Public Policy – Page 69 – The Aleph Blog

Thoughts on my Last Two Posts

Posted on 24 February 2010 by David Merkel

Some follow-up on my last two posts.? I will be talking to those that suggested parties that would be willing to create a definitive bond blog.? But, others brought up a good point, which I am well aware of, but forgot for a moment.? The bond markets are mainly institutional.? Institutional bond investors have no lack of research sources to guide them.? Retail investors get ripped of, or are relegated to government bonds, ETFs, or mutual funds.? So, maybe creating a definitive bond blog would not be a good use of time?? Maybe, maybe not.

What is clear is that such a blog would have to be retail-focused.? It could not dwell on minutiae that would be valuable to institutional investors, but would have to deal with the hard problems that retail investors face with fixed income.

The alternative would be to try to do a blog for institutional investors and bright amateurs, and invite institutional investors to write pseudonymously — think of it as a Zero Hedge for fixed income, without so much attitude.? But would institutional investors read it?? They are inundated already.

Now, John Jansen himself has encouraged the idea, which I appreciate.? He did great work while he was at it.? Could we do as well or better?

Thoughts?? I am still game for this idea, write to me here.

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How long to the point of no return?? I don’t know.? In all of the time that I wrote at RealMoney, I tried to point at directions, but not give timetables.? Giving timing is a mug’s game.

But let me consider some of the commentary that I have received.? My last two posts generated so much traffic that people were not able to access my site for a time.

Promises, promises.? What is a promise to pay worth?? All I know is that the more promises there are outstanding, the less a promise is worth.? The same applies to the Federal Reserve, who issues small-denomination short-duration 0% CP, otherwise known as currency.

Some say that so long as a primary dealer can “repo previously issued govt bonds at the central bank to gain reserves to purchase the new issue bonds at a Treasury auction, that nation can never default, no matter what the level of debt to GDP ratio is….” The effect of that is to raise interest rates.? Higher rates will harm the economy.? As more long-term promises are issued, the safety/value of a promise diminishes.? The same is true of short-term promises, but the effect is more immediate.

Which reminds me that nations with a lot of debt to roll over are most at risk.? There are others in worse shape than the US.? The US Dollar may be the best among bad major currencies, as I have argued on many occasions.? Also, banking crises tend to lead to sovereign debt crises.? The nation absorbs the losses of the banks, and then some fail as a result.

In a true free market, no one would care about currency levels.? They would take spot and future currency rates and factor them in as a cost of doing business.

The Keynesian solutions assume that growth will occur as a result of government spending.? I disagree.? In Japan, there has been no end of such spending, and from what I have read, that spending has not resulted in additional productivity.? Additional productivity only comes from projects that yield more benefits than their costs, and Japan has had more than its share of white elephants.

Throwing a brick through the window and having the glass repairman do his work may raise GDP, but the net worth of society is diminished.? True growth comes from entrepreneurs competing for advantage, and finding places where there are needs to be met.

That is one reason why I say that the deficit spending of the US is destructive.? It does not reflect the needs of people, but the needs of politicians currying favor with interest groups.? We need to shrink the US Government, so that it cannot meddle with the details of our lives.? Let it focus on defense, justice, internal security, and public health, goals worthy of a government.? Let local governments deal with other issues.

The budget troubles will percolate down to all municipalities.? It cannot be otherwise.? Local governments will toss out less needed actors, such as social workers, and retain those more needed, like policemen.? On the whole, society will be better off, as we reduce unproductive actors.

Growth matters a lot.? We need to focus on eliminating things that constrain the growth of the economy, without sending the government budget into greater deficit.? Let the US government reduce corporate welfare.? Let them eliminate the deduction for employee health care expense — that will shrink the health care sector significantly.? My view is that we need to eliminate all tax preferences in the economy, and tax people/institutions in their increase in value every year.? Get the government out of the social engineering business.? Let’s have true tax reform.? Let government do what it does well, and leave the rest to the people.

I recognize that I have a point of view here.? My contention is (aside from ethical issues) that when there is a high level of debt in an economy, that efforts to stimulate fail.? Better not to stimulate at all, ever.? Rather, focus on constraining credit, so that speculation does not overcome the economy, whether personal or corporate.

