Category: Public Policy

Book Review: Where Keynes Went Wrong

Book Review: Where Keynes Went Wrong

Posted on by David Merkel

When I was a grad student, I always felt weird about Keynes.? I grew up in a home that was not explicitly “free market” but was implicitly so.? My Dad was a small businessman and my Mom was a retail investor (as well as home manager).? My Dad’s business did well, but it had its share of hard times, including the depression of 1979-1982 in the Rust Belt, where many of his competitors did not survive.? He had to be a member of the local union and run a closed shop, but as an owner, he had no vote in union matters.

I worked for my Dad for two summers.? During one of them, when we went to get parts, the parts dealer said to me,”I’ve heard good things about you.? Even the union steward has heard about you.”? My face and my Dad’s face went white. I was not in the union. After an uncomfortable pause, he said, “Eeeaaah! Got you!” and he laughed.? Dad and I looked at each other, embarrassed but relieved.

My Mom, like Keynes, and like me, has beaten the stock market for most of her life.? There are excess profits available for wise investors, some of which stem from the foolishness of other investors.

Keynes was a fascinating man who understood asset markets well, but when trying to consider the economy in general, looked to what would work in the short run.? The author of Where Keynes Went Wrong points out repeatedly from Keynes’ writings his view that interest rates are almost always too high, and that interest rates should only rise when inflation is rising quickly.? Can lowering short term rates juice the economy.? Yes, in the short run, but in the longer run it fuels inflation and bubbles.

The strength of Where Keynes Went Wrong is that it spends a lot of time on what Keynes actually said, rather than the way Keynesianism developed into a branch of Macroeconomics, eventually becoming part of the dominant macroeconomic paradigm — the Neoclassical Synthesis.? I admit to being surrprised by many of the statements Keynes made — granted, the author is trying to prove Keynes wrong so he goes after what is least defensible.

The author dissects the errors of Keynes into a few main headings:

  • Lower interest rates are almost always better.
  • Growth comes through promoting consumption.
  • You can’t trust businessmen to do the right thing when it comes to capital allocation.
  • Government planning is superior to decentralized planning, because experts in government can allocate capital better than businessmen.
  • Crashes require government intervention.? Using the balance sheet of the government will have no long run negative impacts.
  • Markets do not self-correct.
  • Globalization is good, and the nations of the world can cooperate on creating a standard of value independent of gold.

For the most part, those are my words summarizing the author.? After going through what Keynes said, he then takes it apart point-by-point.? The author generally follows the Austrian school of economics, citing Mises, von Hayek, and Hazlitt.

After that, the book continues by taking on the rhetoric of Keynes, both oral and written.? He was one sharp man in being able to express himself — orally, there were few that could match him in debate.? In writing, where time is not so much of the esssence, there is more time for readers to take apart his arguments, and point out the fallacies.? The author points out much of the fallacies in how Keynes would argue his points.

The book finishes by pointing out the paradoxes involved in Keynesianism, e.g., in order to reflate a debt-ridden system, the government must lower rates and borrow yet more.? Also shows how beginning with manipulating the money supply leads to greater intervention in credit, banking, currency, and other economic policies over time, and why the politicians love the increase in power, even if they realize that the policies don’t work.

One surprise for me was how many ways Keynes suggested to intervene in a slump, and how many of them are being used today.

  • Rates down to zero.
  • Direct lending by the Fed.
  • Directing banks to make certain loans.
  • Bailouts.
  • Nationalizing critical companies.
  • Inflating the currency.

The idea of letting the economy contract in any way was foreign to Keynes.? He felt that a seemingly endless prosperity could be achieved through low interest rates.? Well, now we have low rates, and a mountain of debt — public and private, individual and corporate.? Welcome to the liquidity trap created by Keynesian meddling, together with the way our tax code encourages debt rather than equity finance.

I recommend the book; it is an eye-opener.? It makes me want to get some of Hazlitt’s books, and, read the whole of Keynes General Theory for myself.? The book that my professors once praised as a tour de force has holes in it, but better to read it all in context.

Quibbles

The book could have used a better editor.? Too many things get repeated too often.? The book also has two sets of endnotes, one for reference purposes, and one for expanded discussions.? The endnotes that were expanded discussions probably belonged in small type at the bottom of the page rather than as endnotes.? Many of the endnotes are quite good, and it is inconvenient to have to flip to the back to see them.

Also, on page 274, the author errs.? The risk to a business owner is higher after he borrows money.? The total risk of the business is not higher, but the risk to the equity owner is higher.? Whether that risk is double or not is another question.

There’s another error on page 328.? When I buy stock in the secondary market, I am putting my capital to work, but someone else is withdrawing capital from the market.? There is no net investment.? When I buy an IPO, not only do I put my money to work, but there is more investment in the economy (leaving aside the venture capitalists that are cashing out).? It is hard to say when investment in the economy is increased on net.

The table on page 330 is confusing.? The first row should have been set apart to show that GDP is not a government obligation.

