November 2010 – Page 2 – The Aleph Blog

Notes

Posted on 12 November 201013 November 2010 by David Merkel

I’m on the road in Denver, and tomorrow I deliver this talk Efficient Markets versus Adaptive Markets.? It is similar to the talk I gave to the Society of Actuaries, but has less background data, and focuses on how markets are adaptive, how multiple strategies compete for scarce excess returns.

Away from that, for those that care about the forced place mortgage jive, review this piece from AIZ? Sterne Agee and Assurant.? The issue is not as cut and dried as others would say.

Full disclosure: long AIZ

On Force-Placed Homeowners Insurance and the Effect on Investors

Posted on 11 November 2010 by David Merkel

I had a number of people ask me today, so tonight I am writing about the American Banker article on Force-placed homeowners insurance, and its impact on Assurant, which was down 11% on the 10th.? To give an example, one fellow asked:

David, care to comment on the Assurant (AIZ) news? American Banker magazine is alleging ?kickbacks? to banks that agree to place ?expensive? creditor-placed property insurance on homes. Would you be a buyer here?

Yes, I would be a buyer here, but my rules prevent me from buying here, because the price did not hit my lower rebalance point, even at the lows of the day.

A word about Assurant, from my point of view: Assurant is one of the few insurance firms that if they asked me to come work for them, I would make adjustments that I would not make for other companies.? They are one of the few insurance firms that I think treats their employees right, and does risk control right.? They also choose their markets carefully, and understands what their “sweet spot” is with respect to what businesses their corporate culture will do well at.

After I read the two articles at American Banker, I wrote the following as a letter to the editor:

Your articles on forced-place homeowners insurance left out several significant bits of information:

Most forced-place homeowners policies are only in effect for several months.? Why?

Because people have an incentive to go and get a regular policy after that.? And most do.

These policies also only come into force because a homeowner is neglectful in maintaining the insurance that is required to have as a stipulation of his loan.

Typically, the insured gets warned in advance that the policy will be force placed.? He has time to make other arrangements.

Any homeowner can avoid forced-place insurance.? All they have to do is keep current on their insurance policy, which they have to do as a term of their loan.

As for any sort of long backdating, that’s an abuse that needs to be corrected.? But as for the other competitive dynamics of this industry, it would be impossible for a forced-place insurer to do business without compensating the mortgage servicer, whether through commissions, which should be disclosed, or via reinsurance treaties.? Similar practices exist in other areas of insurance, including warranties and private mortgage insurance, both of which do not disclose the commissions.

In the interests of full disclosure, I am a shareholder of Assurant.

Sincerely,

David J Merkel

The author wrote me back, reminding me that he had met me at the Fordham University Too Big To Fail bank conference.? I hit myself on the head, remembering that I had really liked his approach to the markets.? He said:

Your note came closer to addressing a key issue than any insurer or bank ever did ? and I spent a week asking them. So I figured I?d ask if you wanted to address this question:

— are commissions regular in other fields where the entity receiving it is buying the insurance on behalf of a third party who has not requested it? (It sounded from your e-mail like your answer is ?yes,? but a bit more detail would be helpful.

— Next, what would you say to the allegation that servicers have no incentive to pick the cheapest insurance ? and in fact are incentivized to send business to insurers that pad their rates to account for commissions? This was the key element of the story, and I never found a bank or insurer or trade group that would address it.

So I wrote back the following:

I agree that it gets murky when you have undisclosed commissions.? When I worked for Provident Mutual, in their pension division, we had a rule for pension consultants – you can have undisclosed commissions, so long as you disclose that you are getting a commission, or disclosed commissions, but not both.? Some of our competitors would allow for both.? Legal, but shady, definitely.

Private mortgage insurance has the same practice of reinsurers owned by the banks, which get the majority of the profits, because they control the communications of the transaction.? The insurer is the “back office,” for lack of a better term.? The insureds have no idea that the lender is benefitting from the PMI, I’m pretty certain.

