Monday, March 30, 2009


I enjoyed this phrase, mainly because I thought that the reaction to Citi's 2-month results (who ever heard of two-month results anyhow? talk about a sell signal!) was ludicrous as well.
The excitement of investors last week about Citigroup posting an operating profit in the first two months of the year simply indicates that investors may not fully understand the term "operating profit." Citigroup could burst into flames while Vikram Pandit sells lemonade in the parking lot, and Citi would still post an operating profit. Operating profits exclude what happens on the balance sheet.

All in favor of setting Vikram Pandit on fire in a parking lot?


One of the better essays I've read recently was John Kenneth Galbraith's "Power and the Useful Economist", the presidential address he gave to the American Economics Assosciation in 1973 (no link, but you can find it in The Essential Galbraith).  The basic point of the essay is as straightforward and obvious today as it was in 1973; he criticizes neoclassical economics for ignoring the concept of power.  The vast weight of the whole edifice of modern economics rests, according to Galbraith, rests on the classic image of a competitive marketplace where firms take prices and are ultimately at the mercy of the consumer, and a political system where the state takes orders, and is thus ultimately at the mercy of the voters.

He goes on to point out what anyone with two fingers of forehead already knows, which is that big firms work awfully hard to cultivate and manage the desire for their products, that they often manage the prices of their inputs and the conditions of their labor, and that even the regulations meant to contain or control them comes to be part of their routine management of the environment.  Naked apes toiling under an inhospitable sun no longer.

Galbraith points all this out much more eloquently than I; he gives examples; he attributes this to the very complexity of specialized modern production.  Building something like the iPhone is a multi-year project requiring the organization of people with all kinds of skill sets.  Hence undertaking production of the iPhone requires calculating in advance what the demand for it might be, or better yet, simply creating and controlling that demand, in a way that producing something like, say corn, does not.  This type of production, what he calls the planning organization or the technostructure, has very little to do with the neoclassical image of the market, and yet we all know that most large corporations work like this -- they are price setters rather than price takers, and have a degree of power over the market and over the state that traditional economics is unable or unwillng to incorporate.

Organizations answering to this description of the oligopolistic planning strucuture include not only corporations, but, he also admirably admits, the unions as well.  In fact, in his view, they are the strict symbiot of these corporations, ordered according to a(nother) principal of competition left out of classicl economics, which he calls "countervailing power".  This is, in short, the principle by which monopoly propagates vertically, from distributor to manufacturer to workers and suppliers, each level consolidating in response to the growing power of the one above it.

Your humble blogger has belabored the not-at-all-very-market-like nature of contemporary capitalism so many times that, on this one occasion, he will take pity on you and merely toss in a few links to others who have had related reflections.  Suffice it to say that I agree with Galbraith, though I believe he stops short of realizing the full power of his own idea (at least it isn't in this essay) and maybe doesn't realize just how long this has been going on.  As Deleuze points out in this lecture, capitalism has never been liberal, it has always been state capitalism.

So we are all happily in agreement. 

Christ, what  boring fucking blog post that would make ¿no? 

Actually, Galbraith is wrong wrong horribly wrong.  Not in his diagnosis, with which I certainly agree, but in his proposed cure.  This is a guy, after all, who was one of the chief architects of the Office of Price Administration during WWII, the agency responsible for setting wages and prices so that the monster deficit and easy fiscal policy of wartime didn't set off on inflationary spiral in the domestic economy.  So, naturally, after outlining a situation in which classic liberal economics (in the old school Chomsky-ian, Smith-ian sense) fails to adequately describe a large portion of the economy because it is in fact a privately managed command and control economy and not a free market -- naturally, he proposes to improve things by making it all a command and control economy.  Talk about getting high on your own supply. 

Controlling prices and incomes may work in Vietnam, and it may even work for a few select staple products, but that's no way to run a modern, innovative economy.  Why on earth would you believe that your little command and control planning system would work?  What on earth makes you believe that this lever of power would not also acquire a mechanism that some group would be able to capture for their own nefarious self-interest once your enlightened dictatorshipness is born away on the dusky wings of perfect equilibrium? 

In short, he suffers from the same disease as so many liberals (in the contemporary terrorist-hugging sense) -- a penetrating critque of the structures of power that corrupt our current theories and practices, and an utterly ludicrous and literally fantastic proposal for their solution. 

If the problem is that the large organizations who command and control the economy manage to manipulate supply and demand to their own benefit without thereby being forced, a la Adam Smith, to work towards the benefit of everyone -- then perhaps it's the large organizations that need to go, rather than trying to invent an even larger organization that controls them.  This seems to me especially obvious when you start to realize that this largest organization is itself both the largest predator, and a clumsy dinosaur easily exploited by the more nimble wildebeests of corporate america. 

Saturday, March 28, 2009


This sounds pretty compelling and scary:

After rocks, the human race moved on to writing on animal skins and papyrus, which were faster at recording but didn't last nearly as long. Paper and printing presses were even faster, but also deteriorated more quickly. Starting to see a pattern? And now we have digital records, which might last a decade before becoming obsolete. Recording and handing down history thus becomes an increasingly daunting task, as each generation of media must be migrated to the next at a faster and faster rate, or we risk losing vital records

Until you ask yourself what on earth a trillion tweets and text messages are vital for.

Friday, March 27, 2009

No no a thousand times no

Here's another meme that must die, this one propagated by a full-fledged academic economist:

Since most of these troubled assets are held by banks, the FDIC has already effectively given them non-recourse loans–if the value of the troubled assets in the end doesn't cover the value of bank deposits, the bank shareholders walk away and the FDIC ponies up. I don't understand how moving these FDIC commitments out of the banks and into these Treasury-sponsored funds changes anything.

Yes, the banks deposits are already non-recourse FDIC insured. But it's common equity, preferred equity, and unsecured debt are not. So whether you let the banks first go bankrupt and then bail out (some) of the creditors or bailout the banks from the beginning makes all the difference in the world in terms of who bears the loss on these assets. This has been floating around a lot, and it is a perfectly fallacious in-the-long-run-we-are-all-dead professional economist type argument.

You can argue -- in decreasing order of probability now -- that this is really just a liquidity crisis and we should all calm down and let the bank go back to making the big bucks that their marks indicate they anticipate if they hold these assets to maturity (ie. that there is really no need for a bailout). Or, as many have, you can argue that the US banking system is too big and complex to nationalize all at once, a la Sweden. Or you can argue that there's some other good reason that the greater health of the economy requires that equity and non-deposit creditors be guaranteed up front. After all, if you were clever and sold some stocks, and put the proceeds in a money market fund, you are likely one of these unsecured non-FDIC-insured claim holders yourself, however indirectly.

But you cannot argue that that the Geithner plan and nationalization are effectively the same. That's shamefully misleading, which is actually something I believe Brad DeLong can often be accused of in pursuit of his ideological agenda.

(A more generous interpretation would not have DeLong shilling for Tommy-gun Tim, but simply suffering from an advanced case of economistitis, a near terminal condition characterized by the inability to see that an economy is not always at equilibrium and hence that there are problems that cannot be solved simply by restoring liquidity, because this would entail returning the whole system to what was already an unstable state. Side effects include not understanding that debt is a contract that perhaps should be violated on occasion for the greater good.)

Hard boiled down

All the successes of humanity are the result of cooperation for mutual benefit.  All its failures are the result of free-riders exploiting that cooperation.  But the real misery never starts until we put the free-riders in charge of coordinating the cooperation.

Maybe evolution is like picking up nickels in front of a steamroller.

Anything that is too big to fail is too big to exist.


What would be nice is if the whole concept of right and left in US politics broke down.  Here is Andrew Leonard from Salon.

But underneath all the details, such as whether the FDIC or the Treasury would have the power to close down a bank holding company like Citigroup, or exactly how the government would go about defining what kind of institution would pose "systemic risk" if it failed, or what the exact level of capital requirements will be appropriate, there was one significant question that wasn't being asked, at least not directly. And that was: If we change the rules, will you enforce them?

It's not often that you see leftwing critics like economist Dean Baker and hedge fund traders on the same page -- but both have been saying slightly different versions of the same thing lately (albeit for different reasons): We've got plenty of regulation in place. Dean Baker says all the hoopla about needing a systemic regulator is overblown. The Fed, he says, is already the systemic risk regulator -- it just didn't have the will to do what was necessary with respect to AIG or the big banks. Meanwhile, one hedge fund trader quoted in the Journal complained that there were already plenty of hoops for the hedge funds to jump through. We don't need any more, he whined.

You can make a good case that Wall Street ran amok not so much because the rules allowed it do so, but because a tacit admission from government has been in place more or less since the election of Ronald Reagan that regulators wouldn't be too industrious in applying the rules. So the real question that should be asked of Tim Geithner is not: What are the details, but what do you plan to do?

