« April 2009 | Main | June 2009 »

May 2009 Archives

May 2, 2009

Bleak Housing Data Has a Silver Lining

Housing starts fell 10.8 percent in March from the previous month to an annual rate of 510,000 units, the second-lowest reading on record.

This lack of new housing inventory combined with the banks’ willingness to cut prices on foreclosed properties has made the price of homes more affordable than they have been in years. Record low mortgage rates also will entice new buyers into the housing market, and there finally will be some pricing clarity on all the toxic assets that have paralyzed the financial system since last fall.

The journey from AAA to toxic for mortgage-backed securities is the culmination of several decades of poor regulatory oversight, government policies encouraging lax underwriting standards, low interest rates, extreme leverage and greed.

Mortgage-backed securities traditionally have been considered extremely safe investments. Lenders such as banks and savings and loan associations would make home loans in their communities based on strict underwriting guidelines, and then package them for sale to Fannie Mae or Freddie Mac, the government-sponsored agencies charged with providing liquidity and stability to the U.S. housing market.

The lending institution could use the proceeds of the sale to make new loans, and Fannie and Freddie could hold the new mortgage-backed security or sell it to an investor looking for a safe instrument that yielded more than U.S. Treasuries.

The thought process was that homeowners would do everything they could to avoid foreclosure and that Fannie and Freddie were enforcing strict underwriting guidelines on their approved lenders. If a home did go into foreclosure, it was assumed that the eventual sale of the property would make the loan whole.

This relationship began to break down in the mid-1990s as Fannie and Freddie executives sought higher and higher levels of compensation based on the firms’ ability to borrow at or near Treasury rates and then invest the funds in increasingly risky assets.

These poorly underwritten loans made to less creditworthy borrowers quickly turned toxic when the housing bubble popped and investors couldn’t count on price appreciation to bail out the bad loans.

While it is tragic for anyone to lose their home, it is essential to the overall health of the financial system and our economy to finally begin to reach a clearing price on homes in order to begin to recover from years of bad decisions.

May 4, 2009

Obama's Bias Against Oil and Gas

None of these sources, of course, will quickly provide oil or natural gas. Projects can take 10 to 15 years. The OCS reserve estimates are just that. Oil and gas must still be located -- a costly and chancy process. Extracting oil from shale (in effect, a rock) requires heating the shale and poses major environmental problems. Its economic viability remains uncertain. But any added oil could ultimately diminish dependence on imports, now almost 60 percent of U.S. consumption, while exploration and development would immediately boost high-wage jobs (geologists, petroleum engineers, roustabouts).

Though straightforward, this logic mostly eludes the Obama administration, which is fixated on "green jobs" and wind and solar energy. Championing "clean" fuels has become a political set piece. On Earth Day (April 22), the president visited an Iowa factory that builds towers for wind turbines. "We can remain the world's leading importer of oil, or we can become the world's leading exporter of clean energy," he said.

The president is lauded as a great educator; in this case, he provided much miseducation. He implied that there's a choice between promoting renewables and relying on oil. Actually, the two are mostly disconnected. Wind and solar mainly produce electricity. Most of our oil goes for transportation (cars, trucks, planes); almost none -- about 1.5 percent -- generates electricity. Expanding wind and solar won't displace much oil; someday, electric cars may change this.

For now, reducing oil imports requires using less or producing more. Obama has attended to the first with higher fuel-efficiency standards for vehicles. But his administration is undermining the second. At the Interior Department, which oversees public lands and the OCS, Secretary Ken Salazar has taken steps that dampen development: canceling 77 leases in Utah because they were too close to national parks; extending a comment period for OCS exploration to evaluate possible environmental effects; and signaling more caution toward shale for similar reasons.

Any one of these alone might seem a reasonable review of inherited policies, and it's true that Salazar has maintained a regular schedule of oil and gas leases. Still, the anti-oil bias seems unmistakable. Conceivably, Salazar may reinstate administratively many restrictions on OCS drilling that Congress lifted last year. Meanwhile, he's promoting wind and solar by announcing new procedures for locating them on public lands, including the OCS. "We are," he says, "setting the department on a new path" -- emphasizing renewables.

It may disappoint. In 2007, wind and solar generated less than 1 percent of U.S. electricity. Even a tenfold expansion will leave their contribution small. By contrast, oil and natural gas now provide two-thirds of Americans' energy. They will dominate consumption for decades. Any added oil produced here will mostly reduce imports; extra natural gas will mostly displace coal in electricity generation. Neither threatens any anti-global warming program that Congress might adopt.

Encouraging more U.S. production would also aid economic recovery, because the promise of "green jobs" is wildly exaggerated. Consider: In 2008, the oil and gas industries employed 1.8 million people. Jobs in the solar and wind industries are reckoned (by their trade associations) to be 35,000 and 85,000, respectively. Now do the arithmetic: A 5 percent rise in oil jobs (90,000) approaches a doubling for wind and solar (120,000). Modest movements, up or down, in oil will swamp "green" jobs.

Improved production techniques (example: drilling in deeper waters) have increased America's recoverable oil and natural gas. The resistance to tapping these resources is mostly political. To many environmentalists, expanding fossil fuel production is a cardinal sin. The Obama administration often echoes this reflexive hostility. The resulting policies aim more to satisfy popular prejudice -- through photo ops and sound bites -- than national needs.

Obama to Secured Creditors: Drop Dead

According to U.S. bankruptcy code, secured creditors - that is lenders who have a contractual security interest or claim to specific collateral - have to be paid before unsecured creditors. Unsecured creditors' claims are prioritized according to explicit rules defined by law. With the exception of short-term payments approved by a bankruptcy judge to keep a company running during the reorganization process, each priority level has a right to be paid in full before creditors with the next lowest priority get a dime. That is why secured debt can be had at a lower interest rate than unsecured debt. In fact, that is why troubled companies have any ability at all to raise money. Credit flows because everyone knows the rules of the game, even in bankruptcy.

Well, at least they used to.

The system is not supposed to deliver equal outcomes or demand equal sacrifice. If it did money could only be borrowed at the highest rates of interest, if at all. Under the law, payment priorities can only be modified if all debtors agree. The ability to hold out and force a company into bankruptcy court is baked into the price of a loan or the discount at which bonds trade.

In Chrysler’s case the TARP-backed lenders – that is, banks-too-big-to-fail now living on the dole – chose to kowtow to the executive branch. What they “sacrificed” was the economic interests of their shareholders in favor of the political interests of their management. The non TARP-backed lenders, in this case a handful of hedge funds trying to protect the pension funds, university endowments, and insurance companies that invested in them, balked at getting lower consideration for their secured debt than the UAW is getting for its unsecured obligations. Hence, a trip to court and a tongue lashing by the president.

Forget about the law for a moment. Forget about right and wrong. This exercise should be getting easier now that pragmatism is the basis of government policy, right? So think for a moment only about the pragmatic consequences of the administration’s reorganization plan.

Why would anyone lend money to heavily unionized companies knowing that if things went wrong, the president and his men could trash their security interests by executive decree, hold them up to public vilification, and subject them to future retribution by regulators?

Why would anyone buy the shares of TARP-backed banks or invest alongside them knowing that their executives have proven their willingness to sacrifice shareholders’ interests and throw co-investors under the bus any time the president snaps his fingers?

Why would foreigners buy the distressed debt of American companies knowing that this debt cannot be secured by law but only by political clout?

How is the Federal Government supposed to unwind its ownership in the growing number of companies it has nationalized if prospective buyers know that should things ever take a turn for the worse, Uncle Sam will be back demanding extralegal “sacrifice” in the name of “saving” jobs?

How is private credit supposed to “start flowing again” if the United States of America morphs into a caudillo-run kleptocracy whose explicit policy is to “empower the workers,” chasing ever higher poll numbers by demonizing the very people whose job it is to provide credit?

The fate of Chrysler and its workers pale in comparison to the wrecking ball that would be taken to economic order if bankruptcy judge Arthur Gonzalez approves the administration’s plan to give Chrysler’s secured creditors the shaft. And what prize will we-the-people get in return? A doomed third-rate car company majority owned by its militant union run by Italian management building congressionally designed “green” cars no one wants to buy financed by taxpayers into perpetuity because no private investor in their right mind will touch the company with a ten foot pole. Is this supposed to be economic policy or comic opera?

How many more billions do you think will be flushed down this rat hole before the fat lady is allowed to sing?

May 5, 2009

Jack Kemp's Big Ideas About Growth

Working with Wanniski, Arthur Laffer, Robert Mundell, Alan Reynolds, Steve Entin, Norman Ture, and many others, Jack developed an agnostic economic formula that solved the vexing problem of economic stagflation and malaise.

Lower tax rates for everyone, he argued. Make it pay after-tax to work, produce, invest, and take risks, and the country will get more of all of it. Along with lower marginal tax rates to reignite economic growth, stabilize the free-falling dollar to curb inflation. And add free trade to that mix, since tariffs are nothing more than taxes on the purchase and sale of international goods.

Foster policies that will unleash our God-given creativity and imagination, Jack Kemp argued. And let individuals take it from there.

Jack was always talking about a rising tide to lift all boats, borrowing from the JFK phrase of the early 1960s. In fact, in meetings in the mid-1970s, Laffer and Wanniski helped persuade Kemp to follow in JFK’s footsteps and propose reduced tax rates across-the-board to get the economy growing again.

Jack, an unbelievably energetic activist, then helped persuade Reagan of the merits of this new policy approach. The economic dons of Cambridge and New Haven scoffed. They wanted to raise taxes, allegedly to curb inflation, and pump up the money supply to expand the economy. Kemp and his group told the dons they had it exactly backwards. He was right. The Ivy League was wrong.

Kemp actually thought of himself as a bleeding-heart conservative. First and foremost, this son of a truck driver wanted to improve the plight of the non-rich in the inner-city housing projects and those trapped in the dead-end welfarism of the barrios. He worked to expand the economic fortunes and political rights of all minority groups, including all those blue-collar workers who were getting killed by high tax rates and virulent inflation.

A perpetual optimist, Jack told the Republican convention in 1996, “You see, democratic capitalism is not just the hope of wealth, but it’s the hope of justice. When we look into the face of poverty, we see the pain, the despair, and need of human beings. But above all, in every face of every child, we must see the image of God.” He then added, “I believe the ultimate imperative for growth and opportunity is to advance human dignity.”

Nobody talks like that anymore. Politicians should. It’s inspirational stuff.

Another of Jack’s pet projects was the bringing together of capital and labor, workers and investors, and businesses and jobs. His ultimate goal was to make the non-rich rich. And to achieve that, he knew Wall Street had to work with Main Street; investors had to work with unions; and high finance had to work with the hard-hit folks in the inner cities. He had a true post-partisan vision long before that phrase became fashionable.

Over the years Jack often called me to affirm and encourage my simple paradigm: You can’t have a good job without a healthy business to create it, and you can’t have a good healthy business without the investment capital to fund it. It’s a unifying message.

This week President Obama unleashed yet another attack on international businesses, essentially calling them unpatriotic tax cheats even though they abide by existing laws. Last week, Obama used his clout to undermine investor contract laws in the Chrysler bailout. The president has also blasted banks and Wall Street, and has launched a war against capital.

Jack Kemp knew all this to be wrong. He said we need to stop taxing saving, investment, and business two, three, and four times. Simplify the tax code, he said. Lower tax rates across-the-board for everyone. Understand that Hispanics in the barrio need the very capital that is supplied by investors. Without it there will be no new jobs. And jobs along with economic growth are the best anti-poverty weapons we have.

Jack Kemp never tore people down; he tried to build everyone up. He argued passionately to persuade, not to destroy. He believed in one grand economic coalition that in fact would constitute a rising tide.

So Jack has passed away and we mourn. But his big ideas and dreams will live forever.

The Myths About a Return to the Gold Standard

The cries for gold are surely exciting given the basic truth that had the dollar been stable this decade, there’s simply no way we’d be in the financial mess we’re in today. When money values gyrate, mistakes with regard to investment and trade are magnified and economic corrections always reveal themselves. A dollar defined in gold terms would not erase all economic mistakes, but it’s a certainty that they would be reduced exponentially.

Unsurprisingly, calls for a return to monetary stability have generated not insignificant chatter about the problems inherent with a gold standard. Some have said gold is too unstable, some say a return would drive gold’s price up to nosebleed levels due to a lack of supply, and some actually suggest that floating currencies have actually enhanced worldwide trade.

On the stability front, it’s been argued that the unstable value of the dollar price of gold since 1971 points to an unstable measure not suitable for fostering currency stability. What the detractors miss is that when the gold price moves, this isn’t a signal that gold’s value is volatile; instead it’s a sign that the paper currency in which it is priced is changing in value. Simplified, when the gold price rises that’s a sign that the dollar is weakening; when gold falls that’s a signal that the dollar has strengthened.

Why is gold so stable? The answer is very basic and has to do with the fact that just about every ounce of gold ever mined is still with us today. Unlike commodities such as oil, copper and wheat which are constantly consumed, gold’s almost total non-involvement in the economy explains its value as a money measure. Since there’s so much gold stock in the world, annual flows into the marketplace either due to discovery or central bank sales cannot credibly change its long-term price.

It’s also said that our leaving gold actually fostered increased cross-border trade. No less than the highly insightful senior currency strategist for Brown Brothers Harriman, Marc Chandler, argued in a recent client piece that floating currencies “helped create the conditions for the rapid and dramatic expansion of trade, capital flows and globalization.”

Importantly, there are strong differences of opinion when it comes to floating currencies and trade. Indeed, floating currencies enable the very protectionist impulses that are less likely to reveal themselves when money values are stable. As Stanford economist Ronald McKinnon noted in his 1996 book, Rules of the Game, “In the 1950s and 1960s, when par values for exchange rates were more or less fixed under a common monetary standard the industrial countries experienced an unprecedented increase in the growth rate of GNP and an expansion of world trade.” But with the advent of floating exchange rates in 1973, McKinnon observed that we experienced “an upsurge of ‘new’ protectionist policies-including quotas, VERs, market-sharing schemes, anti-dumping, and countervailing duties.”

The above shouldn’t surprise us owing to one of the chief reasons we left gold to begin with: a desire to undercut Japanese imports with a weaker dollar. Floating currencies led to regular currency manipulations by monetary authorities in countries around the world, but most notably right here in the U.S. Laboring under the naïve assumption that currency devaluations would enhance the economic outlook of countries served, monetary authorities foisted inflation on their respective countries given the belief that this would stimulate exports. That the vaunted gains in exports never reveal themselves didn’t then, nor does it now, seem to trouble our monetary stewards.

In reality, floating currencies are anti-trade for creating winners and losers (thanks to currency gyrations), and anti-globalization for uncertain exchange rates making the smooth transfer of capital across borders more uncertain. Simplified, exchange rate risk, particularly of the devaluationist kind, makes cross-border investment less, as opposed to more likely. McKinnon and Japanese economist Kenichi Ohno wrote in Dollar and Yen that over the last two centuries “periods of vigorous expansion of free trade have coincided with fixed exchange rates." Contrary to assumptions made today, fixed currency values would be a boon for trade and globalization.

Lastly, some argue that a return to a gold standard would be incredibly expensive. Gillian Tett of the Financial Times is of this view, and she cites a recent UBS study which suggests that with U.S. reserves of gold so small relative to the size of its monetary base, “a price above $6,000 an ounce would be needed to reintroduce a gold standard.” Tett goes on to say that if the standard were introduced in China and Japan, the gold price “would be more than $9,000.” The problem with Tett’s reasoning is that it does not describe the kind of gold standard that most of its adherents desire.

First, however, the notion of price needs to be addressed. Perhaps unsurprisingly, similar, but reverse logic was applied before the U.S. left the gold standard in 1971. It was assumed then that the demonetization of gold would lead to a collapse in terms of its price. No less than gold-standard advocate and Nobel Laureate Robert Mundell observed in his 1968 classic, Man and Economics, that if the “United States and the other monetary authorities abandoned all dealings in gold for the indefinite future, it would be quite easy to predict a fall in the price of gold relative to the dollar” due to its “role as international money having been jettisoned.”

But as Mundell later predicted with the collapse of Bretton Woods, once the dollar lost its gold definition, the price of gold skyrocketed alongside the dollar’s plunge. Schumpeter once described the gold standard as the “naughty child that keeps on telling unpleasant truths”, but even without the standard, the gold price was still set in the markets, and its rise exposed impressively bad management of the dollar by U.S. monetary authorities.

Looking at the price of gold if we return to a standard, there’s nothing suggesting that the price of it would rise. That’s the case because as Ricardo, J.S. Mill and others noted, there’s nothing saying a country on the gold standard must have physical gold backing all the currency issued. In fact, under a Ricardian gold standard, monetary authorities would realistically have no gold at all.

Indeed, they wouldn’t need it. If the dollar’s price were credibly fixed for the long-term, the U.S. Treasury wouldn’t need a lot of gold on hand precisely because there would be no desire to exchange interest-bearing dollars for a commodity possessing very little in the way of real-world purpose. Instead, Treasury would merely make the dollar convertible into gold if desired, but if monetary authorities were to simply add dollars to the system if gold were to fall, and extinguish dollars if gold were to rise above its set price, exchanges for gold would be infrequent at best.

About gold, Ricardo observed that “there is probably no commodity subject to fewer variations.” Gold’s inherent stability explains why for most of history the world has been on a gold standard; the nearly 40 years since the collapse of Bretton Woods surely an exception to the historical currency rule.

A gold standard won’t itself make us more prosperous, but for fostering the kind of currency stability necessary for wealth-enhancing production and trade, a return to a stable dollar value would unleash a huge amount of economic activity and trade the world over. In that sense, increased prosperity would be a certain result of a return to a dollar defined in gold for removing economically retardant variables to productivity and investment that we face at present. That economic crises caused by monetary mistakes would decline would be yet another good that would result from this most positive and costless of economic changes.

May 6, 2009

What the Move Toward Green Means

But some time ago, eco-activists and their allies in Congress understood that they could march the country to the left by small degrees if they disguised socialism as environmentalism.

And thus the environmental movement was hijacked.

Decades of sermonizing have indeed nudged us leftward, but we are still — for now — a nation of mostly free men and largely free markets. Credit a public that seems to grasp we don't have to kill capitalism in order to save the planet.

This same public has become increasingly skeptical of the global warming assumption, perhaps the environmentalists' last chance to remake the country in their image.

Now, frustrated with their inability to have forced a deeper leftward shift, the environmental activists feel the need to recast the language of the debate.

Using polling and focus groups, ecoAmerica, an environmental group that develops marketing and messaging strategies, has forged a list of recommendations. It was obtained by the New York Times, which says it's one of "a number of news organizations" that was accidently e-mailed a "summary of the group's latest findings and recommendations."

Rather than talk about "global warming," which is already being replaced by the less-specific "climate change," ecoAmerica suggests that alarmists should discuss "our deteriorating atmosphere." And instead of picking on carbon dioxide per se, it proposes we simply abandon "the dirty fuels of the past."

The memo also recommends embroidering conversations with language about "shared American ideals, like freedom, prosperity, independence and self-sufficiency," which is ironic, since those are the uniquely American qualities that the environmental movement seems to be moving us away from.

What's clear is eco-activists and their allies will do anything to avoid talking about their real goals, which have less to do with cleaning up the environment than with pulling down capitalism.

Every solution they offer to the problems they exaggerate erodes economic freedom, increases regulation or both. Blurring the real meaning of words can't change that.

Chrysler Meets Obama, Man of the System

But this is only the beginning, not the end, of all the levers that the federal government is going to have to pull to save a persistently-troubled company. To work this deal successfully Washington has to intrude on and upset established bankruptcy law. It must extend its role as financier of last resort. It may have to do something about those pesky foreign-car competitors to Chrysler (who will no doubt use their superior brand names, marketing and technology to parry and thrust new Chrysler initiatives). The government may have to find a way to discipline recalcitrant American consumers who disdain the Chrysler brand (and barely know Fiat’s), especially when it comes to small, fuel efficient cars that the company will now produce. And government may be called on to remedy Chrysler’s big cost-disadvantages, a product of its high wages and benefits, without upsetting union allies (one gander at the paltry “concessions” the unions have so far granted indicates how much work is still to be done on this issue). And that’s only the beginning, only the obvious moves based on recent history. Beneath the surface are effects and circumstances which will show themselves at each step of the way, and which must be managed to Chrysler’s advantage. And for how long? After all, we’ve already bailed this company out once?

When President Obama took office he faced an epic crisis of confidence in our economy that seemed unprecedented in recent history. Given the scope of the problem, there was room for reasonable debate on the right course of action. But every day since, and especially now with Chrysler and General Motors, President Obama reveals himself to resemble more and more what Adam Smith called “the man of system,” ready to work the levers of government to try and position large swathes of the economy to his liking or advantage.

In his Theory of Moral Sentiments, the book that preceded and laid the groundwork for Wealth of Nations, Smith wrote of the risks of the man of system in government because he “seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them.”

