As I was just saying ...

The only redeeming feature of Big Brother is his salvational incompetence.

The historical-institutional processes that drive the evolution of the state are quite likely to result in an all-absorbing Leviathan.  This is because the main actors competing for the control of the government and thus of the apparatus of the state are  recruited by political processes that select for people with a hunger for power, ruthlessness,  a belief that the ends justify the means and an unquestioned faith that the common good (as seen by the aspiring politico) always takes precedence over individual rights and liberties.   We have to hobble this would-be Leviathan if  we value what is left of our rights and liberties.

Not Drunk (Enough) With Power

Normally I find myself in pretty close agreement with Paul Krugman, and I even think his Keynesianism is thoughtful and in the current circumstances practical (though his condescension towards the Austrians is a vice), but he has this big government FDR fixation that goes along with it that drives me nuts.  A recent column begins with:

Times have changed. In 1996, President Bill Clinton, under siege from the right, declared that "the era of big government is over." But President-elect Barack Obama, riding a wave of revulsion over what conservatism has wrought, has said that he wants to "make government cool again."

Before Mr. Obama can make government cool, however, he has to make it good. Indeed, he has to be a goo-goo.

Goo-goo, in case you're wondering, is a century-old term for "good government" types, reformers opposed to corruption and patronage. Franklin Roosevelt was a goo-goo extraordinaire. He simultaneously made government much bigger and much cleaner. Mr. Obama needs to do the same thing. ...

I'm all for better government.  And I agree that government could theoretically get both bigger and better at the same time, depending on who is running it.  But someone as smart as Krugman is being disingenuous in writing a column like that without even mentioning that bigger government works like a ratchet -- once you make it bigger, it is impossible to shrink it again.  Combine this simple insight with the realization that FDR or Obama or whoever your patron saint of the day might be will not be around forever, and you have a powerful argument for doing everything you can to minimize the size of the government over time. 

Cleaner government is always needed, and perhaps bigger government is needed in a crisis, but big clean government inevitably gets dragged through the mud and ends up as a big dirty pig.

Clever, maybe

Alistair Milne has an interesting comment over on the forum attached to Martin Wolf's column at the FT.  He wants to encourage the central banks to pursue a specific type of quantitative easing that will work better than the flavor Japan pursued.  The basic idea of quantitative easing is straightforward -- the central bank goes out and buys government securities from banks and private individuals and pays for these with freshly created reserves.  Theoretically, the banks should lend these new reserves to businesses, and the amount of money in circulation should increase, counteracting any deflationary tendency.  In the case of Japan, the problem was that the banks didn't lend the money out.  Alistair's solution:

Quantitative easing will be much more effective if the central bank uses its balance sheet to buy not government bonds but better quality illiquid and undervalued structured and mortgage-backed securities. This eases bank funding constraints and so directly expands the stock of credit. Moreover, as the economy recovers, credit spreads will fall and so the central bank can make a profit.

Quantitative easing will be more powerful still if the central bank takes pure credit spread exposures, using interest rate swaps to remove its exposure to fluctuations in nominal interest rates.

At first blush this makes great sense, and was the basic idea behind TARP -- buy up the iliquid securities so that bank balance sheets are cleaner and more liquid, which should reduce the amount of cash they need in reserve and encourage them to lend to businesses as well as ecourage businesses and investors to once again trust that the lenders are solvent.

Unfortunately this does nothing to answer the question of what you should pay for these things.  If the Fed or the BOE starts to directly target credit spreads by buying "better quality iliquid and undervalued" paper, it must be able to figure out what paper actually fits this description and what it's worth.  But if it were so obvious that these securities were undervalued, there would be private investors willing to buy them.  What makes him so sure that the Fed is so much smarter?  He goes on to argue that the Fed, being the creator of money, can meet and margin call, and so cannot be squeezed out of any trade.  True enough.  But is that why people aren't buying this paper?  Frankly I doubt it. 

All this talk about undervalued MBS takes for granted that the real problem is liquidity, and not solvency.  Probably some of this paper is undervalued.  I wouldn't doubt that.  A lot more of it is worth zero though.  If the Fed buys this worthless paper it is just continuing to subsidize an overly large financial sector.  That may keep credit spreads for real businesses low and (might) keep loans flowing, but it does nothing to fix address the most fundamental imbalance -- the financial sector needs to shrink relative to the size of the overall economy.

Jim Hamilton is a godsend

Certain academic economist are really proving their worth to the greater financial community in this crisis, and high up on the list of contributors is Jim Hamilton of Econbrowser.  Follow the link to the clearest description I think I've ever seen of what the Fed normally does, what it's doing now, what it might do in the future, and why you should give a shit.

Well boo-fucking-hoo

What pathos one has when reading the punchline of this FT article about how the Fed will now lend to Hedge Funds so that they can buy up credit-card securitizations:

The loans will be secured only against the securities and not the borrower. However, the Fed will lend slightly less than the value of the securities pledged as collateral. The Treasury has committed $20bn to cover potential losses.

Since the credit crisis erupted, hedge funds have complained that they cannot get the leverage they need to arbitrage away excessive spreads and meet high hurdle rates of return.

 

I'm literally aghast here.  You mean hedge funds weren't able to meet their high hurdle rates?  That will simply have to be fixed.  I mean, if these guys don't get free money guaranteed by the Fed, then nobody can get free guaranteed lunch, I mean money.  If the sharks don't eat, the whole ecosystem will collapse by god!  This whole bailout has become just a blatant farce with every pig in town feeding at the trough.  It's like we're literally imitating Japan on purpose.

It's so sad to watch America get looted.  I hope there's still enough great things about this country that it one day comes back.

The Greatness of Ponzi

I read somewhere that towards the end of his life, Deleuze was working on a book about "The Greatness of Marx". He jumped out of a window before he finished it, and I don't exactly know in what sense he meant this, but my own fairly recent re-appraisal of Marx (I continue to mercilessly flog Kolakowski's book as the best thing ever written about Marx) has made me realize that a thinker can come at something deep and fundamental -- but from the wrong angle, or in a confused way that obscures the important novelty of the concept.

So this morning I'm eating my bagel and reflecting that someone should write a similar book about Ponzi. The structure of a Ponzi scheme is one of the greatest inventions of all time. In a nutshell it is just a faster version of the concept of trust -- we get together and cooperate today for some mutual benefit tomorrow. As long as the trust continues and expands, a Ponzi scheme is the surest and fastest route to progress. You can get rich along with everyone else.

I already hear some objections to my fevered praise of Ponzi. What, you might acidly ask, about when the trust breaks down and more people are leaving the system than coming in? That's a fair objection. But I never said that Ponzi's scheme didn't have flaws. All I was pointing out was that those flaws were the same as the flaws of our society. It's instructive to realize that some things we recognize as flat out Ponzi schemes can go on for 30 years. To call that unstable, or a scam, is to twist those words far beyond their usual definitions.

In fact, our society is modeled on a Ponzi scheme, and if trust in it were to break down, the results would be as spectacularly bad as Ponzi or Madoff or any of the other situations we recognize as "scams". You could argue that the US political system has gotten to a point where any attempt to shrink the government would cause the whole works to collapse. We already see how the government gets bigger and bigger every year, taking on more and more obligations both for the future and for the control of the present. Ask yourself for a moment what might happen to healthcare and social security and the housing market and ... if the government were to stop expanding in those areas, and even begin to contract. Caught a whiff of chaos ¿no?

And it's not just the government. Our entire productive apparatus (I am now extending this beyond just our financial "system") is based on the idea of a continual and continually expanding progress. If the trading of current consumption for future consumption down the road, if a system that depends inherently on the savings and investment leading to surplus leading to more savings and investment and ... if this concept of progress is not in essence isomorphic to a Ponzi scheme ... well ... then ... I'll have to re-think the title of my book about Ponzi.