The "capitalism has failed" meme makes me want to vomit as much as the knee-jerk defenses of how well the system has worked.  We didn't end up with this crisis because of "raw" or "unfettered" markets.  We got here because we had a corrupt system where the winners wrote corrupt rules (or caused corrupt enforcement of the rules, same difference) so that they could keep winning.  That's got nothing to do with the success or failure of markets.


You have to be extremely careful with anything that comes out of the American Entreprise Institute.  These guys would sell their mother just to get McCarthy back into the senate.  Unfortunately, I find myself in partial agreement with this particular op-ed.

In visits to Asian capitals during the region's financial crisis in the late 1990s, I often heard Asian reformers such as Singapore's Lee Kuan Yew or Japan's Eisuke Sakakibara complain about how the incestuous relationship between governments and large Asian corporate conglomerates stymied real economic change. How fortunate, I thought then, that the United States was not similarly plagued by crony capitalism! However, watching Goldman Sachs's seeming lock on high-level U.S. Treasury jobs as well as the way that Republicans and Democrats alike tiptoed around reforming Freddie Mac and Fannie Mae -- among the largest campaign contributors to Congress -- made me wonder if the differences between the United States and the Asian economies were only a matter of degree.

It might make it slightly more palatable that I came to this thorough Glenn Greenwald at Salon, who obviously hugs terrorists. 

Anyhow, I don't think the question is really whether you agree of disagree with his comments.  Anybody who has had their eyes open for the last few years, any thinking person not blinded by ideology has realized that the US has a major corruption problem.  We have been oozing crony capitalism as never before. 

The question is what to do about this.  And this is why you cannot trust the people at the AEI.  Because everything they ever say all comes back to the same mantra of reduce the budget deficit.  Philosophically, I am in complete agreement with this.  One might ask where these conservative small government types were while Bush was looting the country, but that it water under the bridge at this point.  Right now though, the only thing that is going to prevent us from having a depression is the government smoothing out some of this deleveraging by adding to its own debt.  So I think the fiscal austerity crew are right on a long term basis, but fundamentally misguided at the moment.  The last thing we have to worry about right now is the government crowding out private investment or causing inflation by issuing too much debt.  We can actually afford to have the government expand dramatically for a while.

It's true that if this noisy expansion is as corrupt as the silent Bush coup, then somewhere not far down the road we are well and truly fucked.  But is that any worse than being fucked now, which is where we'll end up if we let the populist rhetoric and the obsession with our debt to derail our efforts to stabilize this system.  I'm not sure we have any choice but to have confidence in Obama, even though I actually have very little, and am totally disocuraged by the mechanics of the financial bailout. 

I'm not really sure how one escapes from the ratchet mechanism of bigger and bigger governmenmt invoked as the solution to the very crises that big and corrupt government itself creates.  Maybe I'm wrong here and cold trukey is the only way to go. 

Thursday, March 26, 2009

A lot more of less

The more you think about the Geithner plan, the less there is to like about it. 

It's a complicated and not terribly transparent way to deal with the problem, and that makes it susceptible to (further) looting.  Given that it operates behind the scenes, at a level few people are capable of understanding, it is not a very democratic way of solving the problem.  It also completely intertwines the Fed with the Treasury, which makes the central bank a quasi-fiscal agent

The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of taxpayers' resources that it entails threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay.

In his book, Koo turned a phrase I had never heard before -- an independent central bank should be considered the fourth branch of government.  That struck me as precisely correct.  If we are not going to be on a gold standard (and I think Keynes has sufficiently pointed out that there are better solutions) we do at least need some sort of sound money.  The Fed mandate of price stability is no longer credible if you are going to use it to bail out private risk-taking.  This eliminates the last remaining check and balance in the original system system of US governance -- the states got squashed by the federal government, congress got run down by the president, and the supreme court was always just a bunch of pansies.  Now we no longer have gold or an independent central bank, which effectively collapses everything into the person of the president and his minions.  Unfortunately, after eight years of Bush, nobody trusts the executive branch to do the right thing anymore, so even if you believed we have just elected a saint, you still have the problem that he is trying to herd cats.  The whole mechanism of power is falling apart.

Wednesday, March 25, 2009

Geithner Plan Matrix.

Now that at least the basic mechanics of the bank bailout plan are known, it's time to try and reduce the still enormous uncertainty surrounding its effect to as few questions as possible.  First, if you haven't seen this stuff already, you need to understand exactly how the structure works.  Start with this simple math based on the original white paper the Treasury put out.  If you want to follow up on that there has been a tremendous amount of good stuff written for and against.  I can recommend Mark Thoma, Brad DeLong, Jeff Sachs, and Paul Krugman.  But you can read till your blue in the face on this one without getting a definitive take on whether it's a good idea or not. 

What is not in dispute is that no matter how you look at it, the plan constitutes the possibility of a subsidy for both the banking industry and the private investors who will be buying these assets with government assistance.  This possibility is created by the fact that the plan allows private investors to borrow against each asset they buy individually, which essentially gives them a cheap put option on the ones that go bad.  So there's no longer any question that the plan is structured to afford, at least the possibility of a back-door subsidy to the banking industry.  This is in and of itself a bit sneaky I think, because officialdom keeps insisting that there is no subsidy, which is just a big fat lie.

How big is this subsidy, who gets it, and what effect will all this have on the economy relative to our other options for dealing with this?  These are tough questions.  The answers really depend on how the program is administered, what prices banks are willing to accept for these assets, and whether the assets . 

Because you see, the whole process begins with banks identifying what assets they want to sell.  This should already raise your hackles.  These insolvent fucks are going to tell me what toxic crap they want to unload?  But that's how it works.  The banks are carrying most of these assets on their books at better than 90 cents on the dollar, insisting that they are unimpaired.  The assets that have actually traded in the market have gone for around 25 cents on the dollar.  That's one hell of a bid-ask spread.  A recent Goldman report does some plausible back of the envelope math that suggest that the plan's leverage and embedded put could raise this bid to 66 cents on the dollar, and the buyer would still make the same return.  The assets are probably worth something like 40 cents if a unlevered investor held them to maturity and made a decent but not spectacular return for taking this risk (note that what an asset is "worth" is not a straightforward question -- these loans are certainly not "worth" their face value, both because some have defaulted, but also because they were risky to begin with, and so anyone making them should have asked for a much better return.  One thing that has been mostly missing from this debate is that we really don't want these assets to go back to being worth face value, because they damn things really shouldn't have existed in the first place.  Sometimes it's hard to see that we're not looking to go back to status quo here, even if that were possible).

So, will the plan work?  Well, if the banks are willing to sell all the toxic crap that's really worth 40 for 66, and stomach the writedown from 95, and the taxpayer is willing to pick up the tab of this subsidy, and then the additional tab that comes from the fact that at least Citibank will be insolvent and require further government capital -- then ... umm ... yeah, the plan will "work".  Work in the sense of transfer billions to the banking and private equity industry to ensure that they are solvent so that we can go back to business as usual. 

This assesment is actually probably a little harsh.  Some of the banks probably are solvent even as it stands, and have simply been cuaght up in the panic.  Others are just mildy insolvent (depending on what you mean by insolvent) and this subsidy combined with a period of low short term rates would probably enable them to earn their way out of it.  For those banks, this plan could legitamately be said to work.  It's not fair.  It involves a big taxpayer subsidy to folks who made loans they shouldn't have.  But of course, it also bails out all the creditors to the banks -- especially the depositors.  If this were the whole story, I guess I would go along with the plan, even though it means higher taxes for me, because for me there really is some value in having the financial system around at least long enough for me to finance by bunker.

Unfortunately, I don't think that the plan will work. 

First, just from a practical perspective, it doesn't look like even this subsidy will be enough to bridge the gap between bid and ask, which suggests that the banks may simply collectively stone-wall the process.  If I were the CEO of Citibank, I'd be carefully preparing a smallish list of slightly dinged assets to sell, without in any way hinting that these are close to the best ones I have on my books.  I offer these up, get a bit of subsidy for them, and insist that all the rest are fine.  See, everything nice and marked to market.  The investors aren't going to quite believe me, and the stock will spend the next three years alternately soaring and tanking, soaring and tanking, but so what.  I'll gradually earn my way out of it, or, better yet, make a bunch of risky new loans and dig the hole even deeper.  After all, at that point my stock options are either worth zero, or a lot if I get lucky, hit the jackpot, and make a bunch of big loans just before the economy recovers.  Once you're effectively bankrupt, there's nowhere to go but up.

I'm exaggerating (a little) but my basic point here is that unless the government is serious about stress testing the banks after this new plan allows us to get an idea of what their assets are really worth, serious about forcing them to take new equity dilutions form the government if they are short of capital, then there really no stick for the bank to offer up any assets for sale at prices that don't hit their current bids.  What does Citibank have to gain from marking these assets down if it will be insolvent afterwards?  They will not commit hari-kari all on their own.