Far from being warned away from the man of system by Smith, by the 20th century many people embraced the notions of central planning and micro-managing of broad economies and individual industries. The Nobel Prize winning economist F. A. Hayek called this the ‘fatal conceit’—men believing they could ascertain and direct all the forces at work in society. And despite its failures, central planning remains attractive in the 21st century, especially among the elite because, as Hayek wrote, “intelligent people will tend to overvalue intelligence, and to suppose that we must owe all the advantages and opportunities that our civilisation offers to deliberate design.”

And so it goes with Chrysler. Since our auto industry is part of a world-wide network that is not so easily managed by government, saving Chrysler will involve more than just some tinkering here or there. It may well involve sweeping and persistent actions to herd consumers, tame the competition and rewrite our laws in the process. How much will be acceptable? And what will be the criteria for determining other American industries which government must similarly try to save?

It’s enough to jar even your typical National Public Radio reporter. Interviewing EPA administrator Jackson last month, it was an NPR reporter who, after listening to Jackson’s rift on government guidance to car companies, naively responded, “That doesn't sound like free enterprise.”

When did they start getting ideas like that over at NPR?

May 7, 2009

War On Investors: The Chrysler Arm Twist

I read this to mean, among other things, that Obama has committed himself quite explicitly not to wage war on any of the countries and foreign-based entities that have declared themselves to be our mortal enemies.

So what does this man, whose political career was formed and marinated in the gangland-style thuggery of Chicago politics, do when he needs to act out?

He declares war on American citizens.

If you don’t like me saying that, well, I can’t help you. There’s just no other way to characterize the actions of the US President in regard to the financial investors in Chrysler LLC.

The big flap on the left is over allegations which surfaced late last week in respect to the New York-based boutique investment firm Perella Weinberg. Tom Lauria, one of Weinerella’s attorneys, said in a radio interview last Friday that Steve Rattner, Obama’s car czar, directly threatened his client.

What was the investment firm guilty of? They were apparently among a group of Chrysler secured creditors who collectively have lent the firm about $6 billion. (More precisely, they acquired bonds totaling that amount in par value from the bankers who originally lent money to Chrysler. Of interest to finance geeks, but not to anyone else, is the unanswered question, whether the debt in question was originally part of the leveraged buyout of Chrysler LLC by Cerberus Capital Management back in 2003.)

Chrysler is unquestionably insolvent. They were forced to accept $4 billion from the Treasury’s TARP fund late last December, in return for what amounts to an unsecured note and a promise to submit a “viable” restructuring plan, to an entity which turned out to be … Steven Rattner.

Perella Weinberg and others hold secured notes. In liquidation, they have an explicit and incontrovertible claim on certain assets of the firm. That puts them in a senior position to the rest of the debtholders, which include the US government, and also the UAW (which holds a contractual obligation by Chrysler to pay a certain amount of cash into their retiree healthcare fund).

Why does a company ever hypothecate its assets to an investor as part of borrowing money? Simple. To get a lower interest rate. In extreme cases (which describes Chrysler quite well), there may not be any capital available at any price, without secured collateral.

Why does an investor require collateral before they will lend money at a particular rate of interest? For the same reason that your bank requires collateral when they lend you money to buy a house or a car: because they need to ensure that they’ll be paid back. Default on your mortgage or your car loan, and a foreclosure or repossession is in your future.

What’s wrong with this? Nothing. It’s the only rational way to run a privately-financed credit-based economy. Not only is the principle of priority for secured creditors enshrined in law and precedent, it’s also been the basis on which people have lent each other money ever since our ancestors lived in trees.

Until Barack Obama became President of the United States, that is.

What the secured Chrysler creditors did a week ago was to tell the President’s negotiators that they wanted a little better than the approximately 38 cents on the dollar they were being offered for their debt. What would you say in such a position?

Well, if you’re a secured creditor, you say: “Look, Mr. President. We have a senior claim on the assets of this company. We’re perfectly happy to petition a judge to force a Chapter 7 liquidation in order to satisfy our claim. But of course that means you get nothing on your $4 billion TARP note. So if you don’t like that idea, why don’t you make us a more acceptable offer?”

Instead, the President went ballistic. He broke off the negotiations, and went on national television the next day (April 29) to publicly take sides in the matter, announcing his own version of a settlement. The UAW would get 55% percent of Chrysler. Italy’s Fiat would get 20% in return for NO CASH, but rather some unspecified small-car technology. And Chrysler would receive an additional $8 billion in taxpayer money.

Meanwhile, the President went out of his way to single out the investor group, angrily denouncing them as people looking to profit unreasonably from the situation (since when is losing 62% of your investment a profit?). And he said, ominously, that he “does not stand with them.”

The United States is, famously, a country of laws. What if Chrysler’s secured creditors were to seek due process of law, in order to obtain a just resolution of their claims? Well, of course, they could have their day in court.

And in the meantime, they’d be subject to every kind of delay the government’s lawyers could imagine, to say nothing of being tortured endlessly by financial regulators and the IRS? Oh, and by the way, to be vilified in the national press, probably to the point that their executives would receive threats of death by piano wire, and bus tours to their private homes organized by left-wing groups, as did the executives of AIG Insurance.
Now, given that prospect, just how badly do you want to press your claims in court? In the event, Perella Weinberg changed their negotiating position, and accepted the government’s offer. In a press release, they pointedly reminded everyone that their fiduciary duty is to maximize the value of their limited partners’s investment, not to go on a hopeless political crusade.

This in a nutshell is the villainy that Barack Obama has perpetrated on the American people: possessed of the overwhelmingly powerful instruments of government, he chose to use them to intimidate one side in a private negotiation. In the process, he overturned centuries of settled law and practice. He used his power to force an outcome of his choosing, and knowing no one would act to stop him.

What made this easy for Obama, in his calculation, was that in today’s political environment, Wall Street financiers are held in low repute by the people. He picked what he thought was an easy target. And of course he could count on a supine White House press corps to spin the story just as he wanted.

To members of the mainstream media, getting close to the crown is what they spend their whole lives trying to do. That goes double in the case of a President that the media are deeply and personally invested in. If anyone on this planet thinks that any member of the White House press corps (which now includes bloggers from plainly left-wing activist organizations) is going to take the side of a bunch of investors against the US President, I very much would like to find out what that person’s brain is made of.

So what are the left-wing blogs all exercised about this week? They’re mad as hell that anyone could have the gall to suggest that there could be something to the accusation that Rattner threatened to vilify the investors through the national press.

As far as they’re concerned, the White House denied it: end of story. But an unctuous credulity is the first step toward the acceptance of tyranny. No matter what you think of Wall Street investors, you could be next on the list. A President who isn’t afraid to act like a common thug against his own citizens is signaling that he thinks of us not as citizens but as subjects. Americans of a past age once waged a revolution to free themselves from such arbitrary and antagonistic deployment of government power, unfettered by principles of justice and law and a proper respect for the rights of the citizens.

Keep your eyes on the news. GM is next.

After Card Check, Don't Forget Binding Arbitration

This legislation, entitled the Employee Free Choice Act, has been in the news for allowing workers to choose to join unions by checking a card circulated and retained by the union—hence the name “card check”—rather than through a secret-ballot election, as required since the 1935 National Labor Relations Act.

Card check has run into opposition because it opens the possibility of union intimidation. Union officers can visit workers at home, and they will know who signed and who refused. This is precisely why organized labor wants to end the secret ballot. It seeks to reserve for itself the intimidation it accuses employers of practicing.

The outlook in the Senate for getting 60 votes for a bill that includes card check is murky. Forty senators, all Democrats, are cosponsors, but several Democrats oppose card check, including Blanche Lincoln of Arkansas, Diane Feinstein of California, and Arlen Specter of Pennsylvania.

Although the card check portion of the bill is unlikely pass to the Senate, the mandatory arbitration portion is more popular, so some are proposing removing card check from the EFCA, and leaving mandatory arbitration and increased employer penalties for interfering with union elections

Unions want mandatory arbitration, this less-noticed provision of the bill, because they believe that the threat of arbitration, followed by the arbitration itself, will force employers to pay better compensation packages. More generally, organized labor, whose share of the private labor force has fallen to 7.6 percent, needs victories—in Congress and then at the bargaining table—to demonstrate to unorganized workers that unions are potent and can help them.

Employers oppose arbitration on the grounds that it could require them to pay excessive compensation to workers, eventually forcing firms out of business. The contrast between the financial position of the unionized Big Three Detroit auto companies and the non-unionized transplants in the south shows how unionization affects the bottom line.

Binding arbitration could have even more pernicious consequences than ending the secret ballot. It would allow an undefined arbitration board, appointed by the Federal Mediation and Conciliation Service, itself headed by a political appointee, to set compensation packages for firms and workers that they would be forced to accept.

Unlike voluntary arbitration, the parties would not have an opportunity to choose members of the panel, nor would they have recourse to a higher authority, such as the courts, if they were dissatisfied with the results. Workers could be required to accept lower salaries and less vacation than they could get elsewhere, and firms could be forced into unproductive agreements that could eventually lead to bankruptcy.

With just a few lines of legislative language, Congress would revoke for newly-organized firms the principle of free collective bargaining—that employers and unions may walk away from a contract they find unsatisfactory.

The bill does not specify who would pick the panel or how many members it would have, because the Mediation Service would write the regulations. The panel would not have to be industry or regional experts, familiar with the firms in a particular part of the country. The bill is unclear on how the arbitration panel would gain information it needs to decide worker compensation—not only wages, but also vacation, sick leave, promotion opportunities, discipline, and pensions.

The arbitration panel would not have to take into account compensation policies of rival firms, surely a relevant factor. A newly-organized firm could find that its costs were set higher than its competitors, leading to loss of market share and the need to downsize. Except, of course, that downsizing would undoubtedly be strictly regulated under the terms of the contract.

The banking and auto crises have shown us that it’s hard to keep political expediency or favoritism out of economic decision-making. Former Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke reportedly pressured Bank of America CEO Ken Lewis not to reveal crucial financial details about Merill Lynch to shareholders. And President Obama attacked hedge funds for wanting to keep shares of Chrysler assets that are legally theirs, while giving the United Auto Workers 55 percent of the company.

Because neither employers nor workers should be forced to participate in contracts against their will, there’s nothing more dangerous than allowing the government to impose binding arbitration on workers and companies. Senators of both parties have wisely rejected card check, and they should also reject binding arbitration.

Deposit Insurance Undermines Bank Stability

Who are these supposed panic-prone depositors? Of the 117 million
households in America, only about 10 million have total bank deposits
above $100,000, or less than 9 percent of all American households.
These same families also have incomes of over twice the median, putting
these households in the top 20 percent of earners. Nor are these
households without significant wealth, with total median holdings of
financial assets alone of almost $600,000. Most households with
deposits above $100,000, given their considerable financial wealth,
demonstrate sufficient sophistication to provide monitoring of a bank's
financial condition. Even if families with bank deposits above $100,000
were to suffer a loss in deposits resulting from a bank failure, the
typical family in this group has both considerable income and wealth to
buffer such a hit. In contrast, the typical, or median, American
household, has only about $6,400 in bank deposits, well below the
previous ceiling of $100,000.

Outside of providing public benefits to a small slice of our wealthiest
families, what else comes with extending deposit insurance? Arguably a
more stable banking system; yet a substantial share of other countries
continue to have functioning banking systems in the absence of any
deposit insurance. A recent academic study across over 150 countries
found that, all else equal, those countries with more generous deposit
insurance schemes also suffered more frequent banking crises.

Similar results hold for the US, as various academic studies have found
that U.S. uninsured deposits provide substantial monitoring of bank
health. The related decline in market discipline that results from
deposit insurance has been documented across time and differing
regulatory structures. Few relationships in economics have been found
in so many different settings as the link between expanded deposit
insurance and bank instability.

FDR and the New Deal have been invoked regularly as a model for solving
our current financial crisis. But FDR vocally opposed the creation of
deposit insurance and threatened to veto the Glass-Steagall banking bill
over its inclusion, saying it "would lead to laxity in bank management
and carelessness on the part of both banker and depositor." Ultimately
he signed Glass-Steagall into law, believing its other provisions
out-weighed the potential harm that might follow from the creation of
the FDIC. History continues to confirm FDR's initial fears toward
deposit insurance.

The performance of the Canadian banking system compared to that of the
United States during the Great Depression illustrates the problems of
deposit insurance. The Canadian banking system, which lacked any
deposit insurance during the 1920s and 1930s suffered only one bank
failure in the 1920s, and none in the 1930s. The U.S., with its
state-based deposit insurance system, suffered over 6,000 bank
suspensions and almost 4,000 mergers and acquisitions in the 1920s
alone. The worst of those failures were found in states with the most
generous deposit insurance systems.

There is no reason to believe that extending deposit insurance will not
again undermine market discipline, as it consistently has in the past.
Congress is poised to now undermine the future stability of our banking
system, largely for the benefit of the country's wealthiest families.

May 8, 2009

We Had a Systemic Risk Regulator, It Did Not Work, It is Still a Bad Idea

I’m not seeking to blame Greenspan alone here. I certainly cannot prove I would have done any better. The point is we had someone on the job, someone with tremendous talent and credibility, someone actively trying to assess whether each of these orgies was in fact a true bubble -- and he could not make that call until it was too late. Of course, it’s a lot easier with hindsight. For everyone so sure “Wall Street bankers” acted irresponsibly, I present Congress with all its raging anger, conveniently ignoring that many of its own members assured us everything was fine until just after it all blew up. It’s harder playing the game real-time.

So, for the last two bubbles we had the Maestro looking and giving the all-clear sign. Would a Risk Czar have worked better? Is he going to be smarter than Greenspan and know when things are bubbles and when they are not? Will he know when actions might be precipitous and choke off economic growth (still the best anti-poverty program ever devised)? Is anyone that good? No one in the history of government or industry has been.

One difference is that this proposed new regulator is not just about spotting bubbles, but about identifying companies that are “too big to fail”, and thus present systemic risk, and then “doing something” about them beforehand. First, this task can’t really be separated from spotting and preventing bubbles. It is precisely the danger of bubbles and their popping that historically has caused “systemic” risk to be unveiled, and even then it has been exaggerated in an attempt to scare people into allowing more government power (remember how we were told LTCM and their “systemic” risk would have brought down the economy if not saved, while looking back now their four billion dollar loss seems almost quaint?). Next, it seems quite startlingly naïve to think that a new government bureaucracy is going to be able to look into the heart (or balance sheet) of all companies, decide which are “systemically relevant” and move logically, but not
unfairly, to curtail any risk they represent, presumably using some coercive powers. That is an exceedingly complex and difficult undertaking in which we should have little confidence.

Government entities have no history of doing anything like this endeavor. While it cannot be proven, as it is hard to prove a negative, this is quite likely to end up looking like Congress running the DMV. Bureaucracy, blame, shouting, horrific inefficiency, and a frustrating way to kill half a day on line waiting for your license to take risk...

Perhaps scariest, adding such a regulator only magnifies the moral hazard problem as the government effectively will be promising that systemic dangers won’t strike again. This new insurance policy could induce more unwarranted risk-taking, making the taxpayer even more deeply on the hook when something eventually blows up. And, if that moral hazard does not lead to more risk-taking, it will only be because the regulator, correctly deducing he has all downside and no upside, neuters the financial system of all risk, devastating growth and innovation.

If we are to spend energy “fixing” markets, let’s spend it learning how to wind down a failed “systemically relevant” institution better. When Lehman Brothers failed, the participants in the financial system ran around like chickens with their heads cut off. It wasn’t so much that the systemic linkages between firms meant massive losses, it was that nobody knew precisely what positions they held or what contracts they had on and with whom, and how their positions and trades would be treated. Essentially, it seems pretty clear that none of the regulators, lawyers, bankers or traders had really given enough thought as to what to do in the event of failure of a complex financial intermediary. As a practical matter, we all assigned zero probability to it.

Serious people devoting serious time to the nuts and bolts of what happens next time someone “too big to fail” indeed fails would be an incredibly productive exercise. It is hard to imagine us collectively perfecting this process to the point of having seamless bankruptcies involving huge intertwined multinational institutions. However, it is even harder to imagine that we cannot get far better at this than we are now.

Now, here’s the magical part, the better we get at it, the more the “too big to fail” concept goes away, and any need for “systemic” risk regulation. We could then lean more towards allowing the market to sort out its own messes, have investors who chose poorly bear their own losses, and even bonuses, if improperly distributed, be judged not in the court of popular opinion, or god-forbid the kangaroo court of Congress, but rather where they are meant to be, in bankruptcy court. Spending our time on this instead of the government program of the week seems like a highly positive trade-off. I really hope I’m not now sued by the Kangaroos for defamation...

Rather, the current plan is to set up yet another government agency, which will expand over time while failing miserably at its near-impossible appointed task. To put it simply - too many Czars spoil the republic.

Well, one good thing will come out of this all. Next time we can all just blame the Systemic Risk Regulator.

The Spring of the Zombies

This downturn is complex: an economic crisis combined with a financial crisis. Before its onset, America's debt-ridden consumers were the engine of global growth. That model has broken down, and will not be replaced soon. For, even if America's banks were healthy, household wealth has been devastated, and Americans were borrowing and consuming on the assumption that house prices would rise forever.

The collapse of credit made matters worse; and firms, facing high borrowing costs and declining markets, responded quickly, cutting back inventories. Orders dropped abruptly - well out of proportion to the decline in GDP - and those countries that depended on investment goods and durables (expenditures that could be postponed) were particularly hard hit.

We are likely to see a recovery in some of these areas from the bottoms reached at the end of 2008 and the beginning of this year. But examine the fundamentals: in America, real estate prices continue to fall, millions of homes are underwater, with the value of mortgages exceeding the market price, and unemployment is increasing, with hundreds of thousands reaching the end of their 39 weeks of unemployment insurance. States are being forced to lay off workers as tax revenues plummet.

The banking system has just been tested to see if it is adequately capitalized - a "stress" test that involved no stress - and some couldn't pass muster. But, rather than welcoming the opportunity to recapitalize, perhaps with government help, the banks seem to prefer a Japanese-style response: we will muddle through.

"Zombie" banks - dead but still walking among the living - are, in Ed Kane's immortal words, "gambling on resurrection." Repeating the Savings & Loan debacle of the 1980's. the banks are using bad accounting (they were allowed, for example, to keep impaired assets on their books without writing them down, on the fiction that they might be held to maturity and somehow turn healthy). Worse still, they are being allowed to borrow cheaply from the United States Federal Reserve, on the basis of poor collateral, and simultaneously to take risky positions.

Some of the banks did report earnings in the first quarter of this year, mostly based on accounting legerdemain and trading profits (read: speculation). But thiswon't get the economy going again quickly. And, if the bets don't pay off, the cost to the American taxpayer will be even larger.

The American government, too, is betting on muddling through: the Fed's measures and government guarantees mean that banks have access to low-cost funds, and lending rates are high. If nothing nasty happens - losses on mortgages, commercial real estate, business loans, and credit cards - the banks might just be able to make it through without another crisis. In a few years time, the banks will be recapitalized, and the economy will return to normal. This is the rosy scenario.

But experiences around the world suggest that this is a risky outlook. Even were banks healthy, the deleveraging process and the associated loss of wealth means that, more likely than not, the economy will be weak. And a weak economy means, more likely than not, more bank losses.

The problems are not limited to the US. Other countries (like Spain) have their own real estate crises. Eastern Europe has its problems, which are likely to impact Western Europe's highly leveraged banks. In a globalized world, problems in one part of the system quickly reverberate elsewhere.

In earlier crises, as in East Asia a decade ago, recovery was quick, because the affected countries could export their way to renewed prosperity. But this is a synchronous global downturn. America and Europe can't export their way out of their doldrums.

Fixing the financial system is necessary, but not sufficient, for recovery. America's strategy for fixing its financial system is costly and unfair, for it is rewarding the people who caused the economic mess. But there is an alternative that essentially means playing by the rules of a normal market economy: a debt-for-equity swap.

With such a swap, confidence could be restored to the banking system, and lending could be reignited with little or no cost to the taxpayer. It's neither particularly complicated nor novel. Bondholders obviously don't like it - they would rather get a gift from the government. But there are far better uses of the public's money, including another round of stimulus.

Every downturn comes to an end. The question is how long and deep this downturn will be. In spite of some spring sprouts, we should prepare for another dark winter: it's time for Plan B in bank restructuring and another dose of Keynesian medicine.

Joseph Stiglitz is professor of economics at Columbia University.

Continue reading "The Spring of the Zombies" »

May 11, 2009

Addressing Overseas Tax Dodge Questions

For most people, the multinational company is a troubling concept. Loyalty matters. We like to think that "our companies" serve the broad national interest rather than just scouring the world for the cheapest labor, the laxest regulations and the lowest taxes. And the tax issue is especially vexing: How should multinationals be taxed on the profits they make outside their home countries?

