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?

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.

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.

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.

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.

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.