Depressions, and severe recessions, attract protectionism.? It’s the nature of the beast.? So long as political pressures are “to do whatever it takes to create prosperity” at home in the short-run, governments will target spending to domestic firms (an increasingly squishy concept in a global world).? What politician would defend to local constituents a bailout package where foreign firms directly benefit from the expenditure of domestic tax dollars?
Though I did not vote for him, I appreciate the principled approach that President Obama is taking here.? He is taking a longer view, and wants to avoid trade wars.? Few politicians take the longer view; that is why they not statesmen.
By their nature, economic crises make people short-termers.? They look to what will help themselves survive amid volatility.? The long-term good of many would involve patience, and a willingness to not press for short-term advantage.? Perhaps Kings could do that, though often they didn’t, but democratic officials are on a short leash from their electorates.
Even Authoritarian places like China tend toward protectionism, though.? Their legitimacy is based on their ability to deliver continued prosperity.? There is increasing unrest in China during this slowdown; expect the Chinese government to do what it can to appease its populace, including measures that protect local businesses.
That’s why I am not surprised at protectionist impulses at this time.? They are short-term rational for politicians, while long-term irrational for economies.? This is just another reason why we are foolish to trust in politicians to assure our economic well-being.? Their short-term orientation is out of sync with what it takes to manage an economy.
We will be best off if after this crisis we realize that the government played a starring role in creating it, and mismanaging it.? Were there businessmen to blame?? Yes, but they took their cues from financial regulators that stopped regulating, and an accomodative monetary policy.? The government did not do its job right, assuring the value of currency/credit.
2) Speed really benefitted us during the original passage of the TARP, right?? No, it didn’t.? So where does Timothy Geithner get off urging speed at this point?? Speed does not eliminate bad debts.? Speed does allow for many venal legislators to push their own pet projects, and use a crisis to disguise their efforts.
3) Read Yves Smith’s piece:The Bad Bank Assets Proposal: Even Worse Than You Imagined.? Our government resists letting banks fail, and then letting the FDIC/RTC2 reconcile them.? They would rather intervene to let marginal or defunct entities live.
There are two groups of nations in the world.? There are those with bad banking systems and too much financial leverage, and there are those with too much industrial/commodity capacity.? These two groups, which comprise most of the world economy, are symbiotic.? The nations that developed their industrial/commodity capacity did not want to import goods from their clients; they were forcing savings on their nations.
So they accepted assets, mainly bonds, of the nations that bought from them.? This stimulated the borrowing economies as interest rates fell, and there was a speculative boom.? Financial companies expanded, making loans they should not make.? Investors pushed up the prices of energy, basic materials, industrial and financial stocks.
It was a thing of beauty.? It was a house of cards.? We can view it as a buildup of operating leverage in one group of exporting nations, and a buildup of financial leverage in the importing nations.
Now, on the other side of the bubble, we have collapsing financial leverage among the importers, leading to a fall in demand for the exporters.? Thus the crisis is global.
For an analogy, think of the tech bubble.? Some companies financed other companies that bought their gear.? They continued to do so, booking sales, while not receiving any real cash.? Then when the companies buying the gear could not pay, both buyers and sellers suffered, and stock values plummeted.
These lists are stylized, but reflect my view of the world:
Importers
United States
United Kingdom
Eurozone
Exporters
China
India
OPEC
Brazil
Russia
Canada
Australia
Japan
Other Asian Tigers
Really, it would be better to break the world down by industry, but there is enough correlation within nations that this characterization works, with a little hand-waving.
This is what makes this depression so tough.? The importers have to eliminate bad debts, while the exporters have to eliminate excess productive capacity.? As with Japan in the late 80s, they overinvested in things that the world would not need in the 90s.? So it is now, and every policy choice is painful.? Making the situation worse is that the crisis is global, but it is the payoff for the exporter nations behaving as neo-mercanilists.? Remember, the mercanilists, the exporters, were the ones that lost originally.
This post is supposed to be a kind of “catch up” post, where I write about a number of small things that I thought were interesting, but weren’t worth a full post.
1) The government can’t fund everybody. The recent backup in the US treasury note market is a great example of that.? As the demands for funds now in exchange for funds later has increased, Treasury interest rates have risen.
I have several biases, but one of them is that the Government can’t unilaterally create prosperity.? It can create conditions that encourage economic activity, through predictable and fair laws, but it can’t make us immediately better off through deficit spending, or tax-and-spending.? The Government does not know what is needed to a better degree than its citizens do individually.
But let the government fund or guarantee everybody.? When they do that, there is just one overleveraged credit that matters, and it will fail, taking us with them.
2) Equity Private is one clever lady.? Fair value accounting primarily exists to deal with investments that are as volatile as equities. How are publicly traded equities valued?? At market.? How about volatile assets where the value is derivable from market prices?? They should be valued at pseudo-market.? If we were back in the old days, and all of our assets were bonds, we wouldn’t need fair value accounting.? Even if we did it, the values wiould not vary much. ? But when you slice and dice the various pieces of bonds, the volatile bits jump around a lot.? To value them at their initial value is ridiculous, the value is too volatile.