As for now, let us encourage short sales, foreclosures and bankruptcies, which eliminate debt.? Prices will reset lower, but predominantly equity-financed businesses will not fail easily.? Once the Debt/GDP ratio gets below 1.5x, the economy will grow on a healthy basis again.

How Long, To The Point Of No Return?

Posted on 20 February 201021 February 2010 by David Merkel

Alea posted a paper, and The Big Picture a slideshow on sovereign debts, by the same author.? We have had a blessed period post-WWII, where there have been no defaults of major nations.? But that is not normal.? Nations default on their debts if they get too large, or they repudiate through inflation, or they raise taxes on a docile public.

The main point of the paper is that we are past the point of no return in most major nations, without significant changes that would diminish living standards for some time.? Add the implicit obligations to the explicit debt, and there is quite a mountain to climb.? Defaults are coming, the only question is what nations will default.

I often think that economists need to get out of the math ghetto, and study history.? Math is not capable of capturing nuances.? I write this as one who uses advanced statistical analyses regularly.? History is more robust than mathematical analyses.? Math occludes understanding in economics because it forces a numerical simplification of matters that have more dimensions than are admitted in the analysis.

Are there doubts about this?? Here are some simple tests: How well do macroeconomic models forecast, particularly at turning points?? On microeconomics, what kind of R-squared are they getting when they test the general equilibrium neoclassical model?? Are many of the testable hypotheses are not rejected?? When last I looked, R-squareds were in the percentage single digits, and most testable hypotheses were rejected.

So why do we think that developed nations could not default on their debts?? The book This Time is Different, should disabuse such notions.?? Major nations have often defaulted on their debts.? It is regrettable, sinful, but normal.

Personally, I think that all of the developed nations as a group have gotten lazy, and also do not realize the degree to which they are interconnected, particularly through their banks.? This is not a call for governments to reach out and help one another, but a yellow flag to say, “Don’t bail out other nations.? Focus on the effects on your own country; if you must do bailouts at all, focus on your local financial institutions, and then create risk-based capital rules that penalize foreign lending, and encourage diversification in what foreign lending is done.? This is logical in a credit-based system, because you only regulate one side of the transaction.

I am not arguing for isolationism in investing, but there is a tendency in the bull phase of the credit cycle to assume that nations don’t default, and so lending to sovereign credits that are weak becomes the trade of the moment.? Good regulation of financials limits the ability of those regulated to be yield hogs, particularly in the bull phase of the credit cycle.

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Nations are mortal.? They don’t last forever, historically, if they last 200 years, that is significant.? Even with nations that last so long, they can repudiate debts multiple times in their lives, though there is a cost — being shut out of the bond market for a time, until lenders forget.

So, what is the calculus on national default?? It is an option, but what influences the choice?

Willingness of public to accept more taxes.
Willingness of the public to accept reductions in services.
Strength of the economy.
Willingness of foreign creditors to buy more debt.
Willingness of locals to save through buying national debt.

Default happens when a nation gives up; they conclude that there is no way that they can pay off the debts incurred.

Nations have not given up so far, but unless economic growth increases significantly, there will be defaults in many places eventually.

A Question of Cultural Failure (II)

Posted on 17 February 2010 by David Merkel

Good cultures balance short and long-term goals.? Focusing too much on the long-term can lead to overinvestment, and problems like Japan still faces.? Focusing on the short-run can lead governments and companies to focus on manipulating budget and earnings numbers to fulfill their own selfish ends.

At present, we have no surplus of long-termism, but a surfeit of short-termism.??? Many economic players have decided that it is in their interest to play for time? — make things look good in the short run, and maybe a magical fix will appear for long run problems.

It seems that the EU thinks that if they can make Greece behave, that all will be right.? Well, tell that to those that protest in Greece.? Let each EU nation rather take a step back and ask, “What is cheaper in the long-run, bailing out Greece, or bailing out my banks with Greece exposure?”? The latter is probably cheaper, but not certainly so.? Given the lack of unanimity, the situation would lean toward bailing out domestic banks, because bailing out Greece requires the cooperation of separate nations, many of which have electorates that strongly oppose a bailout of Greece.

