The Sceptical Market Observer

Davos Man

2012-01-28T23:00:00.008-05:00

Two economists are stranded in a deserted conference room:

First Economist: What policy will lead to recovery?

Second Economist (Larry Summers) : Increasing aggregate demand with deficit spending.

First Economist: How will that help?

Larry Summers: An increase in purchases will revive the ‘animal spirits’ of businessmen and induce them to invest and hire.

First Economist: How will the government finance its deficit?

Larry Summers: Assume an unlimited borrowing capacity.

This recycled economist joke is the sum and substance of Larry Summers’ advice to world leaders on the eve of the annual meeting of the World Economic Forum in Davos and it likely represents the collective wisdom of the elites who will be meeting there (see Prof. Summers’ FT article ‘Economic uncertainty is no excuse for inaction’ Jan 24). It is, of course, quite contentious.

The idea that an increase in demand will have the desired effect requires that businessmen think it will last –and there is no guarantee it will. John Stuart Mill made that point 150 years ago, when he wrote “the demand for commodities is not a demand for labor”. John Hicks, the creator of the ISLM model from which Mr. Summers’ opinion issues restated Mill’s critique a few decades ago, when he questioned the automatic link between increasing the demand for final goods and the inducement to invest. So, if the ability of government to sustain deficit spending is in doubt –and what sane person would not doubt it - then so is the likelihood it will have any good effect. And to bloat government deficits even further risks undermining the fiscal viability of the public sector-a prospect that could make today appear as a Golden Age in retrospect.

Mr. Summers is trapped inside a policy paradigm that simply does not apply anymore. We must look elsewhere for solutions to today’s problems. One avenue I suggest is to take seriously that we suffer from an over-indebtedness that constricts credit expansion and investment, and to implement policies to relieve homeowner debt and deleverage banks to increase both the supply and demand for credit in order to restore credit expansion–even if that means bank bondholders and banks themselves will need to suffer very large losses.

To adulterate a phrase from Keynes, we may need to implement a euthanasia of the (incumbent) banker. Now that is a thought likely to send a chill wind through Davos!

Are We Running Out Of Resources?

2012-01-28T15:04:00.001-05:00

Myths are being exposed these days. Coinciding with the publication of an open letter by 16 scientists on Friday in the Wall Street Journal asking whether we should be alarmed about climate change, here is another piece which establishes that we are not about to run out of resources.

Although the Wall Street Journal article, No Need to Panic About Global Warming, makes the valid point that science can never offer definite proofs of the existence of a phenomen (i.e. you can't confirm a theory, although you can infirm it), the piece could potentially be politically loaded, even if it is written by what would appear to be credible individuals.

The article below does not suffer from the same flaws. Although it might also be politically slanted, it offers indisputable facts about a much simpler problem; the near-exhaustion of our most valuable natural resources. In Everything You Know About Peak Oil Is Wrong, Charles Kenny, a fellow at the Center for Global Development and the New America Foundation, explains that "We’re not running out of resources. Quite the contrary.

Here is the piece which was published last Thursday in Bloomberg Businessweek:

At some point in the coming months, the confrontation between the West and Iran over the Islamic republic’s nuclear program may reach a breaking point. Even assuming the two sides manage to avoid full-fledged military conflict, the crisis could still cause significant disruption to the world economy. An embargo against Iranian oil exports, or a move by Iran’s leaders to close the Straits of Hormuz—or both—could send the price of oil soaring and jeopardize the re-election hopes of leaders from Paris to Washington. And as happens with every oil crisis, pundits will insist that the pain we’re feeling is nothing compared to what it will be like when the world finally runs out of black gold.

We’ve been warned before. Four decades ago this year, five scientists from the Massachusetts Institute of Technology published an influential set of predictions regarding the sustainability of human progress. Titled Limits to Growth, their report suggested the world was heading toward economic collapse as it exhausted the natural resources, such as oil and copper, required for economic production. The report forecast that the world would run out of new gold in 2001 and petroleum by 2022, at the latest.

Over the intervening years, the threat of “peak oil” has stayed with us—the date when global petroleum production was to reach its supposed maximum, afterward and evermore to decline as dwindling reserves were tapped out. And the exhaustion of the world’s oil reserves was just the start. A host of other critical natural resources, from phosphorus to uranium, have been declared peaking or already peaked.

Forty years later, however, rereading Limits to Growth invokes a growing sense of irony. Far from being depleted, worldwide reserves of minerals continue to climb. New technologies suggest the dawn of U.S. energy independence. The biggest concern isn’t that the planet is running out of resources—it’s having too many for the planet’s own good.

Start with oil. In 1971, the Limits to Growth team forecast that the world’s supply would run out 10 years from today. And yet according to renowned oil analyst Daniel Yergin, technology advances and new discoveries have allowed oil reserves worldwide to keep growing. For every barrel of oil produced in the world from 2007 to 2009, 1.6 barrels of new reserves were added. The World Energy Council reports that global proven recoverable reserves of natural gas liquids and crude oil amounted to 1.2 trillion barrels in 2010. That’s enough to last another 38 years at current usage. Add in shale oil, and that’s an additional 4.8 trillion barrels, or a century and a half’s worth of supply at present usage rates. Tar sands, including some huge Canadian deposits, add perhaps 6 trillion barrels more.

We’re awash in more than oil. One British study from the 1930s predicted an acute global shortage of copper “within a generation.” Not so much. The U.S. Geological Survey estimates global land-based copper resources to be 3 billion tons or more—the equivalent of 185,000 years at current production. That’s almost double the estimate of resources from 11 years ago, which means the number may have further to climb. And when we do finally run out of land-based supplies, there are still the undersea sources to use up.

The long-term picture for phosphate, vital for fertilizer production, is also reassuring, despite a price spike in 2008: Estimated global phosphate reserves climbed from 11 million tons in 1995 to 65 million tons in 2010—equal to 369 years of current production. The list goes on: Current resource estimates suggest it will take 347 years to run out of helium, 890 for beryllium, centuries for chromium, more than a millennium for lithium and strontium. And for those Americans worried about the price of makeup, resources of talc in the U.S. alone are enough to provide more than 1,000 years of supplies at current rates of domestic production.

If we keep on using more minerals, and we don’t do a better job of recycling them, and plans to mine the moon don’t work out, we’ll surely run out of supplies one day. But for pretty much every vital mineral resource, that day looks to be a long way off, which is great news for the world economy. Limits to Growth suggested the world would be on the verge of complete economic collapse around about now, with industrial output falling to its level of 1900 by the end of this century, as resources vital to sustaining a modern economy dried up. However dire today’s global financial crisis, we are nowhere near such a doomsday scenario.

What’s more, expanding resource reserves are great news for poor countries, home to many of the world’s recent mineral discoveries. A growing number of developing economies are likely to earn money from drilling and mining, following in the recent footsteps of countries such as Ghana (on the cusp of an oil boom) and Mongolia (ramping up its copper exports). Although development experts often invoke the “resource curse”—the idea that oil and mining industries predestine a country to dictatorship and poverty—recent analysis by the World Bank suggests the fear of the curse is overblown. “As one might intuitively expect,” the Bank reports, “greater natural resource wealth is associated with higher GDP per capita.”

Managing this planetary cornucopia will, however, present significant challenges. Were we to continue expanding our resource use at current rates, we may pollute our way to a denuded planet. Mining, drilling, and moving industrial commodities is a messy business—the Gulf of Mexico oil spill is just one example—to say nothing of the impact on climate change. The tar sands fields in Alberta, Canada, alone contain 1.7 trillion barrels of oil. That is equal to roughly a half century’s supply at current global oil use—and it’s an environmentalist’s nightmare to extract. Two tons of tar sands are needed to produce every barrel of oil. Getting the sludge-like stuff to the surface takes pumping steam into the tar beds, which in turn takes burning natural gas to heat the steam water. Tar sands oil, in other words, requires greenhouse gasses to produce and emits even more when it is consumed. That was a major reason why climate change activists lobbied so hard for the White House to shut down the Keystone XL pipeline from Alberta to the Gulf of Mexico.

And yet the world economy is becoming increasingly lightweight. Industries consume fewer mineral resources for each dollar of output. As much as two-thirds of global economic activity consists of outputs that don’t pollute or even weigh anything at all—things such as entertainment, education, finance, and health care. The services sectors’ share of global output climbed from 53 percent in 1970 to 71 percent in 2010, according to World Bank data. In part because of that, the amount of energy the planet needs to generate the same amount of wealth is declining.

That evolution may not be happening fast enough to stave off climate change, but it suggests the possibility that we can keep improving global living standards even while reining in our collective impact on the global environment. If we tax carbon emissions, provide financial incentives to preserve global forests, and better regulate mining and drilling to reduce spills and toxic waste, perhaps the global population can protect the planet without sacrificing the well-being of future generations.

There are still plenty of good reasons to conserve the world’s mineral resources—just as there are very good reasons to avoid another war in the Middle East. But fear that the resources will run out isn’t one of them.

The Return of the Inflation Narrative

2012-01-25T22:51:00.000-05:00

I mentioned a few weeks ago that "financial repression" was making a comeback. It's being discussed at the highest level to determine whether it can be engineered in today's more sophisticated and more complex financial markets. Not only, inflation has to "fool" people in order for its dirty little magic to work; otherwise interest rates would just go up to eliminate the advantage that the effect of higher inflation has on real interest payments and on the level of debt. But it has also to act as a mild tsunami and pretty much affect everyone equally, or at least be perceived as fair, to be deemed a successful operation.

After WW II, it seems that it was easier to fool people with inflation and force them into accepting that mild inflation was a remedy to over indebtedness. First, financial markets were not as sophisticated as they are today; there were no bond vigilantes yet. Second, back then, inflation probably affected negatively much fewer people than it would today; the post war population was young, if anything indebted and not going to be retiring soon. Recall that financial repression lowers real returns and mainly favours those who have debts at the expense of those who have assets. Today, the importance and the political power of retiring baby boomers and pension funds make inflation engineering a much less attractive political solution.

But finally, and most importantly, had the current government debt been acquired as a result of a war and collective post-war reconstructing efforts as it was the case after WW II, an inflation tax might be socially more acceptable. But today, we find ourselves in a very different context. Those who have acquired debts are deemed to be irresponsible consumers, over-leveraged banks and discredited governments. The latter have promised more than we can afford and are perceived to protect crony capitalists and crony capitalism. And who would want to save such people? Certainly not the Tea Party and certainly not the Occupy Wall Street movement!

Some people would say that the problem is that by denying our government (i.e. our collective selves) an easy exit from its excessive debt burden, we maybe denying ourselves a future. But engineering financial repression might help reduce the current debt level but it won't solve the real problem of future pension and health care costs. Having lower real interest rates will worsen the deficits of defined-benefits pension funds as their asset growth will not keep up with inflation and their exploding liabilities. Public pension liabilities in particular will be governed by pretty nasty dynamics as public pension benefits are usually indexed for inflation. Until we accept that public pension plans need to be converted from defined benefit to defined contribution schemes (at least for all future contributions) and we understand that the practice of fully indexing pension benefits needs to disappear (the sooner the better and for all workers and retirees), government deficits are only going to worsen. Successfully engineering money illusion won't change anything to this outcome.

There is one important lesson to remember here: As much as inflation can reduce the current debt burden of a society, it can't do much to reduce actuarial deficits (i.e. debts incurred into the future). The problem today is not so much the current level of debt in the U.S. and in Europe but the dynamics of that debt in the future as most developed countries have promised their citizens a future that they can't afford. The remedy for this illness is not inflation. The solution lies in cutting benefits to realistically meet our means of providing them.

Postponing the retirement age gradually to fund social security would help tremendously. Let's propose that, starting today, for every year below the age of 65, individuals have to accept to work two more months in their life up to a maximum of five extra years. For instance, an individual who is 64 today, would retire two months after his 65th birthday; someone who is 60, ten months after his 65th birthday; and someone who is 53 today would have to retire when he would turn 67 years old; 2 months x (65-53) = 24 months or 2 years. Everyone who is younger than 35 today, would see their retirement age be raised to 70 years old; meaning that they would have to work 5 years (60 months = 2 x (65-35)) longer than today's retirees before collecting their pension and social security. Such a measure would save the government $100 of billions of dollars in the future and help bring back America on a more sustainable debt path.

The same perverse dynamics holds true for government health care costs if we stick with our current entitlements. Inflation today is not going to reduce the future costs of providing health care to an aging population who is seeing its life expectancy increase. If anything inflation is going to blur market signals and reduce investments and R&D expenditures which could reduce health care costs. The solution lies in accepting lower benefits in the future and sharing the burden of prohibitive costs for instance by imposing larger deductibles.

Thus I cautious against article such as How to Save the Global Economy: Whip Up Inflation. Now. However seductive the arguments made in the piece, which was published in Foreign Policy recently, the strategy carries enormous risks and it does nothing to solve the deeper problem of our future liabilities.

Here is the piece written by Menzie Chinn and Jeffry Frieden:

The American and European debt crises have dragged on for years now. Yet none of the heavily indebted countries -- not the United States, not the peripheral eurozone borrowers -- has been able to use a traditional weapon to fight the debt crisis: inflation. This has been the crucial difference between the current crisis and similar ones in the past.

Recovery from a debt crisis is always painfully slow, for reasons both economic and political. Creditors need to rebuild their balance sheets and are unwilling to make potentially risky loans. Debtors need to boost savings to cover their debts and are unwilling to resume spending. At the same time, debt-ridden countries collapse into political conflict over the question of who will pay to get them out of the red: Should it be taxpayers, bankers, public workers, or investors?

A bit of inflation can help on all these fronts. So long as the debts are denominated in national currency and interest rates are kept low by monetary policy, inflation reduces the real debt burden. This is, to be sure, a forced restructuring that puts some of the onus on creditors -- but that is almost always the outcome of more explicit negotiations in any case. When most of the debts are household debts, as they are in the United States and parts of the eurozone, it is not really feasible to renegotiate millions of mortgages and consumer loans; inflation takes care of that for the whole economy. It mitigates some of the political conflict and lessens some of the economic burden.

So far, though, none of the major debtors has been able to make this option work. The most troubled eurozone debtors -- Greece, Ireland, Italy, Portugal, and Spain -- don't make their own monetary policy, so they cannot inflate away a share of their debt. Indeed, two-thirds to three-quarters of the foreign debts of Greece, Portugal, and Spain are owed to eurozone creditors, primarily in Germany and France. Even Ireland, which has strong financial ties to Britain and the United States, owes about half its debts to other eurozone countries. This means that if the European Central Bank decided to pursue inflation, it would be taking money out of the pockets of creditors that are also members of the eurozone -- and powerful members, too. As politically daunting as this might be, however, some such redistribution would almost certainly be part of any durable settlement of the eurozone debt crisis anyway -- and the apparent inability of Europe's leaders to arrive at such a settlement in anything near a timely fashion has only further confirmed that inflation may be the only politically feasible way forward.

For its part, the U.S. Federal Reserve has run a monetary policy appropriately focused on stimulating the economy, keeping interest rates extremely low, and engaging in "quantitative easing," whereby it twice increased purchases of long-term Treasury securities and mortgage-backed securities. This effort has not, however, been enough to raise prices by more than trivial amounts. The Fed policy should theoretically lead to an export-boosting depreciation of the dollar, but every attempt to moderate the dollar's value so far has been met by countervailing efforts on the part of the big surplus countries, especially China. These policies have also been countered by the dollar's continuing strength as a perceived safe haven in the midst of crisis: Domestic and international investors still think of Treasury securities as the most reliable place to park their money in uncertain times, a view that has maintained the dollar's value in spite of the Fed's interventions.

We're not proposing a lot of inflation -- just enough to reduce the debt burden to more manageable levels, which probably means in the 4 to 6 percent range for several years. The Fed could accomplish this by adopting a flexible inflation target, one pegged to the rate of unemployment. Chicago Fed President Charles Evans has proposed something very similar, a policy that would keep the Fed funds rate near zero and supplemented with other quantitative measures as long as unemployment remained above 7 percent or inflation stayed below 3 percent. Making the unemployment target explicit would also serve to constrain inflationary expectations: As the unemployment rate fell, the inflation target would fall with it.

Today our highest priority should be to stimulate investment, growth, and employment. Raising the expected inflation rate will lower real interest rates and spur investment and consumption. It will also make it difficult for the de facto dollar peggers, such as China, to sustain their policies. The resulting real depreciation of the dollar would stimulate production of U.S. exports and domestic goods that compete with imports, boosting American production. The United States would get faster growth, an accelerated process of deleveraging, a quicker recovery, and a firmer foundation upon which to address long-term fiscal problems.

The Best Paper on the Financial Crisis

2012-01-18T22:25:00.000-05:00

Andrew Lo, professor of economics at MIT, recently wrote Reading About the Financial Crisis: A 21-Book Review. The paper, still unpublished as far as I know, is circulating in academic circles. Although a bit long, it is much shorter than the 21 books in question. I personally read only three of the books on the list but I certainly will read a few others; thanks to the guidance of this review. The author reviews both academic analysis and journalistic accounts of the events; as well as former Treasury-Secretary Paulson's book.

I consider this paper to be the best paper on the topic, not because of its depth (it is only a survey of 21 books after all) but because it allows the reader to compare the different theories that are competing to explain the causes behind the crisis and because it identifies the strengths and weaknesses of these theories as well as promising avenues of research to get to the bottom line of this disaster. The author reminds us that it is much too early to make a definite judgment on which theories are better at explaining what happened and that more data should be collected before we draw final conclusions.

Here is a link towards the January 9th 2012 version. You will need to click on the One-click Download button to get to the paper.

The 21 books that are reviewed in the paper are listed below.

The 11 books in the first category (academic books) are:

Akerlof and Shiller, 2009, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton University Press.

French et al., 2010, The Squam Lake Report: Fixing the Financial System. Princeton University Press.

Garnaut and Llewellyn-Smith, 2009, The Great Crash of 2008. Melbourne University Publishing.

Gorton, 2010, Slapped by the Invisible Hand: The Panic of 2007. Oxford University Press

Johnson and Kwak, 2010, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. Pantheon Books.

Rajan, 2010, Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton University Press.

Reinhart and Rogoff, 2009, This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press.

Roubini and Mihm, 2010, Crisis Economics: A Crash Course in the Future of Finance. Penguin Press.

Shiller, 2008, The Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do About It. Princeton University Press.

Stiglitz, 2010, Freefall: America, Free Markets, and the Sinking of the World Economy. Norton.

The 10 books in the second category (journalistic books + Treasurer Secretary Paulson’s book) are:

Cohan, 2009, House of Cards: A Tale of Hubris and Wretched Excess on Wall Street. Doubleday.

Farrell, 2010, Crash of the Titans: Greed, Hubris, the Fall of Merrill Lynch, and the Near-Collapse of Bank of America. Crown Business.

Lewis, 2010, The Big Short: Inside the Doomsday Machine. Norton.

Lowenstein, 2010, The End of Wall Street. Penguin Press.

McLean and Nocera, 2010, All the Devils Are Here: The Hidden History of the Financial Crisis. Portfolio/Penguin.

Morgenson and Rosner, 2011, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. Times Books/Henry Holt and Co.

Paulson, 2010, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System. Business Plus.

Sorkin, 2009, Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System from Crisis–and Themselves. Viking.

Tett, 2009, Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe. Free Press.

Zuckerman, 2009, The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History. Broadway Books.

Martin Luther King Jr. - The State of Civil Rights

2012-01-15T17:08:00.004-05:00

The anniversary of the death of Dr. Martin Luther King Jr. is an opportune moment to reflect on his message and the present state of Civil Rights and race relations in America.

It appears to me that much of the legislative eco-system that has grown out of the Civil Rights movement is intrusive, oppressive and inefficient. By extending the reach of the state so deeply into personal and social matters it contributes to undermining families and mediating social institutions like the Church and in so doing it threatens our liberty and our social cohesion.

The Civil Rights Movement and the Left

Since its inception in the 1950's, the civil rights movement has been affiliated with the liberal left. There are few known Civil Rights champions in the Republican party today, and libertarians, for whom equal rights, defined as equality before the law and unbiased enforcement of the law, have not been associated with the movement. Yet Dr. King correctly linked the goals of Civil Rights movement to "the heritage of our nation and the eternal will of God", finding precedent in the Declaration of Independence, the Gettysburg Address and the US Constitution. How is it then, that people on the right, many of whom share the values articulated by Dr. King, have not played a significant role in the movement he once led ?

I believe Civil Rights supporters gravitated to the left early on primarily for two related reasons: First, because social and economic equality had long been a credo of the left and secondly, because the left’s agenda involved the use of political power to compel government to effectuate its desired outcomes. The Civil Rights struggle was focused on southern states that used legislative and police power to subjugate blacks, which were widely supported by the white majorities in those states, while the majority of the rest of the US population had come to detest the institutionalized racism of the south. So it was natural for Civil Rights leaders to look to the federal government both as a forum to lobby for legislative changes that would improve the lot of blacks, and to use federal law as a justification to intervene into the affairs of southern states on behalf of blacks. For these reasons –and because the conservative and libertarian right opposed federal intervention into the internal affairs of states- the practical aims of the Civil Rights movement became fused into the broader liberal left agenda.

(US) Liberals believe change and best results are achieved through activist and interventionist government, rather than through equality before the law and effective and impartial enforcement of rules governing the interactions of free people. Because they do not appreciate the possibilities and morality of spontaneous orders, they view social issues solely through the lens of political struggle between competing interest groups; thus they can only conceive of achieving their goal of realizing "the lesson beneath any theology…that we must act toward all creation in the spirit of equal souls and equal votes" by state intervention; only the government can 'make' white folks accept blacks by busing black kids into white schools, and white employers will be made to hire black workers and must be told what to pay them.

Civil Rights and the Right

But increasing the power of the state carries some risk for an –often disliked -minority:

-What if racists gain the upper hand in an expanded government and use it as tool to keep blacks down?

-What if whites recoil at an attempt to 'force' them to accept blacks into their lives without their consent? Does this not risk a backlash?

-What if intervention into the labor market and imposition of social welfare programs -beyond income subsidies that allow recipients to spend the cash as they wish-serve to impede the opportunities for blacks to progress by reducing market opportunities?

-What if affirmative action policies cause people to discount the legitimate achievements of black professionals?

-What if the rights of individuals get drowned by collectivist rewards and penalties administered by group affiliation?

Unfortunately, because the political 'right' in the 1950’s included both racists and libertarians, there was no chance for the libertarian ideals of 'life, liberty and the pursuit of happiness' to permeate the Civil Rights movement. Black people probably surmised, correctly, that those who advocated a 'hands off' policy on states rights and economic intervention, were not their friends.

But more than forty years after the death of Dr. King, with the persistence of a black underclass and many of the vexing issues of race relations remaining unresolved , it is high time to reassess the appropriate practical action to achieve the noble aims of the Civil Rights movement and to make the case that a libertarian approach is more humane and more likely to succeed than is the government interventionist approach tried so far . It is more humane, because the libertarian ideals of equality of individuals under the law, unbiased enforcement of laws and the right of individuals to pursue their own course in life, constitute the basis of fundamental human rights. It is more likely to succeed because populations, and particularly those at the bottom and minorities, have always fared better economically over time in a free market system.

What Needs to Happen

However, conservatives must acknowledge that, underlying their argument is the assumption that libertarian laws will be enforced fairly. If not, as in the ‘old’ south, the struggle for existence among blacks becomes political and the only possibility for relief from oppression is resort to winning battles over legislation and the police power of the state, no matter the risks involved.

Conservatives and others on the right in public life who are deeply moved by the moral and theological foundations of Civil Rights, who agree that "lasting power grows against the grain of violence" and who believe, as did Dr. King, that the US is founded upon the ideals expressed in our Declaration of Independence, the Constitution and the Gettysburg Address, need to make clear their affinity with the Civil Rights movement and must endeavor to make black people and other 'outsiders' feel genuinely welcome in their presence.

When Should You Believe Forecast?

2012-01-15T12:14:00.002-05:00

I never believe story tellers (mostly macro economists and strategists) as they try forecasting the future. Their stories are often interesting and can sometimes offer valid perspectives on how current events can unfold and influence the markets and the economy. But the probability that one given economist is right about the future is always minimal even if he or she is only forecasting the short-term future.

That nobody can predict the future should be obvious. In the real world, there are too many variables to account for and too many unpredictable events that can arise at any given time to influence the course of events to realistically rely on anybody or any organization for that matter to be making accurate forecast. Moreover, it is most often impossible to determine with any precision which of these variables should have the most weight in any forecast even using the most sophisticated techniques. Finally, assuming honesty (a big assumption), who are we to believe? When randomness is so high, it is very difficult to attribute any credibility to even the economists with the best track records!

However, there are situations where it is worth trying to make sense of upcoming events, to try to make a forecast or, at least, reduce the uncertainty of what is lying ahead. For instance, I can predict where and when a ball will fall given the speed and angle at which it was thrown. The wind is likely to influence this forecast but I could attempt to measure the speed and direction of the wind to take it into account in my forecast. That forecast should be better than a random number picked out of a hat. Other factors may also influence the trajectory of the ball rendering the forecast wrong (e.g., a bird may pass by and collide with the ball). Some of these factors may only have a minor significance and may safely be ignored. Others may have a significant influence on the ball trajectory but only a low probability of occurrence (such as the bird colliding with the ball). Ignoring these factors will lead to frequent accurate forecasts and to completely inaccurate ones some of the time.

Betting the house on the frequently accurate forecast could lead to ruin however. Yet, it would even more foolish to make even a weak bet against this forecast as it's likely to be correct most of the time as the probability that a bird will collide with a thrown ball is obviously very low. The totally safe bet, however, is to bet on the "no collision" forecast and take insurance against the collision event; if such insurance exists and is "reasonably" priced. Managing the risk by checking for birds before throwing the ball could reduce the risk of being wrong and might reduce the cost of insurance but it won't eliminate the risk completely. The only way to completely eliminate the collision risk is to take insurance against the event if such insurance exists; and then again, the provider of insurance has to be credit worthy when the event occurs …

Moreover, I am assuming here that there are no black swans (i.e. there are no unpredictable events not covered by the insurance that could occur and deflect the ball). As described by Nicolas Taleb, the ignorance of black swans most often fools people into denying existing but unknown risks. The insight form Taleb is that unforeseen events, such as black swans, can make you lose lots of money on bets that appear to be fairly priced and completely safe. History has shown that the incidence and consequences of such events are most often ignored, underestimated or mispriced by market participants. Thus, they often lead to disastrous outcomes for which market participants were unprepared when they unfold.

Obviously, the assumption of that no Black Swan exist is a strong assumption in many economic situations. In such situations, events are generally not completely riskless even when one is insured against all known risks. But I make the assumption of no Black Swan in this essay as it is not even necessary to show that forecasting exercises can often lead humans down the fool's path.

Let's come back to our ball example and the non-zero probability that a known possible event; such as a thrown ball colliding with a bird randomly passing by. In real life (i.e. in economic situations), such events will often have a "price". Depending on the price of the risk, some people will decide that it is worthwhile taking the insurance against the probability that the ball will collide with the bird while others will prefer to provide the insurance. This preference will depend on the relative risk aversion of the parties and the relative costs of getting the forecast wrong as well as other factors. Obviously, the more risk averse individuals and those most negatively affected by the event will tend to express an interest in buying the insurance. If there are also people able to pool the risk and charge insurance buyers more than the costs of that risk, there will also be an interest in selling insurance. We will thus have a "market" for the risk. The strategy that you would yourself adopt would then depend on your own situation and characteristics as well as the market price of the risk.

This is when things get interesting. We are now coming to the good part.

Two features of the event "throwing a ball" described above will help the forecaster. The first one is the fact that the number of variables influencing the trajectory of the ball is limited and the laws governing the ball's motion are known with great precision; which is rarely the case in economics. Things are more complex in real life and the laws governing history are only the results of the imagination of our historians at best. The "bird collision" sub-event is one such complexity: a known event but with very little predictability. The bird collision event introduces an element of randomness which, although we might know about the potential occurrence of the event and even its probability, still carries much unknown elements (timing, speed, angle, size of bird) and thus unknown consequences on what we are trying to predict (the timing and location of the fallen ball). In other words, although we may know about the possibility of a bird collision, its effects on the trajectory of the ball remains unknown. This implies that, even if it is possible to insure oneself against the occurrence of the event, it's impossible to predict where the ball is going to fall when hit by the bird. Yet, many forecasters will ignore this complex reality and unreliably predict an outcome. You know that they are not to be believed but may have a hard time resisting the temptation to consider the forecast a valid one. But this is not even the most interesting feature of the event.