3) Felix is right.? There needs to be more of a debate over bank nationalization.I’ve written my pieces there, influenced by the better regulations of the insurance industry, and how they deal with insolvencies.? Mark assets to market.? Do the triage.? Send insolvent institutions to RTC 2, and take stakes in some marginal institutions.? That is where the money will do the most good.
4) “We have to buy up assets that are selling at fire sale prices.? We will even make money for the taxpayers.” So go the arguments of those that want to create a “bad bank”.? Oh, please.? Profits are rare in bailouts.? They happen by happy accidents, a la Chrysler (80s, not now), which possibly could have made it without a bailout.
Assets are at fire sale prices because there is not enough balance sheet capacity to buy and hold them over a period where the realization of value is likely.? I’ve seen structured assets rated AAA where the collateral is okay, and the likely realization of value is in the 90s, if you can hold it for 5 years.? Where does it trade?? Around $60.? Another asset, which would likely be worth $35 if it could be held for 15 years, where does it trade?? It doesn’t trade, but you could get rid of it to a broker for zero.
Strong balance sheets can’t be created out of thin air, though.? Remember how formidable Fannie and Freddie used to be, or many of the FHLBs?? Strong balance sheets only exist through investments where the cash flows will not be needed for decades, like pension and endowment plans.
5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please.? First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation.? Our dear government had many lending programs pre-crisis, and even more post-crisis.? They further encouraged the increase in debt through the tax code.
Why is debt finance tax deductible, and equity finance not?? What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be?? Leverage would have been a lot lower, and the system would be a lot more stable.
Market efficiency means many things.? In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way.? They reveal problems that need to be solved.? Some might call those market failures but they aren’t.? In the present crisis, the invisible hand is saying to us: reduce debt levels; your economic system in too inflexible.? The visible hand, the government, says: “Have some more of the hair of the dog that bit you.? We need lower mortgage rates.? We need more consumer lending.? We’re going to borrow more than ever before in an effort to create prosperity.”? Caroline Baum takes a similar view, and as usual, she expresses it well.
Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems.? Some things become revealed as truly public goods that the government needs to regulate.? But that is not the majority of human actions.
6) AIG is one black hole for cash.? Selling or IPO-ing units during the bust phase, when valuations are compressed does not seem to be an optimal strategy here.? If all of the assets were sold, would there be enough for the junior debt or preferred shareholders to get paid?? (Forget the common.)? So, in the face of it, do they IPO partial stakes in enterprises, with an eventual end of IPO-ing or selling the whole thing later?? If so, there is little free cash flow being generated to pay down debt.
What this implies to me is that the huge loans that the government made to AIG will likely hang out there for a long time.? Is this the best use of the government’s credit?? I think not.? If there are still systemic risk issues, wall those off separately, and send the rest of AIG into liquidation.? The insurance units are intact; let others buy and manage them.? Speculating on a future boom in asset prices is not a reaonable government policy.? Hope is not a strategy.
7) It is simple to blame the US for the current global crisis.? Simple and wrong. The US deserves blame, true, but not even the majority of the blame, just a slightly larger than proportionate amount for its size.
But when China blames the US, it goes too far.? In the era of neo-mercantilism, China had political goals to achieve.? Industrialize the country.? Get surplus workers off of the farms and into the cities.? Keep the currency undervalued to support export-led growth.? Force savings through restrictions on imports.? As a result, suck in developed country debts and companies where strategically desirable and possible.? Do these deals in their currencies because of the need to keep the Yuan cheap.
China made its bed, let it sleep in it.? They knew that they were lending to the US in its own currency; it was a necessary part of the bargain to achieve their own goals.? Just as the mercantilists sucked in gold, and then found it to be less valuable than they imagined when they had to draw on it, so it will be when nations want to draw on the US dollar assets that they have hoarded.
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My phrase, “the humility of realism” is meant to get us thinking about the system as a whole, and about the long-term consequences of societal actions, whether by the government or private parties.? Humility says that sometimes we have to say, “No, we can’t.”? It also says that we should think carefully about major policy actions, and not let ourselves get bullied by those who rush, shouting “crisis, crisis,” while quietly angling for their favored pet projects to get swept in while no one is looking.? Realism sometimes means the government has no good solutions, so it should inform the public that they aren’t omnipotent, and humbly say the crisis must be borne with grace.
The problems generated by the short-termism of the past three decades will not get solved by more short-term thinking.? The present rush to assure prosperity will not end well, in my opinion.
How do you create a Black Swan? It’s not that hard.? Start with something that you know is seemingly useful, true or good.? Then slavishly rely on that idea until it fails.? I’ll toss out a few here:
The more people that live in houses that they own, the better.? The government should encourage home ownership.? You should own the biggest house you can afford.? (In 1986, a Realtor pitched me with that idea, and I thought it was dumb then.)? Residential housing is an investment for the masses; the prices never go down for the nation as a whole.
Continually maximizing return on equity will maximize stock prices.? Optimal capital structures and all times.
We all want high, smooth returns from our investments — high Sharpe Ratios, everyone!
Proper central banking practice can lead to near-permanent prosperity with moderate volatility.
Our government can borrow without limit to promote or common prosperity.? Our central bank can cleverly intervene in markets with their assets, and fix things without getting stuck, or creating inflation.
