Raghuram Rajan made a name for himself at the Jackson Hole conference in 2005, which was a kind of send-off for the victorious Alan Greenspan.  Alas, but the paper he brought was not appreciated at the time, as it pointed to imbalances in the financial system.

He was ahead of the curve.  Thus his book on the economic crisis deserves our attention. More than most, he sees the problems in a global way, across nations and across asset classes.

His view is that for a variety of reasons, income inequality grew in the US, and in order to paper over that, the government encouraged a credit-oriented society to allow people to stretch for prosperity, hoping that the debts would not catch up with them.

It was a fool’s bargain.  Debt deceives average people.  They overestimate their ability to repay, and end up defaulting at high frequencies.

Like me, he is critical of the Fed’s monetary policy during the ’00s as being too easy.  The “Great Moderation” was a result of over-stimulus, not of sound policy.

Similarly, he faults banking regulation for being too easy, leading to private profits with public risk.

This is a well-written book from a man who was ahead of the curve.  I recommend it.

Quibbles

Where I differ with Dr. Rajan is how easy it would be to fix income inequality in the US.  He suggests a number of policies, many of which sound good, but have the Federal Government intervene in matters that they can’t handle effectively.  Persistent unemployment is a problem, but should that be handled by the Federal Government.  Far better in my opinion that it be handled informally and locally, by family and friends, that there would be more urgency, and more willingness to compromise in finding work.

Retraining is a good thing, but also not something the Federal Government does well.  One of the beauties of the US is that we have community colleges, which can retrain people at modest costs.

He also levels a decent amount of the blame at Fannie and Freddie and the Community Reinvestment Act, for making too many lousy loans.  He is correct in direction, but not likely in degree.  Yes, they were problems, but not the leading problems.

But these are mere quibbles on an otherwise excellent book.  If you want to buy the book, you can buy it here:  Fault Lines: How Hidden Fractures Still Threaten the World Economy

Who would benefit from this book

Anyone who wants a comprehensive view of the crisis would benefit from this book.  It does a fairly complete job, and is not long at ~230 pages.

Full disclosure: The publisher sent me a copy, because I met the author at a conference, and asked to receive a review copy.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

I am not sure how many current economic crisis books I have reviewed.  I think I am getting close to a dozen and I am currently reading “Fault Lines.”  I’m not sure I want to do many more crisis book reviews.  Tonight’s review is Complicit, by Mark Gilbert of Bloomberg.

Bloomberg columnists are typically good writers, with detailed knowledge of their subject areas, and a no-nonsense approach to writing.  This book from Mark Gilbert is no different.  As Joe Friday often said, “All we want are the facts, ma’am.”

And for the most part, that’s what you get in Complicit.  It is not a long book at 173 pages, but it comprehensively chronicles the growth in leverage, and how it spread to many areas of the investment markets.

When bubbles grow, everyone is a friend.  Underwriting becomes lax, limits are stretchable, FICO scores are pessimistic approximations, etc.  Risk is transitory; we originate to sell.  Regulators don’t want to stand in the way of seeming prosperity.  Nor do politicians.

Leverage gets higher in explicit and implicit ways.  Credit spreads get tight as a drum.  It is a virtuous cycle… until it become a vicious cycle.

In the bust, credit spreads rise, cutting off the possibility of refinancing.  Then asset defaults come, and GSE and bank insolvencies.

Central banks did not view inflation broadly enough, focusing on goods price inflation, and ignoring the asset inflation that was distorting the economy.  They disclaimed an ability to see, much less deal with bubbles.

The high yield market became a frenzy for yield, with CDO equity bidding for lousy bonds and default protection on lousy corporations.  Debt spreads tightened to levels that indicated perfection had arrived.

Investors chased risk, seeking returns.  There were too many parties willing to make fixed commitments, because they needed to earn a lot.  Balance sheets were ignored, and income statements were everything.  History being bunk, was thrown out the window, because it was different this time, we were in a new era.

The crash in Shanghai was the first warning in February 2007, followed by the equity quant crisis in August 2007, and the breakdown in the money markets.  All of the clever ways parties used to lever up short-term credit blew up, forcing banks to take credit back onto their balance sheets.  At that point, everyone should have dumped the banks, but few did; leverage was too high, and asset prices were falling.

The critical decision was bailing out Bear Stearns.  I agree with Gilbert; either both Lehman and Bear should have been bailed out or neither.  I think not bailing Bear and Lehman out would have led to the best outcome.  After Bear failed, other banks would have moved to straighten themselves out.  We might not have had as much failure had as we eventually did. The inconsistency of regulation, as well as the unwillingness or regulators to be tough added to the crisis.

The book covers the September 2008 climax well, but takes us past that, offering possible solutions.  I particularly liked the ideas of limiting the number of academics in important regulatory posts, and having more regulators with practical experience.  I also liked central bankers being proactive on bubbles, and the asset/liability matching inherent in paying those that make long term decisions with financial instruments that last for the term of the decision, and are contingent on the credit quality of that decision.  An example would be paying securitization originators with pieces of the subordinated tranches.

I liked the book; for those with limited time, the book is particularly suitable, because it is brief.

