simply Capitalism

posted by Doug Reich @ 5:50 PM

If I were to urge you to grasp one principle of economics, a principle that would help you throughout your life dissect and refute virtually every government scheme to take your money in the name of the "public good", it would be the Broken Window Fallacy. This parable was created by Frederic Bastiat in 1850 and popularized by Henry Hazlitt who used it to refute dozens of economic fallacies in his famous book Economics in One Lesson. Despite over 150 years of knowledge and experience, this fallacy permeates every facet of politics today and is committed routinely by politicians and Nobel Prize winning economists alike.

I gave detailed descriptions of this principle in two past posts here and here so I will not go into full detail. Briefly, the principle is that one must focus on both the direct consequences of an action AND consequences that would have occurred in the absence of the action. In certain contexts, it could be called the law of unintended consequences. Another way to put it: in order to understand the consequences of government action, do not just look at what it does directly, but also imagine what could have happened and what did not happen as a result of government action.

For example, in the parable, when a brick is thrown through a shopkeepers window, observers are led to believe that the broken window is "good" for the economy since it increases the revenue of the glass maker. Such a view might lead someone to think that destruction is good for the economy and even to conclude that wars are actually a benefit. As a result, someone might advise routinely burning the entire town to the ground to "help" the economy. Sound familiar? Isn't this the argument at the base of the claim that World War II helped end the Depression? What is not seen by these observers, is the action that would have taken place if the shopkeeper had not had to pay for the broken window. He would have had more money to spend elsewhere on the movies, new furniture, or perhaps to expand his own business. In this instance, although the glass maker benefited, the broken window is at best a zero sum game as far as the economy is concerned since the movie theater, furniture maker, or anywhere the shopkeeper would have spent the money has lost potential revenue. (In actuality, I would argue that the broken window is less than a zero sum game - it is highly destructive to the economy to the extent that it subdues capital investment which subdues innovation and productivity.)

Once one fully grasps this principle by applying it to numerous instances as Hazlitt does, it becomes clear how futile and destructive are government policies implemented on the basis of this fallacy.

One of the most obvious applications of this principle is to the idea of "make work" jobs which are jobs "created" by the government for the purpose of employing individuals. For example, say the government announces a plan to employ 10,000 individuals digging ditches. For the 10,000 people who get this job, it clearly is a benefit. After all, they are now working and making wages which they can use to support themselves. However, is such a plan "good" for the economy?

First, where did the government get the money to pay these workers? It obtained the money through taxation which means the wages paid to the 10,000 workers is money no longer available to those who paid the taxes. These taxpayers now have less money to spend on other things like food, computers, or automobiles. Again, it is at best a zero sum game and in actuality worse since the government generally spends the money on activities that no one wants or needs.

How could anyone think that robbing money from some people and giving it to others could result in a "better" economy? If that's true, why don't we legalize theft by, for example, the Mafia. Then, when the economy needs a jolt, the government can urge the Mafia to shake people down for their money in order to spend it. Won't that be good for the economy? How is the logic any different?

If such a notion seems absurd - it is, yet, this is the exact reasoning behind the "stimulus" package unveiled by Congress earlier this year. It is exactly the reasoning behind the argument being offered that the cap and trade energy bill, despite the fact that it will increase energy costs, is actually good for the economy since it will "create" so-called "green jobs".

In this case, the stimulus bill and the climate bill are supposed to actually create jobs since the government will spend money in various areas. In fact, in this Yahoo article, seven "lucrative" new jobs from the Obama stimulus plan are highlighted. What are they? Among others include "solar panel installer", "cost estimator" to estimate costs of spending the stimulus money, and "physical therapist" since so many people are unemployed and apparently will need physical therapy (I'm not making this stuff up...). This means that individuals rather than being motivated to enter productive professions like medical research or computer science will instead be encouraged to install solar panels and to monitor the expenditure of loot that is robbed from taxpayers.

Let's ask another important question: is the government literally magic? Can it simply spend other people's money and, voila, create prosperity? Apparently, the government is magic since Nobel Prize winning economists like Paul Krugman endorse the government's plan to spend other people's money and in fact call for even more spending. Obama claims that the climate bill will create "millions of new jobs" which, of course, relies on the Broken Window Fallacy.

What creates real wealth? Making more with less effort or productivity is what leads to real gains in prosperity. "Jobs" in the sense of "people doing things" is not necessarily good for the economy nor does it necessarily lead to increasing prosperity. In other words, "activity" should not be confused with "productivity". When people make more with less effort, it frees up time so that people can work and produce in other areas. Hundreds of years ago, virtually everyone spent their time simply producing food and subsisting from day to day. More efficient agriculture due to new technology allowed the same amount of food to be produced by less people and freed people up to work on things like inventing electricity, the locomotive, and medicine. Robbing some people and giving it to others to spend does not benefit the economy in terms of creating real wealth and prosperity. Such a plan only redistributes wealth to some for the unearned benefit of others.

In April 2009, Dr. George Reisman posted Green Jobs in which he facetiously discusses how Obama's stimulus plan is capable of creating an infinite number of "jobs":

Indeed, advancing the goals of environmentalism is capable of creating a virtually limitless number of jobs. Big-rig trucks and their “polluting” emissions might be done away with by replacing them with human porters who would carry freight on their backs. Ocean-going ships and their emissions might be done away with by replacing their “dirty engines” with the clean labor of banks of oarsmen. (Sails would be a substitute too, but they are no match for oarsmen when it comes to the number of workers needed.) Automobiles and their emissions might be replaced by sedan chairs and teams of litter bearers.

Later, he discusses a brilliant idea that could literally "employ" millions:

And finally, think of all of the jobs that a program of environmental “stewardship” might make available. Thus each patch of desert, each rock formation, each clump of grass, and each tree stump, might have assigned to it one or more “stewards” whose job would be to watch over it, protect it, and “preserve it for future generations.” To carry out this valuable work, there could be a whole corps of “stewards.” They could be dressed in special uniforms displaying various ranks and medals, all gained in “service to the environment” and the defense of nature and its resources against the humans.

Indeed, once we put our minds to it, nothing is easier than to think of things that would require the performance of virtually unlimited labor in order to accomplish virtually zero result. Such is the nature of all job-creation programs. Such is the nature of environmentalism. Such is thought to be the path to economic recovery by most of today’s intellectual establishment.

When you understand the Broken Window Fallacy, programs offered to "stimulate" the economy and "create" jobs seem laughable. It's too bad it's not funny anymore.

posted by Doug Reich @ 9:29 AM

Below is an updated version of a post from May 2008.

Amidst all the hysteria related to rising gas prices including Congressional "investigations" of the oil companies and threats of additional taxes on their profits consider the following:

If you drive 15,000 miles per year and get 18 miles to the gallon you will consume 833 gallons of gas per year. This means that if gas prices rise $1 per gallon it will cost an extra $833 per year and if they were to rise another $2 per gallon it would cost an extra $1666 per year. Of course, no one wants to pay more, but consider the value you obtain from driving an automobile. It is an almost indispensable part of most of our lives and adds tremendous value in terms of our ability to travel and work. Consider that oil companies are delivering fuel to the consumer at about $2.50 per gallon despite regulations preventing domestic drilling which forces them to rely on hostile foreign governments, regulations that have prevented any new domestic refineries in the last 30 years, and TAXES on the production and sale of gasoline.

Now, if you make $40,000 per year in income, which is about the average yearly income in the United States, consider this back of the envelope calculation of the taxes you must pay the government:

Sales Tax on a 2010 Toyota Prius Hybrid: 6%*$24,000 = $1,440
Income Tax, say 15% = $6,000
Social Security Tax, 7.5% = $3,000
Employer Match (which could be yours) , 7.5% = $3,000
Medicare, 1.45% = $580 State Income Tax,
average 5% = $2,000
Sales Taxes (say you spend $10,000 per year at 5%) = $500
Gas Tax (0.40c per gallon at 833 gallons per year) = $333
Property Tax (say you own a $150,000 house at 1.5%) = $2,250

TOTAL = $19,103 or 48% of yearly income, and were not done!

Consider the hidden taxes one pays, which I will not even attempt to quantify. For example, consider that taxes on businesses get passed on to consumers and make the price of goods and services higher than otherwise. Consider that government caused inflation and regulations drive up the cost of everything on the order of 3% to 6% per year as well as having the effect of destroying capital and reducing the productivity of labor which further reduces real wages. Consider the lost return on money you could be saving that instead went to Social Security. Consider the cost of simply filing a tax return which often requires the assistance of a trained accountant if you itemize deductions or own a business. Consider the lost productivity due to the fact that legions of highly intelligent people, viz. accountants and tax attorneys, which could be doing something valuable, are instead employed in the preparation and understanding of the 70,000 page tax code. Consider the cost of health care which is generally deducted from an employees salary as part of an employer sponsored program which reflects the high costs caused by government intervention into medicine and the insurance market. I could go on, but I think I have made my point.

Perhaps most importantly, consider that if you don't like the price of gas then you do not have to buy it! You could simply choose not to purchase it or drive less. The oil companies don't put a gun to your head and demand you buy their product. They offer a product that is of the utmost value and people are voluntarily willing to pay the price. On the other hand, if you don't pay the government you will end up in jail, i.e., the government takes your money under the threat of physical force. This represents the difference between "economic power" and "political power", i.e., the voluntary exchange of value for value versus the point of a gun.

To top it off, consider this recent article which states that

Taxpayers are on the hook for an extra $55,000 a household to cover rising federal commitments made just in the past year for retirement benefits, the national debt and other government promises, a USA TODAY analysis shows.

The 12% rise in red ink in 2008 stems from an explosion of federal borrowing during the recession, plus an aging population driving up the costs of Medicare and Social Security.

That's the biggest leap in the long-term burden on taxpayers since a Medicare prescription drug benefit was added in 2003.

The latest increase raises federal obligations to a record $546,668 per household in 2008, according to the USA TODAY analysis. That's quadruple what the average U.S. household owes for all mortgages, car loans, credit cards and
other debt combined.

In summary, consider that the government takes roughly 50% of what you earn in a given year through income and various taxes, impedes productivity and capital formation, and then saddles each household with an additional $546,668 in debt to be paid for out of future taxes including interest. If the government takes 50% of what you make, is it a surprise that both parents must now work to support a household despite massive increases in productivity over the past 100 years? Consider this crushing tax burden in relation to the fact that when gas went from $2 to $3 per gallon it cost the average person an extra $833 per year.

Why are we investigating the oil companies and not our own government?

posted by Kendall J @ 9:34 AM

The conventional wisdom today lays the blame for today's financial crisis on the free market. The mortgage market collapse is thought to be due to unscrupulous lenders who relaxed lending standards and then sold risky mortgages to unsuspecting investors. Both Presidents Bush and Obama used this narrative in justifying their policy actions. Closer examination reveals that government interference played a much more fundamental role. Specifically, the ballooning of the secondary mortgage market by government sponsored entities, followed by the "cheap money" policy of the FED created the basic structural distortions which would ultimately lead to the financial crisis.

Government sponsored entities [GSE] such as Freddie Mac and Fannie Mae are key players in home mortgage markets. They were created by and have a specific mandate from congress to help assure "affordable" housing. Although these entities operate as "private corporations" today, they receive favorable treatment by the government and their boards and hence their operating policies are primarily government controlled.

The secondary mortgage market was created primarily by these GSE's. Up through the 1990's, most mortgages were held by private corporations in what is known as the "originate to hold" model. However, GSE's increased the flow of capital into the mortgage market through what is known as the "originate to distribute" model. Through this model loans are bought, packaged into securities, and sold to investors on the secondary market. GSE's either perform this activity directly or they insure the securities created by private firms. Practices like these effectively mask risk from investors and give mortgage originators no reason to closely examine the quality of the loans they issue. GSE's fueled the mortgage practices that today are blamed on the free market.

GSE involvement had been relatively small up until the 1990's. The most striking growth in the secondary mortgage market occurred in the 1990's, before the housing boom, with that market reaching a size of $3.3 trillion by 2001. Eighty five percent of that market was based upon securities issued or insured by the GSE's. This growth was fueled by specific changes to GSE policy to stimulate home ownership.  Structurally, the stage had been set for a large housing boom, and all that was needed was a precipitating condition. 