The second problem is related to the first.  Let's assume that we somehow convince the deeply insolvent banks to mark things to (already subsidized) market, and they are now well and truly insolvent.  Are the monkeys that run our congress going to have the political will to nationalize a big chunk of the banking industry?  Or are they going to avoid this isssue just like Citibank would like to?  Instead of forcing the banks into receivership, or FDIC restructuring, or nationalization, or whatever you want to call it, they are more likely than not to keep kicking the can down the road by dribbling out another $100b here and there to keep them afloat for a while longer.  Look how they are treating GM.  Why would it be any different with a perpetually bankrupt Citi?  In fact, it would be worse, given that the price of letting Citi fail would be larger, and given that you can garner a lot more in the way of campaign contributions from CEOs by perpetually putting them on congressional life support. 

If you want to look at the bright side, you can imagine that the Geithner plan is step one -- a very generous price discovery mechanism -- of a multi-part plan to deal with the whole banking system.  Step two would be serious stress-testing or the remaining assets, and step three recapitalizaiton, if necessary. 

If you prefer dark meat, you can see this big up front subsidy as just a prelude to larger lootings in the future. 

I hardly think you need to ask where I stand.  And the worst part about the whole thing is that fianancial history contains clear lessons about how kicking the can down the road costs much more over the long-term than dealing with the problem in a straightforward way.  So the difference between the good and bad interpretation of the plan is not simply one of fairness, but also one of total cost to the overall economy.  I guess I hope I am wrong.

How do you spell debt-deflation?

I've now accepted the basic framework that Richard Koo and Martin Wolf have expounded, namely that we are in for a balance sheet recession a la Japan -- the economy can't grow if we all try to save up and pay off our debt at the same time. The only question is how this works when big chunk of the debt is not in the hands of a corporation which can be declared insolvent, but of a consumer who cannot. In Japan, and as you can see here, during the Great Depression, the debt was mainly corporate. Corporations can't remain underwater for long, given that their creditors and equity owners tend to rapidly pull the plug on them. So they have a strong impetus to pay down debt as fast as possible. Nobody forces you to sell your house as soon as you get upside-down on the mortgage. As long as you don't lose your job (or wise up and send some jingle mail) you just keep working it off like an old-time sharecropper. This might make you spend less, but it probably doesn't lead you to literally pay down your mortgage more rapidly. I'm still unclear if the macro-economic consequences of this are different.

Saturday, March 21, 2009

Dead Dogs Two

From the height of the highway onramp
We saw two dogs, a-dead in a field
Glowing on the Oakland Coliseum
Green seats wasteland
Dogs, dogs we thought were dead
They rose up, rose up when whistled at
Their rib cage inflating
Like men on the beach being photographed
A guard dog, guard dog for what, for what
Against overzealous penniless athletic fanatics
Getting into games through a whole in the fence
For the owner of the blue tarp tent
Pitched by a creek, beneath an onramp
In the privacy of the last three
Skin and bony trees, devoid of leaves
And us undeceased and our new cd's
Dippin' on dead east, Oakland

It's hard to stand the sight of
Two dogs dead under a sky so blue
You have to stop the blood to your head
To fit the breath in front of you

We secretly long to be some part of a car crash
Long to see your arms stripped off the tendons
The nudity of swelling exposed vein
Webbing the back of your hand
To be a red-tendoned dog
To be red-tendoned dogs
Blood breathing by the side of the highway

I long to be dead
Center of a curious crowd
To be touched
Sticky like nearly dried paint
Their soft silent stare nursing your face
Anticipating the slightest pinch I flinch of pain
Everyone blank in accident awe
As the car crash fiberglass dust
Straight up settles on your raw muscle tissue


To be a red-tendoned dog
To be red-tendoned dogs
To be red-tendoned dogs
To be red-tendoned dogs
To be dead center of a curious crowd

"Against my misery I don't think I've seen my screeching pain. I can now feel what's around us it is some sort of harmony, the harmony of overwhelming and collective murder"

Friday, March 20, 2009

More AIG-ony

The Baseline Scenario has a post that goes into a bit more detail than I have here about the bailing out of AIG. The basic points are the same though. First, making sure AIG didn't fail by guaranteeing their insurance was the whole point of the bailout at the time. Second, that doesn't mean that you have to protect those who bought the insurance forever:
I, for one, don’t think that “saving” the too-big-to-fail financial institutions is or was among the legitimate purposes of our financial policy. The idea is—or at least ought to be—that we’re trying to prevent them from failing in a way that causes everyone else’s business to go under.
And third, the goddamn bonuses are a pimple on an elephant's ass already. Pay them or don't pay them, whatever. Just don't let congress cynically bog down the debate with this pseudo-populist crap. Focus on the important and systematic stuff.

Thursday, March 19, 2009

Deep thought of the day

I'm nearing the end of V. Gordon Childe's What Happened in History: A Study of the rise and decline of cultural and moral values in the Old World up to the fall of the Roman Empire.  Childe is an Australian archeologist from the 1940's who writes a brief history of the human race's "rise" from ape to ape-with-suit, with our intervening daliances as neothlithic hunter, barbarian farmer, civilized bronze age statist, iron age merchant, barbarian farmer once again, and finally western democrat courtesy of the Greeks. 

Childe is not exactly a Marxist, nor even an economic determinist of ambigous politics, but he does lay quite a bit of stake by the effect a particular economic system has on the functioning of society.  Humans organize themselves differntly depending on whether they are picking bananas, fighting each other with bronze chariots, casting iron plows, or deerhunting with jesus.  This is not super surprising of course, but the interesting thing is that after a while, you start to see a pattern amongst these forms of organization.  Society seem to proceed through periods where technology produces productivity gains, which are then captured by some ruling class.  At first, this capture serves to coordinate the reinvestment of the surplus thereby produced, generating even more of it.  Eventually, however, all the surplus gets concentrated in the ruling class, which can only effectively reinvest so much of it, and the whole structure topples under its own weight because only the emperor can afford to buy anything. 

Later, this same cycle gets extended via the use of money and particularly debt.  Debt at a high interest rate is just a sneaky way for a creditor to capture the surplus production of a debtor without appealing overtly to religious considerations such as the duty he owes to the emperor-god-president-dad.  This works for a while longer, but he points out how it ends at the same state where one rich guy has all the money, and everyone else is in his debt.  If he can only blow so much money on hookers and golden palaces, then most of it is effectively taken out of circulation, which any good macroeconomist will tell you is some sort of Ur version of the Great Depression (literally). 

So anyway, I don't think that line of reasoning is terribly new, and I'm sure there a Marxist moldering away in some Italian jail whose already written all that down.  My little thought was just that these periods normally seem to end with the poor people being in the rich guys debt, whereas, the current situation has perversely left the rich people in the debt of the poor.  This is true in a couple of senses.  First, all those bankers are being bailed out by a taxpayer who has seen the real income stagnate for a decade, and yet one who is the main creditor to those banks in the form of his savings deposits and money market funds.  Perverse.  And then on top of that, the US isn't even self-sufficient in terms of credit -- we have borrowed from the Chinese et al ... who are now worried they may not see their money again.

Isn't is odd that the system should fail because the "rich" guy goes broke?  I mean, from an archaeological perspective.

New Investment Advice

I take back everything I said a few posts ago; this chart succinctly sums up how to allocate your retirement funds.

American International Gaffe

Given that this AIG thing just will. not. die. I feel the need to comment briefly on what has become a truly ludicrous story.  Let's begin with the fact that I am entirely sympathetic to the populist and general pitchfork-wielding ire that is out there at the moment.  Every morning I walk past Morgan Stanley's headquarters on the way to work, and the other day I thought I saw John Mack standing out front surrounded by a bunch of television cameras.  My immediate and visceral desire was to hock a huge lugie in the  bum's face and yell crook.  Fortunately no pitchfork was ready-to-hand.  That being said, however, I think we should try to think through what's really at stake in these bailout and not let our instincts or the media lead us astray wehn it comes to trying to do the greatest good for the greatest number in this financial and economic crisis.

So first, let's talk about why we bailed out AIG in the first place.  We bailed out AIG because we let them write tons of insurance that they couldn't possibly have paid off.  And it looked like they might well have to pay it off, given how bad things were getting.  The people who had bought this insurance -- Goldman Sachs, Morgan Stanley, various hedge funds through their prime brokers and banks -- were counting on it paying out if things went bad.  In other words, these entities were using AIG as a counterparty in a hedge.  Having theoretically hedged the risk of some bad stuff happening, they could then go out and invest as if that bad stuff couldn't happen.  This is the whole idea of a hedge.  If these companies hadn't been able to buy this insurance, they almost certainly would have been more cautious and concerend about the bad stuff happening. 