With warranties, buyers are not told that the retailer is getting a large amount of the premium.? The typical breakdown is something like an even split between retailer, loss costs, insurer expense, and insurer profit.

Insurance brokerage was another area where undisclosed commissions to brokers led to a scandal 6-7 years ago.? The big guys discontinued the practice, the little guys didn’t, and the laws were never changed.? It’s still legal, and at least one of the big brokers has returned to the practice — can’t remember which one.

This highlights how these deals come to be, in any complex (multiparty) insurance arrangement.? The one who controls communications gets the lions share of the value of the transaction.? Even though forced-place is an oligopoly, the servicers have the advantage, and they take little to none of the risk, typically.

Assurant may have some advantage here, because they are the biggest, and their systems do actively troll for policies going out of force.? I have talked with management several times about the business, and how they warn potential insureds that their existing policy has gone out of force, etc.? They claim to follow all existing laws and regulations, but in a big firm, when many things are automated, who can tell for sure.

So, when I read your piece, I agree with a lot of it.? The trouble is that the average person in such a crisis does not think straight because he is in a crisis that he can’t get out of, and everyone is pinging him for money that he doesn’t have.? Most could mitigate the forced place, and get a cheaper policy in force, but they don’t even have the money for that.? Everything goes against people who are on the brink of bankruptcy, and I feel sorry for them.? Trouble is, as a nation, we encouraged

people to take on too much mortgage debt, and now we are dealing with the aftermath.

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Please pass the above onto your editor, so that he knows that I am not one-sided on this issue.? If he wants, I could reformulate a longer letter that embeds more of the complexity of multiparty insurance deals.??Most financial scandals require three or more parties to be effective.

I did not comment on the lack of incentive to choose the cheapest insurance, because I missed it.? That is one of the perversities of multiple party arrangements.? When you sign an agreement that allows someone to make choices for you if you fail in your obligations, and bill it back to you, or bill it back to the one that will pay if you default, you have essentially said, “If I default, you are free to harm me in some limited way.”

The author responded to me:

Thanks. This is well thought out. I sent your e-mail to our web folks, and expect they?ll follow up. For what it?s worth, I thought your original letter was solid.

The only quibble I?d have is that I guess when it comes down to it, the borrower isn?t actually the entity that I think is usually getting harmed. The investor/GSE is.

That?s sort of the point I wanted to make with the lead of the sidebar (Don?t know if you saw that one: http://www.americanbanker.com/issues/175_216/losses-from-forced-place-insurance-1028475-1.html)

While the borrowers do get a notice of the commission sometimes, the investors have no say in any of this ? but are paying for the commission at the time of foreclosure. When it comes down to it, most force-placed policies aren?t a choice ? they?re bought on homes owned by people who can?t/won?t pay their mortgage, making the information about force-placed costs and commissions useless.

So it seems to me that no amount of disclosure to the borrower could fix that problem. Even if the commissions are being disclosed, they?re being disclosed to a party who is no longer in the game.

The author is entirely correct here, and I hit myself on the head and go “duh” as a result.? There is a hole in the securitization agreements, because if the borrowers go into foreclosure and won’t pay, it comes out of the hide of the junior certificateholders of the securitization.? With GSE loans, that means the taxpayer takes a hit.

From one of the articles:

“It is clear that [the Real Estate Settlement Procedures Act] prohibits fee splitting and unearned fees for services that are not performed,” said Brian Sullivan, spokesman for the Department of Housing and Urban Development. Foreclosure defense and legal aid attorneys say force-placed insurance is found on most of the severely delinquent loans in this country. If so, the cost to investors may well be in the billions of dollars.

“This is clearly not in the investors’ interest,” said Amherst Securities analyst Laurie Goodman, who in May noted the potential for misconduct with Bank of America’s force-placed-insurer subsidiary, Balboa Insurance Group. “Servicers are getting a huge chunk of money from force-placed insurance, and investors pay for it by higher loss severity at the liquidation of the loan.”