The second and most relevant factor here is the fact that the accuracy of the "regular" forecast (the one conditional on no collision) depends largely on the premise that the ball has already been thrown (i.e. speed, time and angle are known) and the universe in which this happened (winds and birds) can be assessed at least probabilistically. In real life, however, this is most often totally unrealistic. That is, even if we knew in details the laws of physics governing the thrown ball, assuming that we know the circumstances and timing of the event is a mistake. It’s an event bigger mistake to try to model this behavior as the intent of the ball thrower are not governed by the laws of physics but rather by a complex human chemistry which escapes mathematical modelisation; at least with the current state of knowledge. Too often economics focuses on what happens after the ball is thrown forgetting that the most complex part of the event is what happened before (motivations, incentives and intents). These being more difficult to control, monitor, measure and model, they tend to be ignored. Yet, what is the good sense of predicting when the ball is going to fall when you don’t know when it is going to be thrown.

Thus, based on the potential of predicting where a thrown ball could fall in a controlled experiment, we often end up with a black box where the mechanics of the ball are modeled perfectly but where everything else is basically ignored or brushed aside; the winds and the bird dynamics as well as, more subtly, the intent and the timing of the ball thrower. As intents often constitute the heart of economic decisions, predicting the future without taking them into account renders the forecast meaningless. But the magic of the black box of a forecasting model often obscures the fact that forecasts are being made using unreasonable assumption. In other words, even if we know everything perfectly about the process of throwing a ball, if in reality we have absolutely no idea about how to model, and especially how to quantify, motives and intent, a forecast is totally useless. But forecasters, like magicians, make money by selling illusions. If they can make you forget about the wrong assumptions of their model, you may just believe them.

John Maynard Keynes had already warned R.F. Harrod in a letter written in 1938 of the dangers of relying on models and making analogy with the physical science to explain economic phenomenon:

“The point needs emphasising because the art of thinking in terms of models is a difficult--largely because it is an unaccustomed--practice. The pseudo-analogy with the physical sciences leads directly counter to the habit of mind which is most important for an economist proper to acquire.”

“I also want to emphasise strongly the point about economics being a moral science. I mentioned before that it deals with introspection and with values. I might have added that it deals with motives, expectations, psychological uncertainties. One has to be constantly on guard against treating the material as constant and homogeneous in the same way that the material of the other sciences, in spite of its complexity, is constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple's motives, on whether it is worth while falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth.”

So what is one to do? Stop attempting to forecast the future? There is not a chance in the world that this warning could be heeded as it is in the human genes since the early ages to attempt to read the tea leaves. The answer is to try distinguishing the consequences of events that have already been set in motion from the rest of events which heavily depend on randomness, human motives and have yet to occur.

For instance, the recent rapid growth of emerging economies has set in motion a growing demand for resources which, given the short term inertia of economic growth, has some predictability for commodity prices. It is impossible to know for sure what will happen to the prices of resources but it is correct, from the moment that we understand the dynamics of emerging country growth, to simply predict that the increased demand for resources will put an upward pressure on their prices. This forecast cannot be as precise as in the case of the thrown ball experiment as timing and magnitude cannot be modeled but the direction can be sufficient to make a sound (yet still risky) investment decisions if prices have not increased yet.

It is also correct to predict that higher prices will provide incentives to grow the supply of these resources and to look for alternatives as well as predicting that these efforts could eventually reduce the pressure on the price of such resources. An attempt at quantifying the price increase in the short run, while the supply is still held constant and alternatives are not yet available, could be made using historical data and yields some credible results (very likely better than a random walk forecast) but the results from such historical models should not be confused with the certainty stemming out of the laws of physics governing the motion of a ball as to when and where the ball (or the apple) is going to fall once it has already been thrown; and then again, Newtonian mechanic was shown to be only an approximation of reality by quantum mechanics. Moreover, to then turn around and try to predict the timing of the reversal of commodity prices following an eventual supply response to their short-term price increase (when the response has not yet occurred) could be interesting but certainly not believable. Any attempt at modeling this process would be pure speculation; and most certainly, the forecasts from such a model would not be sufficient to make a sound investment decision.

The only quasi-certainty which we have here is that, by virtue of the universal law of demand, prices of resources should increase as demand for resources increases; everything else held constant. However, no one has come up with any theory or concept to quantify the price increases, nor their timing, as in the case of the ball. Thus, a forecast about a price increase will be credible; one about the magnitude of the price increase and its timing should be wrapped in warnings and handled with care. Any attempt to extent the horizon of the forecast, based on a supply response from the market which has yet to occur, which would involve modeling complex human motives and interactions and the timing of scientific discoveries that would offer alternatives, is not credible. In short, all longer term forecasts about events that have not been set in motion are speculative in nature and any suggestion that a model can capture more than the eye can see is alchemy and fraud. They should thus be automatically treated with the highest suspicion and essentially be considered as pure speculation from a good story teller.

Also, remember that in the ball example, other factors could affect the ball trajectory (winds, birds, etc.). The same would also apply here if we attempted to forecast prices. But it is worth stressing that these “other factors” are not the only risk involved in the price forecasting exercise; yet, that is a reality which is often neglected by forecasters. This is because the inferred historical relationship that allows quantifying the dynamics between quantities and prices is not a law of physics and most often does not hold. Unlike in the case of the ball, where the laws of physics are pretty much set in stone, in economics, a historical average does not carry any scientific weight and may, in fact, never have occurred. Like with any average (that of two individuals of 20 and 60 years old respectively for instance), the statistics alone does not give us any idea of the dispersion of the variables in the sample or population. Although, it is possible to get an estimate of this dispersion in many cases, it remains an estimate and an estimate made under several assumptions (such as the normality of the distribution of the random process governing the variable). Tell me who is to verify these assumptions? And under which assumptions will these assumptions be verified? Good story tellers usually don’t bother with such details.

As you can see, both the quality and the scope of the forecasts get degraded as we go from the thrown ball (for which we can predict both the position and time of the ball with some precision) to the short term forecast of the prices after an increase in demand (we only get the direction of the move), to the yet un-thrown ball (randomness that may be confined to a limited set of possibilities) and, finally, to a long term forecast of the price of resources after the supply and the technology have had time to adjust to the incentives provided by higher prices (total randomness).

What matters here is the stability of relationships: Newtonian dynamics are very stable (as long as we stay on earth) while the law of demand is very imprecise even if predictions about the direction of prices following an increase in demand is also very robust in the short term (as long as we are dealing with humans). However, this stability tends to erode as time passes because other significant human reactions emerge, interact with the initial reaction and, as a result, modify behavior. We may know a lot about the direction in which each individual variable will influence others but because we often know nothing about the magnitude of these individual reactions, it is most often impossible to combine them to get even a sense of the timing and the direction of the “aggregate reaction”.

This being said, advances in predictive power are still possible for events that have already been set in motion if one can discover the laws that are governing their dynamics. A lot can be gained by developing such approaches and having the discipline and honesty to stick to these dynamics. It does not mean that there are no risks to a forecast made with such tools. We saw that, even in the case of a thrown ball, a collision with a bird could cause a deviation of the ball that would invalidate the “no collision” forecast. Still, the laws of physics governing the motion of a ball, once it is launched, are powerful forecasting tools. This is because making a forecast based of these laws to determine where a thrown ball should fall is likely to yield credible results; credible in the sense that such forecast would systematically yield more accurate results than a random forecast.

The same applies to aggregate demand; the sum of very large number of individual demand functions themselves derived from individual utility maximization under a budget constraint. As long as we attribute some weak property to the utility function, the aggregation of individual demand function (the result of the complex interaction of many consumers) still yields in a downward sloping aggregate demand curve and the powerful forecast that an increase in demand will put upward pressures on prices.

Watching the following fascinating video on using the stable structure characteristics of social networks as a forecasting tool, should convince you of the power of certain relationships for predicting behavior. Stick to such principles to know who to believe next time you hear someone talk about the future and you won’t get fooled by snake oil forecasters anymore.

Can European banks’ problems affect Latin America?

2012-01-14T09:13:00.009-05:00

European banks provide 45% of all the external credit lines to Latin America. Could a pull back from their international lending activities affect the operations of Latam companies?

According to the Bank of International Settlements (BIS), European banks provide USD 206bn in credit lines to Latin America, making them the biggest providers of external funding for the region. Continued pressure from the financial crisis in Europe raises questions about the extent to which these banks will need to restrain or even reduce their global lending activities. One can assume that it will take time before European banks regain their ability and willingness to extend international credit at the pace they have during the last decade. Most of the international claims reported by the BIS are trade-finance related and inherently short term.

For the region as a whole, the impact of such a potential deleveraging does not appear to be significant. However, some countries would be more vulnerable, namely Chile and Uruguay where European banks provide 63 and 57% of total funding respectively.

We look at a few factors that can be used to measure the impact of a shift in European bank lending on Latin America.

1- How fast can the current credit lines disappear?

Looking at the maturity of these loans can give us an idea of how quickly European banks could restrain credit. Hence, data show that a significant amount of credit lines to Latam corporates need to be renewed in the next 12 months and apparently a majority are not being renewed. Short term maturities of less than one year account for 40% of international bank claims in Brazil and Mexico (Table 1). In the case of smaller economies like Uruguay and Colombia, that number is over 50%.

Table 1. International claims by European banks, less than one year maturity

% of total claims

Argentina 60
Brazil 40
Chile 49
Colombia 61
Mexico 41
Peru 57
Uruguay 58
Venezuela 33

Source: BIS, HSBC

2- What is the reliance of the region’s economies on credit lines?

We use the ratio of European banks claims on foreign exchange reserves. Here the data show that Mexico, Chile and Uruguay are quite dependent on European banks’ funding while Brazil, due to its high level of foreign reserves, is in a comfortable position. For Argentina and Peru, exposure to European banks funding is fairly low. In their case, this is the result of the limited access these two countries have had to international financing over the past few years.

3- Are there alternative sources of financing to fill the gap left by European banks?

The sheer size of the involvement of European banks in Latin America suggests that funding may turn scarce for a while and result in higher borrowing costs for exporters. There are already signs of retrenchment by some European banks in Brazil. Banco Santander, Spain’s largest bank by market capitalization, which underwrote 11% of Brazilian debt sale in 2011, is currently not working on any large size underwriting deal.

Inevitably Asian banks will eventually step in but probably only gradually. Asian banks for the most part are very well capitalized-- in fact exceeding Basel III requirements-- quite experienced in trade finance and looking to expand globally. The three Japanese mega banks-- MUFG, SMFG and Mizuho-- in particular and a handful of Chinese banks could well become the next major funding partners for Latam exporters. In the case of Mexico, the close association with its northern neighbor could possibly bring American banks to play a larger role in that country.

Regional development banks such as the Inter-American Development Bank (IADB) and Corporacion Andina de Fomento (CAF) could also provide USD credit lines. BNDES in Brazil, a large development bank, will most likely be able to maintain access to capital markets even during a period of stress and supply exporters with reasonably priced credit lines. Other possible sources of USD liquidity are the central banks. In Chile, in 2008, the central bank provided liquidity through a program of swaps and repos to the country’s financial system. Given the size of its foreign exchange reserves—USD350 bn-- Central Bank of Brazil could auction a small amount of its international reserves to its domestic exporters.

4- What is the ability of Latam exporters to absorb potential higher costs associated to a reduction of European banks lending activities?

Industrial exporters are likely to be more affected than commodity-related exporters due to the real appreciation of some currencies in the region during the past decade. The Brazilian Real has nearly doubled in value, in inflation-adjusted terms, since 2000. During the same period the Chilean Peso, the Colombian Peso and the New Sol in Peru have all appreciated between 18 and 26% in real terms. Commodity-related exporters have a better protection against higher funding costs because terms of trade in the region in general remain historically high. That is, export prices have risen faster than import prices so higher funding costs are unlikely to erode export competitiveness and profitability.

5- Can the size of local subsidiaries of European banks become destabilizing?

Local subsidiaries of European banks in the region act like local banks due to their size. Their deposit base is domestic and in local currencies. Three of the five largest banks in Mexico and Argentina are subsidiaries of European banks as well as two out of the five largest in Brazil. In Chile, Banco Santander of Spain is the largest bank by far. However, local subsidiaries are generally independent of their headquarters when it comes to making decisions on funding activities. There is obviously a risk that local subsidiaries receive ‘orders’ from Europe to become more conservative in their lending decisions. That seems far fetch as the opposite is most likely: grow more aggressively overseas to compensate for a slowdown at home.

Since Latam as a whole is expected to experience GDP growth of around 3.5% in 2012, local subsidiaries of European banks are unlikely to suddenly stop credit expansion. Moreover, it is worth remembering that many of these local subsidiaries are listed on domestic stock markets, hence owing part of their capital base to local investors.

Conclusion

The risks to Latam exporters arising from a reduction of European banks funding appear manageable. USD-denominated funding costs will likely increase during the first half of 2012. Industrial goods exporters, having suffered from a decade of appreciating currencies, are more vulnerable than commodity-related exporters. The latter will fare better because raw material prices remain high by historical standards, making the sector very competitive.

Chile and Uruguay appear most vulnerable due to their substantial reliance on funding from European banks. At the other end of the spectrum are Argentina and Venezuela, which have very little dependency on foreign funding. Brazil, Mexico and Colombia are in the middle.

Different Measures of Unemployment and Implication for Labour Markets

2012-01-10T23:54:00.001-05:00

It is nothing new: the official unemployment rate of 8.5% does not catch the extent of the current job crisis as discouraged unemployed individuals (who stopped looking for work and consequently been officially dropped out of the labour force) are no longer part of the unemployed statistics. Similarly, people who settled for a part time job but who would prefer to be employed in a full time job are not considered unemployed or partially unemployed. If one included these people in the unemployment statistics, we would get closer to a 16% unemployment rate (15.6% actually). As I said, we already know this by now.

But the situation is even worse than this statistic suggests. These “revised” statistics do not include the mass of people who are employed full time but, for lack of better options, had to settle for a job that is less than optimal given their qualifications and skills. These people are partially unemployed as well. After all, they most likely had to accept a lower salary than they would otherwise get in their “optimal job”.

It might be good for America's competiveness to have overqualified workers in certain jobs but this is only true in the short-run. In the long run these people are not developing their skills as much as they would as they are not being challenged to the maximum of their capacity. Moreover, when labour markets start to improve, these workers might not be able to move back up on the job ladder as their skills might have deteriorated; or, at least, there is a good chance that the perception of employers will be that the skills of such workers have deteriorated even if they have not.

This is because employers mostly value and rely on a worker’s recent experience to make hiring decision. Older experience might no longer be relevant and older skills might have been lost. The longer the situation will persist, the worse will be the phenomenon.

But even has it stands now, it is most likely that, once the crisis is over, the U.S. economy will have sustained a permanent loss of skills. For workers, it will mean a permanent loss of future income as it will become harder and harder for many of them to get reinserted in the labour markets at their former skill level and wages. The possibilities of getting a promotion that would have allowed such workers to catch up (i.e. getting a job that they would otherwise have, had they not been forced to accept an interim in a lower skilled job) are even slimmer.

But the question is also whether the job market is eventually going to recover. In other words, once this crisis is over, will the U.S. economy be ever the same? In the short run, the problem seems to be of lack of demand. But in the longer term, it is a question of supply and demand of available skills at prevailing wages. Given that there is an excess demand for skills by businesses and a shortage of skilled labour available, isn’t it an enigma that many high skill workers have to settle on lower skills jobs?

I suspect that there are many reasons for this situation. For instance, labour market rigidities due to regulations and the situation on the housing markets which is making it more difficult for people to sell their house and move where good jobs are available may play a bigger role than in the past. This is being disputed by some economists. These argue that since many unemployed workers have underwater homes, it is as easy for them to just walk away from them as it would be to sell them in healthy housing market.

There are, however, other reasons to explain why labour mobility is lower today than it has been in the past. Over the last few decades, the entry of women in the labour force gradually reduced labour mobility as there are less compelling reasons for an unemployed individual to move to another city to get a job if it means that her/his spouse is going to have to resign from her/his current job and look for a job in that other city.

But more importantly the problem seems to be that workers who were considered skilled yesterday may no longer have the skills needed to perform the tasks required on the jobs that are available today. Finally, competition may force many of us to take a pay cut as skills that were considered in high demand yesterday have found new sources of supply putting pressure on the wages of these workers.

As globalisation extends its reach, expect this phenomenon to gather steam. The longer the unemployed remained unemployed and the sub-optimally employed remained in their sub-optimal jobs, the worse the skill mismatched will become but the trend was already there. The boom before the crisis was only hiding it from plain view. Now that we are deep into the crisis, it is easier to observe but we are still in denial. By thinking that all will come back to normal once the crisis is over, we fail to accept that the world has changed forever but the crisis, while temporary, is making both the situation worse and the eventually recovery more difficult.

This means that pretty soon firms will not be leaving this country chiefly because unskilled workers are much cheaper abroad but mainly because they won’t even be able to find the skilled labour that they need to grow. Isn't it surprising then that businesses do not spend more on training workers to ensure that they have access to this skilled labour force? Maybe. But they don’t see it as their responsibility. The way I see it, firms are under so much competitive pressure in the current context that they prefer stealing skilled workers from one another than to train their own workers and risk seeing the competition steal them away.

In other words, we are confronted with a classical free-rider problem which affects the supply of skills, a public good. To make an analogy, we could compare the situation to that of a country which does not have efficient roads to facilitate trade and the conduct of business. Who will or should provide the road? While the roads could be built and eventually be paid by the private sector, the question is more who should finance and coordinate their construction?

What are the solutions in the case of skills? I am not sure but certainly, they pass by ensuring that people have the incentives and the proper environment to acquire the skills that are needed to guarantee our prosperity.

In Tracking the Unreported (15.6%) Unemployed, written by Aparna Mathur and Matt Jensen and published in Real Clear Markets recently, the authors explain how the gap between the official unemployment rate is higher than it has ever been and that this gap has been stagnating at this level for a few years now. This is suggesting to me that there is something more fundamental (other than just the normal business cycle) percolating under the labour market to explain the situation in which we are today and which is likely to persist beyond the end of the current crisis. In other words, a structural shift in our economy is taking place and we better start ackowledging it if we are to find solutions.

Here is their piece:

President Barack Obama took office in January 2009 after having campaigned on the broad promise of "hope" and "change." However, to stay in office, there is one thing President Obama should hope for: an improvement in the employment picture before the 2012 elections.

The last three years have seen some of the highest unemployment rates reported since the Great Depression. The official rate moved from 5 percent in January 2008 to a high of 10.1 percent in October 2009, and a current rate of 8.6 percent. It rests 3 points above the 1948-2007 average of 5.6 percent. Unfortunately, the reality is even worse than these numbers suggest.

This is because of the way the Bureau of Labor Statistics calculates the official unemployment rate. Conceptually the unemployment rate seems simple - it is just the number of unemployed divided by the number of people in the labor force. However, deciding whom to include in the labor force is a complicated task. In the official unemployment rate, the Bureau of Labor Statistics measures the labor force as those who are employed or who have actively looked for work within the last four weeks. As a consequence, the official rate excludes workers who have decided to drop out of the labor market altogether because economic conditions have discouraged them, or for other reasons. The official rate also ignores those who settle for part-time work since they are unable to find a full-time job.

So, the way in which we calculate unemployment might mask the actual weakness of our economy. Paradoxically, if pessimism about the economy drives workers to stop looking for work or to settle for a part time job, it could actually cause the official unemployment rate to fall because of a bad outlook.

To compensate for this problem, the Bureau of Labor Statistics has published an alternative measure of the unemployment rate based on an analysis of the Current Population Survey, a household survey. This measure, referred to as the "U-6 rate", includes those that would still like a job and have looked for work in the last twelve months, not just the last four weeks. It also includes people who opted to work part-time even though they would like full-time jobs. Unfortunately, this measure is not cited nearly enough.

The U-6 rate offers a clearer picture of how precarious a situation we are in. It has moved from 8.8 percent in December 2007 to 17.4 percent in October 2009 and 15.6 percent in November 2011. Today the gap between the U-6 rate and the official rate is 7 percentage points, meaning that the number damaged by the weak job market is almost twice what the official number would suggest. At the start of the recession, there was only a 3.8 percentage point difference. By comparison, during the 2001 recession, which lasted only a few months, the difference grew by a meager 0.9 points from 3 percent to 3.9 percent.

For a historical perspective, we obtained data on these two measures going back to 1994. The evidence reveals the gap between the official rate and the U-6 rate has averaged less than 4 percentage points, and has not exceeded 5 percentage points except for the first month in 1994. October 2008 is the first time that the difference exceeded 5 points, and since then has averaged around 7 points.

Currently more than 5.7 million Americans have been unemployed for more than 27 weeks, or an astounding 43 percent of all unemployed. The tremendous increase in long-term unemployment is one factor driving the unprecedented disparity between the official measure of unemployment and the alternative measure. Long-term unemployment has a damaging psychological impact on workers' willingness to keep searching for work and motivates them to accept part-time work.

More importantly, however, long-term unemployment has a real impact on their ability to find a job because skills erode and employers tend to recoil from large gaps on a resume.

The silver lining of this bleak jobs outlook might be that more workers are settling for part-time work rather than dropping out of the labor force completely. When individuals opt for and are able to obtain part-time work, it enables them to retain their skills and, at least partly, finance their household expenses and needs. In December 2007, only 0.2 percent of the labor force was discouraged from looking for work for economic reasons. Today, the number is 0.7 percent. The percent of the labor force that is willing to settle for part-time work has grown much more, from 3 percent to 5.4 percent.

The frailty of the labor market may be a symptom of broader issues facing the economy. Trillions of dollars of spending portend an unsustainable fiscal future, and regulatory uncertainty is high. The reasonable response of businesses to higher expected tax rates and the possibility of new regulations may be to offer part-time and temporary jobs instead of hiring full-time workers. As bad policy forces businesses to seek flexibility, the chasm between the U-6 and official unemployment rates may become a permanent fixture of the economic landscape.

The main challenge facing the Obama administration is to improve the employment situation. An easy way to start is by restoring faith in the economy and providing certainty about the future in the minds of consumers and businesses. To do this, President Obama needs Benjamin Franklin's kind of "change." A penny saved is a penny earned, and today, it may also be a job saved.

Wicksell, Keynes and Hayek: a Unified Explanation of the US Financial Crisis

2012-01-07T22:36:00.006-05:00

A neo- Wicksellian perspective on the financial crisis and the common core of Keynesian and Hayekian Economics Part 1 -Theory

“Thornton does not only recognize (as Hume had done) that in the short period monetary causes may have real effects; he also recognized that in a credit system the reverse can happen. Real causes have monetary effects”[1]

Abstract

This paper makes three points about the current economic cycle (the ‘Cycle’) in the US. First, when the economy was booming from 2002 – 2007, the sum of domestic consumption and investment exceeded the value of domestic output. The difference was reflected in a growing trade deficit. Without the trade deficit there could not have been a sustained housing investment and price boom with full employment, because domestic output constraints would have caused prices and interest rates to rise to offset the pressure for increased spending, which would have countered the increased investment demand and damped asset prices. This point holds independently of financial market structure and leverage. Thus, Fed Chairman Ben Bernanke and former US Treasury Secretary Henry Paulson correctly identified, as a necessary condition for the boom to occur, the glut of savings in Asia that was transmitted to the US economy.

Second, modern macroeconomic theory is unable to account for this type of economic cycle because its basic conceptual framework does not allow for the existence of autonomous, market determined credit expansion and contraction. This bias was consistent with financial market conditions in developed countries for nearly a century, when currency monopoly and tight banking regulations conferred on central banks significant control over aggregate credit. But financial deregulation that has progressed over the past 20 years has enabled significant autonomous credit creation by commercial banks and financial markets, which has reduced the control over credit possessed by central banks.

Third, the cycle can be understood in the context of an earlier tradition of monetary theory, developed by Keynes and Hayek. Doing so requires a shift away from the modern framework descended from Ricardo and towards one descended from Wicksell[2].

Background

The severe US boom and bust cycle in trade, credit and asset prices of the past decade has some unique features relative to other postwar business cycles.

(1) The current account deficit reached unprecedented heights during the boom phase.

(2) Credit expansion, financial sector leverage and financial asset prices increased at comparatively higher rates than in the past during the boom, and then collapsed.

(3) Losses in the banking sector during the recession have caused a severe contraction in credit.

These features were present during the late 1920’s boom and subsequent Great Depression and many of these features, particularly the co-incidence of large trade deficits and financial crisis, have repeated themselves throughout history[3]. Because the severe expansion and subsequent contraction of credit is so prominent a feature of the Cycle, any attempt to understand it requires a framework in which such phenomena can occur and can have an effect on other economic variables.

Modern Macro

Modern macro-economic theory has proven itself an apparatus incapable of explaining a cycle characterized by an explosion followed by an implosion of privately created credit. The Dynamic Stochastic General Equilibrium (DSGE) framework starts from an assumed general equilibrium in which Say’s Law –the proposition that aggregate demand for goods is equal to the aggregate of goods produced – holds, and examines deviations from this optimum arising from exogenous shocks and rigidities in price movements. There is an interest rate, but no financial intermediation sector in the models.

There are two dominant approaches in modern macro: Real Business Cycle models explain fluctuations in GDP and its components as arising from equilibrium responses to movements in non-financial variables exogenous to the economy, like productivity growth rates and time preferences of individuals. New Keynesian models derive fluctuations from disequilibrium responses to movements in real and financial variables interacting with slow adjusting prices. Leverage is ignored as credit and money is either assumed controlled by the central bank, or eliminated altogether. None of the leading graduate Macro textbooks have so much as a chapter devoted to banking and the economic effects of expansions and contractions in credit.

The ‘toy model’ introduced by Olivier Blanchard (currently IMF Chief Economist) in his 2008 review of ‘The State of Macro’[4], has no financial sector, only interest rate setting by the Central Bank. Indeed, a financial sector has no place in a complete markets model in which there is no issue of inter-temporal coordination failure –because agents can contract in advance for future delivery of goods - and the composition of finance –debt and equity - is irrelevant to the macro-economy because all debts cancel out and there is no possibility of bankruptcy[5].

This was not always so. From the late 18th century, when financial innovation accelerated in the UK, until the 1930’s, economists often looked to the banking sector as the locus of economic fluctuations. According to John Hicks, economists like David Hume and Henry Thornton believed

“ …there is the penalty that the credit system is an unstable system. It rests upon confidence and trust; when trust is absent it can just shrivel up. It is unstable in the other direction too; when there is too much ‘confidence’ or optimism it can explode in bursts of speculation”[6]

The principal protagonists of the academic debate of the 1930’s, Keynes and Hayek, agreed that the depression had its roots in a failure of financial intermediation. They believed the supply of, and demand for, ‘inside’ money –bank credit and mutual funds – created by the banking sector, expanded and contracted due to market determined fluctuations in the supply of credit and the demand for borrowing ; such fluctuations sometimes spilled over, and sometimes were caused by , excess demand for goods. They debated within a paradigm constructed by Knut Wicksell that identified the expansion and contraction of credit as central to explaining price movements, and expanded Wicksell’s model to allow for credit fluctuations to affect aggregate output.[7]

John Hicks’ IS-LM interpretation of Keynes’ General Theory marked a turning point[8]. Hicks’ model, which became the canonical macro model until it was replaced by the DSGE framework in the 1980’s, embedded a neo-Ricardian assumption that monetary aggregates –base money and bank created credit - could be controlled by the central bank, therefore private banking activities per se, had no macro-economic effects. Hicks’ innovation was carried further along by the Monetarist Counter-revolution, led by Milton Friedman and his colleagues, who asserted that economic fluctuations resulted primarily from movements in monetary aggregates under the control of central banks. Friedman famously advocated that central banks operate with fixed monetary policy ‘rules’, as preferable to traditional ‘discretion’ in managing the banking system; as the promotion of price stability is the most effective way to reduce deviations from the natural rate of employment.[9] Friedman claimed the weight of empirical evidence supported his position

“ It is a matter of record that periods of relative stability of in the rate of Monetary growth have also been periods of relative stability in economic activity…Periods of wide swings in the rate of monetary growth have also been periods of wide swings in economic activity”[10]

Friedman’s assertion may be correct, but it does not settle the question of causality, Post Hoc Ergo Propter Hoc?[11] Was the monetary environment a product of monetary policy, or of market forces? It may be that the answer to that question differs by circumstance and depends on the contingencies of financial institutional structure. From the early 20th century, government monopoly on currency issue and mandatory reserve requirements for banks prevented the demand for base money from vanishing, thus conferring Central banks with continued monetary influence, while the Post WWII Bretton Woods system that tied developed country currencies to the dollar and Glass Steagal impediments to financial innovation, restricted the growth of non-bank, privately created credit. Indeed, it is probably no mere co-incidence that the correlation between monetary aggregates under central bank control, like M1 and M2, and GDP have broken down since the advent of financial deregulation in the US and UK beginning in the 1980’s.