That condition came in the form of the monetary policy of the Federal Reserve during 2001-2004. During that time the FED lowered and held interest rates at near record lows. Chairman Alan Greenspan noted that he was attempting to stimulate the economy, and specifically home ownership. He states in his autobiography, "I was aware that the loosening of mortgage credit terms for subprime borrowers increased financial risk, and that subsidised home ownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened home ownership are worth the risk."

The FED is a government entity and itself acknowledges the role of low interest rates in fueling housing boom cycles. From a 2005 study on housing booms and monetary policy, FED analysts indicate that "house price booms are typically preceded by a period of easing monetary policy, but then diminishing slack and rising inflation lead monetary authorities to begin tightening policy."

Demand for housing, previously steady at 3% annual growth, ballooned to 9% as a result of FED policy. Construction boomed, home prices escalated significantly, and debt levels rose on this rising tide of newfound "home equity." The well-established secondary mortgage market served as a ready catalyst to funnel capital into the market to meet this ballooning demand, magnifying the size of the boom.

During an artificial boom, risk levels are masked. Because house prices are escalating dramatically, borrowers feel that they can take on more debt. Because foreclosure rates actually go down, lenders begin to feel that they can lend to borrowers who before might have been perceived as risky. And because mortgage securities continue to pay out well, investors continue to demand them. Some even begin to think that this boom will be sustained and increase their risk levels beyond what would normally have been considered prudent. These effects are not a result of an unexplained aberration in the free market. Rather they result from the fundamental distortions that created the boom in the first place.

The FED's fiscal tightening in 2005-6 precipitated the crash. Because of the extended boom however, a significant amount of capital had been placed into poor investments, and the magnitude of the crash had already been determined, left only to play itself out.

While the conventional wisdom may blame markets for the financial crisis, government interference in the mortgage market for the expressed purpose of stimulating home ownership was at the heart of the collapse.

[Editor’s Note: this article was written for a writing class I’m taking, as an example of an op-ed article.]

posted by Doug Reich @ 4:52 PM

One reason why spending at the state level can rarely get out of control is because states lack the power to print money. In other words, they must rely on taxation or municipal bond offerings to raise money to fund their budgets. Since taxation is unpopular, there is an obvious political limit to increased tax rates. Since private municipal bond investors can only buy so much debt before asking for higher interest rates, there is also a limit to the amount states can raise through borrowing. The federal government figured out how to get around this limit by creating the Federal Reserve System which is a pseudo private bank with the power to create money. The Fed can buy federal government debt from the public with fake money. Therefore, the federal government always has a buyer for its paper.

Now, the states want to get in on the action.

Of course, the states will not ask for the direct power to print money. They have a more clever way.

In a move with only one modern-day precedent, California Gov. Arnold
Schwarzenegger and Democratic lawmakers are pressing the Obama administration and members of Congress for federal loan guarantees to help the state out of a desperate, multibillion-dollar jam.

California is not asking for cash, like the tens of billions given to AIG, General Motors or Morgan Stanley. (MS) Instead, the state with the worst credit rating in the nation is asking that Washington act as a sort of co-signer on the state's borrowing, to be backed up with money from the Troubled Asset Relief Program.

California leaders say that would make it easier and cheaper for the state
to borrow money on the bond market, reducing the interest rate by as much as
half and saving taxpayers hundreds of millions of dollars.

So, here we go. The states are "not asking for cash" - only federal government "guarantees" to get them out of a "jam". Sound familiar? This is exactly the premise of government sponsored agencies (GSAs) like Freddie and Fannie that were to "guarantee" pools of mortgage backed securities. Such guarantees resulted in the massive issuance of mortgages since they could be pooled and sold to GSAs all in an effort to "help" first time home buyers by keeping mortgage rates down (and underwriting standards lower than otherwise). That worked pretty well, right...?

If the federal government offers similar guarantees to state municipal bond offerings, it will effectively remove any constraint to state level spending. States will no longer have to face the politically unpopular choice of raising taxes to generate revenue or, gasp, cut spending. They will be able to borrow ad infinitum since the federal government will stand behind the state debt with its printing presses in tow. Such a mechanism would effectively transfer the power of printing money to the state level with all of its attendant consequences: reckless spending and runaway indebtedness all backed by the United States taxpayer who will shoulder the burden directly through increased federal taxes or by paying more for everything in the form of inflation as the dollars created to pay for this mess work there way into circulation.

Because this idea is unjust - it effectively spreads state level obligations to other states - and because it is economically disastrous - it will encourage states to spend and borrow more thus crowding out private investment and spurring inflation - and because it mitigates the short run need for politicians to face the consequences of their actions - look for it to pass unopposed.

posted by Realist Theorist @ 3:33 PM

Falling off a roof, I'd rather have a soft landing than a hard one. Metaphorically, people speak positively of a "soft landing" for the economy. However, the economy is not a single organism that is falling. When an economy falls, individual units -- people or companies -- "fall": individual people become unemployed, individual homes are foreclosed upon, and individual businesses go bankrupt. I think the notion of a soft-landing for an economy is often a fallacy of composition.

Consider the experience of two countries. The unemployment rate is shown in this diagram:

posted by Beth @ 10:43 AM

The president has also proposed savings on a much larger scale. The president has proposed ending the bank middle man for college loans, saving $94 billion over a ten-year period of time.

--Robert Gibbs, Press Secretary for President Obama

In yesterday's (4-21-09) press conference, Mr. Gibbs used the above statement to defend the President's $100 million budget cuts. Set aside for the moment that $100 million is only 0.0028% of the $3.6 trillion budget, and stop to consider the full implications of this casual comment. This assertion flowed effortlessly from Gibbs as part of his explanation on how the government is going to save us money. In the very next sentence, he implies that private insurance companies needlessly duplicate coverage the government already supplies through Medicare. (video clip; transcript)

What does this reveal about the administration's beliefs on the relative roles of government and business in meeting the economic needs of this country?

Just who exactly is the "middle man" and what are the implications of cutting him out?

The "middle man" is private enterprise, and our leaders, in the highest executive office of our country, view private enterprise as less efficient than government.

What system views government as the preferred manager of business?
Socialism.
What system views private enterprise as the proper mechanism for economic transactions?
Capitalism.

It doesn't get much clearer than this.

posted by Realist Theorist @ 10:23 PM

A tale of three homes: Consider this tale of three modest suburban homes on Adams Street (1). The one in the middle is owned by Mr. and Mrs. Chips who have lived there for 28 years. The homes on either side of them were bought more recently.

Mr. and Mrs. Chips, retired in 2000. Purchased in 1980 at $100K, their house was valued around $200,000 in 2000 [a nominal appreciation of 3.5% a year (2)]. They paid off their 30-year mortgage in 25 years, using a few extra principal payments when they could afford them.

Between 2000 and 2006, the market price of the Chips' home started to rise by 6-7%, then 8-10% a year. Finally, in 2006, similar homes were being sold for about $320,000! These higher valuations were of little use to the Chips. If they sold, they would have to buy something else at equally high prices. Then, in 2007, home prices began to fall; by Jan 2009 their home was valued somewhere around $220,000!

In terms of direct impact, the housing boom and bust made no difference Mr. and Mrs. Chips. It was as if it did not happen. It was like a storm they slept through. If prices in general flatten out (deflation-like) while credit-money contracts, they would be happy, because their savings will go the extra mile.

The Ketchums moved in next door to the Chips, buying a similar house for almost $300,000. Their home value has plummeted too and they feel terrible, because it is far below what they paid. Of course, their 30-year mortgage is unchanged. They had originally budgeted for certain monthly payments and can continue to meet those even if the economy turns down for a while. This would eat into the "buffer" in their budget, and they would have to scrimp, but they would pull through as long as things weren't too bad for too long.

The Smiths: The house on the other side of the Chips was bought by the Smiths. They suspected they could not afford it; but, they stretched to buy it. They lied about their income and borrowed 90% of the purchase price. Even while taking on a long-term commitment, they did not think of checking what interest rates were (say) 10 years ago; they took an interest-only ARM with extremely low introductory payments, and hoped it would not reset at too high a rate. They hoped that in a few years their home would have risen in value and they would refinance and end up with a better "cushion" of equity. The Smiths' plan did not work out. Their home value fell, ruling out refinancing. Meanwhile, their interest rate went up from their introductory rate. They are hurting. If things do not get better soon, they might not be able to afford their mortgage.

posted by Beth @ 12:32 PM

While checking out blogs on Tax Day Tea Parties, I discovered a wonderful post written back in January on Haight Speech.

Who could have Foreseen?

Oftentimes people respond to a crisis by claiming that it could not have been foreseen. (Government officials said this in the wake of 9/11, as one example.) With regard to the housing crisis, I have an answer: Henry Hazlitt. From his 1946 book Economics In One Lesson:

The case against government-guaranteed loans and mortgages to private businesses and persons is almost as strong as, though less obvious than, the case against direct government loans and mortgages [for homes]. … Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize the bad risks and to defray the losses. They encourage people to ‘buy’ houses that they cannot really afford. They tend to eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief, in the long run they do not increase overall national production but encourage malinvestment.

Over sixty years ago, and he nailed it. What a shame nobody was listening.

Hazlitt's book is a wonderful introduction economic analysis in which he takes a fundamental principle and applies it to a number of commonly held, but erroneous, economic assumptions. In the introduction, he summarizes the principle as follows:

The art of economics consists in looking not merely at the immediate but the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

Using this approach, Hazlitt examines the ignored effects of policies such as rent control, minimum wage, protectionist tariffs, make-work schemes, subsidies and bailouts, and several others. He clearly and simply demonstrates that by looking beyond the immediate effects, what at first glance appears to be beneficial is in fact harmful. Written for the intelligent layman, this book can also be read by an interested high-schooler.

Hazlitt's formulation is a recipe to correct the error in thinking of known as "context dropping." Ayn Rand explains this error in her essay "The 'Conflicts' of Men's Interests."

[T]here are two major ways of context-dropping: the issues of range and of means.

A rational man sees his interests in terms of a life time and selects goals accordingly. This does not mean that he has to be omniscient, infallible, or clairvoyant. It means that he does not live his life short-range...It means that he does not regard any moment as cut off from the context of the rest of his life, and that he allows no conflicts or contradictions between his short-range and long range interests. he does not become his own destroyer by pursuing a desire today which wipes out all his values tomorrow.

A rational man does not indulge in wistful longings for ends divorced from means, He does not hold a desire without knowing (or learning) and considering the means by which it is to be achieved.*

Leonard Peikoff elaborates further:

Whenever you tear an idea from its context and treat it as though is were a self-sufficient, independent item, you invalidate the thought process involved. If you omit the context, or even a crucial aspect of it,then no matter what you say will not be valid...

A context-dropper forgets or evades any wider context. He stares at only one element, and he thinks, "I can change just this one point, and everything else will remain the same." In fact, everything is interconnected. That one element involves a whole context, and to assess a change in one element, you must see what it means in the whole context.*

Looking at the whole context is key to evaluating the effects of any action or policy. Attempting to raise the number of home owners through government-guaranteed home mortgages drops the context both in terms of range and of means.

In terms of range, subsidizing loans for people who in fact can not afford the homes the loans are intended to purchase, has created not home-owners but mortgage defaulters. The effects of artificially lowered interest rates spread through the economy, distorting risk and profit calculations, leading to outrageous levels of leverage, culminating in the recent collapse which has destroyed the businesses and savings of millions of people and trillions of dollars. All of these events are intricately interconnected.

In term of means, all government subsidies necessarily involve violating property rights in the name of the "redistribution of wealth," which is nothing more than today's euphemism for the Marxist principle, "From each according to his ability, to each according to his need." No policy which violates a fundamental right can be considered valid.

When evaluated in the entire context of range and means, government subsidies are neither moral nor practical. With the application of properly constructed principles to the full context, the destructiveness of such policies can easily be foreseen.


*Quotes for Ayn Rand and Leonard Peikoff were taken from The Ayn Rand Lexicon, edited by Harry Binswanger, New American Library, 1986, pg 105

posted by Kendall J @ 8:00 AM

I enjoyed this Blogging Heads video featuring Arnold Kling, and Russell Roberts discussing the roots of the economic crisis. Both came to the Austrian school from others, specifically Keynsianism, and Monetarism.

In this video they discuss a little bit of the history of these schools and their arrival at an Austrian perspective. I enjoyed their initial discussion of “perils of Econ 101” where they illustrate the danger in macroeconomics of rationalism (using the C + I + G formula). They do a nice job of illustrating how one must go back to reality to ground the theory (“curing cancer vs. filling holes”).