But, that could mean a virtual dissolution of the Eurozone.? Not necessarily.? You could end up with a lot of nations in default, and shut out of the bond markets (the PIIGS), while the rest do seemingly fine, as they quietly bail out their banks.

In that situation, the Euro would still exist, and might continue to be the currency of nations that are in default.? They just could not borrow any more at any rate in Euros, and perhaps not in any currency.

But the Eurozone itself would be in tatters, at least from a marketing standpoint.? What is good about being in the Eurozone?? Free trade?? Well Britain has that, even though they are a basket case, at least they control their own destiny, sort of.? The veneer that being in the Eurozone means that you are a high quality borrower is shattered.? Credit spreads over the German Euro benchmark will be high indeed for nations that have been undisciplined in their finances.

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People and governments like stasis.? No change.? Why?? It makes policy simple.? If something is in trouble, give it aid.? But — what if the trouble is an indication that people don’t want what is being produced by the one that is in trouble?? Capitalism is wonderful because it is dynamic. It can quickly adjust to changing conditions, unlike socialist bureaucrats.? Rather than volatility being a negative, with capitalism it is a positive.? It shows that the economy needs to change, that losses on prior bad investments should be recognized.? Failure to see things like this lessens the flexibility of the economy, and makes the eventual adjustments much larger than they would have to be if we did not interfere in the economy.

Now, this applies all over the world.? China is creating some of the biggest white elephants in history, so it seems.? Like Japan in the late 80s, they are building up useless industrial capacity.? Naive Keynesianism says that it does not matter what one spends money on, what matters is that the money gets spent, and quickly.

We may as well throw bricks at every window we see with that logic, knowing that GDP will record that glassman’s wages, but will not record the loss from a broken window.

Alas, we have too much automotive capacity, so we support automotive firms in the US.? We have too many bankers and too much capacity to build homes, so we support that as well.? Far better that we let firms fail, and let the assets be released to better uses.? Why waste your life or capital in an industry where there is not enough demand?

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In one sense, my claim of cultural failure boils down to not being willing to recognize losses.? In another sense, it is using the political process to invalidate economics.? Why should the government bail out company A and not company B?

The present political climate in the US could be summarized as a question of fairness.? Why should some benefit from bailouts, and not others?? There should be some answer here that doesn’t sound lame.? Lame answer: we were protecting the whole economy by protecting banks.? Better answer: we goofed in protecting the banks.? We should have let them fail, and bailed out depositors.? Don’t bail out anyone; let housing prices drop until ordinary people can afford them.? But if you must bail out, go down to the lowest level, and bail out those with mortgages, which will benefit not only them, but everyone above them.

This leaves aside moral hazard — all bailouts are a mistake.? Far better to let all fail, and let the system reset.? Run a hard culture where failure is punished.? That will cause people to avoid failure with greater assiduousness.

I will have more on this in the likely final segment for this topic.

A Question of Cultural Failure

Posted on 13 February 201014 February 2010 by David Merkel

I’ve said this before in different ways, but I will say it once more, “Governments are smaller than markets; markets are smaller than cultures.”? The reasoning is simple:

Governments can only control a fraction of what an economy or culture does.? Governments that are overbearing on an economy or culture may gain greater proportional control, but the size of the pie will shrink.? More of the economy or culture goes into hiding, away from the prying eyes of the government.
Markets only express a fraction of what mankind does.? They cover the tradeable aspects of what we do, but typically do not give us our deeper goals or desires for ourselves, and the culture as a whole.

When I look at the biggest economic problems facing the world today, many of them stem from deeper cultural problems.? Let’s start with the current poster child, or, canary in the coal mine, Greece.

Greece got into the Eurozone via subterfuge; they lied about the true status of their indebtedness, and Wall Street (with its counterparts in European investment banking) helped them do it.? So did a number of the other nations in the Eurozone that are presently under stress.

Now, the core members of the Eurozone wanted the Euro to grow as a currency — they were committed to an ever-wider and -deeper union.? The dream of a united Europe made them willfully blind to the low probability that the nations which were fiscal basket cases had genuinely changed.? The core should have been skeptical, and now they are paying the price, though not paying any money, yet.