More recently, the ‘New Neoclassical Synthesis” (NNS), embodied in Woodford modern classic Interest & Prices ( sometimes referred to as the ‘Bible” of Central Bankers), models an economy without a monetary aggregate. In this framework, the central bank sets the rate at which it lends to private banks and the resulting money supply is endogenously determined. The NNS adopts the concept of a ‘natural rate’ of interest developed by Wicksell.[12] The basic form of the model does not track any monetary aggregate and the ‘market rate’ of interest is set by the central bank in its lending policy to private banks.

The NNS view can be represented by a three equation system: An aggregate supply relation, an aggregate demand relation and a monetary policy equation. In this framework the central bank controls the interest rate rather than a monetary aggregate, so, while the NNS has rejected the quantity-theoretic analysis of Monetarism, it assumes the central bank can achieve the same degree of monetary control through its control over the market rate of interest and there is no room for commercial banks or financial markets in the creation of credit or the influencing of the level of economic activity.

In recent decades, our monetary system has moved away from the Ricardian/Monetarist world of rigidly quantity constrained metallic money and much closer to the pure credit world of Wicksell; A world, unlike that described by the NNS, in which the process of credit creation is not fully under the control of the central bank.

We now turn to an earlier tradition, where, in John Hicks’ phrase “the market makes its money”[13], to establish a framework for understanding the Cycle.

The Wicksellian Framework

“prices constitute…a spiral spring which serves to transmit the power between the natural and the money rates of interest; but the spring must first be sufficiently stretched or compressed. In a pure cash economy, the spring is short and rigid; it becomes longer and more elastic in accordance with the stage of development of the system of credit and banking” (Wicksell 1936)

The problem that concerned Wicksell was this.”Since the days of Ricardo, the non-bank public’s demand for minted gold had gone basically to zero…the entire enormous structure of credit was balanced as an inverted pyramid on the slender gold reserve of the bank of England. Wicksell asked the question: What would happen if both the gold coin to bank note ratio and the bank’s gold reserve ratio went to zero in the limit? The answer was his “pure credit economy” model, in which the supply of bank notes was indeterminate.” [14]

Say’s Law

Say’s Law says that real aggregate demand (Yd) is derived from real aggregate supply (Ys), thus Yd = Ys at all times. Let us assume a closed economy where money (M) is comprised of ‘base money’ like bullion issued by a central bank is the only financial asset. Let P represent an index of prices. Then, by Walras’ Law that supply equals demand across all markets in equilibrium, we have

(1) (Yd - Ys) + (Md - Ms)/P = 0

By Say’s Law, the left side falls to zero and there can never be any excess demand or supply of money. Money is a ‘veil’ behind which the ‘real’ economy operates, the classical Quantity Theory of Money. We can look at this in terms of Investment and Savings. By definition Yd = C+I+G, Where C is consumption, I is investment and G is government spending, and Ys = C+S+T, where S is savings and T is taxation. Assuming , for the sake of convenience only, a balanced government budget (G=T), we can transform equation (1) into

(2) (I - S) + (Md - Ms)/P = 0

Now, by Say’s Law, I = S, so Md = Ms. Say’s Law is in essence a dichotomy, as it separates the real and monetary sides completely –i.e. disequilibrium in the money markets cannot spill over into disequilibrium in goods markets. Money can have no effect on economic activity.

Credit Money: Ex Ante and Ex Post

Wicksell described a process by which money could affect goods markets, by introducing into the neoclassical model a banking sector. His innovation was to make desired investment independent of desired savings, so ex ante aggregate demand is free to rise above or drop below a given aggregate supply. He accomplished this by formalizing the concept of credit money created by banks. Banks create credit by gathering deposits, which function as money, and lending out a portion of the deposits, which is an extension of credit. Banks can increase or decrease the effective money supply by moving loan interest rates in such a manner as to cause a disequilibrium in the goods market, as a credit expansion will be associated with an increase in desired investment independently of desired savings. The distinction between desired magnitudes –ex ante- and actual magnitudes –ex post- is crucial. A disequilibrium occurs when ex ante. Savings and investment may be forced into equality ex post – by definition – but an ex ante discrepancy will set in motion a process of adjustment in prices and quantities until (if the system is stable) the ex ante and ex post magnitudes are identical.

In this way, ex ante disequilibrium in the money supply –or, more generally in credit – can spill over to disequilibrium in the goods market, by inducing agents to rebalance all elements of their budget; expenditure and wealth portfolio. This global rebalancing will cause prices and real variables to move. Money is no longer a ‘veil’ over the goods market. Money and banking can affect real activity.

The ‘Natural Rate’

The Market Rate, i, is the interest rate charged by banks to borrowers and is determined in the market for the supply of, and demand for, loanable funds. Wicksell introduced the concept of a theoretical ‘Natural Rate’ of interest, r, which is the rate at which ‘desired’ –ex ante – savings equals desired investment. The Natural Rate is equal to the marginal productivity of capital. The macro economy is in equilibrium when the market rate, i, is equal to the Natural Rate, r. In this state, economic actors have no desire to change their supply, demand or prices charged and all ex ante plans are realized as ex post magnitudes. Disequilibrium occurs when the Natural Rate and the Market Rate diverge . In this state ex ante plans of economic agents are inconsistent and therefore ex post realizations differ from plans. In this state a process of change is set in motion.

When r > i, desired investment will exceed desired savings and there will be upward pressure on the prices[15].

When r < i, desired investment is below desired savings and the deficiency in demand will place downward pressure on prices.

Wicksell referred to the adjustments set in motion from a discrepancy between the market rate and natural rate as a “Cumulative Process”.

The Cumulative Process[16]

We describe Wicksell’s Cumulative Process more formally. Assume with Wicksell that all saving is deposited with banks, that all investment is bank-financed, that banks lend solely to finance investment, and that full employment prevails such that shifts in aggregate demand affect prices but not real output. Then his model reduces to the following equations linking the variables investment I, saving S (both planned, or ex ante, magnitudes), loan rate i, natural rate r, loan demand LD, loan supply LS, excess aggregate demand E, change in the stock of checkable deposits dD/dt, price level change dP/dt, and market-rate change di/dt.

Equation (3) says that planned investment exceeds saving when the loan rate of interest falls below its natural equilibrium level (the level that equilibrates saving and investment):

(3) I - S = a(r - i)

Where the coefficient a relates the investment-saving gap to the interest differential that creates it.

Equation (4) states that the excess of investment over saving equals the additional checkable deposits newly created to finance it,

(4) dD/dt = I -S

In other words, since banks create new checkable deposits by way of loan, deposit expansion occurs when banks lend to investors more than they (banks) receive from savers. Thus equation (4) admits of the following derivation. Denote the investment demand for loans as LD =I(i), where I(i) is the schedule relating desired investment spending to the loan rate of interest. Similarly, denote loan supply as the sum of saving plus new deposits created by banks in accommodating loan demands. In short, LS=S(i)+dD/dt. Equating loan demand and supply and solving for the resulting gap between investment and saving yields equation (4).

Equation (5) says that the new deposits, being spent immediately, spill over into the commodity market to underwrite the excess aggregate demand for goods E implied by the gap between investment and saving:

(5) dD/dt = E

Equation (6) says that this excess aggregate demand bids up prices, which rise in proportion to the excess demand:

(6) dP/dt = bE

where the coefficient b is the factor of proportionality between price level changes and excess demand. Substituting equations (3), (4), and (5), into (6), and (3) into (4), one obtains

(7) dP/dt = ab(r - i)

and

(8) dD/dt = a(r - i)

which together state that price inflation and the deposit growth that underlies it stem from the discrepancy between the natural and market rates of interest.

Finally, since bankers must at some point raise their loan rates to protect their reserves from inflation-induced cash drains into hand-to-hand circulation, one last equation,

(9) di/dt = gdP/dt

closes the model. This equation says that bankers, having worked off excess reserves, now raise their rates in proportion to the rate of price change (g being the factor of proportionality). The equation ensures that the loan rate eventually converges to its natural equilibrium level, as can be seen by substituting equation (7) into the above formula to obtain

(10) di/dt = gab(r - i)

Solving this equation for the time path of the loan rate i yields

(11) i(t) = (i0 -r)exp(-gabt) + r

where t is time, e is the base of natural logarithm system, i0 is the initial disequilibrium level of the loan rate, and r is the given natural rate. With the passage of time, the first term on the right-hand side vanishes and the loan rate converges to the natural rate. At this point, monetary equilibrium is restored. Saving equals investment, excess demand disappears, deposit expansion ceases, and prices stabilize at their new, higher level.

Extensions of the Cumulative Process Model

Keynes’ Extension of Wicksell

We can add an aggregate output response to excess demand to the Wicksellian model to incorporate an effect of excess investment demand on output, in addition to the price level.

(6’) dy/dt = (1-b)E

Where the adjustment parameter is a function of the output gap ( Ymax – Y), where Y is actual output and Ymax is potential output (full employment).

(12) b = f[Ymax - Y], and db/d[Ymax-Y’] >0

In this manner the Wicksellian Cumulative Process can be extended to include adjustments in real variables.

If the Natural Rate of interest were to decline, and the Market Rate of interest could not decline, there would be an excess supply of savings over investment at full employment, and output would need to contract and/or prices decline until the marginal product of capital rose (and with it the Natural Rate of interest) to restore financial market equilibrium. But in this case monetary equilibrium would be inconsistent with full employment (goods market equilibrium) and Say’s Law would fail. That is where Keynes took Wicksell’s Cumulative Process.

Hayek’s Extension of Wicksell

In the Cumulative Process, an excess demand for investment over savings, leads to price increases (equation 6). The model does not distinguish capital assets from other commodities, but it is interesting to note that the prices of durable assets should be more sensitive to changes in the interest rate than other goods, since interest is the price of inter-temporal substitution. When the rate at which future consumption is discounted falls, for example, the value of durable assets will rise independently of the pressure of excess demand. In this way reduction of the Market Rate of interest will cause durable asset prices to rise and the subsequent increase in the Market Rate of interest –as the cumulative process brings about adjustment- will cause durable asset prices to decline. In this way, the Cumulative Process embodies an asset price boom and bust cycle.

It is also interesting to note that Wicksell could have made a distinction between a capital goods sector, into which the increased credit is channeled, and the consumption goods sector. The Cumulative Process would then proceed by first exerting upward pressure on capital goods prices which later spread throughout the economy.

If we add the possibility of output expansion in response to excess demand to the above two observations, we can describe a Cumulative Process in which the initial reduction in the Market Rate of interest triggers a large upswing in capital goods prices and output of capital goods, which then spreads throughout the rest of the economy. But when the adjustment completes itself, there might be capital goods production processes initiated in the boom as a result of the lower Market Rate of interest, which take time to build and generate revenue in the future, that become uneconomic when the higher Natural Rate of interest re-asserts itself. Those projects will be abandoned. That is where Hayek took Wicksell’s Cumulative Process.

The Debate of the 1930’s

In his reflection on the great economic debate of the 1930’s over the cause of the economic depression, John Hicks wrote “it is hardly remembered that there was a time when the new theories of Hayek were the principal rivals of the new theories of Keynes. Which was right, Hayek or Keynes?”[17] Hicks, who deserves much credit for forging the ‘neoclassical synthesis’ that dominated macro-economics for a half century after the 1930’s, “took quite a time to make up [his mind]”.

Hicks recognized that Hayek and Keynes shared a common methodological framework, descended from the theory of Swedish economist Knut Wicksell, in which economy-wide disturbances emanated from a malfunctioning of the financial sector when interest rates fail to seek a level at which ex ante desired saving and investment are made equal at full employment; the Wicksellian ‘natural rate’. [18] They both understood that Say’s Law, the proposition that there is demand to consume everything that is produced, may not hold as result of failures in inter-temporal coordination between investments made today –which initiates a time consuming process of production – and the future demand for the goods produced by investment. This can occur when production of goods for future delivery turn out not to be desired when completed, or when the cost of producing the good for future delivery is judged too expensive after the process of production has commenced, or when a loss of confidence in the future demand for the goods produced by the capital stock cause a withdrawal of investment. The collapse in investment spending idles plants, reduces employment and, as a result of the decline in household income, reduces consumer spending. Such circumstances could render the appearance of a general glut of productive capacity and goods amidst unemployment – the fundamental paradox of economic depressions. But, Hicks notes, “Wicksell plus Keynes said one thing, Wicksell plus Hayek said quite another”.

Both Keynes and Hayek added to the Wicksellian Cumulative Process, quantity adjustments to savings and investment. Excess (deficient) ex-ante aggregate demand for goods, E, could trigger an increase (decrease) in output.

The central point of Hayek’s theory is that an unsustainable boom is triggered by a credit expansion causing the market rate to fall below the natural rate , which leads to an increase in I and the initiation of capital investment projects that are not sustainable at r. Thus, when prices ultimately adjust and the market rate is brought in line with the natural rate, projects are abandoned, which causes output to contract.

The central point of Keynes’ theory is that r is based on convention, due to our ignorance of the future, and is prone to fluctuate with changes in collective feelings about the future. A contraction is triggered when the natural rate falls below the minimum feasible market rate in this case, E is negative and desired saving is stuck above desired investment I < S and the disequilibrium in the goods market leads to a contraction in output until savings have declined to a level equal to investment.

Keynes

Keynes located his ‘cause’ of depression in autonomous changes in sentiment over the future returns on investment, which engendered fluctuations in investment spending. Either a situation of general panic, or a secular decline in investment prospects –Keynes wrote about both – would cause investment to decline and put downward pressure on interest rates. But there is a lower bound to interest; it cannot fall below zero and will not fall below a level at which a sufficient number of well capitalized speculators judge it must ultimately rise above, nor can it fall below a level at which fearful savers would risk the illiquidity and contingencies of an investment. More generally, when desired saving exceeds desired investment (ex ante) and the interest sensitivity of the demand for money is high- a condition Keynes called ‘liquidity preference’- then increases in money cannot reduce interest rates sufficiently to re-start investment, which triggers a downward adjustment in income and employment to the point where a reduced level of savings equals investment (ex post)[19].

The market dynamics work as follows: The initial decline in investment causes a reduction in employment, which leads to a drop in consumer expenditures (hence sales), leading to further rounds of employment and spending declines. As income declines, given a fixed marginal propensity to consume out of income, the total amount of saving falls, and the process continues until savings (and, hence, income) has declined to a level at which it equals desired investment.[20] Thus does consumption (and employment) spiral downward via the multiplier. For Keynes, liquidity preference prevents interest rates from clearing the market for savings and investment and is therefore the key to co-ordination failures that can generate unemployment. And there from arises the Keynesian prescription of fiscal stimulus to inject government spending to make up for the deficiency in private spending.[21]

Hayek

Where Keynes emphasized the influence of a disequilibrium between savings and investment on the current level of real aggregate demand, Hayek stressed the consequences of such co-ordination failures for the time path of the capital stock and the evolution of the economy’s supply side[22]. Hayek located his ‘cause’ of depression in monetary over-expansion[23]. As Hicks explains “The initial expansion of credit – in ‘pure’ terms, the reduction of the market rate below the natural rate of interest – is that the money value of investment rises, implying a rise in the money prices of producers goods”. The low interest rates encourage increased borrowing from the banking system to undertake investment plans that would not have been initiated at the higher ‘natural’ interest rates. Thus does credit expansion fuel an asset price bubble and investment in projects whose rate of return is below the ‘natural rate’. This is a volatile disequilibrium situation in which the monetary stimulus eventually moves from inflating the prices of investment goods to inflating the prices of all goods, as wages are paid and spent. The spreading inflation ‘reveals’ the distortion in the inter-temporal structure of relative prices as the relative price of capital assets decline and interest rates adjust upward due to an income and inflation induced increase in the demand for nominal money balances, the uneconomic projects –those which were undertaken when interest rates were artificially low and the relative prices of capital assets were artificially high –are abandoned, the prices of capital goods collapse and unemployed resources, including labor, increase markedly.

Policymakers face a choice of further stoking the bubble with ever expanding monetary stimulus, which ultimately can lead nowhere but hyper-inflation and economic collapse, or to hold off and allow market clearing prices to re-establish themselves. This was the position for which Hayek and other ‘Austrian’ economists in the 1930’s were vilified. The unacceptability of official quiescence amidst mass suffering and fears of communist revolution were what probably tipped the balance of popular and professional opinion in favor of Keynes.

Hayek and Keynes centered their explanations of depressions on financial market failures due to deviations of interest from the Wicksellian ‘natural rate’. For Hayek, depression was the aftermath of an artificial boom created by rates forced too low by monetary expansion; for Keynes, depression was triggered by rates stuck too high after a damping of ‘animal spirits’ or secular decline in investment prospects. Both agreed that monetary stimulus provided little help to an economy in depression. [24]

But Hicks uncovered a fatal flaw in Hayek’s model: One that was not clearly understood at the time of the debate, but which became clear (to Hicks, at least) years later. In order for an economy beginning at full employment to generate an investment boom, there must be a corresponding reduction in consumption, at least for a time, since, in a closed economy, the National Income Identity

(13) Y = C + I + G

where Y is output, C is consumption and G is government spending, implies that, at full employment ( Y =Ymax), the sum of consumption and government spending must decline in order for investment to increase. Finite resources must be re-allocated. The Austrians recognized this and called it ‘forced saving’. It is the centerpiece of their analysis of the trade cycle. But where does it come from? What induces consumers to spend less? Moreover, the data (not available in the 1930’s) show that consumer spending increases during booms; the opposite of what Hayek’s theory requires.

As Hicks describes Hayek’s model “Labor is a producer’s good: wages are flexible; so the money wage must go up. But what happens about the spending of those wages?...here, at least, there must be an instantaneous or nearly instantaneous, reaction. The higher wage must be followed, nearly at once…by a rise in the demand for consumption goods…But Hayek will not allow that. In spite of the rise in wages the demand for consumption goods does not rise; so the prices for consumption goods do not, at this stage, rise. This is how he is able to maintain that there is a rise in the prices of producers’ goods, relatively to consumers’ goods, lasting right through the boom: the rise on which so much of his argument depends. There has to be a lag of consumption behind wages”. And, for a closed economy, Hicks is completely justified in concluding “Obviously, this lag is not acceptable”.[25]

The Possibility of Offshore ‘Forced Savings’

Now we consider an amendment to Hayek’s model. Suppose there is an offshore economy that supplies the home economy with its excess savings. Is it not possible that a sustained surplus in offshore financial inflows, driven by a persistent trade deficit with an offshore economy – promoted, perhaps, by a mercantilist policy pursued by the offshore economy in which it accumulates foreign reserves by running persistent trade surpluses with the home economy through pegging an undervalued exchange rate and averting price inflation by sterilizing the monetary inflows – might generate an ‘overinvestment boom’ in the home economy? In this case, home economy consumers would increase their spending on imports while offshore savers recycle their export earnings into investment in the home economy. The sum of consumption by home economy consumers and investment in home economy capital stock would exceed the value of home economy output. Hicks’ fatal flaw disappears in the case of an open economy: When the home economy runs a large trade deficit, both consumption and investment can increase. There is no requirement of ‘forced saving’, as home economy consumers do not need to reduce consumption in order to free up resources for investment (of course, this requires that there be ‘forced saving’ in the offshore economy). They can import goods from offshore. The net transfer of resources from the offshore economy to the home economy is matched by a corresponding debt owed by the home economy to the offshore economy.

More formally, the national income identity is expanded to include net exports

(14) Y = C + I + G + [X – M]

where X represent exports and M represents imports. A country running a trade deficit has [X – M] < 0, so domestic investment and consumption will exceed the value of domestic output.

This describes the interaction between the ‘home’ US economy and the ‘offshore’ Chinese economy over the past decade. The trade deficit, a 'real' cause, triggered the credit expansion that fuelled the US housing boom; as Henry Thorton observed nearly two centuries ago,"Real casues have monetary effects".

Stay tuned for Part II

[1] Hicks, John R, 1967, Thornton's Paper Credit in 'Critical Essays in Monetary Theory, Oxford at the Clarendon Press

[2] And Hume and Thornton. See Hicks Ibid
[3] Rogoff, Kenneth and Carmen Reinhart (2009) This Time is Different: Four Centuries of Financial Crises, Princeton University Press.
[4] Blanchard, O.J. , 2008, The State of Macro, MIT WP # 08-17.
[5] Because future sales and future income can be contracted for in advance in all possible future states of the world.
[6] Hicks, John R, Ibid

[7] Wicksell, Knut (1901) 'Interest and Prices', repreinted 1936 by Macmillan . Wicksell’s most prominent predecessor was Henry Thornton.
[8] Hicks, JR (1937) 'Mr. Keynes and the Classics', Econometrica Vol V, no 2.

[9] “There were at least two strands in classical economics. There was one (represented, roughly speaking, by Ricardo and his followers) which maintained that all would be well if by some device credit money could be made to behave like metallic money…When Milton Friedman tells us that we should have a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money, he is being Ricardian." John Hicks, 'Thornton's Paper credit' .
[10] Friedman (1968) 'The Role of Monetary Policy', Presidential Address to the American Economcis Association, American Economic Review.
[11] Tobin, James ( 1970 ), 'Money and Income, Post Hoc Ergo Propter Hoc?',Quarterly Journal of Economices
.[12] See following section for a description of Wicksell’s framework.
[13] Hicks, John ( 1989) 'A Market Theory of Money', Oxford at the Clarendon Press.

[14] Leijonhufvud (2009), 'The Wicksell Connection, Variations on a Theme' in 'Information and Coordination', Oxford University Press.
[15] And quantities, if the economy is operating at below full employment. Wicksell assumed full employment in his model, but Keynes and Hayek would later relax that constraint.
[16] This is the model described in Humphrey.
[17] Hicks, John (1967) ‘The Hayek Story’ in 'Critical Essays in Monetary Theory'.
[18]The common Wicksellian heritage of Austrian monetary theory, and Keynes’ theory is expounded in detail by Leijonhufvud. See Leijonhufvud, Axel ‘The Wicksell Connection: Variations on a theme’ in Information and Coordination.
[19] A. C. Pigou pointed out that monetary expansion would ultimately stimulate spending. via a ‘real balances’ channel. He reasoned that unemployment would lead to falling wages and prices and, thus, increased ‘real’ money balances and the resulting increased wealth would induce people to spend more, which would reverse the decline and lead the economy back toward full employment. Milton Friedman pointed out that the ‘real balance effect’ could be engineered by a ‘helicopter drop’ of money, and avoid the dislocations caused by deflation. US Fed Chairman Ben Bernanke has, in the past, endorsed Friedman’s prescription and it has formed the centerpiece of his strategy of injecting massive increases in base money to combat the forces of deflation unleashed by the financial meltdown.
[20] This is Keynes’ ‘Paradox of thrift’. An excess of savings leads, via market adjustments, to a state in which savings (and income and employment) are reduced. An increase in spendthrift behavior leads in the opposite direction, to a state of increased savings.
[21] And corresponding government deficits to provide a riskless alternative to hoarding ‘barren’ money.
[22] This passage, and many of the ideas of this paper , were inspired by a recent paper by David Laidler. See his 'Financial Stability, Monetarism and the Wicksell Connection' (the 2007 John Kuszczak Memorial Lecture).
[23] The text refers to the model in Hayek’s Prices and Production, published in 1931, which represented the ‘state of the art’ Austrian model of an interest rate driven ‘monetary’ trade cycle. Later on, after publication of Keynes’ General Theory, Hayek responded with a new ‘real business cycle’ model in Profits, Interest & Investment, published in 1939, which incorporated a Keynesian inspired role for limited fiscal stabilization policy and served as a precursor to the non-monetary ‘structuralist’ trade-cycle model developed by Edmund Phelps in the 1990’s.
[24] The ‘monetarist counter-revolution’; the idea that money is the most significant determinant of aggregate income, underpinned by Milton Friedman’s findings of the imperviousness of consumption expenditures to short term movements in income (permanent income hypothesis), and the higher correlation between money and income than investment and income, lay a generation off from the Keynes –Hayek debate.
[25] The quotes from Hicks in this section are from The Hayek Story cited above.

Dan Aronoff replies to Jeff Sachs

2012-01-02T22:43:00.000-05:00

Our very own Dan Aronoff gets back to Jeff Sachs on government spending. According to Dan, "Prof. Jeffrey Sachs is undeniably brilliant (after all, he is Bono’s Guru), but he lives in brilliant denial." Both the article and the reply were published in the Financial Times recently.

Sir,

Jeffrey Sachs argues that more, not less government spending is the cure for US economic ills, and higher taxes are the way to pay for it (“Death by strangling: the demise of state spending”, December 16). Prof Sachs appears to suffer from a math block of sorts.

His claim that an increase in tax collection of about 4 per cent of gross domestic product is sufficient to cover the increased cost of his recommended programmes leaves out the inconvenient fact that, according to the Congressional Budget Office, federal outlays are already on a path to rise by more than 20 per cent of GDP above current levels by 2050. Prof Sachs’s increase would come on top of that. It is the unsustainability of that fiscal path that has caused US debt to be downgraded.

His proposal to fix education by spending more is contradicted by numerous studies worldwide that fail to establish any link between educational outcomes and spending in developed countries and the US experience over recent decades of rising spending and declining results.

His claim that “high tax-and-spend” European countries “tax heavily and spend efficiently”, even if true, is irrelevant for the US, where government demonstrably spends inefficiently.

In any event, the inescapable mathematical fact is that the US cannot afford to spend more on public goods. Its best option – and the one most in keeping with its entrepreneurial culture and history – is to inject competition into the provision of education and healthcare and unleash market processes to deliver improved results at less cost.

Ron Paul: The Return of Conservatism and Something Else

2011-12-27T05:43:00.000-05:00

Although I am neither a Republican, nor a Democrat and I disagree with many of his positions, I always liked Ron Paul. He has the courage of his life-long convictions and refuses to bow to big money. In fact, sometimes I wish that he was able to formulate some his more extreme positions with a bit more nuance so as not to irritate so many people; including myself. And admittedly, he has over the years found more subtle ways to express himself and make his points. When he does, I find myself listening and forced to acknowledge his points even if I still disagree. And the most amazing thing: I have been hearing about Ron Paul for close to thirty years.

But compare this to most other opportunistic candidates who will say anything to please voters and then will turn around and will do anything to please donors. Up to now, it did not matter that a politician adopted that two-face attitude as everyone else in politics did it; and Ron Paul was just considered to be a fringe type of guy with crazy opinions. Other politicians could thus safely ignore the guy and his wild positions, move on and continue flip-flopping. However, now that his popularity is rising in the face of people being fed up with the old political class, the candidate is making some people nervous: Crises have a tendency to shake up things!

I don't know what Ron Paul would be able to accomplish as President if all other elected officials in Congress remained extremely partisan and partial to the donors who support them. This may not matter much as I believe that he may not be electable ... yet! It might still be too early in this crisis for enough people to desperately look at him as a credible candidate but, in spite of his flaws, his credibility is fast increasing. The crisis will probably need to hurt more and hurt more people before voters capitulate. This is when will Americans will be truly fed up with their current political system which favors the few and finally realise that they need to change the system if they want to move forward socially and economically.

Thus, could Ron Paul have a better chance in the next elections in 2016?

This will all depend on whether the economic crisis and the social malaise deepen. If they do not and we return to "business as usual" relatively soon, people will quickly forget the lessons of the current crisis. However, I don't believe that the crisis will go away so easily and, even if it did, it could soon come back with a vengeance within a few years if nothing is done to eradicate the roots of our currents woes.

Yet, for Ron Paul to have a chance to win in 2016, he would also have to be still willing to run. The guy will be 81 years old next time around. Not only could he be dead or seriously ill by he could be just too old to run and convince people that he has the energy to be President. Also, it looks like the next crop of Republicans might be of higher quality than the current one; both in terms of accomplishments and ability to make hard and sensible decisions. The likes of Paul Ryan, Mitch Daniels and Chris Christie will likely be much more appealing to the electorates than the bunch of lunatics running this time around; with the possible exceptions of Romney who has a strong tendency to flip-flop and Huntsman who is lagging in the polls.

To me, given the current political climate, it looks like it is going to be a continuing crisis for the next four to five years. I don't know where this will bring Americans collectively but it will certainly be interesting to watch from a distance.

In the meantime, for those of us who are invested in the markets, the outlook is certainly grim if nothing changes. Yet, the certainty of knowing that economic growth will continue to be sluggish for a while should help to convince you to position your portfolio defensively. Although inflation does not look like much a threat right now, one should also have a plan to avoid its eventual damage as financial repression is surely coming our way; see IMF Chief Economist's Four Lessons From 2011.

Finally, if economic growth in the Western world does not pick up significantly for another five to ten years, the relative importance of emerging economies will grow faster than anybody anticipated. This should change the global political landscape but also concince you to adjust your global asset allocation strategy accordingly. However, as social unrest here and abroad is likely to grow if the economy stagnates and without the U.S. being able or willing to police the world, investing in foreign markets could become even riskier. The way to play this safely would then be to invest in countries like Canada, Australia, New Zealand and Brazil. These countries have an abundance of resources, their economies are in relatively good shape and social unrest is unlikely to perturb them as much as other countries.