This will be hard to enforce in a court of law, but the insurers are doing the work and bearing the risk; those receiving riskless profits are the servicers.? From my view, banks and servicers will be on the hook for bad decisions here.? The insurers have no discretion.

Now, my perception of Assurant is that they are on the more ethical side of their industry here.? But, this is only a belief, and not a fact.? I am willing to accept contrary data, and I welcome the thoughts of those who know things that I don’t.

Down another 7% percent, I will buy more shares of Assurant, but for those that don’t own it, this is a good entry point.? Assurant is a very diversified insurance company, more than any other that I know of.? Their P&C division will not die, and the other divisions are not affected.

PS — It is really difficult to lose money on stocks where the P/E is below 10, and the P/B is below 1.

Full disclosure: long AIZ (it is a double-weight in my portfolio)

Comment on: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt

Posted on 6 November 20109 November 2010 by David Merkel

I have the fun of speaking at the Burridge Center Conference at the University of Colorado at Boulder this week on Friday.? The CFA Society of Colorado is co-sponsoring it.? As a guide, they have asked my panel to comment on this piece? by James Montier of GMO: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt.? I’m going to comment on each of the ten questions, and show where I agree and disagree.

Lesson 1: Markets aren?t efficient.

“As I have observed previously, the Efficient Market Hypothesis (EMH) is the financial equivalent of Monty Python?s Dead Parrot. No matter how many times you point out that it is dead, believers insist it is just resting.”

I partially disagree.? The EMH is valid as a limiting concept. The markets tend toward efficiency, but there are many disturbances in the market, and some of them are quite big.

The EMH properly understood only means that it is intensely difficult to beat the market, nothing more.? Market prices reveal the current expectations of the market as a knife edge — sharp but thin.? They might be the best estimate of values for the moment, but offer no infallible guide to the future. The crisis tells us nothing about the EMH.

Lesson 2: Relative performance is a dangerous game.

Definitely true.? Those chasing relative performance tend to destabilize markets to the degree that their time horizons are short.? Focusing on short term relative performance leads to an over-emphasis on momentum, and when too many focus on momentum, the markets tend to go nuts — overshooting and falling dramatically, until enough momentum players exit.

Lesson 3: The time is never different.

It’s never different, or it’s always different — which one you choose is a matter of semantics.? The main thing to remember is that human nature never changes.? In aggregate, we don’t learn from market behavior.? We follow trends — we arrive late to the party, and leave the hangover near the nadir.

Most professionals and nonprofessionals tend to chase performance — see lesson 2.? That is a large part of the boom-bust cycle, which no amount of government intervention can repeal.

Here’s some advice: read books on economic history, and avoid current books on how to beat the market.? Learning economic history will help inoculate an investor against greed and panic, and will help the investor understand the guts of the speculation cycle.

Lesson 4: Valuation matters.

You bet it matters.? Excellent long term results stem from buying cheap, among other factors, like margin of safety, earnings quality, and having a sense of the credit cycle, and industry pricing cycles.

Bubble language such as “This time is different,” often appears near the end of booms.? The truth is: it’s never different, or, it’s always different.? Human nature in individual and aggregate, does not change.? Watching valuation is a major way of avoiding getting whipped at extremes, and encourages willingness to invest in the depths of panic.

Lesson 5: Wait for the fat pitch

Also agreed.? One thing that I have focused on in my money management ideas, is to avoid thinking short-term.? There are too many hedge funds, day traders, swing traders, and high-frequency traders out there for me to compete against.? Even mutual funds turn over their positions too rapidly.

I aim to hold investments for three years, but I am not wedded to a time period.? If an investment still looks attractive after five years, compared to the other investments that I hold, I will keep it.? If I find a more? attractive investment than my median idea, I will buy it, and fund it with the proceeds from one of my investments scoring worse than my median idea.