Finally, I don’t think that Say’s Law (“Supply creates its own Demand.” Or in the modern parlance, “If you build it, they will come.”) is true, but neither is its converse (“Demand creates its own Supply”).? The two are interconnected, and either one can cause the other.? Markets are complex chaotic systems, and entrepreneurs sometimes produce goods that no one wants.? Similarly, when consumers discover a new product or service, that demand can help create a whole new industry.? Supply and demand go back and forth — the causality doesn’t go only one way.

Who would benefit from this book: Send it to your Congressman, send it to your Senator.? Make sure every member of the Fed gets one, and the fine folks at the Treasury as well.? Beyond that, think of your liberal friends who think of Keynes as a hero, and give them one.? After reading this, I want to add Keynes’ General Theory to the list of books the everyone cites, and no one reads.? (That list: The Bible, Origin of the Species, The Communist Manifesto)

If you want to buy it you can get it here: Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts.

Full disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don?t buy what you don?t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.

Book Review: This Time Is Different

Book Review: This Time Is Different

Posted on by David Merkel

I love economic history books.? The book that I am reviewing tonight is different because unlike most economic history books, it is mainly empirical rather than mainly anecdotal.

Don’t get me wrong, one good anecdote can deliver more information than a carefully controlled study.? But more often, it is the careful studies that reveal more in their bloodless way.

This Time Is Different takes the reader through the last eight centuries of financial crises globally, subject to the prevalence of available data.? Data is more available recently, so the A.D. 21st, 20th, and 19th Centuries get more play than the more distant past.? Also, the developed West gets more coverage than the East.? This is to be expected.? It all depends on who writes down more.

Crises? have been far more common than the average economics textbook would suggest.? One of the first ideas to toss out of economics should? be that markets strongly tend toward equilibrium.? My own empirical research in the financial markets indicates that mean-reversion is there, but very weak.

The book has a wide number of disasters that it draws us through, namely inflation/debasement, currency crises, banking crises, and internal and external default.

Now, all of these crises tend to happen more frequently than the modern fat, dumb and happy Westerner would like.? Central banking has substituted fewer and larger crises for more and smaller ones.

Regardless, the chapters on sovereign defaults are worth the price of the book.? Will defaults be internal, external, or both?? A lot depends on how much debt will be compromised through default.? If a majority of debt is held externally, foreign creditors should be wary.

This book is needed now because many so-called scholars implicitly assume that the US Government could never default on its obligations.? Yes, it would be a horror, but leading nations in the world have defaulted before, and they will do so again.? It is the nature of mankind that it is so.? Promises happen in good times, and defaults happen in bad times.

Quibbles:

The book is listed as 496 pages, but for non-academics the true length is more like 292 pages.

Also, I would suggest to the authors, that there are predictive variables that they have not considered regarding crises.? Two variables are growth in debt, and yield spreads.? Debt grows like kudzu or topsy prior to crises, and yield spreads are very small prior to crises.? As the crisis nears, debt growth slows, and spreads widen a little.

Summary

This book is not for everyone.? If you tire looking at tables, and prefer more discursive arguments giving anecdotes rather than facts, this book is not for you.

Who could benefit: if you want intellectual confidence that sovereign defaults /currency failures can happen even in the US (note we have had two so far, in addition to many other financial crises), this will give you confidence that you are not a nut.? If you want to educate one of your friends who thinks that such disasters are impossible, this is the book for him.? Just make sure he is willing to endure a semi-academic book.

If you want to buy the book, you can buy it here: This Time is Different: Eight Centuries of Financial Folly.

Full disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don’t buy what you don’t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.

Problems with Constant Compound Interest (4) (and more)

Problems with Constant Compound Interest (4) (and more)

Posted on by David Merkel

At the meeting of the eight bloggers and the US Treasury, one of the differences was whether the recovery was real or not.? The Treasury officials pointed to the financial markets, and the bloggers pointed at the real economy (unemployment and capacity utilization).

With T-bills near/below zero, I feel it is reasonable to trot out an old piece of mine about the last recession.? But I will quote most of it here:

I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the ?auto companies were?dying.?

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On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?

A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts? Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.

It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don?t worry, we?ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus?s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:

I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn?t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don?t?

It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn?t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: ?There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,? Broaddus said. People shouldn?t ?expect too much from monetary policy? to steer the economy, he said.

When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, ?Broaddus says don?t expect too much from monetary policy.? Taken out of context, Broaddus?s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, ?Next time you talk to a Fed Governor, let us know, so we can make some money off it??

PS ? ?Before Broaddus answered, he said something to the effect of: ?I?m glad the media is not here, because they always misunderstand the ability of the Fed to change things.? ?A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.

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And now to the present application:

Why are commodities rising amid surplus conditions in storage?? Why is it reasonable to take over corporations when it is not reasonable to expand organically?? We are in a position where yields on short? Treasuries are nonexistent, investment grade and junk yields are low for corporates, and equities are rallying, but there is little growth, or some shrinkage in productive capacity.? Why?