The question of whether the U.S. is likely to become more isolationist over the coming decade - a position held by Ron Paul - is a crucial one. As you will be able to read below in Why Do GOP Bosses fear Ron Paul?, although isolationism might still be a fringe political opinion in the U.S. right now, its popularity is likely going to grow and become much more mainstream. After all, it finds its intellectual foundations in U.S. history; one of its main proponents was none other than Warren Buffett's father.

Here is the piece authored by John Nichols, who wrote several books that examine the legacy of old-right conservatives such as Taft and Buffett (e.g. Against the Beast: A Documentary History of American Opposition to Empire) and published in The Nation last week:

Ron Paul represents the ideology that Republican insiders most fear: conservatism.

Not the corrupt, inside-the-beltway construct that goes by that name, but actual conservatism.

And if he wins the Iowa Republican Caucus vote on January 3—a real, though far from certain, prospect—the party bosses will have to do everything in their power to prevent Paul from reasserting the values of the “old-right” Republicans who once stood, steadily and without apology, in opposition to wars of whim and assaults on individual liberty.

Make no mistake, the party bosses are horrified at the notion that a genuine conservative might grab the Iowa headlines from the false prophets. Already, they are claiming a Paul win won’t mean anything. If Paul prevails, says Iowa Governor Terry Branstad, “People are going to look at who comes in second and who comes in third. If [Mitt] Romney comes in a strong second, it definitely helps him going into New Hampshire and the other states.”

The party’s amen corner in the media is doing its part. Republican-insider radio and television programs have begun to go after Paul, the veteran congressman from Texas who is either leading or near the top in recent polls of likely caucus goers. Rush Limbaugh ridicules Paul on his radio show, while Sean Hannity’s Fox show has become a nightly Paul-bashing fest, with guests like former Education Secretary Bill Bennett trashing the congressman with lines like: “his notion of foreign policy is impossible.”

Actually, Paul’s notion of foreign policy is in line with that of conservatives used to believe. The congressman is often referred to as a libertarian, and he has certainly toiled some in that ideological vineyard. But the truth is that his politics descend directly from those of former Ohio Senator Robert “Mr. Republican” Taft and former Nebraska Congressman Howard Buffett—old-right opponents of war and empire who served in the Congress in the 1940s and 1950s and who, in Taft’s case, mounted credible bids for the party’s presidential nomination in 1940, 1948 and finally in 1952. In all three campaigns, Taft opposed what he described as the “Eastern establishment” of the party—the Wall Streeters who, he pointedly noted, had little in common with Main Streeters.

Taft was a steady foe of American interventionism abroad, arguing very much as Paul does today that it threatens domestic liberty. Indeed, just as Paul joined US Senator Russ Feingold in opposing the Patriot Act, spying on Americans and threats to freedom of speech and assembly in the first days of what would become an open-ended “war on terror,” so Taft warned during the cold war that “criticism in a time of war is essential to the maintenance of any kind of democratic government.”

“The maintenance of the right of criticism in the long run will do the country…more good than it will do the enemy,” explained Taft, who challenged President Truman’s attempts to use war powers as an excuse to seize domestic industries and otherwise expand what Dwight Eisenhower would eventually define as the military-industrial complex.

Buffett, the father of billionaire Warren, opposed military interventionism during the cold war era, declaring on the floor of the House: “Even if it were desirable, America is not strong enough to police the world by military force. If that attempt is made, the blessings of liberty will be replaced by coercion and tyranny at home. Our Christian ideals cannot be exported to other lands by dollars and guns. Persuasion and example are the methods taught by the Carpenter of Nazareth, and if we believe in Christianity we should try to advance our ideals by his methods. We cannot practice might and force abroad and retain freedom at home. We cannot talk world cooperation and practice power politics.”

When the threat of increased US involvement in Vietnam arose in the early 1960s, the elder Buffett wrote in William F. Buckley’s National Review: “When the American government conscripts a boy to go 10,000 miles to the jungles of Asia without a declaration of war by Congress (as required by the Constitution) what freedom is safe at home? Surely, profits of U.S. Steel or your private property are not more sacred than a young man’s right to life.”

Just as Ron Paul has consistently opposed free-trade deals and schemes to enrich government contractors, the elder Buffett railed against the crony capitalism of his day. “There are businesses that are being enriched by national defense spending and foreign handouts,” Buffett warned in 1948. “These firms, because of the money they can spend on propaganda, may be the most dangerous of all.

If the Marshall Plan meant $100 million worth of profitable business for your firm, wouldn’t you Invest a few thousands or so to successfully propagandize for the Marshall Plan? And if you were a foreign government, getting billions, perhaps you could persuade your prospective suppliers here to lend a hand in putting that deal through Congress.”

Buffett campaigned in 1952 to nominate Taft as the Republican candidate for president. That effort was opposed by the Wall Street speculators and banksters of the day, and it failed—although not without a serious fight that went all the way to the GOP convention.

After his defeat, Taft griped, “Every Republican candidate for President since 1936 has been nominated by the Chase National Bank.”

That was the pure voice of old-right conservatism speaking.

It is echoed now by Ron Paul, who makes no secret of his high regard for Taft, Buffett and the old-right Republicans of the past, and of his disregard for the neocons and crony capitalists of today. Paul is running ads that propose to “drain the swamp,” a reference to the insider-driven politics of a Washington where Republicans such as Gingrich maintain the sort of pay-to-play politics that empties the federal treasury into the accounts of campaign donors and sleazy government contractors.

Paul’s ideological clarity scares the wits out of the Republican mandarins who peddle the fantasy that the interventionism, the assaults on civil liberties and the partnerships that they have forged with multinational corporations and foreign dictators represent anything akin to true conservatism.

The problem that Limbaugh, Hannity and other GOP establishment types have with Paul is that the Texan really is a conservative, rather than a neoconservative or a crony capitalist who would use the state to maintain monopolies at home and via corrupt international trade deals.

Paul’s pure conservatism puts him at odds with a party establishment that has sold out to Wall Street and multinational corporations. But it has mad an increasingly iconic Republican with a good many of the grassroots activists who will attend the caucuss.

The disconnect between the disdain the establishment expresses with regard to Paul and his appeal to the base is easily explained.

The GOP establishment chooses partisanship over principle. The base does not necessarily do so.
In other words, while the party establishment and its media echo chamber reject the Main Street conservatism of the Taft’s and Buffetts, there are many grassroots Republicans in Iowa towns like Independence and Liberty Center (where Paul campaign signs are very much in evidence) who find Paul’s old-right conservatism quite appealing.

That is what frightens Republican party leaders. The notion that the Grand Old Party might actually base its politics on values, as opposd to pay-to-play deal-making, unsettles the Republican leaders who back only contenders who have been pre-approved by the Wall Street speculators, banksters and corporate CEOs who pay the party’s tab—and kindly pick up some of the bills for the Democrats, as well.

What do the party insiders fear about genuine conservatism? Above all, they fear that a politics of principle might expose the fact that the Republican Party has for decades been at odds with the conservative values and ideals of Americans who do not want theirs to be a warrior nation that disregards civil liberties and domestic economics in order to promote Wall Street’s globalization agenda.

Ron Paul is not a progressive. He takes stands on abortion rights and a number of other issues that disqualify him from consideration by social moderates and liberals, and his stances on Social Security, Medicare, Medicaid and labor rights (like those of the author of the Taft-Hartley Act) are anathema to economic justice advocates. But Paul cannot be dismissed as just another robotic Republican. Indeed, he is more inclined to challenge Republican orthodoxy on a host of foreign and fiscal policy issues than Barack Obama. He does so as something that is rare indeed at the highest levels of American politics: a conservative.

And if he wins Iowa, he could begin a process of transforming the Republican Party into a conservative party.

That scares the Republican bosses who currently maintain the party concession on behalf of the Wall Streeters. But it, if the polls are to be believed, it quite intrigues the folks on Main Street who may be waking up to the fact that the “conservatism” of a Newt Gingrich or a Mitt Romney is a sham argument designed to make the rich richer and to make the rest of us pay for wars of whim and crony-capitalist corruption.

IMF Chief Economist's Four Lessons From 2011

2011-12-26T10:38:00.000-05:00

In What a difference a year makes …, Olivier Blanchard, Chief Economist of the IMF, reflects on the year that just passed. Back in January last year, it seemed to most observers that 2011 was going to be a year of solid economic growth due to strong fiscal and monetary stimuli. Most also expected an improvement in the business climate and in consumer sentiment.

I, for one, expected high growth in 2011 but expressed serious doubt that it could persist beyond 2012. I thought that it would falter soon after the stimuli would be retired. It all cratered much quicker than anybody anticipated. Below, Olivier Blanchard draws four lessons from 2011 on why this happened and why the crisis is lingering.

Although there was growth in the first half of 2011, rather than improved over time, economic growth faltered in the second half of the year. To compound the problem, increasingly worrying woes in peripheral Europe finally quashed any hopes that the outlook would soon improved in early 2012. As a result, investment and consumption growth remained modest and the situation is likely to persist into 2012. SME investment also suffered from the continued unwillingness of banks to expand their balance sheets while consumers were constrained by the weight of their indebtedness. And, as inflation did not pick up despite the coordinated best efforts of western central banks, the process of deleveraging continues to progress at a snail’s pace.

This friction is obviously only prolonging the pain of the crisis as it pushes further down into the future the end of this sub-par growth episode. In other words, there is nothing in the cards yet to signal that the proverbial pent-up demand from the private sector (which usually forms during the recession) could spring up anytime soon and eventually propel the economy into a sustainable and lasting recovery.

There was hope this summer that some policies would target damaged balance sheets. The rumored initiatives, aimed at improving the financial situation of underwater home owners whose obligations continue to be a drag on economic growth, never came to life. Some policy makers then started to talk about the need to engineer mild inflation to gradually reduce the burden of our debt on economic growth. It’s a dangerous path to follow and a difficult policy to implement because it could cause interest rates to rise instead. And who needs higher interest rates when we are crippled by tons of debt?

To ensure that such scheme would work, inflation would have to increase by more than interest rates, thereby moderately reducing real interest rates on a long term basis (i.e. for 10 to 20 years). How to successfully implement such an outcome is being discussed at the highest levels of government. It is the solution which is now favored and being considered as the cure to the debt problem. The scheme is being labeled “financial repression”. It is nothing new. Such a strategy was used to gradually get rid of government debt in the decades that followed WWII. Yet, I had not heard of it in years. And for good reasons: alchemy does not usually work!

To succeed it requires that governments increase their control on banks (through regulation and/or nationalization of banks) to force them to channel funds to the public sector at negative or very low real long term interest rates. With efficient capital markets today this is a very difficult strategy to engineer as capital rationing - which would favor public borrowers over private ones - risks choking SME investments and inhibiting entrepreneurship; the machines behind job creation in this country. This is because small firms and would-be entrepreneurs would have to pay higher interest rates to finance their investments and ventures as governments would be crowding out financial markets.

The winners are thus easy to identify: besides governments, they would be large firms without cash constraints. If financial repression is implemented, there is no way to know if it could be successful but it would provide investors with an actionable asset allocation strategy that could be rewarding over the new few years: invest in large firms with tons of cash and little leverage and avoid government nominal bonds which will likely yields less than inflation.

Here is the Blanchard article which was recently published on iMFdirect, the IMF Blog. The piece is also available in several languages (French, Arabic, Chinese, Japanese, etc.). Just click on the link above to have access to these translations:

We started 2011 in recovery mode, admittedly weak and unbalanced, but nevertheless there was hope. The issues appeared more tractable: how to deal with excessive housing debt in the United States, how to deal with adjustment in countries at the periphery of the Euro area, how to handle volatile capital inflows to emerging economies, and how to improve financial sector regulation.

It was a long agenda, but one that appeared within reach.

Yet, as the year draws to a close, the recovery in many advanced economies is at a standstill, with some investors even exploring the implications of a potential breakup of the euro zone, and the real possibility that conditions may be worse than we saw in 2008.

I draw four main lessons from what has happened.

• First, post the 2008-09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.

Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created. Self-fulfilling attacks against pegged exchange rates are the stuff of textbooks. And we learned early on in the crisis that wholesale funding could have the same effects, and that runs could affect banks and non-banks alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets—largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default, and the smaller the distance between the interest rate associated with solvency and the interest rate associated with default. Italy is the current poster child, but we should be under no illusion: in the post-crisis environment of high government debt and worried investors, many governments are exposed. Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there.

• Second, incomplete or partial policy measures can make things worse.

We saw how perceptions often got worse after high-level meetings promised a solution, but delivered only half of one. Or when plans announced with fanfare turned out to be insufficient or hit practical obstacles.

The reason, I believe, is that these meetings and plans revealed the limits of policy, typically because of disagreements across countries. Before the fact, investors could not be certain, but put some probability on the ability of players to deliver. The high-profile attempts made it clear that delivery simply could not be fully achieved, at least not then. Clearly, the proverb, “Better to have tried and failed, than not to have tried at all,” does not always apply.

• Third, financial investors are schizophrenic about fiscal consolidation and growth.

They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease. But it should be, in the words of Angela Merkel, a marathon rather than a sprint. It will take more than two decades to return to prudent levels of debt. There is a proverb that actually applies here too: “slow and steady wins the race.”

• Fourth, perception molds reality.

Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example, nothing much happened in Italy over the summer. But, once Italy was perceived as at risk, this perception did not go away. And perceptions matter: once the “real money’’ investors have left a market, they do not come back overnight.

A further example: not much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away. Many financial investors are busy constructing strategies in case it happens.

Put these four factors together, and you can explain why the year ends much worse than it started.

Is all hope lost? No, but putting the recovery back on track will be harder than it was a year ago. It will take credible but realistic fiscal consolidation plans. It will take liquidity provision to avoid multiple equilibria. It will take plans that are not only announced, but implemented. And it will take much more effective collaboration among all involved.

I am hopeful it will happen. The alternative is just too unattractive.

Vaclav Havel - A Reflection

2011-12-24T02:54:00.010-05:00

In an extraordinary address at the Hebrew University in Jerusalem made soon after the Velvet Revolution, the first elected post Communist President of Czechoslovakia, Vaclav Havel, declared his profound affinity with Franz Kafka.

“I want to take this opportunity to confess my long and intimate affinity with one of the great sons of the Jewish people, the Prague writer Franz Kafka. I’m not an expert on Kafka, and I’m not eager to read the secondary literature on him. I can’t even say that I’ve read everything Kafka has written. I do, however, have a rather special reason for my indifference to Kafka studies: I sometimes feel that I’m the only one who really understands Kafka, and that no one else has any business trying to make his work more accessible to me. And my somewhat desultory attitude to studying his works comes from my vague feeling that I don’t need to read and reread everything Kafka has written because I already know what’s there. I’m even secretly persuaded that if Kafka did not exist, and if I were a better writer than I am, I could have written his works myself.”

In that speech (and in many others afterward) this legendary dissident who, as much as any other individual, brought down the Soviet Union and Communism in his own country through rare courage in speaking truth to power and risking the severest of consequences, shocked his audience by expressing deep existential doubts about himself, in terms that clearly resonate with Kafka.

"I am the kind of person who would not be in the least surprised if, in the very middle of my Presidency, I were to be summoned and led off to stand trial before some shadowy tribunal, or taken straight to a quarry to break rocks… Nor would I be surprised if I were to suddenly hear the reveille and wake up in my prison cell, and then, with great bemusement, proceed to tell my fellow-prisoners everything that had happened to me in the past six months. The lower I am, the more proper my place seems; and the higher I am the stronger my suspicion is that there has been some mistake."

Virtually all of Havel’s literary output –his plays, his political tracts, his letters from prison and his memoirs – have at their core a theme of the alienation of the individual from his fellow man and from his environment. He writes about his ostracism as a chubby scion of wealthy family that set him apart from the other children at school and then his pariah status as a teenage son of a bourgeois family under Communism. The heroes of his plays (at least those few I’ve read) are somewhat confused by, and disconnected from, the world around them, but they achieve a penetrating insight into its absurd dimensions. His iconic Greengrocer, the subject of his most influential political essay, is a frightened man who places a sign in his shop window with the slogan “workers of the world unite!”, that neither he, nor anybody, remotely believes to be true, in order effectuate a hollow and false conformity – to a lie that is the underpinning of the entire, monstrous and oppressive Communist order.

Havel was exquisitely sensitive to the pseudo- legitimacy Communism manufactured from slogans and enforced modes of discourse congruent to a falsified reality, which he recognized to be its soft underbelly, and he ultimately undermined the system with a relentless deployment of language and emotion rooted in reality and moral truth. He diagnosed that, in order to survive, communism had to enforce a universal conformity to its lies, even and especially its trivial and pedestrian distortions like the Greengrocer's sign - what Havel called its 'panorama' - and any dissent threatened to bring down the charade by revealng to everyone, together and at once, that they had acquiesced in thier debasement before an Emperor who has no clothes; to a system that served no human purpose; that no one ever believed in. He understood he was only a catalyst and it was the receptiveness of other people to the undeniably of truth that made the revolution. This was "the power of the powerless".

Havel was an agnostic, but he was no enemy of religion. He attributes the descent into totalitarianism in 20th century Europe to the decline in traditional religion and the belief in a transcendent God to whom all men are subservient and responsible, without its replacement by a new belief in something transcendent to which man stands beneath or is integrally related. He traces this downward moral trajectory to the success of the modern scientific outlook, with its faith that all of reality can be explained by, and subsumed under, impersonal universal laws which have no place for morality, spirituality or human responsibility.

A world devoid of the concept of responsibility – and guilt – and in which there are no limits to what man can do to his fellow men and to his environment, is a dystopia and the very opposite of a free and humane order. That is the central crisis of our civilization. Yet Havel is firm in his conviction that democracy is the only political arrangement in which responsibility can flourish.

“The present crisis of authority is only one of a thousand consequences of the general crisis of spirituality in the world at present. Humankind, having lots its respect for a higher authority, has inevitably lost respect for earthly authority as well. Consequently, people also lose respect for their fellow humans and eventually even for themselves. This loss of a transcendent perspective, to which everything on this Earth relates, inevitably leads to a collapse of earthly value systems as well. Humanity has lost what I once privately described as the absolute horizon; and as a result, everything in life has become relative. All sense of responsibility disintegrates, including responsibility for the human community and its authorities. This is a philosophical, not a political problem. However, even a decaying or diminishing democratic authority is a thousand times better than the thoroughly artificial authority of a dictator imposed through violence or brainwashing.

Democracy is an open system, and thus it is capable of improvement. Among other things, freedom provides room for responsibility. If that room is not sufficiently used, the fault does not lie with democracy, but it does present democracy today with a challenge. Dictatorship leaves no room for responsibility, and thus it can generate no genuine authority. Instead, it fills all the available space with the pseudo-authority of a dictator.

Potential dictators are well aware of the crisis of authority in democracy. The less that atheistic people today heed the challenge that democracy presents, the less they succeed in filling the room it offers by taking genuine and unquestioned responsibility, the faster a dictator, posing as the bearer of universal responsibility, will proceed to occupy that room until finally he will occupy it entirely. Hitler, Lenin, and Mao were typical examples of this species. Filling all the available room with a completely false authority, they closed it off, destroyed it, and eventually destroyed democracy itself. We all know where this leads: to the tombs of the dead, the tortured, and the humiliated. In a word, while democracy paves the way for the creation of real authority, an authoritarian regime blocks that path with a terrible barrier, with the caricature of authority.

The chances for a successful existential revolution -- as I once metaphorically described the awakening of a deeper human responsibility -- are far better under freedom and democracy than under a dictatorship, where the only room offered to anyone who wishes to take responsibility is a prison cell.”

Because “communism was the perverse extreme” of this modern world-view, Havel sees life under communism as “a kind of warning to the West, revealing to it its own latent tendencies”. But the West shows “unwillingness to hear the warning voices coming from our part of the world.” So, it misses the real significance of “the end of communism,” which is “a signal that the era of arrogant, absolutist reason is drawing to a close.”

And so Havel deduces there can be no social order with meaningful or lasting liberty or equality without an acknowledgement of a transcendent and moral “Creator”.

The challenge of today, upon which the continued existence of the human race may well depend, is to develop a sense of spirituality in an increasingly integrated multicultural world. How can the inhabitants of our increasingly integrated planet live decently? This interdependence includes, increasingly, elements of the natural environment on which our survival depends and which can be threatened by our activities. Havel looks for inspiration to antiquity.

The religions of antiquity proclaim in common what modern humanity has lost: “The certainty that the Universe, nature, existence, and our lives are the work of creation guided by a definite intention, that it has a definite meaning and follows a definite purpose.” Despite our superior information about the universe, our ancestors “knew something more essential about it than we do, something that escapes us.” They knew that “people should revere God as a phenomenon that transcends them.” They knew that “true goodness, true responsibility, true justice, a true sense of things–all these grow from roots that go much deeper than the world of our transitory earthly schemes. This is a message that speaks to us from the very heart of human religiosity.”

“To this day, the point of departure has been present in all our archetypal notions and in our long-lost knowledge, despite the obvious estrangement from these values that modern civilization has brought with it. Yet, even as our respect for the mysteries of the world dwindles, we can see for ourselves again and again that such a lack of respect leads to ruin. All this clearly suggests where we should look for what united us: in an awareness of the transcendent.”

Havel could not work out how to effectuate this transformation because, I think, he embodied the essential contradiction. He was a product of Western civilization and could not bring himself to believe in any ancient religion-he was too alienated and too modern for that. This was a man who counted Frank Zappa and the Rolling Stones among his first invited guests to the Prague Castle after becoming President. But he grasped the crux of the problem.

“Dostoevsky wrote that if there were no God everything would be permitted. To put it simply, it seems to me that our present civilization, having lost the awareness that the world has a spirit, believes that anything is permitted. The only spirit that we recognize is our own.

However different the paths followed by different civilizations, we can find the same basic message at the core of most religions and cultures throughout history: people should revere God as a phenomenon that transcends them; they should revere one another; and they should not harm their fellow humans.

To my mind, reflecting on this message is the only way out of the crisis the world finds itself in today”.

Havel lived with massive guilt and doubt. He doubted because so often he just didn’t “get it” about what everyone around him seemed to know or to believe and like Kafka, his questioning led him to discern and dissect the sources of hypocrisy and false convention that made it so difficult for a person in search of truth to make sense of the world around him. He discovered, like Kafka, that his society was a system designed to restrict and degrade human relations to lies; an institutionalized system of systematic lying. It must have been at least in part because of his feelings of alienation – of beginning life as an ‘outsider’ –that he was able to penetrate to the rotten stinking core of the debased society Communism had created and required to perpetuate itself.

"All that I encounter, reveals to me, first and foremost, its absurd dimensions. As if I were pursuing a group of strong and confident men, which I am unable to reach or overtake. I think I am an annoying person, worthy only of mockery…

there is a feeling of deep guilt. As if my very existence were a sin. Furthermore, I sense a feeling of non-belonging - concerning myself and all that which has developed around me. A feeling of deep claustrophobia and the constant need to explain and defend myself. In this, there is a search and aspiration for a higher order”

But unlike his hero Kafka, Havel proceeded to the Public Square –what little still remained of it – and did battle with the Castle. At first in the theatre, where he mastered the craft of orchestrating effects that elicited from a community of actors and audience a shared spontaneous outpouring of true emotion that helped affirm– if only for the moment – that a common bond still existed between them; And then in the political realm, where he wrote and spoke out against the government’s violation of basic rules of human decency – and earned himself years in prison; And finally to Wenceslas Square in Prague where he played midwife to a new birth of freedom in Central Europe.

“A person, whose idealism has brought him to lead his country. I admit, that from the outside, I appear the complete opposite of Joseph K. and other characters, even Franz Kafka. Nonetheless, I will not retract what I said previously. I think that the feeling of non-belonging is an intelligent feeling, and it is the underlying factor which motivates my efforts. Moreover, [I think] that it is my desperate search for a higher order which has dragged me into unlikely adventures. I would even go so far as to say, that whenever I have achieved something good, my actions were probably the result of the need to overcome the metaphysical feeling of guilt. It appears as if I create, organize or fight, only to defend my dubious right to exist.”

Havel understood that speaking truth to power could undermine a system, no matter how powerful, that was built on lies. He spoke the truth about everything, including himself. He had the eloquence, the opportunity and the courage to do it.

And the evil system collapsed.

He was the leading European of his generation.

Shiller: The Neuroeconomics Revolution

2011-12-19T22:13:00.000-05:00

In The Neuroeconomics Revolution, one of my favourite economists, Robert Shiller, Professor at Yale University, writes about the newest developments in the field of economics. I had never heard about neuroeconomics before last night. Nonetheless, the piece which was published on Project Syndicate last week makes for a fascinating read.

I especially appreciated to learn that somehow, somewhere, someone is finally questionning the assumption of rationality in economic decisions. As you will read below, the scepticism of neuroscientist Paul Glimcher could "shake economics to its foundations". This is totally in line with what this blog, The Sceptical Market Observer, hopes to achieve: Bring readers beyond conventional wisdom!

Here is the piece:

Economics is at the start of a revolution that is traceable to an unexpected source: medical schools and their research facilities. Neuroscience – the science of how the brain, that physical organ inside one’s head, really works – is beginning to change the way we think about how people make decisions. These findings will inevitably change the way we think about how economies function. In short, we are at the dawn of “neuroeconomics.”

Efforts to link neuroscience to economics have occurred mostly in just the last few years, and the growth of neuroeconomics is still in its early stages. But its nascence follows a pattern: revolutions in science tend to come from completely unexpected places. A field of science can turn barren if no fundamentally new approaches to research are on the horizon. Scholars can become so trapped in their methods – in the language and assumptions of the accepted approach to their discipline – that their research becomes repetitive or trivial.

Then something exciting comes along from someone who was never involved with these methods – some new idea that attracts young scholars and a few iconoclastic old scholars, who are willing to learn a different science and its different research methods. At a certain moment in this process, a scientific revolution is born.

The neuroeconomic revolution has passed some key milestones quite recently, notably the publication last year of neuroscientist Paul Glimcher’s book Foundations of Neuroeconomic Analysis – a pointed variation on the title of Paul Samuelson’s 1947 classic work, Foundations of Economic Analysis, which helped to launch an earlier revolution in economic theory. And Glimcher himself now holds an appointment at New York University’s economics department (he also works at NYU’s Center for Neural Science).

To most economists, however, Glimcher might as well have come from outer space. After all, his doctorate is from the University of Pennsylvania School of Medicine’s neuroscience department. Moreover, neuroeconomists like him conduct research that is well beyond their conventional colleagues’ intellectual comfort zone, for they seek to advance some of the core concepts of economics by linking them to specific brain structures.

Much of modern economic and financial theory is based on the assumption that people are rational, and thus that they systematically maximize their own happiness, or as economists call it, their “utility.” When Samuelson took on the subject in his 1947 book, he did not look into the brain, but relied instead on “revealed preference.” People’s objectives are revealed only by observing their economic activities. Under Samuelson’s guidance, generations of economists have based their research not on any physical structure underlying thought and behavior, but only on the assumption of rationality.

As a result, Glimcher is skeptical of prevailing economic theory, and is seeking a physical basis for it in the brain. He wants to transform “soft” utility theory into “hard” utility theory by discovering the brain mechanisms that underlie it.

In particular, Glimcher wants to identify brain structures that process key elements of utility theory when people face uncertainty: “(1) subjective value, (2) probability, (3) the product of subjective value and probability (expected subjective value), and (4) a neuro-computational mechanism that selects the element from the choice set that has the highest ‘expected subjective value’…”

While Glimcher and his colleagues have uncovered tantalizing evidence, they have yet to find most of the fundamental brain structures. Maybe that is because such structures simply do not exist, and the whole utility-maximization theory is wrong, or at least in need of fundamental revision. If so, that finding alone would shake economics to its foundations.

Another direction that excites neuroscientists is how the brain deals with ambiguous situations, when probabilities are not known, and when other highly relevant information is not available. It has already been discovered that the brain regions used to deal with problems when probabilities are clear are different from those used when probabilities are unknown. This research might help us to understand how people handle uncertainty and risk in, say, financial markets at a time of crisis.

John Maynard Keynes thought that most economic decision-making occurs in ambiguous situations in which probabilities are not known. He concluded that much of our business cycle is driven by fluctuations in “animal spirits,” something in the mind – and not understood by economists.

Of course, the problem with economics is that there are often as many interpretations of any crisis as there are economists. An economy is a remarkably complex structure, and fathoming it depends on understanding its laws, regulations, business practices and customs, and balance sheets, among many other details.

Yet it is likely that one day we will know much more about how economies work – or fail to work – by understanding better the physical structures that underlie brain functioning. Those structures – networks of neurons that communicate with each other via axons and dendrites – underlie the familiar analogy of the brain to a computer – networks of transistors that communicate with each other via electric wires. The economy is the next analogy: a network of people who communicate with each other via electronic and other connections.