Interfluidity has said it better than I could hope to, though he foolishly fails to mention Ponzi by name:

We, collectively, have not figured out a means of addressing an incompatibility between the incentives by which we encourage production and the means by which we distribute it. Human effort is driven by positional as much as material incentives: We measure ourselves against one another. Two centuries ago, a person could be rich with no running water, electricity, or internet person. But wealth was still wealth, and people worked just as hard to be rich then as now. But since wealth is positional, people's desire for wealth may far exceed their intention or ability to consume. When great wealth is earned by contributing to production, this leads to a surplus, which seems like a good thing, but creates the "problem" of excess capacity. The obvious solution is to redistribute claims on production, so that those with unmet wants make use of the excess. But doing so reduces the differences in station that inspire Herculean efforts to produce, and provokes conflicts over who gets what.

The macroeconomic stories of this decade have all been about squaring this circle: Rather than redistributing claims outright, we adopted the fiction of trading present goods for future claims. The ambitious grew wealthy by accumulating claims on the future of the less ambitious, in exchange for which the less ambitious (and sometimes very distant) consumed present production, and demanded more. Entrepreneurs could measure their position against their fellows by the quantity of their claims. Others could consume in proportion to their ability to manufacture claims that entrepreneurs would accept, that is, they could consume what they could borrow. But high quality claims on future wealth are in reality very scarce. An economic system that depends upon ever expanding claims on the future in order to provide current incentives to produce can not be stable. Once the "wealthy" learn that many of their claims are worthless, the system falls apart. The less-wealthy have no means of consuming, as new claims are shunned. Owners of capital gain nothing but bear costs for maintaining productive infrastructure. "Excess capacity" appears.

The challenge of macro

I find that I'm spending a lot of time these days trying to reconnect financial concepts with real world macro-economic concepts. There's a feeling that I'm trying to break through some sort of veil of analogy in order to see what it actually means when people make proposals to "get credit flowing again" and "stimulate the economy" and whatnot. I'm hardly alone in the effort of course, and a post from interfluidity goes in this same direction:

Think about that: "overcapacity in almost all industries". Perhaps we exist in a more enlightened world than I ever imagined. I've always thought that human want for material goods was basically unlimited. Apparently not! We have enough, not just here in the once gluttonous U.S. of A., but everywhere. All of the nearly seven billion humans of planet Earth have no use for anything more than they already have. Subsistence farmers in Africa prefer to live as they do, because it plays charmingly in National Geographic. If you offered them 10 million Yuan and a shopping trip, they'd shyly refuse.

The world does not now, and never has had, a general problem with "overcapacity". It might be sensible to talk about overcapacity with respect to a particular good or service in a particular setting. Maybe five Starbucks Cafes really are too many for one city block. But as a macroeconomic phenomenon, overcapacity is bullshit. Capacity can be misaligned — there might be too many sock factories for too few shoe factories. But there can be no general overcapacity, only underutilization.

This is an important thought, but only partially true. It leaves out an irreducible psychological element. The human desire for cheap plastic shit is limitless, but it is not constant. People and societies really do go through periods of over and under confidence, over and under desire.

Win some

I don't see why they don't just give me a Nobel Prize right now and get it over with. Or at least a column with the New York Times:

The Madoff Economy, by Paul Krugman, Commentary, NY Times: The revelation that Bernard Madoff — brilliant investor (or so almost everyone thought), philanthropist, pillar of the community — was a phony has shocked the world, and understandably so. The scale of his alleged $50 billion Ponzi scheme is hard to comprehend.

Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

China's big rebalancing act

Interesting comment from Michael Pettis today in the FT:

The second way is for trade-surplus countries to engineer sharp increases in domestic consumption, most likely though massive fiscal expansion, that match the decline in US household consumption and so reduce the overcapacity problem. The problem with this solution is that the scale of the adjustment is beyond the capacity of most countries. A decline in US consumption equal to 5 per cent of US GDP, for example (which is a low estimate), would require an increase in Chinese consumption equal to 17 per cent of Chinese GDP – or a nearly 40 per cent growth in consumption. This is clearly unlikely.

This is an important point. China stimulating domestic demand to compensate for the US going on a diet is all well and good, but we cannot expect it to work miracles. China is growing in importance in the world economy, but it still constitutes a tiny fraction of world GDP.

Fractional Reserve Banking is an Inherently Unstable System

There, I said it. File me away with the unibombers, the conspiracy theorists, and the gold bugs.

But the fact of the matter is that the whole system is really a sort of Ponzi scheme where you pay the people who want their money back with what you get from the people who are coming in. This works great until more people are going than are coming, a la Madoff. It makes you wonder if something fundamental will change once we pass through the steepest part of the global demographic phase transition.

This thought is inspired by a reading some commentary from Robert Bruner who recently wrote a book about the panic of 1907. I haven't read the book yet, but the commentary is probably sufficient to judge the conclusions he reaches. The basic idea is pretty simple. Fractional reserve banking is inherently unstable. Banks have a mismatch in the duration of their liabilities (I can get my deposits back any day of the week) and their assets (especially when they have made loans against that tried and true, but particularly iliquid, asset class -- real estate). Normally not everyone wants their money back at the same time, so this is fine. In a panic, even a solvent bank can be unable to pay its depositors.

The solution to this problem, as far as Bruner is concerned, is also pretty straightforward. You need some entity that backstops the banks, and convinces depositors not to pull their money out of solvent banks. You accomplish this by someone having enough cash in reserve to give the first group of depositors all their money back, so those after them realize that it's unneccesary even to ask for it. Simple enough. It's a con game really. Or a prisoner's dilemma, if you prefer. The success of fractional reserve banking as a business model depends on confidence and trust.

So how do you instill or recover that trust when for some reason people begin to lose it? In 1907 J.P. Morgan restored trust. Personally. I find it both sad and amazing that this could have worked. Sad, because it shows you how dominant a position this man had. In his commentary Bruner poses the question of whether there was a money trust (analogous to the oil trust and the cotton trust, etc ...) at the turn of the century. Poses it as if this were a question. I think the fact that any single man could restore trust in an entire system more or less tells you empirically that he had monopoly power. On the other hand it's kinda amazing that one man commanded such respect and was so competent that he could save an entire system. Imagine anyone trying to do this today. Are you going to put your trust in Geore W. Bush? Bill Gates? The suits from Goldman Sachs?

Bruner is clearly in awe of Morgan, and who wouldn't be? On the other hand, he obviously thinks that this was the last time any person could singlehandedly save the financial system. Today the problem is too big even for Warren Buffett, and requires a central bank instead a central financier (though wouldn't you rather have "Buffett Bucks" than dollars at this point?). A central bank is a perfectly sensible solution to the problem. Who can best restore confidence? The government. Where do all monopolies ultimately migrate to? The government. How do we solve problems of collective action? It's the government, stupid.

It's also the kiss of fucking death.

You haven't actually solved the problem with this, youv'e just pushed it up a level. Because there's no guarantee that we will always have confidence in our govenment. If we think it is run by a bunch of lying kleptocrats and their buddies, legitimized by dozens of pseudo-scientific technocrats who have had their heads in the sand for as long as we can remember, if perhaps we think the government and the people in it might, just maybe, be looking out more for themselves than for us -- well ... let's just say it may not be a foolproof firewall between us and the armageddon of zero-sum-ness.

Is anbody seeing a pattern here? Is it any wonder that this crisis happened when it did? I don't even trust my own shadow anymore, much less Ben Bernanke, Dr. Evil and mini-me over at the TARP. For all I know these guys are going to bomb the credit default swaps market because they heard somebody say that's where the weapons of mass destruction are. We'll have paper everywhere like confetti after the war.

In addition to creating the mother of all free-rider problems, pushing the question up a level and letting the government be the final backstop for the financial system means that the final instability of is now no longer solely financial, but cultural and political. Would you like to see what this slippery slope looks like when you've slid, repeatedly to the bottom of it?

Steve Hsu (hap tip Efrain)

... is another physics type who is interested in markets, though it seems that he is actually a physicist still, so I don't know how much solidarity he'd muster for us dropouts. At any rate, he also has a blog that mashes up all sorts of intellectual endeavour. Today's missive is about Keynes' brand of economics:

As someone with a mathematical bent I was not initially drawn to Keynes' brand of economics -- my interests were in areas of modern finance like option pricing theory, volatility, stochastic models. But like Keynes I have seen a bubble up close -- first in Silicon Valley, and now, from a greater distance, the current credit crisis. What seemed to be reasonable rough approximations: efficient markets, no arbitrage conditions, stochastic processes, etc., are now revealed as terribly naive and dangerous. And so over time my views have come to resemble those described below. (See my talk on the financial crisis, and this Venn diagram.)