The liquidity offered by the Fed is being used by speculators for financial positions, levering up relatively safe positions, rather than speculating on areas that are underwater, like housing and commercial real estate.? This is consistent with prior experience.? When the Fed does not allow a significant recession to occur, one proportionate to the amount of bad loans made, but comes to the rescue to reflate, what gets reflated is the healthy parts of the economy that absorb additional leverage, not the part that is impaired because they can’t benefit from low rates.? They have too much debt already relative to the true value of their assets.

That is why a booming stock market does not portend a good economy.? Banks aren’t lending to fund new growth.? They are lending to collapse capacity through takeovers.? ROE is rising from shrinking the equity base, not by increasing sales and profits.

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There is another current application:

Why do we buy commodities as investments?? Is it that we fear inflation in the short or long run?? Is it that it is a proxy for future prices for consumption in retirement, so we are hedging the future price level in a dirty way?

Think about it.? How do you transfer present resources to the future?? Most consumable goods can’t be stored, or require significant cost for storage.? Services can’t be stored; elderly people can’t store up health care.

Storage occurs through building up productive capacity that will be wanted by other at a later date, such that they will want to trade current goods and services for your productive capacity.? Storage also occurs by purchasing goods that do keep their value, and then trading them for goods and services you need when the time come to consume.

That is how one preserves value over time, and it is not easy.? It will be even harder if there are such disruptions to the economy that markets that are virtual do not survive.? (I.e. paper promises are exchanged, but their is significant failure to deliver at maturity.)

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In an environment where the government is playing such a large role in the economy, it is difficult to see how one can invest for the long term — when we are twisted between deflation and inflation, rational calculations are circumscribed, and simple judgments, such as buying out a competitor and shrinking the overall balance sheet are made.? In one sense, that is the rational thing.? Less capacity is needed.? But unemployment will rise.

That’s sad, but wage rates may be too high for some to be employed, given the lack of demand.? I view this as true in aggregate, but people that are aggressive in seeking employment are able to do much better.? I have seen it.? Even in a bad market, those that strive intelligently get hired.

Notes from Recent Travels

Notes from Recent Travels

Posted on by David Merkel

Before I begin this evening, I would like to comment on my absence for the last week.? I gave a talk on Friday to the Southeastern Actuaries Conference.? I found myself behind the eight-ball, because of my many other projects, and so I had to block out the time to write and prepare the talk.

I?m going to turn the talk into a post, or a series of posts.? If you want to view the presentation before then, you can download it here (PPT PDF).? I needed more time; I wanted to do more with it ? but you reach the end of your time, and you have to make your speech. ?I didn?t feel well on the day I presented it; my throat was sore.? So, my apologies to any at SEAC who felt my talk was marginal.

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One thing that came out of the SEAC meetings was an actuarial analysis of the health bill.? The presenter tried to be as neutral as possible, but the more he said, the more the actuaries I talked with said, ?This bill doesn?t make sense.?? Now, I?m not a health actuary; I am a life and investments actuary by training.? Roughly 1/3rd of the audience were health actuaries, and 2/3rds were life actuaries.? The response was not, ?This will hurt the industry.?? The response was more like, ?This won?t work.? The costs are underestimated, and the taxes are overestimated.? This has real potential to mess up the good parts of the system, and be a very costly fix to the less generous parts of the system.? Taxes are front-ended, and costs are back-ended.? The analyses that show savings over ten years will show significant losses in the long run.

Among my pet peeves is that the bills are likely to do away with HSAs, which more than most health plan designs, gives real incentives to keep health care costs down.? If anything, moving away from first dollar coverage to catastrophic coverage would be a real incentive to keep down health costs.

I genuinely hope this does not pass Congress, and that nothing is done.? Then again, perhaps the Democrats want to commit political suicide.? Not that I like the Republicans much, but cramming through an ill-thought-out plan not favored by most Americans, can?t do much for their chances in 2010.

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Secretary Geithner changed his view on why the AIG bailout was done.? He now says it was not over the derivatives counterparty, AIG Financial Products.? He probably says that because the government could have cut a better deal with creditors and did not, leaving the taxpayers on the hook.? Having thus bailed out Goldman, and other US and foreign investment banks that were due payments from AIG, the malodor of aiding investment banks in an opaque way is something the Treasury wants to lose.

So, now he claims it was to prevent systemic risk from failure of AIG?s operating insurance companies.? Now, I know that the life and mortgage insurance companies would have died, because of research I did in March and April of 2009.? But in September of 2008, no one was arguing about the insurance subsidiaries; it was all about AIG Financial Products.? No one was focusing on the weird losses from securities lending at the life subsidiaries of AIG.

Taking a step back, Insurance companies don?t produce systemic risk to the same degree that banks do.? First, the insurance industry is only one-third the size of the banking industry.? Second, insurance asset investment regulations are stricter for insurers than the bank regulations.? Third, the leverage isn?t as high, and the sources of profit are more diversified.? Finally, the liability structure is longer for most insurers, making ?runs? less likely.

So, what would have happened if the Fed hadn?t come in and rescued AIG?