The brain, the computer, and the economy: all three are devices whose purpose is to solve fundamental information problems in coordinating the activities of individual units – the neurons, the transistors, or individual people. As we improve our understanding of the problems that any one of these devices solves – and how it overcomes obstacles in doing so – we learn something valuable about all three.

China remains in a water crisis

2011-12-19T18:27:00.003-05:00

Natural water shortages exacerbated by rising demand and chronic pollution have transformed China’s water problem into a crisis. The country’s water resources per capita (2,143 m3) are only 1/3 of the world average (6,520 m3), while its consumption per unit of GDP is 4 times the world’s average. The country has 20% of the population living on earth but 6.5% of its water resources.

At present 250 mn people in rural areas do not have a safe drinking water supply while 100 mn people in 400 cities suffer water shortages. By the end of 2010, 32% of China’s water resources were non-potable, according to the Ministry of Water Resources. Although this is an improvement from 37% at end-2008 and 53% at end-2003, water quality remains very much a concern. About 50% of waste water is released untreated as effluent into rivers and the sea.

Problems are compounded by the fact that the northern part of China has only 20% of the country’s water resources but 46% of the population and produces 44% of total GDP. Water resources in the North are mostly already exploited. Uneven rainfall and severe droughts have complicated the situation. For years already the central government has been working on the ‘South-to-North’ water project to bring water from well supplied areas in the South to drought-prone northern cities. The entire project, through three routes, is expected to be completed by 2050, reaching a flow capacity of close to 45bn m3 annually to cover 300 mn people.

We think that water is arguably one of the top environmental issues in China. Half of the emergency incidents concerning the environment reported by the State Environmental Protection Administration in 2009 were over water.

Hence, China has set strict targets for water development in the 12th Five Year Plan (2011-2015) announced in March 2011. Targets to be reached by 2015 include, among others:
• Reduction of water consumption per unit of industrial output by 30% over 2010 level
• Target urban waste water treatment rate of 85%
• Promotion of water supply expansion from cities to rural areas
• Increasing water tariffs and tariff reforms

On the subject of pricing it is notable that China’s water tariff, computed as a percentage of disposable household income, is significantly lower than its international peers. The average water bill as a % of net disposable income is 1% while it is 10% in Turkey and 3% in Brazil, for example.

It remains to be seen how this will evolve over time.

The US Government should ‘Equify’ its Debt

2011-12-17T18:58:00.003-05:00

A Paradox

The yield on US government debt hovers near all time lows. This is because the US is viewed as a ‘safe haven” for investors in an increasingly dangerous global investment marketplace. Yet US finances are very precarious. That is why the ratings agencies have down-graded US debt. The recent failure of the Congressional ‘Super Committee’ to carry out its mandate to find spending reductions, required as part of the August 2011 budget deal, underscores the fear that the US political system is incapable of acting to control spending before the US government is hit by a funding crisis. It may be fairly said that US finances look like Greece on steroids.

It is paradoxical that the finances of the world’s ‘safe haven’ rest on a very unstable foundation. It’s debt is headed above 100% of annual GDP and, according to the CBO, federal government spending –around 20% of GDP for the past 40 years – is on a trajectory to reach nearly 45% of GDP; clearly not a sustainable path. There will be a crisis along the way if it does not undertake significant reform to reduce spending obligations.

It may be that the US has been spared a crisis solely because Europe arrived there first. Capital –always looking for a safe harbor in stormy waters – has come awash on US shores –for the moment.

An Opportunity

The US government is plagued by two financial problems: too much leverage and too much spending. It will take political will to rein in spending – and there is ample reason to doubt the US has that will at present. But there may be an opportunity to restructure debt and improve its sustainability.

The US could issue long term bonds – at low cost under current market conditions - that have a variable repayment structure that ties the level –but not the ultimate amount –of repayment to the rate of growth of GDP; the higher GDP growth, the higher the level of repayment (and the faster repayment of the entire obligation).

Such bonds have an equity –like property; the level of repayment is tied to the ‘profitability’ of the entity. In this case the US economy. The procyclical repayment attribute means the government will be under less stress to raise funds to pay on debt service during recessions. This will better enable the government to resist austerity measures when the economy can least afford it, and the procyclical payment structure should improve investor confidence that the debt obligations can be met.

Here’s the rub. Bond investors crave the certainty of fixed repayment schedules and they normally exact a premium to finance investments with variable repayments. So, ordinarily, the shift to a variable rate structure will cause the cost of funding to increase.

Seize the Day

But we are in moment when investor fear is running so high it may well be possible for the US government to issue variable repayment bonds without any appreciable increase in its funding costs. Moreover, given the precariousness of the overall US financial position, investors may react positively to the improved sustainability of the variable repayment feature of the bonds.

In any event, the US should aggressively extend the maturity of its debt while it is able to do so at low yields. That will better protect it from a shift in global investor sentiment (and global capital flows) away from the US, by reducing its near term funding needs.

This opportunity, if it exists, may be fleeting, as the possibility of a reversal of sentiment and an investor flight from the US is an ever present threat under current conditions.

So the US Treasury should ‘Seize the Day’ and try It out.

Tea Partiers and Occupiers United?

2011-12-15T05:43:00.000-05:00

I have been in Paris all last week, mostly jet-lagged since and thus unable to blog for more than 10 days. Yes, Europe is going down and most people there don't realise it yet. The calm before the storm. But this is a subject for this coming week-end.

Thank you to Clif Carothers for sending me another insightful piece. In it, he echoes others that have made similar comments:

Tea Partiers and Occupiers Should Take Up the Banner Together to Form a New Party

Despondency and Angst is peaking in America. Multiple movements are mounting opposition to what seems to be Congressional inaction toward the will of the people. Rhetoric is flying in attempts to find or divert fault for America’s ongoing and increasingly unstable financial crisis. Occupy Wall Streeters are organizing in opposition to international banks for their having extracted America’s wealth to China and having bank rolled a transfer of jobs and intellectual capital that would otherwise prosper the United States. A growing majority of Americans are sympathizing with the Occupiers, believing that banks and multinational businesses have corrupted Congress to pass legislation supporting their global aims at the expense of America’s future.

Americans are resigned that bankers and multinational businesses cannot be cajoled to protect our sovereignty over profits. It seems for many that America’s last bastion of hope lies in purging Congress of crony capitalism that weakens its resolve to place America’s interest above special interests. Tea Partiers suggest that if America reverts to strict constitutionalism that we might divert Congress from institutional corruption toward fiscal discipline. However, before concluding that our two-party Congress holds the solutions to America’s crisis, we should review whether there is a historical precedence to place our faith in its salvation.

Congress’s constitutional origin has been under miserable attack. As Roman legislators failed their countrymen, our Congress has taken up their fallen banner in succumbing to modern temptations. Congress fed off the world by deflating our dollar as the world’s reserve currency, and debt funded the selfish altruism of our baby boomer’s Great Society and obsession for military dominance with reckless abandon. Congress also vainly fell prey to Big Business’s courting to go along with legislation that greased the gold rush to China’s 1.3 billion consumer market. In so doing, they gave an inside lane for our elite to prosper from globalization at the expense of collapsing our Middle Class. Strengthening Congress’s will against these temptations seems a lynchpin for correcting America’s troubles, yet Congress has proven that it cannot protect Americans even from being devoured by our own.

An emerging theory is that by reverting to an earlier constitutional construct in history, we might be able to eliminate the power of big business and banking to influence Congress and to minimize Congress’s incentive to indebt America. If that were possible, America could return Congress to its historical role and we could regain America’s Constitutional Republic. Yet, if we look back to an earlier period in America’s history, Congress acted much the same as it has today. In 1811 and the fifty years leading up to the Civil War, business and banking dominated Congress under wildly differing circumstances. Their influence yielded the crippling morals of slavery and a devastating war between the states. If Congress was manipulated 200 years ago to such tragic ends, perhaps reverting to nostalgic fixes to mitigate Congress’s modern ills would end just as tragically.

In 1811, America had grown under the financial eye of the First National Bank and political support of Congress, whose strategy was to build America’s industry under the protection of tariffs to compete with the more highly developed commerce of Europe. By 1811, 87 percent of America’s exports were the South’s cotton and tobacco. The majority of these agricultural products were either processed in New England or transferred to England by American ships out of New York and Boston. This balance of banking, Northern industry, Southern agriculture, and shipping depended on slave labor to supply cotton to England, who employed 20 percent of her labor pool making cloth from America’s cotton. Yet, slavery was a growing abomination among many in America, and this shift in public opinion created a dangerous threat to America’s export engine that Congress counted on to bring back gold and foreign goods to America.

Earlier, in 1803, France’s Napoleon sold the Louisiana Territory to America for $15 million dollars to fund his planned invasion of England. Enraged, England retaliated by instigating insurgence of American’s indigenous natives against settlers, by impressing 10,000 Americans off of American ships to fight on English ships, by pirating American ships for the war effort, and by barring American ships from other ports. As a result, America’s slave supported, export industry was severely damaged and her economy was threatened.

Of the two paths, appeasement and war, America’s Federalist Party supported appeasing sanctions, a strategy that only further harmed America’s export industry. The Democrats favored War and in 1810 elected War Hawks to Congress to push for what became the War of 1812. Senators Calhoun (SC), representing the South’s cotton industry, Clay (KY) representing Kentucky’s tobacco industry, and Webster (MA), representing New England’s shipping industry, were the leaders of the war effort. While they suggested publicly that war must be initiated to salvage America’s honor, these members of Congress were much more interested in salvaging America’s business interests, and certainly were less concerned with the dishonor of slavery.

Nervous about the growing antislavery sentiment and the First National Bank’s growing financial power that could upset the balance of states’ power regarding slavery, the Democrats fought and won the congressional battle not to renew the bank’s charter in 1811. Steven Girard, the richest man in America, a shipping magnate who was the largest shareholder of the First National bank, was also a war hawk. When America needed money to continue the war, he lent her his entire fortune. He doubled his wealth during the war and was rewarded as the largest shareholder in the newly formed Second National Bank in 1816. Shortly after the war under his guidance, the Second National Bank focused its efforts once again on rebuilding the agricultural-industrial-shipping-slave dominated economic engine of America. Banking’s interest in 1816 was not in correcting social injustice but in continuing it.

From the Missouri Compromise of 1820 through the 1854 Nebraska-Kansas Act, Congress maintained on behalf of business the balance of power between slave owning states and non-slave owning states, ignoring the North’s increasing condemnation of slavery. This growing antislavery sentiment threatened to destroy the wealth creating engine that banks, factory owners, plantation owners and the shipping industry had built. Any imbalance of state power could have destroyed the export economy, yet the 1820 compromise kept an uneasy denial in place for 34 years.

Antislavery legislation would have impacted the South much more greatly than the North because its entire economy was slave driven. From America’s founding, the North had placed its financial capital into industrial assets while the South had placed the majority of its capital into land and slaves. By 1854, 3 percent of the population of the South owned 90 percent of the land and 20 percent of the population owned 98 percent of the slaves. The economic prosperity of the South’s gentry was too ingrained in slavery to turn from it without devastating the economic and social structure of the South and that fact was reflected in its political defensiveness.

The North’s growing prosperity was also buoyed by low cost, albeit consensual, workers. A steady influx of immigrant indentured servants filled New England’s factories before heading into the Western territories to start new lives as settlers. Senator Douglas (IL) pressed to build a transcontinental railroad that would send these immigrants out from Chicago into the territories, and that would bring immense riches back to the business leaders of his state. In 1854, needing to add the area of Nebraska and Kansas to America’s territories to support the railroad, Senator Douglas pushed to keep the balance of power between slave and non-slave states by increasing the geography of slave territory beyond America’s uneasy compromise of 1820. This reversal of America’s slavery containment policy was the last straw among abolitionists. With the rallying cry to end slavery, they broke from the Whig Party to form the Republican Party.

The 1854 act inflamed the passions of Americans who had grown increasingly intolerant of slavery. All of the Southern Democrats voted for the 1854 act. 44 of 91 Northern Democrats joined them in defying the will of the majority of their states’ constituents, even if their votes did support the business interests of their state elites. At the end of 1854 elections, Northern Democrats had been reduced from 91 to 25 congressman and only 7 of the 44 that had voted for the 1854 Act kept their seats. The Republican Party, founded on principle of human dignity, finally broke with the established business/political balance between the two main political parties. This break tipped the uneasy balance of power and thrust America into Civil War.

From the signing of the Constitution in 1787 until the elections of 1860, American politicians and businesses had attempted to avoid the growing moral voice of America. Had they listened, a new political party would not have formed to coalesce those without a political voice. Could the Whigs and Democrats in Congress have managed the growing animosity toward slavery while still meeting the needs of America’s businesses? In that same vein, could the Republicans and Democrats today give America’s Middle Class its needed political voice while still giving our industries the greatest chance to succeed in international business?

Until the dramatic political shift that led to the battles of the Civil War, Congress was unwilling to find common ground with abolitionists. In the wake of their indifference, a new party rose on the shoulders of the disenfranchised and charged America into a bloody resolution of its greatest crisis. History may prove once again that Congress has an institutional indifference to the will of the American people. Rather than a nostalgic turn to find a congressional balance from our past, Americans must now be willing to take up the banner of those courageous abolitionists and forge a new path forward that places the will of America first.

Are We On the Cusp of Another Financial Crisis?

2011-12-03T15:43:00.000-05:00

In The Rising Fear in Bank Stock Prices, Andrew Atkeson and William Simon, both professor at the UCLA School of Law, argue that "markets are signalling investors' worries about the soundness of bank balance sheets and the adequacy of bank capital".

Similarly, in a Bloomberg piece, Deutsche Bank Could Transfer Financial Contagion, Simon Johnson, former chief economist at the IMF and a professor at MIT claims that we have our heads in the sand about the soundness of the banking system. The financial situation of the large western world economies may appear stable and under control on the surface but it is only an illusion. According to Simon Johnson, many very large banks are as thinly capitalized as they were before the crisis and a significant proportion of their assets are rubbish.

In both articles, the authors expressed the fear that another credit crisis may very soon be coming our way. The first set of authors are making their arguments from their reading of the market tea leaves which seem to indicate that bank stock volatility is in a danger territory (see the graph above) while Simon Johnson bases his own evaluation of the situation on a direct analysis of banks' balance sheets; in particular, the little-known American subsidiary of Deutche Bank, Taunus Corp. which is incidently the U.S.’s eighth-largest bank holding company.

Both articles recommand that banks build much stronger capital positions soon. Atkeson and Simon also argue that "banks should be required to have much higher levels of common equity to reduce their leverage and their incentives to take risks". Simon Johnson also suggests that "this would be a good time for Congress to dig more deeply into the risks that Deutsche Bank poses to financial stability in the U.S. and around the world."

However, as Dan Aronoff, who writes regularly for The Sceptical Market Observer, argued earlier this week in How NOT to Deleverage Banks - The Eurozone Bank Capital Target Risks Disaster, the danger lies in the likelihood that the affected banks will achieve the new capital target by, in large part, reducing lending, which will almost certainly tip Europe into a recession and quite possibly trigger more serious social and political turmoil.

Yet, as Charbel Cordari argued on two LinkedIn Groups (Global Economist Network and Economists Professional Network) in response to Dan's piece:

"Indeed, in the current situation, banks looking to fulfill the new Basel capital requirement will find it difficult to raise capital and, since profits are weak, ... banks will reduce lending. On the other side, ... better adequacy ratios strengthen confidence in the banking sector and facilitate later capital raising (meaning more future lending). In the meantime, ... lending will shrink, asset prices will go down, and European economies may enter into a prolonged recession. Otherwise, ... confidence will deteriorate further, leading all the same to assets’ price deterioration and additional economic problems. Both situations are painful. But since in both cases economic growth will suffer, the implementation of the new requirements seems to be the best alternative. The writer’s recommendation to cap assets at their current level is a good proposal, but I am not sure it can be implemented properly, unless regulators and auditors find a way to segregate asset volumes (over which banks have control) from assets prices (over which banks have no control)."

In conclusion, it might be a matter of "damned if we do and damned if we don't." We might very well be stuck between a "bank" and a hard place. I will let you decide. Here are the two articles.

First, the article by Atkeson and Simon published in The Wall Street Journal last week:

The consensus among public officials and financial experts that the U.S. economy is gradually recovering may be too optimistic. There are emerging signs in the stock market that the U.S. economy is about to face financial headwinds that may lead to another credit crisis and recession next year. The recent volatility in bank stocks is a signal that U.S. banks, large and small, are not as healthy as many analysts assume.

Banking is a game of confidence. So if the investing public is uncertain about the health of bank balance sheets, its uncertainty can turn into fear, setting the stage for a banking panic.

This dynamic has played out twice before over the past 85 years—in the Great Depression and the panic of 2008-09—with devastating consequences for the broader economy. Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices, is back up to levels seen historically only in advance of these two great crises.

The volatility of bank stock prices from one day to the next depends on investor perceptions of the riskiness of the assets held by banks. In tranquil times, when investors feel that bank portfolios are reasonably safe and not excessively leveraged, daily volatility is low. When investors are uncertain about the soundness of bank balance sheets and about the adequacy of bank capital, then daily volatility rises in bank stock prices to double or triple their normal levels.

When uncertainty turns to panic, as it did in 1929-33 and again in 2008-09, the volatility in the daily movements of bank stock prices can shoot up to seven or eight times their normal levels. When this occurs, the damage radiates quickly from the banks to the broader economy.

These dynamics are illustrated in the nearby chart, which shows the volatility of daily movements in an index of all publicly traded bank stocks from 1926 to the present. In normal times, volatility hovers below 1%, occasionally rising as high as 2%, and rarely rising above 3% unless a serious crisis is at hand.

Volatility spiked to an unprecedented level (nearly 9%) with the market crash of October 1929, indicating widespread panic among investors. The panic moderated after the initial crash, but then built again steadily, rising to 4% in 1932 and to 5% on a sustained basis in early 1933. By this time, the banking system had essentially collapsed, causing newly elected President Franklin Roosevelt to declare a nationwide bank holiday in an attempt to stem the panic. Afterward, the volatility in bank stocks steadily declined to more or less normal levels by 1935, then spiking upward again in the recession of 1937-38.

After World War II, bank stock prices were stable for decades, and their volatility never approached the telltale 3% until the stock market crash of Oct. 19, 1987. On that occasion, the measure spiked to Depression-era levels, giving investors a fleeting scare.

Over the last 20 years, however, with deregulation of financial institutions, the daily movements in bank stocks have become more volatile and, interestingly, are now more closely correlated with economic downturns. This volatility increased in 1990 with the recession that began in midyear, spiked again in late 1998 with the Russian default, and once again shortly thereafter with the bursting of the "tech bubble" and recession in 2000-02.

Bank stock volatility increased again in 2007 in much the same pattern as it did in the late 1920s. It rose to extreme levels in 2008 and 2009 as uncertainty gave way to panic in the midst of the financial crisis.

From mid-August through last week, bank volatility has been over 3%. The market for bank stocks is now sending a bright red warning signal that conditions are ripe for another potentially disastrous financial panic.

This extraordinary volatility is not limited to the stocks of large banks but extends to small and midsize banks as well. For example, the volatilities of the daily stock returns of indices of regional and smaller bank stocks have also been hovering around 3% since mid-August, including the KBW Regional Bank Index (KRX), S&P's bank index (BIX), the Nasdaq bank stock index (IXBK), and the ABA Community Bank index (ABAQ).

What can be done? Throughout history, forceful leadership has been the key to restoring public confidence in the banking system. Without it, there is the risk that mounting uncertainty will lead irresistibly to fear and panic, with well-known consequences for the broader economy. This leadership now can only come from the Federal Reserve and the U.S. Treasury.

Given the extraordinary danger, regulators should take immediate steps to restore the investing public's confidence in our banking system—without waiting for European officials to deal with their crisis or for Dodd-Frank provisions and revisions to Basel capital standards to be fully articulated and implemented.

The Fed took a useful first step last week in announcing a tough new stress test. This time around, a larger number of banks will be required to prepare plans for adequate capital under severely stressed macroeconomic and market scenarios, and the results will be made public.

There is no silver bullet for calming the volatility in the market for bank stocks over the past three months. But the Fed's best shot is to apply this latest stress test broadly across banks both large and small and to insist that banks put forward clear plans to build up much stronger capital positions soon.

In addition—and perhaps more importantly—banks should be required to have much higher levels of common equity to reduce their leverage and their incentives to take risks. The recent spike in the volatility of bank stocks is telling us that the banking system is still too highly leveraged and that investors are fearful for the soundness of our banks.

The time to restore confidence is now.

Here is also the article by Simon Johnson published in Bloomberg a couple of weeks ago:

(I suggest that you go to the article to be able to click on the multiple and relevant links within the piece.)

You’ve probably never heard of Taunus Corp., but according to the Federal Reserve, it’s the U.S.’s eighth-largest bank holding company. Taunus, it turns out, is the North American subsidiary of Germany’s Deutsche Bank AG, with assets of just over $380 billion.

Deutsche Bank holds a large amount of European government and bank debt; it also has considerable exposure to lingering real estate problems in the U.S. The bank, therefore, could become a conduit for risk between the two economies. But which way is Deutsche Bank more likely to transmit danger -- to or from the U.S.?

By any measure, Deutsche Bank is a giant. Its assets at the end of September totaled 2.28 trillion euros (according to the bank’s own website), or $3.08 trillion. In the latest ranking from The Banker, which uses 2010 data, Deutsche was the second- largest bank in the world by assets, behind only BNP Paribas SA.

The German bank, however, is thinly capitalized. Its total equity at the end of the third quarter was only 51.9 billion euros, implying a leverage ratio (total assets divided by equity) of almost 44. This is up from the second quarter, when leverage was about 36 (assets were 1.849 trillion euros and capital was 51.678 euros.)

Even by modern standards, this is very high leverage. JPMorgan Chase & Co. has a balance sheet about 20 percent smaller than Deutsche Bank’s, but more than twice as much Tier 1 capital, an important indicator of a bank’s financial strength. Bank of America Corp., whose weakness is a serious worry in the U.S. today, has twice Deutsche’s capital. (These comparisons use The Banker’s ranking of the top 25 banks.)

Healthy Capital Ratio

Globally, Deutsche’s capital ratios are relatively healthy, judging by the banking industry’s standard measures. At the end of the third quarter, its Tier 1 capital ratio was 13.8 percent (up from 12.3 percent at the end of 2010) and its core Tier 1, which excludes hybrid debt that can convert into equity, was 10.1 percent.

How does such a highly leveraged bank become “well- capitalized”? The answer is that “risk-weighted assets” were 337.6 billion euros as of Sept. 30. But what is a low risk- weight asset in the European context today? Incredibly, it is sovereign debt, which of course is far from riskless at the moment.

Perhaps Deutsche Bank holds mostly German government debt, which still has safe-haven value. But it’s likely that Deutsche also holds a significant amount of Italian and French government bonds.

Still, the bigger risks are probably in the U.S. Deutsche Bank is a significant trustee for mortgages, having been heavily involved in the issuance and distribution of mortgage-backed securities during the housing bubble. Yves Smith, writing on the nakedcapitalism.com blog, says Deutsche Bank is one of the U.S.’s four biggest securitization trustees. Many questions on whether paperwork was done properly and whether the rights of investors have been protected hang over these trusts.

Let’s take a look just at Taunus Corp., named after a range of mountains outside the parent bank’s Frankfurt headquarters. The latest figures (from the Fed data, using the consolidated financial statement at the end of the third quarter) show Taunus with total equity capital of just $4.876 billion. This implies an eye-popping leverage ratio of around 78.

Why would the Federal Reserve and the new council of regulators known as the Financial Stability Oversight Council allow Deutsche Bank to operate in the U.S. with sky-high leverage -- with its huge implied risk to the rest of the financial system? Presumably, in the past, U.S. authorities have taken the view that Deutsche Bank had a strong enough balance sheet worldwide that more capital could be provided to its American subsidiary, if needed.

Troubling Questions

Such a presumption now seems questionable, at best. Earlier this year, Bloomberg News reported that Taunus needed almost $20 billion of additional funds to meet U.S. capital standards, and that Deutsche Bank was trying to declassify Taunus as a bank- holding company to avoid capital requirements entirely. It’s unclear where this process now stands, but it’s also not obvious how declassification would help U.S. or global financial stability. Financial reform advocates hopefully will press hard on this issue.

All of this raises troubling questions. Have U.S. bank supervisors really satisfied themselves, through onsite inspections, that Deutsche Bank’s risk weights accurately reflect market conditions and the increasing structural weakness of the euro area? Can U.S. regulators document their satisfaction beyond the materials produced for the European Banking Authority, which earlier this year oversaw stress tests that pronounced now-collapsed Dexia as well-capitalized? (Actually, Dexia had stronger capital ratios than Deutsche Bank.)

In their prescient, pre-crisis book, “Too Big To Fail” (not to be confused with the more recent Andrew Ross Sorkin book of the same title), Gary H. Stern and Ron J. Feldman, in 2004 nailed the incentive distortions that encouraged risk-taking and brought the financial sector to its knees. No one else came close to them in getting this right. Included in their analysis are examples of banks that could have been regarded as having moral hazard issues because of their size. Deutsche Bank is No. 4 on their list of large, complex banking organizations by asset size.

This dog did not bark during the 2008 crisis, partly because most foreign governments were seen as having strong enough balance sheets to back their banks’ worldwide operations. But this is no longer necessarily true for euro-area governments.

Even in 2008-2009, this may have been illusory. According to published reports, Deutsche Bank received considerable assistance from the Federal Reserve, including $11.8 billion through the American International Group bailout and $2 billion through the Fed’s discount window. Deutsche was the second- largest discount-window borrower and the largest user of the Fed’s Term Asset-Backed Securities Lending Facility during the crisis.

Asking for Trouble

Deutsche Bank and, if necessary, the German government should be required to inject substantially more capital into Taunus. Allowing business as usual is asking for trouble, particularly as Deutsche wants to remain focused on relatively risky investment banking. Recently it named as chairman Paul Achleitner, the finance director at Allianz SE, the German insurance company, and an ex-Goldman Sachs executive, worrying even some of its shareholders.

This would be a good time for Congress to dig more deeply into the risks that Deutsche Bank poses to financial stability in the U.S. and around the world.

I Just Want My American Dream Back

2011-12-01T07:02:00.000-05:00

Clif Carothers sent me another wonderful piece "I Just Want My American Dream Back – A conversation from 1981 to 2011"

Here it is:

Factory worker (1981): Ever since the Walmart moved into town, management has been pressuring labor to take pay cuts. Half the work force has been laid off. Thank goodness for low cost goods from Walmart to make up for my lower wages but I still need more money to make ends meet.

Savings and loans banker (1985): Hey, home values have been rising and new laws allow us to lend out up to 100 percent of the value of your home. Sounds risky? I know it does but not to you. If we have troubles, the FSLIC will protect your deposits now up to $100,000 so you might as well get started on your American dream.

Stock broker (1995): I hear the bankers that absorbed the savings and loans from the crash of its bubble are offering not only no money down loans, but now you don’t even have to prove your income and they have some pretty decent rates on home refinancing. With this new internet sensation, the stock market is on fire. Why don’t you just refinance your home and use part to make up for lost wages, but put some into this raging market and you will get ahead.

Factory worker (1999): But the market is up 300 percent when corporate earnings are only up 40 percent. I understand that you think the new fangled dot.com start-ups are going to sky rocket, but why are traditional brick and mortar businesses selling at such high price to earnings ratios?

Real Estate Broker (2001): So the Stock broker talked you into taking a home equity loan to get into the stock market? I am sorry you lost so much of your life’s savings. But perhaps you can make it back in the housing boom. I can show you houses that may seem beyond your reach but they are investment gold mines, trust me. Their prices are going up at 20% a year. In the mean time, just grab a few of the credit card offers being mailed to you each week to get by while you are recovering your retirement savings in your new home investment.

Factory worker (2003): Seems logical but housing prices no longer make sense. It used to be with a 20 percent down payment, rental rates would cover the remaining principle, interest, taxes and insurance but they no longer cover the loan amounts. My income hasn’t gone up and will not cover such a high mortgage.

Real estate broker (2006): Oooooh, umm, yeah, after a couple years you want to sell now. After you bought, the market slowed a bit and I really can’t sell your home for more than you paid for it. In fact, there are three brand new homes on the street that have never been lived in and they are on the market for 10 percent less than you paid. If you want to discount your home 15%, perhaps we can entice buyers to buy yours instead of the new homes that have been on the market for more than six months.

Factory worker (2007): I can’t afford to take a 15 percent hit on my home so I will have to keep it on the market awhile and max out my credit cards to make ends meet in the mean time.

Banker (2008): I am sorry to inform you but when you maxed out your credit cards, they triggered the universal clause and your interest rates are now going to be raised from their original 10 percent up to 32 percent.