Lesson 6: Sentiment Matters

Yes, sentiment matters, at least until too many people follow it.? I do this in an informal way by following the credit cycle — when risky yields are tight, only own safe stocks.? Volatile stocks rely on sentiment — it is almost a tautology.

Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!

Any investment can be overlevered, and die.? Think of Fannie and Freddie.? They ran on thin capital bases for years, thinking that they could never lose.? So long as housing prices continued to rise, they were right.? And for many, the idea of housing prices falling in aggregate was ridiculous.? Those who suggested that it would happen, like me, were roundly derided.

Yes, leverage can make a good investment bad.

Lesson 8: Over-quantification hides a real risk.

Just because you can quantify it does not mean you understand it.? The Society of Actuaries has a vapid motto quoting John Ruskin: The work of science is to substitute facts for appearances and demonstrations for impressions. Easy to say; hard to do.? Scientists are biased? like everyone else.

Mathematics applied to economics or finance serves to show where assumptions are inaccurate.? Mathematical risk controls are less important than changing the culture of a firm, and setting in place checks and balances.? Toss out VAR, and reduce incentives that would motivate people to take inordinate risks — instead, hire idealists that love the work because they would do it even if they weren’t paid.? That’s how I feel about investing; I just love the game, and wouldn’t want to do anything else.

Lesson 9: Macro matters.

Much as I admire Marty Whitman (and Peter Lynch), I am with Montier and Graham regarding the value of Macro.? Whitman, Pzena, Miller and some others rightfully got their heads handed to them when they neglected the key doctrine of value investing , which is “margin of safety.”? Most of my great mistakes have come from similar neglect.

Particularly when times are unusual, macro factors drive stocks.? But, how well can we predict that?? I’ve done okay over the years, but I am skeptical on being able to do that all of the time.

Lesson 10: Look for sources of cheap insurance.

Again, easy to say, hard to do.? I would like an infinite stream of patsies to soften the blow if I make bad decisions.? In the middle of the 2000s, I felt that shorting credit was nearly a free option, but will there always be bulls making stupid decisions during the bull phase of the market?

On second thought, yes, that should always be true, so where you find cheap insurance, like CDS 2003-2007, buy it.

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So, after all that, aside from point one, I agree with Montier almost entirely.? What a great article he wrote, and what a great article to stimulate the panel that I am on.

Ask Ben Bernanke

Posted on 5 November 2010 by David Merkel

A brief note this night, because troubles overwhelm me.? If you know Ben Bernanke, or any of the FOMC members, ask them this: where has quantitative easing ever proved to be effective?? Expect the intellectual equivalent of an “Uh….”, but understand that their is no good answer here, and that monetary policy is in the hands of those worse than amateurs.? They don’t understand what to do, but they are still being paid for it.

Moving Backwards, or not

Posted on 4 November 2010 by David Merkel

On Saturday of last week, I cleaned my office, and filed everything away.? I also sat down and wrote out all of the things that I needed to do to make my asset management business go live.? It had 14 items.? Here is the list as of today:

Decide on Custodian ? Ask opinions from others
Compliance Strategy
Including Web Compliance Strategy
Privacy Policy
Aleph Investments Website and E-mail domain
E&O Insurance
Trademark
Accounting and Tax Software
Attestation
Marketing ? and deal w/e-mail, Linked-in day
Other contacts, Press Release
Strategy for Illiquid names ? DIIBF, PCCC, IBA, NWLI
Procedures for suitability
Proxy Voting Policy?
Update and move disclaimer
Update disclaimers on pitchbook
Create a template for a daily journal of activity
Create checklists for what I give to potential clients, new clients, and old clients.

18 items?? Well, I finished one, and got five more as I did research.? I have made significant progress on half of them.? Here’s where I stand now:

Decide on Custodian ? Ask opinions from others

I have one more demo to watch, but I am leaning toward Interactive Brokers, with Scottrade second, and ETrade being lousy marketers third.? You have any thoughts on this?

Compliance Strategy

I am reviewing the Maryland code on compliance, and designing my methods of capturing all of the necessary data.