Many ideas that are good marginally aren’t so good if pressed to their logical absurd.? By duping marginal homebuyers into buying what they could not afford, we create a black swan — I remember commentators who were saying as late as 2006 year end, that home prices never went down across the nation as a whole.? It wasn’t true if you looked at the Great Depression or episodes in the 19th century, but people beieved that housing prices could not go down, so they piled into it creating a boom, a glut, and now a bust and a glut.? Behold the Black Swan!? Rapidly falling housing prices across the nation as a whole.
Consider the buyback craze, now deflated.? Was it good to buy back like mad in 2004-2006?? I would tell insurance management teams to leave more of a buffer for adverse deviations.? But it was always easier in the short run for insurance CFOs to buy back more stock, and earnings would rise.? Stock prices would improve as well, and that’s fine during the boom cycle, for then, but many would issue expensive hybrid junior debt with an accelerated stock repurchase.? Short term smart, long term dumb.
The insurance industry is my example here, but it went on elsewhere.? How many acquiring CFOs wish they had used stock rather than cash for the last major acquisition that they did?? Most, I’m sure.
There is always a boom-bust cycle, and there is ordinary trouble during a normal bust phase.? But when the boom phase has parties abandoning all caution, possibly with government acquiesence, the boom gets huge, and the bust too, where the Black Swan appears — things you thought could never happen.
The craze for smooth, high, uncorrelated returns led to a boom in alternative strategies in the investment business.? Return correlations change not only due to cash flows on the underlying investments, but also due to investor demand.? Not so amazingly, as alternative investments go mainstream, the returns fall and become more correlated.? When an alternative is new, typically only the best ideas get done.? When it is near maturity, only the marginal ideas get done.? Alternative asset prices get bid up along with the boom in conventional assets.
Now we get a Black Swan — all risk assets do badly at the same time.? Investors in private equity don’t want to fund their commitments.? Some venture capital backed firms will fail (here and here).? Many hedge funds raise their gates, all at the same time, because investors want out.? Liquidity is scarce.? Companies pay in kind where they can, whether it is on “covenant lite” loans, REIT dividends, etc.? The era of buying back at high prices gives way to equity issuance at low prices.
Now for my final Black Swan, and perhaps the most controversial.? Monetary policy is “optimal” when it follows the Taylor Rule.? A good central banker, applying the rule, should minimize inflation and macroeconomic volatility.
My argument here, which seems intuitively correct to me, but I can’t yet prove, is that continuous application of the Taylor Rule will eventually lead us into a liquidity trap.? That might be more due to the human nature of sloppy central bankers like Greenspan, who want adulation, and err on the side of monetary lenience.? Or, it might be that the central banker overestimates the productive capacity of the economy.? Whatever the reason, we followed something pretty close to the Taylor rule for 15 years, and now we are in a liquidity trap of sorts.? I’ve suggested it before, but perhaps monetary policy should not focus on (at least solely) price inflation or unemployment, but on the level of total debt relative to GDP.
As with so many things in a complex capitalist economy with fiat money, there may not be a right answer.? Optimizing for one set of variables often leads to unforseen pessimizing (a new word!) another set of variables.? What works in the short run often does not work in the long run.
In closing, consider a Black Swan of the future.? Governments globally nationalize financial institutions, run huge deficits and borrow a lot of money to do so.? They “stimulate” the economy through targeted spending, and ignore the future consequences of the debts incurred.? They do it in the face of the coming demographic bust for the developed nations plus China.? My expectation is that these “solutions” will not do much to deal with the economic weakness induced by the debt overhang.
As Walter Wriston famously said, “A country does not go bankrupt.”? Perhaps what he should have said was the country remains in place, only the creditors get stiffed.? Short of war, it is tough to reorganize or liquidate a country.? But I’lltake the sentiment a different way and say that most people believe “A developed country does not go bankrupt.”? That is the black swan that will be displayed here, and Iceland is the harbinger of what might be a future trend of developed country sovereign defaults, or their close cousin, high inflation.
I didn’t think I’d see a proposal like this one which would (seemingly) bar investors from purchasing default protection via the credit default swaps [CDS] on corporations without owning the underlying bonds.? But here it is.? (It would also force the creation of a clearinghouse for CDS, something I have been more dubious about — it will work for large liquid exposures, but not others.)? This is more restrictive than I would recommend; consider my earlier piece, Rethinking Insurable Interest.
My basic idea is that people, even artificial people like corporations have a right to restrict who takes life insurance out on them, aside from those that already have a financial interest in the well being of the company.? Also, gambling should be opposed on public policy grounds.? Most of the CDS market is just a series of side bets, with little or no true hedging going on.
Now, what I am suggesting is controversial, though less so than the proposed bill.? There is a very good blog called Derivative Dribble, that took issue with what I wrote in my piece.? The author, Charles Davi, asked me to comment on it, and I ran short of time, and never did.? This proposed bill gives me a chance to comment on his piece, and for you to read his logic.? It is a clear statement of what those that have an economic interest in the size of the CDS business will say.