Factory worker (2008.5): Now what can I do. I cannot sell my home, I have maxed out my home equity line, and my credit cards. I have no more credit because as I pay off my cards, the banks cancel them. My introductory home loan interest rate has expired and my home loan has risen 50%. The local government, hurting for more taxes, is considering raising the mil rate. I am going to have to delay some consumer purchases and not make others. And because I have to survive, I may have to miss a few credit card or home mortgage payments.

Banker (2009): When you missed payments on your credit card, we did lower your credit rating to protect other creditors from your misfortune, and we did demand immediate repayment of your balance on your credit cards. I know it exacerbated your inability to pay us back on your home loan. But a result, I am afraid we will have to initiate foreclosure.

Factory worker (2009.5): I keep lowering my price trying to sell this house but it has now been on the market for over a year. To make matters much worse, my employer just told me that because most other Americans have lost credit, home values, or jobs, they have been unable to buy our company’s products. As a result, I was told that I am being laid off to join 20 million others. And in my hour of misfortune, my real estate broker has informed me that my house value is now worth 40 % less than I paid for it.

Foreclosure lawyer (2010): Let me understand this better, so the banker said he would work with you to comply with government assistance programs, but after asking you four times to send in your paperwork to determine if you qualified, he “misplaced” it each time until the bank finally filed bankruptcy proceedings. I have filed in court on your behalf to delay the inevitable, but because your state is a recourse state, the bank will ultimately take your house, sell it at a fire sale price, and afterward the banker will come after you for the difference, forcing you to file for bankruptcy and to lose your life’s savings.

Bankruptcy lawyer (2010.5): Unfortunately the bank took your house and your credit cards and the court took your newer car, your savings, and your “excess” belongings. I understand that Chinese factories are building the widgets you used to make, you haven’t been able to find a job for over two years and have been turned down in countless interviews. Your savings are gone, your credit is ruined, and your self esteem is crushed. Congress has left you without unemployment compensation, yet is about to pass trade agreements that will leave even more Americans unemployed. Congress will not cut expenses so unfortunately their failure to do their job means even more Americans will lose theirs and America’s interest rates will go up costing Americans even more in higher interest payments that will be passed through to consumers in higher prices. But on the brighter side, I was able to ensure that even though you have nothing, your debts have been discharged.

Occupy Wall Streeter (2011): I know police officers are bloodying us with batons and spraying us with pepper spray, that they are waking us in the middle of the night to take our generators and our tents, that they are throwing tear gas in the middle of our peaceful demonstrations, and arresting us for acting on our right to assemble, but we are voicing our urgent need for change in Zucotti Park. Before you lose all hope, join us.

Employed Middle American (2011): Is this park thing the right thing for the factory worker to do? I dunno. My unemployed college graduate son is down at the park and I am watching every brutal act of policeman on my baby. I am holding Wall Street and Congress responsible for this senseless brutality and I will remember at the polls. But I didn’t demonstrate during Vietnam Nam. Instead, I went to war. And the factory worker is no hippie.

Our leaders tell me that they are doing what they can for America, but they can’t pass a budget even when the world tells them our credit rating will suffer. They can however pass a law that makes pizza a vegetable when big business wants a greasy snack to be called healthy, but they can’t compromise to help America back to work!

Factory worker (2011): I have decided to go down to the park. Be patient with me. I know there are instigators down there but I want a better America and need to do something more. I don’t have the answers to what the banks and Congress should do to fix what they have done but I am going to ask questions. Support my right to assemble with others to debate the potential answers in a democratic way.

If America’s unemployment rate rose to 15 percent, would you lose your job? Some economists are warning of 50 percent unemployment if drastic changes aren’t made. I don’t know whose predictions are right, but please wish me well in doing my part to reverse our fate now. I just want my American dream back.

China cuts reserve requirement ratio

2011-11-30T06:37:00.003-05:00

The People's Central Bank of China announced today that, as of December 5th, the reserve requirement ratio (RRR) for banks operating in the country will be cut by 50 basis points. Hence the RRR will come down from 21.5% to around 20% for most banks, the first cut in nearly three years. The move will ease liquidity after credit tightening over the past year has put pressure on growth amid an export slowdown.

We view this move, obviously orchastrated by the government, as a rebuff to people who thought China would 'bail out' Europe. Here the government sends a strong message saying that it will adopts measures to support its own citizens before it invests in supporting Europe. Real estate accounts for 20% of fixed asset investments, which itself is the driver of GDP growth in China. "Premier Wen Jiabao said last month the government will fine-tune economic policies as needed to sustain growth while pledging to maintain curbs on real estate. Economic growth cooled to 9.1 percent in the third quarter from a year earlier, the slowest pace in two years", according to Bloomberg news.

How NOT to Deleverage Banks - The Eurozone Bank Capital Target Risks Disaster

2011-11-28T23:13:00.006-05:00

I have written a fair amount about my diagnosis that the US and European economies are in a Debt-Deflation slump ( see my 'Policy for a Balance Sheet Recession'), and I have advocated for policies to reduce the indebtedness of households and especially banks (see my recent letter to the editor in the Financial Times reprinted below).

On that basis, one might surmise I approve of the recent increased capital requirement for large Eurozone banks promulgated by the European Banking Association, Europe’s cross border bank regulator, which requires the continent’s 70 largest cross –border banks to attain a core tier one capital ratio of 9% -far higher that the level currently required by regulators - by the end of June 2012. I assure you I DO NOT approve of this policy.

European regulators are undertaking a serious restructuring of large bank balance sheets in response to a collapse in market confidence in the solvency of banks that have significant holdings of European sovereign debt, and in the aftermath of attempts at boosting market confidence with stress-tests widely viewed as bogus. In order to meet the new capital requirement, banks can raise equity capital; restructure debt into equity; alter the mix of assets to reduce regulatory capital charges; retain profits; or reduce lending. Given the poor market for bank issues, it is unlikely there will be much equity raising, and given shareholder resistance to dilution, it is unlikely there will be much swapping of debt into equity. That leaves profit retention (i.e. reduction of dividends), manipulation of asset mix and loan reduction as the tools to meet the new requirements.

The latest attempt at regaining market confidence in Europe’s banks is flawed and dangerous. The danger lies in the likelihood that the affected banks will achieve the new capital target by, in large part, reducing lending, which will almost certainly tip Europe into a recession and quite possibly trigger more serious social and political turmoil. It is flawed both in its objective and its implementation. The objective appears to be narrowly focused on restoring banks to health. But if doing so inflicts damage on the rest of the economy, the cure is worse than the disease. The implementation, in allowing banks to meet the new capital requirement by shrinking lending, will likely trigger an asset price decline – due to a loss of market liquidity – causing bank loan losses to rise, which will reduce bank capital and thus negate the beneficial effect of the initial loan shrinkage on bank balance sheets.

The key problem with the bank capital target lies in providing banks the option to meet the target by reducing lending. The designers of this policy seem to have forgotten that its aim should be BOTH to restore banks to financial health AND to unclog bank lending channels. These two objectives are achievable, if only regulators would dis-allow banks to meet the target by shrinking their balance sheets.

How to do this? One possibility is to set the new capital target for each bank based on the size of its current asset base . Then banks will achieve nothing by reducing their loan book –except to lower earnings. One way NOT to accomplish it is to issue a toothless directive telling banks not to reduce lending -which is the approach taken by the European bank regulator.

So, Europe has embarked on a policy that could lead to disaster or, with one significant adjustment, to economic recovery. An awful lot is hanging in the balance.

__________________________________________________

FINANCIAL TIMES

Nov 25, 2011

Lending contraction must be tackled

From Mr Daniel J. Aronoff.

Sir, Robert Skidelsky and Felix Martin correctly identify the contraction of lending as the proximate cause of sluggish growth in the UK, and the inability of monetary policy to spur credit expansion as a manifestation of the failure of current policy (“Urgently needed: a plan C to save Britain’s economy”, FT.com, November 23).

I would add to their two underlying sources of monetary transmission failure – increased interest rate risk spreads and decreased borrowing demand from an overleveraged (or pessimistic) private sector – a third factor: the contractionary effect of debt overhangs on bank balance sheets, resultant from past and ongoing deterioration in asset values.

But their Plan C – which I surmise to be a return to Keynesian deficit spending – is not viable because it ignores the precariousness of the current deficit funding predicament. One only has to consider the recent German bund auction to recoil at any proposal that calls for an increase in government borrowing.

A policy they should have considered, and which I think policymakers in the US and Europe will eventually be forced to reckon with, if only because of the lack of alternatives, is to address the problem of lending contraction at its ultimate source: the over-indebtedness of banks and households.

What is required is a restructuring of balance sheets. There are many possible ways to do this, but any approach will require banks to raise equity capital and to convert some portion of existing debt into equity and to provide relief (perhaps in the form of partial debt to equity conversions) to overburdened household borrowers.

Daniel J. Aronoff, President and Chief Executive, The Landon Companies, Bloomfield Hills, MI, US

Why We Missed Our Opportunity To Sue the Banks

2011-11-28T22:38:00.000-05:00

Remember that in a post last week, Clif asked why can't we sue the Fed and the banks for incompetence and negligence. Clif Carother provided an elegant answer to the question and argued that may be we should. And you all know that I wish we could.

Yet, I found a rather simple piece of evidence explaining why it might be difficult; an excuse, if you want, for why we can't. Or rather why "the people" would not win their case.

Plain and simple, the case against the banks would not be credible enough because so many homeowners screwed up big time. If it were only naive and stupid people who over mortgaged themselves, then maybe "the people" would have a case against the banks. In other words, if it had been all a big banking scam a la Madoff, we could easily have presented valid and credible arguments to the courts.

However, when even informed professionals behave like they do in the story below, it becomes very hard to convince a judge that all the fault lies on the bankers. It is these kind of people who eventually tainted the evidence against the banks. Too bad!

You and I did knew better and did not behave like this guy and so many others. We also know that banks behaved irresponsibly and should have been held responsible for their actions but did not. Finally, to make it worse, the story ended badly: the banks got bailed out, bankers pocketed huge bonuses while foolish homeowners were left hung out to dry on the curb.

In the end, the problem is that there are enough fools to cover the acts of greedy bankers with enough uncertainty that a law suit would draw a hung jury. Even I have to admit that these fools contributed to the bubble, that they are partly responsible for letting the crisis get out of hands and for bringing the economy to its knees. As I suggested last week, its seems that the responsibility for the disaster is shared by many parties and one of them is homeowners who should have known better. See Who to Blame for the Financial Crisis: 25 Culprits.

Anyways, enough ranting (or should it be enough renting?). Here is the sad story, published a couple of weeks ago in The New York Times, How a Financial Pro Lost His House by the financial pro himself, Carl Richards. The one positive thing that I will say about this guy is that he has enough guts to admit that he was wrong:

"One night a few years ago, when the value of our home had collapsed, our debt was out of control and my financial planning business was shaky, I went to take out the trash.

"There was this enormous window that looked right in on the kitchen table, and through it I could see my wife, Cori, and our four children eating dinner. It was dark outside, so they couldn’t see me, and I just stood there looking at them.

"After a while, I pulled up a bucket and I sat on it, just watching my children eat. I found myself wishing that I could get back there, connected to the simple ordinary stuff of my family’s life. And as I sat and watched, filled with longing and guilt, two questions kept arising:

"How did I get here?

"And how am I going to get out of this?

"There are many stories these days of people who lost their financial bearings during the housing boom and the crisis that followed, but my story is a bit different from most.

"I’m a financial adviser. I get paid to help people make smart financial choices, and I speak and write about personal finance issues for this publication and others. My first book comes out in January, “The Behavior Gap: Simple Ways to Stop Doing Dumb Things With Money” (Portfolio, a Penguin imprint).

"The thing that few people know, though, is that I learned a lot of this from experience. I made a bunch of mistakes, the very same ones that I now go around warning people to avoid.

"So this is the story of how I lost my home, the profound ethical questions that arose along the way, and what my wife and I learned from the mistakes that led us to that point. It made me better at what I do, but it wasn’t much fun getting there.

"Like most financial stories, this one is personal. It starts with me getting into the financial services industry more or less by accident. I answered an ad in 1995 that I thought was for a job related to “security” (as in security guard) but was in fact related to “securities.” That’s how little I knew about the stock market. A few months later I found myself working a phone at a Fidelity Investments call center.

"Things went well, and by 1999 I was a Merrill Lynch financial adviser and a certified financial planner. By then, we also owned a house in Salt Lake City. We’d bought it two years earlier, with a $25,000 down payment.

"A few years later, an opportunity arose to form a partnership with a successful Merrill adviser in Las Vegas. The place was on our top 10 list of never-move-to cities because we had always associated it with the Strip. But Cori and I were looking for an opportunity to have an experience somewhere else, and we met some great people when we visited the city. I took the job, and we moved down there.

"That was May 2003. Housing prices were already crazy, so we rented. But our neighborhood had zero character and lots of cookie-cutter houses. Within a few weeks, we were looking for a place to buy.

"I felt we could afford around $350,000. We called a real estate agent named Mitch, who had signs on all the bus stops: Talk to Mitch! He picked us up in a gold Jaguar, and suddenly we were looking at houses that listed at $500,000 or more.

"It felt a little crazy to be shopping for houses that cost half a million dollars, but my income was growing rapidly. Everywhere I looked, people were being rewarded for buying as much house as they could possibly afford, and then some. There was this excitement in the air, almost like static. I started to think that if I didn’t buy a house right then, I would never be able to afford one.

"At moments during our house hunt, I felt in my gut that something wasn’t right. We’d go to open houses for $400,000 homes and see lines of couples in their late 20s — younger than we were — waiting to get inside. I kept wondering where all the money was coming from. How did all these people make so much?"

Click here for the rest of the story which is a bit too long for me to reproduce here.

Are Skilled Workers Next on the Chopping Block?

2011-11-27T22:23:00.001-05:00

In We Are All Expendable Now, Robert Tracinski explains that, after unskilled workers, skilled workers may be the next victims of globalisation and technology. According to Tracinsky, many skilled jobs are on their way to be done by robots and computers: doctors, lawyers, musicians, most customer service jobs, etc. "This new era will require that we make the transition to working on a higher, more productive level. And that will require the ultimate in "skilled labor": the ability to think." We will have then reached the ultimate destination of the knowledge economy.

My friend Christopher Frey is going to let me know: I told you so!

Yet, until we get there, we ought to get prepared. All of our economic policies, efforts and resources should be directed at making sure that our work force gradually gets these "thinking skills". The faster it does, the easier the transition and the higher our future prosperity will be.

Here is the piece published in RealClearMarkets last Friday:

One of the signatures of the Great Recession is the fact that we have sustained, long-term high unemployment along with a labor shortage. While unskilled blue-collar workers can't find a job, corporations like American Electric Power are struggling to find enough trained electricians, pipe-fitters, and other skilled workers.

This is not just a product of the recession, but a long-term structural issue: the "skills gap" that differentiates the fate of those workers who have acquired marketable knowledge and skills and those who have not. The unskilled can get by when the economy is good, but they can't get ahead, and when there is a prolonged period of economic malaise they find that they are expendable, and they are simply pushed out of the economy.

The fate of the unskilled laborer is only going to get worse. And while this is now primarily hitting blue-collar workers without college degrees, a different sort of "skills gap" is beginning to open up for white-collar workers. Whole classes of professionals who think of themselves as irreplaceable skilled workers--in many cases, highly skilled workers--are soon going to discover how much of what they do can be automated or outsourced. We will all be expendable soon.

It is not new to talk about the need to acquire "irreplaceable" skills. But what is not properly appreciated is the scope of the challenge this poses to people in all kinds of jobs, and the exact defining characteristic of what will make a skill "irreplaceable."

The basic rule of economics after the Industrial Revolution is: if a task can be automated, it will be. Or to put it differently, if a worker can be replaced by a machine, he will be. Call it the principle of expendability. The only thing that has changed since the first power loom is the number and nature of the tasks that can be automated. The first thing the Industrial Revolution did was to automate physical tasks. But now we are beginning to automate mental tasks, and what we are just beginning to see is the scope of the mental work that can be automatized. It is much wider than you probably think.

An awful lot of work that is usually considered to require human intelligence really doesn't. Instead, these tasks require complex memorization and pattern recognition, perceptual-level skills that can be reduced to mechanical, digitized processes and done by a machine. These include many tasks that currently fill the days of highly educated, well paid professionals.

Take doctors. A recent article by Farhad Manjoo, the technology columnist for Slate, describes how computers have begun to automate the screening of cervical cancer tests. A task that used to be done by two physicians, who could only process 90 images per day, can now be done with better results by one doctor and a machine, processing 170 images per day.

Or take lawyers. A lot of work done in the legal profession consists of asking a client a series of simple questions about his needs, using the answers to select a standard, well-established legal procedure (such as incorporation or the writing of a will), and then filling out forms by plugging in "boilerplate" language. All of which can be programmed into a database and done by computers online, as it now is by services such as Legalzoom.com.

Everywhere you look, you see the same trend. A huge volume of trading on the stock exchanges is now done by computer programs, not floor traders. Or take customer service, which might seem to require someone who can understand questions and reply with a comforting human voice. Well, meet Siri.

Multiply this by a hundred different professions, and there is surprisingly little that cannot be automated. Look at your own profession and rather than thinking defensively, listing all of the things you do that you're sure could never, ever, ever be done by a mere machine, start thinking creatively, coming up with all of the things that can be automated, given a sufficiently complicated algorithm. Believe me, if you're not thinking about this, someone else eventually will.

If you're not taking this seriously yet, let me give you one more example. I recently came across a story about a composer and music theorist who created a computer program that writes cantatas in the style of Johann Sebastian Bach. (A cantata is a short piece with a well-defined structure, which makes the task a little easier.) The climax of the story is a concert in which an orchestra played a mixture of the computer's compositions and actual Bach cantatas. An audience of music experts could not reliably determine which was which.

Chances are, you aren't the next Johann Sebastian Bach, so if someone can automate what he did, someone can definitely automate what you do. (Can it be done with commentators and, ahem, columnists? Well, I suppose it depends on the columnist.)

All of which means that an awful lot of well-educated, well-paid people are in for a shock.

To be frank, I'm not that sorry for them. Over the years, I have come to realize just how many skilled white-collar professionals are just phoning it in when they go to work every day. They fill out paperwork and connect the easy dots in pre-established formulas, rather than doing original, creative, conceptual thinking. Chances are you've seen one of those "mystery diagnosis" shows on cable TV, the ones that tell you the story of some guy who suffers a mysterious, debilitating ailment for years before he finally finds a specialist who tells him he has some rare disease. It seems like every one of those shows begins with a doctor who listens to the patient's symptoms, plugs them into a common, familiar, and completely wrong diagnosis, and then lets it go at that. It begins with a doctor who's going through the motions rather than doing original thinking to solve the problem.

There has been a lot of discussion recently about the falling value (and rising price) of a university diploma, and this is part of the reason for it. Much of a contemporary university education is designed to train dot-connectors, to fill students' heads with established formulas and the received wisdom, but not to teach the kind of creative problem-solving that can only be learned, in my experience, by going beyond the canned knowledge peddled in the classroom and dealing with actual, real-world challenges.

More deeply, what cannot be automated is the conceptual thinking that allows us, not just to fit a new fact into an established mold, but to understand facts that do not fit the established mold. This implies a real challenge to workers in the next century.

There has been a lot of anxiety recently about the supposed "disappearance" of the middle class. Well, you ain't seen nothin' yet. Decades ago-think Detroit in the 1950s-people still had the illusion that they could earn a prosperous middle-class living just by turning bolts on an assembly line. Now the machines turn the bolts, and those workers' grandkids are about to discover that they won't be able to earn a middle-class living any more just by shuffling papers and connecting the dots in pre-established formulas.

Whole categories of workers have already disappeared. I was recently talking with my father, whose career spanned from the 1960s to the 2000s, about the disappearance of such a thing as a "secretary." Warren Buffett is apparently the only guy who still has one. Think of the things secretaries used to do, back in the "Mad Men" era. Typing? We have word-processing software, spell checkers, and laser printers now. Taking phone calls? We have cell phones and voice mail. Managing schedules? We have online calendars and project-management software. And did I mention Siri? My dad pointed out who has replaced the secretary in the modern office: the IT expert, whose job is to help us manage all of these virtual secretaries.

The basic pattern is that any job that requires only perceptual-level skills-complex tasks of memory and pattern-recognition-can and will eventually be done by a machine. To justify a claim to higher productivity, we will have to be working on the conceptual level, as creative thinkers and most crucially as entrepreneurs, which is a much more demanding discipline.

This new era is not a curse but an opportunity. The whole reason for automating every kind of human work that can be automated is to increase the productivity of our labor. In previous waves of innovation, mechanization made many traditional jobs obsolete.

A few years ago, I noticed a trend of naming children after old-fashioned blue-collar professions, such as "Cooper" and "Hunter" and "Mason," highlighting the fact that for most people, these names no longer stand for a profession or a kind of work. But those who made the transition to the new era in which many of these old jobs no longer existed are better off because the new technology has made everyone is so much more productive.

Similarly, many of today's jobs will soon be expendable, but we will all be richer because we each have so many machines working for us, from the robot in an automated assembly line to the smartphone in our pockets.

But benefiting from this new era will require that we make the transition to working on a higher, more productive level. And that will require the ultimate in "skilled labor": the ability to think.

Who to Blame for the Financial Crisis: 25 Culprits

2011-11-26T21:55:00.001-05:00

Go through the list of 25 People to Blame for the Financial Crisis published in Time Magazine last week. You will recognise some familiar figures from Alan Greenspan, Bill Clinton and George W. Bush to AIG's Joe Cassano, Fannie Mae's Frank Raines and Merrill Lynch's Stan O'Neal. But some are less well-known and others unexpected.

Let me know if you think that any guilty party was omitted from the list. I have no doubt there are plenty!

Political History: "Oops" moments

2011-11-21T21:26:00.000-05:00

Here is another well researched piece by Clif Carother. Clif reviews the recent political history to uncover major blunders that led presidential hopefuls to lose their election bid. Clif starts with a few quotes from Herbert Hoover who back then signalled to the public that he failed to provide hope and that he lacked both vision and backbone.

Clif then moves up the history ladder to bring us to the most recent election in which John McCain's inability to grasp the seriousness of the financial crisis revealed that he probably would not be able to manage it going forward if he was going to become president. The Choice of Sarah Palin as a running mate confirmed this view and was the last nail in the coffin.

Finally, based on quotes that made waves in the media recently, Clif speculates on what could constitute the next major blunder by a politician that could cost a candidate his chances of becoming the next president. Clif's quotes extent beyond those of current candidates on the realistic assumption that some other politicians could cost their candidate either their party nomination or the next election.

Here is the piece, entitled "Oops":

In the 2008 election, 122 million people voted, 65 million for Obama and 57 million for McCain. Seven million people decided the election. In 2011, 50 million voters are unemployed or underemployed or are voting spouses that are directly affected. Quite simply, 2012 will be overwhelming about one issue, JOBS! It will not be about the important issues of debt reduction, tax fairness, or business environment restructuring, although those are critical issues to America’s future. It will not be about social issues, moral issues, or fringe issues. It will simply be about putting America back to work. If this is obviously the case, why isn’t political dialogue focused like a laser on this topic?

Words sway elections and shift the nation’s path. In the throes of the Great Depression during the 1932 presidential campaign, Herbert Hoover attempted to shift America’s focus from his handling of political affairs by discoloring Franklin D. Roosevelt’s proposals. Nonetheless his own words defeated him as Roosevelt went on to win a landslide victory with 57.4 percent of the popular vote and 90 percent of the Electoral College. From Hoover, America heard a lack of hope, vision, and backbone and concluded that Hoover would not lead us out of the depression. In his own words:

Lack of hope:

“The depression has been deepened by events from abroad which are beyond the control either of our citizens or our government.”

Lack of vision:

“I am able to propose an American plan to you. . . . We plan more leisure for men and women and better opportunities for its enjoyment. We plan not only to provide for all the new generation, but we shall, by scientific research and invention, lift the standard of living and security of diffusion of wealth, a decrease in poverty and a great reduction in crime. And this Plan will be carried out if we just keep on giving the American people a chance.”

Lack of backbone:

“I requested the governors of the Federal Reserve banks to endeavor to secure the co-operation of the bankers of their territory to make some advances on the security of the assets of closed banks or to take over some of these assets, in order that the receivers of those banks may pay some dividends to their depositors in advance of what would otherwise be the case pending liquidation. Such a measure will contribute to free many business activities and to relieve many families from hardship over the forthcoming winter, and in a measure reverse the process of deflation involved in the tying up of deposits.”

President Hoover’s words sealed his fate. And now after 40 years of Post Gold Standard Fiat Currency and Globalization, America is in the midst of another Hooveresque moment. Will our candidates’ words lead them to victory in 2012 or will they join the ranks of Hoover in the junk heap of failed elections. History shows that when candidates foretell their lack of vision, display their lack of character, or demonstrate their lack of desire to fulfill the true needs of America’s citizenry, their candidacies end well short of their life’s aspiration.

During the last 40 years of campaigns in their own words:

1972 George McGovern

"Listen, you son-of-a-bitch, why don't you kiss my ass?" George McGovern to a heckler late in the campaign

"The people don’t know McGovern is for amnesty, abortion and legalization of pot. Once Middle America – Catholic Middle America, in particular – finds this out, he’s dead." - Senator Thomas Eagleton stated off the record about McGovern, his running mate for 18 days.

1976 Gerald Ford

''There is no Soviet domination of Eastern Europe.'' —President Gerald Ford, in a 1976 presidential debate with Jimmy Carter

1980 Jimmy Carter

“I had a discussion with my Daughter Amy before I came here what the most important issue was. She said she thought it was nuclear weaponry” – Jimmy Carter / Ronald Reagan debate answer before slipping 10 points in the poles the following day

1984 Walter Mondale

''Mr. Reagan will raise taxes, and so will I. He won't tell you. I just did.'' - Walter Mondale, accepting the 1984 Democratic presidential nomination

1988 Michael Dukakis

“I think you know that I have opposed the death penalty during all of my life, uh, and I don’t see any evidence that it is a deterrent and I think there are better and more effective ways to deal with violent crime. We’ve done so in my own state. It’s one of the reasons why we have, uh, had the biggest drop in crime in any state in America.” - Dukakis showing both his aloofness and his opposition to gun control when asked if Kitty Dukakis were raped and murdered would he favor the death penalty?

1992 George H. W. Bush

“Read my lips. No New Taxes” – Campaign promise made in 1988 that was used against President Bush in 1992

"I did it, and I regret it" – President Bush responding to raising taxes during 1992 campaign

1996 Bob Dole

“Something is wrong with America. I wonder sometimes what people are thinking about or if they're thinking at all.”

You know, a better man for a better America. That's sort of our slogan.

2000 Al Gore

“During my service in the United States Congress I took the initiative in creating the Internet.” – Al Gore in an interview with CNN’s Wolf Blitzer when asked to cite accomplishments that separated him from another Democratic presidential hopeful, former Sen. Bill Bradley of New Jersey.

2004 John Kerry

"You bet we might have." - Sen. John Kerry when asked if he would have gone to war against Saddam Hussein if he refused to disarm.

"I actually did vote for the $87 billion, before I voted against it." - Sen. John Kerry, on voting against a military funding bill for U.S. troops in Iraq

2008 John McCain

"The fundamentals of our economy are strong." – John McCain’s remark at a rally in Florida on Sept. 15, as Lehman Brothers was filing for bankruptcy

"Make it a hundred...That would be fine with me." – John McCain to a questioner who asked if he supported President Bush's vision for keeping U.S. troops in Iraq for 50 years

"We have sort of become a nation of whiners." - McCain economic adviser Phil Gramm, on worries about the slumping economy, adding that the current downturn is a "mental recession,"

2010 Tea Party Rise

"But we have to pass the bill so you can find out what's in it, away from the fog of controversy.” - Speaker Nancy Pelosi, speaking March 9 to the 2010 Legislative Conference for the National Association of Counties.

Now in 2011, our field of Republican and Democratic hopefuls have the opportunity to wisely use words to sway Americans toward their vision, an America that hopes of returning quickly to productivity. Have our potential leaders demonstrated vision, fortitude, and alignment with the needs of Middle America or have they already condemned themselves to the sidelines of history with their words. You decide.

Rick Perry

”Oops”

Mitt Romney

"Corporations are people, my friend... of course they are. Everything corporations earn ultimately goes to the people. Where do you think it goes? Whose pockets? People's pockets. Human beings, my friend."

Herman Cain

"Go home and get a job and get a life!...Don’t blame Wall Street, don’t blame the big banks, if you don’t have a job and you’re not rich, blame yourself. It is not someone’s fault if they succeeded, it is someone’s fault if they failed,”

Newt Gingrich

“I am convinced that if we do not decisively win the struggle over the nature of America, by the time [my grandchildren are] my age they will be in a secular atheist country, potentially one dominated by radical Islamists and with no understanding of what it once meant to be an American.”