Quibbles

Gilbert’s style is hard-hitting; though many financial companies took advantage of government largesse, few practically considered the possibility of bailouts while the boom was going on; they were pursuing profit with little thought of systemic risk. There was a lot of greed, but in my opinion, few expected bailouts, but took them when they were offered.

Who would benefit from this book?

The book is available here: Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable (Bloomberg)

Full disclosure: The publishers sent me copies of these books, hoping that I would review them.  I review about 80% of the books that get sent to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

But, as I have often said, the beauty of Capitalism is its ability to handle instability.  There is creative destruction as some economic concepts are no longer as useful as they once were — e.g. fixed-line telephones, newspapers, buggy-whips, everyone should own a home, residential real estate is an easy road to riches, etc.

It is dangerous to try to stabilize that instability, to create a great moderation of volatility, to keep marginal concepts from failing, whether through fiscal means (tax incentives and subsidies), or monetary policy (lower the policy rate or some banks will fail).

It’s good to see bad economic concepts fail, along with those who finance them, particularly when a society is not so dependent on debt finance that the failures will not cause a cascade of more failures.  Failures allow resources to be redeployed to more productive uses, and keeps capital focused on the best opportunities.  Unemployment stays cyclical.

But when failures are quickly bailed out through overly easy monetary policy, as well as a fiscal policy that favors debt over equity, debt grows like crazy, because there is little to restrain it.  Why should the politicians care?  Easy money means prosperity today.  Bureaucrats don’t argue with the politicians; that is suicide.

Debt issuers crave stability.  Credit spreads fall when conditions are stable, until enough marginal borrowers take on debts that they can’t afford, and the bust phase of the credit cycle kicks in.  If the central bank eases too soon, as was true for the Greenspan/Bernanke era, then the bust doesn’t get to do its job.  Marginal concepts survive.  The marginal efficiency of capital falls.  Asset prices stay inflated.

This process can continue until the central bank’s policy drives the economy into a liquidity trap, because they can’t drop rates lower than zero.  (Though I wonder, couldn’t the Fed go negative, and require the banks to pay them interest on reserve balances?  Perverse, I know, but what isn’t perverse today?)  The central bank can further lower rates, a subsidy to bad decisions, by buying long debt, and maybe credit-sensitive debt (not yet, but wait and see).

That’s where we are today.  Now there are two competing theories for why we are in this mess.

1. Aggregate demand has failed, so the government needs to step in and spend to keep growth going in the short-run.
2. Our economy is too levered.  We need to adopt policies that reduce indebtedness, and also expect that these policies will cause some pain in the intermediate-term, but that it will give us a healthier economy in the long run, that is, for our children, even if we are dead.

My view is that neoclassical economists are wrong.  Aggregate demand has failed for four reasons:

1. Overleveraged consumers will not readily buy.
2. Citizens of overleveraged governments will not readily spend, for fear of what may come later from the taxman, or from fear of future unemployment.
3. Aggregate demand is mean-reverting.  It overshot because of the buildup of debt, and is now in the process of returning to more sustainable levels.  The same is true of private debt levels, which are being reduced to levels that will allow consumers to buy more freely once again.
4. When the financial system is in trouble, people get skittish.

The thing is, we are not in a liquidity trap, as much as we are in a broken financial system.  Ordinarily, savings in a bank lead to investment.  The bank lends the savings.  When the banks are impaired, or forced to put up more capital against their operations, as financial reform properly will do, lending is light.

If we give it enough time, willingness to lend will recover, without government help.  That implies that debt levels mean-revert across the economy down to levels where people aren’t concerned about their own debt, or the debts of the government.  We are in a process now where the private economy is properly trying to reduce debt levels, and the government is interfering through monetary policy, deficits, and tax credits for borrowing, in order to support the economy of the 1990s, where we needed more houses and cars, and all who created/serviced them.

Thus I will tell you that the current set of policies is not only useless, but unproductive.  Don’t keep interest rates artificially low.  It punishes savers.  Savings are what lead to sustainable investment.  Don’t stimulate the economy via fiscal policy; it never rewards the economy of the future, only that of the past.

Here are my solutions:

• Make interest non-deductible, and dividends tax-deductible.  Phase this in over five years.  Yes, the prices of houses would fall, and many other asset prices.  Venture capital would get whacked.  But the system that would emerge by 2020 would be delevered, more profitable, and much more stable.  It would grow more rapidly as well.
• Issue coupons to taxpayers  that can be applied to repay debt.  That would delever the economy rapidly, aside from the government.  (A weakness of the idea.)
• Bar the Fed from running overaggressive policies.  Fed funds can never be more than 1.5% below the 10-year rate, or 0.5% above the 10-year rate.  Constrain the madness of unelected bureaucrats that see no problem in weakening the credit of the economy.  Also, eliminate section 13:3, so that the Fed can’t do bailouts.  Let Congress, who we elect, sign off on every bailout, so that we can kick them out thereafter.
• Worst case scenario: Inflate the currency, such that it passes into goods prices.  That will lower the value of old debts, making them not as much of a burden to the economy.  But try the other three strategies first.

I write this not because I get any kick out of austerity, but because I think the present set of solutions will not only not work in the long-run, but make things worse.  There will be no recovery without some pain.  People always want something for nothing, and that never works in the long run.  If we want to have two or three lost decades, like Japan, well, keep following the status quo.  But if we want to get this over with, follow my solutions, and stop interfering with the economy.