So now, what happens to the people who bought these insurance policies when they discover that maybe the insurnace isn't worth what they though it was worth, in other words when they discover that bad stuff is happening that AIG may not be able to protect them against?  Naturally, they will go out and liquidate the other side of the bet to protect themselves.  Equally naturally, the forced liquidation of this other side will actually cause that very bad stuff to happen.  Very quickly.  Because the guys who bought this insurance were also leveraged.  Let's say Goldman had $5 to play with and it wanted to be on good things happening.  It went out and paid AIG $5 to insure against a fire that would cause $100 in damages if it happened.  Paying that $5 made Goldman comfortable with the idea of going out and borrowing another $95 to bet on good stuff happening.  If that insurance goes away, even if there has been no fire, Goldman now has to go out and sell all $100 of good stuff, because even a very small $5 fire will wipe out all the money that they had to play with (which in any case they already paid to AIG as the premium on the insurance).  Selling $100 worth of good stuff makes the price of good stuff go down.  Especially if everyone made the same bet with the same insurance company and has to sell it all at the same time.  This is why stuff like this doesn't really make a lot of sense:

Every day, insurance companies sell policies to homeowners to cover the cost of damage in the case of fire. Why would those companies agree to pay out in full to a policyholder even if a fire had not occurred?

That is the type of question being asked about the federal government's bailout of American International Group in which the insurance company funneled $49.5 billion in taxpayer funds to financial institutions, including Deutsche Bank, Goldman Sachs and Merrill Lynch. The payments, which amount to almost 30 percent of the $170 billion in taxpayer commitments provided to A.I.G. since its near collapse last September, were disclosed by the company on Sunday.

Gretchen Morgenstern is usually more thoughtful than this.  I guess thoughful ain't selling papers at the moment.  Because there's no point in bailing out AIG at all, if you are not going to make good on the policies they wrote.  Paying out on those policies, in order to avoid having the policyholders liquidated the other side of the transaction in a hurry, was the whole reason for bailing them out in the first place.  So you can't really act surprised when this is what happens.  It wouldn't have been a bailout without this. In fact, rather than being surprised that 30% of the money went to this, I want to know what the fuck happened to the other 70%. 

You can certainly argue that there should have been no bailout of AIG.  What you cannot argue is that there should have been a bailout of AIG, but that these policies should have been cancelled.

I would argue that the bailout of AIG was necessary, because there literally would be no financial system if all the people who bought insurance from them had to protect themselves from that insurnace ceasing to exist at the same time.  Contrary to popular belief, the financial system not existing is not actually the end of the world.  The species is not going to die out.  In fact, the resultant death toll would probably be very limited.  However, abruptly eliminating money would cause a fair bit of chaos and suffering that it really kinda needless.  Hence I support the bailing out of AIG.  Hence I support these payouts, which was exactly what the bailout was supposed to do.

Of course, while I did and do support the bailout of AIG, I also am not stupid enough to think that all of this came as a surprise to Goldman, Morgan etc ...  These guys knew with 100% certainty that AIG was insovlent, and knew with 100% certainty that the government would bailout AIG when push came to shove.  I defend the bailout, the mechanism of which necessarily involves paying out on these cynically accepted policies.  You can ask why Goldman et al ... were not forced to take a haircut on these policies.  This is like asking why we shouldn't let the house burn down just a little to punish the guy who knowingly bought crap insurance and then sat in the bath tub doing coke off the top of his toaster.  If you could let just his house burn down just a little, this would be a splendid punsihment; unfortunately, you're bound to end up setting the whole neighborhood on fire.

The only thing you can do to solve this problem is to actually have the political sack to bail out the system and then go and lay blame for this directly at the doorstep of those who caused it in individual fashion.  In other words, the government should bailout Goldman in this fashion for the sake of systemic stability, and then it should fucking confiscate some portion of the company from current irresponsible shareholders.  You could do this through forcing them to issue shares, or through taxing them into oblivion.

This brings us to the second big point in the AIG debate -- the bonuses.  I don't really see any reason to pay the guys at AIG any bonuses at all.  None of the arguments I've heard holds even a minimal amount of water, not even when it comes from the pseudo-regretful mouth of the New York Times, rather than from the more defiant posturing of the Journal (who can expected to defend its own, and whose opinion pieces are at any rate incoherent -- I mean, these guys give Karl Rove a weekly space). 

The arguements I've heard have to do with not changing contracts, and with retaining talent.  These are silly.  The government rountinely changes the rules of the game.  They write the rules, and they can change the rules.  They do it all the time.  Ask anyone in healthcare, defense contracting, or pretty much any other industry that has anything to do with the government.  Crap like this is non-sensical:

If you think this economy is a mess now, imagine what it would look like if the business community started to worry that the government would start abrogating contracts left and right.

As much as we might want to void those A.I.G. pay contracts, Pearl Meyer, a compensation consultant at Steven Hall & Partners, says it would put American business on a worse slippery slope than it already is. Business agreements of other companies that have taken taxpayer money might fall into question. Even companies that have not turned to Washington might seize the opportunity to break inconvenient contracts.

If government officials were to break the contracts, they would be "breaking a bond," Ms. Meyer says. "They are raising a whole new question about the trust and commitment organizations have to their employees."
The other argument is about retaining "talent".  Um, no.  This "talent" is what put us here to being with,.  In addition, this "talent" has nowhere else to go.  Have these guys not seen the state of employment in the financial industry?  Nobody is going to hire these idiots now.  They should be glad that they even have a job and are not flipping burgers.  On top of that, this is simply the nature of working in finance and everyone should know it.  You don't make money by loosing money.  It's feast or famine here. 

Quantitative Easing

That's the technical term for the Fed's new plan to print money and throw it into the Treasury market.  Frankly, I don't think too much of it.  As Richard Koo point out, Japan did this for years, and it had exactly and precisely zero effect on the economy.  Why doesn't printing money work, you might ask?  It seems foolproof.  Unless of course nobody wants your stinkin money:

"Even if the Fed could make interest rates negative, that wouldn't necessarily help," Mr. Hatzius said. "We're in a deep recession mainly because the private sector, for a variety of reasons, has decided to save a lot more. You can have a zero interest rate, but if you just offer more money on top of the money that is already available, it doesn't do that much."

After reading Koo's book, I am basically on board with this last train of thought.  He called the Japanese experiment with quantitative easing the great non-event of the century, and he had some pretty convincing graphs to back that statement up.  Intuitively though, you can see how it is unlikely to work -- short term rates have gone from 5% to 0% without stimulating anything, so what makes you think pushing the 10 year and mortagage rates down another 50 basis points is going to shock, awe, or even mildly entertain?  

Monday, March 16, 2009

Unsolicited Investment Advice

Throughout all of last year, though especially with gathering force towards the end of the year, people inexpert in managing the vagaries of our financial markets were eagerly looking for insight from someone involved in them professionally. Certainly, we should admit that it was the first time where it was okay (and maybe even kinda perversely and rubber-neckingly interesting) to pontificate at parties about the merits of the gold standard and the excesses of the "shadow banking system". Beyond the intellectual curiosity of those wondering what all the sound and fury was about was, of course, a real concern with their own jobs and assets, particularly from people of my parent's generation (the baby boomers broadly speaking).

Apropos of this, and of the work I have been doing over the last year on the "endowment model" of investing (there's also an interview with Dave Swensen that lays out the basics in a recent Yale alumni magazine), I felt like I should write something about how I believe the investor should invest their savings. Investing is really really hard. Most baby boomers don't believe this, probably because they only started to have money to invest beginning in the early eighties, coincidentally the exact moment that last and greatest bull market for financial assets got under way. The rising tide lifted all boats, more and more people saw the strong results that came of pouring money into the stock market or the housing market, and folks began to fundamentally confuse saving with investing. Saving is easy. All you have to do is make more than you spend. Put the difference in an interest bearing bank account and it will be there to spend later. Saving is easy and prudent.

Investing, however, is hard and risky. What you are trying to do in investing is actually increase the purchasing power of your savings over the long term. Think about that for a second. Think about what it means in almost protestant ethic type terms -- realize that you are asking for a handout. You are looking for a free lunch. You want to work one day and take two days off, rather than being content to work today so that you don't have to tomorrow. This is what most people don't understand about investing. It's hard. It should be hard. There should be no free lunch. And despite what it seemed like up till 2008, there really isn't any.

A lot of people didn't understand this, and judging from the continued popularity of the non-sensical talking heads brought nightly to the comfort of your living room, a lot of people still don't. Partly I think this is a failure of our educational system. I remember being taught how to mop and spell in fourth grade, but somehow double-entry bookkeeping didn't make it into the cirriculum; u can imagin wich of thees has provd more usefel. But beyond this failure of our educational system, the average educated person's fairly appalling ignorance of the basics of economics and finance has a more sinister cause as well. That's how us pros make money. The profits of the financial system are analogous to the frictional losses of a mechanical system. Finance is all heat and no light. Yeah, yeah, sure, we're matching what you should be saving to where you might be investing, and some value is created there. Banks and financial professionals that transform saving into investment in this manner are providing a public service in a highly competitive market. So we try to make it look like they are doing something more, something arcane and complicated and special and worthy of flying around in private jets. We make it way more complex that it needs to be and even than it can sustainably be. And then we charge you for that. None of us really have any incentive to let you figure it out. In this age of specialization and intellectual fort-building there's certainly a lot of professions like this; I'm not sure it's any different than with doctors and lawyers in this respect, though I continue to believe that our lobbying campaign is tops.

