entrepreneurship. The study estimated that every one percentage point cut in tax rates generates 1.5 percentage points more in entrepreneurial activity and reduces by nearly 4 percentage points the likelihood that those who are already engaged in a start-up will exit the field. Tax increases decrease entrepreneurial activity by like margins.

The authors don’t delineate all of the ways that higher taxes play out in the economy’s entrepreneurial sector, but entrepreneurs themselves will gladly explain it for you. Sramana Mitra, who has founded three companies and is the author of the book Entrepreneur Journeys, observes that, “bootstrapped entrepreneurship,” that is, entrepreneurship at its most basic level, which is often self-funded, “is the true weapon of mass reconstruction.” Few in government understand this dynamic, she suggests, which may be one reason why the Obama administration’s answer to reigniting start-up activity is to create a loan fund that would finance a relatively few new ventures, rather than to focus on tax and regulatory changes that can potentially influence millions of start-ups.

According to Mitra, since most start-ups fund their businesses initially out of their savings and those of their families and friends, not from capital provided by professional investors, personal income tax rates matter so much more to them than venture capital initiatives.

“More often than not, an angel turns out to be the entrepreneur’s uncle, who is a doctor making $400,000 a year and can afford to invest in the nephew’s audacious dream and unproven idea,” Mitra writes. “Thus, the government should be very careful how these $400,000-a-year uncles are treated from a tax policy point of view. The choice may well be between $250,000 being invested in a start-up, versus that $250,000 going into the government’s pocket as income tax.”

In his speech, the president offered a different vision when he said that it was government which “catalyzed private enterprise” with big, bold investments and sweeping agendas—from the national highway building program of the 1950s to the Moon race of the 1960s. Government, in other words, doesn’t just provide the broad outlines for a stable society in which entrepreneurs can survive—like a fair judicial system to enforce contracts—but will help us pick our next generation of winners and losers.

In seems, in other words, that in the process of redefining capitalism, we are also reworking our fundamental definition of what it means to be an entrepreneur--for better or for worse.

Spooky Parallels Between 1933 and 2009

MacDonald was in a rush when the gigantic Cunarder Berengaria delivered him to a municipal tug that steamed to Jersey City for a train to Washington. There was a general sense the Americans didn’t know where they were going.

MacDonald’s “flying visit” had a threefold purpose: to befriend the new president, to debate the causes of worldwide “economic ills,” and to encourage and hurry up the proposed World Economic Conference in London. MacDonald needed the Economic Conference to stop a trade war that he felt was wrecking Britain and Europe.

For four days, Saturday through Tuesday, at the White House and on the presidential yacht Sequoia, the two leaders and their aides ranged over tariffs, deflation, currency policy, market instability, military adventurism in Asia, and the new regime in Germany. Roosevelt was brash and powerful.

Somewhat surprisingly, the seemingly opaque MacDonald alarmed the Americans by making bold remarks at the National Press Club, broadcast nationally on the radio, in which the PM emphasized that the gold suspension was a “great crisis,” his regret that some were using the “ugly” word “retaliation” with regard to the President’s decision, and that there was now even greater need to focus on the London Conference in order to agree upon “common action.”

“I hope our French friends, our Italian friends, and all others will be spurred to seek agreement rather than be discouraged and make no attempt. Tarrifs, restrictions of all kinds, quotas – of what use are they in a free, sane world where exchange is as profitable in trade as in ideas?”

Ramsay MacDonald’s question deserved an answer in 1933 no less than it deserves an answer today. “Retaliation” was the weapon of choice that doomed the London Economic Conference in June of that year, and that opened the door for those who Paul Johnson names the Devils in Germany, Japan, and Russia.

The gold suspension, the paradoxical fears of deflation and inflation, currency policy: all were pieces of the larger face of the protectionist creature loosed in America by the sinister Smoot-Hawley legislation of 1930, and present in many guises in the Four Powers of Europe, as well as in Soviet Russia and predatory Imperial Japan. We know now that the failure of MacDonald and Roosevelt to agree on reversing the trade collapse ahead of the Conference was the last opportunity the two states would have – ever - before the trade war morphed into the military campaigns of 1936 and beyond.

Returning to the present, it is a simple, rational mission for Gordon Brown and Barack Obama. Brown calls his ambition “a global new deal,” but it is not necessary to oversell it with cable news concepts. What Messrs. Brown and Obama need to do, is to accomplish what MacDonald and Roosevelt did not. They must arrive at the G20 meeting next month in London united on trade, and with a vocal sense of alarm that world governments are following an anti-trade script that will surely end wretchedly.

The Myth of Systemic Collapse

The concept is straightforward. A large bank fails, and its counterparties, to whom it owes money, also fail and so on in a domino effect. Those who support this theory invariably point to vast sums of derivative contracts outstanding. If there are tens of trillions of dollars of derivatives contracts, it must be the case that the system is vulnerable to the failure of a large player.

Derivatives, those “financial weapons of mass destruction,” to quote Warren Buffet, are the transmission mechanism whereby the financial world ends with a bang. It has become an article of faith that the system will implode if some of the larger players fail, because the derivative claims presented by their counterparties would go unpaid, leaving their counterparties unable to meet their own obligations, and so on.

We need to question this article of faith, and it might help to start with the Lehman bankruptcy. Lehman’s failure was a perfect storm. Lehman was not only the 4th largest U.S. securities firm, it punched above its weight in fixed income, and specifically in credit derivatives. Lehman was both a huge dealer in Credit Default Swaps (CDS) and one of the most common reference names to be traded in individual swaps and CDS indexes.

Worse, the settlement of Lehman CDS was about as bad as could be imagined. The settlement price determined by dealer auction was a measly 8.625 cents on the dollar. This means that of the $400 billion in Lehman CDS outstanding, Protection Sellers (those long Lehman) had to pay $365 billion to the Protection Buyers (those short Lehman).

Before the settlement of those swaps last October, concerns surrounding the payments were widespread. The New York Times’ Floyd Norris worried that “we do not know how many such swaps are even outstanding, let alone who is on the hook to pay.”

But settlement was a non-event. Given the widespread trading in Lehman CDS, and the near zero recovery rate, it is remarkable that the CDS market was able to function as designed. More impressive, there does not appear to have been a significant knock-on effect where Lehman’s own counterparties suffered sizable losses on under-collateralized trades.

While it is fashionable to decry the unregulated nature of CDS, the market did its job fairly well because the collateral system among banks and hedge funds insured that most of the money protection sellers would need to pay protection buyers was already in place.

Then came AIG. And in order to avoid systemic collapse the government invested $150 billion and counting. Now that AIG’s stock price has fallen below $1 and its market capitalization is about $1 billion, it is worth remembering why this investment was made in the first place.

AIG was a special case because banks would trade with it on an uncollateralized basis. AIG Financial Products was a Protection Seller against mortgage CDOs, meaning it insured the top tranches of these now toxic securities. Because of its size and credit quality, AIG would often not have to post collateral for this insurance, provided it maintained its AAA rating. In retrospect, the decision to buy protection from AIG without adequate collateral mechanics was just another foolish credit decision by the banks.

Facing imminent downgrade, and realizing it would not be able to post sufficient collateral to satisfy its contractual obligations, AIG found an equity partner in the U.S. taxpayer. After this, the story gets murky, but we know a large part of the taxpayer’s investment went to satisfy the “margin calls” of banks and brokers to whom AIG had sold protection. It is something of a national scandal that we do not know exactly how much and to whom.

What we do know is that last September a number of banks and brokers were able to convince Treasury Secretary Paulson that if AIG failed, the stress to the system would be too great and systemic collapse would follow. I believe Paulson was gulled, and I think the Lehman bankruptcy bolsters my case.

AIG was unusual in that very few institutions get away with not posting collateral on derivative trades. The general trade for a bank with a bank or a bank with a hedge fund is two-way margining. That is, as the price of the underlying contract fluctuates, collateral goes back and forth on a daily basis. These arrangements are governed by Master ISDA Agreements and while there are variations among them, it is unusual between large institutions for the contract to be one-sided, meaning one side posts margin and the other side does not.

Where Paulson appears to have been hoodwinked was in believing that system-wide collateral arrangements were hugely inadequate. This myth persists today. AIG’s unusual arrangement became a metaphor for the whole system. But AIG’s collateral arrangements were the exception, not the rule.

Clearly AIG’s failure to post collateral upon a ratings downgrade would have severely damaged a number of its immediate counterparties who traded with it on the basis of “ratings triggers” rather than actual collateral. But in order for the contagion theory to be true, it would need to be true that these direct counterparties of AIG had also not posted sufficient collateral to their counterparties. This is very unlikely.

In the world of derivative trading, Lehman, not AIG, was the norm. What this mean is that in general, banks have adequate collateral against counterparty claims. Those who traded derivatives with Lehman seem to have had sufficient collateral to cover the unwinding of their trades following Lehman’s bankruptcy filing. The system worked as designed, even while unsecured creditors of Lehman can expect to be virtually wiped out in the final bankruptcy settlement.

Thus the Lehman fact pattern indicates that whatever contagion would have followed an AIG failure would have been limited to AIG’s largest direct counterparties and not created wave after wave of failure. Those who convinced the government to save AIG to save the system were really saving themselves.

The hysteria whipped up by those who insist that we must keep moribund institutions alive to prevent financial Armageddon is now bordering on recklessness. Monday’s joint Treasury-Fed announcement mentioned AIG’s “30,000,000 policyholders in the US” and “retirement insurance for teachers.” Surely Bernanke and Geithner know that the insurance subsidiaries of AIG are separately capitalized and insulated, by design, from the problems of AIG Financial Products and the holding company. What possible reason could there be for frightening policyholders and retired teachers?

Nobody expects that we can have a series of large bank failures in America without suffering some pain. But the ensuing dislocation must be weighed against the cost of the bailouts. As the situation continues to worsen, we need leaders who can explain these tradeoffs with credibility. At the moment, we have a perverse situation where our leaders seem to have a vested interest in making the system appear weaker than it is.

March 5, 2009

To Fix Wall Street, Bust Some Trusts

Even AIG knows it's too big. "AIG's conglomerate structure is too complicated, unwieldy and opaque," said Edward Liddy, the company's new chief executive, who came in last fall to try to clean up the wreckage. The tragedy is that this was clear a few years ago, and nobody did anything about it. A former regulator remembers that AIG's transactions were so tangled and incomprehensible that it couldn't close its books on time -- yet nobody thought to call a halt.

Treasury and Federal Reserve officials have continued to operate on the assumption that in finance, bigger is better -- and safer. The argument for these huge, diversified financial institutions has been that in pooling different kinds of risks, they would increase the portfolios' overall stability. That rationale helped create the monstrosity called Citigroup. It was like the argument for securitization of subprime mortgages -- put enough of them together and the danger of default would be less. That didn't work out too well.

And yet the authorities have continued to act as if greater size will provide greater stability. That was the rationale for pushing a healthy Bank of America to acquire a sick Merrill Lynch last fall. A better response to Merrill's sickness would have been to leach out the toxic assets and then encourage an orderly breakup of the brokerage firm; it was too big already.

A case study for today's regulators is President Theodore Roosevelt's response to the financial shenanigans of 1902, when the railroad barons tried to combine the Great Northern and Northern Pacific lines into a huge holding company called Northern Securities Co. Roosevelt wanted to file an antitrust suit to stop the deal. The financiers threatened that the lawsuit would cause a panic on Wall Street, to which TR's attorney general, Philander G. Knox, memorably replied: "There is no stock ticker at the Department of Justice."

When Roosevelt ignored the threats and moved to file the trustbusting suit, he received a hasty visit from J. Pierpont Morgan, the reigning financial titan. "If we have done anything wrong, send your man to my man and they can fix it up," offered Morgan. TR responded unflinchingly, "That can't be done."

Sad to say, but since this crisis began last year, Treasury and Fed officials have been rushing to "send your man to my man" to fix things up in hastily concocted weekend deals. The big financial trusts of our day have been threatening the regulators with ruin, and the regulators have been caving. They don't want another Lehman Brothers. But the authorities should have explored whether, as an alternative to failure, they could dismantle the giants into smaller, more manageable parts that could work their way to solvency.

Historian Walter Lord, in his 1960 book "The Good Years," wrote of Morgan and the other plutocrats: "These men were not naturally callous. They had no evil intent. But they had lost touch. The vastness of the operations, the complexity of their corporate structures kept them from their employees and the people they served." That's a perfect description of the executives at Citigroup, AIG and the other behemoths that brought the financial crisis down on our heads.

The Obama team has been lauded for emulating Franklin Roosevelt's bold response to the Great Depression of the 1930s. And as calls grow for nationalization of Citi and other giant banks, they may be tempted to go where even FDR feared to tread. But financial giantism -- private or public -- isn't the answer. The challenge is how to reconstruct our broken financial system. Let's give Franklin a rest for a while and ponder Teddy's progressive philosophy: When it comes to finance, smaller really is beautiful.

Obama Must Take the Market Seriously

The stock market, he continued, "is sort of like a tracking poll in politics. It bobs up and down every day. . . . If you spend your time worrying about that, you're probably going to get the long-term strategy wrong."

Obama also said "it's not surprising that the market is hurting. I think what we're seeing is . . . as people absorb the depths of the problems that existed in the banking system, as well as the international ramifications of it . . . there is going to be a natural reaction.

"On the other hand, what you're seeing now is profit and earning ratios are starting to get to the point where buying stocks is potentially a good deal, if you have a long-term perspective on it."

That's quite a bit of analysis and advice coming out of the Oval Office. We didn't realize that our president was such a market maven.

To be fair, Obama isn't the first president to counsel a long-term view when the market gets into trouble. Few chief executives, however, make such specific calls as Obama did Tuesday based on what we took him to mean price-to-earnings ratios.

And who knows? If the market follows through on its strong action Wednesday, his call — that stocks are a "good deal" — may be one for the record books: He will have nailed the bottom, and we'll be the first to congratulate — and thank — him.

That said, we take issue with his comparison of the stock market to political polls, and worry he's not taking the market seriously enough. Far from being something that "bobs up and down every day," the market reflects the opinions of millions of investors and thousands of institutions who are super-sensitive to all that goes on — economically, politically and otherwise.

It's for good reason the government uses the market as one of its 10 leading economic indicators. The market is not, however, a long-term indicator. It looks at what's happening right now and what it will mean for the economy six months or so in the future.

If it believes what's happening now is constructive, it will move higher. If it doesn't like what it sees . . . well, that's why we commend recent market action to the president's attention.

As we noted on a chart that ran on Tuesday's op-ed page, the Dow industrial average has sold off 30% since Obama was elected. And as we noted in another chart a week earlier, it has tumbled 44% from mid-September, when the financial crisis came to a head and Obama moved ahead of McCain for good in the presidential race.

We'd hardly call that "bobbing up and down." We'd call it a savage bear market in which investors obviously have yet to see anything constructive on the horizon. Bear markets usually last nine to 12 months; we're in our 17th with no end in sight.

Whether or not he takes the market's action seriously, the president or someone on his team might ask why this is so, and why the downdraft has accelerated since he came on the scene.

Obama's Higher Taxes Hit Working Wives

By raising taxes on upper-income Americans, Mr. Obama would worsen our tax system's marriage penalty on two-earner married couples, and Amanda and Henry would pay even more tax married than single.

In Mr. Obama’s new budget for 2010, he outlined plans to allow the top two tax rates to rise from 33% to 36% and from 35% to 39.6% in 2011. In addition, taxpayers in these brackets would not receive the full value of their itemized deductions, further exacerbating the fiscal disadvantages of marriage for some couples.

Taxes would rise for singles with taxable income over $172,000 and married couples over $209,000. Even if Amanda and Henry weren’t immediately affected by higher rates, those rates might well hit them when they earn more.

Unless, of course, Amanda and Henry decide to have children, and Amanda left the workforce to care for them. Say that Amanda’s taxable income rose to $60,000, so she and Henry had a combined income of $220,000, placing them in Mr. Obama’s new 36% bracket. But with Amanda at home looking after the children, their federal tax rate would be 28%.

And federal taxes aren’t the whole story. State taxes would take another 9% of Henry and Amanda’s income in states such as Oregon, Vermont and Iowa; Medicare takes another 1.45%; and Social Security taxes add another 6.2% up to $107,000.

Our tax system shouldn’t make it harder for women to work. The penalty falls most heavily on married women who have invested in education, hoping to shatter glass ceilings and compete with men for managerial jobs, and the Obama plan would exacerbate the penalty.

When mothers take jobs, earnings are reduced by taxes paid at their husbands’ higher rates, in addition to costs for childcare and her transportation. This discourages married women not just from working, but also from striving for promotions, from pursuing upwardly-mobile careers.

Mothers are more affected by the marriage penalty than other women because they are more likely to move out of the labor force to look after newborn children and toddlers, and then to return to work when their children are in school.

It doesn’t have to be this way. Men and women could be taxed on their income separately, as is the case in Britain. Since 1990, British married couples have been taxed independently, with deductions and allowances split between them.

It’s a revolutionary idea. A married woman has her own tax return, with only her income, deductions, and capital gains. She pays her own tax and has tax refunds returned to her. If she makes mistakes, she pays her own penalties.

One disadvantage is that with separate filing and taxation, spouses who are the sole household earner might pay at higher rates than they do now filing jointly. Alternatively, politicians could choose a flatter structure of taxes, so that couples don’t face higher rates upon marriage.

Yet, rather than proposing changes that help women, Mr. Obama’s new budget will make matters worse. His tax proposals would discourage the Amandas and Henrys of our country from getting married. When married, it would discourage Amanda and other educated women from working. When working, it would give Uncle Sam a bigger bite out of Amanda's future income as it rises.

Labor Department data show that as average number of earners per household rise, so do income levels. One characteristic of the highest-earning one-fifth of households is that they have an average of two earners per household. The middle fifth averages 1.4 earners per household, and the lowest-earning fifth averages half an earner per household—more part-time and unemployed workers, or retirees.

Therefore, when workers marry, more households move into the top fifth of the income distribution. When Mr. Obama tries to raise taxes on top earners then working women are disproportionately affected, even if, like Amanda, they don’t earn a lot by themselves.

For Mr. Obama to announce that he is raising taxes on those at the top end of the scale is an explicit attack on married working women, those who voted for him by a substantial majority. There has to be a better way.

Policy Matters, Now Profit From It

For example, simple economics says if you tax something you get less of it, and if you subsidize something you get more of it. Consequently, an increase in the capital gains tax rate decreases the value of stocks, while a government subsidy requiring that cars use ethanol fuel increases the price of ethanol.

These examples are clearly understood in the framework of basic economic theory. However, what is often misunderstood, especially by investors, is that policy changes often have large ripple effects in ancillary areas and asset classes. Henry Hazlitt taught that all of economics can be reduced to one lesson, “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

It is now clear that implementing a government ethanol policy several years ago had a considerable impact on driving up the price of not only ethanol, but corn, food, farmland, fertilizer, tractors and farmers’ incomes. Investors must understand that the impact of policies can be enormous and far reaching. Small changes in one area can cause very large and unanticipated changes in another.

Not only is it a fool’s game to invest for relative returns, but it is also a fool’s game to invest in only one asset class, like equities. Investors must use a multi asset class investment framework, not only for diversification, but to fully understand and capture investment opportunities.

Which policies are important?

Every single government policy, even down to the local approval of a park, has some far-reaching impact on supply and demand. We break the policy world down into four domains. By examining what is happening in these four broad areas we can make assessments about which asset classes will provide opportunities for positive returns.

Monetary - Monetary policy encompasses all things Federal Reserve. We are believers in Milton Friedman’s teaching that “inflation is always and everywhere a monetary phenomenon.” Therefore, the actions of the Federal Reserve will always be inflationary, deflationary or neutral. This will have large and differing affects on asset classes.

Since well before 2007, the Bush administration’s Fed was running an erratic monetary policy. The current deflation did not truly end until around September 2008 when the Fed began adding excess monetary base to the system. This should have marked the end of the asset price decline, and in some asset classes it did. As the Fed’s monetary base expansion began and accelerated, collapsing spreads and improving credit market conditions sparked enormous rallies in asset classes like municipal bonds, investment grade corporate bonds and precious metals. An investor who ignored the impact monetary policy had on these non-equity asset classes missed some extraordinary opportunities for return.

Tax – Tax policy encompasses taxes on personal income, capital, dividends, businesses, interest, and death. We believe incentives matter, and tax rates change behavior. Importantly, the incidence of a tax can be different from the burden. The Obama administration is clearly hostile towards wealthy individuals, shareholders, estates and businesses, especially Wall Street.

We have no doubt that they will raise tax rates in all of these areas, and the recently released budget outlines the magnitude of some of those increases. These rate hikes are not merely to increase revenues, but to execute their fundamental goal of changing social policy through the tax code. They believe wealth is a consequence of unfairness. Just as monetary policy determines the inflation rate, tax policy determines the operating rate. No matter how high the spending “stimulus,” higher taxes will result in downward pressure on income, output and employment.

Trade – Foreign trade is the visible side of international capital flows. A trade deficit must mean a capital surplus, and any country that imports capital must run what is called a trade balance deficit. Foreigners must sell us their products to earn the dollars to buy our titles to capital - our bonds, stocks and buildings.

We believe that this free flow of capital and trade is the voluntary exchange by which the entire world becomes more prosperous. Capital markets cannot work if product markets fail to work through open trade. Obama campaigned on a platform of protectionism and is now delivering on his promises with tough talk against NAFTA and the inclusion of “buy American” provisions in the “stimulus” bill. If we want the world’s capital, we must take their products. Impeding that process is something we already tried…it was called the 1930’s.

Regulatory – Regulatory policy specifies outcomes that would not be produced by the markets. Some of these can be very useful, like food safety standards, seat belts and standard size rail gauges. We believe that regulation is beneficial, improves commerce, facilitates trade, protects both buyers and sellers, and can strengthen markets.

However, central planning derails the economy. This happened in the Nixon/Carter era and is threatening to happen again. Disastrous regulations imposed by Bush, like mark-to-market accounting rules and the elimination of the uptick rule, continue under Obama. These policies are worsening the financial crisis and adding uncertainty to markets.

The mother of all regulation lurking out there is cap and trade. Based on questionable and unsettled science, cap and trade will dramatically increase energy costs, lower output, increase unemployment, and cause carbon intensive manufacturing to shift out of the U.S. What’s more, closing our borders to the importation of those products will collapse our capital markets. This is not a prosperity friendly policy. We should not sacrifice our economy for uncertain science. We need more data.

How to Invest?

Watching policy tells you not only when to buy/sell, but what to buy/sell. While we think the Bush financial crisis is ending, the Obama central planning crisis is beginning. Our read of the policy landscape has us positioned in the following asset classes.

Remember, in our absolute return approach we do not care about relative results. Our default is 100% invested in risk free Treasury Bills and all other asset classes must compete to pry investment capital away from cash. We do not have to own anything and only put capital at risk when we expect a positive return. We never “play to lose less.”

U.S. Equities – A perfect storm of Bush administration bad policies created the 2008 financial crisis. The Bush administration continued terrible Fannie Mae and Freddie Mac regulations. The Fed botched monetary policy by keeping rates too low for too long, then too high for too long. Then in 2007, after there were already signs of trouble, the Administration implemented mark to market accounting and removed the uptick rule, shattering trust in the banking system.

The final straws on this collapsing camel’s back were allowing Lehman to fail, beginning the process of bank socialization and being unclear about uses for TARP funds. The financial panic was mostly solved by the Fed’s bold and aggressive action. The Fed correctly flooded the system with excess monetary base, thus ending the blackout in credit markets. So why are equities at new lows? Because equities are not pricing the end of the Bush crisis, rather they are forecasting the upcoming Obama crisis.

Equities are titles to capital and very long duration assets. In this way they differ from other asset classes like bonds, which are a stream of payments on a fixed schedule for a time certain. Equities are ignoring stimulative monetary policy and instead are looking ahead at the worsening policy landscape in the tax, trade and regulatory domains. Policies in these areas are anti stock market. We have reduced our equity exposure from over 80% in 2007 to around 30%. We intend to further reduce equity exposure so long as policies remain hostile towards shareholders.

Fixed Income: Almost no other asset class tells the story of our policy and economic situation better than U.S. Treasuries. During the October/November panic, T-bills traded at 0% as investors fled risky assets. This pushed longer term Treasury bonds to unsustainably high prices. We were happy to sell all Treasury bond holdings and move out the fixed income risk curve.

On the heels of simulative Fed policy we invested in municipal bonds and investment grade corporate debt. These areas have rallied over 20% from their October lows and, unlike equities, held onto most of those gains through today. Lastly, we invested in Treasury Inflation Protected Securities (TIPS). We see a perfect storm brewing for inflation as the Fed supplies excess money while Obama’s “stimulus” and tax hikes collapse GDP. This is textbook "too much money chasing a shrinking supply of goods", and it's reminiscent of 1970’s inflation.

Commodities – The same inflation scenario pushing us into TIPS is also pushing us into hard commodities. Precious metals prices are mostly influenced by their nearness to money. Other industrial and agriculture commodities prices are determined by an inflation component plus a supply /demand component. We have a small investment in gold and gold mining companies as a direct play on higher inflation. So far we have stayed away from softer commodities like energy, agriculture and industrial metals whose sustained price increases will also require an increase in economic activity. As in all of our investment decisions, we are not trying to call a bottom.

Real Estate – House prices are not too high, but they are falling. Measures of affordability indicate that houses are as cheap as they'll get…until next month. The Administration is so far failing to grasp the idea that the “just one thing” to fix many of the economy’s problems is to stop the house price decline. We are watching for policies that will restore real estate markets to their normal state. Only then can we begin viewing real estate as a valid asset class for investment. We see no reason to be early into homebuilders, REITS or housing sensitive investments. When the time comes, there will be excellent ways to invest in this important asset class.

Foreign Equities – It will be very difficult for most foreign markets to do well if the United States does poorly. The U.S. is the world’s customer, and no entity can do better if their customer does poorly. Success in foreign markets is connected to growth and stability in the U.S. When U.S. policy improves there are many dynamic and innovative foreign economies that will represent attractive investment opportunities.

