simply Capitalism

Looking at Obama's "Green Jobs" Through a Broken Window

noreply@blogger.com (Doug Reich) — Wed, 15 Jul 2009 21:50:00 +0000

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.

Reality Check II: The Cost of Gas vs. The Cost of Government

noreply@blogger.com (Doug Reich) — Tue, 02 Jun 2009 13:29:00 +0000

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?

Who's Really to Blame for the Financial Crisis?

noreply@blogger.com (Kendall J) — Sat, 30 May 2009 13:34:00 +0000

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.]

Now Your State Can Print Money Too!

noreply@blogger.com (Doug Reich) — Thu, 28 May 2009 20:52:00 +0000

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.

"Soft landings" and "Hard landings"

noreply@blogger.com (Realist Theorist) — Sat, 16 May 2009 19:33:00 +0000

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:

Both countries start and end the period with the same rate of unemployment: 4.8%.

However, they experience very different changes in between. See how unemployment shoots up to 14% in the country of "Blueland" while "Redland" has a far milder rise to 8%.

The rate of unemployment comes back to 4.8% much sooner in Blueland, while it lingers at a 8% for a while in Redland.

So, the alternatives are: a short period of very high unemployment versus a longer period of medium-to-high unemployment.

Should government "help"?: Suppose the government of Blueland could engineer a soft-landing like the one in Redland, ought they do to so? We can object to this because it is not the government's role. Also, every such interference ends up with wealth-redistribution decisions, e.g. "is it better that Mr. Smith stays unemployed for 4 months, rather than having Mr. Jones and Mr. Paulson unemployed for 2 months each". It is not the government's role to pick winners and losers.

However, even if we abstract that away, there is a more technical (though less philosophical) point. Even if one grants the statist premise about the role of government, the soft-landing is still not necessarily "better". While the diagram above may seem to depict that more people lose their jobs in Blueland, it actually depicts the opposite. In this particular example fewer people lose their jobs in Blueland! As a bonus, each unemployed Bluelander stays unemployed for a shorter duration.

Data used: Here is the actual data that was used in the example: Both countries have a little over 10 million employable people. In Blueland, a million people of these lose their jobs in a short, 6-month "hard landing". Then, over the next six months, they start to find new jobs. So, we see a peak 6 months into the Blueland downturn, which then starts to correct. Meanwhile, in Redland, slightly over a million people lose their jobs, but over a two year period, and each of them finds a new job in slightly over six months. So, we see a jump, which stabilizes after 6 months, when people are being re-employed as others lose jobs. This stays steady for about a year and then the new employment surpasses the job losses. (1)

If we look at Blueland and Redland as two different possible scenarios for the same country, and assume that the same people are losing jobs in each, not a single individual is better off in the Redland scenario.

Of course, one might argue that a sharp downturn can create dynamics that makes unemployment or other things still worse. I mostly disagree, but that is a separate argument. In this post, I simply wanted to point out the fallacy of composition in the notion that a hard-landing is worse than a soft-landing as such.

Notes:

(1) If you want to check the data for yourself, get out a spreadsheet and plug in some numbers yourself. I'd be happy to provide more info to anyone who is interested.

(2) Recently another dad in my son's school was laid off. He was telling me that he could comfortably last 6 months on a mix of his savings, unemployment payment and severance pay. He could even drag it out for a year. Much longer than that and he would be in trouble. A little illustration of why -- from the point of view of an individual -- the shorter the downturn, the better.

Cutting out the Middle Man

HaynesBE@gmail.com (Beth) — Wed, 22 Apr 2009 14:43:00 +0000

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.

Chips versus Smiths (or, Main Street versus Wall Street)?

noreply@blogger.com (Realist Theorist) — Wed, 22 Apr 2009 02:23:00 +0000

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.

Freeze: On the continuum between the Smiths and the Ketchums are many, many people who did plan and were fairly responsible, but who were blindsided by the false prices signals brought about by various government actions. These people probably form the vast majority of those who are finding it tough to pay their mortgages. The stock market fell on the realization of what was going on. Having fallen, things have now frozen. Fresh capital is on the sidelines (and parked in U.S. bonds) awaiting the end of the current uncertainty of ever changing government action.