My argument with Derivative Dribble is this: he brushes past my moral arguments and focuses on the right of two parties to be able to contract freely.? (Also, his argument about incentivizing illness is just weird, and does not apply to the discussion at hand.)? Merely because a life insurance company has an economic interest in not selling insurance to someone who might harm the insured, does not mean that the insurable interest argument relies on the self-interest of the insurer.? It is a statement of public policy that we don’t allow parties with no insurable interest to make bets on the lives of others.? It arose out of many incidents where insured parties got murdered.? Innocent people have a right to not be concerned that someone has an incentive to kill them.
In the same way, corporations have a right to not have to worry about being harmed by those that might have an economic interest in their demise.? This is not just for the good of the management, many laborers, suppliers, pensioners, and other stakeholders lose when a firm goes bust.? There are situations where parties controlling the financing of a firm in trouble have acquired CDS protection greater than that of their likely economic loss.? Given that the ability of the firm to refinance in such a situation is limited, this virtually guarantees the demise of the firm.
The right to free contract is limited in our culture, and in most cultures.? Even an economic libertarian like me knows that.? This is one of the areas where the right to contract should be limited, so that corporations do not have to be looking over their back to see if someone has an interest in their demise.
So, though I am nowhere near as good a writer as Mr. Woodward, perhaps my knowledge of the markets might give me a good perspective on what Ben Bernanke should try to understand from his predecessor’s tenure.? With Greenspan, since monetary policy works with a lag, we have a better perspective today on what the true effects of his tenure were.
1) How you accept contributions from lesser players has an effect on policy.
Dr. Laurence Meyer gave a speech once, called Come with Me to the FOMC.? He explained how Alan Greenspan ran FOMC meetings, among other things.? When Greenspan wanted to assure a certain result, he would vote first.? If he was certain of the outcome, he would vote last.
Greenspan also enforced message discipline on FOMC members — there was a party line.? Give Bernanke credit, he lets the main players of the FOMC speak their own minds.
Because Greenspan had quite a reputation for promoting prosperity, this led to groupthink at the highest levels of the Fed.
2) A willingness to throw liquidity at every market fire creates the Greenspan Put.? The promise of liquidity is not free, because economic actors become more aggressive as bad debts are rescued rather than liquidated.
It began with the crash in 1987.? Greenspan was more than willing to throw liquidity at the crisis. Better he should have been silent, and let the market work its way out of the crisis.? He did the same thing with Mexico and RMBS in 1994, Commercial Real Estate in the early 90s, LTCM/Asia/Russia in 1998, Y2K in 1999-2000, and the aftermath of the tech bubble in 2001-2002.
Throughout his tenure the debt/GDP ratio grew, exceeding levels last seen during the Great Depression.? Bad debts grew, leading to our eventual crisis today.
3) Monetary policy should consider asset prices.
Greenspan was unwilling to consider the effect of asset prices on monetary policy in any major way until the end of his term.? Consider this CC post:
When Alan Greenspan Talks, the Market Listens (Apologies to E.F. Hutton)
8/26/2005 10:32 AM EDT
As Alan Greenspan does his “Farewell Tour,” today in Jackson Hole, Wyo., he said the following in his speech:
The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes.
The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.
Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.
The lowered risk premiums–the apparent consequence of a long period of economic stability–coupled with greater productivity growth have propelled asset prices higher.5 The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions.6 The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.
Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums. In short:
Greenspan is factoring asset prices more into FOMC decisions.
Greenspan sees market players as more willing to take risk than before, and thus “risk premiums” are low. (Low credit spreads, investor-owned housing has negative carry, flat yield curve, etc.)
The stability engendering the willingness to take more risk has allowed financial institutions to lever up more.
Greenspan thinks this won’t work out well in the long run.
No one can tell what Greenspan’s successor will do, but rhetoric like this indicates an inverted curve until excesses (real or imagined) can be wrung out of the system.
The market reacted badly when his speech hit the wires. It will do worse if the FOMC carries through on the logical implications of what he has said. (Leaving aside for a moment the friendly foreigners that are more than undoing the FOMC’s tightening actions…)
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Now this had little effect for most of his term, but at the end he was worried.? Reality was catching up with neoclassical dogmatism.
4) Greater length of monetary tightness is a good thing, as is shorter lengths of monetary looseness.
Greenspan had a willingness to loosen for too long, and an unwillingness to let monetary tightness really bite.? This was another part of the Greenspan Put.? He was never willing to disappoint the asset markets for too long.? There is some evidence that he used Fed funds futures to set policy; during the Greenspan years, it was a very good predictor of policy.? I began to wonder whether the tail was wagging the dog.? Fed funds was such a good predictor of Fed behavior one month in advance of FOMC meetings that one did not have to consider much else.
5) Don’t tolerate bad bank loan underwriting.
The Federal Reserve leads bank regulation in the US, and they encourage bank examiners to be tough or loose.? There was a long period of encouraging looseness in bank regulation, and it has led to significant loan losses in our banking system.
In a fiat money system, control of credit is the key thing.? Allowing the banking system to run amok is not helpful to free market economics, because of the resultant depressions.? The ability of banks to extend credit should be limited; without limits, or with loose limits, banks encourage the economy to overexpand, leading to recessions, and occasional depressions.
6) Don’t allow banks to own any assets that you don’t understand, or can’t be valued in tough market environments.