Including Web Compliance Strategy

That includes my blog posts, Twitter, and comments around the web. Ugh.

Privacy Policy

Yes, I need a privacy policy, and I have trolled around the web to see what others in my shoes do.? I should be able to get something together.

Aleph Investments Website and E-mail domain

Not hard to do.? Just have to get it done, and separate my business and personal life.

E&O Insurance

Alas, I think I need Commercial General Liability insurance as well.? Any body else have an opinion here?? Also, if you are an RIA, who insures you?? E-mail me.

Trademark

I need to trademark a slogan of mine.? That will not be completed by the time I go live.

Accounting and Tax Software

I will get this through Intuit, because the business is simple; I just have to do it.

Attestation

I have contacted an accountant for an attestation of my performance.

Marketing ? and deal w/e-mail, Linked-in day

I have a lot of people to write to, and others to talk to on LinkedIn.

Other contacts, Press Release

I may do a Press Release on my startup.

Strategy for Illiquid names ? DIIBF, PCCC, IBA, NWLI

Do I sell them off before I start, or do I keep them and try to add them delicately to client portfolios? DIIBF trades more liquid in Canada, should I buy/sell it there?

Procedures for suitability

What I am doing is only suitable for risk assets.? How do I assure that investors only bring money that they can afford to lose?

Proxy Voting Policy

My consultant said that an acceptable policy was, “I don’t vote your proxies.”? Fair enough, but I went around the web, and found a variety of policies.? I should be able to write one of my own from that.

Update and move disclaimer

I need to strengthen my disclaimer at this blog, and move it higher.

Update disclaimers on pitchbook

I need to update disclaimers on my pitchbook, making them larger and more obvious.

Create a template for a daily journal of activity

I need to design a method of capturing daily activity for my firm, so that each day’s actions are memorialized.

Create checklists for what I give to potential clients, new clients, and old clients.

I want to make sure that I do this right for all of the people/firms that deal with me.

That’s all for now.? I am still shooting for a December 1st start, and I think that is achievable.

Thanks to all who have contacted me and given me advice, or said they would like to invest.

Redacted Version of the November 2010 FOMC Statement

Posted on 3 November 2010 by David Merkel

September 2010	November 2010	Comments
Information received since the Federal Open Market Committee met in August indicates that the pace of recovery in output and employment has slowed in recent months.	Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow.	No real change.
Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.	No change.
Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls.	Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls.	No change.
Housing starts are at a depressed level.	Housing starts continue to be depressed.	No change.
Bank lending has continued to contract, but at a reduced rate in recent months.		Removes sentence.
The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term.	Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.	Deletes one sentence, inserts another.? From the language below, they have lost confidence in ?higher levels of resource utilization? anytime soon.? Attempts to say that inflation expectations are under control, but that deflation is governing the present.
Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.	They highlight that they have a ?statutory? mandate, and a ?dual? mandate. Aside from that, they comment that unemployment is ?elevated.?
With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.	Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.	Translation: we have no idea why our policy is not working, and we don?t know what to do about it.? Monetary policy works with long and variable lags, so we won?t say that our policy isn?t working.? It?s just slow in taking effect.
	To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities.	New sentence.? Launching the QE II.
	The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.	New sentence.? They will stealth-fund the US Government to the tune of $600 Billion.
	The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.	New and meaningless sentence.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.	No change.
The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.		Sentence dropped.
The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.	The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.	Changes from prepared to act, to will act.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	Adds in Raskin and Yellen.
Voting against the policy was Thomas M. Hoenig, who judged that the economy continues to recover at a moderate pace. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and will lead to future imbalances that undermine stable long-run growth. In addition, given economic and financial conditions, Mr. Hoenig did not believe that continuing to reinvest principal payments from its securities holdings was required to support the Committee?s policy objectives.	Voting against the policy was Thomas M. Hoenig. Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.	No real change here; if anything, Hoenig is more firm in his opinions.