The views described below are a piece that is floating around the intertubes this morning from the NYT magazine -- Keynes biographer basically says that Keynes came up with the idea of the black swan and not that self-aggrandizing Taleb bozo.

Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes.

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past (witness all the financial models that assumed housing prices wouldn’t fall) and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

This is all great and I am in complete agreement. Markets are traded by monkeys. The future is hard to predict. In the absence of information (and even sometimes in its presence) we look to our neighbor to figure out what to do. The possibility of feedback under such circumstance is obvious.

But what is new in all this? Anybody who has worked in markets for any length of time already knew that the emperor had no clothes. Disrobing Alan Greenspan and his flawed ideology is not an intellectual challenge. These guys were like the flat earth club -- fine if your in the mood to argue a bit and get into the philosophical details of what the word "proof" might mean, but a boring distraction when it comes to shipping cheap plastic shit from Long Doc to Long Beach.

What is challenging is figuring out if there are patterns to the "irrationality" of markets, and if these patterns are stable enough to be studied and related to other systems we can study in the same way that classical economics is related to physical systems that tend toward equilibrium. The sad things is that I'm sure there are economists out there studying this stuff. Only physicists (not Hsu of course) think that physics is the only science just because it happens to be the simplest one (excepting perhaps mathematics). Why don't these guys get a voice? Why is orthodoxy such a stunningly powerful force in academia?

I guess I think that the really disturbing thing is not that the emperor has no clothes, but the fact that so many people are surprised by this.

The Amero

Ecuador defaulted on its debt today. Or maybe yesterday, I don't know. For those existentialists out there this is another example that makes you question the very raison d'être of fiat money. From the FT:

Alberto Bernal, Head of emerging market macroeconomic Strategy at Bulltick Capital Markets, said the move was a prelude to a decision to exit dollarisation.

”Dollarisation is popular in Ecuador. Yet president Correa does not believe in dollarisation, and he needs further tools to pump the economy, because he will never receive the support of the private sector to generate employment,” Mr Bernal said. ”We think that a 60 per cent to 70 per cent devaluation is likely to take place at some point in the near future, unless oil prices recover fast.”

Ecuador abandoned the sucre for the dollar in 2000 after the collapse of its banking sector, which effectively leaves Mr Correa with no monetary policy of his own.

This passage makes one realize what the fundamental error is -- the government shouldn't have any monetary policy of its own. In fact, if there's one thing that the government should never ever be allowed to have, it's a monetary policy. If there's one thing you should never let the government do, it's control the supply of money. It always has and always will end in tears. Allowing the government to print money gives it an extraordinary control over society that is never apparent until it's too late.

Our Founding Fathers

I always find it interesting to see how, over the course of time, ideas get distorted into rigid ideological parodies of themselves. It is probably an inevitable consequence of mass adoption (witness religious doctrine in general). One of the cases that particularly fascinates me is how remarkably prescient Adam Smith the man was, given how remarkably awful many of the self-labeled "free market" types are who almost certainly never read a word he wrote.

Today's quote is a propos of this reflection, and the Fed's new plan to make us all rich again by forcing us to buy overpriced houses.

I can only think of Adam Smith’s warning:

The proposal of any new law or regulation which comes from [businessmen], ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

One of the stranger revelations of the last few years for me has been that Adam Smith and Karl Marx could almost be thought of as being on the same team. Naturally, Marx spawned an equally absurd school of misinterpretation, though in his case, you might throw a chunk of the blame at his own doorstep.

Turning Chinese

PREFACE: Scattered thoughts on money from more than a year ago, with a small contemporary addendum at the end.


The more you read, the more you realize that despite enormous amounts of noise and hand-wringing about what we should do, the bigger question is what China is going to do. Exactly like the US in 1929, China is really the linch-pin of the global economy right now. If they fall into protectionism and purposefully try to devalue their currency, we are all likely to go down together -- trade will grind to a halt, and the dollar will skyrocket and then implode, a chart we are all very familiar with right now.

Brad Sester has the best explanation of this stuff, though the Martin Wolf editorial he cites is a close second and a good summary.

China can try to support its own growth by taking a larger share of a shrinking pie, but that hardly helps the world. The G-20 isn’t just meant to bring countries together to discuss the global economy. It also needs to encourage countries to take into account the global implications of their economic policy choices. If China – which has by far the best balance of payments position of any major economy – feels like it has to direct its government policy toward maintaining export market share, efforts to rebalance the world economy will be set back.

Let me try to explain more clearly why China is so important to the current global system.

Recently, I've been thinking a lot about the charts you can find here from Steve Keen (warning: those with heart conditions are advised not to read his blog). In particular there is one that I feel like you simply have to explain, which is the one at the top of this post. So, they send us this chart, and we're supposed to shit ourselves with fear? What's the matter with a little debt? If the system is closed, one man's debt overhang is another's surplus, so where's the problem?

As far as I can make out, the argument about the unsustainability of debt in real terms is quite subtle. First, let's simplify the question and assume that we are on the gold standard or some other system where the amount of money is fixed. Further assume that the system is rolling along more or less close to equilibrium -- that is, that everyone is working and making stuff, and is swapping it for other stuff that everyone else is working and making. It helps to think of capitalism (and science and everythig else for that matter) as an animal behavior pattern. Money is just the index of all the swapping going on, just a way of counting it.

Here you can see the first way that money could get you into trouble. Because, you need different amounts of it to facilitate different structures of swapping. For example, if the economy consisted of two large centralized and vertically integrated agents (China and the US let's say) then all the specialization necessary for production could be swapped internally, without the need for money except at the last step of the interchange between the two agents. So the US could make all kinds of sophiticated goods like blue jeans and rock'n'roll, and at the last minute, we could swap these goods for cheap plastic shit that the Chinese had made. Here you only need enough money to count the value of the final swap, not the value of all the swapping necessary for the specialized production, because you are assuming that this production is organized along the lines of barter or command-and-control or something. In other words, you only need enough money for the swapping of the net value added by the US and by China, which at equilibirum would be equal.

If, however, instead of two vertically integrated agents, your economy consists of millions of tiny producers that need to swap with one another to make one sophiticated good, you are going to need more money to facilitate all of those transactions. You are going to need gross money, rather than net money, so to speak. I think this is basically the essence of the velocity of money. Now you can see how reducing the supply of money suddenly could get you into trouble all by itself, even if nothing changes (or in fact precisely because nothing changes) in the real economy. If I'm used to converting my production into money and swapping that money for the things I need, and there is a sudden scarcity of money, then we will have a calamity. The lubrication has all gone out of the system, and to continue to produce the same amount as before, it needs to be reorganized so that more of the swapping occurs internally to the production. This sort of reorganization is possible, but it can't happen overnight; in the meantime you have a crisis that appears economic but in reality is more an information crisis than anything else. Perhaps if we let Google run our economy we would need less money.

Anyhow, getting back to the debt question. Let's throw this whole system into motion. After all, in a static equilibrium, why would you ever have anything more than the very short-term debt necessary to finance trade receivables? If at all times, everyone were only consuming the amount they were producing, debt wouldn't exist. So, to state the obvious, debt is an inherently time-indexed structure.

UPDATE 090620:

The thing that throws the whole works out of equilibrium is the fact that not everyone is consuming just as much as they are producing. In fact, part of the specialization of modern economies is that some people are busy investing now (and investment is a form of consumption) in order to produce stuff later. And each year, the scale of this investment tends to increase. We live in a capitalist economy, which is not the same thing as a free market economy, in part because it requires large concentrations of capital that are otherwise alien to a perfect market. Once you introduce the idea of large capital projects that need to be financed, you inherently need someone saving and someone investing. While a system like this certainly can reach an equilibrium, isn't it obvious that it must be a dynamic one? And isn't it obvious that this is unlikely to be as stable an equilibrium as one in which each producer and consumer is essentially self sufficient?