Regulators must bar regulated entities from buying financial instruments that cannot easily be valued.? Regulated entities must be safe institutions even if it hurts their ROEs.? Greenspan encouraged a simple-minded approach to derivative instruments, without considering the systemic effect from their use.
Securitization was another tough concept.? Banks and pseudo-banks originated loans that they would not have if they had to retain them themselves.? That created more systemic risk.
Banks should have been barred from holding assets that were new.? By new, I mean any class of assets that has not suffered market failure, so that the loss potential and illiquidity during a bear market could be estimated fairly, and the proper risk-based capital level set.
By encouraging banks to use their own internal risk models, Greenspan and those that favored the Basel II framework encouraged banks to make aggressive assumptions, and do more business than their capital could bear.
7) Don’t become a tool of the Executive branch, nor of Congress
Greenspan happily sat beside First Ladies during State of the Union Addresses.? He met with the executive branch more than any other Fed Chairman.? He facilitated the economic politics of the government, regardless of who was there.? Consider the plunge protection team during the LTCM era, or his statements after Black Monday in 1987.
Better Fed Chairmen dissed both Congress and the executive, and did their duty.? Consider Volcker during the hard times, William McChesney Martin, or Thomas McCabe.? They opposed the political establishment, and left monetary policy tighter than the politicians would have liked.
8 ) The Fed Chairman should not be the Chief Economist of the US
Perhaps it is another way of running down the shot clock when in front of Congress, but the Fed Chairman is not supposed to be a political figure.? Questions not pertaining to maonetary policy should be ignored.? Score a few points for Ben Bernanke.
Aside from that, Greenspan had many dumb comments over — Irrational Exuberance, ARMs, and Derivatives including Credit Derivatives.
9) Obfuscation pays, but jawboning the markets only works in the short run.
Adam, your question is very applicable. My view on Greenspan is that he tries to get the market to do his bidding, rather than always using the explicit policy tools that the Fed has. He speaks ambiguously for a number of reasons:1. If he speaks too clearly, the market will immediately adjust to what the Fed is going to do, and the actual use of their policy instruments will have little impact.
2. He genuinely tries to express the degree of uncertainty inherent in the data and theory underlying economics, as well as the political backdrop.
3. If he answers too quickly and directly, he will get more questions. In basketball, this is called “running down the shot clock.”
4. I think he uses obfuscation tactically to make it easier to adjust market expectations. He can give occasional clear statements to bump the bond market where he wants it tactically to go in the short run, which may be different than where he thinks it has to go in the long run.
5. I think he enjoys it.
At present, I think Greenspan wants to keep things near where they are, which allows the economy to grow fairly rapidly to absorb labor market slack. To me, that means targeting the 10-year Treasury between 4% and 4.50% or so. Unless there is a marked pickup in his favored inflation gauge, or a huge decline in the dollar, I don’t see the FOMC being compelled to raise the fed funds rate. To raise rates for the abstract reason of reducing leverage in the fixed income market will not play well politically, particularly in an election year.
All my opinions, but I have been watching the Fed for 20 years…
No stocks mentioned
In addition, because Greenspan had such a good reputation during his time as Fed Chairman, obscure comments would be reinterpreted to favor the the views of the one questioning Greenspan.
We are currently in an era where jawboning does not work well, because of the overleverage in the financial system. Jawboning works when economic actors are unafraid of systemic worries, and are only concerned with relative performance in the own local markets.
But it led market players to think”Hey, the Fed has my back,” and so they could take more risks on average.
10) Merely because measured employment is strong, and measured inflation is low, does not mean monetary policy is being conducted properly.
There are three factors that led to monetary policy to be more asset-inflationary, leading the more credit-sensitive monetary aggregates to expand more aggressively while measured consumer price inflation remained low.
First, foreigners were willing to stimulate the US economy in excess of the Fed in order to build up their own manufacturing bases. As such, foreign central banks bought in our debt, financiang our current account deficit, helping our interest rates go below where they would have been in their absence. Bernanke and Greenspan called it the “savings glut,” but they should have tightened policy to compensate.
Second, demographics favored high employment and low inflation, as the Baby Boomers entered the prime of life. Through their institutional agents, pension plans, and their own private actions, a greater amount of risk was taken to finance the future cash flow needs of the Baby Boomers. P/Es were bid up, and interest rates bid down through the 80s, 90s, and 2000s.
Credit spreads were bid down as well, culminating in three major credit boom-busts, which peaked in 1989, 2000, and 2006, respectively. Monetary policy facilitated those cycles by being too aggressive in providing liquidity, creating the boom. The punchbowl should have been taken away sooner. At least, margin requirements should have been raised.
Third, through securitization, more credit was extended than in previous periods relative to the Fed’s ability to control it. Some securitization went on outside of the banks, so it was outside of the Fed’s direct control. Some went on through the banks, but the banks bought many of the securitized debts, the creditworthiness of which is presently suspect. As I argued above, the Fed should have not allowed the banks to invest in asset classes that had not been through a failure cycle.
The Fed should have leaned against the wind on all of these factors to slow down the aggressive growth of debt that now paralyzes our economy. To the extent that that is not in their charter, blame should be laid at the door of Congress. But since the Fed has responsibility for the health of the banking system, they should have addressed these three factors, and considered monetary policy in broader terms.