Listen to President Obama, and the status quo seems a cesspool. Pervasive "loopholes" engineered by "well-connected lobbyists" allow U.S. multinationals to skirt American taxes and outsource jobs to low-tax countries. So the president proposes plugging loopholes. Some jobs will return to the United States, he said, and U.S. tax coffers will grow by $210 billion over the next decade.

Sounds great -- and that's how the story played. "Obama Targets Overseas Tax Dodge," headlined The Post. But the reality is murkier; the president's accusatory rhetoric perpetuates many myths.

Myth: Aided by those overpaid lobbyists, American multinationals are taxed lightly -- less so than their foreign counterparts.

Reality: Just the opposite. Most countries don't tax the foreign profits of their multinational firms at all. Take a Swiss multinational with operations in South Korea. It pays a 27.5 percent Korean corporate tax on its profits and can bring home the rest tax-free. By contrast, a U.S. firm in Korea pays the Korean tax and, if it returns the profits to the United States, faces the 35 percent U.S. corporate tax rate. American companies can defer the U.S. tax by keeping the profits abroad (naturally, many do), and when repatriated, companies get a credit for foreign taxes paid. In this case, they'd pay the difference between the Korean rate (27.5 percent) and the U.S. rate (35 percent).

Myth: When U.S. multinationals invest abroad, they destroy American jobs.

Reality: Not so. Sure, many U.S. firms have shut American factories and opened plants elsewhere. But most overseas investments by U.S. multinationals serve local markets. Only 10 percent of their foreign output is exported back to the United States, says Harvard economist Fritz Foley. When Wal-Mart opens a store in China, it doesn't close one in California. On balance, all the extra foreign sales create U.S. jobs for management, research and development (almost 90 percent of American multinationals' R&D occurs in the United States), and the export of components. A study by Foley and economists Mihir Desai of Harvard and James Hines of the University of Michigan estimates that for every 10 percent increase in U.S. multinationals' overseas payrolls, their American payrolls increase almost 4 percent.

Myth: Plugging overseas corporate tax loopholes will dramatically improve the budget outlook as multinationals pay their "fair" share.

Reality: Dream on. The estimated $210 billion revenue gain over 10 years -- money already included in Obama's budget -- represents only six-tenths of 1 percent of the decade's tax revenue of $32 trillion, as projected by the Congressional Budget Office. Worse, the CBO reckons that Obama's endless deficits over the decade will total a gut-wrenching $9.3 trillion.

Whether Obama's proposals would create any jobs in the United States is an open question. In highly technical ways, Obama would increase the taxes on the foreign profits of U.S. multinationals by limiting the use of today's deferral and foreign tax credit. Taxing overseas investment more heavily, the theory goes, would favor investment in the United States.

But many experts believe his proposals would actually destroy U.S. jobs. Being more heavily taxed, American multinational firms would have more trouble competing with European and Asian rivals. Some U.S. foreign operations might be sold to tax-advantaged foreign firms. Either way, supporting operations in the United States would suffer. "You lose some of those good management and professional jobs in places like Chicago and New York," says Gary Hufbauer of the Peterson Institute.

Including state taxes, America's top corporate tax rate exceeds 39 percent; among wealthy nations, only Japan's is higher (slightly). However, the effective U.S. tax rate is reduced by preferences -- mostly domestic, not foreign -- that also make the system complex and expensive. As Hufbauer suggests, Obama would have been better advised to cut the top rate and pay for it by simultaneously ending many preferences. That would lower compliance costs and involve fewer distortions. But this sort of proposal would have been harder to sell. Obama sacrificed substance for grandstanding.

Ominous Parallels: Is Obama the Next Bush?

Despite many obvious differences, these two presidents bear striking similarities. Both are expansive in their willingness to use executive power to tackle existential crises – one a security crisis and the other an economic crisis. Both have a bias for action sustained by an unshakeable belief in their righteousness. Both launched ambitious and unprecedented national programs that initially enjoyed broad popular support. And both govern as if the ends justify the means, giving short shrift to legal and constitutional niceties that might tie their hands.

George Bush surrounded himself with draft-dodging neocons who believed they possessed special knowledge about foreign policy, brooking no debate. Barack Obama has surrounded himself with tax-dodging Wall Street bankers who believe they have special knowledge about economic policy, brooking no debate.

George Bush launched trillion dollar wars in Iraq and Afghanistan hoping to “make the world safe for democracy.” In the process he embroiled the country in a morass with no clear exit strategy. Barack Obama launched trillion dollar government takeovers in the banking, insurance, and automobile industries hoping to “correct the flaws in capitalism.” As he wades deeper into this morass, have you heard him articulate a compelling exit strategy?

Both of these men went “all in” with the nation’s checkbook asking for “sacrifice” from the citizenry, promising a better future. It would be interesting to see how Vegas odds makers compare the two bets. Which will happen first – Iraq becomes a stable democracy with a murder rate lower than Washington DC’s or Chrysler becomes a profitable car company and pays back its federal loans?

Yes, George Bush abandoned all pretense of fiscal discipline allowing his party to spend wildly not just on his wars but on a raft of programs logrolled through Congress. Barack Obama makes a pretense of fiscal discipline as his party spends wildly, not just on his stimulus and rescue packages but on a raft of programs being shoved through Congress by an unrestrained majority.

Bush’s lawyers concocted rationales allowing him to trample the Constitution in his pursuit of the “war on terror.” Congress gave him a free pass, too busy peddling earmarks to look after their constitutional responsibilities. Obama’s lawyers have quietly followed suit, allowing him to trample the constitution in pursuit of “creating or saving jobs.” Congress is giving him a free pass, still too busy peddling earmarks to look after their constitutional responsibilities.

Oddly enough, Bush’s last act as president was to pave the way for Obama’s dive into the banking, insurance, and automobile businesses, making a mockery of the Republican Party’s free market rhetoric. And Obama’s first act as president was to beef up the war in Afghanistan and extend the lease at Guantanamo, making a mockery of the Democratic Party’s anti-war rhetoric.

What kind of willful partisan blindness does it take to deny the common pattern in these two presidencies? The only thing we haven’t seen yet is the collapse of Obama’s popular support. But just wait a few years. With the threat of Carter stagflation looming and voter patience wearing thin for never-ending bailouts, there is plenty of time for the chickens to come home to roost before Obama’s term is up.

Short of total war aimed at the annihilation and unconditional surrender of an enemy nation-state, national problems rarely lend themselves to monolithic solutions hastily promulgated by imperial presidents. The unintended consequences of throwing unlimited resources at intractable problems often become more threatening than the original problems. Just look at the growing army of radical Islamicists waving their fists at Uncle Sam or the swelling ranks of zombie corporations waving their begging bowls.

Yes, the pendulum often swings from one party to the other as voters recoil from the most recent abuses of power. But instead of bouncing back and forth between the lesser of two evils, suppose we all picked up and read a copy of the Constitution? It might remind us that our federal government was not designed to engage in nation building in foreign lands any more than it was empowered to run mortgage banks, insurance companies, or auto manufacturers. Limiting the damage our political leaders can inflict on the country even while acknowledging their best intentions is not a partisan issue. It’s what makes us uniquely American.

May 12, 2009

Where Are the Jobs In the Growth Forecast?

Well, so far this year, 1.9 million jobs have been swallowed by the recession. So he's already nearly five million jobs in the hole.

Now, Christina Romer, chairwoman of the White House Council of Economic Advisors, says don't expect any new jobs this year — and that unemployment could reach 9.5%, up from the current 8.9%, even though she expects the economy to grow 3.5% in the fourth quarter.

We understand that jobs are a lagging, not leading, indicator of economic strength. And this time will be no different.

Yet, in the near term, we're actually more optimistic than the White House. Not because we think what's been sold to the American people as "stimulus" is any great shakes, but because private- sector economic activity and global stock markets appear to have hit bottom and are ready to resume growth later this year.

Manufacturing's plunge and a massive drawdown of inventories late last year mean that any positive change in demand will translate into economic growth and a sudden need for workers. This will be helped by the Federal Reserve holding interest rates close to zero for the rest of this year, which seems likely.

Once a rebound occurs, we'll be hearing the all-hails and hallelujahs for the $787 billion stimulus package that Congress wrote and President Obama signed into law. But remember: The coming recovery will have little if anything to do with stimulus.

Facts are facts.

As of May 1, just $29 billion in stimulus spending, or about 3.7% of the total, had gone out. In a $14 trillion economy, that's nothing. So if the economy bottoms this quarter or next, as seems likely, it can't be due to stimulus spending — though that's what Democrats in Congress and the White House will no doubt claim.

The stimulus money, in other words, isn't getting out fast enough to make a difference. Even if it did, a dollar spent by government is a dollar not spent by you. Government grows at your expense.

More worrying to us are what budget economists call the "out years." In 2010, the White House only expects 3% GDP growth. This coming out of a protracted period during which GDP shrank at a more than a 6% annual rate.

Most economists believe that GDP growth of 2.5% or so, over a long stretch, is the minimum needed to revive job growth. As such, it will take a heck of a lot more than a brief burst of 3% next year to sop up the nation's 13.7 million unemployed.

Indeed, we need sustained growth of at least 3% for years for the economy to reach its potential. How likely is that?

Unfortunately, the smothering hand of government — including massive spending, thousands of new rules, government takeover of key industries, higher taxes on energy, capital and incomes, and up to $4 trillion in added deficits by 2012 — will be everywhere.

That's not a growth scenario — it's a stagflation scenario.

The Mythology Surrounding the Corporate Tax Rate

President Obama has gestured that he would like to close some of the loopholes that lower the rate, particularly with regard to foreign earnings, but absent a parallel reduction in the corporate rate itself, it’s charitably naïve for him to assume that corporations will let their profits lie in wait for the greedy hand of the federal government. When profits are targeted by the tax man, they often disappear. On the other hand, many on the right engage in similarly naïve thinking which suggests profits made overseas, if treated benignly by the feds, would return here such that jobs would multiply. That’s a nice thought, but as dollars are fungible, no matter their locale, they’ll always return here depending on the growth opportunities available.

It’s also frequently stated that businesses don’t in fact pay the corporate tax, but their customers do. What’s striking here is how many free market types buy into this notion. The obvious problem with it is that companies only pay corporate taxes after they’ve made a profit on the goods and services they sell. The prices of both reach market-clearing levels based on what the market will bear, so while corporations would doubtless love to pass taxes paid after profits onto their customers, simple market forces make this a logical impossibility.

Customers do, however, ultimately pay the corporate tax, but for reasons that often go unspoken. Indeed, profits earned by companies are the reward for doing well by their customers. The greater the profit, the more a firm has taken care of the unmet needs of its customer base. When corporations spend time avoiding taxes, as opposed to serving their customers, the latter suffer.

But more than customers, enterprising individuals are arguably harmed most by the corporate tax in the same way that high levies on the rich ultimately hit the non-rich most acutely. When governments succeed in expropriating the earnings of the rich, they reduce the amount of capital in the private sector that would otherwise be available to fund economic growth. Along those lines, it can’t be stressed enough that without capital, there are no wages.

Looking at the impact of corporate taxes on the individual, at first glance we should say that profits retained can be banked so that healthy companies can essentially save for a rainy day. When those profits are confiscated, companies have less of a cushion to tide them over when the unexpected occurs. This should be remembered by readers the next time they hear about mass layoffs within one or many corporations.

Taking this further, when corporations forfeit a percentage of their gains to the federal government, they by definition have less capital to invest in future growth. Democrats and Republicans both talk incessantly about their love of jobs, but in maintaining a tax on corporate profits, they’re allowing the very expropriation of capital that would in many cases fund the kind of expansion that would require hiring.

About the tax treatment of corporate profits, it ultimately must be said that when we tax business success, we create disincentives to greater success while robbing those same companies of their future. Better to abolish corporate taxes altogether so that companies have the incentive to be intrepid agents of growth, rather than careful evaders of the IRS.

In short, corporations very much do pay corporate taxes. But as opposed to passing on the pain directly to their customers, they do it in unseen ways that make them distracted servers of their customer base, and those distractions retard the kind of positive economic activity that if allowed, would lead to more in the way of employment opportunities.

May 13, 2009

Social Security and Medicare: Apocalypse When?

Everyone knew this day would come. And virtually every economist and actuary who had run the numbers could tell you, within a few years' certainty, the system was going bankrupt.

But all this seemed to happen in the distant future. Last year, both political parties virtually ignored the topic during their presidential campaigns. It became a non-issue issue.

Well, thanks to a profligate federal government, which will double the national debt to $11.5 trillion in just four years, and a recession that has weakened federal tax revenues, we can no longer ignore the problem. The day of reckoning is at hand.

The Social Security Board of Trustees reported Tuesday that costs will exceed revenues in 2016 — a full year sooner than expected just last year. And total assets — including more than 70 years of "surpluses" built up in the "trust fund" — will be completely gone by 2037 — four years earlier than in last year's report.

The deficit over the next 50 years is expected to be about 2% of taxable payrolls — up from 1.7% last year. By the way, changes in the last year alone have added $5.3 trillion in costs to the program.

Long-term, unfunded liabilities for Social Security and Medicare top $53 trillion — about four times the size of current GDP. Taxes must either rise or benefits shrink by that amount to close that gap.

"We should be neither casual nor hysterical about the revised insolvency dates," said Michael Astrue, commissioner of Social Security. "As with the economy as a whole, the Social Security system will weather this recession."

With all due respect, a little hysteria might be the best strategy right now. Fact is, the long-term outlook is made much worse by the recession. And the problems of Social Security and Medicare are structural — requiring a massive, root-and-branch reform that Washington seems unwilling to do.

Social Security should have been reformed a long time ago. When President Bush put private accounts on the agenda in a very minor way in 2004, he was roundly criticized. Congress did nothing — on either side of the aisle.

Now we must confront the looming bankruptcy of our federal retirement system. It shouldn't be this way.

The financial meltdown and recession, we've heard repeatedly, "prove" that private accounts are a bad idea. This is flatly false.

Andrew G. Biggs, an economist at the American Enterprise Institute, recently ran the numbers. On average, someone retiring this year can draw a Social Security benefit of about $15,700. If that same worker had a personal retirement account, based on historical returns in the stock market, he'd get $2,300 more than that.

That, after two of the worst stock-market downturns in history.

Funny, but the solution to our crisis looks like it's right in front of us. Private accounts would work, making our retirees richer and our economy bigger while easing the need for massive tax hikes later.

The only question is whether our leaders in Congress are brave enough and smart enough to do what's right — or whether they'll continue to fiddle as the nation's finances burn.

Obama Gets Tax Policy Backwards

But academic research on firms doing business overseas suggests that President Obama has it backwards. Overseas investments rarely cost jobs in a corporation’s home country. Instead, firms that expand overseas are generally businesses that are also growing in their home countries. They are businesses that make a country’s economy competitive worldwide. This is not only recognized by researchers who’ve studied the issue, but also by policy makers in other countries, which is why few other countries now try to tax their multinational corporations’ foreign profits in the manner that President Obama is proposing. The result, most experts concur, is likely to raise the risks of foreign expansion and discourage some firms from going abroad. That doesn’t increase jobs at home.

The notion that U.S. corporate expansions overseas drain jobs here is a vestige of the 1950s and the early 1960s, when American corporations dominated a global economy consisting mostly of European countries recovering from World War II, communist countries whose industries weren’t competitive internationally, and the developing world. In those days, economists believed, the most likely reason a firm would open operations overseas was to take advantage of lower costs in other countries, most especially lower labor costs.

But as global competition intensified, economists noticed something unusual: For the most part, corporations in richer countries, such as the U.S., or a recovering Europe and Japan, weren’t investing in poorer countries where costs were low. Instead, they were investing mostly in each other’s markets, where costs were comparable. This became known as the Lucas Paradox, the notion that overseas investment didn’t happen the way we would predict it should.

As the world economy has advanced in the last 35 years, this tendency of corporations based in wealthy countries to invest primarily in other wealthy countries has only grown: Despite the popular perception in the media that our global firms spend most of their effort opening up sweatshops in poor countries, in the latest period studied, between 1995 and 2000, multinationals in rich countries were five times more likely to invest in operations in other countries where labor costs were comparable, according to a 2005 study by economists from Harvard and the University of Houston.

What we’ve learned is that companies don’t expand overseas primarily to eliminate local jobs, but to tap into other appealing markets where, if they succeed, they only become stronger. And lots of research has confirmed this idea, not just about U.S. firms, but about multinationals in other countries too. Studies of the Italian, French and German economies have found that when a business in one of these countries makes a decision to expand overseas the move rarely results in a net loss in domestic jobs, according to research summarized by Harvard’s Mihir A. Desai in a new paper published by the National Bureau of Economic Research, “Securing Jobs or the New Protectionism?” In fact, a company’s successful overseas expansion brings advantages to a home country, according to a study of Japanese multinationals which found that firms that increased their overseas investments also increased their domestic employment at a growth rate from three-to-eight times quicker than job growth among purely domestic firms.

The same holds true for the United States and its shrinking manufacturing industry. Desai looked at who was responsible for the decline in manufacturing jobs in the U.S. from 1986 to 2003 and found that it wasn’t multinationals. In fact, they have been expanding their manufacturing jobs in the U.S. even as they have been investing overseas. Instead, “the rapid decline of manufacturing employment in the late 1990s and early 2000s might well best be understood as marking the exit of purely domestic, low-productivity players rather than the displacement of domestic activity abroad by multinational firms,” Desai writes.

This shouldn’t be surprising. It’s a difficult and risky leap to go from a domestic company to an international one, and for the most part companies that succeed at it are our strongest firms. In a global marketplace, they are the firms most likely to face down new foreign competitors entering the country. Short of high tariffs to punish foreign products and make them uncompetitive here, it is our multinationals that give us our biggest edge.

But for many politicians, the Lucas Paradox doesn’t exist. To them, the world is simple: Jobs that U.S. firms create overseas are jobs that they are not creating here. We shouldn’t reward firms for doing that with tax breaks.

And so, instead of cutting our corporate tax rate, the second highest among developed countries, to bring it in line with the rest of the world, or treating overseas profits in the same manner as most other developed nations which generally don’t tax overseas earnings, the Obama administration will make our corporate tax code more onerous. One result, the research suggests, will be less job growth here as some U.S. firms contemplating going international decline to do so because we’ve further reduced the returns from setting up foreign operations and increased the risks.

What the research tells us is that patterns of international investment by big companies defy easy characterization because firms behave in ways that surprise us. That’s not the kind of stuff that can be explained easily in a sound bite at a press conference or on the campaign trail.

For a president confronting a world that doesn’t conform to popular opinion, the options are clear. He can attempt to set the country on the policy path that makes the most sense and do his best to explain why. Or he can simply give people a policy that corresponds to their misconceptions. On corporate taxes, we know what course Obama is taking.

May 14, 2009

Obama’s ‘Public’ Health Plan Will Bankrupt the Nation

Think of it: Can anyone name a federal program that ever cut costs for anything? Let’s not forget that the existing Medicare system is roughly $80 trillion in the hole.

And does anybody believe Obama’s new “public” health-insurance plan isn’t really a bridge to single-payer government-run health care? And does anyone think this plan won’t produce a government gatekeeper that will allocate health services and control prices and therefore crowd-out the private-insurance doctor/hospital system?

Federal boards are going to decide what’s good for you and me. And what’s not good for you and me. These boards will drive a wedge between doctors and patients.

The president, in his New York Times Magazine interview with David Leonhardt, said his elderly mother should not (in theory) have had a hip-replacement operation. Yes, Obama would have fought for that operation for his mother’s sake. But a federal board of so-called experts would have told the rest of us, “No way.”

And then there’s the charade of all those private health providers visiting the White House and promising $2 trillion in savings. Utter nonsense.

And even if you put aside the demerits of a government-run health system, Obama’s health-care “funding” plans are completely falling apart. Not only will Obama’s health program cost at least twice as much as his $650 billion estimate, but his original plan to fund the program by auctioning off carbon-emissions warrants (through the misbegotten cap-and-trade system) has fallen through. In an attempt to buy off hundreds of energy, industrial, and other companies, the White House is now going to give away those carbon-cap-emissions trading warrants. So all those revenues are out the window. Fictitious.

Anyway, the cap-and-tax system won’t pass Congress. The science is wrong. The economics are root-canal austerity — Malthusian limits to growth. And there are too many oil and coal senators who will vote against it.

All of this is why the national-health-care debate is so outrageous. At some point we have to get serious about solving Medicare by limiting middle-class benefits and funding the program properly. There is no other way out. We can grow our way out of the Social Security deficit if we pursue pro-growth policies that maintain low tax and inflation rates. Prospects for that don’t look any too good right now, though it could be done. But government health care is nothing but a massive, unfunded, middle-class entitlement problem. (The poor are already in Medicaid.)