Counterintuitively, when the U.S. begins to imitate China’s and India’s tax cutting and pro business policies, this will be the moment to invest. Their young workforce demographics are a perfect counterbalance to our older, pre-retirement population. Demography is the only destiny that is inescapable. Investors will want to be positioned for the rising prosperity of 40% of the world’s population.

The Future

Like so many things in life, our investment strategy is easier said than done. Investors often get trapped into certain asset classes and styles. This is so common that the entire investment industry is arranged in this manner.

There are managers and funds for large cap growth, small cap value, high yield foreign bonds and countless more. They all promise returns based on long term reversion to the mean analysis of their style or asset class. However this boxed thinking limits their observations and prohibits them from using a larger, worldlier lens to shape investment decisions. Many investors know that policy influences the markets, yet they are unable to capitalize on the range of asset class opportunities. Their underperformance continues.

Investors must take a bolder approach. Focus on an absolute return strategy. Diversify across multiple asset classes. Stay tuned to timing. Be risk averse with the default portfolio in cash. This has and will continue to produce attractive returns with very modest risk of loss.

In the face of negative and worsening polices we outlined above, is it time to give up? Far from it. Now is the time for action. We believe the “just one thing” for successful investing is the ability to make assessments, regardless of the direction of their price impact. As policy improves, very large returns can be anticipated due to today’s extremely low valuation levels.

While we don’t know when policy improvement will collide with these attractive valuations, we will be ready for it. In the interim we won’t be holding and hoping for stocks to bottom. We will be “Reading the World” to assess where the policy winds create investment opportunities. To not do so is truly a fool’s game.

March 9, 2009

Obama's Double Talk On the Budget

With today's depressed economy, big deficits are unavoidable for some years. But let's assume that Obama wins reelection. By his last year, 2016, the economy presumably will have long recovered. What does his final budget look like? Well, it runs a $637 billion deficit, equal to 3.2 percent of the economy (gross domestic product), projects Obama's Office of Management and Budget. That would match Ronald Reagan's last deficit, 3.1 percent of GDP in 1988, so fiercely criticized by Democrats.

As a society, we should pay in taxes what it costs government to provide desired services. If benefits don't seem equal to burdens, then the spending isn't worth it. (Exceptions: deficits in wartime and economic slumps.)

If Obama were "responsible," he would conduct a candid conversation about the role of government. Who deserves support and why? How big can government grow before higher taxes and deficits harm economic growth? Although Obama claims to be doing this, he hasn't confronted entitlement psychology -- the belief that government benefits once conferred should never be revoked.

Is it in the public interest for the well-off elderly (say, a couple with $125,000 of income) to be subsidized, through Social Security and Medicare, by poorer young and middle-aged workers? Are any farm subsidies justified when they aren't essential for food production? We wouldn't starve without them.

Given an aging America, government faces huge conflicts between spending on the elderly and spending on everything else. But even before most baby boomers retire (in 2016, only a quarter will have reached 65), Obama's government would have grown. In 2016, federal spending is projected to be 22.4 percent of GDP, up from 21 percent in 2008; federal taxes, 19.2 percent of GDP, up from 17.7 percent.

It would also be "responsible" for Obama to acknowledge the big gamble in his budget. National security has long been government's first job. In his budget, defense spending drops from 20 percent of the total in 2008 to 14 percent in 2016, the smallest share since the 1930s. The decline presumes a much safer world. If the world doesn't cooperate, deficits will grow.

The gap between Obama rhetoric and Obama reality transcends the budget, as do the consequences. In 2009, the stock market has declined 23.68 percent (through March 6), says Wilshire Associates. The Wall Street Journal's editorial page blames Obama's policies for all of the fall. That's unfair; the economy's deterioration was a big cause. Still, Obama isn't blameless.

Confidence (too little) and uncertainty (too much) define this crisis. Obama's double talk reduces the first and raises the second. He says he's focused on reviving the economy, but he's also using the crisis to advance an ambitious long-term agenda. The two sometimes collide. The $787 billion "stimulus" is weaker than necessary, because almost $200 billion for extended projects (high-speed rail, computerized medical records) take effect after 2010. When Congress debates Obama's sweeping health-care and energy proposals, industries, regions and governmental philosophies will clash. Will this improve confidence? Reduce uncertainty?

A prudent president would have made a "tough choice" -- concentrated on the economy; deferred his more contentious agenda. Similarly, Obama claims to seek bipartisanship but, in reality, doesn't. His bipartisanship consists of including a few Republicans in his Cabinet and inviting some Republican congressmen to the White House for the Super Bowl. It does not consist of fashioning proposals that would attract bipartisan support on their merits. Instead, he clings to dubious, partisan policies (mortgage cramdown, union card check) that arouse fierce opposition.

Obama thinks he can ignore these blatant inconsistencies. Like many smart people, he believes he can talk his way around problems. Maybe. He's helped by much of the media, which seem so enthralled with him that they don't see glaring contradictions. During the campaign, Obama said he would change Washington's petty partisanship; he also advocated a highly partisan agenda. Both claims could not be true. The media barely noticed; the same obliviousness persists. But Obama still runs a risk: that his overworked rhetoric loses its power and boomerangs on him.

Two Lessons From London In 1933

It had been thirty months since the start of what came to be known as the “depression” had pushed the industrial states into massive unemployment, crushed commodity prices, and had initiated the belligerent “economic nationalism” of tariffs and currency manipulation. And there was a tone of crisis as sixty-six nations gathered by train, steamer and airplane to find a collective will.

“Civilization itself stands at the crossroads,” announced a full-page advertisement from the Harrod’s department.

Today, after fourteen months of employment declines, a retreat from trade and a roller coaster ride of commodity prices, it is commonplace for prominent commentators such as the Financial Times' Martin Wolf, and MIT’s Simon Johnson to point to the upcoming G20 conference in London as the moment when the big nations must act effectively and collectively to stem the global financial depression.

The London Conference of 1933 is correctly considered a failure that led to a widespread breakdown in national relations, to a helter skelter raising of trade barriers, to random and often sinister currency manipulations, and to a prolonged crushing of commodity prices. It is crucial to understand that the disappointment of the London Conference, the inability of the great powers to find common ground on trade, currency and prices, led to a sense of moral helplessness in Europe.

The breakdown at the Disarmament Conference in Paris in the fall of 1933 was a quick result. So was the steady rearmament of and re-militarization of states with high unemployment that led, within three years, to the military adventurism of German and Italy. However, Britain and America were not exempt from exploiting the industrial demands of war-footing economies, and the observation that the American depression ended when the unemployed went to boot camp is not off the mark. It is crucial to make the connection that failure in economic conferences can and will lead to failure in peace conferences.

So what caused London 1933 to fail? What two lessons can we learn from seventy-six years ago that will guide the G20 as it approaches strikingly similar problems of demand, trade, currency, regulation and collective action?

The first and most helpful lesson is that we are no smarter than our forebears, and they were no less informed than we are of the threats of trade, currency and prices. Our global communications and transportation systems, our swift multilingual video chats, our access to ceaseless data streams watching trillions of dollars of assets and credit, does not give us a clearer vision of the solutions. It is the same world of trade, currency and closely watched commodity prices. It is also the same world with confrontational voices of well informed men who saw in 1933 that the London Conference was headed for trouble because the “larger nations” were selfish, willful and untrustworthy.

The chief problem was the “economic nationalism” of the United States; and this fact was well known at the time. In New York days before the Conference, Benjamin Anderson, economist for Chase National bank, derided the three-month-old Roosevelt administration’s “so called planned economy.” He spoke ruefully of the President’s surprise decision to suspend the gold standard in order to improve commodity prices. "We must get back to gold", Anderson said.

Meanwhile, Congress remained fixated on a sort of “planned economy” that was the opposite of what Keynes and Anderson said was required for success in London. The Senate gave the President what was understood to be sweeping authority -- including the power for FDR to place “an embargo upon all foreign imports which might hinder the successful application of the internal industrial policy…” The report from Washington was clear that “the bestowal of such extraordinary powers suggests the possibility of the United States carrying the policy of economic nationalism to the point of complete isolation.”

The second lesson from the failure of the 1933 London Conference is that no amount of dreadful predictions or chart-based projections, no consensus of economists or brainy professors, can convince the political leadership of powerful states to work together. If the end result does not contain an immediate, tangible, poll-boosting pay-off, the safe course is to loudly restate your fears and do nothing.

In London there was the impression this was a job fair of national brands. It is confounding to see that Ramsay MacDonald’s government chose the dusty reception hall of the Geological Museum to shoehorn in seating for the thousand guests. There was no room for observers, no space for consultations, and by the opening remarks from the King, the proceeding was as dead as the fossils in the museum.

We know now, just as the delegates did then, that there was a supposed secret negotiation going on outside the Hall, between the United States, Britain and France, to solve the currency manipulation crisis. The U.S. Secretary of State, Cordell Hull, arriving on the President Roosevelt a few days before, had given away this secret when he had told the Press Association that the chief problem was trade barriers. By not mentioning what was on everyone’s mind, the gold standard and currency manipulation, Hull was giving away the game.

The delegates knew the formula: economic nationalism led to reduced trade, currency abuse and isolationism. They even had the same alarming words of inflation, deflation, credit drought, capital flight, retaliation. Did they know it would end so badly that not one of them would survive the decade intact?

The host, dour, sober, tidy British Prime Minister Ramsay MacDonald, said on the opening day of the Conference, “The economic life of the world has for years been suffering from a decline which has closed factories, limited employment, reduced standards of living, brought some states to the verge of bankruptcy, and inflicted on others Budgets which cannot be balanced…

“The world is being driven upon a state of things which may well bring it face to face with a time in which the gains of the past are swept away by the forces of despair…”

Watch for two warning notes at the G20 meeting in three weeks' time. If the delegates claim, as a way of asserting confidence, that we today are smarter, wiser, more cautious, more cosmopolitan and communitarian than 1933, then the brain rot has started. If the delegates pronounce, especially if the host, dour, sober, Prime Minster Gordon Brown pronounces, as a way of spurring agreement and success, that the world is on the brink of slipping backwards to a time of protectionism, nationalism, militarism, isolationism, then it is already too late.

The Positive Economics of a Marijuana Tax

Where would you rather see your marijuana taxes go? OK, you’re forgiven if you won’t answer that. Where would you rather see your neighbor’s marijuana taxes go?

The well-worn arguments for and against Drug Prohibition have been repeated a thousand times. Suppose we take a break from the culture wars and instead consider the bald economics of legalization?

The National Organization for the Reform of Marijuana Laws (NORML) – remember them? – estimates that legalizing and taxing marijuana could net the state of California alone over a billion dollars a year. That’s a billion fewer dollars that you and I have to fork over to bail them out of their fiscal mess. And although it may seem like every pot smoker in the country lives in California, recent surveys indicate that over 42% of our fellow citizens have tried the stuff. That’s a lot of people, and they live everywhere.

Whether or not you indulge, why would you prefer to see violent Mexican drug lords reap the financial rewards from satisfying a multi-billion dollar market that is never going to go away no matter how many dopey fried egg commercials they show on TV? Wouldn’t you rather see the money fund local schools, police and fire departments? You have to pick one or the other because sure as the sun rises, marijuana money is going to go somewhere.

Ask the folks who run your state lottery what they think about taking over a socially maligned business that used to be run by the mafia. Their employees might be just as shiftless but at least they don’t gun people down in the streets.

There is so much data out there on marijuana consumption that even a Keynesian economist could correctly total up the potential tax revenues and law enforcement savings that legalization would bring. Alcohol tariffs have been a mainstay of American tax policy since the Whiskey rebellion. Yes, this money briefly financed the mob during Prohibition, just as marijuana’s risk premium does today. But somehow Congress managed to extricate itself from that disastrous experiment in social engineering. Have our politicians become that much more incapable since then?

Worried about the impact of legalization on the young? For the sake of argument, imagine that a marijuana tax is set equal to the current risk premium so that the street price remained the same. That would reduce the chance that plummeting prices might induce kids to switch over from alcohol, although why teenage drunks are preferable is an argument someone else is going to have to make.

Is our culture ready for marijuana legalization? Well, we now have our third president that smoked pot. An entire generation of potheads has started collecting Social Security. Even the editorial board of the Wall Street Journal is running regular commentaries attacking the economic imbecility of the War on Drugs.

So, what’s holding back change? A lack of leadership? True, politicians don’t usually lead as often as they jump out in front of the nearest parade. Would it give them cover if a million protestors showed up in Washington DC, one half wearing suits and ties and the other half wearing tie-dyed tee shirts? Picture the banners. “Tax me now!”

The beauty of the Federalist system is that Washington doesn't have to pretend it has a one-size-fits-all solution to complex problems like this. Congress just has to step out of the way and let the states give it a try. If one state wants to legalize and tax marijuana, another wants to decriminalize and treat it like a medical condition, and a third wants to continue consuming precious tax dollars incarcerating non-violent offenders so it can keep the market safe for organized crime, let's see how each fares. Thomas Jefferson would have approved.

March 10, 2009

Mark-to-Market Doesn't Destroy, It Reveals Destruction

The above is an appealing thought, but it seems mark-to-market’s opponents blame a rational theory of accounting for the real issue weighing on banks. In this case, accounting isn’t driving them into insolvency, but the federal government’s distortion of market prices is.

Going back to last spring when former Treasury secretary Henry Paulson asked mortgage lenders to “voluntarily” reduce contractual mortgage rates, the market for mortgage-backed securities has never been the same. That is so due to the basic truth that the housing and mortgage industries have long been protected and subsidized by the political class in Washington, so when Treasury asks for voluntary changes, the ask is in fact a demand.

Moving to last fall, Paulson rushed the Troubled Asset Relief Program (TARP) through Congress, and its initial purpose was to remove the toxic mortgage assets off of bank balance sheets through purchase of same. But as we all know now, the latter never came to pass. And with TARP’s mission changing seemingly on a weekly basis, the value of the toxic assets corroding bank balance sheets became even more uncertain. Investors blanch at uncertainty in the way that vampires run from the Cross, and with governmental intention with regard to toxic mortgage securities a moving target, their value withered even more.

Then two weeks ago, in another blow for these down-and-out assets, President Obama announced a $275B mortgage relief plan, the details of which included the empowerment of federal judges to rewrite existing mortgage contracts. So while the federal government has been handing out free money to weak banks with one hand, with the other it has been taking through rulings meant to reduce the value of their frozen mortgage assets even more.

The above in mind, is it any surprise that banks with mortgage securities on their books are presently struggling? No doubt horrendous lending and investment decisions have played a major role in this regard, but when governments play with prices, they by definition create disorder such that markets freeze.

As the Wall Street Journal reported just yesterday, “bond investors worry the government’s repeated modifications to its financial-rescue packages are undermining the very foundations of bond investing: the right of creditors to claim their assets first if a borrower defaults. Without this assurance, the bonds of even the most stalwart institutions are much riskier to own.”

The Journal story begs the question of where we might be had the federal government never intervened in mortgage markets to begin with. If not, it’s easy to suggest that the supposedly toxic securities would be far more liquid for a great deal of uncertainty with regard to government intervention having been removed. In a market free of governmental machinations, what investors refer to as toxic assets would be naturally priced, and mark-to-market accounting would be essential for revealing investor views on their future viability. In that case, it’s pretty easy to see that rather than a problem of accounting, we have a situation whereby accounting is showing how governments can turn down-and-out securities into assets that are untouchable.

Mark-to-market opponents could still point to regulations that make banks insolvent on paper, and there they have a point. But just as the Internet darlings of another era were able to raise cash amid real paper losses, there’s nothing keeping banks from raising capital against assets that are presently mispriced. Furthermore, solvency rules speak to a problem of regulation over solvency rather than a problem of market-based accounting.

In the end, it has to be asked if mark-to-market’s opponents aren’t mistaking cause and effect. Indeed, assuming a suspension of MTM, is it realistic to suggest that investors would somehow believe the numbers wrought by a less draconian form of accounting meant to make bad assets look better on paper? That seems a reach. Federal intervention in the mortgage markets has made admittedly weak securities toxic and illiquid, and no accounting fix is going to change this reality.

As we know from the Internet companies of a past economic era, investors will always buy into a positive commercial future no matter how ugly the present appears. Sadly, this in no way describes the assets on bank balance sheets, the “value” of which changes with each alteration of government policy.

So rather than an accounting theory that is destroying banks, mark-to-market is merely a window into the real destruction of financial institutions by other, governmental means.

Drinking the Rating Agencies' Kool-Aid

A Privileged Oligopoly

The predecessors to today’s rating agencies began over a century ago to offer research on the risks of railroads and other bonds, explains Richard Herring, Jacob Safra Professor of International Banking at the Wharton School at the University of Pennsylvania. That earlier system was less subject to conflicts of interest, since rating companies made money by selling their manuals to investors, who would buy more manuals if the credit assessments turned out to be accurate. However, the advent of the Xerox machine enabled other users to photocopy the manuals, compelling the rating firms to turn to issuers for compensation.

By the 1970’s, issuers, rather than investors, were funding the model. The three primary rating agencies, Standard & Poor’s, Fitch and Moody’s belong to an exclusive club of NRSROs, or Nationally Recognized Statistical Rating Organization. The designation, first established in 1975 by the SEC, eventually widened to encompass ten firms, although the others have never gained competitive traction.

The marketplace continues to rely on the big three, as a result of culture, path dependency and investment guidelines. “The SEC unwittingly promoted an oligopoly, rather than designing a process of approval that would permit new entrants and more competition or alternative companies,” says Michael Youngblood, a principal at Five Bridges Capital in Bethesda, Maryland.

Both U.S. and foreign regulators further entrenched the agencies’ dominance, by baking ratings into their rules. The Basel II Standardized Approach measures the adequacy of a bank’s capital cushion. It assigns a capital charge to each asset, which is weighted according to its rating. “It’s ironic that, just as reforms were being proposed in 2008 to remove ratings from SEC regulations, the adoption of Basel II was pushing regulators in the opposite direction,” Herring comments.

The pressures toward grade inflation are obvious, when companies are paying for their own bonds to be rated. To make matters worse, issuers pay maintenance fees for monitoring and re-rating, which clearly undermines any impetus to downgrade, and cloaks poor performance.

On October 22, 2008, the Congressional Committee on Oversight and Government Reform held a hearing on the role of the credit rating agencies in the Wall Street crisis. In his opening statement, Chairman Henry Waxman referenced an October 2007 presentation by Moody’s CEO, Ray McDaniel: “Analysts and MD’s are continually pitched by bankers, issuers and investors,” as McDaniel described in a confidential address to the Board of Directors, and admitted that sometimes we “drank the kool-aid.”

The problem is compounded when rating agencies are paid consulting fees to help to design the structured finance deals in the first place. “Everyone is sitting on the same side of the table at that point,” says Graham Henley, a director at LECG who formerly served as director of mortgage-backed securitization at Societe Generale. “The fox is in the henhouse!”

Faulty Models

Garbage in, garbage out. When models are based on erroneous or insufficient data, they produce misleading results. One of the stumbling blocks for rating securitized instruments was the dearth of long term data for extrapolation. Although the ratings analysts assumed defaults would increase during an economic slowdown, recent history offered no such modeling data for innovations like CDO’s.

Indeed, many CDO’s were simply unratable on the basis of the home loan characteristics in the reshuffled pools of mortgages. In his testimony Chairman Waxman refers to exchanges between S&P employees describing the pressure on analysts to devise shortcuts, based on guesswork, for coming up with some rating, any rating at all. “It could be structured by cows, and we would rate it,” one analyst wrote.

When the rating agencies addressed structured finance transactions, they relied on representations from the issuers that the data submitted was accurate. If it were bound to be false, the issuers were bound to buy back the loans. Yet those “reps & warranties” were not systematically tracked, according to Frank Raiter, a former managing director at S&P, who testified with Waxman. Investors, too, made a leap of faith, notes John Maher of the Secura Group, and formerly head of international strategic development at Fleet bank. “They effectively outsourced the risk of a given investment, taking it on faith that the proprietary information was more sophisticated than they could achieve,” he says.

Outdated models failed to capture the changes in performance of the nonprime products. In a period of rapidly rising house prices, the models could have presumed some long run mean reversion and assessed credit enhancements accordingly. “They assumed static economic activity, and implied that structured finance products should receive the same credit enhancements in, say December 2008 as in December 2006,” says Youngblood. The same principle applies to all consumer products, whether mortgages, credit cards, auto or student loans.

The Bottom Line

The models incorporate fuzzy inputs and methodologies for all types of credit, not just securitized issues. George Strickland, managing director and head of municipal bond investing at Thornburg, laments that rating agencies still tend to put too much credence in projections for many types of projects. He notes that trend among the types of projects he covers, such the Las Vegas monorail, or toll roads, which rarely measure up to optimistic traffic projections and revenue flows and lead to cost overruns. “Issuers hire consultant to produce reports, and consultants are paid to show numbers that work out. Rating agencies, likewise, don’t get paid unless a deal actually happens, so they look at reports with rose-colored glasses.”

Still, the really hefty fees flowed from the securitizations, especially CDO’s. At the three major rating agencies, from 2002 to 2007, revenues catapulted from $3 billion to over $6 billion. Ultimately, about half of those billions were earned from structured debt. A culture directed to profit prevailed over analytical rigor. Jerome Fons, a former managing director for credit policy at Moody’s, noted how the firm management focus increasingly turned to maximizing revenues: “Managers who were considered good businessmen and women – not necessarily the best analysts – rose through the ranks.”

SEC Reform

The Commission has finally stepped into the breach, to try to address the procedures, transparency and conflicts involved in rating, especially toxic securities. On December 3, 2008, it came out with some final amendments to an original bold proposal of six months earlier. The December rules succeeded in mandating increased disclosure, and most important, prevented the agencies from rating those deals they have structured. Herring warns that such a key ban may prove “unenforceable” and “difficult to police”.

However, the Commission appears to have pulled the teeth from the initial Proposal. That June draft contained two other critical reforms. First, it suggested that the agencies differentiate between the risks of straightforward corporate bonds, and those of mortgage-backed instruments. The latter, which are predicated on the payment streams of multiple mortgage holders, can be far more volatile.

The second June proposal, also rejected, was “the most revolutionary”, Herring says. It attempted to remove the use of ratings from all SEC regulations, which would have defrocked the hegemony of the NRSRO’s. No longer would their ratings have enjoyed a sanctified governmental status.

It seems unlikely the rating agencies will ever be able to regain their former credibility, without a thorough revision of their underwriting criteria and models. Yet both internal and external overhauls seem to be taking place episodically, with revised components, rather than as a major clean sweep. Viva Hammer, a tax partner Crowell & Moring, does not mince words, preferring to “disintegrate them and get rid of them.” At the same time, she has some sympathy for their impossible mission. “They carry the whole weight of the financial world on their shoulders, and are used as a shortcut for a snapshot of the health of the widest range of organizations imaginable. Is any institution capable of carrying that kind of burden?”

Alternative Due Diligence

Yet if we throw out rating agencies altogether, small investors in particular, may have limited recourse to alternative analysis. Credit research is difficult and expensive, and only leading firms have a sufficiently deep bench to perform it expertly themselves in house. But the current crisis has at least highlighted the need for investors to either fill out their own breadth of coverage or retain a specialty firm to do it.

Where can wealth managers, and other sophisticated advisors turn to? Among leading independent providers, several names stand out. CreditSights, Gimme Credit and KDP Investment Advisors offer research to the investment community, including mutual funds, hedge funds and advisors. Some of the smaller NRSRO’s, like DBRS, Rapid Ratings and Egan Jones, have better recent track records. The latter two, for instance, contemplated a General Motors bankruptcy even several years back. Morningstar examines creditworthiness of issuers and collateral, while some research outfits focus on specific areas. Green Street Advisors covers REITs. Youngblood’s company, Five Bridges Capital, surveys all debt and equity securities in mortgage and housing markets, including banks, thrifts and credit unions, both for top down and bottom up approaches.

Credit Default Swaps are another tool that managers can use to supplement credit ratings. James Genteman, director of Fixed Income at South Texas Money Management in San Antonio, regularly monitors corporate debt on Bloomberg for his clients’ portfolios. “I check if spreads are widening, as an indication of the market’s perception as to whether a given company poses any default risk,” he explains. Noticing such spreads in late 2007, he prudently moved his clients out of MBIA, Ambac, Citigroup and Bear Stearns.

In addition to spreading their research among a broader base of sources, HNW planners should “demand regular updates on any adjustments to ratings,” Henley suggests. While all the additional due diligence activities take time and effort, they may also provide a chance to wealth managers for providing their own worth to customers. Pouring through prospectuses and associated paperwork may not make for recreational reading, but is a reminder to clients that you are vigilant about safeguarding their assets.

March 11, 2009

Upbeat On Uptick Rule's Reinstatement

Then, as now, the market was under pressure, having sold off 50% from its year-earlier high (which itself was 50% off the 1929 peak). And "bear raids," in which unchecked short sellers hammered stocks with impunity, were the order of the day.

With panic in the air, the uptick rule provided at least some relief, requiring short sellers to wait until a stock ticked up an eighth- or quarter-point before their trades could be executed.

The intent was to prevent them from accelerating the downward momentum from a security already reeling from a crisis-induced decline.

The rule remained in effect until its repeal by the Securities and Exchange Commission in April 2007. The SEC felt the rule was no longer needed in a period of relative market tranquility.

It was also felt that the change from fractional to decimal trading, where trades differed by pennies instead of eighths or fourths, rendered the rule impotent.

The timing could have been better. That was six months before a major top and the onset of the bear market that continues to this day. Then, as the financial system started melting down in 2008, market volatility and unbridled short selling returned.

We may never know, for example, if shorting played a role in the failure of Bear Stearns and Lehman Bros. But for some observers, it could have. Bear plunged from $61.58 to $2.84 in just five days on extremely heavy volume, and Lehman dived from $16.20 to 15 cents over a similar stretch.

It was amid this decline last Sept. 19, after Britain banned short selling in its financial stocks, that we called for the U.S. uptick rule to be reinstated. At the time, the Dow stood at 11,019. Five weeks later, on Oct. 16, with the Dow 2,441 points lower at 8578, we called for it again.