The discussion is technical rather then philosophical, but it is a well-reasoned discussion. They correctly identify government policy in the housing market as the root of the crisis, and they concretize how that happened. They question the use of stimulus and the model that Ben Bernanke is using to prescribe such actions.

Labels: stimulus

posted by Kendall J @ 8:44 AM

Peter Schwartz has a great op-ed this week, “Mob Rule Comes to Washington.” In it he asserts that arbitrary, unchecked use of government power is tantamount to mob rule and that this is what exists today. President Obama even made a concrete reference to the force of the mob when he reportedly told bankers behind closed doors that his administration “is the only thing between you and the pitchforks.” But is this hyperbole? I mean, there isn’t really a mob of people with pitchforks out there, right? What does Swartz mean by “mob rule” and how does it manifest itself in today’s crisis.

The answer is in the arbitrary use of government power, in other words, the imposition of force, or the reversal of previous actions based upon whim. One of the clearest examples of this type of action is the ex post facto taxation of AIG executive bonuses. Congress used it’s legislative powers to essentially rewrite the terms of previously granted TARP investments to AIG. The government issued TARP investments under certain terms, typically as warrants for stock or as preferred stock. The terms of these investments are typically passive as far as company operations are concerned. That is, the investments do not allow the entity providing funds to exert control over the bank’s operations. Yet, the government, after the fact, exerted just such control.

But why is such action so destructive? This action took the form of a law passed by a legislative body, yet it is a blow at the very idea of rule of law. It destroys the idea of a contractual agreement, since the original investment terms mean nothing. And that will destroy man’s ability to use his rational faculty to live, by destroying decisions he has previously made. Had AIG known before hand that such terms would be imposed they might have chosen not to accept TARP funds. Yet they did not know and could not have known that such actions would be taken. These actions are forms of tyranny.

What precipitated this government action? Public outrage over the fact that bonuses were given. It was popular opinion expressed as displeasure to our elected officials. But the concept of rule of law is intended to prevent such expressions from resulting in arbitrary force.

Other examples of arbitrary actions include strong-arming of several of the large banks to “accept” TARP investments in the first place, firing CEO’s as preconditions of investment funds, proposed legislation to regulate any and all salaries at companies, refusing to take back TARP funds, and demanding such things as programs for investment in green auto technology.

Yet, if these companies were in bankruptcy some of the same actions, such as removal of executives, might occur as conditions or restructuring. Is this not the same thing? Clearly not. When we first defended CEO bonuses here, we had a commenter who suggested otherwise.

and i know government played its (small) part in the crisis, but we live in democracy. and as long as this plan is going forward, put into place by our elected officials, i think there should be ACCOUNTABILITY. since i have become a shareholder, so to speak, i say: don't take the money if you can't pay the price.

While I can certainly understand those who rightly fume at the government handing out TARP funds, and feel as though their money should be managed properly, the principled course to take is one that preserves the rule of law, does not unleash the mob, and accomplishes the same thing. This process exists already. It is bankruptcy.

What about the idea that such actions are just because these bank executives (or auto executives ) are deserving of the punishment they receive? Justice is not the arbitrary use of force. The sense of satisfaction that one feels when they see an executive being punished cannot be called justice if obtained in any manner whatsoever. There is a difference between justice in a courtroom and “justice” on the guillotine. The latter is not justice at all, but tyranny, and it is what we see the signs of today.

Schwartz is right. The mob is loose, and arbitrary government action is it’s harbinger.

Labels: bankruptcy, bonuses, Obama, TARP, Wall Street

posted by Doug Reich @ 4:58 PM

Here is an interesting piece on the "impenetrably misguided policy response to this financial crisis, which seeks to address the downturn by encouraging more of what got us into this mess in the first place" by John Hussman. He discusses the U.S. Treasury's "toxic asset" plan and various other measures which do nothing to address the actual causes of the financial crisis and that will likely only exacerbate the problem.

This piece can be read alongside my below post on recent Fed policy and provides further evidence of the utter destruction being wrought by government interference in the economy. It also provides further evidence of the effects of bad philosophy on our lives. Economists and government officials, unable and/or unwilling to integrate facts with valid economic or moral principles or who simply wish to usurp ever more power, continue to propose and execute plans which entail massive abrogrations of individual rights and destroy the economy. Meanwhile, the bewildered American populace, intellectually disarmed by over 100 years of progressive education and modern philosophy, sits idly by hoping things will somehow get better.

posted by Doug Reich @ 9:50 AM

In a previous post, The Fed’s Wish, I attempted to analyze the recent changes in the Fed’s balance sheet and the explosion of the monetary base as a means to understand the mechanism by which the government creates money and understand better the potential effects of such actions on the economy. As well, my purpose was to provide a more philosophical interpretation of the act of money creation in so far as government counterfeiting represents an attempt to evade the law of identity or reality and therefore constitutes a “wish” that reality is not what it is. In analyzing the technical details of the Fed's actions, I followed the analysis done by econbrowser and attempted to distill it into terms that might be more understandable to the non-economist. Econbrowser has two recent posts linked here and here that are very good at explaining what is going on and serve as a good follow up to my post. I will attempt to explain the recent activity in very brief big picture terms and refer you to his post if you want more detail and supporting charts and data.

The Fed’s goal has been to lend money to financial institutions (including foreign financial institutions) that are in trouble as a result of holding asset-backed securities (mostly bonds collateralized by real estate). But where does the Fed get the money to loan to these institutions? Up until about September of 2008, it sold some of its own assets (treasury securities) and used the cash it obtained from the sale. This meant that the Fed was primarily just changing the composition of its own balance sheet (going from holding mostly treasury securities to holding a combination of treasury securities and asset-backed bonds). It then realized that the problem was much bigger than it thought and if it wanted to continue lending money it didn’t have enough treasury securities to sell to raise the money needed. So where could it get the money?

As I explained in more detail in my last post, it has created the money out of thin air. But, if the Fed is creating money out of thin air and giving it to banks, won’t this inflation of the money supply lead to massive increases in prices?

The Fed has found a few "tools" that it has used to keep the money it has created from entering the economic system. Mostly, it began paying banks interest to hold excess reserves at the Federal Reserve. In the past, the Fed would not pay interest on excess reserves so banks would find something else to do with it – like lend or invest it. Since the Fed is paying interest (and because they are scared of lending it), the banks decided mostly to just keep this extra cash at the Fed. In other words, the Fed has created money to lend to troubled financial institutions, and then essentially found a way to keep the money at the Fed so that it doesn't immediately affect the general price level.

To summarize, the Fed has created a pile of money and lent it to banks. The banks leave it at the Fed and this big pool of money is sitting in an account available to be withdrawn at any time and turned into cash. What happens if banks start to pull this money out of excess reserves and begin to lend it? Such an outcome could lead to massive inflation or potentially even hyperinflation.

To prevent these reserves from going into currency in circulation, the Fed could simply sell some of the asset backed securities or fail to renew the loans. This would reduce their assets and correspondingly reduce the excess reserves in the system. However, the post offers this quote from the President of the Federal Reserve Bank of Philadelphia:

It is true that a number of the Fed's new programs will unwind naturally and fairly quickly as they are terminated because they involve primarily short-term assets. Yet we must anticipate that special interests and political pressures may make it harder to terminate these programs in a timely manner, thus making it difficult to shrink our balance sheet when the time comes...

In other words, there will be political pressure on the Fed not to unwind these loans. So then what?

...the following clause in the joint Fed-Treasury statement suggests that perhaps the Fed intends this, like most of the previous balance sheet changes, to not be allowed to impact total currency in circulation:

"the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves."

John Jansen (hat tip: Tim Duy) construes that clause to mean that the Fed is going to request the ability to borrow directly as well as for exemption of any borrowing done by the Treasury on behalf of the Fed from the congressional debt ceiling.

This means that the Fed wants to issue its own debt or borrow endlessly from the Treasury in order to remove the money that it has created! This would have multiple potential effects. First, it would put an unelected body, the Federal Reserve Board, in charge of determining fiscal priorities on a massive scale, i.e., this board would effectively be risking taxpayer money on programs that it deems worthwhile. Not only would it put the taxpayers on the hook for its investments, such borrowing would represent a massive drain on private capital which could otherwise be used to fund productive investments. Although the Fed is doing this to some extent now, the contemplated legislation would provide a formal sanction of these activities which are far beyond the parameters specified by the Federal Reserve Act. Such a sanction would represent a massive transference of power to the Federal Reserve and may actually represent an all out coup d'etat.

Such are the consequences of evading reality. The government caused the economic crisis with a combination of easy money and policies designed to facilitate and encourage reckless lending and borrowing. The government, instead of limiting its errors by allowing bankruptcies, is now compounding its evasion by attempting to bail out banks without having to tax Americans. So it counterfeits money which will lead to a hidden tax in the form of more inflation or it will borrow the money which will crowd out private capital, increase the debt burden on taxpayers of the future, and severely dampen economic growth. In the meantime, ever more power is being conferred to the Federal Reserve and the federal government which will in turn demand control over the enterprises which it chooses to shower with its largess. Such controls and attempts at central planning will lead to more destruction and more failures and more calls for regulation and/or an easy money fix. Investors, faced with massive uncertainty and the threat of arbitrary and/or confiscatory government policies will lessen or stop investing in productive assets altogether and seek the safety of unproductive government bonds or hoard precious metals.

Such an economic spiral accompanied by profound losses of freedom or outright fascism in the form of the loss of private property rights, confiscatory taxation, debasement of the currency, price controls, arbitrary regulations or imprisonment of businessmen, and potentially even the loss of freedom of speech as the state moves to silence its critics (see this post) can only be fundamentally stopped in one way. The ultimate solution is the complete abolition of the Federal Reserve system accompanied by the recognition of a fully private banking system based on sound money, i.e., precious metals. Such a system would be fully compatible with the principle of individual rights including private property and would entail a necessary delimitation of the federal government's role to its proper function as the protector of rights. Although constitutional limitations on the government's abridgment of the freedom of production and trade would be ideal, practically speaking, a system of private banking based on precious metals would necessarily limit the government's ability to intervene in the economy as it would no longer have the ability to fund its deficits surreptitiously through the creation of money.

The Federal Reserve's activities must be monitored closely. This rogue pseudo-government agency has mostly caused the boom bust cycle including the Great Depression as well as the latest fiasco, and is now threatening even greater usurpations of our liberty in the name of promoting financial "stability" (see this post). The first step on the path to abolishing the Federal Reserve is to expose their activities. HT to econbrowser for helping us towards this goal.

posted by Doug Reich @ 9:00 AM

Given the torrent of frightening news related to the abrogation of freedom in America, it is hard for me to be even taken aback anymore. Then I read this article in the Washington Post.

The Obama administration is considering asking Congress to give the Treasury secretary unprecedented powers to initiate the seizure of non-bank financial companies, such as large insurers, investment firms and hedge funds, whose collapse would damage the broader economy, according to an administration document.

The government at present has the authority to seize only banks.

Giving the Treasury secretary authority over a broader range of companies would mark a significant shift from the existing model of financial regulation, which relies on independent agencies that are shielded from the political process. The Treasury secretary, a member of the president's Cabinet, would exercise the new powers in consultation with the White House, the Federal Reserve and other regulators, according to the document.

But not to worry:

The Treasury secretary could act only after consulting with the president and getting a recommendation from two-thirds of the Federal Reserve Board, according to the plan.

So the Treasury secretary would merely have to deem a firm a potential threat to the "broader economy" in order to seize the firm. And who decides this vague and arbitrary standard? He would have to "consult" with the President and get approval from the Federal Reserve Board, an unelected board whose chairman is nominated by....the President.

Once again, we see the devastation wrought by the rejection of reason and principled thinking in favor of pragmatism. Note the line stating that at present the government only has the powers to seize banks. Is it shocking that if the government was given the power to seize banks that it would only be a matter of time before it sought to seize any financial institution? How long will it be before the word "financial" is removed and the government applies this argument to other industries?

This is the pattern of virtually all abridgements of our rights. At first, the government only seeks a limited intrusion to be applied to a small sub-set of individuals or firms and only under special circumstances. Individuals and businessmen especially, unable or unwilling to think in principle, do not see the broader implication of the new policy, and since it appears to not directly affect them right-now-this-minute, they either do not object or are willing to compromise. Of course, granting the government any power sets a precedent, i.e., establishes a justification to be used in the future. Therefore, when the government seeks a broader application of this power, the pragmatist is helpless to resist.