As it is, there are limits to borrowing for any government in real terms, and the present set of policies will test those limits.  Perhaps Greece or Japan will be the canary in the coal mine for the US, but will we learn the lesson early enough to avoid default or a severe inflation?

The paradox of thrift as proposed by Keynes assumes that all saving is similar.  People invest excess monies in some simple depositary instrument that earns interest.  As people panic over bad economic activity, they save more, driving interest rates lower.  But wait.  What if they don’t place their money in depositary instruments?  What if they pay down debt, whether secured or unsecured?  In that case, banks will find themselves more willing to lend, as the surplus/assets ratio rises.  The liquidity crunch at the banks will lessen.  Or, people may save in a different way, by:

• Buying gold, commodities, or non-perishable consumables
• Enhancing their homes, cars, etc., making them cheaper to operate, or giving them longer lifespans
• Investing in foreign debt instruments

Saving can take many forms, some of which may look like consumption or investment.  The main idea is to direct your excess assets to the place that will give you the best long term benefit.

Even corporations will want to save during a tough environment.  Building up cash balances gives flexibility for the future, and gives options to buy assets cheaply if competitors crater.  Some firms even borrow long-term to have cash on hand.  It’s a negative arb, but it gives the firm flexibility.  But even firms may have alternative ways to save:

• Investing in labor-saving or waste reducing technology.
• Stockpiling needed nonperishable commodities, or locking in long-term supply agreements, at attractive prices.
• Retiring stock or debt through buybacks at attractive prices.

Saving need not be in money markets or banks.  There are many ways to save, and there are always alternative uses for money.  Each economic actor has to find the most fitting savings method for his needs.

Now, recently I ran across a paper called The Paradox of Toil.  The abstract:

This paper proposes a new paradox: the paradox of toil. Suppose everyone wakes up one day and decides they want to work more. What happens to aggregate employment? This paper shows that, under certain conditions, aggregate employment falls; that is, there is less work in the aggregate because everyone wants to work more. The conditions for the paradox to apply are that the short-term nominal interest rate is zero and there are deflationary pressures and output contraction, much as during the Great Depression in the United States and, perhaps, the 2008 financial crisis in large parts of the world. The paradox of toil is tightly connected to the Keynesian idea of the paradox of thrift. Both are examples of a fallacy of composition.

This paper does the same simplifications that Keynes did to produce his paradox of thrift.  There is only one type of labor.  Well, certainly if everyone does the same thing, there are diminishing marginal returns to scale.  Big deal.

But labor is different.  We have the ability to choose different firms to work at.  Not all work is equal, and there are often better and worse opportunities available for labor.  Recessions occur partially because capital and labor are misallocated.  Look for the firms that are showing promise in the recession, and angle to work for them.

But beyond that, workers have one more option: work for yourself; start your own firm.  Find a problem that irritates many, and solve it.  Create a product or service that meets the needs of many.  In a deflationary environment that might mean finding a cheaper way to do things.  But it could be creating a new product that meets needs that people or businesses did not know they wanted.  Go for a Blue Ocean Strategy.

The best businesses are often created in recessions.  Flip the paradox of toil, and work many hours for yourself and your ideals.

Summary

I don’t believe in the paradox of thrift or the paradox of toil.  They are bogus results of oversimplified models that do not reflect reality.  As an investor and an economic historian, I know of many times where massive amounts of money were allocated to a single asset class or a single sector of the market.  If everyone follows a mania strategy, whether due to greed or panic, I can guarantee that there will be a bad result.

• The dot-coms of the late ’90s
• The one decision stocks of the ’60s.
• Gold in the ’70s.
• Railroads in the late 1800s.
• Buying stocks in the 1920s.
• Selling stocks in the 1930s.
• Selling bonds in the early ’80s.
• The mercantilist era — exporting cheaply to get gold, then getting less in return when liquidating the gold.

I could go on to various manias in earlier eras, less well-known manias, or individual stocks, but that wouldn’t help make my case any more than I have already.  The main point is the same.  Anytime everyone does the same thing, it is foolish.  It would be stupid for everyone to save using T-bills, or sell their excess labor to agricultural day labor.

I trust intelligent people to seek their best advantage in the markets.  That does not mean that foolish people will not get hosed.  That’s the nature of being foolish.  But bright people see recessions as a time to reorient and look ahead, to see what the new economy will want, and ignore what the old economy wanted.

So, I don’t see any value in:

• Stimulus programs that don’t produce economic value.  If it only pays a wage, that is destructive.  For stimulus to be effective it must produce infrastructure that lowers the costs of the economy.  Think of all the useless projects built in Japan.
• Paying extended unemployment benefits.  Additional consumption today, plus debt tomorrow is a recipe for economic lethargy.
• Running large deficits.  If the money is not being spent on something that will produce future growth, it is a loss.
• Bailouts of large financial institutions.  We have too many of those.
• Housing tax credits.  We have too many houses.
• Bailing out auto companies.  Too many autos are made in our world today.
• Bailing out the GSEs.  They are deadweight losses.  Let them die, and let the senior bondholders feel the pain.  Let the junior bondholders be wiped out.
• Monetary policy that steals from savers, thus depriving the private capital markets of a supply of private capital for productive investments, rather than the government absorbing most of the capital at low rates, and wasting the money on less productive projects.