Sen. Max Baucus (D., Mont.) proposes to solve health care by limiting employer tax breaks. He’s on to something, but he’s only got half the story. All the tax breaks for health care should go to individuals and small businesses. Let them shop around for the best health deal wherever they can find it with essentially pre-tax dollars.

Additionally, insurance companies should be permitted to sell their products across state lines. And popular health savings accounts — which combine investor retirements with proper insurance by removing the smothering red tape — should be promoted. This approach of consumer choice and market competition will strengthen our private health-care system.

So private enterprise can coexist with public health care and not be crowded out by the heavy-handed overreach of government. But the Obama Democrats are determined to force through a state-run system that will bankrupt the country.

I’m not somebody who obsesses about the national debt or deficit. But I have to admit: Today’s spending-and-borrowing is blowing my mind. As a share of GDP, we’re looking at double-digit deficits as far as the eye can see. Over the next ten years, the CBO predicts federal debt in the hands of the public will absorb 80 percent of GDP. And that doesn’t include the real cost of state-run health care. Other than the temporary financial conditions surrounding WWII, we’ve never seen anything like this.

The president’s grandiose government-takeover-and-control strategies are going to make things worse and worse — that is, unless members of that tiny band known as the Republican party can stand on their hind legs and just say no. The Republicans must come up with some pro-competition, private-enterprise alternatives for health, energy, education, taxes, and trade that will meet the yearning of voter-taxpayers for a return to private-enterprise American prosperity and opportunity.

Free-market competition will lower costs in health care just as it has every place else. It also will grow the economy. The GOP must return to this basic conservative principle and reject Obama’s massive government assault.

Is The Republican Party A Distressed Asset?

President Obama hosted his first White House Correspondents’ Dinner this past weekend to much fanfare. While much of the dialogue seemed to be fairly predictable, the line above actually garnered a great deal of applause and is a very insightful point.

In fact, the Republican party is currently in trouble and does have a bit of a Rush Limbaugh problem. While Rush may not be a troubled asset, the Republican Party does need a bailout, or at least a massive makeover. We recently heard from a contact of ours who is a major conservative fundraiser and he wrote us the following:

“I was on the Hill this past Thursday. Very discouraging. Republicans seem exhausted. The party will take years to recover.”

Installing Michael Steele as the Head of the RNC and the recently completed listening tour by Jeb Bush, Mitt Romney, and various other Republican leaders are certainly steps in the right direction in reinventing the face and energy of the Republican party, yet this process is in its early days. In the meantime, the Democrats are consolidating power and President Obama’s polling numbers continue to improve, while the Republican Party is trading at cents on the dollar.

In the past, we have quoted the Rasmussen presidential approval rating as a proxy for how President Obama is doing in terms of popularity. We use this poll for consistency purposes and also because Rasmussen has been rated as one of the most accurate pollsters over the last decade. For the last five days, Obama’s approval index has been in the +7 to +9 range (this is the difference between Strongly Approve and Strongly Disapprove), this range is at its highest since the first week in April.

While that poll is interesting and indicates a shift up in approval for President Obama, an even more interesting poll is the right direction / wrong direction poll. Currently, 38% of likely voters believe the country is headed in the right direction. While this does not seem like a large number, it is a five year high and is the highest number of the Obama Presidency. In fact, it is up 11 points from his inauguration and 17 points from when he was elected. President Obama has inspired a view among likely voters that he is getting this country back on track and with this popular support will come even more political capital.

On April 28th we wrote the following in a note about Senator Specter’s decision to change parties:

“Make no mistake about it, the balance of power in the United States has officially swung to the left and as a result we should analyze both risk and reward accordingly with this new geo-political input.”

In that note we made the call out that one way in which we could see this power shift manifest itself was on unionization and the potential that Senator Specter would reverse his view on Employee Free Choice, which relates to voting on union representation. This shift in national political influence with the consolidation of Democratic power in the Senate and increasing popularity of President Obama, combined with the view that he is leading the country in the right direction, will also manifest itself in more subtle ways.

Specifically, the recent capitulation of bondholders in the Chrysler bankruptcy has the appearance of a situation whereby the bondholders are deferring to the strengthening power of President Obama and the Democratic Party. According to the Boston Globe, “The group eventually came to the conclusion that there wasn’t enough of them to withstand the enormous pressure and machinery of the US government.”

Obviously the bondholders are likely attempting to promote their own interest to the media, so the quote must be taken in context. Nonetheless, the context is concerning. Bondholders have rights and fiduciaries responsibilities, and in this situation chose to acquiesce to the government rather than aggressively pursue those rights. Clearly, part of the decision making process on the side of the bondholders was that they were not only facing off with the U.S. government, but one that has a popular executive branch combined with a consolidated legislative branch – so would be difficult to beat.

While this was a loss for the bondholders of Chrysler, it was also likely a leading indicator of future events. These capitalists had clearly weighed the risk / reward and decided that based on the potential for future interactions with the government, according to simple game theory analysis, the best outcome was to acquiesce on their position quickly and quietly. That said, not all investment managers have walked away from this situation quietly.

In fact, hedge fund manager Cliff Asness recently wrote the following in an open letter:

“Here's a shock. When hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back. However, they know, or should know, they take the risk of not being paid back. But if such a bad event happens it usually does not result in a complete loss. A firm in bankruptcy still has assets. It’s not always a pretty process . . .the above is how it works in America, or how it’s supposed to work.”


Continue reading "Is The Republican Party A Distressed Asset?" »

The Minimum Wage and Its Employment Impact

So, this summer, some of the 68,000 residents of this United States territory will celebrate the higher minimum wage. Their ranks are unlikely to include people who now hold the 2,041 jobs—12 percent of total employment, almost half of all cannery workers—to be lost when the cannery closes. And the 2,700 employees of Star Kist, the other American Samoa tuna canning company, will be hoping that they keep their jobs.

American Samoa’s loss is Georgia’s gain. Chicken of the Sea will move to Lyons, Georgia, (2007 population 4,480) employing 200 people in a new $20 million plant on a more capital-intensive production line.

It didn’t have to be this way. In January 2007, when Congress debated the bill that raised the federal minimum wage from $5.15 to $7.25 over a two-year period, the legislation originally did not include American Samoa. Until then, the Labor Department had set wage rates in American Samoa every two years, following an extensive study of economic conditions on the island. But before final passage, Congress included American Samoa.

The result was a big wage boost for residents of American Samoa. In 2007, the hourly minimum wage for fish canning and processing was $3.76. The minimum wage for government employees was $3.41. Shipping had the highest minimum wage, at $4.59. Garment manufacturers got the lowest, at $3.18 an hour.

Back in 2007 there might have been general rejoicing in American Samoa on hearing that many workers would get a raise. But not so. Governor Togiola Tulafono worried that increasing the minimum wage “would kill the economy” and Congressional Samoan Delegate Eni F.H. Faleomavaega forecast that it would devastate the local tuna industry.

Fans of minimum wage increases say the hikes have no depressing effect on the economy or on jobs, but American Samoans were smarter. They knew that industries would go elsewhere if they have to pay $7.25 an hour.

And they were right. American Samoa will lose not only the 2,041 jobs at the Chicken of the Sea canning plant, but also secondary jobs from the ripple effect of loss of income—stores and eateries that cater to cannery workers, shops that mend fishing nets, shipyards, and buses that transport workers.

In addition, the cost of goods sold on the island will rise, because the ships that exported the cans of tuna came back with products to sell to the American Samoans. Now ships with imports to American Samoa will have to return empty or stop at other destinations.

In a telephone conversation this week, Representative Vaito'a Hans A. Langkilde of the Ma'oputasi District #10, representing the villages of Leloaloa, Satala and Atu'u, described the prospective devastation of the community. His district is home to the two major tuna canneries, Starkist and Chicken of the Sea.

According to Mr. Lankilde, “Over the past 50 years the industry provided massive job opportunities for unskilled labor. The increase in the minimum wage was the beginning of the end for the tuna industry and the cause of massive job losses for our already fragile economy. The only way to resolve the trend towards total economic disaster is for Congress at its soonest opportunity to reverse its position.”

With the recent laying of fiber-optic cable linking American Samoa to the United States, Samoans could get jobs in call centers. Yet the higher minimum wage could discourage firms.

In his campaign, President Obama promised to increase the minimum wage to $9.50 an hour by 2011. This would drive even more jobs away from American Samoa. In the United States it would have the effect of shifting jobs from low-skill to high-skill workers, raising unemployment among those who are least equipped to handle it. Requiring employers to provide sick leave and paid maternity leave, legislation also under consideration in Congress, would cause additional low-skill workers to lose their jobs.

Rather than having to accept direction from a government thousands of miles away, where they have no voting representation, residents of American Samoa should be given the power to decide on their own minimum wage. And perhaps Congress should leave further minimum wage increases and employer mandates to individual states, to choose as they see fit.

It takes American Samoa to show us that higher mandated compensation causes workers with low skill levels to lose jobs. What can harm American Samoa can also harm the United States.

Short Sales, and the Uptick Rule Revisited

Back in the early ‘30s, much like last fall, federal curbs on short sales were put in place. But as is well known now, they didn’t arrest stock-market declines. This was unsurprising given the basic truth that today’s short seller in falling markets is tomorrow’s buyer as short sales are covered.

It was assumed back then that short sellers were driving down stock prices, but to suggest this was to ignore the many legislative mistakes that made shares unattractive. Those included, but were not limited to, the imposition of the Smoot-Hawley tariff in 1930 that retarded trade and the efficiency wrought by an expanding worldwide division of labor, FDR’s increase of the top tax rate from 62 to 79 percent, and our departure from the gold standard. In short, the blame placed on short sellers in the ‘30s ignored the true causes of ill health within the stock market.

And with stocks not having recovered in the way investors liked by 1935, another rule with regard to short sales was added to the previous ones. On May 27, 1935, the SEC ruled that no member of the stock exchange could “use any facility of the exchange to effect on the exchange a short sale in the unit of trading below the last regular sale price.” This was the “uptick rule” that so many want restored today.

It should be said that the Dow Jones Industrial Average rallied from 109 on June 1, 1935 to 190 by August of 1937 while this rule was in place. But were the two related? It has to be remembered that on the same day of the imposition of the uptick rule, the Supreme Court unanimously voted down the economy sapping National Industrial Recovery Act (NRA). As Hillsdale professor Burton Fulsom recently wrote, under the NRA, the federal government was enabled in its desire to oversee “how much a factory could expand, what wages had to be paid, the number of hours to be worked, and the prices of products.” The NRA turned entrepreneurs into lackeys of the state, with predictably bad results.

Further along, from August of 1937 to March 31, 1938, the Dow dropped from its aforementioned high of 190 all the way to 97; all this with the uptick rule in place. The imposition of the Wagner Act and the resulting rise in unionism no doubt played a role here, but this merely speaks to the importance of short sellers. Had they not been hamstrung by the uptick rule, they doubtless would have profited from the market’s aforementioned decline, but they also would have arguably arrested it above 97 given their desire to take profits on their short sales.

Shares ultimately recovered a lot of their gains by October of 1939 with the Dow at 155, but far from an effect of the uptick rule, this was merely due to the fact that the last significant piece of New Deal legislation was passed in 1938. By 1939, the makeup of Congress had changed for the better, FDR’s “court packing” scheme had failed, the Undistributed Profits Tax had been repealed, and with war possibly in the future, FDR knew well that he could no longer impose economy-enervating rules on business.

The uptick rule on short sales was softened somewhat in 1944, and it remained in place as was previously noted until 2007. Still, despite this allegedly bullish banning of bad news and trading from the markets, investors weren’t spared major declines in the ‘70s, in October of 1987, or during the Internet bust of 2000-2002. Bear markets don’t spring out of nowhere, or thanks to eased rules on short sales, but are the natural result of government error. In the ‘70s it was dollar debasement combined with high rates of taxation, in 1987 it was the threat of further dollar weakening in concert with looming protectionism and curbs on leveraged buyouts, and in 2000 markets reversed due to a deflationary dollar followed by the 2002 passage of Sarbanes-Oxley, a bill meant to turn entrepreneurial CEOs into accountants.

Looking at markets today, Benjamin Anderson once observed about inflation that it “may seem harmless for a long time and then suddenly break forth into great violence.” Anderson’s words describe this past decade well. For a time the falling dollar brought cheer to the housing sector, and banks prospered. But the money illusion can only last so long, and eventually the inflation which revealed itself in the gold price broke forth with great violence. Stocks hate inflation, and then the federal government piled on with economy-retarding stimulus plans and corporate bailouts that turned what should have been a relatively benign decline into something much worse. The uptick rule is being partially blamed for stock declines that history tells us we should have expected.

Peeking into the future, it should be hoped that the uptick rule isn’t reinstated. Unfettered markets when it comes to the trading of shares don’t so much cause market declines as they allow for markets to reach their natural level as quickly as possible. This alone is a positive, not to mention that the bearish short sellers who perhaps bug us when stocks are falling will, if left alone, give us cheer when they cushion the seemingly endless declines that bother us even more. Let’s ban the efforts to banish the uptick rule, a measure that would only serve to reduce the number of stock buyers when we need them the most.

May 15, 2009

The Hidden Agenda Behind Card Check

Under binding arbitration, if firms and newly-organized unions cannot agree on their first collective bargaining contract within 120 days, the Federal Mediation and Conciliation Service, a government agency headed by a political appointee, would set up arbitration panels to craft two-year contracts. Neither the union nor the employer would have an opportunity to choose any members of the panel, and the Mediation Service would write the regulations.

Unions want mandatory arbitration because they believe the threat of arbitration, followed by arbitration itself, will force employers to pay better compensation packages. That will help them recruit more members, providing a fresh infusion of funds for daily operations as well as for failing pension plans.

On May 11 a group of union pension fund investors, including representatives of the AFL-CIO and the Service Employees International Union pension plans, endorsed EFCA in a letter to Iowa Democrat Senator Tom Harkin, cosponsor of the Employee Free Choice Act, and Chairman George Miller of the House Education and Labor Committee. “As fiduciaries with broadly-diversified portfolios,” the signatories wrote, “we must be cognizant of these trends and their impact on our investments.”

Failing pension plans are a major problem for unions. Unions create these multiemployer, collectively-bargained plans in order to provide retirement income for workers in several different places of employment. This requires the union, the sponsor of the plan, to negotiate with each employer to join and contribute to the fund.

The health of pension funds can be compared by looking at reports that plans are required to file with the Labor Department. Union plans are in worse shape that non-bargained plans. In 2005, 87 percent of large non-bargained pensions had at least 80 percent of the money they needed to pay all liabilities. In contrast, only 61 percent of the collectively-bargained pension plans were at least 80 percent funded.

In 2006 the SEIU National Industry Pension Plan, covering 100,787 workers, had only three-fourths of the money it needed to pay benefit obligations of workers and retirees. And the Sheet Metal Workers National Pension Fund, although it guaranteed $7.4 billion in benefits to active and former workers, had accumulated only $3.1 billion is assets—less than 42 percent of the amount required to make good its guarantees.

Although pension plans have not filed their 2008 reports, the decline in the stock market over the past two years has undoubtedly made the financial positions of all pension funds, including collectively-bargained pensions, far worse.

The Pension Protection Fund of 2006 requires pension funds to meet certain actuarial standards, either by increasing contributions or by reducing payouts to existing and future retirees. Both options would be unpopular with members. What are unions to do?

Mandatory arbitration provides a solution by requiring an arbitration board to set compensation packages, including possible enrollment in collectively-bargained pension plans.

If the arbitration panel were to require a firm to join one of the many underfunded plans, the firm could well become liable for the pensions of workers, some already retired, of other firms. This would generate an inflow of new cash to the plan but harm the financial position of the firm. According to Brett McMahon, vice president of the construction company Miller and Long, “Strengthening underfunded plans is an unstated union motive for seeking mandatory arbitration.”

Under EFCA, if a trucking company were unionized by the Teamsters and could not reach an agreement with the union, the case would go to mandatory arbitration. Arbitrators could require the company to participate in a Teamsters pension fund, such as the Central States Pension Fund, which was 64 percent funded in 2006. This pension fund is used by United Parcel Service and other trucking companies.

Under a multiemployer pension fund such as the Central States fund, if some contributors go out of business then others have to pay the obligations. This concept is known as “last man standing.” Only if all the companies go out of business does the Pension Benefit Guarantee Corporation, a government pension insurance fund, reimburse workers a maximum currently set at $12,820.

With fewer workers joining unions, the collectively-bargained multiemployer pension funds are characterized by an increasing number of retirees supported by fewer younger workers. Many systems are typical Ponzi schemes, with new contributions paid out in benefits rather than being saved for contributors’ retirement.

Union pension funds can only survive through new contributions. That’s why unions will do anything to raise participant levels—including taking away secret ballots and forcing workers into underfunded pension plans.

America’s workers should not have to give up secure retirements in the name of a compromise on the Employee Free Choice Act. Just as workers deserve secret ballots in union elections, they also deserve the right to consider judiciously their labor contracts, and walk away from those that they deem unfair.

May 16, 2009

Story Time for the Economy

Speculative booms are driven by psychological feedback. Rising stock prices generate stories of smart investors getting rich. People become envious of others’ successes, and begin to wonder if rising prices don’t portend further increases. A temptation arises to get into the market, even among people who are fundamentally doubtful that the boom will continue. So rising prices feed back into more rising prices, and the cycle repeats again and again – for a while.

During a boom, people considering getting into asset markets weigh the fear of regret if they don’t against the pain of possible loss if they do. There is no authoritative answer about what the “right” decision is, and no consensus among experts about the proper level of exposure to these markets. Should it be 30 per cent in stocks and 70 per cent in housing? Or the reverse? Who knows? So the ultimate human decision must be based on the relative salience of these discordant emotional factors. In a boom environment, the emotional factors are biased toward getting into the market.

But one must ask what would sustain such a movement now. There seems to be no dramatic fundamental news since March other than the price increases themselves. The human tendency to react to price increases is always there waiting to generate booms and bubbles. The feedback is only an amplification mechanism for other factors that predispose people to want to get into the markets. The whole world can’t recover all of the enthusiasm of a few years ago from feedback alone, for there is a giant coordination problem: we are not all attentive to price increases at the same time, so we make decisions to buy at very different times. As a result, things happen slowly, and, meanwhile, more bad news may be revealed.

The only way world confidence can return dramatically is if our thinking coordinates around some inspiring story beyond that of the price increases themselves.

In my 2009 book with George Akerlof, Animal Spirits, we describe the ups and downs of a macro-economy as being substantially driven by stories. Such narratives, especially those fueled by accessible human-interest stories, are the thought viruses whose contagion drives the economy. The contagion rate of stories depends on their relation to feedback, but plausible stories have to be there in the first place. The narratives have substantial persistence in that they affect our views.

The story that drove the worldwide stock-market bubble that peaked in 2000 was complex, but, put crudely, it was that bright, aggressive people were leading the way to a new era of capitalist glory in a rapidly globalising economy. Such people became new entrepreneurs and world travelers on the way to prosperity. This narrative seemed plausible to casual observers, because it was tied to millions of little human-interest stories about the obvious successes of those — friends, neighbors, and family members — who had the vision 
to participate enthusiastically in the new environment.

But it is hard today to re-create such a narrative, given so many stories of trouble. The stock markets’ rebound since March seems not to be built around any inspirational story, but rather the mere absence of more really bad news and the knowledge that all previous recessions have come to an end. At a time when the newspapers are filled with pictures of foreclosure sales – and even of surplus homes being demolished – it is hard to see any cause for the markets’ rebound other than this “all recessions come to an end sooner or later” story.

Indeed, the “capitalists triumphant” story is tarnished, as is our faith in international trade. So, here is the problem: there isn’t a plausible driver of a dramatic recovery.

Starting an economic recovery is like launching a new movie: nobody knows how people will react to it until people actually get to see it and talk about it among themselves. Our efforts to stimulate the economy should be focused on improving the script for those stories, making these stories believable again.

This means making capitalism work better, and making it clear that there is no threat of protectionism. But the rationale must be to get the world economy out of its current risky situation, not to propel us into yet another speculative bubble.

Robert Shiller is professor of economics at Yale University and chief economist at MacroMarkets LLC.

Continue reading "Story Time for the Economy" »

May 18, 2009

Barack Obama's Risky Deficit Spending

But wait: Even these totals may be understated. By various estimates, Obama's health plan might cost $1.2 trillion over a decade; Obama has budgeted only $635 billion. Next, the huge deficits occur despite a pronounced squeeze of defense spending. From 2008 to 2019, total federal spending would rise 75 percent, but defense spending would increase only 17 percent. Unless foreign threats recede, military spending and deficits might both grow.

Except from crabby Republicans, these astonishing numbers have received little attention -- a tribute to Obama's Zen-like capacity to discourage serious criticism. Everyone's fixated on the present economic crisis, which explains and justifies big deficits (lost revenue, anti-recession spending) for a few years. Hardly anyone notes that huge deficits continue indefinitely.