To resist such government policies would require the ability to think in principle. It would require the ability to understand the fundamental justification of a policy and the power to abstract the broader implications. It would require at least a cursory understanding of the nature of individual rights and the proper role of government. It might even require a knowledge of history to be used as a guide by which one can isolate similar events in the past and observe the consequences. In short, it would require the ability to reason.

And where would anyone obtain such an education today? The universities teach that reason is invalid, that objective knowledge is impossible, and that there are no black and whites. Therefore, economics today consists of the study of empirical relationships of quantitative data divorced from any general understanding or principles. History, they teach, is always biased by the historian and can only be seen through the prism of race, gender, and ethnicity. The history of the nation which brought about the greatest prosperity and happiness in world history is reduced to the study of the native American "genocide", slavery, and misogyny. Business schools use the "case study" method to reinforce the idea that the world is a stream of random concretes with no connection to one another. Psychologists tell us we are a product of our genes or environment. Moralists argue that ethics consists of self-sacrifice to God or in modern times, the "environment", and that man by his nature is a cancer to the planet. In short, the modern student is taught that principles are useless, everything is relative except that man (well, Western man) is evil and is destroying the planet, and his duty is to sacrifice.

Given the state of modern philosophy and its ripple effects throughout university curriculum's, is it any wonder that this country is in decline?

Jefferson was supposed to be the source of the quote: "The price of freedom is eternal vigilance" which is absolutely true. Vigilance means paying close and continuous attention and implies an ability to understand the broader implications of any action by the state. If man is stripped of his essential faculty, the reasoning mind, and told that it is useless to seek knowledge and abstract principles - if man is told that life is meaningless - if man is told that he has no control over his life and is a product of his genes or environment - if man is told that he is evil by nature and that his sole purpose is sacrifice and/or to minimize his "carbon footprint" - how can he be "vigilant" in this sense?

It is not the Obama's and Geithner's of the world that are responsible for our loss of freedom. The cause is a lack of "vigilance" brought about by the systematic attack on the efficacy of the human mind and therefore on individual rights. Nothing short of a philosophical revolution will allow and inspire vigilance once again.

posted by Galileo Blogs @ 12:11 AM

What is bankruptcy?

Bankruptcy is the financial state that occurs when a person or business can no longer repay its debts. In the legal sense, bankruptcy begins when a court recognizes that the financial state of bankruptcy exists. The bankruptcy court takes charge of the bankrupt entity and disposes of its assets or reorganizes it to pay off as much of the debts as possible.

A bankruptcy proceeding recovers money for the creditor, but both parties benefit.

The purpose of a bankruptcy proceeding is to facilitate the maximum recovery of the money owed to the creditor. But it also benefits the debtor. After the debtor pays off what he can, his remaining debt is extinguished. This is not a “get of jail free” card; the debtor, whether a person or business, must face the damage to its reputation and a greater difficulty in obtaining credit for a long time into the future. Rather, it is an acknowledgement that the debtor simply cannot repay his debt. For both parties, bankruptcy offers timely resolution to an otherwise unsolvable dilemma. The creditor regains a portion of the money owed, and the debtor, relieved from the burden of a debt he cannot pay, can move on with his life.

Bankruptcy is economically valuable.

In economic terms, a speedy and fair process of bankruptcy allows both assets and people to resume being productive as quickly as possible. The creditor regains cash that it can redeploy as it sees fit. If it is a bank, it has regained funds that it can loan out again to more productive businesses or creditworthy individuals. The creditor can also redeploy the assets of the bankrupt entity into the hands of a more capable manager.

Take the financial malaise of General Motors as an example. Although effectively bankrupt, there has been no legal recognition of this fact (as of this writing in March 2009). As a result, its factories and workers continue to be tied up inefficiently making mediocre cars. General Motors is a drag on the American economy.

Bankruptcy would free General Motors’ factories and employees to be more productive. Once a court legally acknowledges General Motors’ bankruptcy, it could allow General Motors’ new owners, its creditors, to appoint a more competent manager. Or the creditors could sell the plants to a superior car manufacturer, such as Toyota. Either way, after reorganization under bankruptcy, the plants would be used to make cheaper, more attractive cars that customers want to buy.

The creditors may also choose to shut down some or all of the plants and sell them for scrap. But recycling the old plants into new steel that becomes the girders of modern, efficient factories is a better use for those plants if they are obsolete. No party is in a better position to make these judgments than General Motors’ creditors, who have their financial self-interest at stake.

While General Motors is just a single, albeit enormous, example, speedy and fair bankruptcies end the bleeding of money-losing operations across the economy, and re-direct inefficiently utilized assets and capital to more productive activities. In sum, bankruptcy facilitates economic recovery. A failure to permit bankruptcy prolongs stagnation.

Some fallacies about bankruptcy

Bankruptcy always means shutting down a business. This is not true. Creditors, in consultation with the bankruptcy court, decide whether to shut down and liquidate, or to operate under new management. Creditors have every incentive to make the decision that maximizes their pay-out over time, not just the amount of cash that can be had right now.

Bankruptcy is bad for employees. Considered in full context, bankruptcy is good for employees. An economy with speedy and fair bankruptcy procedures is one where healthy, growing companies predominate. Healthy companies can pay employees more because their labor is worth more to them. Therefore, employees benefit from bankruptcy, even if someone occasionally faces dislocation or the uncertainty of working for new management. But, even if employees dislike such occasional dislocation, there is no alternative to bankruptcy if their employer is not financially viable.

Bankruptcy allows deadbeats to avoid meeting honest obligations. When bankruptcy laws are properly drafted and applied, this is the exception rather than the rule. Bankruptcy laws are designed to protect the rights of all parties, not to unfairly favor debtor or creditor. Bankruptcy acknowledges a fact, that the debtor cannot repay all his debts, and it facilitates the repayment of all debts that can be repaid.

Government should stop bankruptcies. During financial panics, governments sometimes try to prevent bankruptcies by putting moratoriums on them, subsidizing bankrupt entities, or changing the laws governing bankruptcy to favor debtors. Such interventions are both unjust and impractical. They are unjust because they deny the legitimate right of the creditors to collect what they are owed. The money they are owed is their property, and they have the right to collect it, to the extent it is reasonably possible. Such interventions are unjust and impractical because they attempt to deny reality. “Stiffing” the creditors or forcing innocent third parties to bail out the bankrupt entity through subsidies does not change the fact that the bankrupt entity cannot repay its debts.

Bankruptcy is moral.

Bankruptcy is just, if resolved through a fair and speedy judicial process. A bankruptcy proceeding acknowledges the actual state of affairs that exists, that the bankrupt entity cannot repay its debts. It resolves this dilemma for the maximum benefit of the creditor, but in so doing allows both parties – debtors and creditors – to resolve this matter with finality, and move on with their lives. Bankruptcy only involves the parties to the debt obligation. It does not require that innocent, third parties be forced to subsidize or bail out creditors or debtors. In doing so, it respects the rights of all concerned.

A just process of bankruptcy is also economically practical. Bankruptcy removes assets from those who have mismanaged them, and puts them into the hands of those who are most capable of putting them to productive and financially responsible use. The institution of bankruptcy is an essential part of a prosperous and just capitalist society.

Labels: bankruptcy, General Motors

posted by Beth @ 6:00 AM

[O]ne of the high points of the semester, if you’re a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off.
--Paul Krugman, "When Consumers Capitulate" 10-31-08

Savings a public vice? Krugman tells us we have a savings glut, and explains how we are suffering from too much savings. How can we have too much savings and too much debt at the same time? Ah, yes. Foolish non-Nobel Prize winners. You fail to understand the mysteries of the "Paradox of Thrift," "Liquidity Traps," and "Damnification." It's obvious that what we need is "a surge in public spending," and to quit worrying about the deficit.

If you think Krugman's recommendations defy common sense, you would be right. They also fly in face of good economics. What Krugman, and his influential predecessor John Maynard Keynes, fail to understand is the difference between real savings and the artificial "savings" of credit and money created out of thin air. Their convoluted arguments in defense of increased deficit spending crumple into nonsense once you grasp the real meaning and role of savings.

Savings consists of production which is not immediately consumed. Savings is the excess wealth we have already created, which can then provide for our immediate needs while we expend time and resources to produce an even greater amount of wealth in the future. Without savings to sustain us, no investment in the future is possible. We can not sustain ourselves on paper, so printing money only creates the illusion of wealth. Reality eventually catches up, and all the plans that were constructed on that illusion come crashing down. Sound familiar?

I recently stumbled across an example of real savings in an unexpected source: Up from Slavery, the autobiography of Booker T. Washington. Washington, an American statesman and former slave, tells the remarkable story of his struggle to better the lives of blacks in America following the Civil War. To provide them with the knowledge and skills needed for self-improvement, he built from almost nothing the Tuskegee Normal and Industrial Institute. As an essential part of the educational program, students and faculty at the school built and operated all of the facilities themselves. School farms provided a substantial part of their food. Even so, the impoverished condition of his students required constant fund raising in order to purchase materials they could not supply themselves. Occasionally, Washington was able to secure a sizable donation of $1000, but the bulk of contributions were small--$10 or $25, or even less. The following encounter is one of many similar vignettes which poignantly illustrates the real meaning of savings.

I recall one old coloured woman, who was about seventy years of age, who came to see me when we were raising money to pay for the farm. She hobbled into the room where I was, leaning on a cane. She was clad in rags; but they were clean. She said: “Mr.Washin’ton, God knows I spent de bes’ days of my life in slavery. God knows I’s ignorant an’ poor; but,” she added, “I knows what you an’ Miss Davidson is tryin’ to do. I know you is tryin’ to make better men an’ better women for de coloured race. I ain’t got no money, but I wants you to take dese six eggs, what I’s been savin’ up, an’ I wants you to put dese six eggs into de eddication of dese boys an’gals.”

Six eggs. Six eggs were the sum total of her excess production, not immediately consumed, and thus available for "investment." Those six eggs were eggs that Washington and his students would not have to produce themselves, thus freeing their time for activities aimed at the future, a future of increased prosperity through the improved productivity their education would make possible.

We have moved beyond a barter economy but the fundamental nature of savings has not changed. Before we can invest in the future, we must first produce the wealth to meet our immediate needs. Production beyond immediate consumption is what we call savings. Only with this excess can we afford the luxury of production aimed at future goods. Only with our immediate needs provided for do we dare take risks on new, and hopefully improved, methods and products. With this excess, our savings, we can accumulate the capital required to increase productivity.

We now trade in money rather than eggs, but to serve its proper function, money must remain directly and irrevocably linked to real, existing wealth. To inject into the economy paper money not backed by real goods disrupts our ability to calculate how much we can afford to invest in the future. Because of its historical connection to real wealth, paper money is treated as equivalent to real wealth (but it is not.) Personal and business plans are made on the assumption that those paper dollars will provide for our immediate needs while we spend our efforts and resources on projects which will not come to fruition until a future date. But, if Washington's benefactor had given him six pieces of paper, and he made plans as though it were six eggs, when dinnertime came around, he would go hungry.

Now it is our dinnertime and we are realizing we are out of eggs. Common sense tells us we need to restock our egg supply rather than exchange them for less immediate needs, or before taking risks on a future supply of eggs. Krugman, and his followers in Congress, want us to continue to pretend our larder is full. Paper money and credit creation help with that deception. By ignoring the true meaning of savings, it is possible to construct a host of sophisticated arguments which make it appear as though the answer is more spending, and more debt. But it all falls apart if you start with the fact that real money means real goods, and anything else is a paper fantasy that won't feed you come dinnertime.

posted by Doug Reich @ 1:44 PM

Post on the absurdity of the idea that the "boom-bust" cycle is inevitable.

Frequently, you hear Obama and his ilk make the claim that economic conditions are "likely to get worse before they get better." Now in the practical sense that his administration's policies are designed to destroy the economy, I agree with them. However, those making this claim are the ones who are in control of the policies and therefore they are unlikely to believe their polices are the cause. In other words, they appear to be making this claim on the premise that it is a metaphysical absolute that things must get worse before they get better. It's almost as if they believe there is a mystical force shadowing the nations' economy which necessitates recession and malaise and which can not be understood or resisted.