  • I recommended at the time that the government wall off the derivatives counterparty, and then analyze what the risks would be to the system as a whole if AIG did not pay on its derivative agreements in full.
  • The life and mortgage companies would have failed.? The mortgage companies would have added to the losses of Fannie and Freddie.? No state guaranty funds there.? The life companies might have passed $1-3 billion of losses to the state guaranty funds, hitting the life insurance industry when it was weak, but it would have killed few companies.
  • There were support clauses in many of AIG?s main P&C companies for some of the Life companies.? The P&C companies could have made good on those, and perhaps the state guaranty funds would have been clear.
  • Perhaps International Lease Finance or American General Finance would have been weak, but they would not have died immediately? and there would have been little systematic risk from any failure.
  • Common and preferred shareholders would have been wiped out, and maybe junior bondholders.? Senior bondholders might have been forced to compromise.

This isn?t good, but it is also not systematic risk.? After walling off AIGFP, there was no systemic risk from letting AIG fail.

Holding companies should never be bailed out.? There is no case for protecting them.? Operating subsidiaries are another thing; they are regulated for the good of consumers, ostensibly.

Ergo, I find the logic of the Treasury and Secretary Geithner wanting if he is claiming he was trying to avoid systemic risk in bailing out AIG, outside of AIGFP.? These arguments were not made in 2008, and in general, it is really difficult for an insurance company to generate systemic risk.? Systemic risk stems from short-funded financials, and in general, insurance companies do not fit that description.

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This is just another reason why average Americans don?t trust the Fed.? But there are many reasons:

  • The Fed will not submit to full transparency of its actions.
  • They will not comply with legitimate FOIA requests.
  • They can?t be replaced by the people, but they have a big impact on the lives of the people.
  • Congress does a lousy job regulating them.
  • They acted high-handedly in bailing out entities like Bear Stearns and AIG that should have been put into bankruptcy.? Bailouts violate the sense of fairness that most Americans have.? Systemic risk could have been avoided without bailing them out in entire.

Is it any surprise then, the Congress, having done a lousy job of regulating the Fed and the Treasury, points the finger and blames those that they have been appointed to rule?? Alas, I see a lot of room for blame to go around, but few are willing to take it in DC.? There is no equivalent of Truman?s ?The Buck Stops Here.?

In a bad environment like this, many governmental entities worry for their survival.? Good.? They should worry.? There is the outside possibility that things could change dramatically after the next election.? Perhaps ending the Fed won’t be a pipe dream then.? After all, the US did quite well without a central bank for most of its existence.

Deeds, not Words on the US Dollar

Deeds, not Words on the US Dollar

Posted on by David Merkel

From Bloomberg, I quote our Treasury Secretary:

?I believe deeply that it?s very important to the United States, to the economic health of the United States, that we maintain a strong dollar,? Geithner told reporters in Tokyo today.

Before I write, I can hear my friend Caroline Baum of Bloomberg gearing up her mental energies to say something like, “Again?? How many times can they say that with a straight face?”

If I wanted to create a strong dollar, what would I do?

  • I would have the Fed raise short-term rates.
  • I would reduce the creation of dollar claims by bringing the Federal budget into balance.

Neither of these are realities.? Thus the weak dollar.

But perhaps there is another way, and if you are reading me at the Treasury, please listen.? The idea is to make the countries that have acquired a lot of Dollar obligations realize that they are likely better off acquiring goods and services from the US now, rather than at a lower exchange rate later.

There is brinksmanship here, but when I was a bond trader, I could make it happen.? In the present context, there is no value to piling up more dollar obligations in exchange for goods today, unless one has a domestic political agenda to fulfill.

Now, with Japan and China, (and OPEC) both should be encouraged in this way.? Buy today, your dollars will likely buy less tomorrow.? That one action would restore balance to the global economy, as less business would be done on a credit basis across nations.

After that, the harder problem of dealing with structural US budget deficits becomes paramount.? What do you do with a government that has promised more than it can deliver?? The French Revolution comes to mind, but maybe we can do something more gentle.? The President addresses the nation, and tells the Baby Boomers that benefits from Medicare will be reduced.? It becomes a small medical needs and hospice program.? The nation can’t afford anything more, and if you were paying attention, you knew that.? Oh, and the foolish Part D, created by Bush gets eliminated, with no replacement.

As for Social Security, it becomes means-tested, and becomes an old age welfare program, complete with stigma.? “If you are receiving Social Security, you couldn’t have done that well.”

If we take actions like that, the US can survive.? Short of that, we face significant inflation, and a greater diminution of our living standards.

Until then, whoever is our Treasury Secretary will go around the world and say, “The US is committed to a strong dollar.”? And this is a valuable service.? We all need fairy tales to help us fall asleep easily at night, both here and abroad.

How to Regulate the Banks, and other Financials

How to Regulate the Banks, and other Financials

Posted on by David Merkel

At the Treasury meeting, I commented that the insurers were better regulated for solvency than the banks.? One of the reasons for that is that they do harder stress tests, and they look longer-term.

So, if one is trying to regulate banks for solvency, there are two things to do:

  • Set risk-based capital formulas so that few institutions fail.
  • Make it even less likely that larger institutions fail.