One reason Obama is so popular is that he has promised almost everyone lower taxes and higher spending. Beyond the undeserving who make more than $250,000, 95 percent of "working families" receive a tax cut. Obama would double federal spending for basic research in "key agencies." He wants to build high-speed-rail networks that would require continuous subsidy. Obama can do all this and more by borrowing.

Consider the extra debt as a proxy for political evasion. The president doesn't want to confront Americans with choices between lower spending and higher taxes -- or, given the existing deficits, perhaps both less spending and more taxes. Except for talk, Obama hasn't done anything to reduce the expense of retiring baby boomers. He claims to be containing overall health costs, but he's actually proposing more government spending (see above).

Closing future deficits with either tax increases or spending cuts would require gigantic changes. Discounting the recession's effect on the deficit, Marc Goldwein of the Committee for a Responsible Federal Budget puts the underlying "structural deficit" -- the basic gap between the government's spending commitments and its tax base -- at 3 to 4 percent of GDP. In today's dollars, that's roughly $400 billion to $600 billion.

It's true that since 1961 the federal budget has run deficits in all but five years. But the resulting government debt has consistently remained below 50 percent of GDP; that's the equivalent of a household with $100,000 of income having a $50,000 debt. (Note: Deficits are the annual gap between government's spending and its tax revenue. The debt is the total borrowing caused by past deficits.) Adverse economic effects, if any, were modest. But Obama's massive, future deficits would break this pattern and become more threatening.

At best, the rising cost of the debt would intensify pressures to increase taxes, cut spending -- or create bigger, unsustainable deficits. By the CBO's estimates, interest on the debt as a share of federal spending will double between 2008 and 2019, to 16 percent. Huge budget deficits could also weaken economic growth by "crowding out" private investment.

At worst, the burgeoning debt could trigger a future financial crisis. The danger is that "we won't be able to sell [Treasury debt] at reasonable interest rates," says economist Rudy Penner, head of the CBO from 1983 to 1987. In today's anxious climate, this hasn't happened. American and foreign investors have favored "safe" U.S. Treasurys. But a glut of bonds, fears of inflation -- or something else -- might one day shatter confidence. Bond prices might fall sharply; interest rates would rise. The consequences could be worldwide because foreigners own half of U.S. Treasury debt.

The Obama budgets flirt with deferred distress, though we can't know what form it might take or when it might occur. Present gain comes with the risk of future pain. As the present economic crisis shows, imprudent policies ultimately backfire, even if the reversal's timing and nature are unpredictable.

The wonder is that these issues have been so ignored. Imagine hypothetically that a President McCain had submitted a budget plan identical to Obama's. There would almost certainly have been a loud outcry: "McCain's Mortgaging Our Future." Obama should be held to no less exacting a standard.

The Yin Yang of Value Creation and Value Capture

There are countless ways to create value. All must ultimately pass muster in the-eyes-of-the-beholder if they are meant to enter the economy as objects of exchange. Since this exchange is normally transacted using money, value capture can be readily measured in dollars providing a “score” that all can see.

You say that value capture can also be measure with non-economic factors like satisfaction and prestige? Of course. One must also take into account the counterproductive forces of envy. But however you total it up, economies only thrive when the motivations driving individuals to create value and the mechanisms determining who gets a chance to capture this value are in balance. Practices and policies that disassociate the two are not sustainable.

A scientist can create enormous value by publishing a breakthrough paper even if he never captures a penny of it. Satisfaction and prestige provide the motivation, along with lifetime tenure and the ease of living largely on the dole. A risk-taking entrepreneur can both create and capture value by bringing a new product or service to market, charging willing customers top dollar. Take away a shot at riches and the entrepreneur decamps to another clime. A hold up man or tax collector can capture value without creating any by sticking a gun in your face and taking your money. The former knows no law. The latter better understand that value creation and value capture achieve linkage through the rule of law, and there are lots of ways to get that wrong.

Which brings us back to our arguing ideologues.

Do you think collectivists will ever openly acknowledge that motivated individuals routinely add to the sum total of things-that-we-want, whether it’s a better way to sell a sack of potatoes or finding a cure for cancer? As obvious as this seems, advocates of zero-sum economic policy obsessed with redistributing wealth make no distinction between bank robbers who steal from others and inventors who earn and keep a portion of the value they create. The lack of acknowledgment that wealth is not prima-facie evidence of theft and that you can only distribute value that someone has been motivated to create is the sort of willful ignorance that drives laissez-faire capitalists crazy. Occasionally, this propels them into government office, ushering in transformations like the Reagan revolution.

One the other hand, do you think laissez-faire capitalists will ever openly acknowledge that financial intermediaries can sometimes become wizards at disproportionately capturing value created by others, even to the point of milking asset bubbles until they burst and crater the economy? The lack of acknowledgement that some forms of financial intermediation can metastasize into stealing is the sort of willful ignorance that drives collectivists crazy. Occasionally, this propels them into government office where they promulgate economic interventions that can grow to become worse than the disease they are trying to cure.

In catalyzing both the Reagan and Obama revolutions, the failure of incumbents to acknowledge these realities coupled with supporters’ attempts to defend the indefensible precipitated change. In both cases the ensuing excesses have, or inevitably will, foment counter revolution as political momentum sweeps economic policy back past the point of sustainable equilibrium.

The disturbing aspect of these pendulum swings is that we never seem to learn from them. Why are most people happy to talk past each other as they loyally defend their political tribe, grasping for their turn at the whip hand while refusing to acknowledge that the other side may have a point? Skillful politicians use this tribal fealty and lack of intellectual integrity to play us off against each other, warping the interpretation of both current events and the lessons of the past as it suits their reelection needs. Meanwhile, attempts to achieve a just and sustainable balance between those-who-contribute and those-who-are-rewarded continue to elude us.

It’s probably safe to predict that this circus will go on as long as politics exist. But imagine how much more effective we could be at dampening the swings if we withdrew our reflexive sanction from tribal chieftains and together leaned against the excesses they propose rather than leaning into them?

May 19, 2009

Obama's Chrysler Hold Up Sets Chilling Precedent

Thus the law was stood upon its head. The so-called “absolute priority” rule of bankruptcy demands that senior creditors be paid in full or consent to juniors jumping the queue. Andrea Belz, a management consultant in Pasadena, California, compares the strategy to that of private equity or venture capitalists owners, who “lend money to a company, so by calling in the note can seize control of the organization.”

There Will Be Consequences

“If you change the rules of the game, midstream and without prior notice, you make it riskier to become a secured lender,” warns Stephen Selbst, a Manhattan attorney with Herrick Feinstein. Upsetting established legal rights sends a signal. Now, more than ever, the American economy needs private investment to help shore up failing industries. The damage incurred by monkeying with the sanctity of contract law may exceed any benefits from sustaining a zombie car company.

Lenders, both secured and unsecured, will think twice about investing in distressed bonds, and if they do so, will seek higher interest rates. “It won’t make me less interested in being a lender to strong companies that are unlikely to fall into a government situation,” notes wealth manager Mike Martin in Columbia, Maryland. “But it will raise the risk premium demanded by junk bond investors or even eliminate the category.”

Investors should beware of an unrealistically short window for alternative bids. Is Fiat the ideal partner? The bankruptcy judge is allowing only two weeks to assemble a deal, a tall order indeed. A bankruptcy court normally permits a full and fair opportunity to market a company, to seek competing bids.

Disrupting the expectations of secured lenders creates a paradigm shift, and threatens to raise the cost of capital, a lifeline on which companies often survive. Belz points out a further risk. When new creditors exercise regulatory power, new interests may not align with those of commercially motivated investors. Suppose the government pressures the auto maker to produce green cars, as part of a social agenda, even if they are not economical? Such meddling may not dovetail with IRR, payback times, or other standard business drivers. A board member/creditor may not be acting with the company’s best interests at heart. Up goes the cost of capital again, indifferent as to whether President Obama “stands with” those making sacrifices.

Power of the Purse

The law could have been rewritten – in Congress. In another messy and complex bankruptcy case, the Italian government enacted changes to insolvency legislation in 2003. Selbst, who was involved in those Parmalat proceedings, maintains that the Obama administration neglected such an intermediate step. Since they might have made a legitimate public policy case, they might have succeeded. The question is, when does the ranking of recovery rights among classes take a back seat to the rehabilitative, fresh start principles of bankruptcy? Per Selbst,“at least there would have been a public debate.”

As the Chrysler bankruptcy unfolds, we will witness tension between two very equal interests, predicts Bob Dremluk, an attorney in New York with Seyfarth Shaw. There is no neat dividing line between haves and have-nots. The denigrated holdouts are not just greedy vultures, but are pension funds, insurance companies, and others to whom people gave money to invest. “Consider a schoolteacher,” Dremluk posits, “who paid money into a pension fund that is now in Chrysler bonds. On the other side, Chrysler workers and union members will lose jobs and funding. As you peel back the onion, both sides demonstrate compelling arguments.”

The American government has picked its winners and losers. With almost unlimited ability to print money, and thereby influence the regulatory environment, the administration can direct the workings of the free market. “Obama’s spin is that he represents all our interests, and puts himself in the same position as the rest of us,” Belz comments. “Most Americans understand being a shareholder better than they understand subordinated debt.”

The next chapter will focus on General Motors, which “could conceivably learn lessons from Chrysler to shape a bankruptcy case,” says Dremluk. That carmaker is much larger than Chrysler, and does not appear to be tempting buyers, the way Chrysler attracted Fiat. Right now, GM and its bondholders are jockeying to stay out of court. Unlike Chrysler’s, GM’s lenders are unsecured and have no lien, so rank lower in the pecking order. Again, however, the government is offering the union a better recovery than the bondholders, disfavoring speculators, and resorting to the power of its chequebook for pursuing industrial policy. It is fine to have a policy discussion, but the U.S. Bankruptcy Code does not draw those distinctions.

The Media's Broken Business Model

All that friction and industrial activity meant that there was huge money to be made in controlling the distribution of media. And because content producers have no access to consumers without distribution, distributors had all the power to influence content. But in the electronic age, when anyone with a computer can produce content and distribute it to anyone on the planet for little more than the cost of breathing, there’s no inherent value anymore to being a content distributor.

This has the big media distributors (you can name them: Murdoch, Redstone, Bronfman, Disney, Sony, iTunes, Bewkes, Sulzberger, not many others) realizing that they have to do something, anything, to protect their sinecures.

At this point, you may remember one of the Internet boom’s big gurus, Harvard Business professor Clay Christensen, the father of the “disruptive technology” meme. If you remember when you read his book ten years ago (while sandwiched into a coach seat on the cross-country redeye because you hit SFO too late to get an upgrade), one of his most key points was this: the best-run and most successful businesses are precisely the ones that are least able to change when change becomes necessary.

Apply that to the media industry, and you get the response that we’re all seeing from them: they’re madly trying to figure out ways to get you to pay for content, as you’ve always done in the past.

There are only two ways to do that. First, you can do what the music business has been doing for years to counter the threat from online sharing services: you can try to educate your customers into thinking that it’s their patriotic duty to pay you for content. (If education doesn’t work, you sue them.) Second, you can do what all media businesses have done for centuries: you can try to keep controlling the distribution media. The former is strictly for suckers. The latter isn’t going to work (the iPhone and the Kindle notwithstanding), because there’s simply too much free content out there that will compete with paid content, no matter how effectively media companies manage to restrict access to it.

Newspapers are a special case for several reasons. First, there’s the reality that printed local advertising has long had a huge amount of commercial value. The only reason this business hasn’t been totally subsumed by Internet search yet, is because of one of the few things that Al Gore got wrong when he first took the lead in inventing the Internet, back in the late Sixties: IP addresses are only weakly location-specific. Google can’t easily tell where you are, so they can’t easily show you an ad from your local Government Motors/Fiat dealership.

Because it’s easy to add editorial content alongside printed local and classified advertising, we’ve had for centuries a fourth estate which has now come to see itself as a coeval branch of democracy, a guarantor of our freedoms. The newspaper and broadcast-news business even have their revenue model enshrined in the Constitution (in the First Amendment), which they will defend and protect because their life depends on it, even as they deny that the rest of the Bill of Rights has any relevance outside of the late Eighteenth Century.

Now that model is coming to an end. Craig’s List and others will find ways to get local advertising out to the masses, which means there’s no reason but nostalgia to buy a local newspaper. (And why do you think, of all the companies that deal in prurience and pornography, none other than Craig’s List is now the target of multiple government probes into its role in enabling people desiring sex to find each other? It’s because Craig’s List presents an existential threat to existing media.)

If there’s no reason but nostalgia to buy a newspaper, then the people who print newspapers will spend the next few years staving off inevitable death. They’ll all try to emulate the success of the Wall Street Journal in inducing people to pay for content (which they pay for not because it’s good, but because business information is actionable for the few seconds before everyone else knows it). In so doing, they’ll shrink their readership drastically and create major new opportunities for alternative voices to spring up and find an audience. But because they’ll be making moderate amounts of money, they’ll call it “success.”

And where does that leave the proud profession of journalism itself? In a jam. By the serendipity of the local advertising models which enabled newspapers, and by broadcast rules which favored large networks for many decades, journalists have come to think of themselves as a special class, protected from the realities of the business world. Now that professional journalists are confronting the horrible fact that no one actually needs to pay attention to them, they’re falling back on the argument that we need them because they’re the defenders of truth and freedom.

This is where branding comes into the picture. Branding is one of the very few things left in our world of commodity production that can actually add realizable value to any product or service in a sustained way. People buy technology products from IBM not because they’re better (they’re not), but because they believe in IBM’s brand identity of safe, corporate power, projected by the three blue letters. People eat at McDonald’s because they know that, wherever they go in the world, the “golden arches” will give them a familiar, consistent experience.

And people keep reading the New York Times because it’s the fount of journalistic integrity and excellence. At least, that’s what the New York Times believes. They’re about to find out that people outside of the journalistic profession (and media junkies) keep reading them out of inertia more than anything else, and that they’ll flock to other media outlets when the Times tries to put everything behind a micropayment wall.

The point is not that people want to be well-informed. It’s that people simply want the illusion of being well-informed. They choose what to read not because they know how to tell which media sources are balanced and objective. (Who but committed political and cultural liberals would otherwise read the New York Times at all?) They choose what to read based on what their friends are reading, and on their sense of which media properties are “cool” at any given time.

That means that success in the new age of media will be determined by branding. Whoever manages to convince a large and sticky audience that, for whatever magical reasons, their media are worth reading and hearing, will win in the new age. It’s possible that some of the incumbent players will make this transition, but most won’t, and many people will succeed wildly that you haven’t even heard of yet. What’s certain is that no one will be able to build up a long-term successful enterprise based on controlling the means of distribution.

Again, this still leaves the journalistic profession without a clearly-defined place at the table. They sell themselves as having a monopoly on truth, which is laughable on its face. And yet if you look into the earnest faces of the icons of broadcast journalism (from Jim Lehrer all the way down to George Stephanopoulos), what you’ll never see is laughter. These are people who honestly believe they’re the arbiters of truth and objectivity.

Professional journalism no longer serves the market created by local and classified advertising. They do, however, have another critically important constituency: the government in Washington. The politicians and bureaucrats who control our lives depend on nationally-prominent journalists in a fundamental way. Because it’s impossible to observe its activities closely without seeing the deep corruption that animates it at every turn, populist government is only sustainable when abetted by a national press that is at once sycophantic to its power and respected by the people.

The kind of journalism that inhabits the New York Times, the Washington Post, the major broadcast-news organizations and CNN will not disappear. The government needs it too much, because national news is how the government does its PR. As the media business embarks on a bruising process of transformation, professional journalists will become a fourth branch of government in reality as well as in their own minds. Somehow, but inevitably, today’s mainstream news organizations will become government-sponsored entities funded with taxpayer dollars.

Are You Down With O.P.E.C.?

While there is a great deal of speculation as to what was driving the rampant rise in oil prices into the summer of 2008 (Was it the financial speculators? Was it the evil-doer short sellers?), the fact of the matter remains that based on the measurable data, "oil producers were operating at 98 to 99 percent of capacity". As the global oil market began operating closer and closer to capacity, it became even more susceptible to marginal changes in supply, such as those related to geo-political risk. Currently, OPEC is operating at about 4 million barrels per day of surplus capacity versus the 30-year low of 1 million barrels of surplus capacity in Q3 2008. The current level of surplus capacity is comparable to the level that was maintained for much late 1990s and early 2000s, when oil was at a much lower level even on an inflation adjusted basis.

This spike in OPEC capacity correlates with an increase in U.S. Crude Oil Days of Supply, which has been solidly above 25 days of supply since mid-March, which is a level not last seen since 1995 / 1996. This chart is outlined below. Clearly the major spike up in days supply has been a drop off in demand due to the recession and increasing unemployment, though there has been a sizable increase in domestic production on a y-o-y basis as well. In fact, from February to the week ending May 8th, 2008 domestic oil production in the U.S. has been up on average 5.7%. In aggregate for the year-to-date, the U.S. has produced ~4.163MM more barrels than the year before, which while not insignificant is still less than 10% of the 44.8MM build-up in oil stock we have seen y-o-y. Thus even if domestic production dropped back to levels from a year ago, we would still have had a surplus of oil domestically.

Despite these negative fundamentals, Oil is up ~33% in US$ year-to-date and we see a positive quantitative set up going forward. In fact, we see the TREND upside line at $77.09 versus the TREND support line at $47.94. Based on the current price of oil at ~$59 / barrel, we see a compelling risk / reward of $11 downside and $18 upside, with our TRADE support at $53.84.

The price of oil appears to be signaling one of two things: either demand will at some point in the near future accelerate or that there is a geo-political event on the horizon that will reduce supply.

In 2007, many corporate management teams responded the following way when we asked them about their macro view: "We have no crystal ball." In this case, we really do not have a crystal ball, but one thing we have learned in our careers is that price is a leading indicator and historically reported fundamentals are, by their very nature, a lagging indicator. As always, price rules.

Daryl G. Jones
Managing Director


Research Edge Macro Team


Continue reading "Are You Down With O.P.E.C.?" »

The Flat Tax vs. the Fair Tax

When it comes to tax simplification, the debate seems to come down to the merits and demerits of the Flat Tax and the Fair Tax. The former would tax income at one flat rate, while the latter would tax our consumption.

At first glance, it should be said that both tax solutions are dreamy when we consider their economic implications. Both, if applied correctly, would lead to the abandonment of all manner of deductions that distort behavior and retard economic growth. If either were passed, the economy would no longer suffer under economy enervating incentives that cause people to plow money into sinks of wealth like housing, not to mention the purchases of federal and municipal debt that would be much less attractive absent their tax advantages. For the abolishment of the various deductions alone, the economy would boom given the more rational path that capital would take in the direction of productive investment.

Regarding the flat tax, its greatest appeal is its simplicity. As its most prominent advocate (Steve Forbes) frequently notes, under a flat tax individuals could calculate what they owe the federal government on what would amount to a postcard. The potentially greater unseen here would be the economic boost that would result from smart minds producing, rather than evading the tax collector, not to mention all the money formerly consumed on lawyers and accountants that would flow into the productive economy.

Assuming these taxes weren’t withheld, but instead were paid on a monthly or quarterly basis, the dynamism of the flat tax would be even greater. Indeed, one problem with tax withholdings is that individuals don’t as much feel the sting of writing a check to the federal government with regularity. If this were to be implemented under a simplified tax code, Americans would become intimately aware of the cost of government, and hopefully ask for less of it in return for lower tax bills.

The obvious negative of a flat tax has to do with the basic truth that taxes on income are a price put on work. Work is penalized when income is taxed. And while the most productive among us would presumably embrace with vigor a lower, flatter rate, there is the problem that usually materializes under low rates of taxation whereby the rich provide the vast majority of federal revenues. In that case, it seems a flat tax perfectly applied would include a ceiling after which the rate would go to zero.

Considering a consumption tax, or what its advocates call the Fair Tax, if applied correctly this is surely the ideal tax. Rather than a system that penalizes work and savings, we should have a tax that only shows up when we consume. This would insure that more money would be saved and flow to productive investment, plus with each purchase, Americans would see up close the horrific cost of government.

It’s pointed out by many that a consumption tax would be more equitable for those in the underground economy paying their share of taxes given the difficulty of evading taxes assessed at the time of purchase. On its face this is a positive, but it could be argued that we shouldn’t cheer big increases in government revenues. We shouldn’t because rather than save those revenues for a rainy day, governments invariably use revenue spikes to create new programs that are difficult to sunset. Higher revenues could well be the result of flat or fair taxes, but this wouldn’t necessarily be a good thing.

Naysayers suggest that a consumption tax is regressive due to the reality that the poor almost by definition consume more of their total income. But those naysayers speak with a forked tongue. Indeed, out of one side of the mouth they decry regressive tax rates, but out of the other they frequently wail about what they deem the ‘wealth gap’.