Is this true? Must things get worse? Also, many in the financial industry and elsewhere are absolutely bewildered by Obama's plans which fly in the face of logic and history. Why would he propose such policies?

posted by Beth @ 6:00 AM

I've been reading lately that President Obama is over-worked and tired because of trying to deal with the financial crisis. This fatigue has even been offered as an excuse for his shabby reception of British Prime Minister Gordon Brown. (From the article: "Sources close to the White House say Mr Obama and his staff have been "overwhelmed" by the economic meltdown and have voiced concerns that the new president is not getting enough rest.")

Maybe that's because he is literally trying to do the work of millions.

A market economy is the result of an uncountable number of individual decisions and actions, coordinated through price signals which provide crucial information on the availability of every imaginable resource. Profit and loss calculations provide essential feedback on the relative efficiency with which a multitude of producers use those recourse to meet the needs and desires of an even larger number individual consumers.

Central planning consistently fails because it is impossible for a small number of individuals, let alone one man, to obtain the requisite information, create the necessary plans and subsequently attempt to implement them.

Mr. Obama, meet the Fatal Conceit.

Labels: Obama

posted by Realist Theorist @ 3:00 AM

Warren Buffet is not a supporter of a real free-market. He's for a "mixed economy", and thinks the government ought to be taxing him more, redistributing his money to the poor. He talks about an "ovarian lottery" being responsible for much of his own success (I guess he's either read John Rawls, or simply picked it up second-hand). As a super-rich self-made man, he's a prime example of the "sanction of the victim", asking to be hurt. Neither is Buffet great on economics. Here too, he has bought in to a standard the Keynesian/Monetarist mixture.

So, when Buffet gives advice he's not saying how we can get to a thriving free-market; rather, he's really saying: "Here is how we can get to a more stable mixed economy that does not cross the line into stagnation or a downward spiral". He did this yesterday, appearing on CNBC for a 3-hour special. Since he is somewhat influential, I thought some readers may be interested in what he said. There's much to dislike in what Buffet says, but I want to present his views in this post; a critique can wait.

I'm going to paraphrase. Also, be warned that I'm going to read between the lines, but I do so with my full sense of honestly. [For what is probably a good transcript: see Gurufocus, but I got my summary from watching the show.]

With all those caveats, here is Warren Buffet's advice to Obama:

Do not demonize people: Do not portray businessmen as evil. People are getting the impression that every big bank is like Citibank. This is false. If people act on that false assumption they'll do the wrong things and ask for the wrong things to be done. This false impression destroys the very confidence we need at this point. [RT, using a Buffet example, but extending it: Imagine a set of generals launching the invasion of Normandy, and one general does something wrong. Now, imagine the President starts criticizing generals as a group, commentators speak of "Main Street vs. Military Street", while Congress starts holding hearings where general are called from the front to testify and then criticized for not flying back commercial. End-Aside] It is not fair, and it undermines good people. We need good people at times like this: we do not need villains, we need victories.

Drop all the other noble goals: Ever the altruist, Buffet thinks it's a good long-term goal for the government to help people with health care and to raise taxes on the super-rich. However, he says, now is not the time. The idea of "not wanting to waste an emergency" is a poor notion; that's like a president saying he does not want to waste a war. This is not the time to do things that the GOP is strongly against. For now, forget about health-care and about raising taxes on the rich. This is a time to focus on the single task at hand, with a sense of unity. You cannot expect unity on things people strongly disagree about. So, you have to drop that part of your agenda. Also, unity is not helped by demonizing people. Even the stimulus should not be the main focus: it should be all about fixing the financial system.

Some goals aren't even worthy: Card-check is a bad idea. Secret ballot is a good idea for unions too. As for global warming, Buffet does not express an opinion. If we want to prevent carbon-emissions, he agrees that some type of tax will be required. However, we should be honest that this is a tax on consumers. He owns huge utility companies, and the state utility commissions will simply pass that tax on to consumers. His top men who run his utilities tell him that cap and trade is a bad idea.

Clarity and predictability are vital: It has been some months now and we do not have clarity on what the government will or will not do. People will stay partially paralyzed, waiting, until they see more clarity and predictability of direction. Smaller details of any plan do not matter as much as having a clear plan that people can count on, without the rules being changed on them. Also, one cannot get this clarity from lower officials. The president is the one who has to make the large strokes absolutely clear, by stating them and committing to them.

We're mostly done enough: The previous administration stepped in and pushed money into banks, money-market funds and AIG. Buffet supports most of what was done. He thinks that the government should continue to guarantee bank deposits (even over the current $250k number) and also guarantee bank debt. However, he does not think banks need more government money. In his view, the most important thing is to create an environment where the good banks, like Wells Fargo, can grow their way out of this on their own. (Buffet is a large shareholder in Wells Fargo.)

Curtail "mark to market": The biggest risk he sees to banks is if the government forces banks to take new capital at today's low share-prices. The immediate cause will be if the government thinks the banks have too little capital. In turn, the immediate cause for that will be if the government uses "mark to market" to calculate that banks have too little capital.

Buffet is a strong supporter of "mark to market" for accounting. He thinks it should not only be reported in accounting footnotes, but should be the primary figure. Let management's estimates be in the footnotes; and let shareholders decide whether to believe management. However, he also thinks the government should not use "mark to market" alone, when calculating legal capital requirements for banks during a panic. In a panic, that forces banks into being viewed as unrealistically worse than they really are. It creates the basis for government to put in more capital where no more is really required; and, in doing so, the government undermines private capital. Instead, the government should modify its (very recent) rules on using MTM to calculate capital-requirements and make them clear. While doing so, it should guarantee that if the capital turns out to be really inadequate, it will nevertheless guarantee depositors and bank-debt.

Finally, Buffet thinks the country will come out of this and grow to even wealthier times. However, the choice is between years of struggling and finally emerging despite government action, or having government set an environment that let's banks and other companies to grow out of the current state more quickly.

RT again: That's the summary.

Buffet is not making any call for radical change. He fully supports much that got us into this mess. He ignores much of the government-caused mess that brought us to where we are. In effect, he's suggesting we fix things so that we leave something for the politicians to mess with. Buffet's message is: don't kill the goose that lays the golden egg. While he is no radical for capitalism, his interview basically makes the case that Obama should not be a radical anti-capitalist.

Yet, while there are many things to disagree with, I have to admit that when the general on the war-path is calling for business to be cut to shreds, it is heartening (in a "choose the lesser evil" way) to hear one sage from the general's side say: "let's just cut off a finger or two; we'll have time enough to do the rest later when they stop wiggling". Unless one thinks we must head to apocalypse first, it is a good sign that some voices are not so radical.

posted by Kendall J @ 8:00 AM

In a follow up to Monday’s post on why bank nationalization is a bad idea by any name, Monday’s New York Times had an article that indicates that Freddie and Fannie will probably stay in government control. If you think a bank nationalization will necessarily need to reprivatization, it looks like that sentiment is in question.

Despite assurances that the takeover of Fannie Mae and Freddie Macwould be temporary, the giant mortgage companies will most likely never fully return to private hands, lawmakers and company executives are beginning to quietly acknowledge.

The possibility that these companies — which together touch over half of all mortgages in the United States — could remain under tight government control is shaping the broader debate over the future of the financial industry. The worry is that if the government cannot or will not extricate itself from Fannie and Freddie, it will face similar problems should it eventually nationalize large banks.

Part of the reason is that as implicitly government-backed entities, Fannie and Freddie are where a significant part of the home mortgage mischief took place. If we think that private banks at a 30:1 leverage ratio were acting recklessly, what does that say about a 1000:1 leverage ratio over at Freddie/Fannie?

Labels: mortgage

posted by Realist Theorist @ 1:06 PM

How high are house prices? News reports often focus on the short-term: "prices fell last month". In this post, I summarize the medium-to-long-term history of house prices. I hope this will provide the reader with context necessary to integrate those news stories into a longer-term perspective.

In this post, I look at prices alone. There are other important metrics: for instance, "were people taking larger loans even for the same underlying house?" I hope to address those another day.

The blue line is a 10-region average. (The red line is a newer, broader version that covers 20 regions.)

posted by Kendall J @ 8:00 AM

The answer: when we simply call it something else.

Nationalization of key large banks has been the talk for the past few weeks. This seems to be the dominant mechanism being discussed for a thorough restructuring of bank balance sheets. Harvard University economist Greg Mankiw suggests that in order to describe what is really meant by the process, you have to properly describe it.

If the government is to intervene in a big way to fix the banking system, "nationalization" is the wrong word because it suggests the wrong endgame. If banks are as insolvent as some analysts claim, then the goal should be a massive reorganization of these financial institutions. Some might call it nationalization, but more accurately it would be a type of bankruptcy procedure.

Megan McArdle at The Atlantic.com adds,

If nationalization is just a way to take control of the downsizing and ensure that equity shareholders and creditors don't profit at the expense of the taxpayer, all well and good.  If it is a way to avoid recognizing the full extent of the losses as quickly as possible, not so much.

This confusion regarding what is meant by a possible nationalization highlights a key issue with the whole scheme. It doesn’t have a “playbook” or in other words there is no rule of law that covers the powers that must be exercised to complete such an action. If you are worried by the concept, you have a reason to be. It is because we have very little recourse against the arbitrary exercise of power should such action be taken.

This seems to be the biggest issue I have with those economists who are discussing the option. They discuss the mechanics of such action in the abstract, as if government is simply taking the role of a surgeon operating on his patient, rather than a political entity composed of conflicting ideologies and agendas devouring their kill.

The issue of politicization was taken up in a Wall Street Journal op-ed, “The Problem with ‘Nationalization’” last week. Given Washington’s track record of not doing what it started out claiming it would do in regard to the crisis, is there any reason to believe that what starts out as a “type of bankruptcy procedure” would not end up becoming institutionalized government encroachment in the financial sector?

From the beginning, the handling of the U.S. crisis has been politicized. The partisanship is as toxic as the bad assets on bank balance sheets. Both parties are coming up with schemes to impede the process of foreclosing on homeowners who can't afford their homes, which would get those homes into the hands of new owners who can afford them. Does anyone believe that a government bad bank will squeeze homeowners? To ask the question is to answer it.

Moreover, we know how the government runs financial institutions -- consider Fannie Mae and Freddie Mac. Or IndyMac, whose management by the FDIC has been criticized for inflating the rescue costs through its liberal loan-modification program. A money-center bank in government hands would become a conduit for politicized lending and grants disguised as loans. That's what's happened at Fannie and Freddie. The government would never let go of its political ATM. You might as well consolidate such an institution with the Fed from the outset.

Mr. Geithner wants a public-private partnership to buy toxic assets from banks. All that government has done thus far has only scared private money off. As bankers now realize, when you turn to the government for financial assistance you take on an untrustworthy partner. Outside money will not come in only to see its investment diluted later on when the government injects additional funds.

Rather than focusing on ways in which we can further involve the government in the financial system, we need to find ways to extricate banks from government's deadly embrace. Banks, at least the behemoths, were public-private partnerships before the crisis. Deposit insurance, access to the Fed's lending, and the implicit (now explicit) government guarantee for banks "too big to fail" all constituted a system of financial corporatism. It must be ended not extended.

While the government currently ‘nationalizes’ banks as part of FDIC’s mandate, former FDIC head William Isaac points out that nationalization of one of our largest institutions is far beyond the scope and complexity of any nationalization ever attempted by FDIC.

The fact is that there is a process already covered by the rule of law meant for such instances, Chapter 11 bankruptcy reorganization or Chapter 7 liquidation. Yves Smith at naked capitalism argues that this is not an option for these large banks.

It's hard to convey to people outside finance why a big complicated bank isn't the same as a manufacturing business or a retailer, where you can resort to Chapter 11. The simplest explanation may be that banks are much more tightly integrated into various customer and counterparty webs than most other businesses are. If a big automaker wants to shut down a production line for a few hours or a week. it can be done with little disruption to outside parties if planned. It isn't acceptable for a trading desk to shut down for a day, say to do "routine maintenance". Counterparties would run for the hills the next chance they had a chance to initiate trades. Now one might argue that this is convention, but as a customer, not being able to trade, not having ready access to one's funds is seen as an unacceptable risk, and that business requirement makes it impossible to resort to Chapter 11.

The short explanation of Yves point is that banks are supposedly special beasts. For instance, when an airline goes into Chapter 11, people are still willing to fly. There’s not much chance on any given flight that the plane will take off without fuel. However, banks use your money as “fuel",” and there is a chance that if you give your funds to one in Chapter 11 that you might never see them again. As a result, bank bankruptcy has a confidence problem and risks a potential run.