I continue to chug through Minsky, and my update here is coming mostly from that line of thinking. He makes the very interesting observation that capitalism is inherently unstable precisely because it is not capable of incorporating large capital projects in a stable way. I'm sure I'll write some more about this later, but his basic idea is straightforward -- stability breeds instability as the initiators of large projects and their lenders over-extend themselves. His ideas put the actual functioning of money and finance back into economic theory (don't even ask why they left it out to begin with, it's a long story). The dismissal, until just recently, of all his ideas is part of what made it so difficult and heretical feeling to think about all of this stuff last year.

Double entendre

There are two ways to look at a chart like this. You can either wonder what the Japanese market would look like if they invested more like Americans, or what the American market would look like if they invested more like the Japanese. God help us if the second came to pass.

Mixed company

Normally I don't have much use for our collectively clueless superego -- the UN. But occasionally they agree with me, and a recent update to their economic report warns that the current strength in the dollar may be temporary. They also point out that the world is a closed system, and that we can't all stimulate at the same time. What would make more sense is if the US cut back on consumer spending and Japan and China took up the slack by buying things from us. Is the solution really to yet again encourage Americans to go out and do their patriotic duty and shop? From the report:

Continuing, he said the current tendency in macroeconomic policy was not all in the right direction, particularly in the surplus countries where there had been a tightening of monetary and fiscal policies, particularly in Germany and Japan, making it more difficult for the United States to lower its external deficits by export growth. The United States would also need to adopt some contractionary policies to slow down its deficit. Another way to compensate without a major recession in the world economy was for the surplus countries to make more expansionary adjustments in their economies. The more expansionary fiscal policies of some Asian countries seemed to be insufficient to compensate for the possible deflationary effects of an adjustment in the United States.

The report called, therefore, for a coordinated strategy that would think about how to adjust global imbalances while avoiding recessionary tendencies in the global economy, he said. International policy coordination could take place outside of the mediation of the International Monetary Fund, provided that the Fund pushed ahead with its reforms and enhanced representation of the votes and voices of its members.

Obviously the second stanza here is why nobody listens to the UN. I too think that thinking about the problem is a good idea, but they don't publish a news release about that.

Dabbling in Anarchism

Normally I consider myself an anarco-theist was capitalist tendencies, but what's in a name?

At any rate, this Rothbard sounds like an interesting dude (expect for maybe the part about supporting Pat Buchanan). I'm going to read his book on the Great Depression. Just don't ask me when.

What made the Depression Great.

All the movies, I expect.

But seriously, there are lots of people using lots of suspect analogies at this point, and we should at least get straight which terms correspond to what. Yves has some thoughts about this that I can't claim to have completely processed yet, but they are interesting.

... one thing that continues to surprise me is the frequency with which the US in 2007-2008 is being compared to the US of 1929-1930. I've mentioned in passing that China is in the position that the US occupied in the late 1920s: a massive manufacturer that was generating large trade surpluses, to the point where the imbalance was destablizing (under a gold standard, the US was sucking the metal out of its trade partners; the modern analogy is China's massive foreign exchange reserves). And as the US was the epicenter of the Great Depression, we cannot be certain of the trajectory of this economic crisis until we have a sense of how bad things are getting in China and how good its policy responses are.

By the way, the first thing this makes me realize is that my understanding of the Depression is totally deficient. For example, I know that the US saw massive deflation. But at the same time, relative to gold, I also know that the dollar was substantially devalued. So was there actually any deflation at all in terms of gold? I also know that Germany saw hyperinflation and ended up defaulting on its debts. What happened to France and England though. Was the depression inflationary or deflationary? In terms of pounds or francs, or in terms of gold?

Next, we might wonder how useful the great depression is as an analogy is to being with. I mean except for Iraq and parts of Africa, no one has seen the entire productive apparatus of their society bombed with the last decade. Okay, the US has built a lot of houses that are uniquely useless for making more stuff, but this hardly seems comparable in scale.

Also, comparing the US debt to the German debt between the wars also seems a bit suspect. The German debt was basically a monetized grudge. China is likely to be a bit more pragmatic if push comes to shove, and find some way to force the US into Chapter 11 more gracefully, both for our sake and their own. And the Japanese are like lapdogs. I mean this is a culture built around taking direction from teenage girls who dress up like Southern belles. We'll send them two million Barbies and call it even.

Things that sane people are not sitting around reading on a Saturday night

Here's an interesting piece Warren Buffet wrote back in the seventies, dealing with a paradox I've been at a loss to explain myself -- if equities represent an ownership stake in a business with real assets, why are they such shit in an inflationary environment (historically speaking, of course). So check out

How Inflation Swindles the Equity Investor

an unsually long and detailed piece from a bygone age of Buffettelia.

A propos of nothing, it's interesting to me how long Buffett has focused on the way the market works "in aggregate". Now that I've read years of his letters, I see that it is a theme with him. He pretends to ignore macro questions, and I really do believe that he spends little time thinking about what economists think growth will be next year in Argentina. 1.2% by the way. At the same time, he almost always has one eye on the overall state of the economy and the markets with respect to their historical norms. When he says to buy stocks, it's because they have historically returned 6% in real terms from the current levels of valuation. When he says that America will end up share-cropping, it's because the aggregate math of spending more than you earn simply becomes unsustainable at some point. And when he talks about the market, he always, always includes a disclaimer that in aggregate, we simply cannot beat the market. In fact, as he puts it in the article, in aggregate, we cannot even reduce our exposure (buyer for every seller). It makes me wonder if the only important things in investing are patience, humility, and not blowing up with borrowed money.

Managed bankruptcy for GM

Luis Zingales has a piece at VoxEU that is the most sensible thing I've seen written on GM (which isn't saying much, I know, but the thing is worth reading anyhow).

We believe that a Chapter 11 bankruptcy filing for GM is the only possible solution. However, we recognise that in the current environment, there are several likely inefficiencies associated with the bankruptcy process. In particular, if we do nothing and wait for GM to file for bankruptcy, which would likely happen in a month or so, we would risk a bad outcome of the proceedings, namely an inefficient liquidation of the company and a substantial amount of social disruption from the sudden loss of jobs. We therefore propose that the government oversee a prepackaged bankruptcy for GM that would give the company the restructuring it badly needs and avoid inefficient liquidation.

Finally, something lucid. You can't bailout the morons at GM with just cash. The history of the company and the industry proves that if nothing else. At the same time, the last thing we need right now is a large and panicked bankruptcy and liquidation of the company which sets of a chain reaction in the suppliers, lenders, employees, etc ... The government needs to provide debtor-in-possession financing and allow the private lenders who are still onthe hook to force an orderly restructing of the company. Shareholders should be wiped out and all management should be canned.

The next question is why we don't follow this same model with the big banks.

If we are going to have a government, now is the time for it to LEAD -- not be the dog wagged around by the ass-end captains of private industry who have already proven their incompetence beyond a shadow of a doubt.

Science

Predicting the returns for an entire stock market are darn near impossible, and in the short-term I don't think you can do much more than guess. Over the longer-term, however, you can appeal to a bit of historical science to make a more educated guess. The simple conclusion is that when stocks are expensive, the markets future returns are low, and when they are cheap, the future returns are high.

The PE in the chart below is based on E being the average of ten years of trailing earnings, the idea being to average out the business cycle.

The money hole

I thought this was Warren Buffett quote was very funny:

[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head...

It kinda reminds me of Douglas Adams' parody of money on prehistoric earth:

"Thank you. Since we decided a few weeks ago to adopt the leaf as legal tender, we have, of course, all become immensely rich."

Ford stared in disbelief at the crowd who were murmuring appreciatively at this and greedily fingering the wads of leaves with which their track suits were stuffed.

"But we have also," continued the Management Consultant, "run into a small inflation problem on account of the high level of leaf availability, which means that, I gather, the current going rate has something like three deciduous forests buying one ship's peanut."

Murmurs of alarm came from the crowd. The Management Consultant waved them down.