Now, with the Dow well under 7000, comes word from Rep. Barney Frank, chairman of the House Financial Services Committee, that the uptick rule may be reinstated in about a month.

Yes, it would have been nice if Congress and regulators could have moved 4,000 points ago. But better late than never. We hope the new system will be similar to the old one and require an uptick, or upward price increase, of at least 10 or 25 cents.

We also hope that the market's reaction is similar to that after the original rule was set. After undercutting 100 on March 31, 1938, the Dow industrial average shot up 50% in four months. Yesterday's 390-point rally, with the uptick-rule news getting at least some of the credit, looked like a pretty good start.

Our Real Estate Obsession Endures

Reading these stories, I felt as if the housing bubble had never happened. For one thing, the media oohed and aahed over these deals based on little more than how much lower the winning bids were to the “previous value” of the homes listed by the auction company. Never mind that the previous values were vastly inflated, driven by dicey loans issued under discredited underwriting standards that aren’t likely to reappear any time soon to prop up home prices. Or that properties were auctioned with severe restrictions, such as requirements that some homes had to be bought with all-cash. Sorry, no financing allowed.

As far as I could tell, none of the reporters actually visited any of the properties that they judged to be “steals.” As someone who has researched and attended foreclosure auctions in the past, including in the days when the Resolution Trust Corp. sold homes seized from owners who had been lent money by failed savings banks, I’m reasonably sure some of the homes now being auctioned are not remotely in livable shape. Calling them fixer-uppers would be a stretch in many cases. Yes, those homes represent an opportunity for people willing to invest sweat equity and the cost of materials in making the places livable and salable again. But the work will be tough and the payoff is well down the road, when a market that hasn’t even hit bottom yet finally recovers years hence.

And to see a payoff, buyers will have to hope that the communities they are investing in make a comeback. You see, many of these properties are in struggling neighborhoods where real estate values have been depressed, in some cases for decades. Many homes for sale in New Jersey, one of the markets served by this auction, are in lower-income towns and struggling cities in two counties, Essex and Union, which a Federal Reserve Bank of New York study identified as ground zero for the mortgage meltdown in its district. In these places abandonments are leaving streets littered with boarded up homes. These auctions will certainly help that problem if the owners take possession and make improvements, but their ultimate payoff from these deals will depend at least somewhat on what other people in these neighborhoods do—or don’t do over time. Somehow the media forget to mention that risk.

In his new book The Ascent of Money, Niall Ferguson discusses the obsession that Anglo-American people have with investing in residential property in a chapter he ironically titles Safe As Houses. As Ferguson notes, the countries with the highest level of home ownership in the world are all English-speaking save Iceland—which is hardly an inspirational model. “No other asset allocation decision has inspired so many dinner-party conversations,” he writes.

So deep-seated is this obsession that we in the Anglosphere move seamlessly from discussing rising home prices and house flipping to conjecturing about the opportunities that waves of foreclosures will bring. Turn on your TV at 4 a.m. these days and you will find infomercials with titles like Profiting from Foreclosures have replaced infomercials with titles like How to Buy Real Estate With No Money Down.

This is nothing new. The housing downturn of the late 1980s and early 1990s, bound up as it was in the messy savings and loan crisis, nonetheless gave way to the housing boom of the late 1990s and then the housing bubble. The foreclosure crisis of the Great Depression, when at one point 1,000 homes a day were going into foreclosure, gave way to a post-War housing boom that sparked foreclosure problems by the 1950s. The frenzy that the New York Times describes seems to be in our DNA when it comes to housing.

The problem is that this obsession is not just a function of our cocktail party talk or front-page reporting. It goes right to the heart of public policy discussions in America, which is why our government often enables housing bubbles.

Even now, in the midst of our current woes, members of the Congressional Hispanic Caucus caution against reining in affordable housing lending because, “We need to keep credit easily accessible to our minority communities,” as Congressman Joe Baca has put it. And both Republicans and Democrats in Congress continue to put forward new programs to subsidize home ownership and kick start the housing market, without wondering whether further subsidies might just spark new foreclosure problems.

Our biggest danger, in other words, may very well be not the depth of this crisis, but the fact that we won’t learn much from it.

AIG's Demise Speaks to Mark-to-Market's Importance

Or at least somebody knew. And the way they knew was by marking-to-market the assets AIG Financial Products had insured. AIG is now turning into a scandal of the highest order. Consider the fact pattern: the Treasury Secretary convinces Congress to spend $150 billion to bail out one of the largest trading partners of his former firm. If something similar happened in a third world plutocracy, we’d shrug.

As details emerge, we now know a bit more about what happened. We know AIG Financial Products sold insurance protection to banks and brokers on over $440 billion of mortgage CDOs and other fixed income assets. We know the protection did not require AIG to collateralize its trades unless they were downgraded. And we know that the Fed’s first $85 billion loan facility was necessary to prevent the AIG FP default that an unmet margin call would have triggered.

What Congress did not know in September was that the collateral calls were based on marking-to-market the assets guaranteed by AIG FP. Those who claim these assets are impossible to value are either ignorant or deceptive. At least 20 firms would soon be calling AIG for margin based on the market value of these toxic assets and AIG’s impending downgrade. AIG was not disputing the valuation. It simply did not have the cash.

AIG’s collateral arrangement probably did not require it to post the full mark-to-market loss upon a downgrade below AA. More likely AIG would have to post some fraction of the mark-to-market loss. It would need to post more as its ratings continued to fall or the insured assets continued to weaken.

Suppose the $440 billion of assets AIG FP protected were worth 50% in September. AIG would have had an expected loss of $220 billion. But since it was still single-A, it might have only had to post some fraction of that number, perhaps 25%. That would have meant a $55 billion margin call. AIG’s initial $85 billion loan facility would have been viewed as a down-payment on a much bigger bill that would shortly come due.

Would politicians in Washington have allowed the initial funding if they knew it was only a fraction of the expected loss? I use “expected loss” and “mark-to-market” somewhat interchangeably. Many commentators have objected to this, claiming that in a distressed or illiquid market such as we now face, mark-to-market over-estimates the expected loss. Some optimistically argue that we just need to give AIG enough money to wait out the storm, and when prices recover, the taxpayer will be paid back.

Waiting out the storm is unlikely to work here. Nearly all of the CDOs of the type AIG insured have built-in Events of Default (EOD). EODs are triggered by ratings downgrades in the CDO’s underlying asset pool. If an EOD is triggered, the structure of the deal requires that the assets be unwound, i.e. sold into the market. In such cases, waiting for the market to recover is not an option. The assets get sold, and depending on the proceeds, the classes of the CDO are paid off sequentially.

It is entirely possible that there are not enough proceeds to pay off the senior-most class, the class AIG insured. The required payment from AIG to the owner of the asset would need to be made immediately, with no hope of recovery. We ain't kidding when we say toxic.

Knowing the mark-to-market in September would have given policymakers a good grasp of the magnitude of AIG’s troubles. Had Congress known the size of the expected losses, and the composition of the counterparties that were being bailed out, they might have refused to begin pumping money into a hopeless situation. They might have made the more sensible decision to abandon AIG to its own folly, and let AIG FP’s counterparties lick their own wounds.

If any taxpayer money needed to be spent, it would have been better spent making sure that the insurance subsidiaries of AIG were unaffected by the travails of the holding company. Astonishingly, the initial reaction by regulators was the reverse. Back in September, Eric Dinallo, the New York State Superintendent of Insurance and the man charged with protecting policyholders of AIG’s insurance subsidiaries, actually proposed sending $20 billion of capital FROM the relatively healthy insurance companies TO the sickly holding company.

It is unquestionable that some reasonably good valuations of the assets AIG FP had insured have been known all along. These valuations were, after all, the basis for the collateral calls. Now as values continue to fall, and AIG continues to weaken, we are being asked to cough up more money. AIG and its counterparties know the extent of the expected losses. One would hope Treasury Secretary Geithner and Fed Chairman Bernanke also know. Congress has not yet been given the full picture.

Congress is finally pressing for details on which firms AIG posted taxpayers’ money to. This is a good start. A fuller questioning would ask the following: Back in September, when the first funds were called for, what was the total mark-to-market loss on all of AIG FP’s exposures? The answer to this question is certainly knowable, and Congress has a right to demand it. If the expected losses were greater than September’s margin call, why was the scope of the problem not fully revealed?

March 12, 2009

The U.S. Capitalism Model Has Failed

The Reagan-Thatcher model, which favored finance over domestic manufacturing, has collapsed. The decline of American manufacturing has saddled us not only with a seemingly permanent negative balance of trade but with a business community less and less concerned with America's productive capacities. When manufacturing companies dominated what was still a national economy in the 1950s and '60s, they favored and profited from improvements in America's infrastructure and education. The interstate highway system and the G.I. Bill were good for General Motors and for the U.S.A. From 1875 to 1975, the level of schooling for the average American increased by seven years, creating a more educated workforce than any of our competitors' had. Since 1975, however, it hasn't increased at all. The mutually reinforcing rise of financialization and globalization broke the bond between American capitalism and America's interests.

Manufacturing has become too global to permit the United States to revert to the level of manufacturing it had in the good old days of Keynes and Ike, but it would be a positive development if we had a capitalism that once again focused on making things rather than deals. In Germany, manufacturing still dominates finance, which is why Germany has been the world's leader in exports. German capitalism didn't succumb to the financialization that swept the United States and Britain in the 1980s, in part because its companies raise their capital, as ours used to, from retained earnings and banks rather than the markets. Company managers set long-term policies while market pressures for short-term profits are held in check. The focus on long-term performance over short-term gain is reinforced by Germany's stakeholder, rather than shareholder, model of capitalism: Worker representatives sit on boards of directors, unionization remains high, income distribution is more equitable, social benefits are generous. Nonetheless, German companies are among the world's most competitive in their financial viability and the quality of their products. Yes, Germany's export-fueled economy is imperiled by the global collapse in consumption, but its form of capitalism has proved more sustainable than Wall Street's.

So does Germany offer a model for the United States? Yes -- up to a point. Certainly, U.S. ratios of production to consumption and wealth creation to debt creation have gotten dangerously out of whack. Certainly, the one driver and beneficiary of this epochal change -- our financial sector -- has to be scaled back and regulated (if not taken out and shot). Similarly, to create a business culture attuned more to investment than speculation, and with a preferential option for the United States, corporations should be made legally answerable not just to shareholders but also to stakeholders -- their employees and community. That would require, among other things, changing the laws governing the composition of corporate boards.

In addition to bolstering industry, we should take a cue from Scandinavia's social capitalism, which is less manufacturing-centered than the German model. The Scandinavians have upgraded the skills and wages of their workers in the retail and service sectors -- the sectors that employ the majority of our own workforce. In consequence, fully employed impoverished workers, of which there are millions in the United States, do not exist in Scandinavia.

Making such changes here would require laws easing unionization (such as the Employee Free Choice Act, which was introduced this week in Congress) and policies that professionalize jobs in child care, elder care and private security. To be sure, this form of capitalism requires a larger public sector than we have had in recent years. But investing in more highly trained and paid teachers, nurses and child-care workers is more likely to produce sustained prosperity than investing in the asset bubbles to which Wall Street was so fatally attracted.

Would such changes reduce the dynamism of the American economy? Not necessarily, particularly since Wall Street often mistook dealmaking for dynamism. Indeed, since finance eclipsed manufacturing as our dominant sector, our rates of intergenerational mobility have fallen behind those in presumably less dynamic Europe.

Wall Street's capitalism is dying in disgrace. It's time for a better model.

Just Say 'No' To Stimulus

"Our objections to the so-called stimulus bill have been well-chronicled for the way it spends money that we don't have and for the way this printing of money could ultimately devalue the American dollar," he said.

Critics will note that Sanford will take some money from the government. He can't let his state suffer, while others gorge at the public trough. Still, any show of principle these days in rejecting federal aid is welcome.

"When one is in a hole the first order of business is to stop digging," Sanford wrote late last month, explaining his objections.

Hard to argue that logic. A number of other governors, all of them Republicans, have expressed similar concerns about the stimulus. To some, this smells of rank politics — GOP leaders trying to make President Obama look bad.

Fact is, the GOP may be the only hope left for reining in the out-of-control juggernaut that federal spending has become. On this, Sanford has credibility: In 1994, he was elected to the House, promising to limit himself to three terms and to be fiscally responsible.

As James Rose of McClatchy Newspapers recently pointed out, "While most of his colleagues abandoned their term-limit pledges, dropped plans to jettison the Department of Education and became less averse to federal spending, Sanford slept on a cot in his office, opposed most appropriations bills — and left after six years."

Compare that with, say, the government wastrels in California. They spent wildly for a decade, pushing their once-wealthy state close to bankruptcy with a $42 billion deficit. Now, they're licking their chops over the prospect of $31 billion in federal money to bail them out from the very problems they created.

Gov. Arnold Schwarzenegger hopes to get an added $20 billion by leveraging the state's outsized presence in the House and the Senate to get more grants in aid.

States that are greedily snapping up the taxpayers' money might want to ask someone who's been there, done that, what all this federal generosity means. Bankers, for example.

In recent weeks, a number of U.S. banks have asked to give back their taxpayer-funded government bailout money. The reason: too many strings attached. As the International Herald Tribune noted, the list of restrictions that comes with bailout money is a long one:

"U.S. financial institutions that are getting government bailout funds have been told to put off evictions and modify mortgages for distressed homeowners. They must let shareholders vote on executive pay packages. They must lower dividends, cancel employee training and morale-boosting exercises, and withdraw job offers to foreign citizens."

In short, despite White House denials, the federal government — not bankers — now runs our banking system. This is unhealthy in the extreme for our financial system and our economy.

Worse, it represents a kind of backdoor socialism and political control that will lead to a heavily regulated economy, and the dead hand of government lying on everything, smothering free enterprise with new rules, higher taxes and incompetent federal control.

So much for the pledges made that the government has "no interest" in interfering with the private sector. It does. Indeed, control, not "stimulus," is the plan.

The first step toward fiscal sobriety is saying no to money you don't deserve. No one gets anything for free. With every handout, you give up a little piece of control. The governors will learn this the hard way, as the federal government ties them down with new rules, requirements and diktats.

Down Markets and Dumb Economic Myths

The logic with housing is completely backwards. The economy is not sagging because home prices have moderated, but it wilts because a weak, inflationary dollar this decade caused a rush into the asset class to begin with, and prices rose. While the average American does not follow the dollar’s movements versus the objective benchmark that is gold with any regularity, a majority of Americans do follow housing prices.

And with the dollar price of gold having soared this decade – meaning a weaker, inflationary dollar – Americans hedged the greenback’s decline as they’ve always done, through aggressive purchases of real estate. In that sense, housing’s moderation was the paradoxical result of what caused it to boom: savings shifted from the wage economy to hard assets, thus driving capital away from the start-ups and existing businesses that cause economies and salaries to grow.

The weak dollar is a wage killer, and worse, it drives investment away from the wage economy. Housing was eventually going to correct slightly (nowhere near the decline in share prices) lower owing to the inability of owners to make mortgage payments alongside wage earners lacking the income to purchase homes altogether.

This is why housing booms that eclipse stock-market returns always end in tears. Think Nixon’s presidency, and similarly think Carter’s presidency when housing was the top asset class. The Bush administration merely followed the weak dollar policies of Nixon and Carter, and fomented another property rally.

Once again, though, inflation is not an economic stimulant. And neither is housing. The latter doesn’t make us more efficient, nor does it expand worldwide trade. It is only the consumptive result of an otherwise strong economy, so rather than policies meant to save housing, Washington should stick to constitutional principles whereby it offers stable money values that make investment in the wage economy more certain. Only then will housing recover, in concert with a much greater stock-market boom.

Obama Can and Should Lift Our Sagging Economic Spirits

The above is a popular media myth, and the view there is that economies can be talked into or out of downturns. If President Obama would merely enhance his already soaring rhetoric, Americans would consume more and the economy would expand.

It’s a nice thought for sure, but in case we’ve forgotten, Obama’s rhetorical father in no way was able to talk the economy out of recession in the ‘30s. Brilliant as his line was about ‘fear’ being our only fear, FDR wasn’t able to get the U.S. economy moving again. Neither will Obama if his policies continue to tilt in the direction of economic intervention, along with rules meant to punish the enterprising among us.

What’s asked less is what makes us economically productive. Policies aside, does the economically comfortable individual work the hardest, or is it the fearful worker? In that case, what should really scare us is when the commentariat is falling all over itself to talk about how great the economy is. It is then that we might become sloppy in our work habits, and work less due to the comfort offered by prosperity.

Economic fear is what focuses us, and when we’re focused we produce; our production a source of new demand. We can only demand if we’ve produced first. So while it’s easy to assume politicians and the media can talk us into or out of a recession, it’s not something to take very seriously.

The Dollar Is Strong

The dollar’s rise over the last few months relative to the euro, Pound, Canadian dollar, and other currencies has given rise to commentary suggesting the dollar is strong. Newspapers have reported this phenomenon, plus if we read what’s left of Wall Street research, much of the dollar commentary addresses the latter’s relative strength versus other currencies.

The obvious problem here is one of relativity. All currencies today are of the ‘fiat’ variety, which means they lack any definition. In this sense, the dollar’s strength against the euro might be hiding the real story. That’s the case at present.

To show why, we need only measure currencies against a stable benchmark such as gold. When we do, we find that the dollar is only strong insofar as other currencies are very weak. Indeed, since last November, the dollar has gained against the euro, Pound and Canadian dollar, but when we bring gold into the equation, we find that while gold has risen 24 percent in dollars, it has risen 28 percent in euros, 39 percent in Canadian dollars, and 41 percent measured in Pounds. So much for a strong dollar.

Free Trade Is the Path to Job Creation

Given the unfortunate rise of protectionism worldwide, one argument made in favor of free trade is that it’s a job creator. Supposedly if we remove barriers to exchange, job growth will soar.

About this, it should be said that trade should always be free, and that tariffs should be abolished in the U.S. regardless of what the rest of the world does. Trade ultimately comes down to the individual producing something of value in order to get something else of value. When tariffs exist, it can’t be stressed enough that work is being taxed.

So while trade should never be inhibited, by its very definition it doesn’t only create jobs. That’s the case because when we expand the world’s division of labor, we are shifting the division of work to other locales. At first blush, we can say that free trade transfers work.

But we must also say that free trade creates better jobs for us alongside the loss of employment that is not in our best interest to engage in. More to the point, free trade leads to higher paying jobs because investors are most inclined to reward those who do that which most productively employs their talents.

We’re Burdening Future Generations with Near-Term Government Profligacy

No, we’re burdening ourselves with all this spending. The latter is nothing more than a tax given the basic truth that government spending detracts from our present wages. When transfer payments come in the mail from the government, the alleged beneficiaries are only receiving monies that would have otherwise reached them through higher pay if the government wasn’t removing the capital from the private sector.

The debt the federal government is presently amassing, while obnoxious in its scope, is still very cheap. That’s a market signal suggesting that at least for now, investors think future generations will have no problem paying it back.

The true burden we’re leaving our children and grandchildren is a less vibrant economy thanks to all the spending. When governments tax or borrow from the private sector in order to spend, they are taking savings that would in many cases fund new businesses, and consuming it instead. The debt is something future generations can pay, but the unseen shame of all this spending is their inheritance of an economic future that will be less bright due to heavy government spending reducing economic innovation and company formation in the near-term.

Sadly for investors and the economy more generally, false assumptions tend to take on a life of their own, and sometimes unfortunate legislation results. The better scenario for all concerned is if the government does nothing, good or bad. When government acts in ways we like or dislike, we empower it to meddle in our economic activities. The answer for the here and now is for Washington to sit idle so that enterprising individuals can produce, and fix what the political class has broken.

Card Check Workers Can Only Check In

The Employee Free Choice Act would allow workplaces to be unionized without secret ballots. If a majority of the employees sign a card that says an employee wants to join a union, a process known as “card check,” the workplace can be unionized. This process strips workers of the protection of a secret ballot and exposes them to coercion by union organizers and leaders.

With card check, workers can check in but they can’t check out. For workers to leave the union, a secret ballot would still be required. This is the height of hypocrisy—that the so-called benefits of “employee free choice” only apply to join a union but not to leave it.

Equally harmful is the bill’s little-publicized mandatory arbitration provision, which short-circuits collective bargaining. If the union and the employer fail to reach an agreement on pay and benefits after 90 days of talks, the bill would require them to submit to binding arbitration, with a mandated contract that would hold for the next two years.

That requirement would be unprecedented in American labor law. It would revoke the basic principle of free collective bargaining—that employers and unions may disagree unless they voluntarily accept arbitration.

The union-sponsored bill is intended to help unions reverse a long-term decline in membership. It would harm the economy by increasing unemployment, potentially making the economies of Texas and Oklahoma look more like those of Ohio and Michigan. And, despite his talk of fiscal responsibility, President Obama has promised to sign the bill if it reaches his desk.

Chairman George Miller of the House Education and Labor Committee offered this defense of the bill: “If we want a fair and sustainable recovery from this economic crisis, we must give workers the ability to stand up for themselves and once again share in the prosperity they help to create.”

The problem is that the Employee Free Choice Act, if passed, would do just the opposite. It would slow economic recovery by increasing unionization, artificially raising wages, and therefore raising unemployment. It would turn states with below-average unemployment rates, primarily in the South, into states with high unemployment rates.

What Mr. Miller is asking for American workers is less than what he once sought for Mexican workers. In a letter dated August 29, 2001, coauthored with 15 other congressmen, Mr. Miller wrote to the arbitration council in Puebla, Mexico, “We feel that the secret ballot is absolutely necessary to ensure that workers are not intimidated into voting for a union they might not otherwise choose.”

Why would Mr. Miller strip American workers of that protection? With union membership declining and now at a weak 7.6% of private sector workers, building up dues-paying membership is the unions’ paramount goal, despite the harm it would do to the economy.

In the 2008 election cycle, unions gave millions to Democratic candidates for Congress. Now they want to collect on their investment.

But the deep slump in the economy has eroded support for the Employee Free Choice Act among members of Congress. The bill will pass the House, even though its number of cosponsors has slipped from 230 to 223.

The Senate, however, is a different story. Whereas the bill had 46 cosponsors in the Senate in 2007, it now has 40. If the bill does pass, President Obama has said that he will sign it.

Organized labor made repeal of the secret-ballot requirement a high priority because the intrinsic rationale for unions has been weakening.

Fewer workers see the need to belong to unions because basic health and safety conditions have become standard. Many unions price their workers out of jobs, sending jobs overseas or to more efficient nonunion firms, while taking dues from members to spend on political campaigns and high salaries for union officials. Workers can see that unionized domestic auto companies, notably GM and Chrysler, are in worse shape than foreign companies with nonunion American plants, such as Toyota, Nissan, and Honda.

Nonunion firms have more flexibility to adapt to changing conditions than do unionized firms. States with laws protecting workers from being compelled to join unions saw increases in nonfarm employment of 47% over the past 20 years, double the 21% increase in states with no such worker protection.

With jobs at risk now and personal assets shrinking, people are scared. To enact a bill that is likely to make economic conditions worse would be both foolish and irresponsible.

March 13, 2009

It's Time to Stimulate Supply, Not Demand

Supply stimulation is achieved through the transfer of productive assets from those who paid too much, to those who can put the assets to profitable use at a lower purchase price. The current owners who overpaid are now likely to be capital constrained with few sources of liquidity, and additionally may be contending with significant levels of debt used to acquire the assets during the age of easy credit. The burdens of current owners are creating a situation in whic assets either sit idle, or they’re being operated unprofitably in ways that further erode capital. Examples here include GM’s shuttering of plants, not to mention unoccupied homes that lie empty as symbols of failed attempts at speculation. Both scenarios speak to underutilized assets whose underutilization holds back economic growth.

In order to put those assets back into use to satisfy what is unlimited demand, the current owners must sell their holdings at a loss to a new owner. The new owner, having purchased the assets at a lower entry price, can now put the physical capital to profitable use by offering the finished goods the assets yield at lower, market-clearing prices. This means the ‘fire sale’ purchaser of GM’s idled plants can afford to produce cars more cheaply. Much the same, the real estate speculator must take a loss on his property at a price that is serviceable for a family that is taking on a mortgage. Through the creation of supply at lower prices, demand is stimulated.

There is unlimited and insatiable demand for goods and services, assuming they’re offered at a market-clearing price. Therefore, demand stimulation is unnecessary and, given the ultimate burden on the taxpayer, unproductive.

This economy will not emerge from the current recession, or any recession for that matter, until the supply of goods and services falls to prices at which demand resurfaces. The government’s fixation with propping up assets, whether it be homes or banks, is exactly the wrong solution. The best thing the federal government could do would be for it to take the steps necessary to ensure the bankruptcy process for businesses and individuals is swift and just. If it does that, a natural process will reveal itself whereby productive assets will reach those who will operate them at a profit.

March 16, 2009

Blame the Economists, Not Economics

Very few among them (notable exceptions including Nouriel Roubini and Robert Shiller) raised alarm bells about the crisis to come. Perhaps worse still, the profession has failed to provide helpful guidance in steering the world economy out of its current mess. On Keynesian fiscal stimulus, economists' views range from "absolutely essential" to "ineffective and harmful."

On re-regulating finance, there are plenty of good ideas, but little convergence. From the near-consensus on the virtues of a finance-centric model of the world, the economics profession has moved to a near-total absence of consensus on what ought to be done.

So is economics in need of a major shake-up? Should we burn our existing textbooks and rewrite them from scratch?

Actually, no. Without recourse to the economist's toolkit, we cannot even begin to make sense of the current crisis.

Why, for example, did China's decision to accumulate foreign reserves result in a mortgage lender in Ohio taking excessive risks? If your answer does not use elements from behavioral economics, agency theory, information economics, and international economics, among others, it is likely to remain seriously incomplete.

The fault lies not with economics, but with economists. The problem is that economists (and those who listen to them) became over-confident in their preferred models of the moment: markets are efficient, financial innovation transfers risk to those best able to bear it, self-regulation works best, and government intervention is ineffective and harmful.