Don’t listen to the fools that insist that we must run huge deficits and run a loose monetary policy.  A “big bang” would be preferable to the “Chinese water torture” that we are now undergoing.  Far better to take a short dose of sharp pain, where asset prices fall, some more banks fail, and bad debts are purged from the system, than to endure another lost decade, where the ability to employ capital productively is difficult.

As it is, we are pursuing the Japan solution to our overleverage.  They have had two lost decades, and are starting on their third lost decade.  Is that what we want?

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Onto tonight’s topic: asset allocation.  So, we had a bad quarter for equities.  Not that I can predict things, but I pulled in my horns progressively over the last nine months, culminating in buying a bunch of utilities at the last portfolio reshaping.  I own mostly energy, insurance, utilities, and consumer nondurables stocks, with a little tech thrown in for fun.  At present, median P/E is around 9, and P/B around 90%, with strong balance sheets, and around 17% of the portfolio in cash.  I missed roughly half of the carnage of the last quarter, and this week, I put some money to work, cash falling by 1%.

So, when are equities cheap?  Next question: cheap relative to what?  It’s difficult to say when equities are absolutely cheap, but here are some ideas on cheapness:

• Stocks are absolutely cheap when they trade in aggregate at less than book value, or less than 8x trailing earnings.  Think of Buffett getting excited back in 1974.
• Stocks are relatively cheap to Baa bonds when the earnings yield of stocks plus 3.9% is above the yield on Baa bonds.  But this at present depends on very high profit margins continuing, and sales not shrinking, neither of which are guaranteed.
• When there is significant debt deflation going on, determining cheapness is tough.  Better to ignore the market as a whole, and focus on survivability/cheapness.  Aim at companies in necessary industries with relatively little debt, strong accounting practices, and cheap to earnings/book/sales.
• I don’t have a good metric for when equities are cheap/dear to commodities.  Ideas welcome.

With respect to bonds, credit spreads are not wide enough to make me yell buy, as I did in November 2008 and March 2009.  Beyond that, the spread on GSE debt and guaranteed mortgages is thin.  TIPS look attractive, as few care about inflation.  The US dollar has been strong lately, largely due to weakness in the Euro.  I would be light on non-dollar bonds for now.

What we have been experiencing is creeping illiquidity, where the prior stimulus from the Fed and US Government has been declining.  There isn’t enough private demand growth to drive the economy, because we need to pay off or compromise on debts.  Also, the private sector looks at the growing debts of the government, and gets concerned.  How will the government deal with it?  Higher taxes, inflation, default?  No good scenarios there.

When an economy is overleveraged, there are no good solutions.  If sales fall, then corporations will fire more people, and idle more capacity in order to maintain profits near prior levels.  High quality bonds do well, but stocks do poorly, until enough debts are paid of or compromised, and the economy can work without the fear of mass insolvency again.

I have written before on a new approach to asset allocation.  Broadly, I am looking at a system that:

• Considers the credit cycle first.  Great returns typically happen after credit spreads are wide, and are lousy after they are tight.
• Considers the slopes of the Treasury nominal and TIPS curves.
• Looks at the cash flow yield of all asset classes relative to history, relative to other asset class yields, etc.
• Factors in safety provisions for each asset class.  Stocks need the most, then junk bonds, then investment grade.
• Looks at the short-run and the long-haul returns of each asset class, attempting to analyze when the short run is way above or far below long-haul trends.

At present, I am still happy playing conservative, because I am less confident about debt deflation than most investors are now.  There will come a time to be much more bullish, but it will come after earnings decline, and firms have delevered still further.

That said, I needed to make changes and had been delaying doing so.  I have modified my blogroll to reflect who I regularly read.  For the most part, I feature those that say more, but say it less frequently.

I will modify my leftbar to make it shorter, so that the site loads faster.  I will categorize my book reviews, and place the least recent of them on a separate page.

Though I like long post blogging, I will do more short posts.  My site will load a lot faster, so for those that visit the site directly, it should not be as much of a pain.

I expect to have this complete over the next month.  Much as this episode was a pain for me, I kept a good attitude about it, and am looking forward to the better blog that may result from the changes.

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In order to write tonight’s essay, I scanned Kartik Athreya’s letter, and used OCR to turn it into a tractable file.  I had to correct OCR errors, but I left his spelling and grammar errors alone.  The formatting is slightly different, and fits on three pages, not the original four.

In many ways, economics and finance are about competition.  Writing about economics and finance is tough.  There are many facets to write about; there are feedback loops galore.  So, why do some writers in the blogosphere gain followers, and others don’t?

Tough question.  Being an engaging writer helps in the intermediate-run, and being a scandalmonger helps in the short-run.  In the long-run, all that matters is that the writer is right frequently, makes sense to readers, and has the humility to admit errors.  The economics and finance blogosphere is highly competitive, and talent tends to prevail over long periods of time.  Blogging is more of a meritocracy than peer-reviewed journals.  It more closely resembles “perfect competition.”

There is another aspect to blogging that is different from writing for economic journals: we have more of a slant toward positive economics than normative economics.  Ethics plays a larger role in what bloggers write about than what timid Ph.D. economists will write about.