Instead, Greenspan aided every boom, and never let the busts clear away marginal investments by coming to the rescue too soon. That is his legacy, and we are living with it now.
John looked at the deep brown wood.? When he first came to the boardroom ten years ago he was impressed at its seeming splendor, and thrilled to be a new CEO of Wonderful Life.? Today, the thrill was gone and the wood just seemed dark.
?Hiya, Johnny! Howya doin???
With a jolt, John Davidson turned to face Brent Fowler, CEO of Whata Life.? He answered, ?Just fine, Brent, and you??
?Oh, Johnny.? There are always opportunities to be pursued in our business, and we are doing well in exploiting all of them.?
?Indeed, sir.? Congratulations on another good year.?? John choked up a bit as he said this, because he did not get how Whata Life could be so profitable and grow so fast at the same time.
?Thaaank you , Johnny.? If you are in the right place at the right time, the profits just flow, and that is where we aim to be!?
John didn?t have much to say to that, so he bid Brent adieu for the moment, and bumped into Henry Goldsmith, who was the head of Mega?s Bermuda P&C reinsurance company.? He had always found Henry to be a straight shooter, so he smiled as he asked, ?Hi Henry, how goes it on the rock??
Henry smiled and said, ?Not so bad.? No major disasters, so we make a lot.? We just have to leave some of it to the side for future disasters.? And you??
?Could be better, Henry.? The credit crunch is eating at our assets, and growth has been marginal, despite our best efforts.?
?How much money have you lost??
?We?re making money, Henry, but less than last year.? We can?t dividend as much back to Mega.?
Henry?s eyes widened, and he said, ?Oooh.?? My sympathies.? Look, it?s a tough environment; every life company is having a rough time of it.? Just look at AFLAC.? If they can?t make it, no one can.?
?Very true.? Thanks, Henry.?
?Don?t mention it, John.? Hey remember, if things go bad, I?m here for you.?
?Thanks again, Henry.?? John knew that Henry kept his word, so he considered it an offer to help him in his next job search.? Good guy, bad day.? At that moment the head of domestic P&C, Marc Blitztein, walked into the room.? ?Hey, John, old man, how?re you doing??
Marc was the youngest of the subsidiary managers, but he had turned around the flagging domestic P&C division by focusing on new quantitative underwriting tools before most of the smaller competition caught on.
?Good to see you, Marc. How?s business??
?Could be better.? Competition is rough, but we keep finding new ways for people to know us.?
?Indeed you do.? That Zebra mascot of yours is ubiquitous.?
?Ziggy?? What a concept!? It?s amazing what one good idea will do.?? John wished that he had Ziggy.? Maybe that Zebra could sell life policies as well.? Alas, he had no fancy logos or cartoon pitchmen.
John said, ?Well, more power to you.? Worried about this meeting??
?A little.? We aren?t growing the way we used to; we?re only around 10% growth, and loss costs are catching up with us, somewhat.? How about you??
John shook his head.? ?I don?t know.? Things weren?t great prior to the credit crunch, but given the effect on asset values, we are pinched here.? We won?t be able to dividend as much next year.?
Marc looked at him sympathetically, and said, ?I?ve heard what that can mean.? My heart goes with you.?
?Thanks,? said John, distracted as his cell phone bleeped.? It was his wife.
?Hi honey, you won?t believe what John, Jr., did today??
?Uh, dear?? Can I call you back this evening?? The big meeting is about to happen.?
?I?m sorry, dear.? Call me back.? I?m praying for you.? Love you.?
?I love you too dear.? Bye.?
As he turned his cell phone off, he saw that the CEO of Mega Insurance, Brad Baldwin, had entered the room, together with Stan Bullard, scion of the family that owned Mega.? Behind them was the CFO, the corporate actuary, and a person he had never seen before.? John wondered what might be going on, and thought that this would be one bad day.
With more than a hat tip, but a full bow to my reader Eric, I present a recent comment of his:
Eric Says: Regarding your existing portfolio, you?ve sometimes held FXF and other Proshares Currency funds. Based on the following excerpt, does it seem to you that these funds are too dependent upon the solvency of JP Morgan?
?The Trust has no proprietary rights in or to any specific Swiss Francs held by the Depository and will be an unsecured creditor of the Depository with respect to the Swiss Francs held in the Deposit Accounts in the event of the insolvency of the Depository or the U.S. bank of which it is a branch. In the event the Depository or the U.S. bank of which it is a branch becomes insolvent, the Depository?s assets might not be adequate to satisfy a claim by the Trust or any Authorized Participant for the amount of Swiss Francs deposited by the Trust or the Authorized Participant, in such event, the Trust and any Authorized Participant will generally have no right in or to assets other than those of the Depository. In the case of insolvency of the Depository or JPMorgan Chase Bank, N.A., the U.S. bank of which the Depository is a branch, a liquidator may seek to freeze access to the Swiss Francs held in all accounts by the Depository, including the Deposit Accounts. The Trust and the Authorized Participants could incur expenses and delays in connection with asserting their claims. These problems would be exacerbated by the reality that the Deposit Accounts will not be held in the U.S. but instead will be held at the London branch of a U.S. national bank, where it will be subject to English insolvency law. Further, under U.S. law, in the case of the insolvency of JPMorgan Chase Bank, N.A., the claims of creditors in respect of accounts (such as the Trust?s Deposit Accounts) that are maintained with an overseas branch of JPMorgan Chase Bank, N.A. will be subordinate to claims of creditors in respect of accounts maintained with JPMorgan Chase Bank, N.A. in the U.S., greatly increasing the risk that the Trust and the Trust?s beneficiaries would suffer a loss.?