Comments

The Fed launches the QE II.? As I have commented, elsewhere, but can?t find now, the market was looking for about $1 Trillion in QE, so the long end of the Treasury curve sells off.
They highlight that they have a ?statutory? mandate, and a ?dual? mandate.? They are trying to say that they are required by Congress to do these things, and that it is a tough job.? The flip side is that they admit the Congress has the right to tell them what to do, which Ron Paul may make clear as the Chair of the House?s subcommittee on Monetary Policy.
The question is this: will the mechanisms of credit transmit inflation to goods and services?? So far, it has not.? Lowering the policy rate does little to incent borrowing when enough people and financial institutions are worried about their solvency.
Beyond that, if they succeed, how will it be received on Main Street, especially if price inflation is not accompanied by increases in employment, or is accompanied by higher interest rates or lower stock prices?
Hoenig still dissents; hasn?t gotten bored with it yet.
That said the economy is not that strong.? In my opinion, policy should be tightened, but only because I think quantitative easing actually depresses an economy.? It does the opposite of stimulate; it helps make the banks lazy, and just lend to the government.
The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.? As a result, the FOMC ain?t moving rates up, absent increases in employment, or a US Dollar crisis.? Labor employment is the key metric.
My guess is they have no idea why their policy is not working, and they don?t know what to do about it.? Monetary policy works with long and variable lags, so they won?t say that their policy isn?t working.? It?s just slow in taking effect.

The Fed Loses Twice

Posted on 3 November 20103 November 2010 by David Merkel

The Fed lost twice tonight, in that it will face a more skeptical Congress, and that fiscal policy will be jammed for the next two years, meaning that so-called monetary policy will have to do more of the heavy lifting.

Bad timing for the Fed.? They are powerless, or even negatively powerful (They will achieve the opposite of what they are intending), because they don’t understand how monetary policy really works, particularly during times of crisis.

The Fed is imitating Japan, which has done horribly over the last 20 years.? Can’t they learn from recent data?? Interest rates that are too low cause businessmen to make bad decisions.

My advice to the Fed: raise rates.? You might be surprised to find that higher rates lead to greater employment. Economies don’t work well when there is no place for savers to park funds, or when investors don’t have an alternative to risk assets.? Economic agents don’t react well when crisis measures are used… it makes them sit on their hands all the more.? Nothing good ever comes from punishing the prudent, and rewarding the imprudent.? (And, I really fell sorry for seniors in this environment — their ability to generate income in an environment of QE is reduced.)

If the Fed is trying to create inflation, it will find that the creation of asset inflation in what they buy for QE is easy.? But where it goes after that is anyone’s guess.? Currency markets will reflect the debasement, and prices of things we import will rise, like oil, but until Ben buys the helicopter fuel and sends the imagined virtues of currency debasement to the people directly, rather than stealth-financing the government, the price rises of goods and services will be anemic.

But if goods price inflation comes, it may come more aggressively than expected, and be much harder to control than economists presently think.? We don’t have a good model for monetary policy, yet.? After all, consider the last 100 years.

Fed created to provide an elastic currency, so as to avoid another panic of 1907.
In response to a minor economic crisis ~1920, the Fed adopts a loose monetary policy, leading to a large buildup of debt, and then the Crash and the Great Depression.
By 1941, debt levels return to normal.
Post WWII, high inflation, but short-lived.? The Greatest Generation sucks it up, and accepts the high taxes necessary to pay down the war debts.? Their great error: not paying enough attention to child-rearing.? After all, they created the Baby Boomers, of which I am one.
Post WWII, the Fed is restrained an functions relatively well, until the ’60s when monetary looseness leads to foreign governments/central banks trading US Dollars for gold.
The Phillips curve is discovered, and someone decided to experiment with more inflation in exchange for higher employment.
Add in dissolving the final link the dollar has to gold under Nixon.
Alas, the result is stagflation — higher inflation and higher unemployment.
It takes an unorthodox and painful monetary policy from Volcker in the early ’80s to get ahead of the curve.? All rates rise; the short rates go through the roof; unemployment is higher then than today.? But the recovery is brisk.
Under Greenspan, a policy of letting the markets implicitly dictate monetary policy leads to The Great Moderation.
Looks like genius for a time, but the debt builds up to higher levels than during the Great Depression.