The problem there is that the only way for an individual to amass wealth is if that individual saves. The beauty of a consumption tax is that it would drive incentives among the non-rich to save more, and in doing so, build their wealth. The alleged regressive nature of taxes on consumption would in fact reduce gaps in wealth. It says here the wealth gap is not a problem – if anything it’s a positive for the risk taking it engenders – but if a reduction of wealth inequality is the goal, a consumption tax is the answer.

Another potential negative of a consumption tax involves the certain frenzied lobbying that would ensue for exemptions. With “our children’s future” used as an excuse, the education and book publishing lobbies would seek exemption from the tax altogether. Following them outside the office of each legislator would be the lobbyists for every weak industry in the United States (think carmakers, airlines, newspapers to name three) looking for similar exemptions. The good would likely outweigh the bad, but it’s not unrealistic to fear that the imposition of a consumption tax would also lead to a process whereby exemptions would serve to prop up the weak, thus blunting the healthy process of Schumpeterian “creative destruction.”

Despite the negatives mentioned about both taxes, assuming either were a possibility, it would be foolhardy to let the perfect be the enemy of the good. At present, our wildly complicated tax code saps our productivity all the while driving massive amounts of precious capital away from the productive economy. Be it the Fair or Flat tax, either one would drive massive economy-wide gains alongside large wage increases for all.

So while things may look bleak today, the looming failure of our bipartisan flirtation with collectivism means that somewhere down the line there will exist the opportunity to right our economic course. Here’s hoping that when that day comes, the coalitions are in place to push through the very tax simplification that would forever discredit the impoverishing notion suggesting we’re better off economically when we penalize the work and savings of the productive.

May 20, 2009

Capitalism and the Cheating Ethic

In Sunday’s personal account of his troubles, Andrews remarkably admits that he was fully intent on using deception, in the form of a liar’s loan, to get his own mortgage. In August of 2004, just two months after his Times story about the increasingly irrational mortgage market, he resolved to buy a $460,000 home in Silver Spring, Md., for himself and his new fiancée. The problem is that he had just $2,777 a month left from his paycheck after paying $4000 in a month in alimony. And so, following his mortgage broker’s advice, Andrews did not list the alimony payments on his application, though the standard mortgage form explicitly asks for such information. To accomplish the deception he applied for a no-doc loan so he wouldn’t have to submit income tax returns or pay stubbs, which would indicate that alimony payments were being deducted from his paycheck.

Still, basic underwriting procedures almost foiled him. A credit check by the lender’s underwriters revealed he was still carrying a mortgage on the home his ex-wife lives in with his kids, which raised questions. So Andrews shifted tactics. Knowing that he couldn’t own up to the divorce without owning up to the alimony payments, he applied instead for a “no ratio” mortgage that doesn’t calculate a borrower’s debt-to-income ratio, so he wouldn’t have to worry about the underwriter asking uncomfortable questions about the house that was still in his name. After he got a mortgage using the new application Andrews admitted that he couldn’t shake the feeling of “having done something bad,” but he also admitted he felt “kind of cool” for making such a big score.

At this point I leave it up to you to decide whether Andrews is guilty of mortgage fraud or not, though the good nuns who educated me in grammar school would have pointed out that his intent was clearly to cheat. Still, it is emblematic of the culture of home lending in the bubble that rather than report Andrews for filing a fraudulent application, the lender, American Home Mortgage, merely let him re-file for another kind of even riskier mortgage. And so, American got what it deserved when Andrews, awash in debt, eventually defaulted on the loan. The only problem is that so did tens of thousands of other borrowers of American, which eventually collapsed and was seized by the government--costing taxpayers untold millions.

Since Andrews published his provocative personal story a few days ago, the tale has evoked online comments ranging from outrage at his taking out so much debt, to empathy at his predicament. But what I find remarkable is that a Times reporter would admit in so blunt a way his intention to defraud—a fact which itself has caused barely a ripple of comment. It’s a reminder that during the housing bubble cheating became so commonplace that those who did it were barely considered to be engaging in fraud. While authorities have pursued rings of con artists who used the mortgage market to swindle builders and banks, the kind of ordinary, everyday deceits that went on have largely been ignored, though they probably played a far greater role in the market’s meltdown than we understand.

The FBI says reports of mortgage fraud increased a whopping 10-fold from 2001 to 2007, while mortgage servicers who have investigated portfolios of bad mortgages have found as many as 70 percent had “misrepresentations” on them. It is possible that hundreds of thousands, and even millions, of borrowers, brokers and salespeople cheated over the space of just a few years, helping to bring down themselves and an entire industry, and contributing mightily to the economic and fiscal predicaments in which we find ourselves.

The German sociologist Max Weber once noted that capitalism was not the pursuit and accumulation of wealth by any means—something that lots of societies had engaged in over the millennia. Rather, Weber noted, what set capitalism apart was that it was an ethic which evolved for “the pursuit of profit, and forever renewed profit [Weber’s italics], by means of continuous, rational…enterprise.” Looking out over the brief history of capitalism when he was writing in 1904, Weber observed that America best embodied this capitalist ethic thanks to what he described as our “ideal of the honest man of recognized credit.” Although we had our share of con men, speculators and robber barons, nevertheless in America, Weber noted, “the infraction of [capitalism’s] rules is treated not as foolishness but as forgetfulness of duty.”

That was a long time ago, apparently. Today, the infraction of capitalism’s rules is opportunity for a publishing contract. Andrews’ remarkably frank tale of his mortgage failings is going to be published in a provocatively titled book, "Busted: Life Inside the Great Mortgage Meltdown,” even while the rest of society grapples with the fallout from such misdeeds.

Is there a larger consequence to such shifts in attitudes? Adam Smith would certainly have thought so. A moral philosopher, Smith laid the groundwork for his ideas on trade and commerce in his first book, Theory of Moral Sentiments, in which he traced the evolution of mankind’s ethics from our nature as social beings who feel bad if we do something that we believe an imagined impartial observe would consider improper. Out of this basic mechanism for making judgments, what Smith called sympathy and modern psychology calls empathy, we create civilizing institutions, like courts of law, to help us govern our economy as it becomes more complex. Over time a society relies on these institutions to reinforce our individual values.

But when real neutral observers—a book agent, an editor at a newspaper, the paper’s readers—no longer blanch at outright deviousness so frankly told, society has lost the mechanism that restrains its citizens from widespread cheating. That’s exactly what happened in the mortgage meltdown, when untold numbers of applicants, their brokers, real estate agents and assorted others openly discussed how to collude in obtaining mortgages through fraudulent means without stopping to consider the implications for society as a whole. And without the slightest sense of embarrassment, apparently.

Insured Capitalistic Failure Looms; Once Bank Bitten Twice Shy

Some are concerned that commingling public-private monies will lead to free-market and societal paralysis. Paradoxically, venture capitalists that may have come up with a cure for this psychological paralysis now find their free-market umbilical cords clogged with public regulations if they say "Yes” to TARP. Will any say "yes"?

The long-run corporate capital structure mutations will not be fathomed for many months, perhaps years. This cloud of uncertainty will work to cripple valuations, as yet other micro elements of our financial system are deemed too big to right themselves. Risk capital will likely shy away from the TARPed public-private insurance companies (LNC and HIG?). The stigma of 'government run' will induce the talented to exit TARPed doors, severely damaging the ability to attract risk/growth capital.

Perhaps we should in fact blame these insurance CFOs for mismanaging balance sheets and now holding their bloody palms out to government, yet greater shame on Big Brother for endorsing such anti-capitalistic measures and creating what Pimco's Mohamed El-Erian coined the ‘new normal’. Our Capitalist Pig Bob actually calls it the "new abnormal."

If the government was to step away from private sector bail-outs today, and not act as the arbiter of "who fails and who succeeds”, the U.S.'s capitalistic cow the world has milked for a two hundred years would heal itself and rise up to the healthy "new normal" referred to by the brilliant thinker El-Erian.

Government cannot insist on public-private capitalistic risk, as the government is the lender of last resort and ironically deemed too big to fail in university text books. The words backed by the "Full Faith and Credit of the U.S. Government" come to mind. Well, that phrase must be reprinted if the government continues on its path of adulterating private balance sheets. A more sensible wording today would be: backed by the "Full Faith and Credit of the U.S. Government and the Many too-Big-to-Fail Public-Private Sectors."

Long live Wall Street, long live winners and losers, capitalists and socialists, peaks and troughs, bubbles and busts, fear and greed, all necessary micro and macro phenomena. What made the U.S.A. the model capitalistic society, and what enables healthy market cycles is fewer political strings, not more. Even though this latest economic bust was arguably more costly and psychologically painful than any in the past, we realize every generation goes through a time when they feel the world is coming to an end. Yet the beauty of capitalism is rooted in risk takers. Take the winners and losers away and our free-market future dies.

Capitalist Pig Bob thinks the reaction from the donkey regime today is too extreme and will have far worse consequences than allowing free-market organic evolution to right itself. Entrepreneurial seeds that would have been sown if normal market forces allowed bankruptcies will now be hoarded. The current regime is more concerned with social welfare than Darwinian capitalistic evolution. What does Barack, Tim, Larry, Paul to pay Peter not understand?

The midterm elections will fall on Nov, 2, 2010. We are monitoring the behaviors of the Washington D.C. donkeys and elephants. Never before has the bell tolled so loudly against free-market capitalism. Perhaps one of the aforementioned species is on the verge of Capitol extinction: you decide.

Continue reading "Insured Capitalistic Failure Looms; Once Bank Bitten Twice Shy" »

May 21, 2009

Obama's Upside-Down Energy Logic

Days after Mr. Obama’s inauguration, the new president declared, “It will be the policy of my administration to reverse our dependence on foreign oil while building a new energy economy that will create millions of jobs.”

Yet in the 2010 Budget that he sent to Congress earlier this month, Mr. Obama specifically seeks to raise taxes on domestic oil exploration by $31 billion over 10 years, a larger tax increase than on any other industry. In addition, oil and gas producers would bear a disproportionately heavy share of other tax increases on business, more than $320 billion.

The ostensible rationale for these tax hikes is that the current tax system “distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent expensing encourages overproduction of oil and gas, it is detrimental to long-term energy security…” This reasoning is repeated eight times in the Treasury Department’s Green Book, a description of proposed spending and revenue changes in the budget.

No mention anywhere in the Budget of the distortion of the $60 billion in expenditures in the stimulus bill to “reduce dependence on foreign oil and create long-term, sustainable economic growth in the green industries of the future.” Subsidies for renewable energy, only four percent of America’s energy supply, and more than would occur under a neutral system, are acceptable to President Obama. But a tax structure that encourages the production of oil, 39 percent of America’s energy share, is termed “detrimental.”

Mr. Obama’s proposals include increasing effective income tax rates on oil and gas to levels higher than for other manufacturing industries; disallowing “write-offs” for certain types of extraction equipment and exploration methods; levying a new excise tax on Gulf of Mexico oil and gas; and taxing carbon emissions through a “cap and trade” program.

If America is to reduce use of imported fuels, it needs to raise domestic production as well as to conserve. This increases our long-term energy security, rather than harming it. Every single additional barrel of oil produced in America is one barrel fewer that we need to import—and as we produce more at home, we employ American workers and produce revenues for all Americans.

No one knows the full extent of American oil and natural gas reserves, and to move towards energy independence, it pays to be looking. In 2007 200 trillion cubic feet of natural gas, equivalent to 33 billion barrels of oil, about 18 years of U.S. oil production, were found in the Haynesville Shale rock formation in northern Louisiana. Texas, Arkansas, and Pennsylvania are also home to new gas fields. New optimism about gas reserves and production has been pushing prices down. With the fuel there, why discourage production with new taxes?

Rather than leading towards energy independence, Mr. Obama’s proposals would drive oil and gas production abroad and make American oil and gas uncompetitive in a global market. The levies would punish domestic American companies and benefit countries with large reserves such as Venezuela, Saudi Arabia, Iran and Russia. Does Mr. Obama really want these countries, all under fire for their neglect of human rights, to get richer at our expense?

Until America has technology to operate its 250 million motor vehicles without gasoline and natural gas, we need more domestic exploration, not less. At some point, maybe later this year, maybe in 2010, our economy is going to shift to post-recession recovery, and oil and gas consumption are going to rise. We want to avoid $5 gasoline and sky-high home heating bills.

Although Congress is spending billions of dollars to create jobs and promote energy independence, President Obama wants to deny access to development of our own oil and gas resources in some of the most geologically promising areas available, and to increase the tax costs of developing these resources.

This is upside down logic. If enacted by Congress, it would make us less secure.
Congress might succeed in imposing draconian efficiency standards on automobiles and appliances; requiring electric utility output that comes from renewable sources—wind, solar, geothermal, biomass—to rise from 4 percent now to 25 percent in 2025; and mandating greenhouse gas emissions in 2050 that are 17 percent of 2005 levels. (Whether Congress could enforce such wildly optimistic goals is a question.)

Americans might become greater conservationists, prodded by guilt or by higher energy taxes. But even if they do, they will still need oil and natural gas for driving, home heating, and electricity generation for many years to come. If Mr. Obama is serious about pursuing energy independence, he should withdraw his proposals to increase taxes on domestic oil and gas production.

Up From Poverty

A Theoretician’s Paradise

Traditional explanations of America’s success—our exceptional national character rooted in the Mayflower Compact, our heritage of liberty and equality stemming from the Declaration of Independence, the unique presence of our frontier, our unparalleled capacity to innovate—have been, if not exactly refuted, at least written out of “enlightened” discourse by revisionist social, political, and historical scholarship. Retreating to economics provides no certain perspective: the discipline has produced a wonderland of competing theories. Some attribute America’s growth to free trade; others retort that the U.S. was protectionist during its years of growth. The role of institutions is highlighted by some, while others reply that the U.S. succeeded in spite of a poor institutional structure. Despite the fact that we don’t really know what caused the acceleration of our own growth, the literature on economic development operates from the premise that not only do we know, we know how to engineer the growth of other countries as well.

Only within the past 20 years has development economics produced comparative data on the behavior of various national economies. Lacking data, the discipline had in the previous three decades become a theoretician’s paradise. Every theory was as good as another—none could be proved or disproved. This empirical dearth can be ascribed, at least partly, to context: it was during the Cold War that international development emerged as a popular intellectual pursuit. We needed a strategy right away to ensure that fledgling democracies were able to outgrow Communist regimes notorious for their false promises of economic competence. State-funded aid, official gifts, and even bribes to foreign governments were intended to shore up sometimes democratic and sometimes capitalist allies that might otherwise by force, temptation, or inertia find themselves drifting into the Soviet orbit.

As an early part of this Cold War strategy, the Marshall Plan, in addition to its undisputed success in rebuilding war-shattered economies and helping to keep the western half of Europe free, produced one major unintended consequence. Experts with necessarily limited perspectives stretched the Marshall Plan approach to non-European nations, many of which had been desperately poor throughout their histories. The U.S. thus provided aid even where there were no economies to restore. At first, we simply determined to go through the motions (and garner the supposed goodwill that results from public acts of generosity), even though we didn’t honestly believe modern economies could emerge in, say, Africa.

In time a consensus theory did emerge, one that all but ruled out the possibility of the emergence of modern economies anywhere they didn’t already exist. Formal development theory can be said to have rested on three assertions—all of which should have discredited it. One was that ethno-cultural characteristics limited the likely spread of modern capitalism. The leading books of the time clearly show that the academic establishment was certain that (say) Hinduism and Confucianism operated as impenetrable bars to economic growth. At best, India and China (if even mentioned!) could hope for subsistence futures, though social disintegration was held to be more likely. The second was an unswerving focus on natural resources as the key to growth. This unreconstructed colonialist worldview—extract what you can and send it home, or at least abroad—drove the construction of massive public infrastructure (in large part to move material to port), littering poor countries with projects that to this day look like incongruent artifacts of western economies that never emerged. Finally, and most tellingly, development theory aggressively argued that economic growth was possible only in the absence of population growth; raising indigenous agricultural production to levels high enough to sustain high birth rates was assumed to be impossible. This tenet above all should have been suspect even at the time. It was already well known that, between 1820 and 1920, the population of Europe increased at an unprecedented rate—while Europe enjoyed rapid economic expansion. Yet the former was explained away as a result of the latter when in fact it was one of the causes. (Similarly, today’s anti-growth literature ignores the trend, which emerged in the second half of the last century, that as populations become richer their birth rates decline.)

Later, however, this endemic pessimism gave way to some cautious optimism. Economist Walt Rostow argued in the 1960s that sufficient capital had to be present in an economy for it to reach the point of “take off.” Poor countries’ development was held back by a lack of capital: expanding populations consumed resources too fast for capital to accumulate. The answer, therefore, was to provide generous infusions of foreign capital.

But any hope of establishing self-sustaining economies was doomed by the method of intervention. A lesson of America’s record of growth—that development is often, despite government involvement, messy and unpredictable—was shelved. Aid administrators preferred instead formula-based, orderly, central planning. Much of the mental framework for our own overseas economy-building efforts was borrowed from Soviet theory and practice. The foreign policy community held a tight grip on the process, and insisted that only schooled experts could deploy development grants and organize internal resources to achieve “self-sufficiency.” America’s success was not a model to be emulated or a goal to be sought. Other countries would have to learn to do with less—even after factoring in all that American, and later developed-country, largesse. Indeed, first generation thinking on economic development took for granted that the populations to be assisted were intrinsically incapable, or perhaps unworthy, of building and sustaining a modern economy. Much of early (and, sadly, contemporary) development policy is tinged with a kind of paternalism that implicitly despairs of other races ever managing their own growth.

Eradicating Poverty

After capitalism’s victory in the Cold War, interest in development waned. Lately, however, economic development has returned to fashion, mostly because the “take off” that Rostow theorized is occurring all over the world. In the touchstone year of 1820, 84% of the world’s population lived in what would today be judged “extreme poverty.” Today, only 16% do. That is such an astounding achievement that it is difficult even to comprehend. According to the World Bank, in the last 30 years alone—a time of rapid globalization—the number of people living in extreme poverty fell by 25%, or 500 million people. The outbreak of entrepreneurial capitalism within the Communist political system of the People’s Republic of China accounts for most of this achievement, but almost every region of the world has seen a decline in the share of its population living in extreme poverty. Bright spots such as Israel and Mauritius, moreover, have proven that growth can occur in regions previously thought allergic to it.

All this appears to have happened in the absence of, or even in spite of, those infusions of foreign aid once presumed to have been poor countries’ only hope. In fact, the one factor we can say with certainty is a force behind global growth is capitalism—a reality stubbornly resisted by those who seem blinded either by the now fashionable resistance to growth, often dressed as anti-globalism, or by their unbreakable embrace of planning as the predicate for economic success, or both. But beyond that connection, which not even capitalism’s most fervent supporters would say explains everything, lies continued uncertainty. We still don’t know why this economic development happened, or how it ever happens. Brilliant economists have developed elegant models to explain the “why” of growth after the fact. Theories, however, are supposed to be predictive. No honest economist would argue that such models could help a country lay out a practical strategy for making growth certain, or even more likely.

Appreciating this reality helps us weigh several recent contributions to the development literature. In his recent book, One Economics, Many Recipes (2007), Harvard professor of international political economy Dani Rodrik wisely reminds us that there exists no general theory of growth, though he offers pragmatic suggestions in individual cases. In many ways this is an anti-planning book but it is unlikely to be read as such. Many will inevitably see his advice as merely a different way for outsiders to impose answers that necessarily involve more capital investment from the West. Those readers—looking for justifications to continue Western aid programs—are likely to overlook Rodrik’s careful elucidation of how the eradication of poverty is the natural result not of foreign aid but of the emergence of free market economies.

In this regard, One Economics, Many Recipes echoes a sound and sober work of some years back by Deepak Lal, The Poverty of “Development Economics" (1989). Lal, a professor of international development studies at UCLA, characterized the debate among development experts as polarized between state-guided capitalism, a descendant of Keynesian thought, and classical laissez-faire liberal economics. He called the former “dirigiste dogma” and declared that it rejected much of what modern, empirical economics has to teach. In later editions of his book, he contended that the restoration of confidence in markets in the 1980s, more or less formulated in what came to be known as the Washington consensus, had two unintended consequences. First, it provoked a backlash in many developing countries and among many Western observers. And second, it became conflated, unfortunately, with the view that the welfare state, too, had to be exported to poor countries.

Planning Utopia

The title of Jeffrey Sachs’s new book, Common Wealth: Economics for a Crowded Planet (2008), suggests its argument: because the developed world is not generous enough with its wealth, some of it must be seized to prevent the rest of the world’s further impoverishment. For Sachs, a Columbia University professor, advisor to the secretary general of the United Nations, and author of the credible earlier work, The End of Poverty (2005; a book strangely out-of-step with his recent work), the very presence of poverty in the world demonstrates the failure of international economics. There are too many people, too little water, not enough of the right kinds of foods, too much carbon emission, and too unquestioned a reliance on the nation-state’s right to operate without regard to global welfare. The only reason poor people still suffer on our rich planet is because markets have failed them. Sound familiar? The vicious-cycle thesis of the last century reemerges as the “poverty trap” of the new. The only acceptable, moral choice is for rich nations to send money. Common Wealth is, by any account, a political book—one that aspires to recruit and satisfy an audience that wants complex public policy to be as accessible as an issue of Vanity Fair.