As a clever old boss of mine once said, “A banks liabilities are its assets, and its assets are its liabilities.”? The idea is this — banks that focus on their deposit franchises have something of real value — that is hard to replicate.? But any bank can invest their funds aggressively, which will lead to defaults with higher frequency.? It is true of insurers as well, most financials die from bad investing policies, and short-term liabilities that require complacent funding markets.

The essence of a good risk-based capital formula is that it forces intelligent diversification, and forces adequate liquidity.? No assets should be bought that the liability structure of the bank cannot hold until maturity.? There should be no concentration of assets by class, subclass, or credit, that would be adequate to lead to failure.

My view is that a proper risk-based capital regime would start with asset subclasses, and double the capital held on the largest subclass, and 1.5X the capital on the second largest subclass.? After that, within each subclass, the top 10 credits get twice the level of capital, the next 10 1.5x the level of capital.

Having managed assets in a framework like this, I can tell you that it creates diversification.? But the next part is even more important, because short-term funding structures are a recipe for default.

It is almost always initially profitable to borrow short and lend long.? That said, it is a noisy trade.? Who can be sure that short rates will remain below the rates at which one invested long?? The second component of a good risk-based capital formula is that there is no investing in assets that are longer than the liabilities that fund the financial institution.? (For wonks only: regulated financial institutions should be matching assets versus liabilities as their most aggressive posture.? Unregulated financials can do what they want.? And no investing in unregulated financials by regulated financials.)

But after all that, there must be a capital penalty on larger institutions.? Let financial institutions get as large as they like, but once they get to a certain level of assets, say $100 billion, start raising capital requirements so that it is uneconomic to manage more than $500 billion in assets.? If we had regulations like that, the too big to fail issue would not occur.? As they got close to the barrier banks would break themselves up, without any external intervention.

Beyond that, no modeling of asset correlations would be brought into the modeling because risky asset correlations go to one in a crisis. Any advantage derived from diversification should be accepted as earned, and not capitalized as planned for.

Dodd’s Proposals

There are good things in Senator Dodd’s proposals, but I want to focus on a few things.

Either eliminate the Fed, or let it manage systemic risk.? Why?? The Fed creates most systemic risk through its monetary policy.? What tools would a new regulator have to constrain the Fed?? None?? I thought so.? In a fiat currency economy, the central bank must constrain credit in order to constrain monetary policy and systemic risk.

I don’t think there has to be a single regulator, as much as the regulators should choose whom they regulate, rather than vice-versa.? Options are always bad for financial institutions.? One should want them to apply to the Treasury for a regulator, and the Treasury assigns the regulator that will minimize risks to the nation.

As for changing governance of the Fed, Dodd’s bill misses the point.? We don’t care who governs it. We do care what their goals are.? We want them to minimize goods and asset inflation, while not letting the economy go fallow through capital or labor unemployment.

I’m not crazy about Dodd’s plans to select members of the FOMC by a vote from the Fed Board.? That just centralizes power in the hands of incompetent Fed Board members.

Personally, if I can’t eliminate the Fed, I would rather its members be democratically elected each congressional cycle.? Yes, initially the electorate would make errors, electing those that promise greater prosperity, but eventually they would realize that they need to elect those that will restrain inflation, regardless of the consequences.? I trust the people of America more than the elites that have mismanaged it.

My Visit to the US Treasury, Part 7 (Final)

My Visit to the US Treasury, Part 7 (Final)

Posted on by David Merkel

Things have been busy for me, so this final part should be short.? What did I learn that I did not already know?? Not much, except:

  • The Treasury wants to convince? the public that it is doing its best, but that Congress is a slave to the Financial Services industries.
  • When asked about the latest bailout of GMAC, they said that didn’t qualify as a financial — the aid was to help the auto companies.? (If so, send it directly, and let GMAC expire.)
  • They said that they worried about the same things we did, though they had to maintain public confidence, and did not think it was as likely as we thought.
  • They did not bring up the GSEs.
  • They pointed at the financial markets as evidence of recovery, and did not speak of the real economy, which is weak.
  • There is no acknowledgment of what could go wrong in the long-run.? They are only playing for the next 3-7 years, at most.? Everything is done to goose the next year.
  • That the Treasury is trying to reduce its footprint in the economy is welcome news to me.
  • They said that they were trying to be wise stewards of the economy, but that Congress had questionable motives.

May I go back to my original questions:

  1. Haven?t low interest rates boosted speculation and not the real economy?
  2. We are looking at big deficits for the next seven years, but what happens when the flows from Social Security begin to reverse seven years out?? What is your long-term plan for the solvency of the United States?
  3. We talk about a strong dollar policy, but we flood the rest of the world with dollar claims.? How can we have a strong dollar?
  4. None of your policies has moved to reduce the culture of leverage.? How will you reduce total leverage in the US?
  5. Why did you sacrifice public trust that the Treasury would be equitable, in order to bail out private entities at the holding company [level]?? People now believe that in a crisis, the government takes from the prudent to reward the foolish.? Why should the prudent back such a government?
  6. If we had to do bailouts, why did we bail out financial holding companies, which are not systemically important, instead of their systemically critical subsidiaries?
  7. We are discussing giving tools to regulators for the tighter management of the solvency of financials.? There were tools for managing solvency in the past that went unused.? Why should we believe the new ?stronger? tools will be used when the older tools weren?t used to their full capacity?? (The banks push back hard.)