Now we deal with the aftermath.? During the bust there are no good solutions; the best one can do is expedite the compromising of debt, and move toward an equity based economy again.? The process is painful, but there is no free lunch.? If you want robust growth, you must allow recessions to do their work, and force marginal uses of capital out of business.

Instead, we adopt a policy that forces rates lower, favoring borrowers over savers, and leads to greater stagnation.? And all this from QE, a theory that is untested, and has not worked in Japan for two decades.? Letting academic economists, who don’t have a good handle on how monetary really works, run monetary policy is lunacy.? They didn’t get it right in the past.? They are not getting it right now.

More later today when I comment on the FOMC statement.

On Long Blog Comments

Posted on 2 November 2010 by David Merkel

I appreciate those who comment at my blog, even those who run on and on.? I will go further: you have a talent, and why waste it at my blog?

You have ideas and energy.? Build your brand.? Why waste your wisdom on the paltry few that read blog comments?? Start your own blog.? Write positively, proclaiming your own ideas.? Send me a link, so that I can read it.? If I like it, I will promote it, as I have done with many other blogs in the past.? Or, link to a post of mine, whether positively or negatively, and I will see it — my googlebots will send me a note.

I do not write this with respect to any single writer of comments at my blog.? Indeed I have had many that have written a lot there, and I thank them for it.? Thanks for your interest in me.

But you could do better.? I try to write six decent articles per week, and it is an effort.? It is always more difficult to put forth content positively than to respond to it.? I challenge you — start your own blog.? I will support you in it, if you write good stuff,? and you send me a link to review.

That’s all.? Phrased another way, if you are willing to write blog-length posts at my blog, you should be writing your own blog, and telling your readers what a dope/hero I am.

Time to Grow Up

Posted on 2 November 2010 by David Merkel

This is a post about economics, but it will probably sound more political than most.? Part of being mature is learning to live within boundaries.? No, not everything is possible.? Immature people like Bush II, Obama, JFK, and FDR tell us that we can have our cake and eat it too.? It is not an uncommon positions for assume, particularly when they can use a particularly large cohort of workers as a tool to sap revenue from, while not retaining the funds for retirement benefits.

That said, I can look at the past and be a critic.? That’s easy, there have been real jerks that have milked our society, and retained a good name, though they robbed the future to pay the past.? It is criminal what municipal politicians have done, hiding behind high assumed investment assumptions, supported by brain-dead consultants who assumed markets are magic, and always provide high returns.

But there are enough targets in the present.? The evil party, the Democrats, ignore the long run effects of their deficits, and ignore the entitlements crisis that will engulf the nation.? The stupid party, the Republicans, rolled over for the idiocies of Bush II, and ignored the long term effects of debts and entitlements.

But there is a new force of anger, the t-party.? And that is about all they have, is anger.? They want their taxes reduced, but don’t want large entitlement programs reduced, or defense.? They represent small-minded libertarianism.? I am an economic libertarian, but I recognize that my views mean real pain for many in the short run, though I think those policies will be best for all in the long run.

There was a real loss in our nation when we abandoned the idea that national budgets needed to be balanced.? It brings out the worst in politicians when they think money is free, and they can engage in the basest demagoguery with no cost.? As it is today, we would probably be better off electing our politicians via random selection.

I have no sympathy for the t-party.? If you only have economic interests, and aren’t willing to take stands on broader ethical questions, you do not deserve to be our rulers.? Government is ethical as a rule, and the most important questions are what behaviors we encourage and discourage in our society.

I have a further concerns.? Leaders should not be merely facile rhetoricians, but should be genuinely mature.? I cringe listening to the t-party endorsed politicians, because they aren’t mature enough to rule.? If you can’t control what you say, and how you say it, you don’t have enough control over yourself to be one who promotes order in society.