The core nations that could pay or guarantee to help Greece are playing a tight game.? They act as an internal European IMF, insisting on reductions in the Greek budget deficit.? Greece does its part by saying it hasn’t asked for aid, which is unlikely.? At the same time, reductions in the Greek budget deficit bring the competing political factions inside Greece out in force.? Protests!? Strikes!? There are few arguing for what is best for Greece overall, and many arguing for a larger piece of what is a shrinking pie.? In a situation like this, it might be better for outsiders to let Greece fail,but they won’t do that.? Why?

The banks in the core nations can’t afford a default by Greece if by contagion it leads to defaults in Portugal, Spain, Italy, and Ireland.? A failure of the banking system does not conduce well to maintaining power for elites.

I have already talked about the perverse incentives for the core European nations to do anything to support Greece.? If Europe was rational, they would abandon the experiment now, or press for a Federal Europe akin to the US.? I don’t see either happening — I just see slow suffering for now, and futile playing for time.

Dubai is a place where anything can get done.? Anything indeed, but who pays the bills?? Dubai is a place of big ideas and little responsibility. ?? It is a moral flaw to bite off more than you can chew, particularly if you do so on behalf of others.

Many US States and Municipalities are in a world of hurt, because they compromised their long-term financial position to solve short-run budget crises.? That is the nature of the crises that we face today.

The same is true of the current US government — they fight for short term political advantage, rather than the long term good of the nation.? Who will favor the long-term and sacrifice for the greater good?

A simple summary statement here is “Greed is not good.”? Societies that are willing to sacrifice self interests have a much better probability of succeeding than societies that pursue self interest.

That’s all for now, I will pick this up in part II.

Ignore anyone who tells you that debt levels don’t matter.

Posted on 12 February 2010 by David Merkel

Debt levels in an economy matter.? They matter a lot.? An economy that is financed primarily by debt can be like a chain of dominoes.? If one fixed claim fails, and it is large enough, many other fixed claims that rely on the first claim could fail as well, triggering a chain of failures.? This is a reason why a fiat-money credit-based economy must limit leverage particularly in financial institutions.

Why financial institutions?? They borrow and lend.? They also lend to other financial institutions.? A? big move in the value of some assets can make many banks insolvent, and perhaps banks that lent to other banks.? The banks should have equity bases more than sufficient to absorb losses at a 99% probability level.? That means that leverage should be a lot lower than it is now.

Economies are more stable when they limit fixed claims and encourage financing via equity rather than debt.? Imagine what the economy would be like if interest was not deductible from taxable income, but dividends were deductible.

People would save money to buy homes, and would put more money down when they borrowed.
Corporations would lower their debt-to-equity ratios, and would pay more dividends.
Fewer people and corporations would go broke.

Pretty good, but in the short run, the economy would probably grow slower.? The debt bonanza from 1984-2006 pushed our economy to grow faster than it should have, where people and firms took more chances by borrowing more, and making the overall economy less resilient.? Debt-based economies lose resilience.

What was worse, the Federal Reserve in the Greenspan and Bernanke years facilitated the debt increases because the Fed never took away the stimulus fast enough, and offered stimulus too rapidly.? This led to a culture of unbridled debt and risk-taking.? If only:

Greenspan had been silent when the crash hit in October 1987.
Greenspan had not given into political pressure in late 1990, where he set up a process of cutting interest rates too much.
Greenspan had not cut rates in 1995.
Greenspan had not cut rates during the LTCM crisis.
Greenspan would have cut far less 2000-2002.
Instead of tightening 1/4% at a time 2004-6 , they would have raised the rate far more rapidly, completing the rise in one year.
Bernanke would not have let the fed funds rate go to zero, but would have limited fed funds to never go lower than 1% below the ten-year Treasury yield.? We never need more than that to stimulate, but some patience is necessary.

What’s that you say?? The economy would have grown more slowly?? Right, and the economy should have grown more slowly, rather than gunning the engine through the overaccumulation of debt.? As it is, the economy will grow more slowly for some time a la Japan, until we delever the economy enough that it can once again grow without stimulus.