"So in order to obviate this problem," he continued, "and effectively revaluate the leaf, we are about to embark on a massive defoliation campaign, and . . . er, burn down all the forests. I think you'll all agree that's a sensible move under the circumstances."

Broken Record

Either I am a terrifically narrow-minded and boring person, or when you have a truly good and simple idea, you find that it appears everywhere. Please don't respond to this question. I only ask it a propos of James Surowiecki's column in the New Yorker where he discusses the state of global agriculture and the Perils of Efficiency.

His basic point is that 'market reforms' have over-optimized the agricultural system and made it more fragile; more crops are now grown in fewer places as countries have moved away from food security, and the centralization of this system has made it more vulnerable to the propagation of initially small shocks vis a vis when this system was less efficient and more redundant -- ie with everyone growing their own food.

While I think this is a valid and insightful description of the current situation (and one that can be applied to the over-optimization of our financial system as well, which is in fact the context I found it in) it is profoundly misguided as a piece of analysis. Because the conclusion he draws from this bit of thinking is that the problem is due to the de-regulation and 'marketization' of agriculture, implying that the way global agriculture looks today is the way markets inevitably end up looking.

I can't think of ANYTHING that is less of a free market than agriculture. Seriously. To use the centralization of global argiculture in a few highly, highly subsidized places like Kansas as a paradigm for the natural endpoint of markets is to fundamentally miss the point. Surowiecki claims that the elimination of all the little subsidies people used to use to control agriculture -- the marketing boards and grain reserves and millions of tiny distortions -- has made the system more 'free market'. This is crazy. We didn't exchange these subsidies for an unsubsidized market. We exchange a ton of little subsidies, for a few giant, centralized, subsidies that not only tremendously distorted the agricultural markets, but threw a giant red state monkey wrench into our entire political system. Agriculture today isn't more 'free market' than 30 years ago unless all you are counting is the sheer number of regulations. But who cares about how many bad laws there are -- what I want to know is how bad the laws are.

They are bad.

They are almost always bad.

This is the basic insight of classic liberal thinking a la Adam Smith. It is still as completely valid today as it was then. Surwiecki is not providing a counter-example to this point. The financial meltdown is not disproving this thesis. Rather, these problems are proving that a few giant distortions that create fundamental mis-alignments of interest and perverse incentives on a grand scale are even more dangerous than a lot of small misalignments that maybe reduce efficiency, but tend to cancel each other out systemically (two sides of the same coin I guess, actually).

The danger is, indeed, monoculture, and the susceptibility of monoculture to a virus. But monoculture is fundamentally anathema to the idea of markets. In fact, if you think about the dangers of monoculture and where it crops up, you are very quickly led back to the single biggest monoculture of all -- the government. Interestingly, the monoculture at the heart of our current problem is the US government's ability to print money, and the fact that it was willing to print a lot more of it than it should have, creating a type of monoculture that propagated down the lines as the government printed money, the banks took it and lent it out, people used it to finance their houses and spent it on cheap plastic shit from China, and the Chinese lent it back to the US government so the whole loop could start over again. What makes the loop run, both forward, and, now, backwards, is monoculture. Federal Reserve monoculture. Chinese monoculture. Banking regulation monoculture. Without these bottlenecks, the feedback loop that created this problem is much less stable, the (mis)-alignment of interests much less precise, the propagation of problems much less rapid. But these features of the system aren't created by market principles, but by governments, and the way the centralization that is the hallmark of government propagates throughout a system once it is introduced at one point.

This leads me to my thesis for this morning: the government is a virus.

Kashkari and the Cash and Carry Economy

There are lots of fairly sophisticated theories out there about how we got ourselves into our present national financial dilemma. There are people who write terrific stuff about how the incentives of lenders and investors were not aligned. There are folks who blame the greed of Wall St. There are those who think the whole thing started with the miscalculation of a once proud technocrat who found a flaw in his equations. There are even those who think that the whole thing can be chalked up to simple government incompetence.

Of course these things are all true. They have all had an impact and are all (partially) to blame. But to me, none of them gets at the fundamental problem we are facing, not just in the US but globally. Fundamentally we no longer trust this economic and political system.

I don't mean this in an ideological sense, as if we might somehow come to trust socialism or authoritarianism more. The question is not which ideology you think best optimizes the parameters of freedom, development, and justice. No, I mean to say that we no longer trust that any of these political systems is actually working for us. Everywhere you look in the world you see the same basic pattern -- huge, highly centralized political units run by tiny enclaves of the well connected. Once upon a time we (foolishly, certainly) trusted that these people actually ran their countries with at least one eye towards the benefit of 'the people', whoever that is. Our problem, fundamentally, comes from the fact that these political units have an enormous influence over our lives, and yet we no longer feel that we have any control over them, we no longer trust that those in charge of them have our collective benefit in mind.

In short, the cause of the sub-prime crisis in neither economic nor technical. It was not the result of too little or too much regulation. It is the result of something at once much simpler and much deeper. It is the result of a basic breakdown in our trust in government, the result of a lost decade of crony capitalism, the result of the US sliding incessantly towards the fate that has ever hovered at the edge of our country, and which has engulfed so many other colonies in our hemisphere -- the sub-prime crisis happened because we have become a banana republic.

And we have taken the rest of the world with us.

Once you believe that your government only exists to enrich itself and those connected with it, there is simply no way back from the abyss. If no one capable of even contemplating our mutual benefit is in charge, then it is every man for himself. Trust and cooperation are the foundations of all societies and all economies, whether they are organized along socialist or free market principles. Without that trust, it doesn't matter what you call your crumbling sham of a system.

So no, I don't think that Bush and Paulson and Kashkari are chumps, as Rep. Elijah Cummings so delicately puts it. I just think they are more rational than the rest of us -- they are first in the race to fuck everybody before they get fucked.

Roubini on deflation

My working theory has been that the current crisis will produce several years of deflation or at least disinflation, along with low rates, followed by higher inflation in the medium term.  The Fed's liquidity programs are not themselves inflationary (they are not, as is so often claimed, printing money, or at least not the kind that they can't unprint later).  However, ultimately somone has to pay for all this bailing out, and it will either be through higher taxes, lower spending, inflation, or all three.  An independent central bank would not allow the govenment to inflate its way out of debt; we have proven repeatedly in the last year(s) that we no longer have an independent central bank.

But enough of my thinking.  Roubini has the other side of the debate, arguing that the Fed will never let inflation happend, and instead, if need be, will push us into a double-dip recession to return to price stability.  I think he's wrong, but he's worth reading.

Finally, while in the short run a global recession will be associated with deflationary forces shouldn’t we worry about rising inflation in the middle run? This argument that the financial crisis will eventually lead to inflation is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system and that this sharp growth in the monetary base will eventually cause high inflation. In a variant of the same argument some argue that – as the US and other economies face debt deflation – it would make sense to reduce the debt burden of borrowers (households and now governments taking on their balance sheet the losses of the private sector) by wiping out the real value of such nominal debt with inflation.

So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question is: likely not.

First of all, the massive injection of liquidity in the financial system – literally trillions of dollars in the last few months – is not inflationary as it accommodating the demand for liquidity that the current financial crisis and investors’ panic has triggered. Thus, once the panic recede and this excess demand for liquidity shrink central banks can and will mop up all this excess liquidity that was created in the short run to satisfy the demand for liquidity and prevent a spike in interest rates.

Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized as opposed to being financed with a larger stock of public debt. As long as such deficits are financed with debt – rather than by running the printing presses – such fiscal costs will not be inflationary as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.

Third, wouldn’t central banks be tempted to monetize these fiscal costs - rather than allow a mushrooming of public debt – and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view: even a relatively dovish Bernanke Fed cannot afford to let the inflation expectations genie out of the bottle via a monetization of the fiscal bailout costs; it cannot afford/be tempted to do that because if the inflation genie gets out of the bottle (with inflation rising from the low single digits to the high single digits or even into the double digits) the rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary policy tightening to bring back the inflation expectation genie into the bottle. And such Volcker-style disinflation would cause an ugly recession. Indeed, central banks have spent the last 20 years trying to establish and maintain their low inflation credibility; thus destroying such credibility as a way to reduce the direct costs of the fiscal bailout would be highly corrosive and destructive of the inflation credibility that they have worked so hard to achieve and maintain.