That, then, would be where my advice to folks like my parents or friends begins (not that any of them read this blog). Probably the single soundest piece of financial advice I have for the non-professional is to ignore most of the financial advice you hear. Investing is hard. A lot of really smart, highly incentivized people go to work everyday and deploy an immense quantity of resources in an attempt to lap each other around the same hamster wheel. Some of us will win and some will lose (by definition we can't all beat the market) but you can be certain that the fuel that powers the whole infernal apparatus is the money we take from you in the form of fees and transaction costs. And the more we obfuscate how the whole thing works, the more you think those fees and transaction costs must somehow be justified, till it gets to the point where you don't even realize that you're paying them because we've made the whole thing so damn complicated that we don't even have to officially charge you for it anymore. If anybody is going to get ahead with this scheme, it is us, not you. So I know I sound like a Cretan liar, but take my most basic piece of advice -- ignore my advice.

Having said that, I now have some hot stock tips.

Understanding that, as a part-time individual investor, the deck is stacked against you as far as investing goes is an important first step, but it doesn't tell you much about what you should do. So let's start boiling it down to some more concrete advice. First, some general suggestions for the management of your financial assets:
  1. Lower your expectations. Mostly you will spend tomorrow what you didn't spend today. You're free lunch, if any, will be very small. If it weren't, the demand for it would be much higher, and would push the price up. In a second, I'll go over the various types of financial assets, the returns you can expect from each on an inflation adjusted basis, and how much of each you should own, but to summarize quickly, most people should expect the purchasing power of their savings (ie. savings adjusted for inflation) to grow at a compounding annual rate of a bit more than 3% after all fees
  2. Lower your fees. Once you adjust your expectations to reality, you'll see that investing is so hard, and people are fighting so ferociously over such a tiny pie, that saving even a little money by avoiding getting involved in the rat race in the first place turns out to be pretty significant in the end. Mutual funds charge huge hidden fees that can top 2% a year once you tally everything up. Your broker and your bank and everybody else and his dog want to tack some fee on somewhere, because that is how they make their living. Those fees can eat through your 3% pretty quickly. The little graphic on the Vanguard site sums it up (Vanguard, by the way, are the pioneers of low cost investing, and run a decent, ethical outfit. They are always the first place to stop and compare costs, and the products are generally designed around exactly the philosophy I am giving you here).
  3. Lower your risk as you get older. There is a great rule of thumb that says you should allocate your age to bonds. If you are 55 years old, 55% of your savings should be in bonds and 45% in stocks (the rule is not counting your house, which is the other main asset people have). It's a pretty good rule. With people living longer these days, it might arguably shift to your age minus 10 years. People have forgotten over the last 30 years that stocks are risky assets. They remembered this quite suddenly last fall, and the forgotten lesson is all the more painful for those who were retired or closing in on it. The closer you come to retirement, the more you may want to spend your savings over a shorter time horizon. Bonds are less volatile, and pay a fixed amount of interest every year. It's even safer to have some of that money just in the bank. The money you keep in stocks should be money you will not need to spend for 10 years. Stock markets go though long cycles. On average you do better in stocks than bonds, and over a long time period, the difference can be significant, but the key here is on average and over time.
Fortunately, once you've seen the light with respect to the low expectations, low fees and low risk philosophy, investing turns out to be very simple, because you can basically ignore most everything. Investing is hard and you are overwhelmingly likely to lose trying to bet against the house, so don't try. Know thyself -- admit to your own ignorance and plan accordingly.

How does this all work in practice?

The typical middle class American has four basic assets. They own a home. They own some stocks. They own some bonds. They have a bank account. Let's go through what to expect from each of these investments one by one.

Safe as Houses

Contrary to popular wisdom, houses are not actually investments. Owning a house is a fine idea, and can be a good way to force yourself to save money, but over time, houses do not make an economy more productive and they do not tend to appreciate in value in real terms. In other words, houses are consumer goods.

I've discovered that most folks, even now, have an extremely difficult time understanding this. They were told that a house is a great investment, that it was always better to buy than to rent, and that they could always expect their home to appreciate in value. Unfortunately, they were misinformed. Houses, as you can imagine, have been around for a long time and have been built in many places. Accordingly, if you look at the data from these times and places, you will find that, on average, the long-term inflation adjusted price appreciation of a home is about 0%. The only times housing appreciates rapidly and consistently is during a bubble. In fact, history has shown that rapid and consistent increases in the price of housing is almost inevitably the sign of a bubble. In addition to being a solid and empirical fact, this conclusion also kinda stands to reason, if you think about it for a moment. After all, unlike building a factory, building a house doesn't allow you produce more stuff, which is the basic hallmark of a true investment. And there's only one part of a house that has any value that might be expected to appreciate over time -- namely the land -- and while this may be fixed in quantity and hence scarce, there really is a lot of it, as even a quick glance at suburban sprawl will show.

Given that for many middle class folks their home is their largest asset, this alone makes it difficult to have high expectations for their returns. Mostly, a house is a consumer item that everyone needs, the cost of which is reflected in your mortgage payment, and a means of ensuring that you save the down-payments instead of blowing it on high-living and fast cars.

So don't expect much real return from your house.

Bank On It

The other thing most people have that won't appreciate in value is a bank account. A bank account is a fine way to save money, and if properly managed can serve to maintain its purchasing power -- the interest the bank pays you will offset the loss due to inflation. Unlike with houses, people seem intuitively to understand that a bank account is just a way to store savings in a manner slightly safer than your sock. The point of having these savings is to manage to daily expenses of life and to have something for those unexpected expenses that everyone expects to appear periodically. As with houses, you should expect a real return of 0% here, so there's really no reason to leave any more money in the bank that what you expect to spend in the next several years, plus some rainy day money just in case. Obviously, as you retire you tend to have less money coming in from a salary or pension, and more money going out in expenses, suggesting that the amount you need to have ready in the bank to meet immediate needs should increase.

Buy Some Bonds

Finally, we get to the first true investment that the average Joe is going to make. I think most folks know more or less what bond is. You loan someone your money for a specified length of time, typically at a specified interest rate (known as the coupon), and at the end they give it back to you (the principal). The hope is that they pay you an interest rate sufficient not only to compensate you for the inflation that reduces the purchasing power of the principal, but something more for the risk that they don't pay your money back.

Taking this risk the the borrower will not be creditworthy, which you are not taking by having your money in a bank, means that you might hope to make a few percent annually in real terms. The exact amount of course depends on how much risk you want to take. The bond market is both very large (much larger than the stock market) and very complex -- all different levels of risk are available in all sorts of exotic flavors. Luckily, this is where the aforementioned philosophy of ignorance comes in handy. If you don't know what risk to take with your bonds, don't take any at all.

People consider US government obligations to be "risk-free". This is clearly an exaggeration. The US government has already defaulted once (in the Great Depression they devalued the dollar relative to gold, at the same time as they made it illegal to privately hold gold) and is perfectly capable of doing it again. Given that we no longer have a gold standard and the state now prints up, at essentially zero cost, the little green pieces of paper that count as satisfying its obligations, in practice the US would default on its debt by creating inflation. This risk exists not just for US government bonds, but for every bond; inflation corrodes the purchasing power of a bond, because both the coupon and principal are paid in fixed nominal dollars which lose value every year in an inflationary world.

Hence the simplest and therefore best bond would be a US government bond indexed for inflation. Fortunately, such a bond exists. It is called a Treasury Inflation Protected Security (TIPS). These bonds see their principal and coupon increase at a rate equal to the annual change in the consumer price index. Thus, they provide a guaranteed real return over the life of the bond -- typically of around 2%. This is the most basic investment you can make, and it is the benchmark rate for risking any of your money. Again, in my opinion, for the non-professional, there is no reasons to bother investigating any other type of bond. Other bonds will often produce higher returns, but they are also inevitably more risky. Many intelligent people compete to evaluate those risks and find those returns. The average investor is unlikely to beat them at this game by playing in his spare time. So if some bond appears to be paying more, there is likely to be a reason for it. This is not to say that the bond market is perfectly efficient and rational like they tell you in textbooks and neocon talk shows -- this is just to say that I'm likely to find out where it's inefficient long before you do.