The economy is at a fork in the road.? Do we:

Leave rates low and leave quantitative easing in until price inflation unfolds?
Let rates rise gradually and drain quantitative easing slowly?
Raise rates significantly and drain quantitative easing rapidly?

The third view is off the table.? No one wants to see any failure.? Bad decisions of the past must be grown out of, even if it takes a long time of subpar growth to do that.

When Eastern Europe left the Soviet orbit, the countries that did the best were the ones that freed their economies most rapidly.? Well, not in the short-run.? Letting companies fail is always a drag in the short run, but in the longer-run it leads to faster growth, because bad investments fail, and are replaced by better investments.

The same is true with monetary policy.? The US grew faster during periods where failures were reconciled and liquidated, rather than attempting to smooth the economic cycle — leading to fewer failures in the short run, much but bigger failures when the amount of debt became too large.

Before the crisis, when I was writing at RealMoney.com, I usually encouraged taking the less risky macroeconomic route, suggesting policies that would not increase debt levels.? The trouble was, that all of those ideas were losers in the short-run, and so they were not followed.? In the long run we are all dead, leaving the failures of short-run policies to our kids.

Personally, I would raise the Fed funds rate to 2% immediately, and let it shadow the 10-year rate less 1% thereafter.? But no one likes jolts, except when the Fed is loosening.? After that, I would rather the Fed allow inflation to raise collateral values and end the home and commercial mortgage crises.? But no, what we are likely to get is a Japan-style muddle-in-the-middle where they struggle with a slow raising of rates, and a slow end to quantitative easing, with a premature giving in when the economy has a negative burp before the removal of policy accommodation is complete.? I expect us to move in the direction of Japan.

What may change the story are sovereign defaults as government debt levels get too high.? In the short run, that may favor the dollar — it won’t fail rapidly.? But perhaps the euro might fail.? Even the yen might.? The era we are in is like the mid-1800s, when nations were constrained by their debt levels.

From the recent book “This Time is Different,” we know that countries with high debt levels grow more slowly, and defaul more frequently.? Ignore anyone who tells you that debt levels don’t matter.

The Rope Limit, Redux

Posted on 9 February 2010 by David Merkel

Sorry I haven’t written much recently.? The recent snowstorms have tossed me around, as I care for my family, and those around me.? It is amusing in a backwards way, to see Washington, DC frozen at a time when there is so much volatility in global finance.? Yo, Treasury, make sure the skeleton crew on international finance gets in, regardless.

The incentives are perverse in every way in Europe.? If Germany, France, and the Netherlands don’t bail out Greece, then what will become of Portugal and Spain?? And later, Italy and Ireland?? In aggregate, this is big.

But, if Germany, France, and the Netherlands do bail out Greece, then will Portugal and Spain be next in line?? And later, Italy and Ireland?? In aggregate, this is big.

Perverse, indeed, and I criticize my own thoughts on the Euro that I thought would die from inflation.? No such thing.? The Euro is strong –? So strong that marginal nations were able to borrow at rates lower than they ever dreamed imaginable.? The debts built up like mad, ignoring the day when the inevitable weakening in aggregate demand would come, and debts of marginal, overindebted nations would prove weak.? The EU is validating the idea that currency union requires political union.? We learned that in the US 200 years ago, but the youngsters in the EU have to learn that lesson the hard way.

This is an ugly situation, as ugly as China forcing exports into the rest of the world, or the US Government continuing to borrow with abandon.? What seems to have no limit may find the limit more rapidly than one anticipates.

Just be aware that sovereign volatility has negative impacts on asset prices.

Default, Inflation, Higher Taxes — Choose One

Posted on 7 February 2010 by David Merkel

When I look at the present economic environment, I am not encouraged.? But if you really want me to be discouraged, talk to me about politics.

For the last 40-80 years we have been borrowing, whether implicitly (pensions, retiree healthcare) or explicitly, deferring problems into the future, where they will be compounded with interest and survivorship (lifespans have lengthened, Kaiser, and sadly for those who pay, they want a high quality of life in their dotage).

So, at present, legislators are more partisan, whether in the states or at the federal level.? Why?? There is less slack.? Let’s start at the state level, because most of them have to balance their budgets, and can’t print money to help out.