They forgot that there were many other models that led in radically different directions. Hubris creates blind spots. If anything needs fixing, it is the sociology of the profession. The textbooks at least those used in advanced courses - are fine.

Non-economists tend to think of economics as a discipline that idolizes markets and a narrow concept of (allocative) efficiency. If the only economics course you take is the typical introductory survey, or if you are a journalist asking an economist for a quick opinion on a policy issue, that is indeed what you will encounter. But take a few more economics courses, or spend some time in advanced seminar rooms, and you will get a different picture.

Labor economists focus not only on how trade unions can distort markets, but also how, under certain conditions, they can enhance productivity. Trade economists study the implications of globalization on inequality within and across countries. Finance theorists have written reams on the consequences of the failure of the "efficient markets" hypothesis. Open-economy macroeconomists examine the instabilities of international finance. Advanced training in economics requires learning about market failures in detail, and about the myriad ways in which governments can help markets work better.

Macroeconomics may be the only applied field within economics in which more training puts greater distance between the specialist and the real world, owing to its reliance on highly unrealistic models that sacrifice relevance to technical rigor. Sadly, in view of today's needs, macroeconomists have made little progress on policy since John Maynard Keynes explained how economies could get stuck in unemployment due to deficient aggregate demand. Some, like Brad DeLong and Paul Krugman, would say that the field has actually regressed.

Economics is really a toolkit with multiple models - each a different, stylized representation of some aspect of reality. One's skill as an economist depends on the ability to pick and choose the right model for the situation.

Economics' richness has not been reflected in public debate because economists have taken far too much license. Instead of presenting menus of options and listing the relevant trade-offs - which is what economics is about - economists have too often conveyed their own social and political preferences. Instead of being analysts, they have been ideologues, favoring one set of social arrangements over others.

Furthermore, economists have been reluctant to share their intellectual doubts with the public, lest they "empower the barbarians." No economist can be entirely sure that his preferred model is correct. But when he and others advocate it to the exclusion of alternatives, they end up communicating a vastly exaggerated degree of confidence about what course of action is required.

Paradoxically, then, the current disarray within the profession is perhaps a better reflection of the profession's true value added than its previous misleading consensus. Economics can at best clarify the choices for policy makers; it cannot make those choices for them.

When economists disagree, the world gets exposed to legitimate differences of views on how the economy operates. It is when they agree too much that the public should beware.

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

Originally published at Project-Syndicate.org

The Shadow of Depression

What's more, the Depression changed our thinking and institutions. The human misery of economic turmoil has diminished. "American workers [in the 1930s] had painfully few of the social safety nets that today help families," Romer said. Until 1935, there was no federal unemployment insurance. At last count, there were 32 million food stamp recipients and 49 million on Medicaid. These programs didn't exist in the 1930s.

Government also responds more quickly to slumps. Despite many New Deal programs, "fiscal policy" -- in effect, deficit spending -- was used only modestly in the 1930s, Romer argued. Some of Franklin Roosevelt's extra spending was offset by a tax increase enacted in Herbert Hoover's last year. The federal deficit went from 4.5 percent of GDP in 1933 to 5.9 percent in 1934, not a huge increase.

Contrast that with the present. In fiscal 2009, the budget deficit is projected at 12.3 percent of GDP, up from 3.2 percent in 2008. Some of the increase reflects "automatic stabilizers" (in downturns, government spending increases and taxes decrease); the rest stems from the massive "stimulus program." On top of this, the Federal Reserve has cut its overnight interest rate to about zero and is lending directly in markets where private investors have retreated, including housing.

Government's aggressive actions should reinforce some of the economy's normal mechanisms for recovery. As pent-up demand builds, so will the pressure for more spending. The repayment of loans, lowering debt burdens, sets the stage for more spending. Ditto for the runoff of surplus inventories.

So, are Depression analogies far-fetched, needlessly alarmist? Probably -- but not inevitably. Even some Depression scholars, who once dismissed the possibility of a repetition, are less confident.

"Unfortunately, the similarities [between then and now] are growing more striking every day," says economic historian Barry Eichengreen of the University of California at Berkeley. "I never thought I'd say that in my lifetime." Argues economist Gary Richardson of UC Irvine: "This is the first business downturn since the 1930s that looks like the 1930s."

One parallel is that it's worldwide. In the 1930s, the gold standard transmitted the crisis from country to country. Governments raised interest rates to protect their gold reserves. Credit tightened, production and trade suffered, unemployment rose. Now, global investors and banks transmit the crisis. If they suffer losses in one country, they may sell stocks and bonds in other markets to raise cash. Or as they "deleverage" -- reduce their own borrowing -- they may curtail lending and investing in many countries.

The consequences are the same. In the fourth quarter of 2008, global industrial production fell at a 20 percent annual rate from the third quarter, says the World Bank. International trade may "register its largest decline in 80 years." Developing countries need to borrow at least $270 billion; if they can't, their economies will slow and that will hurt the advanced countries that export to them. It's a vicious circle.

Just as in the 1930s, there's a global implosion of credit. What's also reminiscent of the Depression are quarrels over who's to blame and what should be done. The Obama administration wants bigger stimulus packages from Europe and Japan. Europeans have rebuffed the proposal. The United States has also proposed greater lending by the International Monetary Fund to relieve stresses on poorer countries. Disputes could fuel protectionism and economic nationalism.

No one knows how this epic struggle will end -- whether the forces pushing down the global economy will prevail over those trying to pull it up. "Depression" captures a general alarm. The vague fear that something bad is happening, by whatever label, causes consumers and business managers to protect themselves by conserving their cash and slashing their spending. They hope for the best and prepare for the worst. When people stop worrying about depression, when the shadow lifts, the crisis will be over.

A Shotgun-Wedding Proposal

But this anticipated-profits turnaround doesn’t seem to have anything to do with the TARP. It’s about something called the Treasury yield curve -- a medical diagnostic chart for banks and the economy.

When the Fed loosens money, and short-term rates are pulled well below long rates, banks profit enormously from the upward-sloping yield curve. This is principally because banks borrow short in order to lend long. If bankers can buy money for near zero cost, and loan it for 2, 3, or 4 percent, they’re in fat city. Their broker-dealer operations make money, as do all their lending divisions.

So the upward-sloped yield curve is the real bailout for the banking system.

Now, turn the clock back to 2006 and 2007. In those days the Treasury curve was upside down. Due to the Federal Reserve’s extremely tight credit policies, short-term rates moved well above long-term rates for an extended period, and that played a major role in producing the credit crunch. Since interest margins turned negative, the banks had to turn off the credit spigot, and all those exotic securities -- like mortgage-backed bonds and various credit derivatives -- could no longer be financed.

The Fed’s long-lived credit-tightening also wreaked havoc on home prices and was directly responsible for the recession that began in late 2007. At the time, Fed head Ben Bernanke said the inverted yield curve wouldn’t matter. Gosh was he wrong.

Today, however, after about a year of a positively sloped yield curve, bank interest margins and profits are turning up. In fact, despite the perpetual pessimism, the normalized yield curve is a leading indicator of economic recovery, according to models created by the New York Fed and others.

Here’s the second big point: Instead of spending a trillion TARP dollars to rescue toxic assets, why not ease or liberalize mark-to-market accounting rules? You see, banks still have a bunch of underwater toxic assets on their balance sheets. And unless the SEC or someone in Washington changes these rules, the banks may have to erase their new cash-flow-rich profit margins by marking down the value of mortgage- and consumer-related loans.

These loans can’t be sold in the current market. But if somebody tells the banks they don’t have to sell these loans at distressed prices, and therefore don’t have to take a big hit on profits and capital, the banks will enjoy plenty of breathing room to reap the benefits of the upward-sloping yield curve.

Let the banks hold these investments over a long period, rather than force them to sell now. The economy will get better, as will housing and other impaired assets.

You could even have a two-tiered disclosure process: Accounting purists could be satisfied with a full mark-to-market disclosure, while regulators could forbear capital-standard rules that shouldn’t apply during this period of severe distress. As a result, banks would be in better shape to pass the Treasury’s new stress test and wouldn’t need new TARP capital-injections that further extend taxpayer liabilities.

Think of this: As net interest and profit margins rise while the yield-curve is upward-sloping, higher bank profits can be used to replenish capital. Meanwhile, government authorities can cease and desist -- not only their punishment of private-equity shareholders, but also their clumsy attempts to control various bank operations (compensation, golf outings, means of transportation, etc.). Then, if bankers are so dumb they still can’t make money with zero borrowing costs, the FDIC should shutter them and sell them off piece by piece.

Right now there are promising signs of mark-to market reform, with bipartisan support in Congress. New SEC chair Mary Shapiro says she’s looking into it, as is Robert Herz, the head of the Financial Accounting Standards Board (FASB).

So let’s have a shotgun marriage. Let’s wed the upward-sloping yield curve with mark-to-market reform. It sure beats another trillion in taxpayer dough, or a federal takeover of our biggest banks.

It all seems like such a simple solution.

How to Turn a Recession Into a Depression

Knowing the odds and payouts, as well as your own preference for a jackpot over pocket change, would you wager $5 on twenty-seven red at the roulette table? Enough people do to support a multi-billion dollar industry. OK, do you think anyone would play if the house was allowed to change the odds and payouts as well as any other rules of the game after each bet is placed?

That is the difference between risk and uncertainty.

Red and Blue tribal pundits agree that economic recovery can only occur if private capital returns to the market. That’s swell, at least they agree on something. So why is our brain trust in Washington doing every conceivable thing to maximize uncertainty, which only keeps us hiding in our caves hoarding gold?

My partners and I get paid to assess and manage risk when we deploy the money entrusted to our firm to start and grow new businesses. Sometimes we get it right and sometimes we get it wrong. Either way, we don't get paid to sit on the sidelines avoiding risks at all cost. But our investors do expect us to have enough street smarts to walk away from the table when faced with massive and unrelenting uncertainty.

Multiply that behavior times the millions of decision makers that occupy every nook and cranny of our economy, subject us to a barrage of ever-shifting policy pronouncements that may or may not become law, brandish unlimited power to redistribute gains and losses without rhyme or reason, ceaselessly monkey with fundamental accounting rules, empower shadowy officials to make things up as they go along, indiscriminately conflate and then demonize success alongside fraud, and top it off with a fear-mongering campaign designed to work the populace into a frenzy so you can beat the rival tribe into legislative submission, and you have the perfect policy for turning a recession into a depression.

Populist democracy may be wild and capricious but there is hardly an abuse or distortion government can serve up that the market can't figure out how to live with once the rules of the game are set. That’s because nothing is more important to the functioning of capitalism than the rule of law. Even crappy law will suffice, which may be the best we can hope for.

So can we have some and get on with it?

Do you want to get the country moving again instead of wallowing? Then consider this proposal, similar in spirit to the decision to declare a date-certain for our military withdrawal from Iraq. Give us a date-certain when the Congressional circus and its media handmaidens will turn off the uncertainty machine so we can get back to work under whatever set of rules, subsidies, taxes, bailouts, and regulations they choose to saddle us with. Then freeze the plan and shut up.

April 1st might be a fitting date to kick off a Machinations Moratorium. After that, please, no more hearings, TARPs, TALFs, czars, ex-post facto criminalization of business practices, coerced abrogation of private contracts, new and undefined Federal Reserve powers, or "Be Afraid!" speeches from the President.

That doesn't mean Congress has to give up performing legislative theatrics. After all, our elected officials have to do something to stay in the headlines. But how about going back to entertaining the media and polarizing the electorate by fighting over things that only impact a tiny number of people who don't matter, like whether the NEA subsidizes filthy art?

March 17, 2009

Jon Stewart Shouldn't Blame Jim Cramer

Or take Richard Fuld. He is the former chairman of Lehman Brothers, which, as we all know, is no more. He lost about $1 billion.

Or take Citigroup's former chairman, Sanford Weill. He lost about $500 million.

Or take all the good people at Bear Stearns, the company Cramer adored almost to the bitter end. They went down with their stock.

If these people kept their money in these companies -- financial and insurance giants they had built and knew from the inside -- how was even Jim Cramer to know these firms were essentially hollow?

I give you one other name: Richard Cohen. He who writes this column had some of his (extremely) hard-earned retirement funds in AIG stock. This was because I was a cautious investor, and what could be safer than an insurance behemoth? Who knew that in faraway London, a division of AIG was fooling around in stuff that virtually cratered the whole company? Not my broker. Not me. Not even Greenberg.

Now we get back to Stewart. The gravamen of his charge is that the financial media, particularly CNBC and Cramer, knew all the time what was happening and was, in effect, shilling for the industry. "Listen, you knew what the bankers were doing, yet were touting it for months and months," he told Cramer in probably the most celebrated showdown since the Earps and Doc Holliday met the Clantons and others at the O.K. Corral.

The Washington Post and the New York Times both covered Cramer's appearance on Stewart's show and so did the august Financial Times, on Page 1 yet. Trouble was, Cramer almost instantly sank into a classic case of Stockholm syndrome, agreeing much of the time with his captor. He came with sleeves rolled up but with the droopy eyes of a chastised puppy. He allowed that he actually was, really, an entertainer. No!

The acclaim visited on Stewart for spanking Cramer tells you something. In the first place -- and by way of a minor concession -- he's got a small point. CNBC has often been a cheerleader for the zeitgeist -- up when the market's up, down when it's down. This is true of the business media in general.

But the role that Cramer and other financial journalists played was incidental. There was not much they could do, anyway. They do not have subpoena power. They cannot barge into AIG and demand to see the books, and even if they could, they would not have known what they were looking at. The financial instruments that Wall Street firms were both peddling and buying are the functional equivalent of particle physics. To this day, no one knows their true worth.

It does not take cable TV to make a bubble. CNBC played no role in the Tulip Bubble that peaked, as I recall, in 1637, or in the Great Depression of 1929-41. It is the zeitgeist that does this -- the psychological version of inertia: the belief that what's happening will continue to happen.

Stewart, too, rides the zeitgeist. The hunt is on for culprits and scapegoats, and Stewart has served up a cliche: the media. As with the war in Iraq, for which credulous media should take some responsibility, the sins are blown out of proportion. It would be one thing if Wall Street titans by the score were selling their company stock and the media were failing to report it, but when someone puts his money where his mouth is, you have to pay attention. The big shots believed.

Stewart plays a valuable role. He mocks authority, which is good, and he mocks those, such as the media, who take the word of authority as if, well, it's authoritative. But given the outsize reception to his cheap shot at business media, he ought to turn his wit inward: Mocker, mock thyself.

Does China Know Markets Better Than U.S.?

He sounded not like the Communist dictator he is, but like the concerned head of an institutional investment firm warning the management of some troubled insurance company or mutual fund in which he has placed confidence to shape up and start behaving like successful businessmen.

It isn't the first time the land of the Tiananmen Square massacre has been found being more capitalist than the free world.

As former British Governor of Hong Kong Chris Patten has noted, "China has been the world's largest economy for 18 of the past 20 centuries."

In a Financial Times article last year, Patten pointed out that after Europe went protectionist in 2007 to block the import of cheap Chinese goods, "Europe found itself in the humiliating position of being lectured on free trade by a totalitarian regime."

No one in the West should fall under any sentimental illusions about Wen's underlying aim, shared by his predecessors Mao and Deng: maximum global power, economic and otherwise, for the Chinese regime.

Tens of millions perished in the Great Leap Forward and the Cultural Revolution, when the government was committed to Marxist-Leninist economic ideology, but government forces also slaughtered thousands at Tiananmen Square in 1989, a decade into China's transition from central planning to a more market-oriented economy. As the post-Mao Chinese government has often admitted, it is simply embracing "what works" economically — which is also what advances its own global competitive interests.

Nearly a half century ago during the Great Leap, with all private farming banned, two thirds of the workers at the remote nuclear weapons development base in Qinghai province were dying of severe malnutrition. Why should there be any wonder in the Red Chinese recognizing that letting Maoist agricultural policy starve those assigned the task of building an atomic bomb contradicted their regime's totalitarian aspirations?

So when Wen Jiabao (who of late has been touting capitalism's intellectual founding father, Adam Smith) warns America not to overexpand government, it's not out of humanitarianism.

It is because he understands what too many in Washington have forgotten: Reduced economic freedom can break a superpower.

Why We Need Not Fear A Bigger Stimulus

Getting another round of spending boosts and tax cuts will, however, be problematic. Partisan opposition is mounting. That there is partisan opposition is very strange. We know John McCain’s chief economic advisers – people like Douglas Holtz-Eakin, who made an excellent reputation for himself as head of the Congressional Budget Office, like well-respected forecaster Mark Zandi, like AEI’s Kevin “Dow 36000” Hassett. We know how they think. We know that had John McCain won last November’s presidential election a very similar stimulus plan (but with fewer spending increases and more tax cuts) would just have moved through congress with solid Republican support. So the current 98% Republican opposition (except by governors who have to, you know, govern) leaves us scratching our heads.

So as we get ready to try to go and buy a bigger fiscal stimulus boat to deal with this Jaws recession, whose bite pushed the unemployment rate up to 8.1% in February, it is important to be clear why we ought to be doing this. And the first point that needs to be made is that the strange right-wing talking point that a government fiscal boost would not spur the economy because... because... well, it's not sure why... is badly mistaken at best and disingenuous at worst.

Four legitimate fears
But there are legitimate reasons to fear that deficit-spending fiscal boost programs would not work well enough and would have high enough longer-term costs to be not worth doing. I classify these legitimate fears into four groups.

    Bottleneck-driven inflation. The fear is that although more deficit spending will increase total spending, and although businesses seeing increased demand for their products will indeed try to hire more workers to boost production, they will succeed only by offering their new workers higher wages – wages higher enough that they then have to boost their prices – and by snatching scarce commodities out of the supply chain by paying more and then having to boost their prices more as well. Thus rising inflation will make the increase in real demand an order of magnitude less than the increase in nominal demand. And if the inflation produces general expectations that prices will continue to rise – well, then we are back where we were in the 1970s, with everybody focusing on changes in the overall price level rather than whether their business plan made sense given individual goods and services prices. An inflationary economy is one in which the price system does not do a very good job of telling people and businesses where to focus their energy. It is likely, over the decades, to be a slow-growth economy. Breaking an inflationary spiral would require another recession on the order of 1979-1982. It is better not to go there, and a fiscal stimulus plan that takes us there is not worth doing.
    Capital flight-driven inflation. The fear is that the stimulus package will cause foreign holders of domestic bonds to believe that inflation is on the way and trigger a mass sell-off of US Treasuries and other dollar-denominated assets that will push the value of the dollar down. And as the value of the dollar falls, the dollar prices of imported goods and services rise – and we are off to the inflation races once again.
    Crowding-out of investment spending. The fear is that additional government borrowing may – not will, not must, but may, for this is a fear not a certainty – push up interest rates, make financing expansion even more expensive for businesses, and so discourage private investment. The boost to spending would thus come at a high cost-benefit ratio as much additional borrowing leaves us with only a little additional demand. Moreover, it would leave us with a low productivity-growth recovery that has too little productivity-boosting private investment and too much government spending in the mix.
    Reaching the limits of debt capacity. The fear is that the long-term costs of additional fiscal boosts via deficit spending will be very large because those from whom the US government will have to borrow the money to finance spending will only loan it on lousy terms – high and unfavourable real interest rates that impose substantial amortisation burdens and associated deadweight losses from taxation on America’s taxpayers.

All of these are legitimate fears when a government undertakes a deficit-spending plan. We can all recall historical episodes when they turned out to be not just fears but realities. We remember bottleneck-driven and wage-push inflation from the late 1960s and from the oil shock-ridden 1970s – those episodes were the first fear coming home to roost. Nobody today is happy with American fiscal policy in the late 1960s or American demand management policy in the 1970s.

The second fear became a reality in France in the early 1980s. Capital flight and anticipated-depreciation-driven inflation were the immediate result of Francois Mitterand’s attempt to institute Keynesianism in one country and drive for full employment when he became president of France in 1981.

The third fear was perhaps not a reality but it certainly was greatly feared in the winter of 1992 and 1993, back when I carried spears for Lloyd Bentsen and his subordinates Roger Altman and Lawrence Summers in the Clinton Treasury. They argued that the Clinton-era economy could not afford the crowding-out of private investment that even the steady-course deficits then projected for the mid-1990s were threatening to produce through high and rising interest rates.

And the fourth fear is an even older legitimate fear yet. It goes back to Adam Smith and his Wealth of Nations, which contains pages warning that deficit spending on the imperial adventures of George III and his ministers would produce an unsustainable debt burden that would crack the British economy like an egg – as had been the consequences of debt-financed wars in Holland, France, Spain, and the Italian city-states over the previous three centuries.

Why we need not fear
These four fears are all legitimate fears, but I believe that we, here, now do not need to fear them.

In each of the cases in which these fears are legitimate, we can see in advance that the stimulus program is going wrong. Stimulus packages produce increases in nominal but not real demand when exchange rates fall and prices rise; we can watch the exchange rates fall and the prices rise, and we can watch as financial markets anticipate these events beforehand. Stimulus packages crowd-out private investment when the government’s borrowing causes medium-term interest rates on corporate borrowings to rise. Stimulus packages impose a heavy financing burden on the government when they cause long-term interest rates on government securities to rise.

In all of these cases, that the stimulus is going to go wrong becomes very visible in advance. If the stimulus is going to be ineffective because it generates bottleneck-driven inflation, we can identify that problem as the price or wage of the bottleneck good or service spikes. If the stimulus is going to fail because of capital flight-driven inflation, we will see the value of the dollar collapse as foreign-exchange speculators front-run the capital flight – and then we will see import prices spike and put upward pressure on prices in the rest of the economy. If the stimulus is going to fail by crowding out private investment, we first will see the medium-term corporate interest rates relevant to financing plant expansion spike. And if it is going to impose a crushing debt repayment burden, we will see long-term Treasury bond interest rates spike instead.

Right now, however, we see none of these things. No signs of bottleneck-driven or wage-push inflation gathering force. No signs of approaching rapid dollar depreciation. No signs that the stimulus is pushing up medium-term interest rates on corporate borrowing. No signs that the stimulus is pushing up long-term interest rates on government bonds.

If any of these start to materialise, expect me and a number of other stimulus advocates to start backpedalling rapidly. But so far, so good.

J. Bradford DeLong is professor of economics at U.C. Berkeley.

Editors’ note: This was first posted on theweek.com. Reposted here with permission.

March 18, 2009

Cities, College Grads and the Inequality Gap

Now along comes University of California, Berkley, economist Enrico Moretti with another take on the educated class and their migration patterns. Looking at the data that shows how college grads are sorting themselves into a relatively few expensive metro areas, Moretti wonders whether the cost of living isn’t eating up some of those income gains that college provided to these grads. And if so, why do so many of them still choose to live in these pricey places? What his preliminary findings, presented in an unassumingly titled working paper, Real Wage Inequality, suggest may change some of our ideas not only about the income gap, but about our efforts to bridge that gap.

Moretti’s big leap is to look at the income gap not simply as it is traditionally viewed—by class, by education, by race—but to look at it in terms of local costs, because “skilled and unskilled workers are not distributed uniformly across cities within the U.S.” Using adjustments to the local consumer price indices of metro areas, including the cost of different types of housing, Moretti, a research associate at the National Bureau of Economic Research, determines that prices have been rising much faster for college grads: Housing costs for college grads, for instance, were 19 percent higher than for non-grads in 1980, but by 2000 had grown to 44 percent higher.

Those differences help account for a smaller real income gap than is generally thought during those years. Adjusting for cost of living, Moretti estimates that the increase in the wage premium that one earns because of a college degree is about half what it seems to be when wages are simply compared across the entire U.S. without first adjusting for cost of living. As many professionals in New York or San Francisco can tell you, Moretti’s conclusion is hardly shocking.

Still, the average person might wonder why the heck college grads stream into places where costs eat up so much more of their wages. Prof. Florida would argue that it’s because grads are not only attracted to but willing to pay for the amenities that these areas provide, what New York Times’ columnist David Brooks might call BoBo (bourgeois/bohemian) amenities.

Moretti tests that assumption, however, and finds it wanting. If highly skilled workers are drawn somewhere by local attractions, there should be an abundance (or at least an adequate supply) of talent in these places, which would keep wage increases down. Instead, skilled workers are going where there is already demand for their services—one reason why the wage premium kept increasing over the period he studied, even in places that already had plenty of college grads.

If Moretti’s research is correct, it helps to answer one of the puzzles of the income gap. As the title of Goldin and Katz’s book suggests, the demands that technological changes have created in our workforce have outstripped our educational system’s ability to meet them. The number of college-educated workers hasn’t been growing as quickly as the demand for their skills.

Why, then, haven’t students been seizing the opportunity that seems to be so apparent? There’s plenty of speculation about this—and a lot of blame. Advocacy groups argue we haven’t invested enough in education—though our per-pupil spending in K-through 12 outstrips most other industrialized nations by a good deal. School reformers, meanwhile, have placed some of the blame on our university education schools, who have occasionally favored curricula that are trendy but unproven in our public system. Or maybe it’s just that kids aren’t as motivated as they used to be, even when the payoff seems big.

But Moretti’s research suggests there’s another reason. Maybe kids (or their parents) who are sitting on the fence about attending college understand better than a lot of policy makers that the return produced by a university diploma isn’t all it seems to be, especially if you are a middle-of-the-road student who will have to borrow heavily to get a college degree and then go snare a job that isn’t at the top of the pay scale in a place where it’s expensive to live.

Still, the notion that we should be sending more kids to college is so alluring that President Obama has made it a signature part of his economic revival strategy, and we’re about to embark on another government-sponsored push to get more kids into college and then graduated.

Maybe we should be listening to what the market tells us instead. Labor surveys continue to show that we have enormous demand in this country for skilled trades, which pay their own salary premiums. Our best vocational schools, the ones that serve this market, have exemplary placement records, getting kids good-paying jobs right out of high school or after two years of community college. Yet guidance counselors often de-emphasize vocational training, and in some places per pupil spending in public vocational schools is shockingly low compared to spending within the school system in general. No politician is going to get reelected claiming he helped increase graduation rates at vocational schools. In my home town, they advertise on billboards how many graduating high school seniors are going to college.