So if you reign in your expectations and admit your ignorance it turns out to be really easy to invest in bonds. In practice you can either buy these bonds directly from the Treasury for very low fees, directly from your broker, through a mutual fund, or through what is called an ETF (Exchange Traded Funds are very similar to mutual funds but typically have lower and more transparent fees and trade continuously on the stock exchange like any stock). These last two options allow you to purchase an entire portfolio of bonds that mature at different dates in one go. This may be appealing if you are not inclined to plan out when you want the money back from the bonds in order to spend it. In this case, I would recommend the ETF, which trades under the ticker TIP.

On a final note, a lot of people have lately asked me about whether they should buy gold or other currencies. This is a reasonable question given that they hear a lot about the possibility of inflation and the debasement of the dollar. My advice for the average person is to forget it. Gold produces no interest and is inherently speculative; under no terms should it be considered an investment. Equally, the average person should simply not worry about trying to predict the global macroeconomic trends that govern the movements of other currencies. I have yet to see even experts correctly predict these with any consistency. My advice might be different for someone from some small country like Argentina, or if the US had some specific problem no other nation suffered from, but as it stands I do not believe that the individual investor has any clear option to protect themselves from true global financial meltdown, short of a vegetable patch and a shotgun.

In this regard you should hold to your ignorance like a faith. The government can nationalize companies and wipe out your stock portfolio. They can create inflation. They can fail to adequately insure your bank deposits, and in the final instance, they can even confiscate your house. There is not much you can do about any of these things as an individual investor. You should only lose sleep over these possibilities in your role as a citizen.

Stakes In Stocks

The final asset that most people will own at some point is stocks. Stocks represent a partial ownership interest in a company. Though everyone has heard this definition, most people have not come to grips with its most fundamental implication, namely that the lower stocks go, the more attractive they are from a long-term perspective, and vice versa. After all, if someone was going to sell you their entire business, you would feel much better about buying it at a lower multiple of the profits it was making, and much more uncertain if they asked for a higher multiple, all else being equal.

The same is true of stocks. Over long periods of time, returns in the stock market are governed primarily by the price you pay when you buy in. This is because the return you make investing in a business is composed of two essential ingredients. The growth in the profits of the business, and the amount of those profits that the business can pay out to you relative to the price you paid for this privilege. What makes stocks superior to bonds over the long-term is usually the growth in the profits (though in some periods stocks can be bought more cheaply -- at higher yields -- than bonds) that is directly attributable to the productivity gains in an economy.

Historically, the average real returns from stocks has amounted to around 6%. While this may not sound like much at first, the extra 4% one can make above and beyond bonds can be enormous if it compounds over long periods. Unfortunately, the key thing to remember here is the part about loooong periods. When investing in stocks, you should have a time horizon of close to ten years. This is not only because stocks are riskier, in the sense of suffering from volatile swings related to economic cycles, but also because the stock market experiences long periods of under and over-valuation. In the US, for example, productivity and profit growth has been quite strong over the past ten years, but because stocks began the millennium at such exorbitant valuations, the market has been essentially flat over this time period.

All these considerations of valuation and timing, however, lead us away from our philosophy of ignorance. Suffice it to say that stocks are the highest yielding investment one can make, but also the most risky, and accordingly should represent a decreasing percentage of your financial assets as you get older (remember the age-in-bonds rule).

The final question to confront in buying stocks is exactly which to buy. Here again, ignorance is bliss. If you don't know which stocks to buy, you should simply buy them all. Financial innovation has made this a remarkably easy task. For the first time in history, an individual investor can buy a basket of stock that more or less represents an ownership stake in all the world's enterprises. If you admit that you have no idea whether it would be better to own a piece of Microsoft than McDonalds, or whether the Indian economy might present more opportunity than the Dutch, you can simply opt out. This crown jewel of investor ignorance trades as an ETF under the ticker VT -- the Vanguard Total World Index is a low cost, one stop shop for investing in a diversified collection of all the worlds equities. It's fair to say that it may be the last stock you ever need to own.

So Finally

Where does all this leave us? In the end, the program is remarkably simple and low cost.

Own a home of your choosing, but do not expect it to appreciate dramatically in value.

Leave some money in a bank account or a rainy day. How much depends on how much money you are earning every year.

Of the remainder, allocate your age % to TIP.

Put whatever is left after that into VT.

I am sure many people will be offended by the almost stupid simplicity of that advice. It is a modest portfolio designed to minimize the uncertainty and costs of investing, yet still add something to your savings over time. My only defense is that if someone told me I had to invest all my money tomorrow and couldn't change my mind for another twenty years ... my money would be exactly where my mouth is.

Sunday, March 15, 2009


Proposition One: The government exists to catalyze the solution to collective action problems.

Proposition Two: The government exists to keep us free.

Ergo, freedom is the solution to a collective action problem.

This torturing of logic has a point beyond the simple desire to hear it scream.

Individuals are not free in isolation, or at least that freedom from is only the most tawdry and basic form. Much more profoundly, when we combine and multiply our forces, we are free to create whole new worlds. The deepest purpose of government is to create the conditions of possibility for this freedom. That is why we keep it around as a night watchman to enforce our contracts, and even give it a day job teaching our kids; both free us to become collectively more than we are individually.

It is also why the most total form of government is simultaneously the least free; when catalyst become full blown crystal, all new possibilities have been foreclosed upon. We become locked, collectively, into a frozen parody of paradise, enslaved by a machine of our own making in which the individual has become nothing more than an interchangeable part.

Government is no different than religion or ethics or simple tribal ritual -- it's job is to seed the ground of the group, but only to seed. The flowers bloom on their own.

Thursday, March 12, 2009

Tax what?

Cow farts heat up our planet:

Livestock contribute 18 per cent of the greenhouse gases believed to cause global warming, according to the UN Food and Agriculture Organisation. The Danish Tax Commission estimates that a cow will emit four tonnes of methane a year in burps and flatulence, compared with 2.7 tonnes of carbon dioxide for an average car.

... so the well-meaning Euro types, afflicted as always with an advanced disease of societal over-engineering, would like to enact a tax:

A cow tax of €13 per animal has been mooted in Ireland, while Denmark is discussing a levy as high as €80 per cow to offset the potential penalties each country faces from European Union legislation aimed at combating global warming.

This is brought to you by the same guys whose simply could not accept where the land stopped and the ocean started, and so decided to build an entire country of dikes.  Before that they tied themselves to the mast just to be able to safely hear a wicked concert.  These people are too clever by half.

Now, I like the planet as much as the next guy, but this cow tax thing just sounds perverse.  If what you really want is less cow fart floating around, tax cow farts, not cows.  In other words, use the freaking market already.  If you set it up correctly, a market can be much smarter than you are, Herr Dr. Bureaucrat.  The market, when faced with the entirely appropriate internalization of the previous externality of cow farts, may figure out how to suck the cow farts out of the air, or it may figure out how to get cows not to fart, or who knows.  So instead of taxing something related to the problem, which, yes, will result in fewer cows and hence less cow farting, why don't you just tax the problem itself, and see what kind of solutions people can come up with.  An appropriately regulated market is nothing more than a big evolving brain, an adaptive calculating machines for allocating scarce resources.  When are we going to be able to accept the second rule of evolution and realize that the solution to every problem is not to try and plan the whole thing out in advance?

Monday, March 9, 2009

We are all Japanese now ...

... even though some Japanese are more Japanese than other -- for example, as Wolfgang Munchau points out, the Germans:

In an L-shaped recession, however, recession gives way to depression, despite the fact that both countries thought they had done their "homework". If nobody can afford to run a large deficit for a long time – which is what an L recession effectively implies – the economic models of Germany and Japan will no longer work. Germany had a current-account surplus of more than 7 per cent last year. It is the world's largest exporter. Exports constitute about 41 per cent of national gross domestic product – an extraordinary number, given the size of the country.

So what should these countries do? The right policy response would be to reduce the dependency on exports and undertake structural reforms that facilitate the shift towards non-tradeable goods...

Unfortunately, the opposite is happening. Germany is clinging to its export model like a drug addict. An example is the debate about the future of Opel, the European car manufacturing subsidiary of General Motors. Opel is unlikely to survive without help from the government. The proponents of a state bail-out of Opel argue that the company is systemically relevant. This argument is obviously wrong. There can be systemically relevant banks, but there can be no systemically relevant carmakers. But the answer is also revealing. What it means is that Opel is systemically relevant for the country's export-oriented model.

I reiterate and refine my thesis.  The level of sustainable debt in an economy is governed by the level of trust between private actors, the level of trust between private actors and the government, and the level of trust between governments.  Rising inequality destroys every aspect of this trust and results in a drawn-out period of netting out the debt.  The is the financial analogy to the trade protectionism that made the Depression Great.  If trust is a non-zero sum game, not-trust is a negative sum.

Sunday, March 8, 2009

Now then Sen

Amartya Sen writes an interesting piece about Capitalism Beyond the Crisis. It contains many of your humble blogger's favorite themes -- markets are necessary but not sufficient, the word capitalism is so widely abused as to be meaningless, and if you actually read the original books we hear so many soundbites from, you typically find that they bear almost no resemblance to what you've heard about them -- and comes highly recommended.