Government action: The Smiths vote. So, the government wants to see as few Smiths as possible. Therefore, the government wants to help the Smiths. The typical ways the government "helps" are:

change the contract (the Smiths' mortgage), or -- more within the law -- lean on banks to do so
tax the Chips and Ketchums and give the money to the Smiths, to help them pay their mortgage; or, give the money to the banks to cover some of their losses from the Smiths
use money-creation, so that the Chips and Ketchums don't complain about higher taxes, and if prices rise a few years from now... deal with each election as it comes up

Rough numbers: Investor Jeremy Grantham's (Q4-2008 letter) sums up the aggregate problem thus:

"the National Private Asset Base (to coin a phrase) of $50 trillion supported about $25 trillion of private debt, corporate and individual. Given that almost half of us have small or no mortgages, this 50% ratio seems dangerously high. But now the asset values have fallen back to $30 trillion, whereas the debt remains at $25 trillion, give or take the miserly $1 trillion we have written down so far. If we would like the same asset coverage of 50% that we had a year ago, we could support only $15 trillion or so of total debt. The remaining $10 trillion of debt would have been stranded as the tide went out!"

"Given where we are today, there are only three ways to restore a balance between current private debt levels and our reduced, but much more realistic, asset values: we can bite the bullet and drastically write down debt (which, so far, seems unappealing to the authorities); we can, like Japan did, let the very long passage of time wear down debt levels as we save more and restore our consumer balance sheets; or we can inflate the heck out of our debt and reduce its real value. (In the interest of completeness I should mention that there can sometimes be a fourth possible way: to somehow re-inflate aggregate asset prices way above fair value again. After the tech bubble of 2000 Greenspan found a second major asset class ready and waiting – real estate – on which to work his wicked ways. This time there is no new major asset class available"

"Our path this time is likely to involve a hybrid approach: we will certainly take some painful debt liquidations; this crisis will almost certainly take far longer than normal to play out; and probably, before a new equilibrium is reached, we will see inflation rates that are well above normal."

(PS: This is not an endorsement of Grantham as such.)

Wall Street vs. Main Street: Our current economic situation has often been described as "Wall Street versus Main Street". This is not merely how the "left" sees it. Many on the "right" see it the same way. Witness, for instance, the suggestion that John Rich's populist song "Shutting Detroit Down" could be the anthem of the "tea-parties"(3). Any song that vilifies "Wall Street, in that New york city town, while in the real world they're shutting Detroit down", is based on the same populist thinking that created this mess in the first place.(4)

The culprit in today's mess is the government's promotion of home-ownership over many decades (and every voter who supported those subsidies over many elections is culpable). It is the government that created mortgages deductions, the CRA, Fannie and Freddie. Finally, it is the government that kept money rates down after the Internet bust.

Nevertheless, even suppose we ignore the main culprit and look for the chief accomplice. Then too, we do not find "Wall Street" as such. Rather, we have a few financial companies who were accomplices and the vast majority who were not. And, we had a few Main Streeters, like the Smiths, who were accomplices, and the vast majority like the Chips (and Ketchums) who were not (5). The "Main Street versus Wall Street" idea is false and unjust. Any policy built on that foundation will likely be wrong. The Main Street vs. Wall Street idea must be strongly rejected.

Parallels with the Great Depression: The great depression was started by Republican President Hoover. In 1929, the stock market plummeted. Instead of letting it rebound, as it would surely have done, he decided to go into "freeze" mode. This was the exact opposite of what was required. He convinced businesses not to drop wages. This led to extremely high unemployment. He championed the Smoot-Hawley tariffs, when just the opposite was needed.

Then came Roosevelt, inheriting this depression, and he extended the depression for many more years. One feature of Roosevelt's term was the president's vilification of businessmen in class-warfare terms. We must learn from that history.