But if college isn’t quite the yellow-brick career road that it’s cracked up to be, perhaps it’s time we explore other ways to close the income gap--even though the gap that isn’t quite as large as we thought it was in the first place.

Goldman Sachs's AIG Double Dip?

On the surface, this bailout has always looked unseemly. As we dig deeper, it appears downright scandalous. First we must follow the money. Starting last September, the New York Federal Reserve, with now Treasury Secretary Geithner at the helm, paid the collateral calls that AIG was facing directly to AIG’s counterparties. The largest recipient was Goldman Sachs.

We know that these collateral calls arose because AIG FP had written insurance, or Sold Protection, on a variety of mortgage related Collateralized Debt Obligations. The typical trade for a large bank would have been something like the following: A large Bank might buy the super-senior tranche of a mortgage CDO. This security would likely have a triple-A rating from two major rating agencies. The security itself was at the time of its pricing considered very low risk. Its spread to Libor in 2006 might have been 30 basis points.

The next leg of the trade is where AIG comes in. The bank or brokerage owning the AAA security then went and bought an additional layer of protection from AIG FP. On the surface, this made the trade even safer, because AIG was also AAA. So the bank owned a AAA asset, protected by a AAA insurance company. A belt and suspenders approach.

Not really, because the likelihood of AIG being able to pay off this claim was low. The risk of losses was then considered miniscule, but they were no further reduced by the purchase of an additional layer of protection from AIG. The reason for this is that AIG, through the process of writing hundreds of billions of this protection, became perfectly correlated with the assets it was insuring.

The analogy of a passenger on the Titanic buying life insurance from another passenger on the Titanic is apt. It doesn’t make much sense, but the Titanic is unsinkable. And home prices never decline.

Why would banks buy protection they knew was unlikely ever to pay off? Because traders had an enormous incentive to do so, even knowing the value of the protection would likely never be realized.

In our example, the bank owns the asset and earns 30 basis points, assuming it funds itself at Libor. On a $1 billion CDO tranche, the trader would earn about $3MM per year on this position. Not bad, but a clever trader can do better.

If the trader pays 10 basis points to AIG FP for protection on the asset, the net spread falls to 20 basis points. But by hedging the asset with AIG he or she could capture the full present value of that 20 basis point stream into current income. So on the same $1 billion CDO tranche, with an average life of 10 years, the trader might recognize close to $20MM immediately. From the bonus-minded trader’s perspective, making $20MM today is far better than making $3MM per year for 10 years.

This explains why a banker might buy insurance from an entity whose very existence is so highly correlated with the risk he is insuring. Not so much greed, or the lack of regulations, but the presence of bizarre regulations. This also explains why firms such as Goldman Sachs and Bank of America found themselves so heavily exposed to AIG.

But why was Goldman Sachs first in line at the bailout parade? Goldman Sachs representatives have alternatively said their exposure to AIG was “immaterial” or “hedged.” Goldman Sachs spokesman Michael DuVally recently told Bloomberg that “Goldman Sachs would have been unaffected by the failure of AIG.” Well, $12.9 billion is not immaterial, so the only reasonable explanation is that their net exposure to AIG was immaterial because they had hedged.

Which would mean that when the government paid AIG’s claims, Goldman Sachs had something like a $12.9 billion windfall gain on its hedges. We know Goldman Sachs is populated with smart traders, so it is perfectly believable that they had taken precautionary measures to protect themselves against an AIG payment failure. They may have hedged with Credit Default Swaps or some other instrument. It does not really matter, because, taken at its word, Goldman did not need the government bailout money.

Given how unseemly it is for Goldman to have taken this taxpayer money, which it didn’t need, while their former chairman was running the Treasury Department, one might expect, or even demand, that they pay it back. In the scheme of things, the bonus payments the Obama administration is so fussed about are a pittance compared to Goldman’s apparent double dip.

An Interview with Jack Welch

Fed Chairman Bernanke on 60 Minutes:

I slammed the phone more than a few times on discussing AIG. I understand why the American people are angry. It's absolutely unfair that taxpayer dollars are going to prop up a company that made these terrible bets, that was operating out of the sight of regulators, but which we have no choice but to stabilize, or else risk enormous impact, not just in the financial system, but on the whole U.S. economy.

KUDLOW: You know Jack, I hate like heck to sound like Barney Frank, but I think I’m going to sound like Barney Frank by asking you this question. If the US government can cram down General Motors auto workers, the UAW contracts, compensation, benefits and what not, why can’t we cram down AIG? After all, really unlike GM, at least so far, the American taxpayer is the primary owner of AIG, certainly the primary creditor.

JACK WELCH: Hey Larry, why don’t we step back for a minute. There’s been 24 hours of wild emotion over this thing. Who owns AIG? The US government owns AIG. Now why are they not taking charge of their situation? They appointed a CEO; it’s their CEO. He happens to be a very good man, Ed Liddy, who ran Allstate for many years. They ought to be working as a board of directors with their CEO on what the compensation ought to be. Then they ought to be either agreeing with their CEO, who’s making $1 a year, and doing it as a good citizen, or they ought to get their own man in there, this administration ought to put somebody in.

KUDLOW: But they’re saying, you know Liddy, okay he’s a good man. Basically I agree with you Jack. But you know Liddy is throwing up this blue smoke at us about the contracts. He says there are contracts.

WELCH: Larry, Larry, Ed Liddy is their CEO! They’re the board of directors! Why are they not working with the CEO to get a resolution? These guys want to be critics on the outside, and not owners on the inside. They are owners.

KUDLOW: Geithner and his group should have called Liddy down to Washington. I don’t understand this. And just sat him down and say, okay, here is the way life works. Here’s the way it’s going to work. Is that what you’re saying?

WELCH: It should have been resolved between Liddy and the Treasury, or the Fed, or whoever it is that represents the US government who is the owner of AIG! The idea that these guys who own it, can now all throw rocks at it, makes no sense. It would be like a board of directors throwing rocks from the outside and not being responsible.

KUDLOW: Well why didn’t we put them in bankruptcy in the first place? Some kind of government sponsored bankruptcy which nullifies and voids all the contracts? Why didn’t we do that? In fact, for that matter, why didn’t we do it for General Motors?

WELCH: Look Larry, I’m not going to get into whether Lehman was right, AIG was right, the way they handled that. We’ve already crossed that bridge. I want to stay on this one though. I don’t think these guys as owners, are acting like owners who want to get their $180 billion dollars back. They’re not acting like owners. Let’s challenge them to work with the chairman, to work as a board of directors. Have them designate Geithner, or Bernanke, or whoever, and have them work it out so that the government is working in concert with the CEO, not at cross-purposes, Larry.

KUDLOW: So what you’re saying is we need a grownup in the Treasury. Is that what you’re saying? We need someone with some business seasoning in the Treasury to do exactly the kind of thing you’re recommending?

WELCH: We need a government group representing the owners who are responsible for dealing with the CEO in the same way governance happens in any company. Not having—we’ve got the New York State attorney general, we’ve got Barney Frank, we’ve got everybody—the government owns the company!

KUDLOW: So they’re really not doing their job. They’re whining a lot. They’re whining a lot, they’re throwing a lot of faux populism. But you’re saying they have other tools. They should just do their job.

WELCH: My argument is Larry, they ought to work with the CEO as any owner would. As we do with our private equity companies. Try to encourage the CEO to get the right answer so we get a return on our money. I don’t want this $180 billion to just go up in smoke because we’re all fighting with each other.

KUDLOW: All right, I hear you. Now hang on Mr. Welch, hang on. We have so much more for you to do…Kudlow Report, stay with us, we’ll be right back.


KUDLOW: All right we’re back with business legend and great friend Jack Welch. Of course, the former chairman and CEO of General Electric, the parent of this network. Mr. Welch I cant help but admire your green tie. I’m sure there’s an inner meaning to that.

WELCH: [Laughter] I don’t think so.

KUDLOW: Okay, tomorrow’s St. Patrick’s Day. Anyway, Ben Bernanke makes his national television debut on 60 Minutes. They have a couple more viewers than his usual CNBC venue. Here’s Mr. Bernanke on the economy with a touch of optimism. Let’s hear it.

Fed Chairman Bernanke on 60 Minutes:

Ben Bernanke: We’ll see the recession coming to an end, probably this year. We’ll see recovery beginning next year. And it’ll pick up steam over time.

Scott Pelley: You think the recession is going to end this year?

Bernanke: In the sense that this decline will begin to moderate, and we’ll begin to see leveling off. Now we won’t be back to full employment, but we will see, I hope, the end of these declines that have been so strong the last couple of quarters.

KUDLOW: All right Jack, what do you think? That’s his forecast. Now he’s had some that turned out okay, and some not okay, and we’re all guilty of that. What do you make of it?

WELCH: Well I’m sort of in his corner. I’m not a great expert on this, but I’m in his corner. Larry I have a fact here that may be of some interest. I’m involved with a private equity firm, a partner in a private equity firm, Clayton Dubilier, where we have several companies. A beauty company; a car rental company; an industrial distribution company; a food services company. And February was the first month since May, where we did not have sequential downs over the prior month. February was about equal to January, and so was early March.

Now I gave this comment, this little tidbit, and said don’t take it to the bank or do anything else at a JP Morgan conference a week ago. And as I went to lunch, several CEOs came up to me and said, ‘you know we’re seeing the same thing. We didn’t want to say it.’ So Larry there is sort of a feeling, now it’s by no means guaranteed, but there is somewhat of a feeling that the acceleration down has somewhat moderated. And we seem to be flattening out a touch.

KUDLOW: Well I like the story, and we try to show some of this stuff each evening. We’ve seen a bottoming, even an increase in key commodity prices—the Baltic Dry Index. Here’s one Jack, core retail sales, underlying retail sales, which feed into GDP, have actually been up two straight months. And the energy price plunge in retail gas, real incomes, disposable incomes from consumers have been up the last four of five months. So there may be some stability.

Let me throw one more Bernanke sound tape at you. Here’s his pitch to Main Street and backing around the country.

Bernanke on 60 Minutes:

You know I come from Main Street, that’s my background. And I never have been on Wall Street. And I care about Wall Street for one reason and one reason only. Because what happens on Wall Street matters to Main Street.

KUDLOW: Jack is he making the sale in your judgment? Is he winning the support of the people? This is such a controversial issue. Opinion polls show that folks do not like these bailouts. Do you think Bernanke himself personally made the sale last night?

WELCH: Well he gave a tremendous presentation Larry last night. He was thoughtful. He was measured. He really radiated confidence. And we need more than anything else, confidence. And he also laid out the challenge for the political forces. He said the pressure will be do we have the political will to make the fix? And that is a real challenge for Washington. He said we’re going to need to go after it with a vengeance. He studied the Depression more than anyone. He’s making a lot of right moves; he’s made a lot of right moves. I’ve been supporting him in our column for the last four months. I think he’s made a ton of right moves, and I happen to believe that he laid the gauntlet down to Washington. Do they have the political will to back up what he needs, the firepower he needs, to get the job done Larry. I think he did a magnificent job.

KUDLOW: You know, I worked for Arthur Burns and Paul Volcker at the New York Fed. Of course like you I knew Greenspan very, very well. I think this is the best television communications performance of any Fed chairman in my lifetime. And I agree with you sir, he did get the job done. And I think he did more to help Obama and all the issues toward recovery than anything we’ve seen so far. He stood alone. He deserves reappointment doesn’t he?

WELCH: Absolutely Larry. He did a job on a broad spectrum. H e grabbed the country and he challenged the politicians.

KUDLOW: All right. So Jack, let me go to this controversial Financial Times—holy cow, I’ve never seen such a thing for you. You give a little interview in the Financial Times and you’re all over the blogosphere, the Internet, and what not. It says here Jack Welch regarded as the father of shareholder value, he is now saying the obsession with short term profits is all wrong. And I’m going to read you the key quote, the money quote. “On the face of it Mr. Welch said, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy.” Please, elaborate.

WELCH: Larry, I was having an interview on the future of capitalism. And I was asked, what do you think of shareholder value as a strategy? I said it’s the dumbest idea possible. It isn’t a strategy; it’s an outcome. A strategy is something like, an innovative new product; globalization, taking your products around the world; be the low-cost producer. A strategy is something you can touch; you can motivate people with; be number one and number two in every business. You can energize people around the message. They come to work every day. It’s tangible. It’s something they can feel and be proud of.

Shareholder value? What the hell is that Larry? It’s the result of you doing a great job, watching your share price go up, your shareholders win, and dividends increasing. What happens when you have increasing shareholder value? You’re delivering better employees to their communities and they can give back. Communities are winning because employees are involved in mentoring and all these other things. Customers are winning because you’re providing them new products, value propositions…

KUDLOW: But we’ve got to have profits. Profits are the mother’s milk…

WELCH: Absolutely!

KUDLOW: …not just of the stock, but of the whole company. A healthy company’s got to have earnings. And it’s got to have capital investment. Now, what do you say now? What’s your advice now? Or let me put it differently. If you were at the business roundtable meeting yesterday, all the bigwigs met with President Obama—not yesterday Thursday, I beg your pardon. I’m time insensitive. If you were there, what strategy would you have recommended to your colleagues and to your president?

WELCH: Look, it’s always the same. You’ve got to eat while you dream. You’ve got to deliver on short-range commitments, while you develop a long-range strategy and vision and implement it. The success of doing both. Walking and chewing gum if you will. Getting it done in the short-range, and delivering a long-range plan, and executing on that Larry. That is what it’s all about. That’s what management is—making choices. Any jerk can have short-term earnings. You squeeze, squeeze, squeeze, and the company sinks five years later. Any jerk can sit there and say, ‘hey, come back in five years, I’m doing my long-range thinking.’ Get out of here. Management is all about managing in the short term, while developing the plans for the long term.

KUDLOW: Is it time, as some people say—now this is interesting, Fred Smith, our great friend, the CEO of FedEx, he’s got to be one of the smartest businessmen in this country.

WELCH: Very good.

KUDLOW: He says we’ve got to do something to boost American manufacturing and industry, the stepchild of business. We always talk about tech. We always talk about financial services, and Lord knows, we’re spending multiple fortunes of taxpayer money today on financial services. Jack, GE once was a great industrial manufacturing superpower. I don’t know, it seems to have receded in its priorities. I’m not asking you GE specific. In general, what could this country do to boost its manufacturing and industrial base?

WELCH: Larry, again, obviously we have to do the education job, we can’t be having H1B visa restrictions and sending the best and brightest technical people we get and send them home. We’ve got to change government policy on that regard. But just a quick line on GE Larry, I can’t let you get away with that. GE is without question, the leader in jet engine manufacturing, with sophisticated engineering and design. It’s the leader in power generation, power plants all over the world, powering electricity…

KUDLOW: But it’s a smaller share of the company. I mean, I’m not an analyst of General Electric. As I’ve said on this program…

WELCH: Larry…

KUDLOW: I heard [GE CEO] Jeff Immelt give a brilliant speech, I was there in South Carolina at the New Years weekend. But Jack, it has shrunk. Right?

WELCH: No it hasn’t shrunk!

KUDLOW: Look at financial services. GE Capital became the big swinging you-know-what and the manufacturing side took second place.

WELCH: Larry, manufacturing grew from something in the neighborhood of $20 billion to $90 billion over the period. Financial services grew faster. But manufacturing became bigger and more powerful during that period. That’s why manufacturing throws off $10 to $15 billion of cash flow that will support the financial services through this period.

KUDLOW: So you’re saying it never left, it’s still there, and nationwide it’s still there. Is that your message?

WELCH: Well I think you’ve got some great industrial companies. You’ve got United Technologies, you’ve got Emerson Electric, you’ve got Eaton, you’ve got all kinds of good industrial companies. Larry, this is somewhat of a myth. But I’ll tell you one thing, Fred’s right. We’ve got to have the policies to keep the best and brightest in our country.

KUDLOW: Well he wants immediate write-offs of investments. He wants full cash expensing for investments to lower the cost of capital. That is something I am not hearing from Washington, frankly, in either party right now. And I think that would help. You’re right about the H1B visas. We’ve got to get out of here. Mr. Jack Welch, I love getting smacked down by you. It is my favorite smack down anywhere.

WELCH: I didn’t mean to Larry, I love being with you. Thanks for having me.

KUDLOW: All right sir, it’s wonderful to see you again.

AIG: Why the Government Shouldn't Run Anything

But as things stand now, there still is no clear roadmap for the dissolution of AIG. There are ideas, but nothing is set in concrete.

And as for the $165 million or so in AIG bonus payments, the Obama administration -- including the president, Treasury man Tim Geithner, and economic adviser Larry Summers -- knew all about them many months ago. They were undoubtedly informed of this during the White House transition.

So there’s no big surprise. Nobody should be shocked. But President Obama is doing his best play-acting ever. He knows full well that the nationwide outcry against federal bailouts and takeovers is only going to get worse on his watch. His poll numbers are already falling, and this AIG episode is going to pull them down more.

Incidentally, has anybody asked Team Obama why it is more than willing to break mortgage contracts with a bankruptcy-judge cram-down, but won’t cram-down compensation agreements for AIG, despite the fact that the U.S. government owns the company? Kind of odd, don’t you think?

The Wall Street Journal editors get it right when they ask: Who’s in charge and what’s the game plan? The whole AIG story is an outrage.

What’s more, AIG is acting as a conduit for taxpayer money that is being sent to dozens of derivative counterparties, including foreign banks and American banks like Goldman Sachs. If we’re going to bail out all these other firms, why not bail them out in full taxpayer view? Why is the money being laundered furtively through AIG? And where exactly is the end game for AIG? How are the taxpayers going to be repaid?

And what is Treasury man Geithner’s role in all this? He appears to be the biggest bungler in what has become a massive bungling. My CNBC friend and colleague Charlie Gasparino thinks Geithner can’t survive this. I am inclined to agree.

Nevertheless, behind the furor over AIG, there is some good news to report on the banking front. This week’s decision by the Federal Accounting Standards Board (FASB) to allow cash-flow accounting rather than distressed last-trade mark-to-market accounting will go a long way toward solving the banking and toxic-asset problem.

Many experts believe mortgage-backed securities and other toxic assets are being serviced in a timely cash-flow manner for at least 70 cents on the dollar. This is so important. Under mark-to-market, many of these assets were written down to 20 cents on the dollar, destroying bank profits and capital. But now banks can value these assets in economic terms based on positive cash flows, rather than in distressed markets that have virtually no meaning.

Actually, when the FASB rules are adopted in the next few weeks, it will be interesting to see if a pro forma re-estimate of the last year reveals that banks have been far more profitable and have much more capital than this crazy mark-to-market accounting would have us believe.

Sharp-eyed banking analyst Dick Bove has argued that most bank losses have been non-cash -- i.e., mark-to-market write-downs. Take those fictitious write-downs away and you are left with a much healthier banking picture. This is huge in terms of solving the credit crisis.

In a column last week I suggested that not one more dime of government money is necessary for the banks. Instead, the marriage of the cash-flow valuation of bank assets and the upward-sloping Treasury yield curve will do the trick. Net interest margins are rising as banks purchase money for near-zero interest and loan it out at profitable rates. And the new mark-to-market reform will allow banks to hold their toxic assets for several more years and work them out -- just as they did back in the 1990s.

We don’t need more TARP. We don’t need to take over more big banks. And we don’t need to have the government run things it simply isn’t capable of running.

March 19, 2009

Economic Populism Is a Virtue

Yet there is much hand-wringing that this populist fury is terribly perilous, that the highfliers who could not control their avaricious urges have skills essential to repairing the damage they caused in the first place.

Beware populism, we are told. Honor those AIG contracts. Forget about any moral reckoning and just fix the economy.

This view is wrong on almost every level, especially about populism. Of course not all forms of populism are attractive. But as historian Michael Kazin argued in "The Populist Persuasion," the "language of populism in the United States expressed a kind of idealistic discontent" and "a profound outrage with elites who ignored, corrupted and/or betrayed the core ideal of American democracy."

Is this not an entirely appropriate reaction to elite decisions dating to the 1980s that ultimately ran our economy into the ground?

The Obama administration has sent thoroughly ambivalent signals on this question. Its initial response to the $165 million in AIG bonuses (the president's lieutenants said there was little to be done about them) suggested that it did not want to join in the populist anger and maybe didn't even realize that it was there. On Monday, President Obama made clear that he got it, denouncing the bonuses.

It was the right first step. He should build on this by showing that he shares in the public's morally justified intuition that our society's rewards to the very wealthy are totally out of line with their contributions to the common good.

A study of compensation levels in 2007 found that average CEO pay at S&P 500 companies was 344 times higher than the average worker's wage, and that the top 50 investment fund managers took home 19,000 times -- yes, that's with three zeroes -- as much as typical workers earned.

Now, I am not against people getting rich or entrepreneurs reaping profit from their investments of time and energy. But there is no moral or practical justification for such levels of inequality. Capitalism worked extremely well in the three decades after World War II without such radical inequities. It's when inequalities soar that the system runs into trouble -- precisely what happened at the end of the 1920s, when inequality reached levels similar to today's.

With the populist furies unleashed, the Obama administration has two choices. It can try to fight the public. Or it can use the public's outrage to move the country in a better direction.

Rep. Barney Frank (D-Mass.), the chairman of the House Financial Services Committee, points to the irony that populism threatens to work against Obama even though the president has proposed "a populist budget." It's a budget that raises taxes on the wealthy, cuts them on almost everyone else and spends money on programs -- notably health care -- that are of benefit to the poor and the middle class. Obama needs to show that his budget is itself a direct response to the injustices aggravating the country.

The president needs to do two things at once. The administration has no choice but to spend piles of money to unwind the financial mess. A share of the largess, as Frank acknowledges, may indirectly benefit some of the malefactors in this saga. But Obama has to be unambiguous in asserting that the purpose of this spending is not to reward those who got us into this fix but to solve a problem that affects us all.

To make this case, the administration should be unafraid to use its proposals on health care, taxes, education, energy and financial regulation to argue that it is building a new economy on the ashes of the old -- an economy based on fair rewards to capital and labor alike, not on an ethic of greed and excess.

Obama can work with the populist wave or he can be overwhelmed by it. As Kazin notes, American progressives have succeeded in improving the "common welfare" only when they "talked in populist ways -- hopeful, expansive, even romantic."

Kazin cites the line popularized by Ralph Waldo Emerson, "March without the people, and you march into the night," and then adds: "Cursing the darkness only delays the dawn."


AIG Bashing Is a Political Smokescreen

What is puzzling is why it has taken the Administration so long to discover that AIG had, in the first quarter of 2008, committed itself contractually to pay bonuses to 400 employees in its financial products unit. That was months before Congress approved the Troubled Assets Relief Plan (TARP) and before the Bush administration funneled $85 billion into AIG to prevent its collapse.

These contracts to pay bonuses should have become known to Treasury officials a half-year ago, when they reviewed AIG’s financial position before the first September 16 injection of funds. Basic due-diligence scrutiny of the firm’s books would have revealed the contractual obligations to make bonus payments to retain talented staff.

If the bonus agreements weren’t known to the Treasury before September 16, they should have come to light in the months since, during which AIG has received over $170 billion in federal aid. Mr. Obama and Mr. Geithner should be outraged at their staffs for not having discovered the obligations and raised red flags much earlier. Such ignorance may be a cautionary lesson for those in government and academia who would have the government dictate management of, if not manage overtly, distressed firms in any sector, most obviously the auto companies.

According to documents from AIG, the bonuses are compensation owed to employees under Connecticut law. Under the Connecticut Wage Act, the company said, if the bonuses are not paid, AIG becomes liable for legal costs of employees who try to collect, as well as penalties that could equal twice the bonuses owed. AIG might also leave itself liable to shareholder suits.

Despite the sense of public outrage to which the President and Congress are playing, it would be unwise for the federal government—as de facto owner of AIG, as Democratic Representative Barney Frank has commented—to go back on the contracts and sue to recover the money. This could make America resemble Russia, where trumped-up charges are used to prosecute companies that fall out of favor with the ruling elite.

Members of Congress are also discussing emergency legislation to tax away part or all of the bonus. This would set a precedent—corrupting if not unlawful—of using the IRS and the tax code as weapons of the state to go after individuals whom the Administration and Congress want to punish. Such sanctions might amount to ex post facto punishment, legislation that makes unlawful behavior that was lawful when it occurred. The Constitution prohibits such legislation. Even President Nixon, who had an enemies list, never dreamed of this.

The wave of public sentiment against the AIG bonuses presents the government with a choice. It can try to run companies that receive bailout funding in a way calculated to win public approval, micromanaging every detail. To do that successfully in a business sense is impossible. The government cannot even manage its own federal agencies efficiently, with episodes of wasted resources surfacing regularly.

Better, the government should get out of the business of rescuing ailing companies. The bailouts have won little support among Americans. In a CBS poll published on March 16, 53% of Americans disapprove of the government giving money to banks and financial institutions even as a way to help the economy, and only 37% approve.

With good reason. When TARP began in early October, it was supposed to resolve the problems of the financial sector and avert an economic slump. In late September, President Bush warned the country of dire consequences if a bailout bill did not pass: “More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet. Foreclosures would rise dramatically. “

All of that has happened, even though TARP passed on October 1. Since then, 28 more banks have failed (although depositors have been protected by FDIC insurance), the stock market has dropped by almost one-third, and median home prices have declined by nine percent. It’s natural that Americans have become disillusioned.

The bipartisan attack on AIG over bonuses is being used by the Administration and Congress to bolster their sinking approval ratings and hide the failures to date of the $700 billion TARP and the $787 billion stimulus package, as well as the uncertain outcomes of the proposed $275 billion housing bailout plan, the $634 billion health fund, and higher individual and carbon tax increases. The outrage would be put to better use abandoning bailouts altogether.

Schumpeter, and the Slow March Toward Socialism?

Schumpeter was of course talking about a United States that he envisioned post World War II, but his fears then don’t stray too far from the concerns of many today. Indeed, he worried that as wars usually accrue to the power of the state, that heavy government spending “would likely evolve into total government control over investment.” So far we’ve got the stratospheric spending to the tune of a $3.6 trillion budget, and from planned investment in everything from green energy to mortgage securities to autos, it seems that the alleged good that comes with government largesse will morph into the bad of government-directed investment.

