The Humility of Realism — II

This post is supposed to be a kind of “catch up” post, where I write about a number of small things that I thought were interesting, but weren’t worth a full post.

1) The government can’t fund everybody. The recent backup in the US treasury note market is a great example of that.  As the demands for funds now in exchange for funds later has increased, Treasury interest rates have risen.

I have several biases, but one of them is that the Government can’t unilaterally create prosperity.  It can create conditions that encourage economic activity, through predictable and fair laws, but it can’t make us immediately better off through deficit spending, or tax-and-spending.  The Government does not know what is needed to a better degree than its citizens do individually.

But let the government fund or guarantee everybody.  When they do that, there is just one overleveraged credit that matters, and it will fail, taking us with them.

2) Equity Private is one clever ladyFair value accounting primarily exists to deal with investments that are as volatile as equities. How are publicly traded equities valued?  At market.  How about volatile assets where the value is derivable from market prices?  They should be valued at pseudo-market.  If we were back in the old days, and all of our assets were bonds, we wouldn’t need fair value accounting.  Even if we did it, the values wiould not vary much.   But when you slice and dice the various pieces of bonds, the volatile bits jump around a lot.  To value them at their initial value is ridiculous, the value is too volatile.

3) Felix is rightThere needs to be more of a debate over bank nationalization. I’ve written my pieces there, influenced by the better regulations of the insurance industry, and how they deal with insolvencies.  Mark assets to market.  Do the triage.  Send insolvent institutions to RTC 2, and take stakes in some marginal institutions.  That is where the money will do the most good.

4) “We have to buy up assets that are selling at fire sale prices.  We will even make money for the taxpayers.” So go the arguments of those that want to create a “bad bank”.  Oh, please.  Profits are rare in bailouts.  They happen by happy accidents, a la Chrysler (80s, not now), which possibly could have made it without a bailout.

Assets are at fire sale prices because there is not enough balance sheet capacity to buy and hold them over a period where the realization of value is likely.  I’ve seen structured assets rated AAA where the collateral is okay, and the likely realization of value is in the 90s, if you can hold it for 5 years.  Where does it trade?  Around $60.  Another asset, which would likely be worth $35 if it could be held for 15 years, where does it trade?  It doesn’t trade, but you could get rid of it to a broker for zero.

Strong balance sheets can’t be created out of thin air, though.  Remember how formidable Fannie and Freddie used to be, or many of the FHLBs?  Strong balance sheets only exist through investments where the cash flows will not be needed for decades, like pension and endowment plans.

5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please.  First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation.  Our dear government had many lending programs pre-crisis, and even more post-crisis.  They further encouraged the increase in debt through the tax code.

Why is debt finance tax deductible, and equity finance not?  What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be?  Leverage would have been a lot lower, and the system would be a lot more stable.

Market efficiency means many things.  In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way.  They reveal problems that need to be solved.  Some might call those market failures but they aren’t.  In the present crisis, the invisible hand is saying to us: reduce debt levels; your economic system in too inflexible.  The visible hand, the government, says: “Have some more of the hair of the dog that bit you.  We need lower mortgage rates.  We need more consumer lending.  We’re going to borrow more than ever before in an effort to create prosperity.”  Caroline Baum takes a similar view, and as usual, she expresses it well.

Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems.  Some things become revealed as truly public goods that the government needs to regulate.  But that is not the majority of human actions.

6) AIG is one black hole for cash.  Selling or IPO-ing units during the bust phase, when valuations are compressed does not seem to be an optimal strategy here.  If all of the assets were sold, would there be enough for the junior debt or preferred shareholders to get paid?  (Forget the common.)  So, in the face of it, do they IPO partial stakes in enterprises, with an eventual end of IPO-ing or selling the whole thing later?  If so, there is little free cash flow being generated to pay down debt.

What this implies to me is that the huge loans that the government made to AIG will likely hang out there for a long time.  Is this the best use of the government’s credit?  I think not.  If there are still systemic risk issues, wall those off separately, and send the rest of AIG into liquidation.  The insurance units are intact; let others buy and manage them.  Speculating on a future boom in asset prices is not a reaonable government policy.  Hope is not a strategy.

7) It is simple to blame the US for the current global crisis.  Simple and wrong. The US deserves blame, true, but not even the majority of the blame, just a slightly larger than proportionate amount for its size.

But when China blames the US, it goes too far.  In the era of neo-mercantilism, China had political goals to achieve.  Industrialize the country.  Get surplus workers off of the farms and into the cities.  Keep the currency undervalued to support export-led growth.  Force savings through restrictions on imports.  As a result, suck in developed country debts and companies where strategically desirable and possible.  Do these deals in their currencies because of the need to keep the Yuan cheap.

China made its bed, let it sleep in it.  They knew that they were lending to the US in its own currency; it was a necessary part of the bargain to achieve their own goals.  Just as the mercantilists sucked in gold, and then found it to be less valuable than they imagined when they had to draw on it, so it will be when nations want to draw on the US dollar assets that they have hoarded.

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My phrase, “the humility of realism” is meant to get us thinking about the system as a whole, and about the long-term consequences of societal actions, whether by the government or private parties.  Humility says that sometimes we have to say, “No, we can’t.”  It also says that we should think carefully about major policy actions, and not let ourselves get bullied by those who rush, shouting “crisis, crisis,” while quietly angling for their favored pet projects to get swept in while no one is looking.  Realism sometimes means the government has no good solutions, so it should inform the public that they aren’t omnipotent, and humbly say the crisis must be borne with grace.

The problems generated by the short-termism of the past three decades will not get solved by more short-term thinking.  The present rush to assure prosperity will not end well, in my opinion.