Notes:
(1) Serves as demonstration, but is fictional
(2) The CPI more than double from 1980 to 2000, so their home actually lost value in real terms. This is quite typical for real-estate.
(3) Here's a blogger who objects to that characterization
(4) Analysing that song could be a blog-post on its own.

(5) To repeat, this is not to suggest that everyone who is trouble now -- bank or borrower -- was irresponsible. When the government interferes with the market, it is hard to know what is irrationally risky and what is irrationally cautious. So, while some borrowers and lenders were irresponsible, many were victims themselves.

Predicting from Principles

HaynesBE@gmail.com (Beth) — Sat, 18 Apr 2009 16:32:00 +0000

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

Austrian Economists on the Crisis

noreply@blogger.com (Kendall J) — Mon, 13 Apr 2009 12:00:00 +0000

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.

Government: The ex post facto “Investor”

noreply@blogger.com (Kendall J) — Fri, 10 Apr 2009 12:44:00 +0000

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.

Hussman: Fighting Recklessness with Recklessness

noreply@blogger.com (Doug Reich) — Tue, 07 Apr 2009 20:58:00 +0000

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.

The Fed's Wish Part II: Coup D'Etat

noreply@blogger.com (Doug Reich) — Tue, 07 Apr 2009 13:50:00 +0000

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.

Beware - Don't Do "Damage to the Broader Economy"

noreply@blogger.com (Doug Reich) — Wed, 25 Mar 2009 13:00:00 +0000

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.

GUEST POST: The Case for Bankruptcy

auric777@yahoo.com (Galileo Blogs) — Mon, 23 Mar 2009 04:11:00 +0000

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.

The cause of our suffering: too much saving?

HaynesBE@gmail.com (Beth) — Sun, 22 Mar 2009 10:00:00 +0000

[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.

Must Things Get Worse Before They Get Better?

noreply@blogger.com (Doug Reich) — Sun, 15 Mar 2009 17:44:00 +0000

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?

The Fatigue of Central Planning

HaynesBE@gmail.com (Beth) — Thu, 12 Mar 2009 10:00:00 +0000

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.

Buffet's advice to President Obama

noreply@blogger.com (Realist Theorist) — Wed, 11 Mar 2009 07:00:00 +0000

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.

Freddie, Fannie to stay nationalized?

noreply@blogger.com (Kendall J) — Wed, 04 Mar 2009 13:00:00 +0000

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?

A snapshot of home-prices

noreply@blogger.com (Realist Theorist) — Tue, 03 Mar 2009 18:06:00 +0000

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.

Prices: The most well-known index of house-prices is the "Case-Schiller Index". It tries to measure how much people are paying for the same underlying "real house" across the years. Look at the blue line in this graph:

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

Notice the initial spurt in 1987-88, followed by prices staying almost flat for a decade. Then, they began to rise in 1998. They "made up" for the flat years, rising for about 8 years. Then, around 2006, they began to drop and have fallen 35% up to Dec 2008.

What would be normal though? Should we expect home prices to stay flat forever? The two straight green lines on the graph show what steady 3% and 6% annual increases would look like. I chose 3% because the official CPI rose 3% per annum for the period 1987-2008. I drew the 6% line, because I've heard many people suggest that the government understates CPI; so, I wanted to depict where a slightly higher rate would lead.

House prices were flat, then rose sharply. Nevertheless, even with the housing bubble, prices did not go beyond above where a steady 6% per year rise since 1987 would imply. If they were to revert all the way to a 3% yearly level (the CPI average), they still have 25% to fall.

The graph shows where we've been and where we are. Also, it gives a sense of the scale of the increase, compared to the rising CPI. This graph does not give us enough to judge whether prices are really "too high", or not high enough.

OFHEO index: Another index (this time from the government) shows the same pattern of acceleration (albeit slower than Case-Schiller), and the same downturn (though in 2007 rather than 2006). (1)

In this, we basically have confirmation of the Case-Schiller index.

Regional variations: One last thing... do not apply the above to your own house or city. The U.S. index "hides" the great deal of regional variation.