Ron Paul

"A lot of people will say, 'well cutting a trillion dollars in one year is radical.' Well, I operate under the assumption that the radicals have been in charge for way too long….They're going to raise the debt limit, and then they're going to print the money, and then they'll default by inflation, and that's much more dangerous than facing up to the facts of what's happening today."

President Obama

“We can no longer wait for Congress to do its job. So where Congress won't act, I will."

"You should pass it right away."

Harry Reid

"It's very clear that private-sector jobs have been doing just fine; it's the public-sector jobs where we've lost huge numbers, and that's what this legislation is all about."

John Boehner

"As I read the Constitution, the Congress writes the laws and you [Obama] get to decide what you want to sign."

Eric Cantor

"If you read the newspapers today, I, for one, am increasingly concerned about the growing mobs occupying Wall Street and the other cities across the country. And believe it or not, some in this town have actually condoned the pitting of Americans against Americans...."

The Fall and Rise of Apple in the Age of Moore's Law

2011-11-20T22:11:00.005-05:00

The Rise and Fall of Apple

In their only extended joint interview –which took place in 2007 – Steve Jobs commented that Bill Gates had been right about the predominance of software in the PC era, but noted, rather smugly, the advent of a ‘post-PC’ era, then shaped by the iPod and the iPhone, and soon to be rocked by the advent of the iPad.

We know the familiar story of the breakthrough Apple II that established the personal computer era and the Macintosh, with its Bauhaus inspired elegance and visual appeal and its introduction of the iconic Mouse, GUI and typeface, which have become the defining standard of the PC. And we know about the Mac’s loss of market position to the Windows network, with its ‘open’ standards, network externalities and lower cost – and lower quality – implementation with commoditized ‘boxes’.

The dominance of Windows over Apple appeared (and still appears) to be a classic network externality along the lines of the inefficient and technologically obsolete QWERTY keyboard system, which even Steve Jobs dared not challenge. Once established, a network for sharing and storing information is extremely difficult to dislodge. That is what fuelled the rise of Intel and Microsoft – the ‘Wintel’ duopoly – to become the most valuable corporations in the world.

That is, until Apple rose from near death to overtake Wintel and become the most valuable tech company in the world. What happened?

The Incessant Drumbeat of Moore’s Law

In the background of the microprocessor revolution has been the steady drumbeat of Moore’s Law – a successful prediction that the number of transistors in a chip will approximately double every 24 months. Translated into cost, this means the effective cost of computing halves every two years. Translated into spatio-temporal terms, this means the size device required to house a given amount of computing power halves every two years. It means that each of these dimensions has diminished by a factor of 2 to the 13th power since the introduction of the Mac roughly 26 years ago. It is, as Vice President Biden might say, “a very big deal”.

Since the introduction of the Mac in 1985, the cost of manufacturing has similarly -though not quite to the same extent – experienced a dramatic reduction, due to the creation of globalized supply chains that have brought into the industrial workforce the populations of Eastern Europe and China and to unprecedented automation enabled by the advent of affordable computerization of machinery (due to Moore’s Law, of course).

The Revival of Apple in the Post PC Era

In 1997 Steve Jobs returned from the wilderness to reclaim his throne at Apple and by 2002, when Apple had introduced the iPod and iTunes, its remarkable ascent to dominance had commenced. Why did Jobs succeed the second time around? I am not so foolish as to attempt to answer that question directly, but I do have an observation I think possibly relevant to the case.

Steve Jobs, as Malcolm Gladwell so adroitly describes in his recent New Yorker piece, was a tinkerer of technology. He was also a designer with an exquisite sense of the aesthetics of the ethereal, visual and tactile dimensions of the objects he manufactured. The stories are legendary; of his obsession with the visual display of text, of the intuitiveness of his software, of the sleekness and compression of his devices, of their beauty and integrity, of the quality of materials and coherence of colors; And for the past decade Jobs bestowed on the world a cornucopia of new devices doing new things within new networks.

It was clear in 1985 that Jobs had it in him, and he may have simply mis-read the market (one of his first moves back at Apple was to support Windows on Mac software). But in 1985 the Mac was too expensive for the mass market and its software was too slow – it overburdened the processing capacity of its machine. At Next, which Jobs formed after exiting Apple, his dream machine – much of which formed the basis of the successful iMac – failed to find a market. It was too expensive and aimed to do too much.

But within a decade Steve Jobs was transforming the technology industry, and this time doing it profitably. The iMacs, iPods, iPhones and iPads were more compact, more beautiful, more functional and more affordable than anything he had designed before.

I think the decisive factor may have been the dramatic decline in processing and manufacturing costs that occurred in the period between the Mac and the iPod, due to the operation of Moore’s Law, which drove down cost and device size limitations beyond a point that enabled Steve Jobs to exercise his talent as an industrial tinkerer and designer in an uninhibited way and still produce products affordable to a mass market. Moore’s Law had removed the limitations of processing cost and space that had previously limited the scope of Jobs’ genius.

Let Me Say It in Plain English

2011-11-19T22:03:00.001-05:00

Here is a week-end little humour. Thanks to Frozen in the North for the tip. Click on the table to enlarge.

Why Can’t America Sue the Fed and the Banks?

2011-11-16T22:26:00.001-05:00

In fact, the full title of Clif Carother's post was "Why Can't America sue the Federal Reserve and Banks for Violating Their Fiduciary Responsabilities? There is not much to add. As usual Clif is very eloquent in making his case.

Here is his piece:

The United States of America is claimed to be the wealthiest nation on Earth. Certainly, our GDP is the highest by some measures, our accumulation of long lived assets and infrastructure is historic, and our country is abundant in natural assets and commodities. Yet do the lives of our citizens in terms of material well being and quality of life reflect this great wealth? If a nation’s health is proportional to its material wealth, are our financial liabilities that are four times the size of our GDP degrading our nation’s health? Many are concerned that no matter how America’s wealth is measured, that we have reached our pinnacle and are now in decline. Some suggest that globalization is the cause.

When Adam Smith first penned “The Wealth of Nations” in 1776, the concept of wealth existing within the organism of a nation was not questioned. Nations had grown from their feudal beginnings into mercantilist empires and had begun to develop industrial capitalism within their mostly agrarian societies. However, the concept of businesses being melded to the future prosperity of their growing nations was the accepted paradigm.

Now that globalization is upon us, this marriage of business and nations is no longer a given. The traditional measurement of a nation’s wealth as that of the output of its businesses no longer fits now that cross border transfer of financial, physical, people, and intellectual assets are fluidly afforded multinational corporations. If we can no longer measure a nation’s wealth as that of its corporations, what is the paradigm shift that replaces this measurement?

If we divorce a nation’s wealth from that of its businesses, then a new picture of its material wealth emerges. The sum of a nation’s true material wealth is its natural resources and commodities, its capacity to maximize the value of these resources, and its ability to protect them from plunder. A nation’s wealth depends on its distribution infrastructure, its fixed assets that are capable of production, and the strengths of its people; their legal infrastructure, learning institutions, accumulation of national core strengths enhanced by interconnectiveness of innovation and production, and their accumulated learnedness and capabilities.

In addition, a nation’s material wealth depends on financial liquidity to transfer these assets to their highest and best use. Currency is the oil that lubricates a nation’s wealth producing assets. It provides for the efficient and fluid transfer of commodities, people and productive assets to create a maximum efficient output that will both meet the demands of consumers and that will simultaneously produce profits to feed current consumption and future growth capacity.

A nation's ability to grow wealth depends not only on maintaining its output at maximum efficient levels but on investing a portion of its output into extending its future capacity. Once again, currency provides liquidity as the medium of capacity extension. Currency is created through debt contracts. A nation’s businesses and individuals enter into contracts to accept debt and, through this process, its banks create currency to supply transactions. Therefore, a nation’s ability to grow depends upon its ability to add debt and to create adequate currency.

A nation’s ability to add debt depends both on its current debt level and on its maximum debt capacity. It can add debt up to its ability to repay it while maintaining current consumption and while providing for future growth at a level that will allow future consumption to be maintained. Adding debt beyond this level will result in excess currency and consumption that lessens its future growth and future consumption, and that heightens its probability of repayment default.

The difference between a nation’s current debt and its maximum debt capacity is its available credit. If a nation adds more debt than its available credit, it adds more currency than its productive output and therefore dilutes its currency, increasing its probability of inflation. Therefore, it is critical for a nation to manage its debt below its maximum effective credit level while growing its available credit through reinvestment in infrastructure and education and through development of concentrated hubs of innovation and productive core strengths.

A nation’s credit capacity is the cumulative capacity of its citizens. Each individual, by his or her own development of education, skills, aptitude, and desire develops an individual maximum credit capacity that grows as these attributes build. An individual’s income reflects his maximum credit and his ability to obtain currency in advance of earning it through loans that add debt. Cumulatively then, a nation's liquidity is the additive ability of each of its citizens to accept more debt.

Liquidity is provided to a nation through currency distributed by its banking system. Once again, the “Wealth of Nations” paradigm of a commercial bank’s primary mission is to match a nation’s currency to its wealth creating activities in adequate measure. In this paradigm, banks are tasked with the responsibility to evaluate a nation’s entities’ and individuals’ capacity to accept debt, and to enter into contracts that ensure that a nation’s and its citizens’ maximum debt capacity is not exceeded.

The “Wealth of Nations” central bank then ensures that the sum total of a nation’s currency supports maximum efficient output at full employment. Through the central bank’s manipulation of interest rates, it controls a nation’s credit capacity. When interest rates are lowered below historical averages, credit capacity is increased and consumers are enticed to add debt to their ongoing purchases by bringing would be future purchases into the present. In this manner, the central bank attempts to offset peaks and troughs of the business cycle.

However, throughout America’s history, and exponentially more so with the advent of globalization, America’s banks have not accepted nor fulfilled the “Wealth of Nations” mission expected of them by the majority of our citizens. America’s banks and the Federal Reserve in fact manipulated debt instruments to support globalization at America’s grave detriment. Doing so precipitated America’s greatest Ponzi ever, our housing bubble, violating their fiduciary responsibility to our nation. They obliterated their “Wealth of Nations” responsibility, enticing America to accumulate debt well in excess of its credit capacity, feeding a bubble frenzy that manipulated Americans into perceiving debt accumulation as investment.

The housing bubble enticed borrowers to think of their increasing debt not as early consumption but as a down payment on rising equity. Individuals were enticed through low introductory rates to take on long term debt well above their asset debt capacity. This became a logical choice because housing prices rose at 20 percent per year, making the housing bubble a logical “short term investment”. Lower introductory interest rates suckered borrowers to reach for higher debt levels than they could endure long term because of the potential to flip their “investment” for profit during the introductory rate period in what amounted to a dangerous Ponzi scheme.

For the two to three year period of watching their “investment” grow, individuals dipped into their savings and covered their short fall with short term consumer credit that was also made plentiful by the banks. To feed the Ponzi, banks enticed consumers to use short term credit in amounts well in excess of their ability to repay by offering introductory consumer credit interest rates as well. This unsecured consumer credit, well in excess of individuals’ total credit capacity, could be used to finance short term short falls in consumption capacity while their housing investment grew. With available savings and additional unsecured credit through credit cards, the “logical” investment choice was to let it ride on the housing bubble.

When the music stopped, many people who were in the game for quick profit lost their savings, destroyed their credit ratings, and maxed out their debt capacity using all of their available credit. Of course most home and commercial property owners that were not playing the game also lost massive value in their long term real estate investments. In addition, as the bubble popped, many credit card issuers increased their interest rates from low introductory rates to as much as 32 percent per annum, further pegging debt at or above sustainable levels.

This housing Ponzi was a manufactured raising of credit capacity well in excess of America’s ability to repay and an enticement to use that capacity to feed the housing bubble frenzy knowing that the bubble would reach an unsustainable height and that greater fools would be stuck in the end with excessive debt that would stagnate not only individuals' future growth, but that cumulatively would stagnate America’s growth as well.

If China had not enticed American bankers and businessmen to use America’s credit capacity, if they in turn had not manipulated Congress to eliminate regulations that had earlier been put in place to mitigate excessive credit speculation, if social engineering for the poor had not provided initial cover for the banks to create manipulative debt instruments, if the Fed had not manipulated interest rates to historic lows, if banks had not thrown out historical debt-to-income loan criteria in favor of feeding the speculation with reckless housing loan products and hysterical credit card offers, and if Americans had not allowed excessive greed to cloud their thinking into believing that a new economy had arisen, the debt bubble would never have occurred. Yet it did, and America’s debt, and that of its citizens, has far exceeded its maximum debt capacity. As a result, we now are faced with lower future consumption, lower future growth, and a very high probability of default.

Given that the “Wealth of Nations” paradigm America has been operating under has in fact been inextricably altered and that our nation’s material wealth can no longer depend on multinational corporations or international banks to align with America’s interests, is it now time to develop a plan going forward that puts America’s interests ahead of our multinational corporations and banks? A plan to turn around America must include restructuring our debt load, immediately bringing it down to a level below our maximum debt capacity. It must include quickly forcing the repair of America’s business and consumer credit ratings. And it must include the simultaneous and immediate addition of 15 million jobs, not the paltry 1 to 2 million offered by our meek politicians. This turn around, as further outlined in the links below, should be and can be the initial step in shifting America’s paradigm to a “21st century Wealth of Nations.”

Must Reads:

Job Voucher Plan

Yes America Can Quickly Turn Around, Here's How

Our Economy Can Be Reignited Like a Boy Scout Fire

New Consumption Paradigm Must Divorce Multinational Corporations and Marry New Business Partners

Why the Housing Recovery Will Take Many More Years

2011-11-15T20:48:00.000-05:00

In The Housing Recovery Will Take Many Years, Robert Samuelson argues just that. Housing won't recover for several reasons. First, there is the huge overhang. Second, there is the bubble's aftermath: "About 11 million homeowners are already "underwater" with mortgages that exceed their house value". Many observers are wondering if the situation will get worse before its gets better. Considering that there are about 65 million homeowners in the U.S., 11 million underwater homeowners represent between 15% and 20% of all homeowners. It is already bad. Getting worse would be a disaster but it is still possible. A further drop of 5% to 10% in home prices would bring close to a third of all home owners who have a mortgage to be "underwater".

Finally, there is a necessary structural adjustment in home size which have to get smaller to become attractive to the new buyers; and this can only happen slowly overtime.

Then Samuelson ask whether anything could be done to remedy the situation. Most efforts so far have been failures. Loan modification programs targeted at least 4 million home owners but have helped less than a million home owners so far and with less than stellar success; many have already defaulted on their "modified" loan.

Samuelson also talks about the possibility of reducing outstanding mortgage to help home owners but he is worried that this would create moral hazard; he is right. However, you already know what I would do to address this problem.

Here is the piece as published yesterday in Real Clear Markets, one of my favorite sites:

We Americans think of ourselves as problem-solvers, but the housing collapse has so far eluded all solutions. Perhaps 10 million homes have gone into foreclosure since 2006; millions more will follow. From their peaks during the real-estate bubble, home prices are down 30 percent, new housing construction has dropped 75 percent and existing home sales are off almost 30 percent. Housing's collapse is one reason the economic recovery is so weak. Construction remains depressed, as are the appliance and furniture sales spurred by home buying.

It may be that patience is the only cure. Home prices have to find bottom; only then will more buyers return. Almost all efforts to accelerate that process by stemming foreclosures have come up short of promises. The Obama administration originally hoped that its Home Affordable Modification Program - lowering some homeowners' monthly mortgage payments - would help up to 4 million borrowers; at last count, the number was 850,000.

Housing's collapse is usually laid to too much unsold supply, which depresses prices and construction. Normally, the inventory of unsold homes equals about six months of actual sales, says economist Sam Khater of the market research firm CoreLogic. Today's inventory exceeds 14 months. This includes homes already for sale and CoreLogic's estimate of "shadow inventory" - homes in foreclosure or headed that way. Mortgage relief aims to help individual homeowners and prevent more houses from being dumped onto the market.

The huge overhang must be worked off, it's said. We shouldn't make matters worse. Fair enough. Unfortunately, the real problem is too little demand. One reason is that the recession curtailed new household formations - a key driver of demand. Young adults returned to their parents' homes and crowded into group houses. Immigration slowed. Before 2008, household formation totaled 1 million or more annually. Since then, it's dropped to 400,000 to 700,000, says Dan McCue of the Harvard Joint Center for Housing Studies.

A larger cause of weak demand is the bubble's aftermath. Falling prices keep people on the sidelines. Who wants to buy a $250,000 home that may be worth $235,000 a year later? About 11 million homeowners are already "underwater" with mortgages that exceed their house value, CoreLogic estimates.

The scandalously lax lending standards of the bubble years have also been tightened. Down payments have increased; loans made without documentation of borrowers' incomes are gone. But some economists argue that lenders have overcorrected. "If [lending] standards just went back to normal, we'd have 10 to 15 percent more sales," says Lawrence Yun of the National Association of Realtors. Interestingly, Federal Reserve Chairman Ben Bernanke is in this camp, complaining that the Fed's low interest rates have been neutralized.

"One area where monetary policy has been blunted," he said recently, "has been the mortgage market, where very tight credit standards have prevented many people from purchasing or refinancing their homes."

Finally, plunging prices of existing homes mean new homes need to get smaller and cheaper; otherwise, they'll be unattractive. This is slowly occurring. Since 2006, new homes have dropped about 5 percent in size. "Disappearing are formal living and dining rooms, two-story foyers and second staircases," reports the Wall Street Journal.

Home prices have to stabilize before many potential buyers will venture forth. Slowly subsiding mortgage delinquencies suggest the worst might be past. But the big supply-demand imbalance indicates another 5 percent to 10 percent price drop, says economist Patrick Newport of IHS Global Insight.

Can anything be done? The Obama administration is considering proposals to sell up to 200,000 foreclosed homes held by Fannie Mae and Freddie Mac to private investors, who would commit to renting them for a fixed period. This would achieve two goals, says Sarah Rosen Wartell of the liberal Center for American Progress. First, it would take properties off the market and help stabilize prices. Second, it would provide rental housing for the growing number of people needing it.

A more controversial idea is for lenders to reduce the principal of mortgages now "underwater." It's argued that this would both cut monthly payments and encourage people to stay in their homes - rather than defaulting - because they'd have a stake. But who would be covered? Lenders usually oppose principal reduction as inciting "moral hazard." Many borrowers capable of paying would maneuver to qualify for the write-down.

Americans assume that all problems have "fixes." But some don't. History suggests that it will be hard to overcome the housing bust's powerful undertow. Pent-up demand and attractive prices may be the only cure. Economist Khater has studied regional housing collapses and finds that it takes seven to nine years before prices regain previous peaks. If anything, he says, today's bust looks much worse.

Some Great Tax Reform Ideas

2011-11-13T21:33:00.000-05:00

In response to Dan's recent post, A Capitalist Appeal to the Wall Street Protestors, Douglas Hopkins wrote:

"I agree entirely that a return to key principles of capitalism is what we need. But those principles would be better served by reforming investment tax policy to remove cronyist subsidies, than the kind of regulatory agenda cited in your argument. If the populist energy that drives both Occupy Wall Street and the Tea Party would shift focus to the perverse mis-incentives that are embedded in existing tax policies toward investment income, I believe we would have a far more productive debate about potential reforms."

Douglas also offered his own comment to the Wall Street protestors in A Message for Occupy Wall Street, a post which can be found on his blog, A Citizen's 2% Solution, devoted to finding solutions to repealing investment income taxes, avoiding a value-added tax and still balancing the budget.

Curious, I visited Douglas' site and found his ideas coherent, structured and clearly worthy of a being exposed to a larger audience. I know that the topic of tax reform is politically toxic. Douglas wrote to me that is also aware that his solutions are politically difficult to implement and that his "rhetoric is too sharply critical of leadership" to engage politicians in a public debate on the subject.

Yet, he also wrote that he anticipated that someone would promptly illuminate the flaw of his facts or reasoning and that he would have to sheepishly toss his work into the trash and slink away into the night. But, to date, no one has presented him with a substantial rebuttal. Until someone does, he vows to keep trying to find a forum to stimulate a debate:

"Unfortunately, the productive debate has been substantially derailed by factual distortions. We allow the debate to be framed by the intellectually dishonest claim that nearly 50% of the population pays no taxes. Both sides have dug in their heels on flawed arguments. There is a broad call today for political compromise. But I believe that is the wrong approach.

"You can’t compromise two highly principled bad ideas into one good one. But if we would stop “spinning” the facts and acknowledge reality, and receptively examine the arguments and perspectives in order to reconcile them…

"Well, that is the approach that has lead me to perceive a different path. I have developed a perspective I believe offers potential to bridge the gap between liberal and conservative principles and objectives.

"I don't think we can make progress on the tax debate until we stop allowing both sides to distort the facts of current policy - and force them to confront the l way our tax policies toward investment income have diverged from fundamental principles of democracy and capitalism. My proposed alternative is intended to stimulate more productive deployment of our national wealth by returning to foundational principles of democracy and capitalism: equal treatment and fair competition. I believe that in the battle for political advantage both sides in this debate have lost sight of those goals and principles."

Douglas invites us to take a look at some of his postings on his blog. I encourage you to read them. A couple of the arguments he particularly favor are included in:

Re-thinking Investment Income Taxes

Our Current Tax Debate is Intellectually Dishonest

Could Higher Taxes Stimulate More Productive Investments and Growth?

You can read his summary piece of his proposal for a rational and equitable tax reform. In the final page Douglas describes how he believe "this structural alternative offers a confluence of benefits toward goals that are generally argued as being mutually exclusive".

A wasted year for Latin American stock markets! 2012 should be better.

2011-11-11T18:46:00.000-05:00

A wasted year for stock markets in Latin America! 2012 should be better.

Sequential economic growth is currently weak by historical standards in most emerging markets countries. There can be little doubt that investor concerns about the crisis in the Euro zone coupled with weak growth in Europe and the US have been key drivers of the fall in emerging markets growth momentum.

Latin America has underperformed global emerging equity markets so far in 2011 but the long term picture is still largely positive. Hence the MSCI Latam is down 16% so far year-to-date in US$ terms but up 17% annualized over the past ten years (Exhibit 1). Among emerging markets only Indonesia (+3%) shows positive returns in US$ terms in 2011.

Exhibit 1: Emerging stock markets returns

MSCI Index, US$	Return 2011, %	Return 10 years, annualized, %
Emerging Asia	-13	+13
Emerging Markets	-14	+14
EMEA	-15	+12
Latin America	-16	+17
BRIC	-17	+16

Source : MSCI

Note : Data as of Nov. 7. BRIC is Brazil, Russia, India and China. EMEA is Emerging Europe, Middle East and Africa.

However equity markets growth could resume quickly in Latin America for a couple of reasons.

Economics:

Latin America’s economy, while in general not very dependent on exports – total exports to GDP is only 21% - is still highly geared to the commodity cycle. Commodities represent 48% of total exports and in some countries like Venezuela and Chile that number is quite high (see Exhibit 2). Any pick up in commodities exports once global growth resume will have a significant positive impact on the region.

Exhibit 2: Latam Export Profile

Data for 2010	Total Exports (% of GDP)	Commodity Exports (% of GDP)
Argentina	19	60
Brazil	9	55
Chile	35	75
Colombia	14	57
Mexico	29	21
Peru	23	78
Venezuela	29	100
LATIN AMERICA	21	48

Source : JP Morgan

The outlook for global agribusiness is positive since an escalating proportion of China’s household income is spent on food. The country is increasingly dependent on the global agriculture market in part because of a lack of arable land. Latin America is the clear candidate to capture global food demand growth because it is a structurally low-cost producer in many commodities.

Policy maneuvering room to counter the global crisis looks narrower than in 2008, but still wide enough to keep growth around trend levels. We think inflation in most countries has peaked in the third quarter. Brazil is clearly in easing mode while Chile might cut interest rates in December. Even in Mexico there is room, although not much, to ease interest rates if need be.

Credit to GDP is low at 34% while financial linkages show hardly any exposure to Spanish banks, except for Chile. The region may be at the cusp of a turning point for growth. The Citigroup Economic Surprise Index is now -0.1. A positive reading suggests that the economic releases have been on balance better than the consensus. It appears that economists and analysts have been too sanguine about the outlook for the region.

Exhibit 3:

Source : Citigroup

Valuations:

The MSCI Latam index trades at around 10 times its 12-month forward earnings price to earnings ratio. According to our calculations this is 20% below the Gordon growth fair value of 13.3x. The price to book value for the region is 28% below its average during the period 2002-07. The MSCI Brazil price/ book value ratio is now almost back to the 2008 crisis level which seems too low given the weight of Brazil in the global commodity universe (see Exhibit 5).

Exhibit 4:

Price to Book Value	Avg 2002-07	Current
Latam	2.2x	1.6x
Emerging Asia	2.0	1.6
EMEA	2.3	1.3
Emerging Markets	2.1	1.6

Source : JP Morgan

Exhibit 5: MSCI Brazil Price to Book Value

Source : Bloomberg

Earnings:

How much downside to earnings? During the 2008-2009 global financial crises Latam earnings per share (EPS) fell 49% y/y. However, 2011 EPS are only 10% above that trough level and the consensus expects around 12% growth in 2012. In the consumer sector, profitability could surprise to the upside by more than 15% in 2012.

With inflation peaking or declining and with short rates on hold, we expect real rates to rise in Latin America. Historically, the forward relative performance of emerging markets has been negatively related to changes in short rates and inflation, and positively correlated with changes in real rates. In other words, emerging markets have tended to do well when real interest rates rise, especially when that is driven by falling inflation.

In conclusion, improving economic data, resilient earnings and underweight investor positions should be positive for Latin American stock markets in 2012.

What OWS is All About

2011-11-10T06:32:00.000-05:00

For those who have not seen this, Henry Blodget, a former top-ranked Wall Street analyst and the host of Yahoo TechTicker, has written the piece below and documented it using a series of 41 graphs. Although the protestors do not have a clear message, the reasons they are on the street and why their grievances resonate with many of us, are rather clear.

Moreover, regardless of what the OWS protestors have agreed on so far, it is impossible that these people come up with a platform that would appeal to 99% of the population. Re-establishing a fair game, a leveled playing-field, however, would go a long way to satisfy a large proportion of them. Any leader that could show courage to do just that would draw a large consensus and send of lot of the protestors back home. Of course, there are some idiots in there but they will always exist. This is not a reason to reject the basic message of the protestors.

Here is the piece, Here's What The Wall Street Protesters Are So Angry About... published last month in Business Insider and viewed over 5 million times:

The "Occupy Wall Street" protests are gaining momentum, having spread from a small park in New York to marches to other cities across the country.

So far, the protests seem fueled by a collective sense that things in our economy are not fair or right. But the protesters have not done a good job of focusing their complaints—and thus have been skewered as malcontents who don't know what they stand for or want.

(An early list of "grievances" included some legitimate beefs, but was otherwise just a vague attack on "corporations." Given that these are the same corporations that employ more than 100 million Americans and make the products we all use every day, this broadside did not resonate with most Americans).

So, what are the protesters so upset about, really?

Do they have legitimate gripes?

To answer the latter question first, yes, they have very legitimate gripes.

And if America cannot figure out a way to address these gripes, the country will likely become increasingly "de-stabilized," as sociologists might say. And in that scenario, the current protests will likely be only the beginning.

The problem in a nutshell is this: Inequality in this country has hit a level that has been seen only once in the nation's history, and unemployment has reached a level that has been seen only once since the Great Depression. And, at the same time, corporate profits are at a record high.

In other words, in the never-ending tug-of-war between "labor" and "capital," there has rarely—if ever—been a time when "capital" was so clearly winning.

To access the graphs, please click on the title of the article or on 41 graphs.

Financial Movies - Hall of Fame

2011-11-08T21:27:00.000-05:00

Louis Cesario, a connection on Linkedin and member of the Roubini Global Economics group, commented on the review of the recent movie Margin Call which I posted here last week on the Sceptical Market Observer.

After a few exchanges, Louis accepted to send me a list and a short review of his favourite "finance" movies. Some of them are less about finance than about the financial players themselves, their behaviour and the dilemmas they face about right and wrong. Thank you Louis.

I had reviewed Inside Job and written a few blog entries about the movie last year when it came out (here, here, here and here). Louis enjoyed the movie a lot but felt it was biased. As an insider, he thinks that people from Wall Street took offense, including himself, at way some of the interviews were conducted. However, I am an insider myself and I rather enjoyed seeing these guys being grilled. Yet, like Louis, I would have liked to see Barney Frank take the stand as well. Anyways, here are the list and the reviews:

Margin Call - Margin Call is a must see MOVIE! Believe it or not, if you’re a member of Amazon prime account or a Direct TV subscribers like me, you can rent it for $3.99 and stay home and watch it! Or watch in on you tube for $6.99. It's better than I thought!

Kevin Spacey portrays the head sales manager of the MBS desk, who takes a position (pardon the pun) that clients are more important than the politics we see on the street. His conscience gets to him during a time when he is faced to make some really tough choices.