On the business front, Schumpeter envisioned what would essentially be a two-tier system in which the government would largely stay out of the doings of retailers, laborers and clerks, all the while nationalizing what some call the “big business” parts of the economy. So while the hapless Fed Chairman Bernanke not long ago suggested that bank nationalization would not materialize, a few days later the federal government took an 80 percent ownership stake in Citigroup, the largest bank in the United States.

Federal investment in Citi and other supposed beneficiaries of TARP money was supposed to be passive, but as the New York Times reported last week, the financial institutions that took TARP funds are now being told by their federal minders to among other things “put off evictions and modify mortgages for distressed homeowners”, slash dividends, and cancel job offers made to individuals lacking a U.S. birth certificate.

Before Citigroup’s nationalization the U.S. economy had already been whacked by the nationalization of AIG, once the largest insurer in the world. And as is well known now, the federal government’s supposed compassion toward AIG had little to do with saving it, and a lot to do with aiding the banks whose risk was insured by AIG. So while Goldman Sachs protested that it didn’t need TARP funds, it’s increasingly apparent that GS and others were the beneficiaries of an AIG bailout that insures greater control from the Commanding Heights over bank and investment bank activities.

Schumpeter saw the investment banker as “the capitalist par excellence” for providing capital to entrepreneurs, but in our new economy the investment banker will have to please the political class first, and in ways that likely mean the disruptive entrepreneur will find it difficult to access capital. If war is the health of the state, then economic crises are its oxygen, and Washington has used what should have been a minor financial hiccup and turned it into an opportunity to greatly expand its footprint.

Schumpeter correctly saw Washington as usually the place for lesser minds. Along those lines, the previous administration “blessed” us with our current Fed Chairman, which means that the man who blinked with regard to Bear Stearns, and as such, helped author our financial problems, will now oversee “tougher capital requirements for big banks, limits on investments by money-market funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions” and “possibly run them temporarily.”

The irony of a government that fostered our financial destruction overseeing its resuscitation has seemingly never troubled Bernanke, so now the very regulations that failed so impressively when it came to rooting out previous financial mistakes will be expanded. What’s rarely asked is how the very people who achieve stature through something called “pay grades” could ever successfully regulate those who make millions by gaming those same regulations and regulators.

Once this is considered, it has to be remembered that a bigger regulatory state simply insures that there will be more big failures, and more Bernie Madoffs to contend with. Regulations, rather than a deterrent when it comes to nefarious activity, actually encourage it for the existence of rules that sharper minds in the private sector will always work around. Regulations merely tell those eager to cheat or take excessive risks what they’ll have to comply with while cheating and taking excessive risks.

Better it would be if Bernanke et al were to acknowledge how tragically unequal they are to the task of outsmarting private sector minds. If so, if the regulatory state shows an appealing modesty with regard to its shortcomings, it can be assured that private individuals, with money on the line, will do for themselves what Washington has never been able to do. Future Madoffs will be caught long before they can grow big enough to cause international scandals.

And while he was talking about the New Deal, Schumpeter was very troubled by a widespread prejudice against business, one in which private wealth was under a “moral ban” alongside public antagonism that would “make it impossible to accumulate venture capital.” Today we have politicians scrutinizing bonuses up and down Wall Street, all the while talking up increased taxes on work and investment engaged in by the “rich.” Simplified, politicians will seek to redistribute wealth away from the vital few, and into the hands of what some deem the “working classes.” Marx and Engels observed in the Communist Manifesto that “A heavy progressive or graduated income tax” was a certain way for the proletariat to seize power, and its apparent Washington will try to make taxes even more progressive.

All of the above should be remembered the next time overly sanguine economists talk about economic recovery that’s either here, or just around the corner. Indeed, unless the laws of economics have significantly changed, any supposed recovery will be a certain shadow of previous ones seared in our memory. The federal government has greatly expanded its role in the economy, and as such, future activity will have a flaccid quality if history is any kind of indicator.

Schumpeter may have been early in his suggestion that socialism would win out over capitalism, but this in no way detracts from his visionary predictions. In much the way that he foresaw, we’re on a slow march toward socialism; one that insures a more austere future for rich and poor alike.

March 20, 2009

Ben Bernanke's $1.2 Trillion Bet

This move, so-called "quantitative easing," is both momentous and perilous. With interest rates now at zero, it's the only real arrow in the Fed's quiver to fight a deflationary economy.

But why is the Fed doing this now?

An academic expert on the Depression, Bernanke no doubt understands that the government during the 1930s did too much tax-hiking, tinkering and regulating, and too little on the monetary side of things, and that this was a big reason why the economy collapsed.

He's well aware that other experts, such as Milton Friedman and Anna Schwartz in their monumental 1963 tome on U.S. monetary policy, laid much of the blame for the economy's collapse in the '30s on Federal Reserve wrongheadedness.

And indeed, since the Fed let money supply contract more than 30% as the economy plunged 27%, it's hard to argue that fact. Bernanke hopes to avoid the same mistakes.

That said, we face a far different situation today, with neither a GDP down 27% nor a quarter of our people out of work.

More appropriate, however, is the experience the last time the Fed tried quantitative easing in 1961—in the so-called "Operation Twist." According to the Fed's own later assessment, it failed.

In the end, what did work were the broad-based tax cuts pushed by President Kennedy and passed after his death. That's how that booming decade became known as the "go-go" years.

Perhaps Bernanke sees an administration and a Congress recklessly layering on new spending, new regulations and needless government programs that will inevitably slow growth and crimp productivity. Absent any real stimulus, such as tax cuts, he may feel quantitative easing is a risk worth taking.

Yet this is the equivalent of applying monetary policy with a set of defibrillator paddles. It carries a huge inflation risk — especially if, as Bernanke says, the economy's second-half recovery is a tepid one. That $1.2 trillion in new money will have to be paid for one way or the other — through taxes or higher inflation.

As for those who argue a major cash infusion is desperately needed to end our "credit crunch," we'd only note that credit, while tight, isn't close to being in a crunch. Consumer and business loans are running 7.7% ahead of last year, and total commercial bank lending is up about 4.8%.

In short, money is being lent, and the economy is perking up even without benefit of a federal bailout effort that could add $9 trillion or more to our national debt over the next decade.

It may be that Bernanke, a good economist, is tired of waiting for Congress and the White House to do what needs to be done and is moving to do what he can. If so, we applaud his courage and leadership. We just hope we'll be able to applaud the results.

Was March 9th a Bear Bottom?

The dramatic decline in share prices over the last quarter has been directly attributable to the absolutely frightening disrespect for the markets shown by the Administration. Consider that on January 18th, shortly before his boss took the oath of office, David Axelrod oafishly told the press that President Obama has a strong message for banks: “Start lending.” This statement echoed similar sentiment in Washington from Congressional Democrats. Embedded in this edict was the failure of U.S. political leadership to understand that attractive risk opportunities drive the lending business, not the other way around.

Then on February 12th, in an interview with the Washington Post, Axelrod was asked about the stock market and its daily drop. Paraphrasing, Axelrod said ‘Well, it can drive a White House. It may not drive ours. We don't care what's going on in the stock market. That's not our plan.’ While this sounds like a nice long term perspective in the private equity world, it is an absolute killer to the stock market.

Then, yet again, in his Senate confirmation hearings, Treasury secretary Geithner was asked directly if he thought raising taxes on savings and investment would be harmful or helpful to the economy. His tepid response was that it would be premature to speculate on those provisions of the Bush tax cuts until 2010 -- not exactly a convincing response to investors that must make subjective investment decisions in part based on their cost of capital. But at least it was the typical Obama response from his campaign that left wiggle room for negotiation. The budget that was unveiled on February 26th, however, went in exactly the opposite direction, aggressively seeking an acceleration of the expiration of the Bush tax cuts.

Now, contextualize these comments leading up to what we all hope is the bottom on March 9th. What changed? In this writer’s opinion, a flurry of good news from the policymaking front has given investors hope.

After the President’s budget was unveiled, a few Democrats started to openly question it. Senator Conrad said essentially that the cap and trade provision in the budget would be very hard to pass without some sort of help to the energy producers forced to bear the costs of such a system. While being unsure what help can exactly be extended to energy companies that would compensate for such a punitive regulatory system, words must be parsed here. While not as frontal as Dick Gephardt once telling the press in 1993 that ‘the House takes its orders from America’s houses, not the White House’, clearly the proposal was going to have difficulty. A few days later, on March 11th, Conrad told Energy Secretary Chu that the cap and trade system was tantamount to a tax on the consumer in the midst of a recession.

The President ran into more trouble with his budget from congressional Democrats who immediately took issue with scaling back charitable contributions. Charles Rangel and Max Baucus were quick to point out the absurdity of limiting charitable contributions in a downturn. There were, however, not exactly forthcoming statements from either that indicated support for the other planks of the tax-hiking budget. Furthermore, Obama told the Business Round Table that a corporate tax cut was on the table in exchange for support for his health care initiatives. Charles Rangel has for some time been an advocate for reducing this tax to a level that makes the U.S. competitive with its foreign competitors. In an era of Sarbanes–Oxley, this is an imperative.

But the most positive signal yet from the Obama administration is the desire to eliminate some capital gains taxes for small businesses. There are ultimately problems with this proposal as it has been posited so far. For one, God only knows how ‘small business’ will be defined. This is significant for the obvious reason in that it could potentially establish a nice constituency for zero capital gains taxes and be expanded at a later date, in particular if the exemption can be expanded to the capital providers to small businesses who can reap the potential rewards.

The Obama administration appears to be moving toward a more market-friendly approach. The seeds of a conversion seem to be in place. When Bill Clinton took office, he is said to have realized that the success of his presidency depended on the Federal Reserve and a bunch of bond traders. Implicit in this exchange was Clinton’s realization that markets do ultimately determine the fate of presidencies. Obama would be wise to do the same.

Furthermore, given the initial opposition to his budget by some of his own party members, markets should be hopeful that consolidated Democratic control will not overstep early on, as in the early years of the Clinton administration. If developments in Washington continue on their present course of the last couple of weeks, we just might be looking back on March 9th as the bottom of the bear market.

March 21, 2009

Hidden Agenda Behind the 90% Tax?

Note that the $250,000 cut-off point for the tax is the same line drawn in the sand in Obama’s budget for tax hikes on investors and successful earners. The president is proposing a tax rate of 40 percent, not 90 percent. But connecting the dots between Speaker Pelosi and Pres. Obama, it will be interesting to see if the president dares sign this bill.

And even though the 90 percent tax is a reaction to the AIG bonus fiasco, you have to wonder if the very-liberal-left House Democrats have a much broader agenda: to completely overturn the supply-side tax cuts of Ronald Reagan and John F. Kennedy.

A bit of history is in order. Following WWI, the Harding-Coolidge-Mellon Republicans returned the country to tax normalcy by reducing Woodrow Wilson’s 75 percent wartime tax to 25 percent -- thus triggering the roaring growth of the 1920s. Then came the Depression, spawned in large part by Herbert Hoover and FDR, who raised the top tax rate to 63 percent, 70 percent, and finally 94 percent.

The Robert Taft Republican Congress elected in 1946 lowered those tax rates, but they later bounced back to 91 percent, where they held until JFK proposed sweeping tax reform in the 1960s. The top tax rate was reduced to 70 percent, igniting the 1960s boom -- until it was undone by the inflationary Fed and Nixon’s de-linking of the dollar from gold. But Pres. Reagan slashed the top tax rate all the way down to 28 percent. This launched a multi-decade boom, with the top rate not straying far from Reagan’s vision.

Now, Pres. Obama has said that he has no intention of returning to the 70 or 90 percent tax rates of the past. But one wonders if the 90 percent House Democratic tax rate on so-called unearned income (bonuses) might not be the congressional tail that wags the presidential dog.

Most folks will say this scenario is farfetched. But it’s worth pondering. Is there truly a tax-the-rich hidden agenda in Washington that goes far beyond the Obama budget?

I wonder about this simply because there’s a much better way to recoup the misbegotten AIG bonuses. Though no one in Congress is paying any attention to beleaguered Treasury man Tim Geithner, he explained in a March 17 letter to Nancy Pelosi that the Treasury “will impose on AIG a contractual commitment to pay the Treasury from the operations of the company the amount of the retention awards just paid. In addition, we will deduct from the $30 billion in assistance an amount equal to the amount of those payments.” So the AIG bonus problem can be remedied in a much calmer and simpler way than returning to 90 percent tax rates.

But the bigger point is this: A 90 percent tax rate on financial bonuses is so punitive that it will surely drive away the best and brightest from the very banks that must heal the credit system. Do we really want D-minus students -- who are willing to accept massive tax punishment -- in charge of a trillion dollars in taxpayer money and spearheading economic recovery? The perverse incentives of tax retribution against AIG and other TARPed banks will surely backfire, and taxpayers and economic recovery will take the hit.

You see, taxes matter. They hugely impact economic behavior. The whole economic system is run on incentives to work, invest, and take risks. And it must pay, after tax, to ignite the entrepreneurial activity that really drives the economy. Like it or not, our free-market capitalist system is driven by the economic activist, provided he or she is properly rewarded.

So the real battle here in fact could be a war between the left wing of the Democratic party and the Reagan supply-side incentive model of economic growth.

Republicans in the House who just voted for massively high marginal tax rates had better think twice. When financial calm returns to the country, the GOP will not want to be accomplice to a confiscatory tax system that will stifle the economy and push America into decline for decades to come.

March 23, 2009

American Capitalism Is Besieged

Almost everything about Schumpeter's diagnosis rings true, with the glaring exception of his conclusion. American capitalism has flourished despite being subjected to repeated restrictions by disgruntled legislators. Consider the transformation. In 1889, there was no antitrust law (1890), no corporate income tax (1909), no Securities and Exchange Commission (1934) and no Environmental Protection Agency (1970).

We have subordinated unrestrained profit-seeking to other values. "We've gradually taken into account the external effects (of business) and brought them under control," says economist Robert Frank of Cornell University. External costs include: worker injuries from industrial accidents; monopoly power; financial manipulation; pollution.

Great reform waves often proceed from scandals and hard times. The first discredits business; the second raises a clamor for action. Parallels with the past are eerie. "No one in 1928 thought that the head of the New York Stock Exchange would end up in Sing Sing (prison) in 1938," says historian Richard Tedlow of the Harvard Business School. That was Richard Whitney, convicted of defrauding his clients. Flash forward: Bernie Madoff, once head of Nasdaq and a member of the financial establishment, goes to the slammer, a confessed swindler.

Some guesses about capitalism's evolution seem plausible. The financial industry -- banks, investment banks, hedge funds -- will shrink in significance. Regulation will tighten; required capital will rise. Profitability will fall. (Until recently, finance represented 30 percent or more of corporate profits, up from about 20 percent in the late 1970s.) More of the best and brightest will go elsewhere.

But Schumpeter's question remains. Will capitalism lose its vitality? Successful capitalism presupposes three conditions: first, the legitimacy of the profit motive -- the ability to do well, even fabulously; second, widespread markets that mediate success and failure; and finally, a legal and political system that, aside from establishing property and contractual rights, also creates public acceptance. Note that the last condition modifies the first two, because government can -- through taxes, laws and regulations -- weaken the profit motive and interfere with markets.

The central reason Schumpeter's prophecy remains unfulfilled is that U.S. capitalism -- not just companies, but a broader political process -- is enormously adaptable. It adjusts to evolving public values while maintaining adequate private incentives. Meanwhile, the striving character of American society supports an entrepreneurial culture and work ethic -- capitalism's building blocks. As for new regulations, many don't depress profitability because costs are passed along to consumers in higher prices.

It's also wrong to pit government as always oppressing business. Just the opposite often holds. Government boosts business.

Some New Deal reforms helped "by making risk more manageable," says Stanford historian David Kennedy. Deposit insurance ended old-fashioned bank panics. Mortgage guarantees aided a post-World War II housing boom. Homeownership rates skyrocketed from 44 percent in 1940 to 62 percent in 1960. Earlier, the federal government distributed 131 million acres of land grants from 1850 to 1872 to encourage railroads. Land, as well as bank charters and government contracts, often went to the well connected. Cronyism is sometimes capitalism's first cousin.

Still, the present populist backlash may not end well. The parade of big companies to Washington for rescues, as well as the high-profile examples of unvarnished greed, has spawned understandable anger that could veer into destructive retribution. Congressmen love extravagant and televised displays of self-righteous indignation. The AIG hearing last week often seemed a political gang beating.

If companies need to be rescued from "the market," why shouldn't Washington permanently run the market? That's a dangerous mindset. It justifies punitive taxes, widespread corporate mandates, selective subsidies and meddling in firms' everyday operations (think the present anti-bonus tax bill). Older and politically powerful companies may benefit at the expense of newer firms. Innovation and investment may be funneled into fashionable but economically dubious projects (think ethanol).

Government inevitably expands in times of economic breakdown. But there is a thin line between "saving capitalism" from itself and vindicating Schumpeter's long-ago prediction.

Graduating MBAs Heed Washington's Siren Song

As investment banks serve out their penances in purgatory as wards of the state, it's ironic that the same skills and values that brought the finance industry to its knees are being called into service by these fallen companies’ new owner - Uncle Sam. These kids will likely report to the same executives that traded their imploding Wall Street jobs for posts in the new Administration, recruited to fix the problems they created. Bit of the hair-of-the-dog treatment, eh?

How's that for change you can believe in?

Top business schools churn out a crafted product, transforming bright, ambitious twenty-somethings with one entry-level job under their belts into confident generalists, educated to believe that two years of reading business cases makes them especially equipped to solve the most complex business problems. Gangway - they are destined for the top and in a hurry to get there! It doesn’t matter whether they've ever scrambled to make a payroll, launched a dicey product, flushed a salesman's lie, or learned the wages of hubris watching reality demolish their best laid plans.

What they lack in hard-won experience they make up for in education. Tutored by the world's wisest professors - four out of five of whom have never held a job outside academia - there's one phrase they're trained to avoid lest it pierce their cloak of competence. "I don't know."

Does anyone really believe that reading a hundred war stories is a substitute for leading troops into battle? Or that studying Cliff note interviews with disabled veterans is as powerful a teacher as getting your own butt blown off? Or that writing a boffo strategic plan qualifies you to quell a panicked retreat?

It's like asking priests to do marriage counseling. Or policy wonks to plan a national economy. Wait a minute. We are asking policy wonks to plan a national economy!

How can failure truly teach when it doesn't really hurt? Think about it, how often do you find yourself rubbing your own scar tissue when you need a reminder to practice prudence? It's easy to be fearless when life is a videogame. Showing up at the high stakes table with someone else's money to win and nothing of your own to lose is exactly what just happened on Wall Street. Do we really want the same cast of characters repeating that performance in Washington?

Ah, but civil servants are never in it for the money, right? No fat bonuses here! What do these MBA newbies have to gain besides a steady paycheck, a good health plan, and a safe place to lay low while this storm blows through?

Think ahead a few years. Imagine 20,000 MBAs fresh off cobbling together 457,000 pages of enabling regulations controlling the financial industry, the energy industry, the healthcare industry, the pharmaceutical industry, the insurance industry, the auto industry, and whatever other industries Congress decides to "fix." Think of all the relationships these uber-schmoozers will have cultivated with Congressional staffers, K Street lobbyists, beltway bandits, and the countless other courtiers that infest the 20004 zip code. Now picture the lot of them fanning out through the revolving door once the coast is clear, a diaspora eager to cash in their guanxi in a Pelosified economy.

Goodbye entrepreneurship. Hello crony capitalism.

Sorry, but Capitalism Did Not Fail

Every night, men from the U.S. Bureau of Standards sneak into the Free Market Sawmill and the offices of Capitalism Builders and replace all of the rulers and tape measures. Some days the inches get longer, but most days they get shorter. By March, 2008, the inch is only 25% of what it was seven years before.

As a result, the two-by-fours being produced by the Free Market Sawmill in 2008 have only one-sixteenth the load-bearing capacity of 2001 lumber. Some workers express concern because the latest two-by-fours are looking pretty flimsy. However, when checked, the boards still measure two inches by four inches.

In September, 2008, a group of school children is taken on a tour of the just-completed third floor of the house. The building collapses, causing many injuries. The Krugman Blame Bureau surveys the wreckage and declares that Capitalism and the Free Market have failed.

Capitalism and the free market can only do their job if the government supplies constant, reliable units of measure. This is why Article I, Section 8 of the Constitution of the United States says: “The Congress shall have Power…To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures”. The Framers seemed to understand that the dollar is a unit of measure, just like the foot, the pound, and the second.

In April, 2001, the price of gold was $255/oz. In March, 2008, it peaked at $1011/oz. The dollar, which is our unit of market value, had lost about 75% of its real value in seven years. (Today the gold price is around $950/oz.)

What does the free market do in the face of an unstable unit of measure? It tries to cope.

The classic way for a private entity to protect itself from inflation is to buy real assets with borrowed money. This is what drove the recent housing and commodities booms. For a long time, it made perfect economic sense to build houses (real assets) at a frantic pace and finance them with borrowed money. Between at least 2004 and 2007, anyone who didn’t borrow to buy real assets was a sucker—they were allowing themselves to be victimized by inflation while others profited from it. America as a whole benefited to some degree because much of the money was borrowed from foreigners.

All of the financial instruments now derided as “toxic assets” were developed as part of the private sector’s effort to protect itself from the inflation that the Federal Reserve visited on the world economy. Before 1971, while the dollar was still anchored to gold, there were no “derivatives”, no “tranches” of this or that, no Credit Default Swaps. There was no need for such things, and there was no economic driving force to pay the enormous costs of creating and managing them.

Now the companies that manufactured and held today’s “toxic assets” are being denounced as fools or even criminals. However, if the Fed had not stopped the inflation when it did, these organizations would look like geniuses today. If the Fed had permitted the price of gold to rise to (say) $4000/oz by (say) 2015, all of the derivatives strategies would have paid off and all of the condos in Las Vegas would have been successfully “flipped”.

An unstable dollar puts the private sector in an impossible situation. People hate inflation. It makes them angry. They feel like they are being robbed—because they are. When the markets experience inflation and expect more inflation, they will start trying to protect themselves from it. The longer the inflation goes on, the more real resources the private sector will spend trying to defend itself against it. The most recent inflationary “bubble” was allowed to go on for a long time.

While defending against inflation makes sense for individuals and firms, the allocation of real resources to inflation hedges makes the overall economy less efficient. This effect is visible in numbers published by the Bureau of Economic Analysis. The misallocation of investment into inflation hedges (mainly housing) reduced 2007 GDP by at least $1.6 trillion, or 12%. The cost of the recession caused by stopping the inflation and unwinding the inflation hedges will be even higher.

Unfortunately, the government is now trying to solve a problem created by printing too much money by printing even more money (plus tax increases, plus economic-superstition-based “stimulus” borrowing and spending). This will not work.

What will work is the Constitution of the United States. On February 3, Congressman “Judge” Ted Poe (TX-02) introduced H.R. 835. This bill would require the Federal Reserve to “regulate” the value of our money by making the dollar equal in value to 0.002 ounces of gold. The Fed would do this by using its Open Market operations to establish and maintain a gold price of $500/oz. H.R. 835 would also give a powerful supply-side stimulus to the economy by providing “first year expensing” for all capital investment.

Once the integrity of the dollar (and the Constitution) is restored, the markets can begin to right themselves. Stabilizing the dollar is an essential ingredient in any recipe for economic recovery.

March 24, 2009

If Geithner's Plan Is Bad, Why Do Markets Like It?

And, collectively, markets seem relieved at the Treasury plan.

After Treasury Secretary Tim Geithner released the first outline of his plan last month to derisive hoots and hollers all around, people feared the worst. But the plan that Geithner formally unveiled on Monday wasn't the worst. It might even help.

True, it could eventually expand to as much as $1 trillion in size. But it will for now limit the amounts coming directly from the government — that is, you the taxpayer — to about $75 billion to $100 billion. And that's from money already approved by Congress under the Troubled Asset Relief Program. That means the program can start right away — without congressional action, a big plus in this case.

The rest of the cash will come from private investors, with some of the financing provided by collateralized loans from the Federal Deposit Insurance Corp. Private investors could make hefty profits from becoming the government's partners, but it's no slam dunk.

All told, under the so-called Public Private Investment Program the Treasury and private investors will be able to leverage up to $500 billion to buy troubled assets from banks — the so-called "toxic assets" that have now morphed into the more genteel "legacy assets" in Treasury's new nomenclature.

One other thing: Just last week, the Federal Reserve itself announced a plan to buy up to $1.2 trillion in Treasuries and mortgage-backed securities from banks both to push down long-term interest rates and move cash into the banking system.

Though that announcement caused some dyspepsia in the markets at the time, investors now appear to believe this one-two punch from the Fed and Treasury will help unclog the banks' balance sheets of junk home loans and shaky mortgage-backed securities and get them lending again.

We're still not sold that this is the best route to take. But as we said early on in this mess, the best model for getting out of it — if the government had to be involved at all — was the Resolution Trust Corp., which in the early 1990s bought up banks' bad loans and then slowly sold them on the open market, sometimes at a profit.

That seems to be what Geithner is trying to replicate. And if he can end up doing it more cheaply than expected, with the government actually making a profit on some of the beaten-down mortgage investments it buys from banks, all the better.

As Barclays Capital said Monday, "The policy response to the economic crisis has entered a new era." But actually, Geithner's plan is hardly new. Indeed, it's similar to what the Bush administration pushed early last fall.

Even so, this "new era" will be a treacherous one. We of course fear the heavy, smothering hand of big government. We hope Geithner is wise enough to lighten government's grip on our struggling financial system once it takes wing, despite repeated calls for ever-stricter regulations in Congress. Contrary to popular belief, this crisis was caused not by too little regulation, but by too much.

A de facto nationalized financial system will serve no one's interest. Rather, it will impoverish us all by removing salutary market signals from the allocation of capital in favor of political mandates.

That said, it's entirely possible this could be a turning point for the financial system as it struggles to get on its feet after a year and a half of bankruptcies, massive writedowns and shrinking lending.