I’ve answered 1 and 2.? The rest are unanswered.? Here are the brief answers.

3) No, there is no strong dollar policy.? Wait for the day when we are net exporters (and our relative wages will be lower then.)

4) They are doing nothing to? reduce total leverage in the US.? My own guess is that it is increasing.

5) And there is the question, aside from fairness, were the bailouts Constitutional?? A narrow reading of the Constitution says no, but our government does many, many things that violate a narrow reading of the Constitution.? The fairness question was not raised either, the bloggers there were attacking effectiveness, not fairness.

6) This is my guess — we bailed out holding companies because it was the simplest way to do it.? More thought would have led to a cheaper solution, but thought is rare during a panic.

7) I have no answer to point 7.? There is no good reason to hand over stronger tools to a culture that has not used weaker tools.

Aside from all that, we could have spent more time on international issues.? There was the joke at the beginning of the session that one fellow tasked with raising money was “fluent in Mandarin.”?? From the chuckles, I gauged it to be a joke.

But that might prove to be the most significant point economically.? The Treasury is putting pressure on the Dollar through high debt issuance, and the Fed through the creation of short-term credit to heal various debt markets.? The benefits are going to debtors, not creditors.? What value should the creditors assign to the Dollar?? The simple answer should be less than previously.? Yet, nations follow many noneconomic goals, many of which benefit the US as the reserve currency in the short-run.

The ultimate answers are complex, because they rely on how other nations will act.

Final Note

I have found interesting the commenters that automatically assume that being willing to go to the Treasury and eat one cookie equals compromise.? There are a lot of scared and frustrated people in the US, and they see their prosperity ebbing, and are looking for someone to blame.

Let me try this — as the world has gone capitalist, the edge of the US has been eroded.? Now we face a world where doing certain jobe should pay the same, regardless of where they are located.? Wages in the US will converge with those from the rest of the world, adjusted for capital investments.

Throughout human history, “middle classes” have been abnormal.? The current adjustment in the US may be showing the once large middle class that it is not a normal thing, and is hard to maintain.

There is no conspiracy.? The US Government is up against economic forces larger than it can combat.? The rest of the world is out-competing the US, and the US? has a shrinking portion of the pie as a result.

My Visit to the US Treasury, Part 6

My Visit to the US Treasury, Part 6

Posted on by David Merkel

Now, none of us knew when we came that only bloggers were invited.? Personally, I expected it to be a broader press briefing that some bloggers could come to as well.? “Deep background” is well understood to the press, but new to bloggers.? My blogging friends at the meeting can correct me, but all of us were surprised that it was only bloggers at the meeting.

My only clue that they might have treated us nicer than some other gatherings, was that some staffers not at the meeting came in after the meeting to raid some cookies.? Now, maybe that is normal regardless there.? I’ve seen the same things in corporate settings.? The e-mail announcement, “Open season in room 406!”? That said, the chocolate chip cookies were all gone. :(? I had one, as did Tyler, I think.? Maybe the Treasury officials had the rest.

Personally, I am comfortable with the restrictions on reporting from the meeting.? The Treasury’s high-level staff sound the same tune.? It doesn’t matter if we identify them or not, they reflect the policies of the Obama Treasury.? With restrictions on not identifying who said what, to me it does not matter, because they were senior Treasury officials.? We can quote, or approximately quote.? We can’t tie it to a single person.? That doesn’t affect us much.? We know what they think, and we can write about it.? We just can’t say exactly who said it, or whether they were there.

Making Money or Not

Few areas of the US government are designed to make money.? One of the main points that Treasury made to us was that the TARP would cost little, or might make money.? TARP is a piece of a larger puzzle.? My question is this, counting in all of the bailouts, including all stimulus programs, what is the cost to the taxpayer?? Now, I ask my readers what they know here. E-mail me with any comprehensive pieces that you have seen, or put it in the comments, so that all can see.

When I look at the bailouts, AIG, Fannie, and Freddie have sucked up /are sucking up resources.? With respect to the GSEs, I appreciate the view that the Administration views Fannie and Freddie as a hole in the system that they can use to funnel money to housing without asking Congress for approval.? Certainly their financial result show it.? Fannie lost a lot of money last quarter and is begging for help.? Freddie lost less, but is not asking for money now, but they likely will in the future.? As for the Treasury, they have opted to not maximize the value of Fannie by allowing her to sell of tax credits to others, notably Goldman and Berky.? They are not interested in maximizing the value of the GSEs, only of using them for their policy goals.

One slide the Treasury showed us was that they thought they were making money across all of the TARP bailouts that they did.? Also, that their guarantee programs had made money as well.

True, so far the guarantee programs have made money.? That does not mean that the government should be in that business, as it may encourage greater risk taking later, because they think the government will rescue them in times of trouble.? In England, at least some think it is a bad precedent.