I have written about credit risk of ETNs before, but now I have to write about credit risks of ETFs. When an investment consists of foreign currency bank deposits of a single bank, there is a concentrated credit risk. In this case, the credit risk is to JP Morgan’s London branch. A default could be messy, with different laws in the UK.
This just highlights the risk involved with esoteric asset classes, where the “cheap” way of getting the exposure comes through credit or derivative agreements.? Be wary as you consider unique ETFs and ETNs; there can be credit risks that you have not considered.
This leson goes way back with me, to my graduate student days, where I was assisting the teaching of Corporate Financial Management.? At UC-Davis, this was the class that attracted the bright and motivated students.? I happened to get it as my first assistant role at UCD, not realizing it was a plum role.
One of the things we taught was that most firms suffer financial distress from a failure to manage cash flow properly.? That is a salient lesson in the current environment.? I learned it again as a young life actuary, because life insurance companies can die from credit risk, run-on-the-company risk, or both.? Consider Mutual Benefit, which wrote fixed-rate GICs [Guaranteed Investment Contracts] putable on a ratings downgrade, or General American and ARM Financial, which wrote floating-rate GICs putable on a ratings downgrade.? The downgrades hit.? They were toast.
Illiquid assets must be funded by equity or long-term noncallable debt, where the term is as long as the asset’s horizon.? (Near asset price tops, longer, near bottoms, long enough for comfort.)? This is the first step in orthodox risk management: assuring that you can hold onto your assets under all conditions.
But in this current crisis, this rule has been violated many times:
Investment banks and mortgage REITs that relied on short-term repo funding.? Bye-bye, Bear and Lehman.? Mear miss to Merrill, protected by Bank of America.? Many mortgage REITs dead, or nearly so.
Derivative counterparties like AIG do not factor in the need for more collateral during times of credit stress.
ABCP and SIVs presume that easy lending terms will always be available.
This is the advantage of the actuarial model of risk over the financial model of risk.? I have previously called it table stability versus bicycle stability.? A table always stands, whereas a bicycle has to keep moving to stay upright.? What happens if markets stop trading in any reasonable fashion?? WIll you be broke?? I submit that that is not an acceptable risk to take, because markets do fail for moderate amounts of time.
Better to manage such that you can buy-and-hold for moderate lengths of time, with enough financial slack to tide over rough patches in the market.? Analyze your cash flows over pessimistic scenarios, and ask whether you can carry your positions with sufficient certainty.? Sell down your positions to levels where you are comfortable.
When I was the risk manager for two life insurance companies, one of the first things that I did was analyze the illiquidity of my assets and liabilities, making sure I had liquidity adequate to fund illiquid assets.? The second was analyzing cash flow needs and making sure there was always more cash available than cash needed, under all reasonable scenarios.
This is risk management at its most basic level.? Many on Wall Street looked at short-term asset/liability correlations, and missed whether they could adequately finance their businesses under stressed conditions.
With that, I ask you:
Do you have an adequate liquidity buffer against negative events?
Are you only risking money that you can afford to lose in entire?
Are the companies that you own subject to financing risks?
Asset allocation is paramount in investing.? Bonds and cash get sneered at, but they play an important role in risk reduction for both individuals and institutions.? As my boss at Provident Mutual taught me, “Never risk the franchise.”? That motto guided me, and I avoided crises that other companies suffered.
Will it be the same for you and your assets?? Analyze your survivability in personal finance, and that of your assets, and make adjustments where needed.
2) I have never read Atlas Shrugged.? I have better things to do.? But, I still believe that much of what the government is doing will cause more harm than good, because they delaying the reconciliation of bad debts.
3) We must restore confidence!? But what is confidence?? Are we talking about some loony Keynesian idea like “animal spirits?”? (We are sentient men, not animals, and have our own unique follies.)
When am I confident about my economic status?? I am confident when I think my goods and services have adequate demand, and my assets are going to throw off cash flow because the economic processes they depend on have adequate demand.? But that is a bicycle stability answer.? What if I am in debt, and most of my economic contacts are in debt, and many of our assets rely on the repayment of debt that is coming from assets with impaired prospects?
Confident men are willing to take on debt; they are so confident that they are willing to take some risk of a large loss from borrowing.? Men who are frightened try to preserve some subset of what they have.
My point is this: in the bust phase of the economic cycle, it is normal for those that have not planned prudently, keeping debts down, and leaving enough in reserve, to be scared.? Given the foolish nature of our government to encourage, rather than discourage debt, it has left us all less confident in the future.? 1984-2007 was one incredible bull phase, and it will be followed by an similarly large bust phase, as debts will have to be reconciled.
Instead, our dear government layers on more debt to try to solve the problem, risking the national credit for political gains.? Some of the debt proceeds are used to buy up other bad debts, others are used to recapitalize marginal institutions.? Nothing much happens, and the big risk appears slowly, that needed change has been postponed through government intervention, leaving a larger problem to solve later.