I don’t buy it. Citi today is almost certainly insolvent. Given the government’s arbitrary actions in dealing with each problem as it comes along, there is a high level of uncertainty that any one party will be kept whole in a government led restructuring. Yet Citi continues to do business.

The key here is that a bad bank still consist of healthy operations which can be sold off intact as part of bankruptcy proceedings. In a free market, investment capital would seek out clean, vetted acquisitions of healthy chunks of these banks. Proven management teams who can perform adequate due diligence would field this capital to acquire portions of these banks. This would result in orderly transfers and recapitalizations of healthy portions of these banks, under rule of law.

Nationalization by any other name is still nationalization, because it is an arbitrary act of government, and as such unpredictable and uncontrollable. Instead of increasing arbitrary involvement of government in the financial sector, we need less government intervention.

Labels: Wall Street

posted by Realist Theorist @ 10:53 PM

"War prosperity" is an odd, but enduring myth. On the one hand, wars destroy some men and material; and, they divert others from making "butter" to making "guns". Nevertheless, one hears people say things like: "spending lots of money fighting Hitler, brought the U.S. out of depression"(1). In this post, I want to examine the FIRST world-war.

posted by Realist Theorist @ 6:45 AM

The fear of foreclosures and falling home prices is often an irrational fear. Obviously, the person losing his home may be fearful. Also, neighbors who wish to sell their own homes are nervous about low prices. However, most people have not budgeted around the notion of refinancing. Most people plan to stay in their homes for (say) another four years or more. For this vast majority there is no reason to fear foreclosures.

posted by Kendall J @ 9:00 AM

One of the troubling issues that arise during a recession, especially when we have arbitrary central bank monetary policy makers casting about looking for solutions to new problems is that there is a strong tendency to see inflation bandied about as a possible tool of monetary policy. RationalTheorist has looked at possible indicators of coming price inflation.

There are a couple of key reasons that inflation is considered as a policy tool. First, whether government officials believe in the value of inflation as a monetary policy, there is an implicit temptation to use inflationary policy to deal with the problems of financing massive government spending programs, such as the recent TARP, Obama stimulus package, and the FED’s various credit facilities. Inflation rewards those who hold debt, since an inflating money supply in the face of fixed debt payments means that debt loads shrink. A key problem that the FED has today is how it is going to issue enough debt in the form of Treasury bills in order to fund the stimulus programs. In addition, because asset values are inflated, any effort by the government to buy so-called “toxic assets” at prices that are too high will be ameliorated as the values of those assets would artificially inflate.

This temptation alone should give one concern about what might happen in the future. However, the second reason should give one even more concern. There are those who explicitly believe that inflationary policy is actually beneficial for the economy during a recession. Two examples have popped up recently in the media; one from a report of a Fed governor’s remarks, “FED’s Bullard: U.S. Facing Risk of Sustained Deflation” and the other from a Financial Times op-ed “Coordinated Inflation Could Bail Us All Out.” (free registration may be required)

The basic argument here is that monetary inflation (i.e. inflation of the money supply) can be used to combat a “deflationary trap” or deflationary spiral. The argument for a deflationary spiral says that due to a contraction in spending at the outset of a recession demand, and thus price, drops. However this leads to cutbacks and layoffs in the private sector and as a result, average incomes drop, and average debt levels actually rise. This in turn forces even more saving, with resultant demand drops and further cutbacks. This process is said to continue on in a spiral, eventually destroying the economy. This effect does happen during a recession, but I question its severity, and whether or not monetary inflation is proper to combat it.

In an economy that has been over-stimulated as ours has, a correction in asset values must occur. If we’ve been improperly subsidized to build too many houses over the last decade, then the price of housing must come down. Part of what we’re seeing is the market’s natural response to reset these asset values. This will hurt those who’ve over-estimated their ability to absorb risk (and should be a strong reminder why we don’t government interfering and creating distortions in the economy in the first place); however, it must occur. But the existence of falling asset values is its own stabilizer to continued fall because falling prices stimulates demand. Not everyone in the economy sees their incomes and asset values fall, and for those who do not, falling prices create an incentive to consume, thereby stabilizing deflationary pressures.

But the secondary and even more important issue here is that one cannot combat demand deflation with monetary inflation. Yes, inflating the money supply will cause prices to rise, seemingly reversing falling prices; however the mechanism of price movements are completely different in each case and one is not an antidote to the other. In a time of recession such as this where market distortions have resulted in the destruction of investment capital, what is needed is recapitalization. We need to use our current productive capability to accumulate savings (which if deposited become investment capital). Those who have over-borrowed need to pay down debt or sell off assets and their concurrent liabilities. Those who are in the best shape risk-wise can afford to spend, and those who are in worse shape should save and get rid of debt.

However, inflation destroys this process. Inflation destroys real wage levels, i.e. productive capability. It favors those who have large debts, and it destroys the value of accumulated assets. It is unjust. Those who have over-borrowed see their debts effectively forgiven. Those who were prudent and have saved see their assets destroyed.

Those who think that this sort of policy can be a good thing suffer from a form of macro-economic rationalism. That is, they view the economy as an aggregate machine, a sort of “black box.” They have correlated increasing money supply with rising prices and recession with falling prices and simply see one as a way to combat the other. Faced with a condition of falling prices, they know they can make prices rise by printing money. It is as if they are pulling levers and turning knobs on this black box simply to keep the gauges reading what they were. They care little what the fundamental mechanisms of each are. The articles I referenced show this.

From the WSJ blog:

Bullard also said a more systematic approach to countering deflation would entail more communication about what the Fed is trying to accomplish. He suggested setting “quantitative targets for monetary policy, beginning with the growth rate of the monetary base.”

“By expanding the monetary base at an appropriate rate, the FOMC [the Fed's policy-making Federal Open Market Committee] can signal that it intends to avoid the risk of further deflation and the possibility of a deflation trap,” Bullard said.

In his comments on the economy, Bullard said “macroeconomic expectations are very fluid and volatile.” He added “the current recession is a global phenomenon” and “it seems likely that output and employment will continue to shrink in the first half of 2009.”

“There is a risk that core prices may continue to stagnate or decline slightly for some time to come,” Bullard said.

The article is devoid of any reference to what market prices should be, or any mechanisms of operation of the market. Output and employment are falling, therefore the FED should act to increase prices. The “gauge” does not read correctly therefore we have to pull this “lever” to make it do so.

Even more brazen or bizarre is the Financial Times article, where the author clearly advocates for an inflationary policy, after explicitly and correctly articulating the various positive effects of such a policy, while all but ignoring the negative effects.

It [an inflationary policy] would help government finances by inflating away 10 per cent of total government debt. This lowers the interest burden for future taxpayers. Since taxes are levied primarily on income, this has both equity and efficiency benefits. It is (more) equitable as the cost of recession will be borne by wealth holders as well as income generators, and it is (more) efficient in that it reduces the extent of incentive-reducing tax rises on income in the future.

Companies will benefit in two ways. First, a portion of their debt will disappear, with the benefit being the largest for those companies that have debts with fixed interest, such as corporate bonds.

Second, while real wages seem to be downwardly flexible, nominal wages are less so. Higher inflation allows more companies and workers to agree to real wage cuts than would otherwise be the case. This is both useful for those firms that are currently uncompetitive, and preferable for society, because wage cuts are more equitable than unemployment.

A rise in inflation also means that declines in real house prices translate into less negative equity, freeing up the housing market. This is beneficial for labour mobility and helpful to the real economy because additional house sales spur economic activity.

Banks would gain in three ways. Inflation reduces future bad debts by making debt servicing easier. It makes defaults less costly because real collateral is more likely to exceed nominal debt. Finally, it makes existing bad debts less onerous on the balance sheet. This reduces the need for government recapitalisations and “bad banks” and increases the ability of governments to sell recently acquired banks. This, in turn, reduces the debt burden on future taxpayers.

An extra 2 points of inflation for five years is not a “get out of jail free card”. Bank shareholders, rightly, will still lose greatly from their managers’ decisions. Future taxpayers will, inevitably, still bear most of the cost of counter-cyclical government spending.

It is not costless. Regrettably, prudent savers will see their assets reduced. That might be the price society has to pay to keep the banking system afloat without crippling future taxpayers.

In terms of direct costs, the negative effects are equal and opposite to the claimed benefits. For every dollar that a debt holder’s obligation is lessened, the capital lender is punished by an equal amount. To call that a “cost” is to suggest that when a thief steals from you, that your loss is simply a “cost” of the benefit he gains. When the costs equal the benefit, there is no benefit. The indirect costs however are even greater because it is the asset holders that will restart the economy and it is they who are punished in an inflationary environment. Inflation destroys the very process of recapitalization that the recession will facilitate if left alone!

The rising debt levels that the United States is experiencing should concern those who see it as a temptation on the part of regulators to use inflation to “finance” their efforts. However, when inflation is explicitly advocated as a monetary policy by those in power, it is all but sure to rear its ugly head. It can only prolong the recession.

Labels: INFLATION, stimulus, TARP

posted by Realist Theorist @ 12:06 PM

Previously, I described one particular measure of Consumer Price Index (CPI) expectation.That measure implied that five years from now (in Jan 2014) the CPI will be almost the same level as it is today. This expectation is unusual. Historically, people expect CPI to rise. So, I wanted to point out two other details about this anomaly:

Labels: INFLATION

posted by Kendall J @ 4:00 PM

Two more expensive failures this week from our government. I am of course speaking of the Obama stimulus package which the Senate passed on Tuesday and the Treasury Department’s proposed plan for its continued effort to shore up our financial system, also unveiled on Tuesday. If someone had asked me to predict the worst possible scenario for these two efforts I would have suggested that a huge stimulus package (which fundamentally does nothing to help) and “more of the same” from Treasury (which doesn’t address the fundamental problems in the banking sector) would have been my picks. That is exactly what we received.

The stimulus bill is predicated upon the flawed view that the economy is in some sort of deflationary spiral, i.e. that the problem is fundamentally one of consumer panic, and for which the antidote is a government burst of spending. By putting money back into the pockets of Americans it is thought we can restore their confidence as they see that burst of spending stop economic decline. This of course ignores the question of how such spending is financed, through the sale of Treasury notes, in effect pulling that money from the pockets of consumers before putting it back, and mortgaging future taxpayers to do it.

On the other hand, there are real structural issues in the financial sector. But Treasury’s plan was almost universally panned across the economic spectrum, even before Treasury Secretary Tim Geithner had finished laying it out. Where he was specific enough to give details, the plan looked like a version of the pervious TARP, with Treasury providing capital to banks, albeit somewhat more “judiciously.” The plan was short on details where most needed, in the area of restructuring bad assets on bank balance sheets. For initial responses to the Treasury plan see naked capitalism posts “Geithner Plan Smackdown” and “Geithner Plan: Fiasco” and Andrew Sullivan’s Geithner Reax Part I and Part II.

Both efforts promise nothing substantive will change, and that the government will spend incredible sums attempting it.

It’s time for a new batter: the free market. Unfortunately, I am very pessimistic that this batter will get his chance at bat. There are two reasons for this.

First, the conventional wisdom being promoted is that the free market is the culprit that got us unto this mess. This is especially prevalent within the current administration. A question during Obama’s press conference on Monday night illustrates this point.

Q: Thank you, Mr. President.  In your opening remarks, you talked about that if your plan works the way you want it to work, it's going to increase consumer spending.  But isn't consumer spending or overspending how we got into this mess?  And if people get money back into their pockets, do you not want them saving it or paying down debt first before they start spending money into the economy?

THE PRESIDENT: Well, first of all, I don't think it's accurate to say that consumer spending got us into this mess.  What got us into this mess initially were banks taking exorbitant, wild risks with other people's monies based on shaky assets.  And because of the enormous leverage where they had $1 worth of assets and they were betting $30 on that $1, what we had was a crisis in the financial system.  That led to a contraction of credit, which in turn meant businesses couldn't make payroll or make inventories, which meant that everybody became uncertain about the future of the economy, so people started making decisions accordingly -- reducing investment, initiated layoffs -- which in turn made things worse.

This statement by Obama shows both his negative view of the free market, and his Keynesian view that the crisis is a problem of consumer confidence. One can hardly be expected to look to the free market for the best solution to the crisis, when free market forces are supposedly responsible. This was the basic narrative put forth both by President Bush, and by then candidates Obama and McCain at the time of the crisis.