Friday, March 6, 2009

Gee ...

... I wonder how we got into this mess:

WASHINGTON -- Two candidates for top jobs at the Treasury have withdrawn their names from consideration, complicating efforts by Treasury Secretary Tim Geithner to staff his department at a time of economic crisis, according to people familiar with the matter.

The Obama administration has recently ratcheted up its scrutiny of potential nominees. Lawyers have been poring over several years of potential Treasury appointees' tax returns and other financial and personal information, such as the legal status of household help.

Mr. Obama curtailed the ability of lobbyists to work in the administration. The Treasury also wants to avoid hiring anyone with ties to a bank that received bailout aid.

Now that there are rules, we discover that nobody qualifies. Finance before the bust was like Vietnam.

UPDATE: NC has some more thoughts on the same subject. Apparently, once you've eliminated the first round of looters because it looks bad, you have to proceed to the behind the scenes second stringers. She also mentions some upcoming changes to the blog, and I would sadly echo here departing sentiment.
Maybe I am getting burned out from the crisis, but I feel too much of my commentary keeps circling back to the same topics. The problems are not going away, and even if there are new news hooks, the themes aren't changing all that much, the bad policies, the bad assets, the lack of will to reform, the doublespeak. I suppose in times like these, making sure one is not part of the problem and doing what one can, even in a small way, to get things on a better path is a contribution. But the trajectory of policy seems immune to public opinion and reason.
And, no, this is not to say that I'm in the camp with Kudlow and Cramer and those jackasses.

Thursday, March 5, 2009

The Equilibrationists

Tim Duy has some somewhat rambling reflections on the "Bernanke Paradigm".  They fit vaguely together with my own rambling reflections on why so many people seem so fundamentally unable to grasp the dynamic engulfing the economy, and why, as a result, they tend to support a lot of very half-assed measures for dealing with it.  BARF, TALF, the stimulus package, and the housing plan are so far but drops in the proverbial bucket.

The question is of course extremely technical.  And we really don't understand macroeconomics, so it's very difficult to judge between the validity of the various proposed answers (I am reminded again of McCloskey's essay about why economics is not a science).  But it seems to me that one basic problem that keeps popping up in the responses is the assumption that the economy was more or less in equilibrium before the crisis.  Even people like Paul Krugman, who I expect does not believe in the efficient markets hypothesis in any strong form, seem to assume that the problem is one of restarting a stalled engine -- as Keynes put it we have magneto trouble (magneto, for those as ignorant as I, turns out to be some ancient British word for what early cars used to juice the spark plugs -- Krugman translates this as alternator, though that analogy confuses me).  This unspoken underlying assumption of equilibrium may be related to some deep debate between neo-classical economics and the Austrian school; given that I don't really understand that debate, I may be just re-phrasing some version of a well known argument when I complain that there is more to our current problem than simply jumping the engine, and that there were some fundamental structural problems that built up in the boom and pushed things very very far from perfect equilibrium, if such a thermodynamically improbable animal exists to begin with.

This debate is abstract and academic until you realize that it has real consequences for what you think we should do.  If we just have a credit crunch or liquidity crisis, then the solution is simply technical -- print more money and restore confidence and the engine will start again immediately, and of its own accord.  If you think there are more fundamental problems of one sort or another, then some other solution may be warranted, and you might expect that opening up the choke and givin'er a jump may not produce the desired result. 

But let me back up a step and trace the whole argument.  At first, the temptation when the economy suddenly stalls seems to be to think that this is punishment for our sins.  Somehow, inevitably, these moments of financial panic and crisis are preceeded by a euphoric new era bubble and followed by a major downturn in economic activity of all sorts.  We jump immediately from correlation to causation, and insist that the downturn is caused by the excesses of the past.  Greed, fraud, and risk-taking are all roundly condemned as having ruined the puritanical paradise.

Unfortunately, while it may satisfy our sense of morality, what Paul Krugman has called the Hangover Theory has some problems with it.  After all, a sudden stop in economic activity just doesn't seem to make sense.  The workers are still there.  The factories can still produce stuff.  All of the inputs are still available and the consumers presumably still want the newly out-putted color televisions just as much as before they got laid off.  In fact, the bubble that preceeded the hangover served to get us all off of our keisters and out building railroads or internet companies (or houses) even faster than we might have normally.  Greed, in short, is productive.  So, how is the bubble a bad thing, and exactly what is a bubble?  Or, in other terms, what exactly is a recession or depression?  If we all just kept doing what we were doing yesterday, we could all just keep on doing what we were doing yesterday ¿no?  Is a downturn no more than the madness of a collective depression fit to match the mania that preceeded it?  Tulips to turnips?

If you think about this response for a moment, it starts to grow on you.  "Yeah ... what the hell are we thinking ... everybody back to work!".  This is the stalled car view.  It implies that all we need is some trick to get us out of our funk, and everything will go back to normal.  Martin Wolf (via Paul Krugman via Mark Thoma) does a nice job of explaining how Keynes provided the spark to get the whole thing going again:

Keynes's genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge. 
So great, now instead of a hangover, we have a little of the hair of the dog that bit us.  The solution to our bubble is another bubble, though this time one backed by the sound Keynesian stimulus of the government.  "Bubble" here loses all meaning.  No price is too high for an asset, and there is no limit to the amount of stuff we can produce if we all just keep working our asses off. 

Except I still feel like there's something wrong with this solution.  There's a reason we're not all waking up from our nightmare and going back to work immediately.  There's a reason that the economy has this tendency to liquidate after the excess buildups of bubble.  Irving Fischer pointed out in 1933 that it's the debt, stupid.  The reason that these enormous crashes and panics occur just after some period of euphoric investment is because that investment was driven by borrowed money, and suddenly the guy you borrowed it from wants it back. 

From the perspective of the system as a whole (presuming that the money wasn't lent to us by martians) this is no excuse to stop working.  My debt is your credit; they all net to zero; forced liquidation of everything in order to try and pay off the debts is like mass suicide, so let's skip it and get on with things.  In theory I think this makes perfect sense.

In practice, creditors are loathe to give up their claims not simply for moral reasons, but for reasons of self-interest.  We know you've got the money.  We takes the money.  This sort of thinking leads directly to the cycle of mass liquidation you saw in the Great Depression.  Even if everything collectively nets to zero, the individual incentive of each creditor is to liquidate the estate of the debtor in an attempt to get his money back.  This problem is especially acute if that creditor has yet another creditor presuring him.  Once the stress starts talking, things get fucked fast -- a worker may have loaned his money to the bank who loaned it to a factory who loaned it to the worker to buy the product that the factory makes.  As we've seen with counter-party issues and CDS trades this year, that kind of circle can be a nightmare to unwind, even if it nets to zero in the long run.  So what at first seems like mass irrationality -- to be blamed on a failure of animal spirits, fear of fear itself, or simple lack of monetary liquidity, as you wish -- actually turns out to be mass rationality from an individual perspective, and collective madness from the perspective of the group.

At this point, the State enters, to solve what is clearly a prisoner's dillema type problem of collective action.  It seems to me that the State has a few options for dealing with things.

If the State were socialist, it could just redistribute money at will and cancel all debts.  After this reboot, there would be no remaining reason not to just go back to what you were doing before.  Of course, arguably, this simply teaches everyone that there's not much point in working in the first place.

If the State didn't want to violate the sanctity of previous private contract and simply redistribute wealth, it could itself borrow money and spend it.  In a closed system, it can either borrow that money from one particular group (the creditors obviously), essentially replacing the private debt they are owed with public debt, or it can borrow equally from everyone in the form of reducing taxes.  From a cash flow perspective, either of these things are going to be accomplished by printing money, though in both cases the money might initially take the form of little pieces of paper with IOU written on them -- aka Treasury bonds.  You can either give these to the creditors, who if they believe that they will someday be worth something will accept them in lieu of the proceeds from liquidation, or you can give them to everyone, which, again, if they believe they will be worth something, will pacify them enough so that they go back to work.  You can decide later whether you want to simply print more money to back these up when they come due, causing inflation, or whether the economy is doing better, and you want to raise taxes to pay them off, resulting in no net growth in the money supply.  The net redistributive effect of this scheme depends on how you tax folks when it comes time to make that decision.

In the end, this mechanism isn't really all that different from lowering interest rates.  Instead of pushing on a string, you shove it down people's throats.  If you believe that fundamentally there's nothing really out of whack about the economy, it's not clear to me exactly why this would work if the interest rate thing didn't, unless the whole explanation is one of timing.  Lowering interest rates is sure not to work if the economy has already fallen into deflation.  At that point, offering people loans even at 0% rates is unappealing because if prices are falling, the real interest rate may still be fairly high.  You need instead to support the price level by spending money (or simply fixing prices or creating inflation).