Fourth, inflation can reduce the real value of debts as long as it is unexpected and as long as debt is in the form of long-term nominal fixed rate liabilities. The trouble is that an attempt to increase inflation would not be unexpected and thus investors would write debt contracts to hedge themselves against such a risk if monetization of the fiscal deficits does occur. Also, in the US economy a lot of debts – of the government, of the banks, of the households – are not long term nominal fixed rate liabilities. They are rather shorter term, variable rates debts. Thus, a rise in inflation in an attempt to wipe out debt liabilities would lead to a rapid re-pricing of such shorter term, variable rate debt. And thus expected inflation would not succeed in reducing the part of the debts that are now of the long term nominal fixed rate form. I.e. you can fool all of the people some of the time (unexpected inflation) and some of the people all of the time (those with long term nominal fixed rate claims) but you cannot fool all of the people all of the time. Thus, trying to inflict a capital levy on creditors and trying to provide a debt relief to debtors may not work as a lot of short term or variable rate debt will rapidly reprice to reflect the higher expected inflation.

In conclusion, a sharp slack in goods, labor and commodity markets will lead to global deflationary trends over the next year. And the fiscal costs of bailing out borrowers and/or lenders/investors will not be inflationary as central banks will not be willing to incur the high costs of very high inflation as a way to reduce the real value of debt burdens of governments and distressed borrowers. The costs of rising expected and actual inflation will be much higher than the benefits of using the inflation/seignorage tax to pay for the fiscal costs of cleaning up the mess that this most severe financial crisis has created. As long – as likely – as these fiscal costs are financed with public debt rather than with a monetization of these deficits inflation will not be a problem either in the short run or over the medium run.

Actually, it was structured by pigs

From NC:

In a hearing today before the House Oversight Committee, the credit rating agencies are being portrayed as profit-hungry institutions that would give any deal their blessing for the right price.

Case in point: this instant message exchange between two unidentified Standard & Poor's officials about a mortgage-backed security deal on 4/5/2007:

Official #1: Btw (by the way) that deal is ridiculous.

Official #2: I know right...model def (definitely) does not capture half the risk.

Official #1: We should not be rating it.

Official #2: We rate every deal. It could be structured by cows and we would rate it.

Continuing on with our regularly scheduled progam

Keynes quote (via Krugman):

Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.

China vs. India

There is an interesting piece comparing potential future growth in China and India over at VoxEU. The author defends the growth potential of China against a common-sensical viewpoint that a country like China who has built its economy on the back of manufacturing exports faces a tough road in a likely rich world recession in the near term, and what can only be a long-term rebalancing of consumer spending in these highly leveraged economies over the medium term. His argument doesn't deal with this head on though, so much as in an oblique manner -- he argues that the difficult thing to build in the long-term are strong state institutions, such as those China has, while having a thriving private sector is relatively easy to create, given that all it requires is deregulating industry and letting it "hustle" to use his word for it. Of course, the wording already reveals the basic fallacy of the thinking, which is that state institutions are on par with a dynamic private sector in terms of their impact on long-term growth. This is only true if you take "state institutions" to mean the thoughtful setting up of markets, that is, the tending of the non-zero sum garden that truly allows an economy to flourish. The author, however, has in mind the much more rigid state institutions in place in China, where the economy is still controlled top-down to a large extent. This may make for faster growth, and maybe even be harder to build (though I would debate this point), but in the long-run that kind of centralization cannot help but be inflexible. It works until it doesn't.

Zen trade

Yves points to a very interesting paper on exactly what a globally balanced world would look like in real terms. The surprise finding is that the biggest beneficiary of all this is Japan. Japan is actually interesting me more and more these days.

The US as a share of the world economy falls by just 4.5% while Japan's rises by 3.3%. The inflexible case, however, requires a much more radical realignment in the relative size of the major economies. The US declines by nearly 30% relative to the world while Japan grows by over 26%. (Combining the numbers, the adjustment would require over a 50% devaluation of the US dollar in terms of the Japanese yen).

Maudlin Melodies

John Mauldin typically posts some pretty good stuff at a reasonable frequency and with an emphasis on longer more thoughtful pieces, as opposed to the quick one off that has become the blogging norm. Today he has something from David Rosenberg, Merrill's chief economist. Rosenberg is pretty bearish, as is anyone in their right mind, frankly, though there's nothing that I would call new in what he's saying. A few things did catch my attention though. First, screw GDP:

More to the point, if you're waiting as an investor for GDP to actually turn negative, you're going to miss a lot of action along the way. I think the best example is to just go back to Japan. They had a real estate bubble that turned bust and they had their own credit contraction back in the early 1990s. Guess what; Japan didn't post its first back-to-back contraction of real GDP until the second half of 1993. By the time the back-to-back negative that people seem to be waiting for happened, the Nikkei had already plunged 50%, the 10-year JGB yield rallied 300 basis points, and the Bank of Japan had cut the overnight rate 500 basis points, which said a thing or two about the efficacy of using the traditional monetary policy response of cutting interest rates into a credit contraction (as we're now finding out here in the US).

Second, not everything gets marked to market instantaneously:

I was around in the 1980s, and I remember that it played out very similarly. What people called resilience and people called contained and people called decoupling were all very pleasant euphemisms for lags. That's what they are; they're lags. There are built-in lags. Housing peaked in 1988, rolled over, the credit crunch intensified in 1989 when RTC got into real action. Then 1990 ... two years after housing peaked, we had this very surprising consumer recession that caught even the Fed off guard.

Perhaps I'm just constitutionally bearish, but I feel like it's just common sense to suggest that the depth of the pullback in the US will eventually have an impact al over the world. But not right away. People take time to adjust to the reality that a lot of the wealth created in the last 10 years was illusory, and that the baseline is much lower than they think because they aren't accounting for the fact that we had one giant credit bubble that came in two episodes. We're not going back to 2005, but 1995.

In-de-flation

The inflation-deflation question is to me the trickiest macro-economic call at the moment, probably due to the fact that it is really a political question at bottom. If we still used gold as money, the limited supply would mean that when the music stopped after the exuberant debt creation party, the room still had the same number of chairs. The fact that we print money calls this into question, though it does not assure it, as you still have to get that money into people's hands so that they spend it and it flows through the system. Interfliudity makes an interesting comment on this point, which speaks directly to the two great examples of modern deflation:

Japan's experience in the 1990s and the US' in the 1930s are often cited to suggest the inevitability of deflation, despite monetary policy heroics. But in both cases, the deflating country had a large, positive international asset position. To the degree money was owed by foreigners in domestic or pegged currency, the "national interest", looking past winners and losers, was to tolerate deflation.

This actually has a compelling ring to it -- to inflate or deflate is a political question that depends on whether you are a debtor or a creditor. If you are a net creditor nation, even though deflation is painful in domestic economic terms, it's even worse to let your debtors off the hook. As a net debtor, there's no reason to accept the pain of deflation, and the political calculation will always be to inflate.

The question in the current case of the US is to wonder aloud whether the US can engineer a quiet bailout where we exchange China and the gulf's ongoing support of the dollar for an agreement to actually pay these bills (i.e. not inflate). This would allow us to avoid the nastiness of a default, including a major currency collapse and a severe recession, and gradually bring our balance of payments in line via years of subpar growth and reduced standards of living. Theoretically you could engineer a kind of cancelling of the inflationary and deflationary forces -- debt restructuring as opposed to simple default. I'm not sure that's a geopolitically viable course of action unfortunately.

What ever happened to Stephen Roach?

I feel like he used to be much more visible, and I haven't seen him get a lot of airtime lately. Maybe this is just what happens to you if you see the bubble too early. Yves has dug him up however ...