Just as Law is too important to be left to lawyers, with all of their self-protecting biases, even so Economics is too important to be left to economists with Ph.Ds.  The economics guild protects its own in much the same way as described in Thomas Kuhn’s The Structure of Scientific Revolutions. Bad paradigms survive until a significant number of young scientists displace the paradigm, and replace it with a new one that explains things better.

Economics needs a better paradigm, and I do not mean better mathematical formulas.  For decades economists have been playing sterile math games assuming what they define as rational behavior which is not rational.

Simple example: when I was much younger, I was traveling with the two senior members of my Ph. D. dissertation committee, and I asked them, “But what if consumers don’t maximize?  What if they conserve on maximization, because maximization takes a lot of effort, and take the first ‘good enough’ solution?”  Their answer was the intellectual equivalent of a shrug.  Without maximization, mathematical economics falls apart.  Besides, Milton Friedman taught us that the realism of assumptions doesn’t matter.

I disagree.  It matters a great deal.  If we can’t get optimization to work, all of the implications of a model will fail; there is no way to get correct significant estimates of an optimization model, if people merely satisfice.  And most of us know that we are under time and knowledge constraints, and do not optimize.

The same issues apply to the Microeconomic theory of the firm.  But now let us consider Macroeconomics, which is even squishier.  Academic macroeconomists did not distinguish themselves regarding the recent economic crisis.  Few predicted it, versus a greater number of economist in the business world that did predict it.  Think about it: what should we say about macroeconomic models that claim that the financing structure of the economy is neutral?  That it does not matter how much is financed by debt versus equity?

As I said to Dr. Carmen Reinhart when I met her, “We need more economists that are students of history, and fewer that can do the pretty math for the ideal world that does not exist.”  She seemed to agree.

Get in contact with real data.  Abandon theories that don’t make sense when applied to the real world.  Work in the markets; see if you can make money.  Be practical and adjust.  If businesses can’t lever up infinitely, why should we assume that governments can do so?  Because they can tax or inflate it away?  Ah, but each comes with a cost.

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With respect to Athreya’s letter, I would tell him to grow up, and genuinely compete with those who blog on economics and finance.  Though I am not a Ph.D., I did pass my comprehensive exams and oral exams from UC-Davis, an institution far more prominent than the University of Iowa, at least as far as applied economics goes.  That my dissertation committee left me, and that I could not set up a new committee killed my Ph. D.  It did force me to become an actuary, (my wife-to-be and I wanted to marry and start our family) and learn a lot of practical things about markets and funding structures that most economists will never bother with, to their practical detriment.

In my days at Johns Hopkins and UC-Davis, the longer that I studied, the more I learned that economics waves its hands at the problems that come whenever detailed studies attempt to test the main theories.  The results aren’t pretty; far better to have ad hoc theories that work over a limited range, than theories that proceed from basic principles, but do not work.

Yes, economics is hard.  Much harder than most economists think.  They need to abandon Keynesian, Chicago, and Neoclassical thinking, and aim for something that fits the data more closely.  That may not be the Austrian School, but it will be closer to that than the Neoclassical School.

We need an economic paradigm that is willing to tell the politicians that their actions will do no good, and will likely do harm; that central banks can’t create prosperity.  Governments exist to enforce justice, not goose the economy.

When we are in the bust phase of the economy, there are no good solutions, except to take the pain, realize the losses, and come to a quick end through a painful “big bang.”  This is the solution our central bank and politicians are fighting.  The “Japan solution” that is being followed refinances assets that are in oversupply at progressively lower rates, allowing bad assets to survive, and encouraging unproductive investment.  Real progress comes from accepting that there is no easy solution, and allowing the economy to liquidate bad investments without hindrance from the government or central bank.

The solution comes in preventing booms from getting out of hand, and always letting recessions be hard enough to liquidate bad investments.    We can’t do that now in the midst of the bust, but after the bad debts of our economy are liquidated, much as the Depression ended in 1941 when Debt/GDP reached 1.4x due to compromises and payoffs, and not due to the government or Fed, there can be real growth again, because less-indebted consumers and businesses are ready to act.

To Mr. Athreya, I would say that he has insufficiently embraced the complexity of the economy.  It is so complex that reducing it to mathematics does not work well.  But in a spirit of friendship, I invite him to visit me in Maryland and have lunch or dinner with me, at my expense.  Maybe I will tell him the story of when I got to question the head of the Richmond Fed.

That’s all for now.  There is more to say, but I am tired, and might not continue the essay so well.

Comments

• Two months ago I wrote: The FOMC is overly optimistic on employment and housing issues.
• Now the weakness is evident.  Hope has given way to modest pessimism, as they have shaded virtually all of their views of economic strength down.
• Implicitly blaming the Eurozone is cheap, we have enough issues on our own for the weakness – residential housing, commercial real estate, and over-indebted consumers.
• Hoenig still dissents; hasn’t gotten bored with it yet.  Have we gotten bored with him yet? J
• The key variables are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.

1) You know that I have mixed feelings about the Fed.  They have done a poor job with bank regulation, monetary policy, and managing systemic risk.  The trouble is, if you’re going to have a fiat currency, monetary policy is credit policy, and so your central bank should broadly control credit if you are going to do that at all.  (If not, then set up a currency board, or back your currency with silver/gold.)