Many states are screaming in pain.? As such, they tell their legislators in the Federal Congress to send back money.? But that toughens the debate on the Federal level.

With almost all state budgets fighting against a deficit, and some in deep trouble, it makes for interesting and ugly politics.? Much of this was created by optimistic assumptions of what could be earned from equities over the long run, much of which is now being slowly repudiated, as markets fail to live up to expectations.

The Federal budget is hopelessly out-of-whack, with 4-5% of GDP deficits out as far as the eye can see.? So, what do we do about it?

1) Raise Taxes.? I don’t like this idea, because the US Government has entered many areas where it should not be.? I would rather see the discretionary government shrink considerably.? Also, remember, Social Security and Medicare are not guaranteed.? Congress could wipe out all benefits tomorrow, and face a political firestorm.? But remember, in the Great Depression, that is just what they did.? This is why I don’t insist that rates must head higher.? It depends on society as a whole.

Raising taxes has the perverse result of slowing economic growth, which affects future taxes.

2) Inflate the currency.? Ugh.? Oppress the elderly, who cannot work to make up the difference?? Create a new inflation mindset that has all of us focusing on the short-term.? Inflationary economies by their nature become more and more short term.

3) Default on obligations.? There are several forms of this:

a) Total default: anyone with a Treasury Note is a sucker.? Global depression ensues.

b) External default: we do not honor external obligations, but honor internal ones.? Global depression ensues, but the US does relatively well.

c) Internal default: what, are you joking?? Why do we pay off the losers who lent to us?

As we look at Greece, Spain, and Portugal, we chuckle over the foolishness of the EU thinking that they could have monetary union without full political union.? It didn’t work under the Confederation, why should it work elsewhere?

But we should not chuckle.? After all, we have California, Illinois, and New York, and more waiting in the wings.? There is no bankruptcy code for the states.? I am not sure what happens if one state does not pay, aside from being shut out of the municipal bond market.

So, my point remains — what are we going to do?? Raise taxes, inflate the currency, or default?? Perhaps in a real crisis, we would slim down the government.? We might also decrease Social Security and Medicare benefits.? We might also amend ERISA, to allow for reductions in pension payments.? In a real crisis, nothing is fixed.

Or, we might tax a lot more — the depression was an example of that.? That is a reason that I am not a total bear on Treasuries.

The government has choices to make.? What should they do?? Offer your answers as best you can.

The Deadly Dozen

Posted on 4 February 2010 by David Merkel

I have been thinking about the the forces distorting the global economy.? In the long run, the distortions don’t matter, because economies are bigger than governments, and eventually economies prevail over governments.? Here are my dozen problems in the global economy.

1) China’s mercantilism — loans and currency.? The biggest distortionary force in the world now is China.? They encourage banks to loan to enterprises in order to force growth.? They keep their currency undervalued to favor exports over imports.? What was phrased to me as a grad student in development economics as a good thing is now malevolent.? The only bright side is that when it blows, it might take the Chinese Communist Party with it.

2) US Deficits, European Deficits — In one sense, this reminds me of the era of the Rothschilds; governments relied on borrowing because other methods of taxation raised little.? Well, this era is different.? Taxes are high, but not high enough for governments that are trying to create the unachievable “permanent prosperity.” In the process they substitute public for private leverage, and in the process add to the leverage of their societies as a whole.

3) The Eurozone is a mess — Greece, Portugal, Spain, etc.? I admit that I got it partially wrong, because I have always thought that political union is necessary in order to have a fiat currency.? I expected inflation to be the problem, and the real problem is deflation.? Will there be bailouts?? Will the troubled nations leave?? Will the untroubled nations leave that are the likely targets for bailout money?

4) Many entities that are affiliated with lending in the US Government, e.g., FDIC, GSEs, FHA are broke.? The government just doesn’t say that, because they can still make payments.

5) The US Government feels it has to “do something” — so it creates more lending programs that further socialize lending, leading to more dumb loans.

6) Residential real estate is still in the tank.? Residential delinquencies are at all-time highs.? Strategic default is rising.? The shadow inventory of homes that will come onto the market is large.? I’m not saying that prices will fall for housing; I am saying that it will be tough to get them to rise.