At the root of the problem was America’s audacious shift from income- to asset-based saving. The US consumer led the charge, with trend growth in real consumer demand hitting 3.5% per annum in real terms over the 14-year interval, 1994
to 2007 – the greatest buying binge over such a protracted period for any economy in modern history. Never mind a seemingly chronic shortfall of income generation, with real disposable personal income growth averaging just 3.2% over the same period. American consumers no longer felt they had to save the old-fashioned way – they drew down incomebased saving rates to zero for the first time since the Great Depression. And why not? After all, they had uncovered the alchemy of a new asset-based saving strategy – first out of equities in the latter half of the 1990s and then out of housing in the first half of the current decade.....

Blogging Blodget

Henry Blodget has a post that gives the latest update on the only two overall market valuation measures that have ever made any sense to me -- Tobin's Q and the cyclically adjusted PE ratio. The upshot is really just what you'd expect, namely that US stocks are still a bit expensive by historical measures, and that's without even imagining that we are going to experience a tougher than normal cyclical downturn. Take a look at the chart to see just how bad it can get.

Good Quote

From Yves Smith:

Too many developed economies got addicted to asset inflation - the increasing valuations were the only source of yield to service the debt incurred in their purchase - a Ponzi scheme in the Minsky sense. Now that bubble has burst. Houses are a non-productive asset, a consumption good. Values have to fall to where they can be serviced from current incomes - whether via a mortgage payment or rent - or incomes have got to rise via wage inflation. I still don't see any other way out. The first decimates (many) banks, the second decimates the dollar.

This seems to me the crux of the inflation-deflation debate. The question is whether the Fed will backstop the fake money creation of the last ten years and bail out the banks and the housing market by inflating away the purchasing power of the dollar, or whether that invented money will be disavowed and we will end up with a deflation that begins with asset values and spread backwards to goods and services (imagine if your favorite cafe sits on real estate worth only half as much and so pays only half the rent).

Grantham

Jeremy Grantham can be a bit of a perma-bear, but there's a point in his most recent letter that rings especialy true to me:

China’s ability to sustain rapid growth and avoid a
serious stumble has become an article of faith that
I was buying into without much skepticism. But
why? No sooner do we fi nish wallowing in the idea
of Soviet incompetence than we start to believe that
Chinese central planners can wonderfully manage
a complicated economy, growing unprecedentedly
fast and transforming overnight from a rural society
to a capital-intensive industrial wonder using half of
some of the world’s resources. Economic logic and
history suggest that their governmental interferences
will be sub-optimal, and that China’s current level
of investment will turn out to be dangerously high,
encouraging waste. They continue to build basic
capacity on automatic pilot even as they encounter
dangerous times for their export-led economy, since
we are all facing the rising probability of a global
slowdown in economic growth and trade. China also
has to deal with rising energy costs in their particularly
energy ineffi cient economy. Surely they will stumble.
And if we are all unlucky, they will stumble right into
the global credit crisis.

Magical Mystery Accounting

As usual, Barry Ritholtz has some good points:

Just when you think there is a glimmer of hope that some of these ne'er do well, lying, cheating, sniveling, cowardly bank CEOs might finally be forced to step up to the confessional and tell all, this comes along: FASB Postpones Off-Balance-Sheet Rule for a Year.

There will eventually be a financial sector recovery, and some smart people will make loads of money off of it, but I'm afraid they will be smarter or luckier (or simply better connected) than I. Right now though, I can only imagine investing in some special case that I can actually understand, and I'm setting the understanding bar (understandably, given the eternal litany of writedowns) pretty high.

Question: How can anyone value a financial company if they cannot tell what are on their balance sheets?

Answer: You cannot. If you buy a financial under these conditions, you are flying blind.

Investment Thesis: Ritholtz Rule #1: Know What You Own.
Whoever buys Financials under these circumstances loses the right to whine down the road about companies not being forthcoming. If you own them, don't complain when you get what you deserve.

Google Lobbies

I recently wrote about this in a more reflective mood, but it's worth revisiting in the sobriety of the office: Google spent $730,000 to lobby in second quarter.

US Socialism

I like this one:

Two major related threats loom over the world economy: credit crises and rising inflation. What do these two menaces have in common? Bankers, hedge-fund managers, speculators and capitalism in general have been taking the hit for the economic turmoil, both for credit risk and inflation. But the looming collapse of Fannie Mae and Freddie Macin the United States should help change the focus a little. We are now getting down to the heart of the matter, which turns out not to be rampant capitalism but out of control back-door socialism.

- Terence Corcoran, The culprits behind credit, inflation risks

Learning about markets

Despite its academic cachet and theoretical appeal, I've never been much of a believer in the idea that markets are truly efficient. Free and open markets are a pretty good tool in a wide variety of circumstances. They are an equilibrium tending process both theoretically and (usually) in practice. However, they consist of monkeys buying and selling stuff (capitalism is an animal behavior pattern after all) and they occasionally suffer from the flaws associated with this status. I've never believed markets were completely efficient, because if they were, I wouldn't have a job and companies would in general not have profits, both of which predictions are verifiably false.

What I don't understand about the current market crisis is all the people who claim we have recently learned something fundamentally new about markets. Even a cursory knowledge a financial history extending beyond the last 10 years will show you that a boom-bust credit cycle tied to over-investment in real estate is the most often repeated error in all of capitalism. We've got literally two centuries of examples of this phenomenon, from all over the world, with all different kinds of economic backdrops, states of technological development, and monetary conditions. We've got an entire century of data about how this phenomena occurs even when there is a lender o last resort. The current situation is the most predictable, least surprising economic fact I can think of. We have run this experiment literally hundreds of times; we know how it ends.

So, when someone like Paul De Grauwe in the linked article, claims that we have now had a cherished myth about markets destroyed, that only now it has become apparent that unregulated financial markets are not perfect, I go nuts. On two levels.

First, I can't possible see how this is surprising. All the fancy econo-physical models about risk and volatility and rational expectations and whatnot were obviously and transparently wrong right from the beginning. Anybody who has spent any time at all actually looking at how a business or a stockmarket works knows this immediately and intuitively -- the only way to make money is precisely to avoid the places where there is an eficient market. Make whatever model you want, but don't ask me to be shocked when it turns out that assuming the cow is a point in space isn't good enough to turn you into a dairy farmer.

Second, stop coming to conclusions about how markets have failed us when in reality all that has happened is that the reality of these markets hasn't corresponded to the toy model you made of them. It reminds me of the idiocy of people in the 90's saying that the USSR collapse somehow proved that "communism doesn't work". The truth is that you can't come to any conclusions about "markets" from the current experience, because the financial system doesn't even come close to resembling a free, open, and transparent market. The problem here is that there are three definitions of "market" involved in this discussion -- the economist's efficient market, real functioning markets (of which they are many concrete examples called 'commodities businesses' which no one is very excited about owning in general, the current euphoria for this sector aside), and the most common type of market, which is not at all free, but a system which whole going under the name of the 'free' market is actually rigged by the biggest players to their own advantage via the political system. The implosion of Freddie and Fannie has absolutely nothing to do with the first two definitions of the market because these companies never ever operated in a truly free market. They have always been the classic example of a government sponsored private monopoly -- the precise opposite of what a market is supposed to be.

This is why it drives me so nuts when the opportunistic moralists come out of the wood-work to proclaim that "unregulated markets have failed". Because there is no such thing as an unregulated market -- it's a complete oxymoron. The only unregulated market is the one where we go around hitting each other over the head with sticks and dragging women back to our caves by their hair. All real markets are regulated extensively with legal systems defining and enforcing property rights, contracts, etc ... There can be no market without regulation. The question is whether the regulation puts everyone who wants to play the game on the same foot, or whether it unfairly advantages the biggest players in the game. The current crisis is a failure of regulation -- that regulation failed to create the conditions of a free market because (among other things) it let people who knew they would be bailed out by the government gamble with other people's money. The current crisis is not a failure of anything resembling a "market" -- but it is a dramatic failure of something vaguely resembling a government.

The Banana Republic Club

Yves Smith has inaugurated the Banana Republic Club, which aims to commemorate respectable folks comparing the US to a Banana Republic. Given that the first members are William Buiter of the FT, and Mohamed El-Erian of PIMCO and Harvard Endowment fame, the company looks good, and I would like to sign up for a front-row seat at the next event. Maybe we can all get together at Burning Man?