What Did Paulson Know, When Did Geithner Know It?

Now, what is material to you and me might not be material to Goldman Sachs. But I would wager that if we were to define “material” as “more than the $165 million AIG bonus pool everyone is so excited about”, then the windfall was probably material.

Still, our quibble must not be with AIG employees who had the bad taste to accept their contractual compensation. It is not really with Goldman, for being clever enough to get paid twice for the same risk. Our outrage must be directed at those who made AIG’s mess the public’s mess. Those who put the U.S. taxpayer at risk under the questionable threat of systemic collapse. The focus should be on Treasury secretary Timothy Geithner and his predecessor Hank Paulson.

It is not surprising that Goldman Sachs hedged itself against AIG’s collapse. Since Goldman bought insurance on CDOs from AIG, and probably knew they weren’t alone in this trade, they certainly realized that AIG was heavily exposed to the impending housing correction. It was back in 2007 that the super-senior tranche of the ABX index started to explode in spread, and this is about the same time, according to Viniar, that Goldman began hedging their AIG exposure.

Good risk management, apparently. So Goldman, at the top of the list of those bailed out in the AIG debacle, did not need the money. Who did? Were Citibank, Merrill and Bank of America completely unhedged? If they were hedged, even partially, did they really need the bailout funds? If domestic banks were hedged, how was it that the collapse of AIG would lead to an implosion of the world financial system?

What really needs to be clarified is why Paulson and Geithner started us down this path. How did they become convinced that AIG’s demise would lead to the end of our financial system? Did they ask if the main counterparties to AIG had, like Goldman, protected themselves? The question is not why an institution 80% owned by the government is paying bonuses; the question is why that institution came to be owned by the government in the first place.

It is time to clarify how we came to this pass. Congress must compel former Treasury secretary Paulson and current Treasury head Geithner to answer some questions about what happened last fall. Here is an initial list.

1) News reports have circulated stating that last fall bank executives met with both of you gentlemen to discuss a bailout of AIG. Mr. Paulson, Mr. Geithner, with whom on Wall Street did you discuss the travails at AIG over the last part of 2008? What was their advice?

2) The view that the failure of AIG would risk systemic collapse was apparently shared by both of you. How did you reach this conclusion? What specific evidence did you have that AIG’s failure would cascade through the system?

3) When did you realize that the largest beneficiary on the list, Goldman Sachs, had protected itself well enough that it had no material exposure to AIG?

4) Goldman Sachs had collateral and hedges to protect itself against AIG’s default. Which banks did not?

5) When did you realize that if the taxpayer were to fund a risk Goldman had already hedged, Goldman would receive a windfall gain?

6) Concerning the other U.S. banks on the list. Did they also hedge, in whole or in part, their AIG risk and thereby receive windfalls when the bailout funds came in?

7) We now know the original $85 billion was a very low estimate of the amount of money AIG would ultimately need. Did the $85 billion reflect the full expected-loss at the time? If not, why was Congress not told that the final bill was likely to be much higher?

8) When did you realize that almost two-thirds of the initial $85 billion was to go to non-U.S. banks? Did you feel it was relevant to Congress’ approval of this expenditure to know that most of the money would service non-U.S. institutions?

9) Mr. Geithner, in your March 2nd press release announcing further aid to AIG you mentioned the risks to the millions of policyholders of AIG in the U.S. Are not these policyholders protected by separate capital pools and therefore insulated from the woes of the holding company? Can you explain specifically how the problems within AIG FP affect the policyholders of the insurance companies?

10) Assuming there is some risk to policyholders, back in September, when AIG was first approaching us for aid, did you consider taking proactive measures to help protect AIG policyholders by placing AIG’s insurance subsidiaries in stronger hands? Were potential buyers of AIG’s insurance subsidiaries contacted?

Lately Congress has been far more insistent when it comes to seeking answers to tough questions. This is a welcome relief from last fall, when they seemed content to let experts dictate terms to them. We have allowed the threat of systemic failure to justify unlimited public expenditures, with very little evidence of how the dominoes supposedly might fall. The Goldman story shows a robust system, not a weak one. It’s time for our leadership to explain why they initiated this flawed bailout.

About Great Depressions, David Brooks Isn't Serious

Indeed, it’s possible that the Republicans have figured out that the spending explosion this decade on their watch led to market returns under President George W. Bush of -36 percent. Maybe the same GOP leadership saw how Japan drove government debt as a percentage of GDP from 45 percent in 1989 to 179 percent today, only to see its economy not recover. That the Nikkei Index is still down 80 percent from its highs of two decades ago similarly served as a warning sign that government spending is a false economic God.

It’s also possible that the GOP leadership finally did its homework on the Great Depression and found out that after a monstrous increase in spending then, the U.S. economy was still on its back after 8 years of FDR stimulus. Even better, this same GOP leadership might have done even more homework and figured out that the U.S. economy experienced a major Depression in 1921, but with the federal government’s actions still informed by a Constitution that greatly limited the activities of the federal government, it quite simply did nothing.

Sure enough, during the early ‘20s downturn the federal government correctly deduced that the last thing it wanted to do was burden the business sector with more federal spending, so it actually decreased government outlays, reduced taxes slightly, and balanced the budget. And the U.S. economy soared. Maybe the truly misguided GOP of the George W. Bush years has figured out how totally ineffective government spending always is.

But in case Brooks is not convinced, a thought experiment is in order. Let’s assume that the New York Times’ Metro desk is on one floor in the venerable paper’s new building, and that editorial staff is on another floor. After that, let’s assume that the Metro staffers enter the offices of Brooks, Nic Kristof, Maureen Dowd and Paul Krugman, steal whatever cash is lying around, and then go spend it wildly in Manhattan. Would midtown-Manhattan’s economy be stimulated, or would Brooks, Kristof, Dowd, and Krugman be that much poorer the next time they wanted to go hog wild in Times Square? What Brooks never bothered to explain as he smacked the GOP for its allegedly born-again thriftiness is how government profligacy with money borrowed or taxed from the private sector would actually enhance economic growth.

Brooks correctly suggests that the GOP should talk up capitalism as “in innovative force,” then contradicts his previous suggestion by adding on that “we have been reminded of its shortcomings.” All this begs a basic question about what our present economic predicament has to do with capitalism?

Indeed, wasn’t it the federal government (on Bush’s watch) that made a weak dollar its specific policy such that hapless Americans did as they’ve always done and hedged government thievery with real estate purchases? When Fannie Mae and Freddie Mac followed congressional orders to make home loans available to the weakest of credit risks, was this a failure of capitalism? When some of the federally subsidized borrowers predictably proved unequal to the task of paying off their mortgages, wasn’t it the U.S. Senate (with the Obama administration’s approval) that introduced a mortgage “cramdown” bill that insured “frozen” markets for the mortgage securities that are destroying bank balance sheets?

No doubt lots of mistakes were made of the public and private variety, but it would be nice if just once, Brooks or someone else explained where capitalism was at fault. Logic says capitalism was never practiced, but now that some Republicans have woken up to the utter disaster that is TARP, a non-capitalist concept if there ever was one, Brooks decries “all this populist talk about letting Citigroup fail.” In truth, had Washington let Citigroup fail, that would have been the sole example of true capitalism being practiced in that we know the latter is working when, yes, businesses fail.

Had true capitalism ever been considered amid this mess, failing companies regardless of sector would have been allowed to go bankrupt so that more effective managers could have taken over their assets. Instead, and in a repeat of Japan’s mistakes over the last twenty years, taxpayer money will prop up the walking dead, including GM, Chrysler, AIG, and Citigroup, which means we’ll weaken the various capitalistic companies that did not take government funds in order to “save” those that did.

Brooks is troubled by a GOP that fails to treat our present problems “like a genuine emergency”, but assuming this is true, it seems the Republicans have at long last found their way. Indeed, wasn’t it the GOP controlled Congress that gave the U.S. economy the bodyblow that was Sarbanes-Oxley after the Enron and Worldcom “crises”? Wasn’t it the same GOP-led Congress that foisted the first of two “stimulus” packages on President Bush’s watch that did nothing to stimulate the economy? Wasn’t President Bush’s selling of the free market down the river in the dying days of his administration example enough for Brooks of how tragically his party overreacted?

In a 2007 column for the Weekly Standard, Brooks perhaps gave voice to the kind of Republican Party he wanted. In the column he observed that, "American purpose can find its voice only in Washington." Judging by activist government activity by the GOP in the aftermath of the column, it seems Brooks’s advice was followed, albeit all the way to a party change at the White House, and Democrat control of both houses. So while Brooks decries what he deems the party of “no”, it just may be that the Republicans have finally figured out that big government and excessive government intrusion in the economy not only offend the base, but fail miserably.

March 25, 2009

Beware the Encroaching D.C. Leviathan

In comments before testimony from both Treasury Secretary Tim Geithner and Fed chief Ben Bernanke Tuesday, Frank said he wants to regulate pay on Wall Street — even for companies that aren't getting bailouts.

And he called retention bonuses — a time-honored practice on Wall Street and elsewhere in America in which key employees are compensated for their enormous value — "extortion" and "bribes."

Frank, one of the chief architects of the housing mess that's brought us so low, isn't satisfied merely with pretending he and his Democratic pals aren't to blame for all this. No, exploiting voter anger over the now-infamous AIG bonuses, he also wants to dictate to American capitalism what it can earn and what it can't.

This is the kind of thing that normally happens in Third World countries ruled by tinhorn dictators, or in fascist states, where the democratic rule of law has collapsed. Not the U.S.

Yet, that's where we find ourselves today, isn't it? Democrats in Congress, who steadfastly rejected virtually all efforts to reform Fannie Mae and Freddie Mac as they went on the wildest, most irresponsible lending binge in the history of finance, now pose themselves as the saviors of fallen capitalism.

The hypocrisy is nothing short of stunning.

Take Frank. As we've written before, he spearheaded congressional Democrats' efforts in 1992, 2000, 2002, 2003 and 2005 to block reform of Fannie and Freddie.

Those two "government-sponsored enterprises" were the nexus of this crisis, holding $5.4 trillion of the $12 trillion in U.S. mortgages, while originating or funding 90% of the subprime market.

Their failures presaged the subsequent financial meltdown from which we're still trying to regain our economic footing.

Then there's Sen. Chris Dodd of Connecticut, another posturing moralist in the flap over AIG bonuses. He turns out to have inserted the bonuses into the bailout legislation in the first place.

An innocent move? Please note Dodd was No. 1 on the list of recipients of AIG's political contributions. Also that his wife was a former director of IPC Holdings, a company controlled by AIG.

We wish all this tinkering with the private sector was limited to Congress. But it isn't. The Treasury wants what the Washington Post called Tuesday "unprecedented powers to initiate the seizure of non-bank financial companies, such as large insurers, investment firms and hedge funds, whose collapse would damage the broader economy."

Citing the AIG precedent, White House spokesman Robert Gibbs defended this radical move, saying on CNN, "We need resolution authority to go in and be able to change contracts, be able to change the business model, unwind what doesn't work."

Breathtaking. Coupled with the vast expansion of government spending over the next 10 years, this is socialism, pure and simple.

Yes, we know it's unfashionable to use the "S" word. But we're willing to be unhip in the service of the truth.

It's a frightening thing to see a once mighty, and free, capitalist economy placed under the heel of an incompetent government. But that's precisely what's happening now.

Executive pay, the focus of much public fury right now, is only the start. Your pay will be next, rest assured. So hold on to your wallets, sure, but also hold on even tighter to something even more precious that now seems at risk: your freedom.

The Dancing With the Stars Economy

Now, after eight seasons of Dancing With The Stars and twenty-five million viewers an episode, the world of competitive dancing is no longer flying beneath the radar screen in the U.S., and no longer quite as economically cyclic as it once was. First the phones started ringing off the hook at studios. Then promoters started paying professional couples unheard of prices to perform. A touring company from the TV show fills arenas at ticket prices that are typical of Broadway musicals. Entries at the national championships ballooned to record numbers last year even amidst the meltdown on Wall Street. Instructors have rushed to open new studios and train teachers to meet the demand, and just when they catch up, a new season of DWTS, as it’s known in the industry, debuts and the cycle starts all over again.

All of this has happened entirely apart from the conversation we’re now having in Washington and in elite circles about the future of capitalism, bonuses, regulation, subsidies and taxation. You would be hard-pressed to find many dance establishments on the list of firms that receive loans from the U.S. Small Business Administration. No politician—federal, state or local—is going to propose bailing out studios that go bust. There are no tax credits or deductions that subsidize ballroom lessons. Efforts to inject billions of taxpayer dollars into venture capital funds to jump-start entrepreneurship in the U.S. won’t matter one bit to competition organizers.

In this respect it’s still an industry that’s flying below the radar screen. But by that definition, so is most of the rest of the American economy. The poet W.H. Auden once observed that even when seemingly momentous events are taking place, “the dogs go on with their doggy life.” And so it is with the entrepreneurial economy right now. The dance studios go on with their dancing life. The new store-front accountant down the street scrambles to meet his deadlines. The talented guy who engineers custom-made kitchen cabinets isn’t holding his breadth hoping the fed’s mortgage bailout plan will somehow unlock new capital for home improvements.

In fact, ask the typical dance studio owner about government and the first thing he or she will probably tell you about are all the ways it makes life difficult: the building inspector who suddenly decides there’s something wrong with the ceiling in the studio that he’s seen a dozen times before but now deems a violation. The incessantly rising property taxes that eat up some of the incremental revenue you’ve earned from expanding. The state labor department that keeps trying to get you to pay unemployment insurance for that freelance instructor who shows up once a month to teach a random lesson—forcing you to tell the guy he can’t come to your place anymore because it isn’t worth the cost of hiring lawyers to fend off government.

It was just such headaches that helped prompt my wife to give up a few years ago her studio in New York City, maybe the toughest place to do business in America. There were simply too many other options and opportunities in the DWTS economy to keep slugging it out with government there—even in a business that is as much a passion as a job.

This is the reality of most of the economy. Beyond the hearing rooms of Congress, beyond the meeting rooms at Treasury, beyond the view of city halls and state capitals is the economy where people come up with wacky ideas, take risks, work hard, and rarely expect anything of government except that it do the basics well and leave them otherwise free to dance to their own beat.

Replacing the Anti-Capitalist AIG Paradigm

But what if this paradigm is completely and totally wrong? Indeed, a moment’s reflection reveals its myriad inanities. Of what does greed consist, and how is it a meaningful causal mechanism? What exactly is meant by “reckless?” What standard determines whether a given risk should have been taken at the time or not? To what level is a CEO supposed to micromanage, what critical things did the CEO fail to understand, and how did it lead to the company’s downfall? How exactly did the mortgage bubble bursting lead to this state of affairs? Since AIG suffered virtually no credit losses on its financial products (so far), by what standard is its product array a manifestation of bad judgment? What specifically brought down AIG?

Now consider an alternate explanation, one suggested by the known facts. AIG’s financial executives rightly pursued as much profit as they could, and they were having some degree of success with this. Their products, under the watchful eyes of cognizant and totally empowered regulators, were generally making money. The company ran into serious trouble not because their products failed, but because the company was hit with sudden requirements to post massive amounts of new collateral, which it could not meet.

This requirement was triggered because the company was downgraded in its credit ratings. It was downgraded in its credit ratings because it took significant write-downs in its credit default swaps because the securities underlying them took severe write-downs, and it also took write-downs in its own mortgage-backed securities. All these securities took significant write-downs because they experienced a significant drop in market price, and market price was being used as the accounting standard by which they were valued.

Market price was being used as the accounting standard because the SEC imposed this standard on them in November 2007.

Because every other financial institution in the civilized world was also in write-down purgatory for the exact same reason, no one had any capital to lend, and AIG, although solvent, faced a liquidity crisis that resulted in the government’s decision to intervene.

Note that the entire sequence of events was started by the imposition of an accounting method. If the imposition of mark-to-market was wrong, then this is a case where government intervention caused a disaster.

If this alternate explanation is true, then how could so many people come to believe in the first version of events? The same way all myths and religions spread. In this case, people took Marxist doctrines being preached on faith.

And if the alternate explanation is true, it has some shocking implications. It means that the company executives were not in fact reckless, that their dealings were generally unproblematic and even beneficial to the economy, and that the government brought down AIG. It means that AIG was the victim and that the demonization of its executives is therefore a gross injustice.

It means that the “reckless” individuals who really are responsible for causing the damage are every Congressman who voted yea on Sarbanes-Oxley, President Bush, every public or private citizen or organization who lobbied for mandatory mark-to-market accounting, everyone at the FASB and the SEC who pushed for it and continued to defend it, the heads at the FASB and the SEC who approved it, every current member of Congress who knew about it but sat on the knowledge, and the D.C. Circuit Court majority—for its decision in Free Enterprise Fund vs. PCAOB.

It means that AIG’s CEO was telling the truth in October about the cause of his company’s problems and was not making up excuses. It means that AIG employees deserve their bonuses.

It means that grandstanding politicians—who would not recognize a CDS sitting in front of them and who are clinically indistinguishable from drunkards as they bandy about terms like “disgraceful” “appalling,” and “suicide”—are disgraceful, appalling, and should resign. It means that the underemployed protesters who bask in their envy outside opulent colonial homes are the greedy ones, and those who make death threats against the company’s executives are not misguided protagonists, but despicable criminals.

It means that those who are currently regarded as destroyers are in fact creators, and those who mindlessly seek to exact vengeance on them are the destroyers of the very kind of people on whom their lives ultimately depend.

Most important of all, it means that the paradigm that free markets are inherently flawed, requiring government intervention to preserve them, has just received yet another, perhaps lethal, blow. It means that the paradigm that free markets always function well when left alone has just received its latest, and perhaps historically decisive, validation.

March 26, 2009

Once Again, Tim Geithner Gets It Exactly Wrong

Geithner began by blaming Americans in total for the nation's economic difficulties. He wrote in the Wall Street Journal that, “as a nation we borrowed too much and let our financial system take on too much risk.” No, some Americans borrowed too much, and some banks acted in risky ways that were inimical to their health.

Geithner’s desire to foist collective guilt on all Americans in many ways strikes at the heart of our problems today. That's the case because in analyzing how we got here, we should make no mistake about the causes. This financial crisis we’re experiencing is a failure of collectivism rather than a failure of capitalism as so many assume.

Within a capitalist system there would never have been the dollar debasement that drove the rush into property, but that was imposed on the American economy as a way of helping failing manufacturers. Similarly within a capitalist system, loans would have been issued solely based on the borrower’s presumed ability to pay them back. And banks would have lent with the certain knowledge that a failure to lend with profit in mind would be an economic decision that could result in bankruptcy.

But thanks to the collectivist thinking that got us here, government subsidy of the Fannie/Freddie variety made mortgages accessible to those who could not pay them, while some banks chased risky returns based on a belief that any failure would be backstopped by a political class that irrespective of party thinks home ownership is a public good that should be subsidized. The Constitution be damned.

And while Geithner argued in one sentence that “every policy we take be held to the most serious test,” he soon contradicted himself with his line about government initiatives meant “to stabilize the housing market by encouraging lower mortgage rates.” Simplified, lots of Americans bought houses they couldn’t afford and that are presently millstones around their necks, so now we’ll subsidize more of the bad choices that helped get us here.

What remains to be explained is how government subsidies that create even greater incentives to consume property can help the economy. Indeed, with credit tight as is, will it be easier or harder for future Googles and Microsofts to sprout up if government intrusion in the marketplace means more capital will be shifted into the proverbial ground? More to the point, where are the Adam Smith disciples in politics or the commentariat who might innocently suggest that housing is the consumptive reward for productive economic activity, not the driver of same. Basically, Geithner gets what drives economies exactly backward.

Some say a better housing situation will aid the gasping banks, but the very assumption is contradictory in nature. It was the vibrant housing market that made banks comfortable lending to bad credit risks to begin with. That being the case, how will we improve the economy if banks repeat the very mistakes that have them on their backs? Wouldn’t the true economic boost result from banks learning the lessons of the past such that they make less in the way of home loans in the future? Geithner doesn’t seem to think so.

To help ailing financial institutions, Geithner noted that “we established a new capital program to provide banks with a safeguard against a deeper recession.” Translated, we’re going to prop up the banks that should have gone bankrupt, and in doing so, we’ll weaken the many responsible institutions that didn’t need government help, but that will have to compete against banks using money not their own.

A real-world example of the faulty nature of the above was actually revealed in the Wall Street Journal just this week. AIG, now serving federal investors who want said investment to be profitable, is now undercutting its competitors with non-economic prices made economic by federal loans. In the future we should expect the same from the supposed beneficiaries of TARP, who will undercut their competition with full federal approval in the name of “getting taxpayers their money back.” Won’t mergers handled by TARP-funded banks get less scrutiny than those overseen by firms not on the federal dole?

And with banks “still burdened by bad lending decisions”, Geithner, rather than let those same banks pay for their mistakes, is forming a “Public-Private Investment Program” that “will purchase real-estate related loans from banks.” The message here is for banks to lend in non-economic ways given the certainty that their mistakes will be absolved. The government response to today’s crisis is authoring future ones.

Once we’ve established the obvious moral hazard here, we can then point out what a sham the notion of “Public-Private” is. Geithner is of course including private sector investors to attach credibility to a plan that lacks it, but no one should be fooled. Taxpayers will largely fund these “private” purchases of bank securities which means that private sector investors will not “establish the value” of loans and securities weighing on bank balance sheets. Instead, the market for “toxic” bank assets will become even more uncertain thanks to private investors playing with money not their own.

Geithner concluded by saying that we must “start the process of ensuring a crisis like this never happens again.” So despite the fact that regulators have always proven unequal to the regulated, Geithner will take his own whack at creating what he presumes will be a foolproof system.

Sadly, it is there that he showed the greatest naivete in a piece that spoke to a Treasury Secretary not up to the job. Indeed, the failure of companies big and small means that capitalism is working. It is only when governments feel the need to act that we actually experience what he deems crises. Geithner’s inability to comprehend these basic truths foretells an austere future where he will seek to outlaw failure, and in doing so, he’ll blunt the essential market lessons that tell us how to achieve.

Obama's Spending Masquerades As Investment

“We invest in the renewable sources of energy that will lead to new jobs, new businesses, and less dependence on foreign oil,” Mr. Obama declared. “We invest in our schools and our teachers, so that our children have the skills they need to compete with any workers in the world. We invest in reform that will bring down the cost of health care for families, businesses, and our government.”

Such “investments,” he argued, will in the long run make the economy operate more efficiently and bring down government spending.

Mr. Obama, as is the wont of presidents, was optimistic about how his policy recommendations, if enacted by Congress, would play out. But the Congressional Budget Office took a more restrained view. It estimated that government spending and the deficit would grow steadily from 2012 through 2019.

After “bottoming out” at $658 billion in 2012—a level more than 40 percent above the highest deficit under the presidency of George W. Bush— CBO projects the deficit to increase to $1.2 trillion in 2019, or 6 percent of GDP. By 2019 government spending would take up nearly a quarter of GDP, far higher than at the peak of Iraq war spending, and the highest, excepting 2009 and 2010, since World War II. And, as the UK government’s failed bond auction showed yesterday, investors are not always ready to finance the debt.

Mr. Obama’s stimulus plan and budget are not one-time investments followed by years of reduced spending. Instead, they form patterns of increased spending that continue into the indefinite future. The vast majority of this spending is not what a well-run business or the Internal Revenue Service would count as investment—plant, equipment, and other tangible assets. Most of the Obama spending would be for services whose lasting value is difficult to measure.

Take energy. Mr. Obama proposes to “invest” in wind, solar power, and other renewables. They now produce about 3 percent of U.S. energy, and, if doubled, no mean achievement, would yield 6 percent. If the president wants to diminish our dependence on foreign oil, the government needs to enlarge use of our conventional sources of energy—domestic oil, nuclear power, or coal.

Unwisely, Mr. Obama does not propose oil production or nuclear power, and his cap-and-trade carbon tax, meant to address global warming concerns, would fall most heavily on coal, which we have in abundance. Until all countries agree to reduce carbon emissions to combat climate change, America is only hurting itself by going it alone, with no reduction in global warming.

In addition, Mr. Obama announced last week in California that he wants to spend—oops, invest—another $2.4 billion in development of plug-in hybrid electric cars. These expensive vehicles have a short range, making them useful only for local driving. Batteries may be prone to catching fire, a safety hazard, and many motorists must park on the street, where charging is impractical. In any case, electricity needed to charge the batteries would come from power plants, reducing energy savings.

Let’s look at health care. It’s true that encouraging or requiring doctors and hospitals to use electronic health records could save billions of dollars a year from avoided medical error. The stimulus bill allocates $20 billion to this effort. But this sum is a small fraction of the president’s “down payment” of $634 billion on a fund for universal health care, so-called because it leaves open the possibility that the number will grow over time.

Mr. Obama in the 2008 campaign spoke of setting up a new health insurance plan, similar to the Federal Employees Health Benefits Program, open to all, with “affordable” premiums and co-payments. The Federal plan is of a higher quality and more costly than typical private-sector coverage. The government’s making it available to the public would bump up federal spending, year after year.

In the campaign, Mr. Obama suggested that employers who don’t offer health insurance to employees would be required to pay into the new plan, a new tax. A new National Health Insurance Exchange would set standards and regulate private insurance underwriters and those who could not meet the standards would close, potentially raising the costs of care and driving people to the new, expensive public plan.

On Tuesday, Mr. Obama said that “this budget is inseparable from recovery, because it lays the foundation for secure and lasting prosperity.” In fact, what it does is lay the foundation for unprecedented levels of peacetime deficits and government spending. That’s not an "investment" that the American people need to make.

March 27, 2009

Geithner's Public/Private Plan Won't Work

First of all, it is unlikely that banks will embrace an auction process. These firms have generally not sold their assets at discounts to par over the last 15 months specifically to avoid having to sell at auction–type prices. But over that same time, firms have been busily reducing their exposure to commercial real estate by shifting assets to hold-to-maturity accounts, hedging, and of course, taking write downs and impairment charges. In fact, the nine largest firms by commercial real estate holdings have reduced their net exposure from $255 billion to $95 billion, according to the industry trade publication Commercial Mortgage Alert.