Upon further study though economists are coming to understand the role of government intervention in the housing market, fueled by the desire to stimulate home ownership, and resulting in the “originate to distribute” mortgage model, and the cheap money policy of the 2001-2005 Federal Reserve Board. Both of these interferences are key causes of the financial crisis.

The second reason that we won’t see the free market allowed to clean up this mess is that the free market will not preemptively step in while government is continuing to act in an arbitrary fashion. As long as government acts unpredictably, free market capital will sit on the sidelines.

Why is this?

The market is not a unified body acting in concert. It is made up of many small players, each acting to advance their own interests. Government, by contrast, is much larger and when it interferes in the market, it makes very large moves. Those moves are not necessarily profit driven and so are much less predictable. They ebb and flow according to political considerations. Thus, small, private, profit-driven interests will not act if such interests stand to lose in the wake of large, unpredictable actions taken by government.

So a banker maybe willing to buy distressed assets from an ailing bank, but only at a price that will net him a profit given today’s market conditions. When government steps in to buy these assets, at prices that show no concern for profit made, the private banker will stand back. He cannot outbid the government for these assets since he would lose money as well.

When a bank becomes insolvent and cannot raise new capital, it goes into bankruptcy. During bankruptcy new investors will provide capital, but only if the bank is restructured so that it has a healthy balance sheet. When government provides "bail-out” capital to banks without regard for their balance sheets, would-be private investors cannot follow along. Those conditions would assure them losses, just as the government is sure to lose their "bail-out" capital.

Just as government regulation takes away man’s ability to use his mind to further his own self-interest, so too, arbitrary regulatory actions, prevent individuals’ rational actions from resulting in outcomes that further their interests, and so they will rationally choose not to act. Irrational action drives out rational action. This one of the reasons why laissez faire is so important (and moral).

The best plans I’ve seen are merely variations of what would happen if the free market was cleaning up the mess. Banks would be forced to write down assets. Those that were insolvent would go into bankruptcy. In bankruptcy, debt holders would become equity holders, and assets would be sold off (presumably to banks who are healthy) in order to restructure balance sheets. The Luigi Zingales plan is a variation of this motif. Private bankers could do this, but until government chooses the free market path, it will not happen.

The free market did not cause the financial crisis. Fiscal “stimulus” will not work. Free market mechanisms are the only mechanisms that will fix the banking sector.

Labels: stimulus, TARP

posted by Realist Theorist @ 10:09 PM

A few days ago, Harvard Law School professor Elizabeth Warren, who heads a Congressional oversight committee, told the Senate Banking Committee."Treasury paid substantially more for the assets it purchased under the [TARP] than their ... market value". Her evaluation was based on a detailed report that concludes that the Treasury overpaid by about 66%, paying $254 billion for assets worth $176 billion. (from: CNN)

posted by Doug Reich @ 6:36 PM

Here is my plan.

posted by Doug Reich @ 2:02 PM

On Bloomberg.com, Betsy McCaughey reports that tucked into the "stimulus" bill is a provision that will dramatically affect individual health care.

But the bill goes further. One new bureaucracy, the National Coordinator of Health Information Technology, will monitor treatments to make sure your doctor is doing what the federal government deems appropriate and cost effective. The goal is to reduce costs and “guide” your doctor’s decisions (442, 446). These provisions in the stimulus bill are virtually identical to what Daschle prescribed in his 2008 book,“Critical: What We Can Do About the Health-Care Crisis.” According to Daschle, doctors have to give up autonomy and “learn to operate less like solo practitioners.”

posted by Doug Reich @ 1:13 PM

As an individual, let’s say you have no savings, owe more money on your house than it is worth, and have a 50% chance of losing your job in the next 12 months. Would it make more sense to:

a) cut your spending and save more money
b) take out another loan and spend more money

Most individuals realize that (a) is the best option. In other words, when times are difficult, shouldn’t there be a tendency for individuals to cut back and save rather than take on more debt and spend? Duhhhh, right? If that is true for an individual, shouldn’t it be true for your neighbors? If it’s true for your neighbors shouldn’t it be true for your town, city, and country? If that is true, why is the federal government attempting to take more money from taxpayers and investors in order to spend it? Shouldn’t the government be cutting its spending like everyone else? If the government decreased its own spending and took less money from taxpayers, wouldn’t that immediately allow taxpayers to save more money by definition? If the government decreased its borrowing, wouldn’t that free capital up to be invested in private companies that are productive? Additionally, if the government decreased its borrowing, wouldn’t that tend to lower interest rates overall? If this is true, isn’t Obama’s proposal literally the exact opposite of what he should be proposing?

posted by Beth @ 7:00 AM

January's unemployment data, published last Friday by the Bureau of Labor Statistics has prompted a spate of doom-and-gloom headlines, usually followed by calls for immediate government action to solve the crisis.

From AP Economics:

Employers ax payrolls by most since `74; jobless rate at 7.6 percent, with more pain ahead The nation lost nearly 600,000 jobs last month, the worst showing in a third of a century, as a vicious cycle of cutbacks by consumers forced ever more layoffs by beleaguered employers. The unemployment rate catapulted to 7.6 percent, the highest in 16 years, and seems headed for double digits. Some 3.6 million jobs have disappeared so far in a deepening recession, which is shaping up as the biggest job killer in the post-World War II period and is raising pressure on President Barack Obama and Congress to agree quickly on a huge economic stimulus plan to stop the hemorrhaging.

An article on Bloomberg.com tells us:

U.S. Jobless Rate Soared in January and Payrolls Kept Plunging
Millions more U.S. workers are likely to lose their jobs after the economy's freefall sent unemployment in January to the highest level since 1992 and payrolls tumbled, reinforcing the need for an economic stimulus plan.

In Great Britain, the Guardian announces:

US Unemployment: highest job losses for year since the second world war. "Clearly the situation is dire. It is deteriorating and it demands urgent and immediate action," Obama said, following a report from the labour department showing employers cut-non-farm payrolls by 524,000 in December. With November's job shedding revised up to 584,000, economists said there was a risk that the US could be facing its toughest challenge since the 1930's.

Today's New York Times quotes President Obama, speaking to a crowd in Indiana, "Economists from across the spectrum have warned that if we don't act immediately...our nation will sink into a crisis that, at some point, we may be unable to reverse. So we can no longer afford to wait and see and hope for the best."

The most recent BLS data show do a loss of 2.6 million jobs for 2008, and a total of 3.6 million since December of 2007, the date now thought to be the start of the current recession. These are alarming figures, but they do not give an accurate picture of what is happening in the economy.

Here is a chart from the St. Louis Fed showing non-farm payrolls in absolute terms comparing the change from the previous year. (Clicking on the image will give you a larger view.) The statistics only go back to 1939 so we unfortunately don't have data for the period 1920-1938. The gray bars indicate periods of depression/recession. The current bar has the width it does because that's as far as the data goes, not because anyone is saying this downturn has ended.


It is pretty dramatic, showing job losses to be even worse than 1945. But to look at it this way is very misleading. This view falsely exaggerates today's situation so that frightening comparisons to the Great Depression seem warranted.

To properly interpret today's events, it is essential to factor in the fact that the size of the work force has tripled since the end of WWII. We are definitely in a period of net loss of jobs, but the magnitude relative to our current work force is nowhere near the magnitude of the loss during the Great Depression. This fact can be illustrated by looking at how the percentage of employment has changed instead of looking at simply the total numbers.


Still not pretty, but it's nothing like the first chart implies.
We can also take a close up view of the 1940's and place it side-by-side with today:



At the Fed site, you can adjust the dates and zoom in further to see that the percent change of employment in 1945 was a loss of close to 7.5%. Today's is closer to 2.5%. This is not to say that things won't get worse---but only to point out that using absolute numbers distorts the picture. Comparisons to the Great Depression are currently unwarranted (for many reasons, and this is just one of them.)

Last Friday, the Labor Department released January data which showed an unemployment rate for the U.S. of 7.6%, an increase from 7.2% in December. The Financial Times reports this as "the single large cut in 34 years," which it is, but let's look at some more historical data for unemployment rates. The Fed data only go back to 1948, so we can't see how today compares to earlier than that--but I can tell you that in 1933 unemployment was 24.9%. That's literally off the chart below which tops out at 12%.

Duration (median and mean) of unemployment is more worrisome, and here the numbers do look a lot like the 80's, but that's still the 80's, not the Great Depression.



As you can see, the trends are not good, but overall, we are not even as bad off as the 70's and 80's--at least not yet. So much depends on WWGD. Will Congress enact some Smoot-Hawley equivalent in the form of protectionist policies within the gigantic make-work "stimulus" bill , or create debilitating chain-and-shackles for industry through a CO2 cap-and-trade? Or will the Treasury and the Fed continue their unpredictable and arbitrary responses to failing businesses, further undermining consumer and investor confidence in our prospects for timely economic stabilization. If the "stimulus" bill is passed, how much temporary reversal in current trends will be achieved before reality once again catches up with us and we experience the destructive effects of the artificially-induced malinvestments spurred by this current round of credit expansion?

We have substantial problems in the economy, but--making it sound as if today's situation is on the scale of the economic devastation experienced in the 30's and 40's creates an atmosphere of urgency, even panic. Since most people believe that the New Deal pulled us out of the Great Depression, the implication is that we need similar intervention--not just now, but RIGHT NOW. The statistics are not cheery and there are reasons for concern, but it's not as dire as those pushing for immediate drastic action would like us believe.

There is another even more important point. All this data says nothing about the cause or the best solution for the problems we're facing. Just as "a picture is not an argument," these graphs simply illustrate effects. They provide no direct insight as to what forces brought us to this point nor do they point to any specific plan of action. This truth needs to be pointed out over and over again. The fact of unemployment, the fact of a credit crunch, the fact of falling stock prices, the fact of failing businesses---none of these facts prove that we need more government intervention. None of them.

Before taking steps to improve the economic situation, an accurate analysis of the cause must occur. Because they lack that proper analysis, the current administration and their statist pundits are driving us in the opposite direction from which we need to head.

This misuse of the data must be halted immediately. Fear-inducing hyperbole, and leaping from raw facts to the conclusion that government should, or even can, fix things, will not lead to a lasting, beneficial solution.

posted by Doug Reich @ 2:39 PM

From The Rational Capitalist:

Proponents of the “stimulus” plan claim explicitly or implicitly that the government can take other people’s money, spend it, and thereby cause a “stimulating” effect on the economy.

First, I’m not sure what they mean by “stimulating”. Do they mean that prices will rise? But if prices rise, then we all get poorer by definition so it can’t mean that. Will prices go down so that we can all afford more? Not really since spending lots of money on consumer goods rarely results in lower prices. The only cause that results in economic benefit in terms of standard of living is an increase in productivity. Productivity allows you to make more with less effort and therefore increases real wages, i.e., increases what you can purchase with the same amount of work. Is this what they mean by “stimulus”? Do they mean that stealing people’s money and spending it will cause an increase in productivity? I would like a proponent of the stimulus plan to explain exactly how that process will work? Can Obama explain it? Can Nancy Pelosi explain it? Can the Republican’s that back it explain it?

If it is indeed true that the government can rob people of their money, spend it, and the effect will be a net benefit to the victims then why don’t we just legalize robbery? Everyone could steal from everyone else and spend the money they obtain in the theft. We could all be stimulated and cut out the middleman?

posted by Realist Theorist @ 6:51 AM

In previous comments, Gross has spoken of a government "umbrella". Imagine U.S. Treasury Bonds at the center -- nothing is better protected by the government (well, maybe dollar bills). Bank CD's upto $250,000 are somewhere under that umbrella too. Once, Fannie and Freddie were somewhere near the edge, but nobody quite knew whether they were just-under or just-outside. Turns out, Paulson blinked, and now they're well underneath. (2)

I'm not saying that Gross's specific advice is good. Ignore the specifics; it is the principle behind the advice rings true: ask yourself "what will the government do"? Every crisis seems to bring more government interference(3), and make the question WWGD more important. This is not the way to create real wealth.

What should we do instead? I can't say it better than Secy Mellon: purge the rottenness from the system.

posted by Realist Theorist @ 1:00 AM

posted by Realist Theorist @ 1:00 PM

Robert Rubin, Alan Greenspan, and Larry Summers.

posted by Beth @ 11:39 AM

Please contact your Senators and let him or her know what you think of the "Stimulus" package which is scheduled to come to the Senate floor this Wednesday, February 4th, 2009.