7) Commercial real estate — there is too much debt supporting commercial real estate, and too little equity.? There will be losses here; the only question is how deep the losses will go.

8 ) I have often thought that analyzing the strength of the states is a better measure for US economic strength, than relying on the statistics of the Federal Government.? The state economies are weak at present.? Part of that comes from the general macroeconomy, and part from the need to fund underfunded benefit plans.? Life is tough when you can’t print your own money.

9) The US, UK, and Japan are force feeding liquidity into their economies.? Thus the low short-term interest rates.? Also note the Federal Reserve owning MBS in bulk, bloating their balance sheet.

10) Yield greed.? The low short term interest rates touched off a competition to bid for risky debt.? The only question is when it will reverse.? Current yield levels do not fairly price likely default losses.

11) Most Western democracies are going into extreme deficits, because they can’t choose between economic stimulus and deficit reduction.? Political deadlock is common, because no one is willing to deliver any real pain to the populace, lest they not be re-elected.

12) Demographics is one of the biggest? pressures, but it is hidden.? Many of the European nations and Japan face shrinking populations.? China will be there also, in a decade.? Nations that shrink are less capable of carrying their debt loads.? In that sense, the US is in good shape, because we don’t discourage immigration.

Fear the Boom and Bust — an Economics Lesson

Posted on 29 January 201031 January 2010 by David Merkel

Ordinarily, I don’t think much of video on the web.? Writing is usually a more concise way to get a view across.? But video can be more effective if it gets past the genre of “talking heads,” in which case, one is usually better off reading a transcript.? Consider the State of the Union message as an example: regardless of who is president, would you rather spend an hour on it, of five minutes?? And, it would be five minutes where you are not distracted by the crowd, and can dissect things rationally.? I pick reading.

There are places where video can be useful, but it has to be well thought out.? I first saw the above video over at “The Big Picture,” which has enough readership to kick up a video’s viewings.? I thought it was clever, representing the economist’s views in a short catchy way, and capturing their philosophies? as well.? The next day, I showed it to three of my boys — they thought it was interesting, and mentioned it the next night at dinner.? My wife, incredulous at the idea of an economics rap video, then watched it the next night with all of the kids, while I cleaned up the dinner dishes.

Then the surprise happened.? “Dad, what are animal spirits?”? “Are animal spirits the bull and the bear?”

Interesting.? The video prompted questions from the children for me to answer.? I’ve written on Animal Spirits before, at least twice.? Animal spirits attributes irrational risk taking and avoidance to businessmen, as if they are irrational animals.

I told my children that businessmen are generally rational, and they make their decisions off of their own balance sheets, and the general willingness of the market to spend, which is related to balance sheets in aggregate.

The contrasts of the video are considerable:

Keynes is known, Hayek is unknown.? Desk clerk immediately knows Keynes.
The two men are hybrid in what they portray.? To some degree they represent the schools of thought that each was a leader of, and to degree the men themselves.
Hayek reaches into the hotel room drawer, and rather than finding the Bible, finds the General Theory. Similarly, Keynes says, “I am the agenda.”? This is a statement of the dominance of Keynesian thought in modern macroeconomics.? Keynes was important, but not as dominant while he lived.
Hayek assumes they will go via the subway.? Keynes hires a limo.? Keynes is worldly wise, having a great time, and Hayek is uncomfortable.? Keynes has alcohol; if Hayek is having alcohol, he is sipping it through a thin straw.
Alcohol is an allusion through the whole piece.? Stimulus is just more of “the hair of the dog that bit you.”? The boom is a good time where we drink freely, and the bust is where we deal with our hangover.? It was no surprise to see that the Bartenders were named “Ben” and “Tim” and that they were serving up alcohol for as long as the patrons would survive.? Even the pyramiding of the glasses had meaning — building up to a stuporous, unsustainable level.
Keynes holds money as he begins his rap, and throws it midway through.? It is an aspect of how incentives from the government or central bank can lead behavior for a time.
Keynes ends his rap with “We’re all Keynesians now.”? Keynes himself did not live to hear that comment uttered by Friedman in the ’70s.
Keynes and Hayek had different views on spending and savings.? On spending, Keynes didn’t think what money was spent on mattered, only that it was spent.? Hayek felt that intelligent spending would grow the economy more.? On savings, Keynes was negative, whereas Hayek said that moderate savings were valuable, and would facilitate future investment.
As for animal spirits, businessmen only get bold when they have sufficient free capital to act.? When interest rates are artificially low some businessmen invest, trusting that good times will continue.? Alas, those good times never last; avoid long commitments when times are good.
There are liquidity traps, but they occur when banking systems are broken due to misregulation.
“In the long run we are all dead.”? Well, Keynes, way to care for our progeny.? You had no kids, for a variety of reasons, but some of us care for how our children, and the nation that we love will do after we have died.