Again, as far as I can tell, this solution rests on the assumption that people were not too far in debt.  Of course, defining "too far in debt" is tricky, because you can just keep rolling it over so long as you believe that the guy who owes it to you will keep coming to work in an effort to pay it off.  The sharecroppers were "too far in debt" but that didn't stop the system from going on for a long time.  Ultimately, being too far in debt is a question of confidence and trust, which is the point of having the government assume the debt built up in the bubble, or the debt necessary to keep the economy growing while the bubble debt is gradually paid down. 

So finally, what if people are simply too far in debt.  And the government is too far in debt and nobody really trusts it.  Now you've broken through the assumptions of the equilibrium model I think.  You've admitted that something was out of whack and that we now have to devote a bunch of energy to gradualy netting out the imbalance in the economy caused by one group being too far in debt and the other having too many claims against them. 

And this is, I think, ultimately, my point.  Past a certain point, debt must be netted.  Nobody trusts the government enough to let it go into debt deeply enough to replace the private debt coming due.  Nor do they wish to let the government instantly net things via socialism or instant inflation (same difference). However, something must be done, so that we don't end up netting things the old-fashioned way, that is via liquidation. 

So we reach a stalemate.  Nobody fails and nobody can succeed.  You are left with a gradual netting out that causes a sort of frictional loss in economic growth because of the paradox of thrift.  The lenders don't lend because the debtors are too far in debt.  The debtors don't borrow because they are too far in debt. Instead they save up to pay down their debt, which destroys demand because we cannot all save at the same time.  And the government borrows enough to keep the whole system from collapsing, but not enough to prevent people from feeling like they need to save. 

Perhaps capitalism itself puts a limit on inquality. 

Munching on TALF

Line 1 here basically sums it up:

The government is still applying cyclical remedies to a secular problem.

The more you look at the different things that government is saying and doing, the more you start to realize that despite the talk of there being no quick fix and whatnot, they are fundamentally treating this whole works as a liquidity problem, and not a solvency problem.  If you are a dyed in the wool democrat, and choose to let the audacity of hope triumph over the snicker of cynicism (insane as that sounds at this point) you can maybe, maybe maintain that Obama is forcing all structural reforms through the fiscal policy side with the new budget, while deliberately sending Geithner and Bernanke out to commit harakiri on the front lines.  I don't really know how to evaluate that statement.  I do know that at this point anything that comes out of the mouth of one of those two is bound to disappoint.  This is no longer wait and see.  We've waited.  We've seen.  We've got bupkes.

The latest example is the Term Asset-Backed Securities Loan Facility, or TALF, designed to reinvigorate the market for bundled consumer and small-business loans and, possibly, commercial mortgages, collateralized debt obligations and more.

That sounds great, if only there were massive pent-up demand for credit going unmet, as is often the case at the end of recessions caused by the ups and downs of the business cycle.

In my opinion, this analysis is correct.  I looked into the TALF as an investment opportunity.  Any US company can get in on TALF and start making making new student loans and car loans and credit card loans.  The program only applies to new loans however, so it does nothing to help the banking system, and really could only serve to try a re-inflate the lending bubble that came before by providing an explicit government support of what was before an implicit government backing in the form of the Geithner put -- the "too big to fail" doctrine.  The thing is structured to restore lending without being accused of giving away taxpayer funds, so it has no risk sharing or loss limitation provision.  It's just a cheap source of guaranteed leverage that can't be called away from you for 3 years. 

"I've been explaining to investors that TALF is not a free lunch," says Carlos Mendez, senior managing director at ICP Capital, an investment bank specializing in credit products.

Mostly, TALF seems to be yet another pipeline for pumping cash into the financial system, in hopes of keeping banks hanging around long enough to enjoy an economic revival, thus avoiding a final, painful reckoning of their assets.

Tim Backshall, chief strategist at Credit Derivatives Research, says: "The longer that goes on, the more likely we are to be in a Japan-type situation, where we're not facing up to the losses and moving on."

As an investment opportunity, this is fine if you're into that sort of thing.  You can get between 7 and 20 times leverage, depending on the type of loan, at attractive rates and with no refinancing risk.  It should entice some people to make loans to ... er ... who?  It's not like you can make a risky loan.  The government is not backstopping sloppy underwriting.  There is no loss sharing or loss limitation.  In the end, I agree with Tim Duy:
Bottom Line:  TALF limitations provide protection for the taxpayer, but curtail the program's effectiveness.  This is not meant to imply that efforts should not be made to support the normal functioning of credit markets; simply to keep expectations about effectiveness in check.

Tuesday, March 3, 2009

Why don't we let the government guarantee the stock market?

I think that might be the ultimate end-point of the type of thinking that Interfluidity is pursuing. It's not terribly different from the type of microequity market I was imagining as a capitalist paradise. Of course, I wasn't proposing that the government actually guarantee some minimal price to equity investors as a way of encouraging them to risk their capital. I was propopsing to force them to risk their capital by making it illegal not to. But this is perhaps a minor difference.

The logic of guaranteeing a floor for the stock market is not as crazy as it first seems. First, you have to realize that we are guaranteeing the banks via the FDIC. History has fairly conclusively shown that banking without the FDIC is inherently unstable.

Banking-as-we-know-it is just a form of publicly subsidized private capital formation. I have no problem with subsidizing private capital formation, even with ceding much of the upside to entrepreneurial investors while taxpayers absorb much of the downside when things go wrong. But once we acknowledge the very large public subsidy in banking, it becomes possible to acknowledge other, perhaps less disaster-prone arrangements by which a nation might encourage private capital formation at lower social and financial cost.
Then you have to acknowledge that the current proposals about public-private partnerships are structure to be more of the same. One way of looking at either of these is to say that the FDIC has been mis-pricing its insurance in the past, and that the proposed "bad bank" structures amount to selling the private sector a put while collecting a very low premium (they are right here that the devil is in the details of how it is structured).

Regular readers know that I view proposals to fund bank asset purchases with high leverage, non-recourse government loans to be an objectionable form of hidden subsidy from taxpayers to private investors and bankers. Calculated Risk agrees.

But John Hempton points out that

all banking capital is non-recourse with the taxpayers — through the FDIC bearing the downside. As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.

I doubt Calculated Risk would have an objection to that. The issue is not non-recourse — it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector. If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets. Numbers — not the concept — should be the realm of debate.

I won't speak for CR, but some of us would disagree with JH's presumption that status quo banking with new money would be unobjectionable. Nevertheless, it is wonderful to see put in writing that all banking capital is non-recourse with the taxpayers. Taxpayers write a put option to depositors (and implicitly to other bank creditors), in exchange for a premium in the form of a deposit insurance fee. JH's plea that we should look at the numbers is characteristically on the mark: In option terms, both the value of the bankers' put option and its "vega" — the degree to which its value is enhanced by bank asset volatility — are dependent upon the amount of non-recourse leverage provided.

These are precisely the terms in which we should view the banking industry's quest for every greater leverage over the past decade, with all those SIVs and AIG regulatory capital products and whatnot. They were trading-up, from a modestly valuable, out-of-the-money option written by taxpayers to a near-the-money option whose value could be dramatically increased by taking big chances. It's as if you sold a put option on a $100 asset with a strike price of $85 to someone, and somehow that fothermucker changed the terms of the contract so that the strike was $100 while you were stuck on the other end of it without being paid a dime more in premium. Any private investor would consider themselves cheated by this kind of switcheroo. Banks were robbing taxpayers ex ante, not just during the crisis, by endlessly maximizing their value on zero-sum option contracts with governments caught on the other side.

Once you realize that we have always been paying for the public good of having people give their savings to a bank so that it can be invested rather than keep it in their sock (though this is only apparent in crises) you can ask if there is any better way to do encourage this. To wit:

Rather than writing free options, what if we defined a category of public/private investment funds that would offer equity financing (common or preferred) to the sort of enterprises that currently depend upon bank loans? Every dollar of private money would be matched by a dollar of public money, doubling the availability of capital to businesses (compared to laissez-faire private investment), and eliminating the misaligned incentives and agency games played between taxpayers and financiers who would, in this arrangement, be pari passu. Also, by reducing firms' reliance on brittle debt financing, equity-focused investment funds could dramatically enhance systemic stability.
So maybe all capital should be equity capital. The problem of creating the public good of encouraging people to take this risk could be solved either, as he suggests, by increasing their leverage, or by guaranteeing them some minimal worst case outcome, say by agreeing to buy the equity of any company at $1 and restructure it or shut it down. Either way, we should make explicit that financial markets are a public good that we all pay for equally with out taxes -- the question is just how to engineer the public good of sensible private risk taking.

Private-sector banking has not existed in the United States since first the Fed and then the FDIC undertook to insure bank risks. There is no use getting all ideological about keeping banks private, because they never have been. We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we'd like it to be publicly subsidized. How best to meet those objectives is a technocratic rather than ideological question.