TARP may be doing okay, but the same moral hazard argument applies.? Also, bailouts may come after shareholders have lost a lot, but management teams may (and seem to be now) benefit disproportionately from the bailout.? Away from that, the losses from the GSEs, Auto companies, and AIG swamp other gains.? That’s what it seems to me.? Does anyone else know better?? Please put it in the comments, for all to see.

Away from that, consider how the FDIC is basically broke, and that the FHA is not far behind.? This crisis is not over.

A Place of Agreement

One place where I can agree with the Treasury is that there should be only one regulator of depositary institutions.? The insurance industry can choose among states, but for the most part there are states for big companies,and states for small companies.? The states willing to regulate the big insurance companies have done a great job relative to the banking regulators.? There are few failures.? AIG died for non-insurance reasons.? Penn Treaty was a basket case long before the crisis.? Who else died?

Having one regulator for banks will remove the ability of the banks to choose the weak regulator.? It raises the risk that the one regulator will be corrupted.? That’s a lesser risk, because with many regulators, the odds that one will be corrupt are high, and corrupt institutions will go to them to be regulated.? With one regulator, politicians can more easily watch the troubles, and can more easily assign blame.

I have no objection to one national insurance regulator either.? That said, many states will object, because they have differing standards.? But does Congress really want to do insurance law?? It takes up a lot of time and is complex.

The Final Note for Now

Things always look best for a borrower immediately after his most recent loan.? So it is for most programs in our economy that favor giving loans in this crisis to stimulate demand.? So it was in the 70s and 80s with lesser developed countries.? The finances looked great after the loans, but after they had spent it away on consumption, things looked much, much, worse.

So it is with government programs that interfere with the free market through offering cheap lending terms.? They give a temporary lift that leads to greater problems once the subsidy is spent away.? So it is now with government subsidies and loans.

Other Posts

Two more posts on the meeting, one from a blogger who was there:

A Sit Down With Senior Treasury Officials – Part II

and one who was not, somewhat critical, but constructively so:

Treasury and the?Blogs

As for me, I’m glad I went.? I have a better zeitgeist of the US Treasury.? I am not more impressed, nor less impressed with them.? I do want the Federal Reserve to consider inviting us to meet with them.? They are far less accountable than the Treasury, and many of us would like to counsel them on their behavior that seemed smart at the time, but will likely prove destructive to the republic.? Dare you invite us, Ben, or do you have less courage than the Treasury?

My Visit to the US Treasury, Part 5

My Visit to the US Treasury, Part 5

Posted on by David Merkel

One other blogger took his nameplate with him — I’m not sure who; the rest left theirs.? But this is what was in front of each one of us as we sat down to discuss matters at the US Treasury.? Treasury officials had similar nameplates.? It dictated where we would sit as well.? From the front of the room on the left, for bloggers it was Financial Armageddon, (Megan McArdle — not there), Accrued Interest, and Across the Curve.? On the right, Naked Capitalism, Kid Dynamite, Interfluidity, Me, and Marginal Revolution.? Aside from putting the two bloggers with the most traffic at the front, there did not seem to be any rhyme or reason to the seating.

The Treasury officials presenting generally sat in front, a few sat to the side and behind us.? It made for an interesting dynamic during the portion of the meeting where some bloggers disagreed over whether derivatives should be exchange traded or not.? The folks from the Treasury grinned.? See?? These aren’t easy questions to answer!? For me, with a middle view (bring interest rate swaps to exchanges first and see how they work, then try other instruments that are less liquid), I found the exchange to be a waste of precious time, but it was revealing of the attitudes of those in the Treasury.? I knew what the bloggers thought already.

The Biggest Financial Problem

I’ve written a number of pieces on why debt matters. (Or, where is the breaking point?)? I am in the process of reviewing This Time is Different: Eight Centuries of Financial Folly — a book that deals with the reality of sovereign defaults over the last 800 years.

Surprise! Over-indebted countries do default on their debt more often than less-indebted countries.? During the current crisis, we have two mechanisms running to blunt the troubles.? The government is running a large deficit, and the central bank is sucking in longer-dated bonds to lower interest rates.? I talked about why lower interest rates are not necessarily a blessing yesterday.? Today’s thoughts are on deficits.

After the meeting, I said to one Treasury staffer, “One of the quiet casualties of this crisis is that you lost your last bit of slack from the entitlement systems.”

“What do you mean?”

“Just this, prior to the crisis, Social Security and Medicare would produce cash flow surpluses for the Government until 2018.? Now the estimates are 2016, and my guess is more like 2014.? The existing higher deficit takes us out to the point where the entitlement systems go into permanent negative cash flow.? This means that the US budget is in a structural deficit for as far as the eye can see, fifty years or more, absent changes to entitlements.”

He looked at me and commented that it would be the job of a later administration.? No way to handle that now.? To me, the answer reminded me of what I say to myself when I go on a scary ride at Six Flags with my kids.? There is nothing we can do to change matters.? The only thing to adjust is attitude.? So, ignore the fact that you are afraid of heights, and enjoy the torture, okay?