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I wrote the above three weeks ago and sat on it.? After writing it, I said to myself, “This is not one of your better works, are you going to say that?”? After review, I am saying this with full conviction.? Most t-party candidates are not ready for prime time.

Take Sarah Palin as an example. Sarah Palin is a bad joke.? If she is such a good Evangelical Christian woman, why is she not at home taking care of her young children, particularly the one with Down Syndrome.? Or, why was she occupied with Alaska politics at a time when she should have been there for her daughter Bristol, who was about to make some very bad decisions.

Feminism has no place in Christianity.? Men are to lead, not women.? Go home, Sarah.? Homeschool your children, if you can. I would not say this to a woman outside the Church, but since you claim to be one of the disciples of Christ, I say it to you.

I say this as a leader in the Church, ordained by the elders of my presbytery, in a Bible-believing church.? There is no good that comes from neglecting your own home to address the problems of the nation.? Sarah Palin is no Deborah.? Deborah was wise, and Sarah Palin is not.

I fear God more than I care about the political direction of this country.? As the Apostle Paul said, “Shall we do evil, that good may come?”? Paul spoke rhetorically, saying that we should do what is right, regardless of the results.? There is no good that comes from trying to save society, when our own house is not in order.

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I could talk about the other t-party candidates and their idiocies.? Time would fail me.? I am in favor of a brainy libertarianism and Biblical morality, rather than a brain-dead libertarianism, and appeals to general morality.

The most pressing and immediate economic problem is this: we are facing a funding crisis for all of the promises made by governments and corporations regarding retiree employee benefits.? Every day I see more articles about the pain municipalities are going through over funding pensions, with occasional pension strengthening from corporations.

The sins of past governments, making promises that could not easily be fulfilled, or, at least fairly funded in the short run, are coming home to roost.? Funding issues for all levels of government are rising.? It doesn’t matter if you have met the budget this year, however you have done it.? Next year will be worse, because the assets will not throw off enough income to satisfy the liabilities over the intermediate-term, across the whole nation.

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We go to the polls in the US today, but no one dares talk about the funding crisis.? They talk of tax cuts or protecting benefits, while at the same time the economic decay continues, where debt grows, and ability to repay it declines.

It is a sad state of affairs, and indeed, I despair over it.? I love my nation, though I do not support its wars or its economic foolishness.? Unlike what Reagan said, America is not the last best hope of man on Earth, rather it is the God-man Jesus Christ, to whom we must all eventually answer.

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If I have a fault economically, it is that I look to the long-term.? For me, it is Heaven, though on Earth it is what will happen to my great-grandchildren and beyond.? Our policies are slanted to the present, and will force those who are younger to pay far more than they ought to pay, because they will be carrying the profligacy of the Baby Boomers.

No party is seriously looking at the future funding crisis.? There are little hints among the municipalities that are the worst running into problems now.? Those problems will only grow, and spread.? The problems in the unfunded Federal plans will be a plague in their time.

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This is an unusual post for me, prompted partly by the elections, because I don’t think anyone from an economic standpoint is addressing the real problems that we are facing.? Mere politics prevails for now, with fine-sounding but empty words telling the electorate that they will be restored to prosperity.

There are bigger forces in play here.? Consider my old piece, Rethinking Comparable Worth; as it stands, less skilled labor in the US should see wage declines as the rest of the world becomes more competitive.? Unskilled labor is not scarce. Skilled labor is somewhat scarce. Good ideas are scarce.? Real capital is scarce, but financial capital is not scarce.? Commodities vary in scarcity.

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I see this as a time for the US to “grow up,” and see that there are no easy solutions, but that it will take shared sacrifice to preserve our nation.? Taxes will have to rise while benefits are cut.? Keynesians will scream, but the average person in the US will see it as fair, because they know that everything must be paid for; there is no free lunch.