Furthermore, Geithner limits the scope of the securities plank of his plan by allowing for the financing of only AAA-rated securities. Commercial Mortgage Backed Securities are comprised of many property types dispersed across different parts of the country. Currently, the indicative pricing level for these securities is 62 cents on the dollar. But it is unlikely that the AAA tranche of these securities have been marked down. Fair market accounting rules allow institutions leeway in determining value in illiquid markets, and AAA securities backed by loans (and not securities) are insulated from all but the most severe losses.

Another shortcoming was Geithner’s failure to understand that banks have no incentive to sell commercial real estate assets and securities that are still performing by and large. Defaults and delinquencies on commercial mortgages and related securities are still at historic low points given the lag time in contracts from which property cash flow is derived. Given the scope of Geithner’s plan and the efforts institutions have been making to come up with solutions to alleviate the pressure on their balance sheets, the incentive to sell assets at a discount is dwindling.

Ironically, this approach by Treasury seems to be working at odds with the pressure on FASB to revise its fair value accounting methodology. Setting the debate about the effectiveness of changes to accounting rules aside, the question remains that if banks no longer have to mark down their assets, why are they now going to sell them at discounts, particularly their highest rates securities?

Secondly, Geithner did not acknowledge at his press conference that commercial real estate is overvalued, and values are still falling. Both empirical and anecdotal signals are overwhelming. As a lender, I witnessed first hand the unreasonable property capitalizations that began fomenting in the earlier part of the decade. As the Federal Reserve started adding reserves to the banking system and the Bush Treasury mocked the importance of a strong dollar, the dollar weakened and investment capital was directed to commercial real estate at an astonishing rate.

It was astonishing to observe cap rates (earnings yield) compress from the eight percent and higher range to five, four, and even three percent levels. Many times, depending on the volatility in the yield curve, these rates were lower than U.S. Treasuries – the benchmark of all investment! There are really two reasons someone would be compelled to do this: an investor believes that rent growth (and thus income) will bail you out over time, or for some magical reason prices will keep going up. Certainly it became standard that cap rates were lower than the weighted average cost of capital, implying investors were relying on continued appreciation.

As an example of just how far the fundamentals have had to adjust, The New York Times recently sold its own building to raise cash. The property ‘traded’ at an eleven percent cap rate. At the peak, there was no hotter commercial real estate market than midtown Manhattan. Given that properties in this high rent district generally commanded five percent cap rates, one need only do the basic math to get a sense for current property values and how far prices have come down from their peak.

Especially dangerous was the leverage that grew disproportionately to escalating capitalizations. Loan to value ratios soared from a high end of eighty percent for the most qualified credits to leverage that oftentimes exceeded ninety percent of value. One particular apartment builder I know that competes with the large apartment REITs was getting one hundred percent leverage for his projects. This developer is now a shell of its former self. Such high leverage levels are outright suicidal in the commercial market. When the marketplace began to recognize that real estate was overvalued, the de-leveraging process got underway. This is the reason real estate credit markets remain jammed.

And in yet another twist of irony, the Secretary admonished excessive leverage in the financial system. One has to wonder if he sees the contradiction in providing up to ninety five percent of acquisition financing for these assets.

The Treasury’s plan is destined to fail because it attempts to prop up asset prices in the face of deteriorating fundamentals and is contradictory to the Treasury’s own market-clearing price mechanism – the FDIC. The Treasury’s approach is especially confusing given that the FDIC is in the process of seizing failed banks and liquidating secured real estate loans. The sale of these secured real estate loans to private investors is setting the market clearing prices. This is exactly what the RTC did in the early 1990s. This is how the process is supposed to work.

Even if an investor has only five percent at risk, this is real money in the face of deteriorating fundamentals due to the overhang hangover of the commercial real estate investment binge. The Treasury’s plan is a waste of time and will not resolve the underlying valuation problems in the commercial real estate markets and the risk inherent in the financial system due to excessive leverage.

March 30, 2009

Uncle Sam's Massive Hedge Fund

But succeed or fail, Geithner's plan illuminates a fascinating irony. "Leverage" -- borrowing -- helped create this mess. Now it's expected to get us out. How can this be? It's not as crazy as it sounds. Start with the basics on how leverage affects investment returns.

Suppose you bought a stock or bond for $100 in cash. If the price rises to $110, you make 10 percent. Not bad. Now, assume that you borrowed $90 of the purchase price at a 5 percent interest rate. Over a year, the stock or bond still increases to $110, but now you've made more than 50 percent. You pay $4.50 in interest and pocket a $5.50 gain on your $10 investment. Note, however, that if the price fell to $95, you'd be virtually wiped out ($4.50 in interest paid plus $5 lost on the security).

Economist John Geanakoplos of Yale University argues that the economy regularly experiences "leverage cycles." When credit is easy, down payment terms are loose. Investors or homeowners can borrow much of the purchase price of houses and securities. Prices of assets (stocks, bonds, real estate) rise, often to artificial levels because investment returns are so attractive. But when credit tightens -- government policy shifts or lenders get nervous -- the process reverses. Prices crash. Leveraged investors sell to repay loans. New borrowers face stiff down payment terms.

To Geanakoplos, we're suffering the harshest leverage cycle since World War II. Three years ago, he says, homebuyers could put down 5 percent or less. Now they've got to advance 20 percent or more. Hedge funds, private equity funds and investment banks could often borrow 90 percent of security purchases; now borrowing can be 10 percent or less. "Deleveraging" has caused prices to plunge to lows that may be as unrealistic as previous highs.

Grasping this, you can understand the idea behind Geithner's hedge fund. It is to inject more leverage into the economy -- not to previous giddy levels but enough to reverse the panic-driven price collapse. Details remain unsettled, but the plan would allow 6-1 leverage ratios in some cases. Here's an example. Private investors put up $5; the Treasury matches that with another $5. This equity investment could then be expanded by $60 of government-guaranteed loans. The entire $70 could be used to buy assets from banks.

Sounds simple. In practice, it won't be. Given all the deleveraging -- a record 15 percent of hedge funds closed last year -- the market prices of many securities have been driven well below prices that seem justified by long-term cash flows. Geanakoplos mentions one mortgage bond whose market value has dropped by roughly 40 percent even though all promised payments have been made and, based on the performance of the underlying mortgage borrowers, seem likely to continue.

If banks sold this and similar credits at today's market prices, they would have to record huge losses. ("Banks Face Big Writedowns in Toxic Asset Plan," headlined the Financial Times.) Their capital would be depleted, and they'd have to raise more or request more from the government. Presumably, the government-supplied leverage would enable investors to pay higher prices. After all, that's the purpose. Still, whether sellers and buyers ultimately agree on prices is unclear.

If they can't, Geithner's hedge fund will remain puny. Cautious banks will continue to constrict credit. But success also poses problems. Money managers talk about making huge annual returns of 20 percent or more from a scheme in which government puts up most of the funds and takes most of the risk. A political backlash might squash the project before it starts. Geithner treads a narrow line between financial paralysis and populist resentment.

Populist Democracy Declares War On CEOs

Belligerent unions are making it a practice to take CEOs hostage in France as police stand idly by. Tour bus operators are taking gawking populists past the homes of executives in Connecticut so they can hoot and take pictures. When and how this behavior progresses from hurling invective to lobbing bricks, as has already happened in England, depends on whether our civic leaders insist on throwing gasoline on the fire. What will it take, a Corporate Crystalnacht, to wake them up to the danger they’re fomenting?

A little over 100 years ago William Jennings Bryan, in his famous “Cross of Gold” speech, asked his party whether it would come down “upon the side of the idle holders of idle capital, or upon the side of the struggling masses.” In the intervening century those masses have seen their standard of living rise faster than in any other period in human history. They owe most of this to the modern corporation, fueled by the capital Bryan condemned. And who was at the helm of every one of these corporations? A CEO.

If you think the world would be a better place if CEOs resigned their jobs, donned hair shirts, retired to the monastery, and turned executive responsibility over to a government agency acting on behalf of all the “stakeholders,” you are either delusional or a member of Congress. But I repeat myself.

Like 99 percent of my fellow man, I have neither the skills nor the talent to be a CEO. But I do hire and fire CEOs for a living, setting their goals and compensation plans, serving as coach or confidante, and watching carefully because my personal economic well being rides on their performance. While all of this occurs on a small scale compared to behemoths like General Motors and AIG, the underlying principles are the same.

Is it such an impenetrable mystery that good corporate governance and goal aligned compensation plans are critical to getting talented CEOs to build and grow thriving companies? If they succeed they generate wealth for themselves, their shareholders, and society while providing gainful employment for citizens that don’t have the gumption to start their own businesses. When CEOs fail they get replaced. If too many fail in a row the company folds, employees move on to other companies that can make better use of their skills, shareholders take a bath, and any remaining resources get distributed to creditors. Real CEOs work without a safety net. This is capitalism as it should be, and still is, for the vast majority of CEOs you’ll never see paraded before kangaroo hearings in Washington.

It takes bad corporate governance and misaligned compensation plans to create disasters like General Motors and AIG. The punishment for disasters like these should be corporate death, as meted out by the market and adjudicated by a bankruptcy court following pre-established rules of dissolution. This is capitalism as it should be but apparently is no more in our country.

Declaring companies “too big to fail,” justifying unconstitutional intervention with vague mumblings about systemic risk, bailing out the chronically dysfunctional with unending rivers of taxpayer money then feigning surprise when that money gets misused, parading chastened executives in front of the media for the entertainment of the mob, and launching an indiscriminate culture war against all highly compensated CEOs is not an example of Washington rescuing capitalism from its failures. It’s an example of Washington propping up and exploiting failures in order to create ever wider dependence on its quixotic largess. Disguising their lust for power with pure demagoguery, our political leaders have so panicked a confused citizenry that many are ready to grab torches and pitchforks in search of demons.

If we don’t put the brakes on this nightmare, we may wake to find that we’ve killed the goose that laid the golden egg. Is that what it’s going to take to get populists to realize that it’s impossible to share wealth that has not yet been created?

March 31, 2009

The Dollar and America's Lost Decade

It was notorious for falling asset values, stagnant growth, massive government infrastructure spending and "zombie" banks. The banks were termed zombie because the government propped up failing institutions and kept them afloat despite mountains of non-performing loans.

Sadly, these banks with impaired capital were of little help in providing the type of credit needed for a vibrant, grass-roots economy. The net result was zombie-like performance for Japan's domestic economy. Japan's one dynamic sector was its export industries - autos and electronics.

Investors, here and abroad, can't be blamed for feeling they are now trapped in an American remake of a bad Japanese horror movie - Godzilla and the Zombie Banks Trash Manhattan - bigger budget, grander scale, worse ending.

The sad reality is that major U.S. stock indexes have already endured a lost decade of their own, with the Dow Jones Industrials and the Standard &Poor's 500 now trading at the lowest levels since May 1997.

In assessing what happens next, it is important to understand the origin of economic downturns. They almost always result from macro policy errors in one or more of four key areas - fiscal (taxes), monetary, regulatory and trade.

Policy errors in multiple areas can compound the trauma and, in a worst case, turn a recession into a depression.

In this case, policy errors in the monetary and regulatory arenas bear the blame but it is monetary policy that has whip-sawed the economy and caused the most mayhem.

A reliable metric for judging the effectiveness of monetary policy is the price action of gold. Why gold? Gold is history's oldest form of money and recognized around the world as a storehouse of value. In fact, gold served as currency thousands of years before any of the modern currencies we take for granted were developed. And lastly, America has spent most of history on the gold standard. It has only been since 1971 that the global economy has operated in a floating rate currency regime.

As a report card on monetary policy and its economic impact, consider the accompanying graphs.

On the top is a 25-year chart of the dollar priced in gold ounces while the bottom chart is the S&P 500 stock index over the same time period. The charts are divided into two 11-year periods.

The first period enjoyed a relatively stable unit of account as shown by the dollar trading at the same level in December 1985 as it did 11 years later in August 1997 - the 5-year moving average fluctuates some but is relatively smooth, indicating a stable unit of account.

Classical economists give monetary policy an A-plus for that period and it is no coincidence that the stock market gained over 400 percent during the same span.

There is good reason for business to flourish during such conditions. Business growth and expansion requires long term plans and commitments and just about every contract, whether for sales, inventory or plant and equipment, is priced in dollars.

A stable dollar greatly increases the probability that those obligations will be successfully met and business plans will work out as projected.

The second period from 1997 to the present has seen wide swings in the value of the dollar. Those swings were instrumental in spawning a decade plus of booms, bubbles and busts. Some might call it a Charles Dickens economy, "It was the best of times, it was the worst of times ..."

The period 1997 through 2000 is best remembered as the high-tech boom but those were tough years for the input side of the economy. Gold fell versus a super strong dollar as did other commodities.

Three notable Mississippi businesses that succumbed to the double whammy of falling prices for production while having to pay interest and debt with ever more valuable dollars were, Mississippi Chemical, Friede Goldman Halter and Birmingham Steel's Flowood mini-mill.

As the chart indicates, the dollar's value changed course dramatically in 2001, and what were once tail winds for some sectors became head winds and vice versa.

In hindsight, the falling dollar was setting the trajectory for the next set of booms and busts - residential real estate and credit.

Instructive on how fortunes can change with a monetary tailwind at your back has been the turn around in the agriculture sector. Grain prices after trading at decade lows in 2000 rebounded to all-time highs by 2008 and even with higher fuel and fertilizer costs U.S. Department of Agriculture estimates that farm income for the year just ended will be a record $89 billion on crop production of $182 billion - the best year ever for the American farmer.

As the first quarter of 2009 draws to a close there are modest signs of economic stability but still precious little evidence that the dollar is stabilizing in value.

It is still near its historic low and monetary authorities remain focused on saving the banking system while stabilizing the dollar is a secondary priority.

Where is the next bubble? Could it be Treasury securities, which are priced historically rich and perceived as the one safe, sure thing?

Perhaps China is the canary in the Treasury coal mine - China's Premier Wen Jiabao recently said he was "worried" about the impact of massive federal spending on China's $740 billion in U.S. Treasury notes and bonds.

Perhaps he has read the rest of Dickens' quote, "... it was the age of wisdom, it was the age of foolishness; it was the epoch of belief, it was the epoch of incredulity; it was the season of Light, it was the season of Darkness ... ."

Could it be Mr. Wen fears the season of inflation?

GM And a 'Truly Breathtaking' Departure

Sen. Bob Corker (R., Tenn.), probably the most knowledgeable man in Congress about the car bailout, and someone who argued months ago in favor of a pre-planned government-sponsored bankruptcy for GM and Chrysler, calls the Wagoner firing “a major power-grab by the White House on the heels of another power-grab from Secretary Geithner, who asked last week for the freedom to decide on his own which companies are ‘systemically’ important to our country and worthy of taxpayer investment, and which are not.” Corker calls this “a marked departure from the past,” “truly breathtaking,” and something that “should send a chill through all Americans who believe in free enterprise.”

Mr. Corker has hit the nail on the head. And I think his idea of “a truly breathtaking” government departure from American free enterprise -- whether it’s the banks or the bankrupt Detroit carmakers -- is exactly what caused stocks to plunge 250 points on Monday.

Incidentally, most of the big bankers who met with President Obama in the White House last Friday want to pay back their TARP money, not take more of it. But the Treasury is conducting stress tests that could stop the TARP pay-downs and force the banks to take more taxpayer funds in return for even more federal control.

The big bankers say they are profitable. And with an upward-sloping Treasury yield curve and some market-to-market accounting reform coming from the Financial Accounting Standards Board (FASB), the outlook for banks should be getting better, not worse. So why is the Treasury jamming more TARP money down bankers’ throats, especially after announcing a new plan to use private capital to clean up bank balance sheets and solve the toxic-asset problem?

It kinda sounds like the Treasury doesn’t want to let go of its new uber-regulator status.

As for Detroit, the carmakers should have been in bankruptcy months ago. And it is a bankruptcy court that should have fired GM’s Wagoner and his board. Along with some serious pain for bondholders, bankruptcy would have broken the high-cost labor contracts with the UAW as well as carmaker contracts with dealers across the country. That’s what bankruptcy courts are for. They’re part of the free-market capitalist system.

Former SEC chair Richard Breeden is arguing against a systemic uber-regulator for banks, and in favor of special financial bankruptcy courts. Once again, the story is court-ordered restructuring, not government control by political bureaucrats who like their power so much they want to keep running the various companies in question.

And why isn’t Obama’s special auto task force ordering a replacement for Ron Gettelfinger, the UAW’s president? Weren’t their oversized pay and benefit packages a big part of the problem? Well, that’s never gonna happen. The election power of the union is too strong. But this does reveal the political nature of these government bailout operations.

Incidentally, in President Obama’s speech on Monday about the Wagoner firing, as well as in Treasury term sheets for GM and Chrysler, there are multiple references to “the next generation of clean cars,” to new CAFE-standard mileage increases, and to green power-train developments. All this is a big green climate-change priority for the new administration.

But the simple fact is, small, tinny, and expensive green cars just don’t work for consumers. And even if those cars are designed better, the cost structure of the carmakers will have to be brought down so far that UAW wages will be forced below those of the non-union shops in Detroit south (including Honda, Toyota, and other foreign carmakers who are now producing in the United States).

So add the green revolution to the industrial-policy plans of the White House. Expect a big increase in CAFE fuel standards, even though small cars are simply not profitable. And plan on bailout nation taking a new left-turn toward the kind of central planning that has held down economic growth in Europe and Japan for so very long.

Has Industry Sold Its Soul for Bailout Money?

This new reality should send a chill down the spines of all Americans. The federal government has begun to run U.S. companies.

President Obama said Monday, "my team will be working closely with GM to produce a better business plan."

To that confident assertion he added these stern sentiments:

"They must ask themselves: Have they consolidated enough unprofitable brands? Have they cleaned up their balance sheets, or are they still saddled with so much debt that they can't make future investments? Above all, have they created a credible model for how not only to survive, but to succeed in this competitive global market?"

Who is in a better position to know the answers to these questions? Rick Wagoner, the GM CEO for nine years and former GM chief financial officer who has been with the automaker since the late 1970s, even running one of its foreign affiliates in Brazil, and who holds a Harvard Business School MBA?

Or President Obama, a former community activist from the south side of Chicago with a great rhetorical gift?

The president answered that question this week by ordering Wagoner's firing.

Imagine if it were not GM, but your own small business employing a handful of people.

How would you like the country's highest-ranking elected officeholder telling you that he and "my team" know better than you about cleaning up your balance sheets and competing against your rivals? How would you like being ordered by the government to fire the person you hired as manager of your company?

Does an entity that is itself $11 trillion (and climbing) in debt have any right to criticize a private business for owing tens of billions, let alone to claim it can do better running that business?

The same arrogance was heard regarding Chrysler. The president announced that, "we've determined, after careful review, that Chrysler needs a partner to remain viable." Why was Fiat picked? Because the Italian firm "after working closely with my team, has committed to building new fuel-efficient cars and engines right here in the United States."

In other words, its politics are right.

The merger will operate under a deadline with Washington holding a gun to Chrysler's head: "We'll give Chrysler and Fiat 30 days to . . . reach a final agreement," the president said. "But if they and their stakeholders are unable to reach such an agreement, and in the absence of any other viable partnership, we will not be able to justify investing additional tax dollars to keep Chrysler in business."

It should now be clear: Federal bailout funds are a corporate narcotic. Once a company starts taking them, a chemicallike dependence develops. The addict does whatever will bring in more of the drug. Ultimately, like heroin, the short-term euphoria gives way to decreased function for the recipient, even destruction.

More importantly for the American people, letting Uncle Sam become a corporate drug dealer — with taxpayer money the addictive poison being peddled — also places Washington in a position of dictatorial control over the private sector.

Housing Resists a Turnaround

The cities on sand—Phoenix and Las Vegas—continued to have some of the biggest price declines.  Phoenix prices dropped by 5.5 percent between December and January; they fell by more than five percent between November and December.  Las Vegas’ price declines have been trending at 4.5 percent down per month.  If the trend continues, by February, Phoenix prices will have dropped by more than 50 percent since the peak. 

I am somewhat surprised that these markets aren’t starting to settle down.  The defining characteristic of these two areas, and many other affordable, growing places like Dallas and Houston, is that their ability to supply housing is essentially unlimited.  Since builders can produce housing in practically enormous quantities at reasonable prices, and land is essentially infinite, it was always a little absurd for people to pay so much more than construction costs for housing in these areas.  But now prices are converging back on construction costs, which is where I had thought that they would land.  However, the rate of decline isn’t slowing, and it now looks as if prices might dip below these costs.  If that happens, then building will essentially cease.  This would be a colossal change, since the Phoenix and Las Vegas areas together permitted more than 30,000 units last year.

After these two places, the most diminished housing markets are in California and Florida. San Francisco, Miami and Tampa all continued to have dismal months. Prices in Los Angeles and San Diego each did slightly better, dropping by about 2.7 percent, but that looks good only by comparison. Prices in these five areas have declined by about 40 percent relative to the peak. These areas had some of the biggest price booms and now they are experiencing some of the biggest price busts. Reversion to the mean is a regular feature of housing markets and they are experiencing that now.

In Charlotte, NC, and Dallas, Texas, buyers seem to have always understood that unlimited supply meant that prices should stay low.  These areas sat out the bubble, and they are experiencing much less of the bust.  In the latest data, prices in Charlotte, North Carolina, fell by only 1.2, making it the best performing area in the Case-Shiller twenty.  Prices in Dallas are down by less than ten percent since the peak. 

The two northeastern cities, New York and Boston, continue to look remarkably stable.  New York City’s prices fell by 1.2 percent between December and January, which made it the second best performer among the Case-Shiller twenty.  New York is the only area where prices today are more than 80 percent higher than they were at the start of the millennium.  In both Boston and New York, prices are down by about 16 percent relative to the peak.  The optimistic view of their stability is that these cities have shown their ability to rebound century after century, and homebuyers are continuing to bet on their resilience.  The pessimistic view is that their crash is coming. 

Until October 2008, Chicago had seemed just as resilient as these cities, but its prices have fallen by more than ten percent since then.  Between December and January, Chicago’s 4.6 percent price fall was positively Las Vegas-like.  Chicago has built more housing than Boston, and it has plenty of Midwestern competitors, like Minneapolis, where prices are also in free fall.  Still, somehow I had expected Chicago’s economic strength to keep the bust at bay. 

The housing news continues to be bleak for the financial actors who are holding mortgages, the value of which is tied to housing prices.  Continuing price declines probably mean that the banks will need even more bailout money. 

Yet, these declining prices aren’t all bad.  When prices fall, buyers get bargains.  One of the glories of America is that people are able to buy high quality houses at affordable prices.  We had lost some of that advantage during the unfortunate bubble, now we are getting it back. 

How To Kick-Start Employment

In response, central banks should purchase government bonds for cash in as large a quantity as needed to push their prices up as high as possible. Expensive government bonds will shift demand to mortgage or corporate bonds, pushing up their prices.

Even after central banks have pushed government bond prices as high as they can go, they should keep buying government bonds for cash, in the hope that people whose pockets are full of cash will spend more of it, and that this will directly pull people out of joblessness and into employment.

In addition, governments need to run extra-large deficits. Spending - whether by the United States government during World War II, following the Reagan tax cuts of 1981, by Silicon Valley during the late 1990's, or by home buyers in America's south and on its coasts in the 2000's - boosts employment and reduces unemployment. And government spending is as good as anybody else's.

Finally, governments should undertake additional measures to boost financial asset prices, and so make it easier for those firms that ought to be expanding and hiring to obtain finance on terms that allow them to expand and hire.

It is this point that brings us to US Treasury Secretary Timothy Geithner's plan to take about $465 billion of government money, combine it with $35 billion of private-sector money, and use it to buy up risky financial assets. The US Treasury is asking the private sector to put $35 billion into this $500 billion fund so that the fund managers all have some "skin in the game," and thus do not take excessive risks with the taxpayers' money.

Private-sector investors ought to be more than willing to kick in that $35 billion, for they stand to make a fortune when financial asset prices close some of the gap between their current and normal values. If the fund does well over the next five years - returns profits of 9% per year -private investors get a market rate of return on their very risky equity investment and the equivalent of an "annual management fee" equal to 2% of assets under management.

If the portfolio does less well - profits of 4% per year - the managers still get a healthy but sub-market return of 10% per year on their equity. And if the portfolio does badly - loses 1% per year - they lose roughly 70% of their investment. Those are attractive odds. Time alone will tell whether the financiers who invest in and run this program make a fortune. But if they do, they will make the US government an even bigger fortune. And 2% of assets under management is an annual fee that many sophisticated investors have been willing to pay private hedge funds - topped off with an extra fee of 20% of annual profits, which the Treasury is not paying.

The fact that the Geithner Plan is likely to be profitable for the US government is, however, a sideshow. The aim is to reduce unemployment. The appearance of an extra $500 billion in demand for risky assets will reduce the quantity of risky assets that other private investors will have to hold. And the sudden appearance of between five and ten different government-sponsored funds that make public bids for assets will convey information to the markets about what models other people are using to try to value assets in this environment.

This sharing of information will reduce risk - somewhat. When assets are seen as less risky, their prices rise. And when there are fewer assets to be held, their prices rise, too. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms.

The problem is that the Geithner Plan appears to me to be too small - between one-eight and one-half of what it needs to be. Even though the US government is doing other things as well -fiscal stimulus, quantitative easing, and other uses of bailout funds - it is not doing everything it should.

My guess is that the reason that the US government is not doing all it should can be stated in three words: Senator George Voinovich, who is the 60th vote in the Senate - the vote needed to close off debate and enact a bill. To do anything that requires legislative action, the Obama administration needs Voinovich and the 59 other senators who are more inclined to support it. The administration's tacticians appear to think that they are not on board - especially after the recent AIG bonus scandal - whereas the Geithner Plan relies on authority that the administration already has. Doing more would require a legislative coalition that is not there yet.

J. Bradford DeLong is professor of economics at the University of California, Berkeley and a former Assistant U.S. Treasury Secretary under President Bill Clinton.

Originally published at Project Syndicate.

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