This prescriptive approach is entirely consistent with Sachs’s broader solution: tax the incomes of rich countries, i.e., extend redistributionist policy beyond the boundaries of the nation-state. Because the nation-state is part of the problem, deploying the accumulated wealth of the world should fall to more informed and neutral non-governmental organizations. (NGOs are the deus ex machina in market-skeptical literature these days.) The long-awaited world free of poverty, deprived of the ultimate cause of war, is within our grasp and Sachs provides the prescription. Surely, a Nobel Prize awaits this kind of contribution.

This book would run the risk of becoming a contemporary gazetteer of utopian thought but for two disabilities: it is much too ambitious and it is poorly written. Embracing “millennium goals” set by the U.N. and invoking a transnational income redistribution might stir applause at undergraduate convocations but the “real world” won’t be moved. Looking to the U.N. for a solution falls outside the constraints of reality.

Economists are reflexively nervous with utopian solutions, especially when these involve enlightened cooperation among the governments of the world which will allegedly cede authority to yet wiser NGOs, entities supposedly above the malignancies of political (and democratic) institutions. Nothing in economists’ understanding of reality suggests that such thinking can lead to anything that will improve human welfare. To the contrary, excursions down these paths have mostly brought genocide, corruption, police states, and the erosion of individual freedom and creativity.

Muhammad Yunus, a Ph.D. in economics who won the Nobel Peace Prize, disregards all such evidence in Creating A World Without Poverty (2008). Having created Grameen Bank, an institution that increased remarkably the welfare of millions of the world’s poorest in Bangladesh through the innovation of micro-credit, he appeals for a new world economic order that does not contemplate growth. “The bigger the world economy, the bigger the threat to planet Earth.” For global welfare to increase, he argues, capitalism will have to be reformed through “social businesses”—entities that put people above profits.

The book is all nostrums and set-piece stories. The reader is left without a clue as to how this new capitalism might be formed or, more importantly, how it might improve human welfare. Yunus might have expounded the lessons of Grameen Bank so that others might expand on his success. He might have described, perhaps, a transitory state of capitalism, in which an innovation in the non-profit sector could be marshaled to help a poor nation reach the point of “take off” into a modern economy. But to understand that, we must turn elsewhere.

Realism and Foreign Aid

William Easterly’s masterly assessment of foreign aid, The White Man’s Burden: Why the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good (2006), is a sober reflection on what really has—and hasn’t—worked. The author, a professor of economics at New York University, concludes that growth is fundamentally driven by local factors that are difficult for outsiders to notice, much less understand. In short, there is no template. In this regard, he anticipates Rodrik’s insight that for outside intervention to have a positive effect, it must be carefully tailored to local circumstances. Development is the product of “searchers”—entrepreneurs, accountable politicians, and the rare aid workers—who take measured risks hoping for large payoffs. Easterly argues that development interventions most often fail because professional aid culture insists on planning within a static framework that seldom engages the target population and never allows for feedback.

A realist of the first stripe, he sees aid as more likely to create worse misery, largely because it does not accept that recipient countries can ever become competent capitalist economies. Implicit in his analysis is that planners—most often careerists who rejected making their way in the private sector—are opposed or at least indifferent to private market solutions. Such assumptions infuse the process of aid with a desperation that may explain why so much corruption is tacitly underwritten and tolerated.

Oxford economics professor Paul Collier helps us understand this trap. In his book The Bottom Billion: Why The Poorest Countries Are Failing And What Can Be Done About It (2007), Collier sees aid as having readjusted its aspirations. In many countries, aid has morphed into a confused anti-growth strategy of “sustainable, pro-poor growth.” He describes an ideological aversion to growth that has created a “deformation” in strategy, whereby growth is embraced and avoided at the same time. So, in pursuit of what central planners believe is the acceptable or right kind of growth, actual growth is sacrificed for fear of making the world worse off. Seeing the destructiveness wrought by prior aid, and unable to think of any other solution, Western officials effectively have given up on these countries. The result is that the poorest one-sixth of the world’s population missed out on the enormous global boom of the past 20 years. In a well-crafted book overflowing with insight there is this further blessing: phrases that capture the essence of important points. The best: “Growth is not a cure-all, but the lack of growth is a kill-all.”

Collier observes that the world’s poorest live in conditions little different from what prevailed in the 14th century. Although it does not contain a panacea for growth, the best of the new development literature presumes that growth is good and should be the shared experience of all. Sachs, to his credit, helped establish this consensus. Yet most of this literature is silent on the most fundamental point: how we in the privileged West were able to grow so rich so fast that we can take our own wealth almost for granted, and worry about producing growth for the world’s poor.

The Secret to Growth

Economists can’t explain growth in part because growth transcends economics. Economic development is intimately tied to the larger historical drama of progress within entire societies and cultures. Growth cannot be divorced from the political environment and its treatment of human creativity. Throughout the development literature, one finds a highly technical debate about which of three ingredients has proven most important to past, and future, development: resources and the capital to exploit them—more infrastructure aid is key; human capital—and therefore more education; and more recently, technology—flood developing countries with laptops and the rest will take care of itself. A credible case can be made for the importance of all three, but their adherents tend to slip into overzealous “magic bullet” rhetoric. The truth is, to a large extent, these solutions are popular because they are so understandable. More capital, more schools, more laptops are manageable concepts to planners. Just paint by numbers.

The debate seems to miss a new ingredient, obscured perhaps by its very ubiquity. Social networks exist and thrive on a scale and to an extent unimaginable even 25 years ago. The cell phone and the internet help well-trained and well-educated individuals multiply exponentially the return on investments in schooling and acquired skills. And the entire world benefits, too. Frictionless information markets, made possible by the world’s nearly spontaneous adoption of English as the language of business, makes the phenomenon of social networking perhaps the single most important factor in economic development.

In the end, however, the economic future of all countries hangs on decidedly hard-to-measure political and cultural conditions in which these factors operate. Economic expansion in the United States, now nearly continuous for 200 years, has no deeper cause than the creative freedom individuals enjoy and the absence of limits on their aspirations. Indeed, individual freedom is the ultimate source of America’s investable wealth (including the largesse that is shared with the world in the form of aid), its demand for schooling (higher education in particular), and the science that leads to the technology that sustains a virtuous cycle of economic expansion. The readiness of individuals to take risks, the predicate of all economic growth, is intimately tied to their ability to envision making the future different, better, and richer for themselves.

The principles of liberal democracy have made sustainable economic development a possibility for the whole world going forward. The application of creative talent by the individual in the context of commerce—once found only in liberal democracies—is now seen as necessary even inside socialist regimes. The rediscovered insight that entrepreneurs bring forth expanding welfare for all is so powerful that growth has regained its rightful place as a legitimate goal of economic theory. Tragically, books such as Common Wealth—its thesis endorsed by many of the world’s most highly regarded intellectuals and celebrities—seek to resist the reality that market-based growth is the only real way to eradicate poverty.

No one should pretend that the state is absent in the process of economic growth—in 1817, after all, work began on the Erie Canal, a government project. Throughout the 19th century, the state and federal governments helped facilitate growth through investments in infrastructure and protection of property rights. The United States raced ahead of Europe in patents, for example, because of the way government institutions treated their filing and enforcement.

This, however, highlights an enduring truth often forgotten (or ignored) by proponents of state-led development: economic growth owes more to the forbearance of the state than to its intervention. Governments do not, indeed cannot, make wealth—only their citizens can. And when government protects their freedom, the world’s growing population of entrepreneurs, in the bargain, expands human dignity and establishes the foundation of ongoing growth on which civil society ultimately depends.

May 25, 2009

The Economic Crisis America Needs

That the programs will ultimately go bankrupt is clear from the trustees' reports. On Pages 201 and 202 of the Medicare report, you will find the conclusive arithmetic: Over the next 75 years, Social Security and Medicare will cost an estimated $103.2 trillion, while dedicated taxes and premiums will total only $57.4 trillion. The gap is $45.8 trillion. (All figures are converted to "today's dollars.")

The Medicare actuaries then note what happens once the trust funds for Social Security and Medicare's hospital insurance program are depleted: "No provision exists under current law to address the projected [Medicare and Social Security] financial imbalances. Once assets are exhausted, expenditures cannot be made except to the extent covered by ongoing tax receipts." Translation: Benefits would fall.

Social Security checks would shrink; some Medicare bills wouldn't be paid in full -- and the shortfalls would progressively worsen. Retirees would scream. Hospitals might shut. No president or Congress would abide the outcry. Even the threat of imminent bankruptcy would rouse them to action. But restoring the programs' solvency would confront Congress and the White House with fundamental questions.

In 1940, life expectancy at birth was 61.4 years for men, 65.7 for women; by 2008, the comparable figures were 75.4 and 80. So: As health and longevity improve, when should people stop working and be entitled (from which comes "entitlement") to receive government retirement subsidies? Stripped of politically pleasing euphemisms ("social insurance," "entitlements"), that's what Social Security and Medicare mainly are. If so, how much should wealthier retirees be subsidized?

Or: How much should obligations to the old displace other national needs -- for, say, defense, education, research, transportation or, more broadly, adequate family incomes? In 1990, Medicare and Social Security represented 28 percent of federal spending; in 2019, their share will be almost 40 percent, projects the Obama administration. As this spending grows, pressures will intensify to raise taxes, increase budget deficits or cut other programs. What's the right balance between the past and the future?

Or: How can the medical system be reorganized to improve care and restrain costs? By some estimates, a third of health-care spending may be unneeded or ineffective.

Unfortunately, the Medicare and Social Security trust funds won't be exhausted until 2017 and 2037, respectively, by the latest projections. Although these bankruptcy dates are moved up from last year's estimates (2019 for Medicare and 2041 for Social Security), they're still fairly distant. Between now and then, the drain on the rest of government will occur invisibly. The inadequate trust funds will steadily diminish. The government bonds in these trust accounts will be presented to the Treasury for payment. Those payments can be financed in only three ways: bigger deficits, higher taxes or spending cuts.

But without a genuinely forcing event -- something requiring a response -- presidents and Congresses sidestep the underlying choices. They profess concern, but their proposals are cosmetic, ineffectual or both. "We must save Social Security for the 21st century," proclaimed Bill Clinton. "The system . . . on its current path, is headed toward bankruptcy," warned George W. Bush. Now, Barack Obama seems to be reverting to this familiar form.

"What we have done is kicked this can down the road," he told The Post. "We are now at the end of the road." Great rhetoric -- but that's all. Although no one expects Obama to have a grand blueprint after just four months, he has yet to signal even general support for needed policies: gradual increases in eligibility ages; gradual benefit reductions for wealthier retirees; a fundamental overhaul of Medicare. Indeed, Obama's plans to expand government-paid health insurance might increase Medicare spending by aggravating medical inflation.

Like General Motors, we continue bad habits because we can -- temporarily. Procrastination is a bad policy. The longer changes are postponed, the more wrenching they will be. The hurt for retirees and taxpayers will only grow with time. Social Security last faced a forcing event in 1983, when a dwindling trust fund prodded Congress to make changes. The lesson: A "crisis" is just what we need.

May 26, 2009

BOOK REVIEW: Ian Bremmer & Preston Keat's The Fat Tail

Those attuned to political risk back in 1929 doubtless saved themselves a great deal of anguish, and in writing The Fat Tail, Bremmer and Keat seek to explain the importance of calculating political risk as a significant part of all investment calculations. Given the growing role of Washington, London, Beijing and other political capitals in the world economy, their book is well timed.

First up, it must be asked what the authors mean by a “Fat Tails”. They describe the latter as “unexpectedly thick ‘tails’” at the “ends of distribution curves”, and they “represent the risk that a particular event will occur that appears so catastrophically damaging, unlikely to happen, and difficult to predict, that many of us choose to simply ignore it.” That is, of course, “until it happens.”

As they make plain, a better understanding of the politics of Russia in the late ‘90s would have made a big difference for investors trying to divine whether or not the regime in place would default on its debt. Russia certainly had the revenue potential to honor its commitments, but a failure to understand the country’s politics left a lot of investors burned.

In this case, it’s important to understand that political success is not always achieved through economic success. Take for instance Mexico in the late 1930s. With policymakers in the United States and England occupied with economic troubles and a looming war, Mexican president Lazaro Cardenas felt the timing was right to make a political statement whereby he nationalized the country’s oil industry.

As the authors note, the nationalization “was a resounding political success”, but as they also point out, from an economic perspective Mexico lost big thanks to the departure of human and financial capital that had previously made this industry so vibrant. In this case, economic analysis would have pointed to the folly of nationalization, while astute political analysts might have reached different conclusions that would have saved investors a great deal of heartache. Political risk must always be accounted for, and differentiated from rational economics.

Reversing the scenario described above, Bremmer and Keat note that investors not only misread Luis Inacio Lula da Silva’s (Lula) electoral chances in 2002, but having heard his often fiery rhetoric, they feared that his victory would among other things lead to a default on Brazil’s debt. Once again, the political economics of his victory were misunderstood in that having suffered previous defeats, once in office Lula moderated his message. As the authors remember for us, “few experts” were able to forecast the political incentives Lula “would inherit to stick to restrictive fiscal and monetary policy.” In short, a correct political read of Lula could have translated into investment gains for those who availed themselves of analysis that went beyond the economic.

And while it’s often said that governments are merely the puppets of corporate interests, the authors helpfully show how that’s not the case. This speaks yet again to the importance that investors must attach to the political outlook in making investment decisions. Specifically, in the lead up to World War I, the authors note that “most British and German bankers bitterly opposed it” with their investments in mind. Sadly in this case, they remind us that “corporations cannot do much to prevent geopolitical shifts from happening.”

Happily, The Fat Tail is more than a book that makes the clear case for applying policy analysis to investment strategy. Indeed, one of its most appealing attributes is the history that it offers. From the psychological impact of ineffective guns when it came to the Spanish invasion of Mexico to the Soviet’s role in the creation of the Eurodollar market to Wal-Mart’s brilliant response to Hurricane Katrina, the authors do a great job of keeping the reader interested in what on its face might seem a bland subject.

The above in mind, the differing fortunes of German aircraft makers Fokker and Pfalz in World War I’s aftermath caught this reader’s eye the most. Fokker thrived after the war thanks to its greatest asset being its intellectual know-how when it came to airplane manufacture. This was easily transportable to the Netherlands. Conversely, Pfalz was less reliant on intellectual property, and instead had thrived due to wartime opportunity. There’s a lesson here for the many businesses lined up in Washington for surely ephemeral government “stimulus.” As for our federal government that presumes it can tax productive businesses and individuals without consequence, it should be known that as we’re increasingly an economy of the mind, excessive taxation may drive our human capital out of the country altogether.

On the regulatory front, the authors make the essential point that regulators, like armies, are always fighting the last war. Sarbanes-Oxley was passed to fix the Enron and Worldcom mistakes with greater balance-sheet clarity, but as the last year has shown, it was very unequal to the task. Ultimately regulators never know what to regulate until after the fact, and even with hindsight they do a poor job. This writer’s not holding his breath, but maybe, just maybe, the political class might in time wake up to the simple reality that as they lack a hotline to the future, regulators are at best an inhibitor of productive economic activity.

There were a few disagreements with Bremmer and Keat. They suggest that the Yom Kippur War triggered an oil “price shock”, but since the U.S. was the recipient of more oil after the war than before, they perhaps could have better described the oil “shock” as a weak dollar shock. Further on they note that for “a local producer, a currency devaluation makes products cheaper to sell abroad.” Were that the case, Argentina, Turkey and Zimbabwe would be economic powerhouses. More realistically, inflation steals the alleged benefits of devaluation, and as we’re nothing if not a world economy, a cheaper currency would drive up the costs of the various imported inputs that make up a finished product. Devaluation’s virtues are frequently extolled, and its demerits not enough.

One other disappointment likely resulted from an editing error: in the second chapter the authors ask if the U.S. has “finally entered a period of relative decline?”, and allude to a full discussion of the question later in the chapter. Their views on this subject would have been very interesting, but they were hard to find.

Despite these small quibbles, The Fat Tail is a very worthwhile and fun read. What’s unknown, however, is how easy it might be to apply very essential policy analysis to the frequently numerical art that is investing. Indeed, as the authors make clear, it’s hard enough to predict future events like the Bolshevik Revolution, and even in hindsight there’s broad disagreement as to its causes. That being the case, we know that political risk is an essential investment input, but can we profitably analyze it?

May 27, 2009

Washington Helped Fuel Our Credit Card Woes

There are many reasons why America went from a nation of savers to debtors, why our personal savings rate dipped from a post-World War II average of about 10 percent in the late 1940s to under one percent annually from 2005 to 2007. But one reason certainly was a policy which emerged in the Great Depression and took hold in the post-war era that expanding access to consumer credit would energize our economy and spread the American dream to more households.

Although installment credit had gained a certain amount of respectability in the U.S. beginning in the late 19th century, starting in the 1930s the government came to see consumer credit as a tool it could use to manage and grow the economy. In that era, “the federal government regarded installment credit as a viable way of expanding mass purchasing power as well as--at times--a regulatory tool in Keynesian efforts of macroeconomic management,” wrote the economic historian Jan Logemann in a 2008 article in the Journal of Social History on credit in America.

The National Housing Act provided loans for home modernization, while the Electric Home and Farm Authority, a New Deal agency, “promoted the purchase of electric household durables on installment credit.” Then in the post-war era, the Federal Housing Administration and the Veterans Administration, building on legislative changes to the home mortgage market instituted during the 1930s, sparked a housing boom with low-cost mortgages, and as mass home ownership grew in the 1950s, so did installment credit as a way that Americans could fill up those homes quickly with appliances and furniture.

True, terms were quite different back then. Although Diners Club started offering a charge card to well-heeled Americans in 1949, by the late 1950s, when financial institutions started pitching cards to middle-income households, the average credit limit was still only $300, or a mere $2,200 in today’s dollars. A preferred customer could get as much as $500 in credit—only $3,600 today.

Credit card debt exploded followed the loosening of underwriting standards in the mortgage industry, and that was no coincidence. Starting in the mid-1970s, advocacy groups and some politicians began complaining that banks were refusing to make mortgages in some lower income neighborhoods, sparking a 20-year effort to loosen underwriting criteria and expand lending, which resulted in a more benign view of debt in general.

In that era banks found that they could satisfy complaints about lending practices registered against them under the Community Reinvestment Act by promising to issue more credit cards in low-income areas. Under pressure, banks also started allowing low income borrowers applying for a mortgage who did not have money for a down payment to borrow the cash via advances on their credit card—even though historically such lending led to greater mortgage defaults. Pushed by regulators like the Federal Reserve Bank of Boston, mortgage lenders also raised their debt ratio, that is, the ratio of income to total debt for low-income mortgage borrowers, in the process allowing a mortgage applicant to carry more credit card debt and still get a mortgage. From an industry average of about 33 percent, the debt to income ratio soared to as high as 50 percent in some special lending programs.

Over time lenders naturally applied these standards, relentlessly championed as ‘safe’ by government regulators and advocacy groups, to most borrowers, not just those in low income neighborhoods, thus sanctioning the rise in debt in America. As mortgage lending grew, so too did credit card debt. Inflation-adjusted total U.S. consumer debt rose nearly three-fold to $2.56 trillion from 1980 through 2008. Of course, the credit card companies extracted a price for this additional debt--since much of it was going to people with risky credit ratings—in the form of higher interest charges and penalties. By 2008, according to a survey of the National Foundation for Credit Counseling, 26 percent of Americans said they couldn’t pay all of their bills on time, and one in six households was making only the minimum payments on their credit card debt.

The meltdown in the home mortgage market has temporarily reversed these trends. As lenders have reinstated historically safer lending patterns, applicants with high levels of credit card debt are finding it harder to get mortgages, and more people are paying down their consumer debt, surveys show. Short on capital, credit card issuers have also been culling risky borrowers from their ranks, trying to head off future problems. Now, the new legislation, passed in reaction to consumer complaints, will make it even more difficult for card companies to profit off risky borrowers by limiting rate increases on existing customers and penalty fees for certain types of late payments.

If you happen to believe that America has gotten drunk on consumer debt, then no doubt all of these developments will please you. But I get the feeling politicians have little idea whose credit will take the biggest hit from this legislation, and I wonder what they will do when they find out. The big losers won’t be people with good credit, but those with marginal credit ratings, who will find their credit lines yanked or sharply reduced. When that happens, some of these folks will undoubtedly turn to less respectable forms of lending. Expect business at payday lenders and pawn shops to increase, for instance. Soon after, expect stories in the press about the burden that borrowers who can’t get credit cards now face in our society. And soon after that expect to hear new proposals from Washington about how to open up access to credit to more Americans.

