The money hole

I thought this was Warren Buffett quote was very funny:

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

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

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

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

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

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

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

Broken Record

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

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

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

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

They are bad.

They are almost always bad.

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

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

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

Kashkari and the Cash and Carry Economy

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

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

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

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

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

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

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

Roubini on deflation

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

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

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

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

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

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

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

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

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

Actually, it was structured by pigs

From NC:

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

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

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

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

Official #1: We should not be rating it.

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

Continuing on with our regularly scheduled progam

Keynes quote (via Krugman):

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

China vs. India

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