Here's the Case-Schiller (blue line same as the first graph in this post).

Notice how Miami and Washington D.C. rose much higher than the average index. In contrast, notice how Chicago rose much less than the index. As for the Detroit area, the index is already at levels last seen in 1998!

Evaluation: Are home prices "too high" today? For starters consider these two quotes, from 2005. First, Alan Greenspan, (using the royal "we") speaking in May 2005: "... we don't perceive that there is a national bubble... ... but it's hard not to see...that there are a lot of local bubbles". And, now one from "American Banker" (May 23, 2005): "... history is definitive... the national average price of a house may remain relatively flat for a number of years, but it doesn't fall" (2)

It is easy to laugh at them in hind-sight, asking "how could they not have seen it?" However, the real problem is that one cannot simply look at prices going rising off norms and conclude they are too high. If Greenspan and that journal ought to have seen the problem, it is other things they ought to have been watching (for instance, how much risk were people taking and whether incomes were growing too).

Similarly, it is difficult to predict if prices will go lower from here. If you are buying a house, you must look at various factors to decide if you think the price is right.

Government policy: It is wrong for any bureaucrat to decide whether today's prices are too high or too low. The only way we will know is as individuals across the economy make decisions, based on their new expectations. A bureaucrat might get it right, but only by pure chance; in principle, such a calculation is impossible.(3)

When prices fall, houses become more affordable. Any government action to nudge prices this way or that is simply more intervention -- a form of redistribution.

Falling prices are "natural". They will fall until the market reaches equilibrium. Lower prices entice buyers; they help "clear" the market. It won't happen overnight with housing; but, it will happen... unless prevented by bad law.

Update (Mar 04, '09): Removed poor example.

Notes:
(1) Case-Schiller is higher that the OFHEO index because of three factors that are equally important: OFHEO includes refinancings, which (it turns out) have used valuations lower than actual sales; OFHEO does not look at "exotic" lower-end mortgages that Fannie/Freddie won't take; and, third, a technical difference in weighting different data,
(2) Quotes for Greenspan and "American Banker" from James Grant's book "Mr. Market Miscalculates".
(3) Economist Ludwig von Mises called this "the impossibility of calculation" that a central planner faces.

When is Nationalization Not Nationalization?

noreply@blogger.com (Kendall J) — Mon, 02 Mar 2009 13:00:00 +0000

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.

War prosperity - WW-I Edition

noreply@blogger.com (Realist Theorist) — Sat, 21 Feb 2009 03:53:00 +0000

"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.

The pro-War case: U.S. production did boom during World War-I. When the war ended in 1918, American production volume was about 25% higher than it had been in 1914. In 1914, the U.S. was a debtor country; by 1918, the positions were reversed: the world owed money to the U.S.

Detailed WW-I timeline: Actually, the U.S. did not enter WW-I in 1914. At first, the U.S. was at peace, while producing and exporting to the warring nations. Only in 1917 did the U.S. declare war. Armistice Day was less than 2 years later, in 1918.

Peace prosperity: Consider the top-most black line in this diagram. It is an index of Production volume(2). When we examine WW-I more closely, we find that the so called "war prosperity" was actually a "peace prosperity".

We see that production volume boomed from 1914 to 1917. During this period, Europe looked to the U.S. for production. They sold much of their investments in the U.S., in order to buy U.S. goods; they sent large volumes of gold to the U.S.; and, added to this, the U.S. government lent money to European nations. In the U.S., commodity prices rose, and wages followed about a year later. Nevertheless, real production volumes rose too. Then, in 1917, the U.S. entered the war. Look at how things flattened out after that.

Europe: By the logic of the "war properity" argument, we would expect Europe to do better than the U.S.. After all, they fought longer. They spent a lot too. At a time when the U.S. national product was about $50 billion, economist Brad de Long estimates(3) that the wartime accumulated budgets of all combatants was $200 billion: four times the entire US national product. WW-I devastated Europe, in terms of lives, an estimated $40 billion in property damage, and lost production of $65 billion. It was the U.S. -- thanks to its "peace properity" that helped Europe after WW-I.