So when I hear that the Fed is winning in reconciliation of the finance bill, I think it is good in some ways – yes, they should oversee small banks, but bad because the Fed should not have bailout authority, or at least they should not be able to hide what they do when monetary policy is unorthodox.  It is one thing to delay oversight of ordinary dealings, but rotten to hide debasement of the currency through special dealings with favored entities.

But I see little value in the size of the Fed.  They have too many people doing too little.  Monetary policy and bank supervision?  Fine if they do it well.  But the institution as a whole could be radically slimmed.  Congress should take closer control of the Fed, slim it down, and focus it on the missions that it should attend to.

2) I am not impressed with Donald Kohn.  He has a farewell interview with the Wall Street Journal, and not once does he mention the buildup of debt in our economy, partially fostered by easy monetary policy from the Fed, as a problem.  Blind guy, and even worse, he still doesn’t get that bubbles are typically able to be seen in advance, or, that the Eurozone isn’t structurally flawed.

Thought experiment time.  What if we tossed out all the Fed governors, and replaced them with a bunch of notable value investors?  Value investors suffer from the problem that we see problems early, and adjust portfolios too soon.  That could be of benefit to monetary policy, because value investors often see when things are becoming overdone, well in advance of it becoming too big to handle.  This would be a big improvement on the current system.

3) I get email from congressional staffs asking for advice on issues, or asking me to write about them.  Recently I was asked what I would ask the nominees for the Federal Reserve Board.  This is what I said:

• We find ourselves in this crisis because the Fed ran an asymmetric monetary policy for years: loosen aggressively when the least crisis comes up, and tighten slowly until there are small squeaks of pain.  This led short interest rates progressively lower, until we found ourselves in the liquidity trap that we are now experiencing.  How are you going to get us out of this liquidity trap?

• How are you going to provide decent opportunities to savers so that capital formation can begin again?

• What have you done in your life that qualifies you for this level of responsibility?

• To the economists: neoclassical economics did us no favors with respect to this crisis.  Only a few Austrian economists predicted it, along with a few practical economists in the business world.  We need a new paradigm for monetary policy.  Are you capable of providing it?

• To the non-economist: You will be working primarily with neoclassical economists, with their theories uncontaminated by data.  How will you avoid being sucked in by their groupthink?

4) When I went to hear Raghuram Rajan and Carmen Reinhart at the Cato Institute, I was very impressed with what both of them had to say.  Rajan was the skunk at the farewell party for Alan Greenspan back in 2005 at Jackson Hole, when he was the only one to fully suggest that imbalances were building up due to debts being incurred in the financial sector.  Few aside from The Economist noted what he said.  More noted Donald Kohn’s dismissive response, which was not erudite, in my opinion.

Both noted that the current financial reform bill would do little to fix the real underlying problems, with which I agree.  It constrains in many areas that don’t need it, and does not constrain areas that were significant to the crisis – e.g., the GSEs and the Fed.  Imagine a simple proposal that would immediately force flexibility onto the economy: dividends are deductible, but interest payments (and preferred dividends) are not.  An easy way to lower leverage, and encourage flexible finance.

Also, they noted the possibility that the US Government would engage in financial repression, which would force people to invest in government securities on unfavorable terms.  Ugly stuff.

And as an aside, we met in the F. A. Hayek Auditorium.

5) Can Hayek be cool?  Perhaps, give the recent rap video.  I am not surprised that few neoclassical economists give Hayek any credit; he cuts against most of what they stand for, so why should they commit treason?

As for Glenn Beck, I get tired very quickly of the facile answers that appeal to the anger of the masses.  There are real problems, and we need to deal with them, but oversimplifying the problems will not get us to the solutions; it will only create a new set of problems.  I have no favor toward the Tea Party; they don’t stand for anything coherent.  I am not an Austrian economist, much as I like some of their ideas.  My ideas have been derived from my observation of how financial systems work over the last 25 years.

6) Following Austrian economics would be a huge improvement over what we usually do, though there is a problem.  Once you hit the bust, nothing works.  The Austrian view will be a “big bang” and clean it up fast, but it will be a lot of sharp pain.  The virtue of Austrian Economics is that it would restrain the boom, and thus make it less likely that one faces the pains of the bust.  But there are no easy solutions in the bust.

Focus on the boom, not the bust.  Solve the boom, and the bust does not come.

7) It is common that many debt classes that have few defaults get an aura about the qualitative factors that forestall default.  Well, what of municipal finance?  Under stress, is it possible that the cultural factors that made default less likely might wither, and defaults cascade in likelihood?  Yes, I think that is possible, and I think that is why Buffett is lightening the boat on munis.

8 ) Solve the revolving door problem for the SEC?  Pay them more.  I get it, but are we really willing to pay market-based salaries for expertise?  I doubt it.  The government tends to be chintzy; penny wise and pound foolish.

But if you hired real experts, would the government be willing to set them free and let them corner real frauds?  That is the question.

9) Fannie and Freddie common stocks are on their way to zero.  Their NYSE delisting is just one more step in the road to total dissolution.  The simplest solution is to fold them into GNMA, and slim down the massive operations that don’t do much for the mortgage market.

10) The unequal signal problem exists with the banks that took TARP money.  We hear a lot about those that repay, but little about those that do not pay.  Well, here is an article about those who did not pay.