The $819 billion-dollar bill passed the House of Representatives last week with a vote of 244 to 188. Read what the Wall Street Journal has to say on a few of the specifics. Or a recent article on how Japan's "stimulus" failed. Other interesting articles can be found here, here, here, and here.

Here is my letter:

posted by Galileo Blogs @ 10:33 PM

“There will be a time for [Wall Street executives] to make profits and there will be a time for them to get bonuses. Now is not that time.” So said President Obama on January 29 to reporters (source: “The Kudlow Report,” CNBC).

So we receive President Obama’s declaration that Wall Street bonuses must be cut. According to him, now is not the time for those bonuses, although he allows that there will be a time – determined by him – when bonuses will again become acceptable.

When Obama arrogates to himself the authority to determine whether, when, and in what amount payments shall be made by an employer to an employee, do not think that such power will only be used to lighten the wallets of Wall Street executives. Such a power demanded today becomes one that will be used in the future to cut the wage or bonus that any American is paid, if doing so should please the Presidency.

If you doubt that, consider that at several times in history the American government fixed the wages of nearly all Americans. It happened during World War II and it happened again in the early 1970s. It is neither a Democratic nor a Republican issue, with the former happening under Democratic President Roosevelt and the latter under Republican President Nixon.

It needs to be said, because Americans have become so used to having their liberties encroached: a man’s ownership of his labor is parcel of the ownership of his own life. If he cannot freely contract with an employer to offer his labor at voluntary, mutually agreed upon terms, then his life is no longer his own. Instead of being a free agent offering his services at a voluntary, mutually agreed upon rate to a willing employer, he becomes a serf, whose labor and life is controlled by his lord and master.

That is the meaning of Obama’s attack on Wall Street bonuses. Attacking the private right of employer and employee to voluntarily agree on salaries and bonuses is an attack on the freedom of both parties. In calling for Wall Street executives to be treated like serfs, President Obama is setting the precedent that will make all of us serfs in the future.

Do not be fooled by the issue of government bailouts. Government had no right to hand out that money. It does not belong to government; it belongs to each one of us. Moreover, this crisis would have ended on its own without any government “rescues.” Recessions always end through the economic adjustments of all participants in the economy. It happens on its own, without a “rescue” or despite it. The current recession is no exception and will end, despite Presidents Bush and Obama’s profligate showering of trillions of dollars of taxpayer money on the problem.

However, government committing a wrong by handing out bailout money does not give it the right to compound its wrong by using that as a justification for further violating the rights of employers and employees. Government should not be handing out bailouts, nor should it be telling employers whether they can pay bonuses.

No one, including President Obama, has the right to forcefully tear apart the private employment relationship between employer and employee. When a private individual does it, it is considered fraud or theft. When the President does it, he takes on the scary personage of a dictator.

Labels: bonuses, Obama, Wall Street

posted by Kendall J @ 11:01 PM

One of the more troubling aspects of the structure of the TARP bailouts is the potential to have government officials and their political agendas influence the day-to-day operations of the corporations who received funds. Already we hear threats from politicians demanding that TARP funds be spent in certain ways. Now we see signs of actual influence in company operations. From yesterday’s Financial Times article “Treasury pushes Citi to cancel jet order,”

The US financial sector’s new political masters began exerting their influence on Tuesday as Citigroup was forced to scrap the purchase of a $50m executive jet that was seen as a misuse of money at a time when the bank is reliant on public support.

Only a day earlier, Citi had insisted it would complete the acquisition of the aircraft. But it backed down after officials acting for Tim Geithner, the new Treasury secretary, expressed strong opposition to the move…

Mr Geithner and his colleagues know that any full-scale overhaul of the financial sector will almost certainly require more funds from Congress. So their immediate priority is to restore confidence in the recapitalisation process, which polls suggest is deeply unpopular. An essential element of this is convincing the public that the money is being used in ways that benefit the wider economy.

As originally pitched, the government stakes were to be in the form of preferred stock and warrants, and these stakes were intended to be temporary. Normally, a stock or bond position does not entitle the bearer to manage day to day operations of a firm. It is an ownership stake whose influence on the company is through a board of directors. The government holds no board seats, but instead has a team of managers behind the scenes looking out for the taxpayer’s interest. It appears that government intends to exert its influence directly.

Expect a slippery slope of increasing involvement in the firm’s management. What was to have been an arm’s length temporary capital injection may soon become a direct, controlling role in the firm’s operation. The original ownership structures will turn out to be nothing more than a thin veneer, conferring respectability upon what may soon become a back room of Commissars directing the operations of financial institutions based upon political agendas.

In the case of Citi, Treasury’s agenda is clear [bold mine].

The Obama team wants to move forward with a comprehensive bank clean-up and recapitalisation programme. Senior Wall Street executives said yesterday that they had been sounded out on plans for an “aggregator bank” that would purchase toxic assets from banks.

Under one of the plans discussed, toxic assets would be valued by an independent third party. Where assets are purchased at prices below their book values, the government might then inject common equity into the banks to make up for capital wiped out by the sales.

Mr Geithner and his colleagues know that any full-scale overhaul of the financial sector will almost certainly require more funds from Congress. So their immediate priority is to restore confidence in the recapitalisation process, which polls suggest is deeply unpopular. An essential element of this is convincing the public that the money is being used in ways that benefit the wider economy.

So, this move becomes part of a public relations campaign to try to sell additional government involvement in the financial sector to an already suspicious public. It doesn’t matter in fact if the cash flow is material to Citi’s survival. It doesn’t matter if the asset will yield potential benefit to Citi. These are the types of things that Citi executives might consider, and things which would be weighed according to their interests. However, their interests no longer matter. It is the interest of “benefiting the wider economy” that must take precedent.

It is sad to see executives compromise the principles of free enterprise and volunteer to be shackled to political interests. They may have saved their jobs, which would surely have been at risk in bankruptcy, but they have lost their liberty, and their dignity in the process.

posted by Beth @ 4:13 PM

Many prominent American figures claim to be proponents of free markets but in practice advocate neomercantilist, corporate welfare policies. These policies eventually, and unsurprisingly, lead to disastrous economic and social consequences. These catastrophes are then blamed on capitalism, free markets, and deregulation, at which point, socialists are easily able to convince the distraught public that capitalism is a failed experiment and only massive government intervention in the markets can save them. Such is the way that capitalism dies.
--Briggs Armstrong "The Enemies of Capitalism" 01-27-09

"I've abandoned free-market principles in order to save the free-market system."
---George Bush on CNN

"I'm a market-oriented guy, but not when I'm faced with the prospect of a global meltdown." ---George Bush before the G-20 summit.

Armstrong continues:

When one of the nation's most visible proponents of capitalism claims that he has abandoned it, because, without big-government policies, capitalism itself would be destroyed, there remains little work for those who desire socialism. Thus it is easy to see how those who believe Bush to be a true capitalist could be persuaded to accept the propaganda that the free market has failed, and that government must step in to save the day.

Before we try to untangle the causes of financial crises, or attempt to project the effect of proposed remedies, let's get our definitions straight.

Capitalism: the social system in which individual rights are applied to the realm of trade; a social system based on private ownership of the means of production. (Reisman, pg 19)

Statism: The practice or doctrine of giving a centralized government control over economic planning and policy (Dictionary.com)

Socialism: an economic system based on government ownership of the means of production (Reisman, pg 264); any of various theories or systems of social organization in which the means of producing and distributing goods is owned collectively or by a centralized government that often plans and controls the economy (Dictionary.com)

Mercantilism: the theory and system of political economy which espouses the need for government intervention into economic affairs in order to assure a favorable “balance of trade,” i.e. exports greater than imports (Dictionary.com, Reisman, 526)

Mixed Economy: an economy which remains capitalistic in its basic structure, but in which the government stands ready to intervene by bestowing favors on some groups and imposing penalties on others (Reisman pg 34); an economy based on the private ownership of the means of production but more or less severely hampered by an extensive list of socialistically motivated government intervention (Reisman, pg 264)

The United States is not now, and never has been a capitalist economy. From its inception, the U.S. has been a mixed economy with an ever-increasing amount of government intervention. We are currently implementing a degree of central planning which can only further undermine the benefits and blessings which capitalism has thus far provided: our wealth and our freedom.

Massive amounts (trillions) of spending have recently been approved, with yet even more being proposed. To implement these programs, government must expand even further into our private lives and businesses. (Full nationalization of the banking system is seriously being considered!)

With the slump in stock and housing markets, the subprime mortgage debacle, the domino-failures of banks, the proliferation of comparisons to the Great Depression and the resurgence in the prestige of New-Dealers and Keynesians, it is time to study economics.

On this blog, we intend to explore and explain the basic tenets of capitalism as they pertain to current events; to tease out the fundamentals and present them in a way that makes sense to the educated layman. The better we understand the laws of economics, the better we can analyze what is happening in the world around us, and speak out effectively in economic self-defense. Let's not let Gresham's Law of money (bad money drives out good) apply to the realm of ideas.

posted by Realist Theorist @ 10:00 AM

Proposing almost $1 trillion in new spending, President-elect Obama said: "...at this particular moment, only government can provide the short-term boost necessary to lift us from a recession this deep and severe. Only government can break the vicious cycles that are crippling our economy..."

"...only government can provide the short-term boost ...": What he means is: sensible people are changing their spending to fit their new expectations. So, government will force them to spend, against their best rational judgment.

posted by Kendall J @ 10:26 AM

Beth Haynes is a physician, retired from active practice, formerly board certified in Family Practice and Emergency Medicine. Autodidact for over twenty-five years in economics, history, politics, and more recently climate change. Currently self-employed in education and curriculum development. She also blogs at Wealth is not the Problem.

Doug Reich has over 15 years experience in the hedge fund industry as a quantitative analyst and hedge fund manager. Current, he is a senior research analyst and portfolio manager for a private asset management firm with focus on global futures, foreign exchange, and fixed income trading. He has blogged at The Rational Capitalist since 2006.

Realist Theorist develops business software. He has an MBA, and a long-time interest in Finance and Economics

Kendall Justiniano is a Marketing Leader for a Fortune 100 chemical company. He has almost two decades of experience in the chemical industry including roles in operations, sales & marketing, and business development. In addition, he has also studied several other industries inluding pharmaceuticals, airlines, coatings and petroleum. He has an MBA, and a long-time interest in marketing, finance, and business strategy. He also blogs at The Crucible.

We welcome your emails. Please use the sidebar links under "Contact" if you'd like to send us a note.

posted by Kendall J @ 8:00 AM

We are a group of bloggers brought together by a common love of business, economics, and free enterprise. Our intent with this blog is to provide a venue for discussion of these topics. We aspire to take a principled look at events of the day, and to disseminate and illustrate principles in action.

We come at these issues from a unique perspective.

First, we are not ivory-tower theoreticians, but we are intellectuals none-the-less. Collectively, we have decades of experience working in various businesses across a range of industries. We have the combined knowledge of the general principles and theories upon which our economy is based and also the day-to-day, concrete decisions, actions and effects which such a system implies.

Second, we are Objectivists which means that we think that capitalism, laissez-faire capitalism, is the only moral political and economic system. It is moral not because it is effective, although that is true, but because it is the only system that preserves individual rights, leaving man free to use his mind to advance his own life, and leaving men free to voluntarily trade with each other for mutual gain.

Today, we live in a mixed economy made up of both semi-free markets and government controls. We live in a culture that views business and businessmen as a necessary evil. While the ability of capitalism to bring general prosperity is begrudgingly acknowledged, big business and naked “greed” are routinely blamed for the country’s problems. Calls continue for more government controls and regulations to fix a "broken" system. We think this view is flawed.

When it becomes difficult to determine which effects are due to government interference and which are due to free market influences, our goal is clarity and proper identification. When we hear calls for pragmatism and “balance” in our approach, our goal is to find the principles that illuminate the proper course of action. When we see a system of political pull and coercive government replacing a system of merit, productivity and voluntary trade, our goal is to defend the individual rights that make the latter possible once again.

Our goal is … simply Capitalism.

If a detailed, factual study were made of all those instances in the history of American industry which have been used by the statists as an indictment of free enterprise and as an argument in favor of a government-controlled economy, it would be found that the actions blamed on businessmen were caused, necessitated, and made possible only by government intervention in business. The evils, popularly ascribed to big industrialists, were not the result of an unregulated industry, but of government power over industry. The villain in the picture was not the businessman, but the legislator, not free enterprise, but government controls.

“Notes on the History of American Free Enterprise,”
Capitalism: The Unknown Ideal