Notes:

1. I don't claim that serious, professional economists think war is good for the economy; but I have heard this from non-economists.
2. "Economics and the Public Welfare" - Benjamin M. Anderson
3. "Economic History of the Twentieth Century" - Bradford DeLong

Foreclosures are a part of the Fix

noreply@blogger.com (Realist Theorist) — Thu, 19 Feb 2009 11:45:00 +0000

The government announced a plan to lower foreclosures. They will use $75 billion of tax money for this. Supposedly redistributing our money to other people is in our self-interest! Here's how Obama tries to convince us of this: "By bringing down the foreclosure rate, it will help to shore up housing prices for everyone".

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.

Banks do not want to sell homes. It is expensive. It makes sense for lenders to re-negotiate new terms if they think the home-owner can meet those lower terms. However, if the borrower cannot meet those lower terms, he is in the wrong house. Foreclosures are a temporary situation. They come from recognition of reality: the reality that -- with the assumptions of today -- the home-owner cannot pay his debt. The quickest way to fix the problem is to foreclose. Home prices will drop, and then they will rise again. A few years hence, prices would have reached a level that makes sense under new assumptions, and the wound will have healed.(1)

Keeping people in homes they cannot afford simply pushes the problem out to the future.

Very few of my middle-class neighbors got carried away by the housing boom. Even the few who did are basically responsible folk who made this one large mistake. Most of them can actually meet their current payments if they skimp and struggle for a couple of years. There is no shame in this. Some might negotiate lower payments that they could meet. Under Capitalism, most would figure they have been burned and have learnt their lesson.(2)

Instead, politicians from both parties want me to do more than help my neighbors. They want to convince me this is in my selfish interest. Why? Foreclosures do not bother me. And, I don't think my neighbors really want my charity. That is to say: they would not want it on those terms. However, when the charity is positioned as saving the economy, they find themselves in a happy position: turns out, that saving them is the right thing to do. They're more than willing to be rescued for my sake. They're happy to be saved if it helps me out!(3)

This post is to say: I don't mind the falling prices and the foreclosures. Any government force used on banks to stop foreclosures does not have my sanction. Every such tax-financed subsidy comes from someones real wealth. Part of it comes from mine. I will not pretend it is in my self-interest.

Notes:

(1) Already, the still-falling prices have caused the following: the number of existing homes being sold is not longer falling drastically. For more, check these Carpe Diem posts.

(2) Look around you at your own friends and neighbors. I think you will see that some made bad decisions, but most can get through this with a struggle.

(3) Not to suggest that people really identify it so explicitly, but they rationalize it thinking that if the government saves them it is "good for the economy".

Inflation Temptation

noreply@blogger.com (Kendall J) — Wed, 18 Feb 2009 14:00:00 +0000

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.

Price-rise expectations - A short-term Anomaly?

noreply@blogger.com (Realist Theorist) — Fri, 13 Feb 2009 17:06:00 +0000

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:

It is not expected to last: Zero CPI change over 5 years does not mean zero in every year. When one looks at measures for shorter durations, one finds the following expectation: CPI going down slightly for a couple of years and then coming back up to where it is today. So, the expectation is that the CPI will start to rise again in a few years.

The expectation itself might be reverting to historical patterns: Historically, since 2003, this measure of "expected" CPI was between 1.5% and 2.5% (see points A and B in the graph below) .Then, in 2008, fears of deflation hit and notice how the relationship changed (See the circle marked C.). So, in late 2008, the market went from implying 5-year CPI will rise @2%. to thinking it will drop; now, the market is implying it will go down for fewer years, but will be flat over 5 years.

If the post-December trend continues, we might soon be back to a situation where a rising CPI is expected over 5 years.

I wanted to follow-up my previous post with this one, to make clear that the current situation is anomalous when considered against the last few years. Will it remain that way, or will people soon expect renewed rises in CPI? That's the subject for a separate discussion. Any opinions?