Would that I could do that with the present situation.? The long term problems are too numerous, and the present crisis saps attention from what is arguably a larger problem.? Medicare, Social Security, unfunded Federal pensions and retiree healthcare, underfunded state pensions and unfunded retiree healthcare, and underfunded corporate pensions (flowing to the PBGC) are the crisis of the future.? We are talking underfunding and debts equivalent to 4x GDP in total.

The deficits may be helping out areas of our economy for which there is already too much capacity — autos, banks, housing, but isn’t aiding the parts of the economy that don’t have excess capacity.? The one advantage to Americans is that a decent amount of the debt is absorbed by the neomercantilists, who will get paid? back in cheaper dollars (if at all) than the goods that they provided originally.

This all feels like the Japan scenario.? Low interest rates, low growth if any in non-protected sectors, soggy debt-laden protected sectors, excess capacity in areas not salable to the rest of the world, high government debt, and a demographic crisis.? Also speculation using cheap leverage for carry trades.

I’ll try to tie this up in another post or two.? Sorry if this is verbose.

My Visit to the US Treasury, Part 4

My Visit to the US Treasury, Part 4

Posted on by David Merkel

So, who did I recommend for the next meeting at the Treasury? (I think there will be one.)

Economists View http://economistsview.typepad.com/
Cafe Americain http://jessescrossroadscafe.blogspot.com/
Market-Ticker http://market-ticker.denninger.net/
Econbrowser http://www.econbrowser.com/
Greg Mankiw?s Blog http://gregmankiw.blogspot.com/
Carpe Diem http://mjperry.blogspot.com/
Credit Writedowns http://www.creditwritedowns.com/
Gregor Macdonald http://gregor.us/
Jeff Miller http://oldprof.typepad.com/
Floyd Norris — NYT http://norris.blogs.nytimes.com/
Market Beat — WSJ and their real time economics blog, deals, and real estate blog… http://blogs.wsj.com/marketbeat/
FT Alphaville — http://ftalphaville.ft.com/
James Pethokoukis — Reuters http://blogs.reuters.com/james-pethokoukis/ (also Matt Goldstein and Rolfe Winkler at Reuters)
Curious Capitalist — Time http://curiouscapitalist.blogs.time.com/
Matt Taibbi — http://trueslant.com/matttaibbi/ (And others at the same site)
Trader Mark http://www.fundmymutualfund.com/
Dealbreaker http://www.dealbreaker.com/
The Epicurean Dealmaker http://epicureandealmaker.blogspot.com/
Ultimi Barbarorum http://ultimibarbarorum.com/
Zero Hedge http://www.zerohedge.com/ (ask for Tyler Durden or Marla Singer)
The Reformed Broker http://thereformedbroker.com/
Crossing Wall Street http://www.crossingwallstreet.com/index.html
Cody Willard http://cody.blogs.foxbusiness.com/

Add to that good ideas from my readers:

Warren Mosler
Bill Cara

Now, Treasury responded to me, thanking me for the list, but said that the mainstream media bloggers already have access.? Fine with me — I was just gauging talent and reach.

The Nature of a Liquidity Trap

Go back in history over the last 25 years.? How did the Fed manufacture recoveries?? They lowered interest rates enough so that borrowers would be willing to borrow and refinance assets that had cash flow streams that were not financable in the higher interest rate environment, but financable in the lower interest rate environment.

With each successive rescue, interest rates at the trough were lower than before, inviting borrowers that were increasingly marginal to buy assets, borrowing money at cheap rates to pay them off over time.? We thought we saw the bottom, 2002-2004, but no.? The Fed Funds rate can go to zero, and what’s more the Fed can buy longer dated Treasuries, Agencies, and Mortgage Bonds, lowering interest rates on the longer end of the yield curve.? This allows even more marginal borrowers to buy assets. If they face some hiccup in their cash flow, they will default, and quickly.? If you doubt this, consider the high currently expected rate of default on FHA loans originated over the last two years.

Yes, low rates can get them to buy, but it cannot get them to hold on.? But wait, these are criticisms of the Fed, not the Treasury.? Mostly so, but what of the expensive housing tax credit? and cash for clunkers.? Those belog to the Treasury.? They are not economic programs — the costs far outweigh the benefits.? But wait.? Those shouldn’t be pinned on the Treasury; Congress, bought and paid for, are pushing these programs on behalf of their lobbyists.

If so, where is the administration to shame Congress over such behavior?? Where is the President who should press for a line-item veto?? (I like Wisconsin’s version. 😀 )? Let the Treasury, backed by Obama, ascend to the bully pulpit, and say that such programs are a waste of taxpayer dollars.

The Fed and Treasury have been able to touch of a speculative rally in financial assets, which benefits financials, but with weakness in? end-user demand, the lower rates do nothing to stimulate investment in plant and equipment.

All that said, there are three things that could go wrong here:

  1. Contrary to the expectations of the Fed, inflation could rise, and cause the Fed to tighten.
  2. All of the excess dollar claims could lead to greater depreciation of the dollar.
  3. Defaults could cause credit spreads to widen.

Those have not gone wrong yet, but they are all threats.? More tomorrow, when I discuss difficulties with entitlement programs.

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