11) Evan Newmark is occasionally annoying, but often perceptive.  Should President Obama do what he does not want to do?  It couldn’t hurt; his allies on the far left are already disaffected. The question is whether he can be as dispassionate as Bill Clinton, and pursue a centrist course.  I don’t think he is capable of that, because he is too smart, and smart people, unless they moderate their idealism, don’t compromise well.

That’s all for now.

1) A response to those commenting on my piece A Stylized View of the Global Economy: when I say stylized, is does not mean that every nation fits the paradigm, only that most do.  My view is that the debt overages will have to be liquidated, and there is no possible policy that can avoid it except large scale inflation.  Those looking for clever ways out of this bind will be disappointed by what I write.  When nations are heavily indebted their options decline, particularly when they don’t control their own currency.  For the US I say that we should have liquidated insolvent firms rather than bailing them out.

Also, read Falkenstein as he takes on the idea that stimulus spending works.  I have little confidence that the linear reasoning behind stimulus spending yields long-term economic benefits.

2) One blogger that I have some respect for, but have not mentioned often is Bruce Krasting.  He writes some good things on US social insurance programs. His recent post Social Security at Mid-Year highlighted what should shock many: we have hit the tipping point on Social Security.  From here on out it will be a drag on the federal budget.  Expect Congress to remove it from the federal budget.  It no longer aids the illusion of smaller deficits.  (What a cleverly hidden illusion.)

As he commented at the end of his article:

-SS is $2.5T of the $4.5T Intergovernmental account. I believe that this entire group is going cash flow negative. The IG account cost us ~$160 billion in interest last year, but some out there are pretending the IG account does not exist. An example of this is in the following link.

Sorry, U.S. Federal Debt Is NOT Approaching 100% Of GDP Anytime Soon

This kind of thinking is not only lunacy; it is dangerous.

And I agree.  There only two ways to look at the balance sheet of the US.  Look at explicit debt vs GDP, regardless of who is owed the debt.  Or, look at total liabilities vs GDP.  But never look at explicit debt not used to fund social insurance funds.  It is meaningless.  The total liabilities number tells the whole story.

3) Spain is in trouble.  Their banks are borrowing a lot from the ECB, with no end in sight.   Perhaps that leads them to push for stress testing across all European banks.  Or, maybe things are so bad that the banks are identified with the sovereign credit, and both are tarnished.

4) Or consider the Eurozone as a whole: the system begs for debt relief, but the Euro and ECB are tough taskmasters.  The Euro has been an excellent successor to the Deutschmark in terms of preserving purchasing power, but perhaps purchasing power needs to be sacrificed in order to relieve debtors.  The ECB is steps away from monetizing the debts of its governments.  Perhaps they could preserve the Eurozone by destroying the value of the Euro.  Germany might not stand for it, but it has significant unfunded liability issues as well.

As with the US, unless there is a large inflation, debts will eventually have to be liquidated, whether through austerity or default.  There is no other way.  Austerity will have its costs, but unless debts are inflated away or defaulted, those are costs that must be paid.

5) Can pensions be cut?  The typical answer is no, but what if a state pays less than what was promised in inflation-indexed terms?  That is what is being tested.  I think that eventually states and municipalities will be forced into bankruptcy because they can’t make employee benefit payments, and still maintain minimal services to the populace.

6) Debtors prison.  I have mixed feelings here, because I think that those that can’t pay should not be put there for long, if at all.  Those that can pay but won’t, should go there.  Regardless, this is a trend, and those that think they can walk away from debts should think twice before doing so.  You may be setting yourself up for prison.

This is just another front in the war against those who can pay but won’t.  More lenders are suing those who won’t pay, and going after their assets.  My only surprise is that it has taken so long for this to happen.

7) Fannie and Freddie are a giant black hole.  It astounds me that there is any respect given to two companies that have lost massive amounts of money since their inception.  The US would have been better off without them, and will be better off with them in bankruptcy.  The US should not promote single family housing as a goal, because it cannot create the conditions where marginal people can be capable of financing housing on their own.

So, when some suggest one last bailout, I say, let them fail.  Cancel the common and preferred stocks, and fold the remainder into Ginnie Mae.

8 ) Occasionally, there are really dumb articles, like this one.  The time for debt was November 2008 through March 2009, when I recommended investing in junk bonds.  There is little reason to borrow now; valuations are relatively high, don’t take your life into your hands.

9) And, occasionally, smart articles, like this one.  If you are in a volatile profession, reduce your risks by investing in high quality bonds.  If you are in a safe profession, invest in stocks.  When I went to work for a hedge fund, the first thing I did was pay off my mortgage, so that I could take more risk, without worrying about getting kicked out of my house.

10) Felix Zulauf has generally been a bearish guy, and so has done well over the past decade.  But is he right now?  Will stocks revisit their March 2009 lows?  It is possible, but I lean against it.  We would need a situation where most of the developed nations decided to aim for recession and stay there a while.  I do not see that yet.

11) Is it is liquidity problem or an insolvency problem?  If you have to ask, it is usually insolvency.  Consider Richard Koo, and his thoughts on the matter.

12) Using the rubric of the “Tragedy of the Commons” Kid Dynamite points out how it sets up the wrong incentives if we bail out profligate states and municipalities.  As a part of my “new mormal,” it is no surprise to me that this is happening.  It should be happening, and will happen for at least the next five years.