The most obvious pitfall is that 401(k) plans shift all retirement-planning risks — not saving enough, making poor investment choices, outliving savings — to untrained individuals, who often don’t have the time, inclination or know-how to manage them. But even when workers make good choices, a market meltdown near the end of their working careers can still blow their savings to smithereens.
“That seems like such a fundamental flaw,” says Alicia Munnell, director of Boston College’s Center for Retirement Research. “It’s so crazy to have a system where people can lose half their assets right before they retire.”
Uh, many of the same flaws apply to DB plans, which are also under stress now.? After large market losses, DB plans will look for ways to reduce their liabilities.? There’s no magic here.? When the market goes down, everyone gets hurt, and corporations do not want to contribute more to their DB plans — they would rather terminate them, or shed them to the PBGC after bankruptcy.
5) As an example, consider the pensions of the automakers.? I was somewhat skeptical about the health of their DB plans, partly because GM had contributed a big slug of its own common stock as an asset in the past.? Where was the PBGC when the bailout discussion was active?? They could have derailed the talks by pointing out the underfunding.? Oh, wait.? They want more money to go to the automakers because it might minimize their liabilities.
6) What GSE (government sponsored enterprise) sounds like a mistake?? The Federal Home Loan Banks [FHLBs, pronounced “flubs.”]? They lurk behind the banks that own them, and provide credit to their owners.? As it is now, a large portion of the FHLBs may no longer deserve their AAA ratings because of the losses they may take from risky mortgage assets.
If the Treasury has to rescue the FHLBs, we are truly in sad shape.? They have operated behind the scenes for so long that few know about them.? Better that the owners bail out the FHLBs than the taxpayers.? As it is, the owners are already taking pain.
7) Do you need a free reading on your credit score?? Consult quizzle.com.? I tried it and found it to be free and safe.
8 ) Need some productivity enhancement tools?? Jack Ciesielski provides a year end list at his blog.
9)? I was unimpressed to say the least with this piece by Dean Baker on Social Security.? If all that he is saying is that some benefits will be paid in some form for some time, then I have no argument.? But if he is saying there is no plausible scenario where benefits will not be paid over the long term, then I disagree.? Here’s my argument:
Consider my piece The Biggest, Baddest Bubble of Them All.? The present value of the net liabilities of the US Government on a consolidated basis was $25 Trillion at fiscal year end 2002, $50 Trillion in 2007, and $53 trillion at the most recent reading.? We are facing deficits verging on $1 Trillion for the near future, and on an accrual basis, those deficits are over $1 Trillion, as we take in more than we pay out on our social insurance programs.
To close annual gap of $1 trillion, or even $450 billion (most recent cash deficit) through tax increases and spending reductions will be painful.? Much of the budget involves entitlement programs like Social Security that would be hard, but not impossible to change.? As William Proxmire said back in the early 80s in this famous exchange:
Senator William Proxmire: “…there are 37 million people, is that right, that get Social Security benefits?”
Social Security Commissioner James Cardwell: “Today between 32 and 34 million.”
Proxmire: “I am a little high; 32 to 34 million people.? Almost all of them, or many of them, are voters. In my state, I figure there are 600,000 voters that receive Social Security. Can you imagine a senator or congressman under those circumstances saying, ‘We are going to repudiate that high a proportion of the electorate?’ No.
Furthermore, we have the capacity under the Constitution, the Congress does, to coin money, as well as to regulate the value thereof. And therefore we have the power to provide that money. And we are going to do it. It may not be worth anything when the recipient gets it, but he is going to get his benefits paid.”
Cardwell: “I tend to agree.”
My point here is that benefits may get paid in dollars that aren’t worth that much. The cost of living adjustments will be limited or eliminated.
Increased means testing will eliminate benefits to those that are better off, and turn the program into an old age welfare program, which will bring back the stigma of receiving benefits, and reduce its political legitimacy, because it would no longer have the useful fiction of something that is everyone’s right.? The “contributions” to Social Security are just another tax to support
Benefits will be cut, and taxes will be raised, to be sure.? The point is that the government took the excess “contributions” and spent them on whatever the government needed at that time.? There was little care for future generations — spend it now.? Each succeeding generation gets a progressively worse deal from Social Security, paying in more relative to what will be received.? (As an aside, I know of few that are more pessimistic about the situation than the actuaries I have met at the SSA.)
It is not impossible that younger generations might finally rebel against the burdens placed on themselves over which they have no say.? Social Security could be dramatically scaled back in such a crisis, to the point where it no longer resembles the current program.? At least that would be better than a failure of the nation as a whole.? There is some level of indebtedness at which the US government would fail, whether through internal or external debt repudiation, or inflation.? I guess we have to test how much US debt the rest of the world can take down before the door finally shuts to the US Government borrowing in its own currency.
10) On that note, I want to close by mentioning my friend Cody Willard‘s new website SpokeUp.com.? Cody has been amazed at the anger he has been hearing over the current crisis, and our government’s seemingly unfair methods of handing out relief.? SpokeUp.com is an effort to enable people to connect over political issues, and possibly organize to effect political change.
. There would certainly be a good parallel piece there.”