That’s when the real burden on credit-worthy customers--who have been called on in the past to subsidize lending to riskier borrowers—will become apparent, I fear.

May 28, 2009

Obama Should Ditch Deadly CAFE Standards

Never mind that the 35 MPG CAFE standard, calculated by the Transportation Department, corresponds roughly to a 26 MPG Environmental Protection Agency standard, the measure that is found on window stickers of new cars. This is met already by 29 car models and 36 truck models. Half these trucks and one third of the cars are made by domestic automakers.

This discrepancy in MPG arises because for CAFE the Transportation Department tests the vehicle on a dynamometer, a machine designed to measure fuel intake in a repeatable pattern that is not the same as ordinary driving. This yields better “mileage” than would the EPA measure of driving over the road.

Hence, there was less to Mr. Obama’s announcement than met the eye—or made the headlines.

Whatever the true MPG measure, CAFE standards aren’t the best way to increase it. If Mr. Obama wants Americans to use less gasoline—a goal that many don’t share—he should propose a gasoline tax. Last summer, when the price of gasoline climbed above $4 a gallon, Americans cut back on their driving—with no extra CAFE standards.

Paradoxically, Mr. Obama’s increased CAFE standards may have the unintended effect of encouraging motorists to hold on to their older gas guzzling cars, as new models become more expensive. In contrast, a higher tax would create incentives to turn over the auto fleet more quickly, as drivers choose more fuel-efficient models.

Motorists should be allowed to choose between purchasing more safety with a larger car, or saving fuel by buying a smaller car. Other things being equal, heavier cars will be safer. Data show that fewer fatalities occur when large cars hit each other than when small cars do the same. In crashes between small and large cars, small cars’ occupants are at a disadvantage.

And poor people will be the most likely to get hurt under Mr. Obama’s new regulations. University of California (Santa Barbara) economics professor Stephen DeCanio in a telephone conversation yesterday declared, “CAFE standards are regressive. They put an undue burden on those who are low-income, who will buy cars that are smaller and less safe. Speaking as someone who is in favor of reducing greenhouse gas emissions, CAFE is not the way to go.”

The first CAFE standards, according to a 2002 National Research Council study, resulted in 1,300 to 2,600 more Americans killed on the roads in a typical year, because cars were lighter. If a toy manufacturer had killed that many children in a year the company would go out of business.

After dead motorists, the biggest losers from higher CAFE standards are Americans who prefer large vehicles to carry families, equipment, and pets on daily trips or long vacations.

One reason that Congress does not want to tax gasoline is that taxes are unpopular. People see taxes, whereas they do not observe the costs of CAFE directly. Despite Mr. Obama’s many calls for transparency in government, CAFE standards hide the costs of the regulation, contributing to poor governance.

Furthermore, CAFE regulations yield no revenue that the government could use to make infrastructure investments, engage in research and development, lower income taxes, or cushion the effects of the cost of the emissions reductions on low-income Americans. A gasoline tax, if accompanied by decreases in income taxes, could be revenue neutral. Low-income Americans who do not pay taxes could receive credits from the revenues to be used against the purchase of gasoline.

By yielding to Congress’s unwillingness to raise gasoline taxes and relying on regulations to increase gas mileage, Mr. Obama offers no incentive for manufacturers to exceed the CAFE standard or motorists to reduce their driving. A tax, on the other hand, would create a continuing incentive to improve vehicle MPG and reduce miles driven.

In fact, CAFE standards may have contributed to lowering the fuel efficiency of the personal transportation fleet because light trucks were not covered. Manufacturers developed a new kind of “light truck,” the Sport Utility Vehicle, built on a truck chassis. Many motorists who could not buy large sedans or station wagons due to CAFE turned to SUVs, some of which had lower fuel efficiency than the prohibited sedans.

Automotive fuel efficiency has been rising without stricter CAFE standards as older cars are replaced with newer ones. If Mr. Obama wants Americans to use less fuel, a tax would be simpler, fairer, and more effective.

Will Bernanke Get Four More Years at the Fed?

Bernanke agreed to sit down for a luncheon interview last week to talk about lessons learned. Behind him through the picture window of his private dining room was a majestic view of the Mall, but the Fed chairman was as reserved and fastidious as ever -- even as he described his battle to contain the greatest financial crisis of the past half-century.

I asked him what message he might leave for his successor to explain what these two tumultuous years have taught him. Bernanke offered a surprising answer: For all the computerized financial engineering that preceded the meltdown, he thinks it resembled a classic 19th-century bank panic. Investors thought their money was parked in securities that were as safe as bank deposits. When these securitized assets proved to be riskier than expected, investors panicked.

"We were seeing variants of classic panic behavior," Bernanke said, remembering the wild days of 2007 and 2008, when supposedly safe markets suddenly locked up as frightened investors rushed to get their money out.

Bernanke recommended studies by Gary Gorton, a Yale economist who has analyzed the ways the recent panic resembled those of the late 19th century. In his latest paper, "Slapped in the Face by the Invisible Hand," Gorton explains that the long-ago panics typically came at the height of the business cycle and involved new information that frightened depositors into withdrawing their money. Such bank panics disappeared for nearly 75 years after the enactment of federal deposit insurance in 1934.

The panic psychology returned with stunning force in 2007, when Wall Street suddenly lost confidence in new instruments created by the shadow banking system, such as mortgage-backed securities. It's hard to imagine now, but these exotic instruments were embraced by risk-averse investors such as money-market funds, pension funds and corporate treasuries. When that safety proved illusory, people rushed for the exits.

As Fed chairman, Bernanke scrambled for innovative ways to pump money and confidence back into these markets. If one tactic didn't work, he quickly tried another. When the panic first hit in August 2007, Bernanke took the unusual step of sharply cutting the discount rate for lending directly to banks. Banks proved wary of using the discount window, so Bernanke created a less-stigmatizing "Term Auction Facility."

Next came special Fed facilities to bolster money-market funds, the commercial-paper market, mortgage-backed securities and asset-backed securities -- all with complicated names and strategies. But the mission was consistent: to lend into the panic, and to reassure the markets that the Fed was really, truly committed to maintaining liquidity, no matter what. Gradually, the panic eased.

More jury-rigged rescue programs may be on the way. Barney Frank, chairman of the House banking committee, is drafting a bill to provide federal insurance for the municipal bond market, which could add hundreds of billions of dollars in new federal obligations. The Fed hasn't objected, saying this is a fiscal problem for Congress, not a monetary issue. A muni bailout would increase the immense debt hanging over the economy and the risk of future inflation.

The challenge ahead for the Fed is to clean up the debris -- including all the special structures created to contain the crisis. Obama will want a Fed chairman who can convince the markets that the central bank will crush inflation, regardless of the short-term pain or the howls from politicians. He will need someone who can reverse gears in a hurry and who can say no convincingly.

Is that person likely to be the quiet radical, Bernanke; or the outspoken, market-savvy former Treasury secretary, Summers; or some dark-horse candidate? Each would have strengths and liabilities at a post-crisis Fed, but there's a strong argument for not changing what, right now, looks like a winning team.

Has the U.S. Recovery Begun?

The optimists back their claims of an earlier recovery by pointing to a variety of statistics. They note that construction activity is rising, home prices are declining more slowly, disposable personal income increased in the first quarter, consumer spending is up, and the labor market is improving.

But a careful look at these data is less reassuring. In each case, the details do not support what the headline number appears to indicate.

While total construction spending recently rose by a very small 0.3% (less than the measurement error), private construction spending actually fell and residential construction was down a much more significant 4%.

Likewise, home prices declined at a very rapid rate of 18.7% in the 12 months to March, which is not meaningfully lower than the 19% fall over the 12 months to February. And the most recent monthly decline corresponded to an annual rate of more than 25%.

Moreover, disposable personal income rose in the first quarter only because of a massive jump in tax rebates and government pension payments. In contrast, salaries, self-employment income, dividends, and interest all fell. The anomaly of rising consumption driven only by tax rebates and social-welfare payments ended in March, when consumer spending declined in response to lower employment and falling labor incomes. This was confirmed by a fall in retail sales in April.

Finally, employment continues to contract rapidly. Although the pace of decline slowed between March and April, half of that improvement was the result of an increase in government employment, owing to a one-time hiring of more than 60,000 temporary staff to conduct the 2010 census.

But, although the recent news is not as encouraging as some have claimed, I expect that the next few months will see some real improvements that will reduce the rate of overall economic decline, or even produce a temporary rise in the GDP growth rate, owing to the Obama administration’s fiscal stimulus measures.

The stimulus package will add about $60 billion to overall GDP during April, May, and June, or roughly 1.5% of quarterly output. But when the GDP figures for the second quarter are reported later this summer, the government’s statisticians will annualize the 1.5% increase and add 6% in calculating the annual growth rate. If economic activity apart from the stimulus package is continuing to decline at nearly the 6% annual rate that was recorded in the last two quarters, the temporary boost from the stimulus package will suffice to make the overall GDP change close to zero or even positive.

But the key thing to bear in mind is that the stimulus effect is a one-time rise in the level of activity, not an ongoing change in the rate of growth. While the one-time increase will appear in official statistics as a temporary rise in the growth rate, there is nothing to make that higher growth rate continue in the following quarters. So, by the end of the year, we will see a slightly improved level of GDP, but the rate of GDP growth is likely to return to negative territory.

The positive effect of the stimulus package is simply not large enough to offset the negative impact of dramatically lower household wealth, declines in residential construction, a dysfunctional banking system that does not increase credit creation, and the downward spiral of house prices. The Obama administration has developed policies to counter these negative effects, but, in my judgment, they are not adequate to turn the economy around and produce a sustained recovery.

Having said that, these policies are still works in progress. If they are strengthened in the months ahead – to increase demand, fix the banking system, and stop the fall in house prices – we can hope to see a sustained recovery start in 2010. If not, we will just have to keep waiting and hoping.

Martin Feldstein is a professor of economics at Harvard University.

Continue reading "Has the U.S. Recovery Begun?" »

Deaf and Willfully Blind

President Obama should take that quote and tape it to the back of his crackberry. America’s currency is on the verge of a crisis, and now so is her Treasury market.

If you’re in the “Jimmy Timmy” camp and think that Cramerica’s solution to all that ails the integrity of the US Financial System runs through CNBC and Timmy Geithner, I’m sorry to hear that. Rasmussen’s latest Main Street “Timmy” poll has over 70% of Americans thinking that the YouTubed Squirrel Hunter is removed from his seat as Secretary of the Treasury by the end of 2009. That’s a bullish catalyst that can’t come soon enough.

What’s the point in having Secretaries of a Treasury market that they don’t manage as a priority? Even tricky Dick Cheney went on national TV last night and finally admitted what we, who aren’t willfully blind, have seen for the last year – Hank The Market Tank Paulson, like Timmy, serves Investment Banking Inc. bailouts first. So… Dear American underlings who aren’t part of the Wall Street Club, take your currency and savings bonds and fall in line.

This is so pathetic and sad that I can only call it out for what it is. The New Reality isn’t about being political, it’s about the US Government being willfully blind and deaf. Obama’s crackberry nation of reactive said leaders can hopefully get at least a feel for this if I keep hammering on it - no need to see or hear boys, crackberries vibrate.

For those who haven’t noticed, the US Treasury market has gone from shaking to crashing. Not unlike that US Dollar chart that I put up in a note yesterday to our Macro subscribers titled “The Chart That No One In Obamerica Is Allowed To Talk About...”, the chart of 10-year US Treasury Bonds is equally as damning. If “the strength of a nation” really does “derive from the integrity of the home”, don’t look to the bonds associated with a long standing American handshake for shelter. The compromised and conflicted bankers of everything Robert Rubin groupthink are still running this joint.

Do I sound surly this morning? Yes, these days I’m in an average mood at best when my alarm goes off at 4:01AM. I was used to sleeping in until 4:03AM, until Geithner started making me allocate an extra 90 seconds of my research time every morning trying to follow his made-up rules to this game. Hockey players can change on the fly, but this guy’s proposed rules, timelines, and selective disclosures for everything from his made-up tests to the PPIF (public private investment fund of funds or whatever he use to call it) can make a Sydney Crosby pass across the neutral zone look slow!

The New Reality remains. American supremacy as the world’s safe haven for currency and fixed income investment is under assault. American Idol season of your local insider trader hedgie who is “smart” because he “makes money” are ending, abruptly. Madoff doesn’t work. The world’s financial markets have voted.

Yesterday I said that the US Equity market was setting up to lock in another lower high, and I gave you levels. All three of those levels (SP500 934, Nasdaq 1764, and Russell 511) were not breached, and right after the US Government issued another boat load of bonds at the 5-year auction, both the US bond and stock markets fell apart.

This morning, I’ll give you 3 more levels on those same US indices, but this time these are levels I consider critical immediate-term TRADE support:

1. SP500 = 885

2. Nasdaq = 1702

3. Russell 2000 = 485

My playbook from here is crystal clear. After selling down my invested exposures aggressively in the last few weeks, I am waiting to see the confirmation of US stock market support. If you believe that real-time market prices (across asset classes and geographies) are leading indicators like I do, you get the drill. Both the US currency and bond markets are already broken. Are they leading this Canadian hockey mule to water on US stocks or not? Only time will tell…

The US Dollar broke my long-term TREND line of support last week. Since literally the day that I rang the sirens on this critical global macro factor, the US stock market has been down in 5 of the last 6 days.

The US Dollar Index long-term TREND line of $81.54 is the one that has the hair standing up on my back – Washington ignoring the alarm bell just makes this worse. If Bush was willfully blind, Obama is apparently willfully deaf.

The strength of this nation depends on a red, white and blue vision that people can trust. President Obama, for the third time now in a public rant, I am going to ask you on behalf of the American people who are allowed to see, do you hear me now?

Best of luck out there today,

Keith R. McCullough
Chief Executive Officer


111 Whitney Avenue
New Haven, CT 06510-1265


May 29, 2009

Obama's Cyber Czar Should Obey "Cybersecurity Commandment"

Broad government cybersecurity regulation is premature. Politicians, when they do weigh in, will seek millions to establish numerous research grants for cybersecurity initiatives; set up cybersecurity agencies, programs, and subsidies; and steer students toward cybersecurity research.

Past regulatory proposals have included mandates for firewalls, virus protection, disclosure, and reporting and sought to impose greater liability on software makers. But legislation—like anti-spam laws—would be ineffective, since the bad guys don’t obey the law anyway, and many cyber-attacks originate abroad beyond the reach of U.S. regulation.

Policy makers should avoid collectivizing and centralizing risk management, especially in frontier industries like information technology. Yes, we need government-backed “police forces” to protect private networks and infrastructure, but we also need the “barbed wire” and “door locks” which private companies continuously compete with each other to improve. When government overrules market competition for information/electronic security, it creates barriers to innovative private security solutions. We become less secure, not more.

Some reports indicate that the administration and Congress are seeking government authority over private networks—like power grids and computer networks—in the event of breaches. The very term “cyber” at once means everything and therefore nothing: American telecommunications, the power grid; virtually anything networked to some other computer is fair game to a new czar. The dominant tenor of the cybersecurity debate today is toward greater federal control over private infrastructure.

Washington has a proper role. It entails protecting government’s own networks and setting internal security standards, not regulating private networks. It involves arresting computer criminals and avoiding creating threats to data security in the form of data retention mandates, national ID schemes, proposals to re-regulate encryption, and czars that set terms for all they survey.

Security is an industry, and industries—and abstract concepts like “technology”—do not need czars in Washington. Innovation in information security and privacy protection do not flow from D.C. Rather, a government tech czar would likely grow in “stature” as a target for lobbyists. A federal technology chief could all too easily become an agent for establishing government authority over frontier technologies.

Both suppliers and customers increasingly demand better security from all firms. Improving private incentives for information sharing is at least as important as greater government coordination to ensure security and critical infrastructure protection. That job will entail liberalizing critical infrastructure assets—like telecommunications and electricity networks—and relaxing antitrust constraints so firms can enhance reliability through the kind of “partial mergers” that are anathema to today’s antitrust enforcers.

Private cybersecurity initiatives will gradually move us toward thriving liability and insurance markets for cutting-edge sectors. Heavy-handed cyber-czar gestures and legislation cannot address the lack of authentication and inability to exclude bad actors that is at the root of today’s cybersecurity problems.

Like everything else in the market, security technologies—from biometric identifiers to firewalls to encrypted databases—and cybersecurity services—from consulting to liability insurance to network monitoring—benefit from competition. Corporate information and security officers deal with cybersecurity concerns every day. It’s not clear what government could really fix—but it could break a lot.

The effects of mistakes made in the market—such as from overly aggressive spam filters—are easier both to contain and to correct than bad legislation. Worse, regulation can become so entrenched that genuine liberalization, however warranted as conditions change, simply cannot occur. To reduce the impact of any given attack, policy makers should seek to “privatize” rather than collectivize responsibility.

The need to preserve a dynamic market role can be summed up in a single Cybersecurity Commandment:

Do not take steps in the name of cybersecurity that make it: (1) impossible to liberalize or deregulate critical infrastructure and networks or (2) impossible or undesirable to “self-regulate” in emerging critical networks and technologies.

Government should not undermine future private sector security solutions beyond what we can foresee today. America seems no worse off without a cybersecurity czar. It could be a lot worse off with one.

May 30, 2009

Little Green Cars

In other words, taxpayers are not going to get their money back. Yes, we the people will be left holding the bag for the mistakes of GM's management and labor leaders over the last four decades.

And with CAFE mileage standards ratcheting up -- all while GM is going down -- Team Obama's green vision for the economy will soon be crystal clear. With President Obama in the driver's seat, we're going to get little green two-door cars that most folks won't want to buy.

Even worse, UAW chief Ron Gettelfinger has made it plain that his powerful union won't let these cars be manufactured in low-cost non-union plants overseas. The result? Obama's little green cars are going to be unprofitable, as well.

But it's the bigger picture that has me most concerned. What does Government Motors say about the direction of the United States? Historically, we don't own car companies -- or banks or insurance firms. But we do now. Tick them off on your fingers: GM, Citi, AIG. Oh, and let's not forget Fannie and Freddie, those big, quasi-government, taxpayer-owned housing agencies. California is broke and likely headed to bankruptcy. Will we the taxpayers own that, too?

Altogether, we're talking about hundreds of billions of taxpayer dollars that will never be repaid. This is the stuff the Italians used to do, and the Brits before Margaret Thatcher, and the Soviets a long time ago. But it's something very new and very different for America.

Is this onslaught of government ownership an attack on free-market capitalism? Yes, it is. Call it Bailout Nation or Ownership Nation, it's an unprecedented degree of government command, control and planning, all in the name of a tough economic downturn.

I don't pretend to know all the answers to GM's problems. Neither do I know all the miscues of the banks and insurance companies. But I do know this: The present level of government control over the economy does not bode well for this great country.

When I sat down with former Vice President Dick Cheney for a CNBC interview this week, I asked him about all this. He wasn't happy. Of course, many of these policies began during the Bush-Cheney administration, and Cheney didn't deny it. But when I asked if he anticipated the current degree of government control, he gave me another honest answer, as is his custom: No.

Regarding the banks, Cheney said the bailout work was done over at the Treasury (under Henry Paulson) and that no critical studies were performed by the White House. Cheney himself opposed the GM bailout, preferring Chapter 11 bankruptcy. He did sign on to the TARP bailout of banks as a stopgap measure. But he didn't anticipate its eventual size, scope and sweep. Then, squarely acknowledging the mistake, he compared Bailout Nation to Richard Nixon's wage-and-price-control program, which touched every enterprise in America. He called it "a terrible mistake; a huge mistake." By implication, Cheney suggested that the original Bush bailout program was itself a big mistake.

As for Nixon's wage-and-price-control policy, the former veep reminded me that "we finally got out of it, but it took a long time to do it, and it (did) a lot of damage."

Cheney was very critical of Obama's big-government spending-and-borrowing policies, too, telling me that there are only two ways out: inflating the money supply or big tax increases. He doesn't like either. Yes, Cheney believes Obama has taken Bailout Nation and government stimulus way beyond anything the Bushies ever contemplated. Nevertheless, the damage is done.

Cheney recalled Bush having said that "we have to suspend free-market capitalism in order to save free-market capitalism." So the big question is this: How long before we resurrect free-market capitalism, and how much damage will current policies do in the meantime?

I won't lose my faith in this country's long-term future. But the issue of how much damage we sustain before returning to the policies of free-market economic growth is very much on my mind.

About May 2009

This page contains all entries posted to RealClearMarkets - Articles in May 2009. They are listed from oldest to newest.

April 2009 is the previous archive.

June 2009 is the next archive.

Many more can be found on the main index page or by looking through the archives.

Powered by
Movable Type 3.33