13) Because of my employment agreement, I can’t tell you exactly what I know about the demise of Finacorp.  But I can tell you that the article cited is wrong.  Finacorp never carried an inventory of assets.  It only crossed bonds between buyers and sellers.  The failure of Finacorp occurred for far simpler reasons.

1) Countries that are importing more than they export, and are increasing debt levels.

2) Countries that are exporting more than they import, and are acquiring debt claims that will provide future goods and services.

Simple enough.  But now look at the two groups.

Group 1 is the developed world with its common problems:

• Bad demographics affects public and private pension systems.  Both systems underfund, rather than tax/pay/borrow to fully fund.
• Sloppy, easy monetary policy in the last 25 years has led to an overage of debt finance which is now difficult to service.
• Governments were too aggressive in trying to service needs that the tax base and electorate would not validate, leading to more borrowing.

My summary for group 1 is that they became less competitive over time, and tried to maintain expanding living standards for their nations via borrowing, and encouraging borrowing.  Central banks became less willing to sponsor harder downturns that would force the liquidation of bad investments.  Much of that stemmed from a fear that liquidations would cascade, leading to another depression, and so, the central banks provided liquidity to support asset prices but not goods prices.

Group 2 is OPEC and the developing world.  This group is more heterogeneous, and has a different set of problems:

• They have populations that are generally younger than the developed world, with some notable exceptions, e.g., China.
• Their laborers are generally less productive than those in the developed world, largely because there has not been the same level of capital investment.
• They are trying to develop industry, and trying more broadly to create societies that resemble the prosperity that the developed nations have.
• There are limits in some nations as to what freedoms will be tolerated.  For some nations, the ideal is a creative, clever workforce, that is highly productive, and has no aspirations apart from their jobs.  Call their representative “the new capitalist man,” willing to sacrifice himself for those above him in the economic hierarchy.

While writing at RealMoney, I would often bring up the problem of neomercantilism.  Given what I have already described, the problem is that Group 2 favors their exporters and producers, and sell cheaply to consumers in Group 1.  Who loses?  Consumers in Group 2, and producers in Group 1.  In any case, in aggregate, nations in Group 2 build up financial claims against nations in Group 1.

And there is the problem.  These nations are overly indebted already, and the ability for them to make good on all of their obligations is speculative, regardless of what their bond rating is.  Few of the nations in Group 1 are doing well right now, unless their economies have a large natural resource extraction component to them, such as Norway, Australia, and Canada.  They look at their economies and say, “Loosen monetary policy!  What do you mean we can’t loosen further?  Run deficits!  What do you mean our ability to do that is limited?!”

When governments are overly indebted, and the demographic profile says that things will only get worse if current policy maintains, there is a pressure to head for austerity.  Keynesians will argue against this, but when you can’t easily borrow more, Keynesian remedies die.  “In the long run, we are all dead.”  Well, guess what, the long run has arrived, and those of us living now have to deal with the accumulated debts, malinvestments, and low interest rates that discourage saving.

It is not as if deficit spending really stimulates.  It may shift money from taxpayers to some government employees, but unless that spending somehow increases the economic capacity of the economy, it is a waste.  We would be better off giving money evenly to all of society, than letting the government figure out what to do with it.  They will reward cronies, anyway.

As it stands, the nations of Group 1 are heading into a scenario like that of Japan.  Don’t liquidate.  Don’t take losses.  Refinance them at low rates, and expand the monetary base to do so.  Coddle the unproductive to save jobs.  Turn the credit of the nation into a safety net for politically-connected industries that have grown bigger than is useful for society.

But what the markets are saying to Group 1 is simple.  “You are living beyond your means.  There is no way that you can fund the retirements/healthcare of so many.  Beyond that, your governments spend too much in areas that are worthless.  Fix that.”

The future for Group 1 is a diminution of living standards, or at least a slowdown in their growth, should financing remain available.  That diminution could happen in several ways: increased inflation, bad debt liquidation, currency revaluation, unemployment with lower wages, or a combination thereof.  It is not a happy future, but happiness is often having expectations set properly.  Time to move expectations down.  Time to start liquidating bad debts.

Group 2 is another matter.  A lot depends on how much their financial systems rely on full payment in current purchasing power terms from Group 1.  Defaults from Group 1 are not impossible; does your financial system rely on full repayment?  It is a mistake to lend too much to anyone, particularly if it is sizable relative to your capital.

Remember the Mercantilist era.  The mercantilists sourced gold dearly, and never got the full good of their investment.  The same is true today of those relying on US Dollar-based investments. You are relying on the kindness of strangers.  Under pressure, do you really think that the US will favor foreign creditors over domestic needs?  Some things do change over time: the ethical generation that fought World War II has been replaced by a bunch of sybarites.

So Where Does This Leave Us?

It leaves Group 1  in a Japanese-style scenario, where it stagnates.  It leaves Group 2 reliant on what will likely prove to be bad assets from Group 1, either from default or inflation.  There are  no easy ways out; Group 1 must accept lower living standards, but shows little inclination to do so.  Group 2 needs to rely less on export-led growth, and should try to deepen their internal markets, and accept imports.  Neither fits with the political goals of each group’s leaders.  Thus the problems we face today.