Have you got rocks?

I no longer remember which year it was, but I do recall Warren Buffett's discussion of the Hadrocks and the Gotrocks in one of his annual letters (2005 it turns out). His point was simply that unlike in Lake Woebegone, not everyone can be above average or beat the market, and that if we all pay hedge fund 'helpers' 2-and-20 in an attempt to do this, we are simply collectively transferring our wealth to the helpers. The appropriate physical analogy is indeed friction -- financial industry profits are the frictional drag on our economic system.

I was reflecting on this this morning, and on the current financial meltdown, and realized that Buffett is right when it comes to beating the stock market, but not quite right about the financial sector in general -- some financial profits can come from creating a non-zero sum game. If I have capital and you have a business idea, neither of us is going anywhere fast unless we can meet and form a partnership. Someone who introduced us would actually generate economic value, and could capture (some of) this value without us being worse off. In fact, I think one of the big problems with the emerging markets is their lack of this non-zero sum game infrastructure, which is every bit as important as roads and schools.

I started wondering how one might measure what percentage of financial profits are real, in the sense of generating economic value, and what percentage are frictional. A tough question, but FT Alphaville has a post today suggesting one simplistic but plausible way of doing this. Barring some radical new-age-of-finance argument, there's nothing to suggest that finance has become dramatically more non-zero sum in the last decade. Hence, the sector's profits as a percentage of GDP ought to be about the same as it was a decade ago. If you check out the graphs in the post, you'll see graphically that financial profits have soared with respect to GDP, and you will find a measure of the excess profits generated over the last ten years -- $1 trillion dollars of light and heat, smoke and mirrors, friction at its most fricative and explicative. Fuckers.

Now, should we really be surprised that some of this excess may have been invested politically in making sure there was no mean reversion? Should we really be surprised that we have to bail these guys out.

Agency Issues

Brad Sester has a (slightly) less polemic and more data driven follow-up on Roubini's idea. It turns out that foreign official holdings of agency debt (Freddie, Fannie, Ginnie) are roughly 20% of the total $5 trillion agency debt outstanding. Looked at from the other side, he also estimates that between teh agency debt and the (explicit) treasuries they hold, China is sitting on a US government obligation position that equates to 25% of their GDP. Canned disclaimer on comparing stock numbers and flow numbers here. No matter how you look at it though, this is an extraodinarily large position for either side.

The basic take-away from this is that China is simply going to have to suck up the inflation that results from pegging to the US economy in this way, and the US is simply going to have to wallow through several years of stagflation. The other options -- letting the renminbi appreciate, or diversifying away from dollars, seem less and less viable every time I think about this. Sester has some interesting reflections on the irony of all this:

In some sense, it is remarkable that the system for channeling the emerging world’s savings into the US housing market - a system that relied on governments every step of the way, whether the state banks in China, that took in RMB deposits from Chinese savers and lent those funds to China’s central bank which then bought dollars and dollar-denominated Agency bonds, or the Agencies ability to use their implicit guarantee to turn US mortgages into a fairly liquid reserve assets — hasn’t broken down after the “subprime” crisis. The expectation that the US government would stand behind the Agencies is a big reason why.

That allowed the US government to turn to the Agencies to backstop the mortgage market once the “private” market for securitized mortgages dried up, as emerging market governments continued to buy huge quantities of Agencies.

And it now seems that this game will break down on the US end before it breaks on the emerging market end. The Agencies will run out of equity before central banks lose their willingness to buy Agency paper.

History, it is said, rhymes rather than repeats. Bretton Woods 1 broke down because some key governments weren’t willing to import inflation from the US. Bretton woods 2 has survived — even intensified — the subprime crisis because many emerging market governments have preferred importing inflation to currency appreciation. China seems more worried about textile job losses than inflation, negative real returns on household deposits or the risk of financial losses on its (large) holdings of Agencies.

Smart idea

Now, here's a smart idea from Nouriel Roubini (via Naked Capitalism). Instead of the government nationalizing Freddie and Fannie, why don't we just magically say that all of their obligations par value has been reduced by 5%. After all, what's really going on today is that the US is defaulting. We borrowed a lot of money from the Chinese and spent it on McMansions and color televisions, and now we can't pay it back. Fortunately for us, we have the reserve currency and the nukes, so the rest of the world is just going to have to resign themselves to having lost money on the deal. This is the sort of things that happens when somebody goes bankrupt -- you restructure their debt and life continues on.

First, notice that the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency – as of now and in the worst scenario of $200 to $300 billion – the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or – for unchanged face value – a very modest reduction in the interest rate on their debt after it has been forcibly restructured.

Second, a 5% haircut is much smaller than the 75% haircut that the holders of Argentine sovereign bonds suffered in 2001-2005, much smaller than the haircuts that holders or Russian and Ecuadorean debt suffered after those sovereign defaults, and much smaller than the 30% haircut that holders of corporate bonds suffer on average when a corporation goes into Chapter 11 and its debt is restructured. So why should Uncle Sam – i.e. eventually the U.S. taxpayer – pay that $250 billion bill when investors in the U.S. and around the world can afford it? The same investors are getting a fat subsidy of $50 billion a year (whose NPV is much bigger than $250 billion) for holding claims that now provide a 100bps spread above Treasuries and are under the implicit guarantee of a full bailout.

Third, of the two options we need to pick one: either we formally guarantee those claims and start paying the Treasury yield on that debt saving the tax payer that $50 billion subsidy; or if we maintain the subsidy a credit event in the form of a small haircut because of insolvency would be the fair cost that such investors pay for earning the extra spread over Treasuries.

Fourth, while the haircut would reduce the market value of such agency debt and inflict mark to market losses to investors such losses are already priced by the fact that the widening of the agency debt spread relative to Treasuries – from 10bps to about 100bps – has reduced the mark to market value of such agency debt. So, in the current legal limbo of insolvent GSEs whose debt is however not formally guaranteed the persistence of the spread would lead to those $250 billion mark-to-market losses regardless of a formal default, restructuring and haircut on that debt. We may as well resolve that insolvency and restore the positive net worth of the GSEs by doing the haircut.

Giant elephant in room

Why is it that we never read anything anywhere any more about to defense budget? This is the first thing that occurred to me when I saw this post about the new for brainwashing ... errr ... educating students on the dangers of social security.

Public Agenda said this week it will get a $500,000 grant to roll out a mini-curriculum at up to 500 colleges and universities focusing on the nation’s deteriorating financial situation. The National Academy of Public Administration and PETLab will get $325,000 to develop a game for college students focusing on “difficult fiscal issues like unsustainable entitlement programs, rising health care costs, and financing investments in alternative energy sources.”

Why is there no game educating students about the danger of electing a monkey as President and letting him appoint most of corporate America to his cabinet?

Socialized Capitalism is called Fascism

Fannie, Freddie, blah blah blah -- you don't need me to repeat what you've already read about their fates, and the fact that you sir, Mr. Taxpayer, will have to bail them out. Nor will I repeat the moaning moral outrage of those like Robert Reich who are shocked shocked to find that the government has loaded the capitalist dice in favor of the house, when in fact as the former Labor secretary he was involved in the process.

Marc Thoma however, seems to be a pretty smart and reasonable guy, and he expresses an opinion you can find in many places now, probably even in the mouths of your very own smart and reasonable friends.

On the too big to fail issue, my view hasn't changed. If failure of these firms endangers the broader economy, and hence threatens to impose large costs on people who had nothing to do with creating the problems, then policymakers need to step in and do what they can to prevent a downward economic economic spiral. In addition, they need to change the rules and regulations that allowed the problem to emerge in the first place, and add new rules and regulations as needed to lower the moral hazard worries going forward.

This stuff absolutely works me into a lather when I read it from someone I know means it seriously and with the best of intentions. Because well ... WHAT THE FUCK DO YOU THINK WE HAVE BEEN DOING FOR THE LAST CENTURY!!! Not to put to fine a point on it, but if any strategy has been absolutely, repeatedly and scientifically proven to be utterly, completely and totally doomed to failure it is the procedure recommended here. Please, I beg you, consider thinking about a different way of dealing with this.