The video portrays a Goliath and David situation.? Keynes is dominant, and totally assured of his position in the world.? Hayek is less certain of himself, but certain in his message.

My wife and my kids have a better understanding of the current economic situation now than they did before the video came out.? I am grateful that the video was made.

Double Down Institutional Investing

Posted on 28 January 2010 by David Merkel

I once wrote a post on university endowment investing that I thought was one of my better ones, but drew little attention.? It helped to inform another piece I wrote that was better received, The Forever Fund.? Okay, two more if you are a glutton for this kind of stuff: Liquidity Management is the First Priority of Risk Management, and The First Priority of Risk Control. (Note: university endowments had a lousy year ending in June of 2009.? Things may be looking better now, but with interest rates so low, university endowments are even more reliant on outperformance of equities and other risky assets.)

The key idea is this: understand what you are trying to fund before you begin investing.? When will the money be needed?? How much?? How realistic is the implied rate of return?? What if everyone with needs like yours tried to do this?? Would it work then?? Is the demand for investments that are optimal for entities with your liability structure greater than the available investments to be had?? Do you have some sustainable competitive advantage that few others have?

When I look at ideas like pension plans employing leverage (also here), I think they don’t know what they are doing.? Anybody remember how New Jersey decided to sell pension bonds and lever up their pension investments in risky assets?

That last article is timely, published today.? What began as borrowing $2.7 billion to plug a gap became a $34 billion gap.? Risky assets, particularly equities, did not perform.? Not only did they not earn enough to earn the actuarial rate needed to fund the defined benefit plan, they also had to pay interest on the pension bonds.

Trying to fill a funding gap via a more aggressive strategy is usually foolish.? If that were the best strategy, you should have been employing it already.

But consider the leverage angle more closely.? A defined benefit plan is by its nature a plan to pay out a stream of benefits over time to beneficiaries.?? Typically they invest some of their assets in bonds that are shorter than the length of the stream of benefits they will have to pay.? Those bonds typically don’t earn enough to cover the actuarial funding rate, so they invest the rest in risky assets that they think that blended with the return on the bonds, will earn the actuarial funding rate or better.

There are at least three problems here:

It would be ideal to invest entirely in super-safe debt instruments that match the expected liability cash flows, but that would require too much in taxes from the citizenry.
But the moment that you move to funding some of the assets into stocks you open up two risks: 1) funding risk — what if the risky assets don’t perform to the degree needed? and, 2) Interest rate risk — the moment you are not matched there are risks if interest rates move against you.? This is usually a risk if rates move down.? It is rare for a defined benefit plan to buy enough long debt such that the value of bonds rises as much or more than the present value of the liabilities rise when interest rates fall.
Pension bonds, or any sort of investments with internal leverage have the potential to increase funding risk, and they increase interest rate risk as well.? Pension bonds add another fixed claim to the existing semi-fixed claim of the benefit stream.

Are we the double-down society as far as investing goes?? It sure seems like it, and if many entities do this as a group the failure of the idea will be spectacular.? Risk premiums are not high now; take a look at Jeremy Grantham’s forecasts on page 4 of this PDF (which has many other useful bits that you can learn from).? Borrowing money to invest when risk premiums are small is playing the exact same game as we were doing with CDOs from 2005 to 2007.? If the spreads are thin, pile on more leverage!? That will get us to our earnings target.

It’s sad to see this phenomenon reappearing.? Don’t we ever learn? 🙁

http://alephblog.com/2009/05/30/the-first-priority-of-risk-control/