It's refreshing and a welcome surprise that not everyone was in this for the money. Spacey's performance reflects the side we never see in the media or read about, a man who actually has principles and morals. The complexity, one is faced with during the time between right and wrong, is nothing I have seen from any Wall street movie. In fact, Greed is Good but at what cost when your firm and clients are at risk?

Jeremy Irons is a believable CEO with charisma and savvy it takes to run a company during the MBS crisis. It's Irons who starts the run on dumping the MBS positions at the request of the company's president played by Simon Barker, the "Golden Boy" who plays the part of Cover your ass perfect!

Demi Moore, I found hard to believe she was cast to play this role. Poor choice guys, she is sexy but an intellectual Giant she is not. As head of the Risk department, she challenges Zachary Quanto about the correction to the model Demi put together. Quanto who holds a PhD as a rocket scientist uncovers the mistake in the formula that leads to this crisis. No way can I believe her as the person who developed the quant formula to leverage MBS and CDS. I found her role a bit insulting to my intelligence that she has the capability to develop a trading model used worldwide that melted this market; especially when she confronts Quinto about his background as a former NASA scientist. Needless to say her stone cold face and eyes of steel make her the perfect villain; performance, at best, is a C minus. This is the only flaw in the movie I can speak of.

Personal note: Quanto's one liner when confronting Moore "If I might speak openly, The money on Wall street is better than working for NASA" will go down as GREED IS GOOD one day!

Margin call uses all the right language, technical setting and surroundings we've all seen as insiders. And for those who don’t know Wall Street, it's the real thing, including the trading floor and Bloomberg terminals. It's not a big time Oliver Stone movie but a Great script. Nothing flashy but soon to be one of those cult movies that will catch on and become the Glenngary Glen Rose of our time! For a low budget film (under $ 5 million), it’s a damn good movie and I rate it 9 out 10!

Too Big To Fail - This HBO special was released in the early spring of 2011. The cast includes William Hurt who plays the former CEO of Goldman Sachs and now Secretary of the Treasury Henry Paulson. Academy award winner Paul Giamati plays Fed Chairman Ben Bernanke who, not only played his role perfectly, but I swear they look exactly alike. James Woods plays the former CEO of Lehman, Richard Fuld, and does a great job in this role. At the center of the storm, Woods and his staff are desperately trying to find a suitable buyer for Lehman Brothers including Warren Buffet who is played by Edward Anser. After Bear Stearns collapsed, Lehman Brothers becomes the target of short sellers who know that the MBS portfolio on their books is worthless and the run on the investment bank is on.

The movie takes us inside the meeting held at the Fed in 2008 as the CEO of Chase, Citi, Morgan, Goldman, StateStreet, Wells, Wachovia, BofA and Merrill are now faced with helping find a solution to bail out the troubled investment bank giant. While Fuld holds out for a better deal and the other banks are asking for a back up from the Fed to help finance the same deal Chase got for Bear, all the banks are willing to help but in the end Lehman goes belly up. Little did these guys know once Lehman goes, soon their companies are now likely to go under. I like to say Hell was empty that day and all the devils were at the table! If you like drama and suspense, mixed in with some laughter and good old country boy club environment, mixed with "He who dies with the most toys wins" Too Big to Fail is your movie.

One of my favourite scenes in this movie comes when John Mack who is played by Emmy winner Tony Schlhoub as the CEO of Morgan Stanley engages in a battle of wits with the NY Fed President Tim Geither, played by Billy Crudup, who is pressuring Mack to find a buyer for his company. The domino effect after Lehman collapsed is now on and no bank is safe! Mack didn't get the nickname Mack the Knife because of his soft disposition; he is ruthless, canny and, above all, a street fighter; and unlike Fuld, smarter in his tactics to fight off the political pressure to sell. I absolutely love his character, especially after he hangs up the phone with the Fed president who calls back demanding to speak to him: "You tell Geithner to blow me, I am trying to save my fucking company" is as true as it gets! Great cast and a great story. A must see movie. I give it 10 stars.

Inside Job - This documentary won an Academy award in 2011. It's narrated by Matt Damon; star of Good Will Hunting and Bourne Identity. The documentary reflects the start of the crisis from Iceland to Wall Street and takes you back to the days when deregulation played an important role on leverage and how the house of cards toppled soon after. It's all facts however; it’s biased at best and it points the finger at the traders and bankers on Wall Street. I simply loved this documentary on the facts but the strong biased opinion is what upset me tremendously! From law makers to lobbyists, the interviews are real, personal and will leave a bad taste in your mouth if you work on Wall Street.

I only wished that they grilled Barney Frank more but the wimp who refused to discuss his role any further than he wanted to admit. The documentary could have added more on the reversal of Glass Steagall which remains, in my opinion, the cause of this whole mess! We can all thank that wonderful Democrat Clinton for signing this into law! Inside Job is a must see for both experienced and non-experienced viewers on the inner workings of Wall Street. Capitalists are not greedy but simply opportunists who work in the boundaries of the law or, in this case, non-existing laws. One of my favourites, I give it 9 stars.

The Associated with Whoppi Goldberg - Comedy but it shows the struggle women go through working on the street. I give it 8 stars.

Rogue Trader - The Nick Lesson story of the futures trader who collapsed the oldest bank in London called Barings. Excellent film. It’s what most of us traders face each day. We simply cannot admit when we are wrong on a bet. 9 stars

Barbarians at the Gate – It’s during the Hay days of corporate buy outs. RJR Nabisco, Shearson Lehman, KKR. Comedy and drama. 9 stars.

Trading Places - Dan Akroyd and Eddie Murphy. If you haven’t seen this movie yet, all I can say is your not from this planet! Its 10 stars!

Trader - May be the best movie I ever seen about Wall Street! But Margin Call is now my favourite... Hard to find but if you do buy the movie! We all know who Paul Tudor Jones is. Enough said! 11 stars!

Enron the Smartest Guys in the Room - Not a movie but damn it should be! Everyone from the governor to the back office people are guilty! Buy it and keep it! Another 10 stars for this.

Bonfire of the Vanity - Great book, horrible movie casting! Tom Hanks plays a corporate bond sales man who gets caught up in a scandal involving a young black boy who was accidently run over on the ramp of the FDR drive in Harlem. It has all the elements of drama and suspense but Tom Hanks and Bruce Willis never fulfill their part. Like I said, a GREAT book but horrible movie. I give it 2 stars.

Boiler Room - Pump and dump penny stock company from Long Island. It's set in a era during the mid 80's. Young hungry kids who don’t live stock from preferred stock. Ben Affleck plays a small role as head of sales, Van Diesel plays a young stock broker driving a six figure car and living in Mutten town Town Long Island. Giovanni Ribisi plays new comer to the stock broker game and develops a conscience and uncovers the pump and dump scam. All the cast are young brokers making it big off the fears of their clients lack of investment knowledge while they party hard and sit around watching the Oliver Stone movie Wall Street. Once the stock doubles in value, look out below! Yup, everyone wants to be Gordon Gekko! Painful to sit through but a must see for those who want to know why Wall Street is viewed as a bunch of Greedy guys. 3 stars.

Other Peoples Money - One of my favourites!! This movie was based off the play from the 80's and stars Danny Devitto as Larry the Liquidator who is a corporate raider prying on a small Wire and Copper company in New England. Although you want to hate him, you can't help but root for him as this parasite who refuses to take Green Mail to walk away from buying the company out and breaking it apart. Penelope Ann Miller is cute and sexy who plays the companies attorney and uses her sex appeal and wit to out fox Danny, but in the end, the Larry the liquidator comes out on top, but a very surprising ending that makes this movie worth seeing. It’s a must see movie and I give it 8 stars.

A Good Year - Another Great book but the casting is so off! Stars Russell Crowe. After his Gladiator success, I guess the producers figured a big star like Crowe would attract some of his new followers. It was a bad bet guys! Russell plays a bond trader from London who inherits a vineyard left by his late grandfather where as a child he spent most of his summers growing up before he leads to London to pursue his dream of making it big on the street. Not much action about the markets but Russell finds a women that he is willing to give his fast life up and settle down. Russel did a good job showing that there is more to life than the Street. Ok movie. I give it 6 stars.

Quants: The Alchemists of Wall Street - Short documentary but it takes us inside the mind of some really smart Quant guys. 9 stars.

Glengarry Glen Ross - Not a Wall Street movie but damn, if you don't know Wall Street then it’s hard to tell this isn't about the incentives we get!! Jack Lemon, Kevin Spacey, Ed Harris, Al Pacino and Alec Baldwin who should have gotten an Oscar for this role ... What a cast!, Great plot, a cult movie that gets better with time! 12 stars.

Working Girl - If you are like me, how can you not like this movie? Harrison Ford plays a down and out stock analyst who teams up with the sexy and misplaced Melody Griffin to promote a deal that seems at times unlikely; but they manage to pull off in the end. The chemistry is awesome and although the possibilities of this ever happening in real life are almost zero, you will Love to root for the underdogs! Sigourney Weaver is the perfect villain you have no choice but to dislike; her character is simple at her best. And those who ever had the displeasure of working for a woman who has to prove herself simply because she thinks women are required to be tougher than men in her position will find it rewarding to see what she gets in the end! Working Girl is a funny movie. Not a Trading Places movie but a nice comedy that Ford and Griffin pull off and I give it 8 stars.

Here is a link to a few other lists. I must say that Louis is right on.

Curing the Dutch Disease

2011-11-07T06:38:00.000-05:00

Read my latest publication Curing the Dutch Disease in Canada, published in the November issue of Policy Options. The piece was written with Célestin Bimenyimana.

A Capitalist Appeal to The Wall Street Protestors

2011-11-03T20:12:00.006-04:00

The Virtues of a Competitive Financial Sector

Heinz Nixdorf, founder of the eponymous German computer company was once asked why almost all start up companies built around the microprocessor were American. In reply, he reflected on the miniscule chance the youthful, hippy, anti-establishment Steve Jobs would have had in gaining a hearing at one of the handful of financial institutions that provided capital in Germany, as compared with the dense, chaotic, decentralized and competitive financial marketplace in the US. To Heinz Nixdorf it was no mystery why Apple grew on American soil.

Nor would it surprise experts in the economics of growth like Stanford’s Paul Romer, who has documented the importance of an economy’s institutional receptiveness to new ideas as a key driver of economic growth. According to Prof. Romer, the ideal arrangement is one in which there is public funding for scientific education and basic research melded to a fiercely competitive economy. A decentralized and competitive market for finance, in which a multitude of lenders and investors compete with each other and provide access and opportunity to people and firms with ideas, is an essential element.

'Crony Banking'

Today, the US financial market is centralizing into an oligopoly dominated by a cadre of elite banks who rely on government support. Between 1990 and 2010 the number of FDIC-insured banks shrank by almost half and the top ten banks’ share of system assets trebled, from around 20% to 55%. This process of concentration accelerated rapidly in response to the financial crisis as the US Treasury and banking regulators focused resources on bailing out the largest banks, thus promoting consolidation. As recently as last month, the Federal Reserve provided assistance to the ailing Bank of America by surreptitiously allowing it to shift risky derivative contracts into the FDIC insured retail deposit taking part of the bank.

And that is not all the US authorities are doing to ensure the prosperity of big banks, at the expense of the US taxpayer. The ultra low policy interest rates and payment of interest on Federal Reserve deposits are designed to ensure a profit margin to banks, but at the cost of robbing people of a chance to earn a decent return on their savings and ultimately saddling the taxpayer with the bill for the interest payments to banks.

So it is with considerable justification, even wisdom, that protesters have converged on Wall Street. But it would be a grave mistake, and a wasted opportunity for beneficial reform, if their righteous anger became fused to an anti-capitalist agenda. That can only lead to more, not less centralization of finance and domination by a – perhaps new –elite. This would take us further away from the fertile soil from which Apples grow; a concentration and absence of competition in banking will breed complacency and groupthink and will dampen growth and social and economic mobility and will exacerbate inequality.

An Appeal

Instead, the protesters’ energy should be channeled into a radical capitalist agenda; one that insists on the re-establishment of a competitive and decentralized financial marketplace and one that demands that bankers and bank investors pay for their own recapitalization and assist in the cleanup of the mortgage mess they helped to create.

A Manifesto

What should be the content of this agenda?

First, the big banks should be broken up and the anti-trust law should be extended into financial services preventing the emergence of a banking oligopoly in the future. This will insure the competitiveness of the system.

Second, all financial institutions that rely on taxpayer insured deposits or short term debt, like overnight repos, should be required to immediately de-leverage and to meet, at least, the Basle III rules on capital, leverage and liquidity, even if doing so requires dilution of equity or conversion of debt into equity. This will insure the safety of the system and eliminate the debt overhang that constricts bank lending.

Third, all institutions holding residential mortgages should be required to offer underwater borrowers the option of reducing the principal balance of their loans to some level below current value in exchange for sharing future equity appreciation with the lender. This will put an end to the downward spiral of housing values and foreclosures that are placing such drag on the economy. This last can be accomplished because the government owns over half US mortgages and regulates the institutions that hold most of the rest. If it is designed intelligently, such an offer may even boost the value of mortgage debt, by reducing foreclosure costs and by reducing the ‘externality’ of home value reduction in neighborhoods blighted by foreclosures.

This capitalist revolution will take the ‘crony’ out of capitalism and keep America fertile ground for future Steve Jobs’, and lots of other jobs as well.

Peggy Noonan on the Current Political Non-Sense

2011-11-02T21:24:00.000-04:00

In The Divider vs. the Thinker, Peggy Noonan argues that "while Obama readies an ugly campaign, Paul Ryan gives a serious account of what ails America". In spite of its partisan title and an equally partisan conclusion to the article, Ms. Noonan gives a pretty fair account of what is happening in the current political arena: Incompetent and clueless Democrats and irresponsible and corrupt Republicans are at each other's throat.

It is interesting that Peggy Noonan cites the recent book Reckless Endangerment by Gretchen Morgenson and Joshua Rosner: "real elites in Washington rigged the system for themselves and their friends, became rich and powerful, caused the great cratering, and then "slipped quietly from the scene."" Further she cites Paul Ryan: "a class of bureaucrats and connected crony capitalists trying to rise above the rest of us, call the shots, rig the rules, and preserve their place atop society." Finally she concludes: "If more Republicans thought—and spoke—like this, the (Republican) Party would flourish. People would be less fearful for the future. And Mr. Obama wouldn't be seeing his numbers go up."

The problem, I think, is that the Tea Party, initially born out of the frustration with Washington and its cronies, has been manipulated by the elites of the Republican Party. Now it represents mainly the entrenched interests of the few who do not want to see their taxes increase. Unfortunately, as long as the leadership of the Republican Party is in the hands of these people, the Party won't flourish.

I think that the same danger looms over the Occupy Wall Street. If unions find a way to manipulate the popular movement, it will lose its appeal and legitimacy. There is a reason why the group does not have a clear message: it's still genuinely grass-roots and it is not controlled by anyone ... yet! Even though Ms. Noonan, a Republican, does not support the group, she now recognises more openly than ever before the need to change the rules of the game. She knows that her Party does not stand a chance to win the next elections if it does not condemn the Washington and Wall Street elites: Without occupying this political space and leaving it to Occupy Wall Street, the Republicans won't occupy the White House in 2012. Reasons indeed to be pre-occupied. I will add that this situation is terrible for the markets.

Here is the article published in The Wall Street Journal this week-end:

People are increasingly fearing the divisions within, even the potential coming apart of, our country. Rich/poor, black/white, young/old, red/blue: The things that divide us are not new, yet there's a sense now that the glue that held us together for more than two centuries has thinned and cracked with age. That it was allowed to thin and crack, that the modern era wore it out.

What was the glue? A love of country based on a shared knowledge of how and why it began; a broad feeling among our citizens that there was something providential in our beginnings; a gratitude that left us with a sense that we should comport ourselves in a way unlike the other nations of the world, that more was expected of us, and not unjustly—

"To whom much is given much is expected"; a general understanding that we were something new in history, a nation founded on ideals and aspirations—liberty, equality—and not mere grunting tribal wants. We were from Europe but would not be European: No formal class structure here, no limits, from the time you touched ground all roads would lead forward. You would be treated not as your father was but as you deserved. That's from "The Killer Angels," a historical novel about the Civil War fought to right a wrong the Founders didn't right. We did in time, and at great cost. What a country.

But there is a broad fear out there that we are coming apart, or rather living through the moment we'll look back on as the beginning of the Great Coming Apart. Economic crisis, cultural stresses: "Half the country isn't speaking to the other half," a moderate Democrat said the other day. She was referring to liberals of her acquaintance who know little of the South and who don't wish to know of it, who write it off as apart from them, maybe beneath them.

To add to the unease, in New York at least, there's a lot of cognitive dissonance. If you are a New Yorker, chances are pretty high you hate what the great investment firms did the past 15 years or so to upend the economy. Yet you feel on some level like you have to be protective of them, because Wall Street pays the bills of the City of New York. Wall Street tax receipts and Wall Street business—restaurants, stores—keep the city afloat. So you want them up and operating and vital, you don't want them to leave—that would only make things worse for people in trouble, people just getting by, and young people starting out. You know you have to preserve them just when you'd most like to deck them.

Where is the president in all this? He doesn't seem to be as worried about his country's continuance as his own. He's out campaigning and talking of our problems, but he seems oddly oblivious to or detached from America's deeper fears. And so he feels free to exploit divisions. It's all the rich versus the rest, and there are a lot more of the latter.

Twenty twelve won't be "as sexy" as 2008, he said this week. It will be all brute force. Which will only add to the feeling of unease.

Occupy Wall Street makes an economic critique that echoes the president's, though more bluntly: the rich are bad, down with the elites. It's all ad hoc, more poetry slam than platform. Too bad it's not serious in its substance.

There's a lot to rebel against, to want to throw off. If they want to make a serious economic and political critique, they should make the one Gretchen Morgenson and Joshua Rosner make in "Reckless Endangerment": that real elites in Washington rigged the system for themselves and their friends, became rich and powerful, caused the great cratering, and then "slipped quietly from the scene."

It is a blow-by-blow recounting of how politicians—Democrats and Republicans—passed the laws that encouraged the banks to make the loans that would never be repaid, and that would result in your lost job. Specifically it is the story of Fannie Mae and Freddie Mac, the mortgage insurers, and how their politically connected CEOs, especially Fannie's Franklin Raines and James Johnson, took actions that tanked the American economy and walked away rich. It began in the early 1990s, in the Clinton administration, and continued under the Bush administration, with the help of an entrenched Congress that wanted only two things: to receive campaign contributions and to be re-elected.

The story is a scandal, and the book should be the bible of Occupy Wall Street. But they seem as incapable of seeing government as part of the problem as Republicans seem of seeing business as part of the problem.

Which gets us to Rep. Paul Ryan. Mr. Ryan receives much praise, but I don't think his role in the current moment has been fully recognized. He is doing something unique in national politics. He thinks. He studies. He reads. Then he comes forward to speak, calmly and at some length, about what he believes to be true. He defines a problem and offers solutions, often providing the intellectual and philosophical rationale behind them. Conservatives naturally like him—they agree with him—but liberals and journalists inclined to disagree with him take him seriously and treat him with respect.

This week he spoke on "The American Idea" at the Heritage Foundation in Washington. He scored the president as too small for the moment, as "petty" in his arguments and avoidant of the decisions entailed in leadership. At times like this, he said, "the temptation to exploit fear and envy returns." Politicians divide in order to "evade responsibility for their failures" and to advance their interests.

The president, he said, has made a shift in his appeal to the electorate. "Instead of appealing to the hope and optimism that were hallmarks of his first campaign, he has launched his second campaign by preying on the emotions of fear, envy and resentment."

But Republicans, in their desire to defend free economic activity, shouldn't be snookered by unthinking fealty to big business. They should never defend—they should actively oppose—the kind of economic activity that has contributed so heavily to the crisis. Here Mr. Ryan slammed "corporate welfare and crony capitalism."

"Why have we extended an endless supply of taxpayer credit to Fannie Mae and Freddie Mac, instead of demanding that their government guarantee be wound down and their taxpayer subsidies ended?" Why are tax dollars being wasted on bankrupt, politically connected solar energy firms like Solyndra? "Why is Washington wasting your money on entrenched agribusiness?"

Rather than raise taxes on individuals, we should "lower the amount of government spending the wealthy now receive." The "true sources of inequity in this country," he continued, are "corporate welfare that enriches the powerful, and empty promises that betray the powerless." The real class warfare that threatens us is "a class of bureaucrats and connected crony capitalists trying to rise above the rest of us, call the shots, rig the rules, and preserve their place atop society."

If more Republicans thought—and spoke—like this, the party would flourish. People would be less fearful for the future. And Mr. Obama wouldn't be seeing his numbers go up.

If you have a subscription to the WSJ, I suggest that you read some of the numerous readers' comments to get a feeling of what people think of the current political situation. The confusion is truly a bad sign of what is to come. Brace yourself for some volatility!

Margin Call: The Movie

2011-11-02T07:04:00.000-04:00

Margin Call, another movie about Wall Street greed, is out. This time, it is not a documentary, like Inside Job, but rather a fiction piece, like the movie Wall Street, with real movie stars. However, the film is based on the events that occured in 2008. It's release while OWS is raging is pure coincidence but well timed. I have not seen the movie as it is not playing in Canada yet; here is the official trailer.

Nicole Gelinas, a City Journal contributing editor, the Searle Freedom Trust Fellow at the Manhattan Institute and the author of After the Fall: Saving Capitalism from Wall Street and Washington wrote a review of the film in City Journal: Greed Is Not Good, A new film takes the measure of post-millennial Wall Street. Based on my reading of this review (and on the trailer), the movie looks like it could help the public understand the origins of the financial crisis a little better.

Here is the piece:

"Using a tool that earnest Zuccotti Park protesters lack—precision—first-time writer and director J. C. Chandor has produced a devastating critique of pre-2007 Wall Street. Opening in theaters last week, Margin Call tells the story of a night in the life of a group of financiers as they save their firm, if not their own psyches. The unnamed firm is a cross between Lehman Brothers and Goldman Sachs, if there could be such a thing. The wizened risk manager, Eric Dale (Stanley Tucci), loses his job. Escorted to an elevator of the building’s mid-Manhattan high-rise, Dale hands off a memory stick to a junior colleague, Peter Sullivan (Zachary Quinto), telling him to “be careful.” As his colleagues hit the after-hours clubs, Sullivan stays at his desk, crunching numbers—and glimpses his employer’s possible downfall.

"What Sullivan learns is that the firm doesn’t have enough capital to withstand a decline in the value of its mortgage-related securities. He calls his boss, Sam Rogers (Kevin Spacey), back to the office. Rogers is disengaged; he’s more consumed with keeping his dying dog alive, spending $1,000 a day in medical costs. But he grasps enough to summon the CEO, John Tuld (Jeremy Irons). Tuld swoops down in the small hours via helicopter to make a clinical decision: the firm will cut its losses, selling its toxic securities the next day before anyone understands that they’re worthless or that the financial system itself—built upon similar toxic securities—is going down. Tuld quells his traders’ concerns about the career impact of selling trash to trusted customers with the promise of $2.6 million individual bonuses if the effort proves successful. Thus the film’s title: Tuld is taking action before the firm’s creditors can “call” for “margin”—that is, more cash—to back its plummeting securities.

"The film’s irreconcilable private conflicts make for rich drama. Each character must grapple with the cognitive dissonance of making so much money for doing little to help the real economy—and even harming it instead. In Margin Call, “easy” money is a psychological prison, not a glittery end that justifies any means.

"That’s a departure from previous financial-movie scripts. The New York Times’s Michael Grynbaum notes correctly that “Peter [Sullivan] is no Bud Fox,” the protagonist of Oliver Stone’s classic Wall Street. In the 1987 film, Fox breaks insider-trading laws to climb the ladder to riches in Gordon Gekko’s “greed is good” world, eventually ratting out Gekko’s role in the crime to avoid a long prison sentence. Stone envisioned Wall Street as a cautionary tale of what happens when you sell your morals for money. Instead, young viewers saw the movie’s stylish props—fast cars and faster girls, early-model cellphones, and park-view apartments—as well worth the risk. They flocked to the Street, having determined that Fox’s only mistake was getting caught.

"Stone tried to correct this failure in Wall Street 2: Money Never Sleeps, which came out in 2010. The long-deferred sequel followed Gekko’s post-prison resurgence to the highest levels of finance to show, in the end, that he hadn’t learned much. “Greed” had irrevocably corrupted him. But the story left audiences with a more perverse lesson: that being anything but super-wealthy was so abjectly miserable that Gekko had no choice but to claw his way back up, while using money to paper over the personal problems his ambition had created.

"In contrast, Margin Call presents the opportunity costs imposed when people fall for the illusion of effortless wealth. In their middle-of-the-night meeting, when Tuld wants to know Sullivan’s credentials, the younger man informs him that he’s an MIT-pedigreed rocket scientist. Why, then, is he in trading? Because it pays. Meanwhile the middle-aged Dale, sitting with a colleague on the stoop of his brownstone after being fired, muses that as a young engineer, he built a bridge over the Ohio River. Dale talks through some impressive math to demonstrate how many hours the bridge has saved drivers over the decades. He thinks he’s wasted his own talent since then. Sullivan is on the cusp of doing the same. These characters serve as fitting stand-ins for the West itself, which is emerging (maybe) from a quarter-century of dominance of the too-big-to-fail financial industry.

"Near the end of the film, Rogers takes a half-hearted stand, telling Tuld that he doesn’t want to hurt their customers. Tuld attempts a Gekko-like defense of the practice. Finally Rogers relents and says he’ll stay, but not “because of your little speech.” Rather, despite the millions he’s made, he needs the cash. The film concludes with Rogers burying his dead dog in the yard of his former home, now his ex-wife’s. It’s hard to imagine Margin Call becoming an accidental Wall Street recruitment video."

Ray Dalio on the Dangers of Partisanship

2011-10-27T23:30:00.000-04:00

Ray Dalio, the founder of Bridgwater Associates, a very large and successful fund manager, talks about the dangers posed by partisanship: First, in an article published earlier this week in The Financial Time, Risk on the rise as political leaders give in to mob rule and, second, in an interview with Charlie Rose taped last week.

Ray Dalio perceives three big threats to the markets and the economy: deleveraging (as people are reimbursing their debt), the fact that we are "out of ammunition" (as monetary and fiscal policies are not longer available) and the current political gridlock (as Democrats and Republicans are at each other's throat). He sees the last one as the biggest risk and he is not very optimistic about its resolution.

The article may require that you register using a username and a password. The video interview however will give you the essential from the article and even more. The first half of the video is the most interesting from a policy point of view. In particular, towards the 14th minute of the interview with Charlie Rose, Ray Dalio makes a very interesting remark on the state of the labour markets today. After recognising that globalisation and technology are having a profound impact of the supply and demand for labour, the investor states: "If you think of a person ... as a tool in an economic machine ... we may enter into a period in which we don't need people as tools". If you think about it, this is basically the death sentence of the unskilled worker in the Western world. It may be a painful reality to accept but it is an undeniable fact that we better recognise ourselves before it is too late.

Although Ray Dalio is not very charismatic and not very entertaining to listen to, it is his ability to search for the truth and then recognise it which probably is at the root of his success as an investor. The second part of the interview talks more about the philosophy of his firm. Yet, it is more difficult to make something out of it. I preferred to hear his macro level thinking, like his remarks on the labour markets, because it illustrates better how he thinks objectively about the world and how he can derive actionable investment strategies from its analysis.

Simon Johnson on Too Big to Fail

2011-10-24T21:54:00.000-04:00

In Bank of America Is Too Much of a Behemoth to Fail, Simon Johnson, professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics and Chief economist of the IMF in 2007-08, argues that Bank of America is in deeper trouble than we think. Since its ill-fated acquisitions of Countrywide and Merrill Lynch, the bank, which had escaped the worst of the financial crisis, is now fighting for its survival. Yet, most casual observers do not realise that the institution is not back to its former self.

Ridiculous accounting rules also confuse the issue as "a large chunk of its most recently reported profit actually turns out to be due to the decline in the market value of its debt, precisely because investors realize it is in so much trouble." Although investors are still prudent, regulators and the public seem complacent. The public is still counting on the fact that the government did what it had to do to ensure a smoother outcome if there was another banking crisis. But nothing is less certain.

Having discussed "with U.S. legal and financial experts and with members of the Group of 20 nations", Johnson argues that they are unanimous in saying that "The Dodd-Frank resolution authority doesn’t help manage the orderly liquidation of a global bank".

Johnson thus calls for higher bank capital requirements. It makes sense: If you want to reduce the risk of another bank bailout in the future, you've got to reduce leverage. And if you think about it, such requirements would also put a damper on bank bonuses much more than any attempts by Congress to regulate corporate compensation; without leverage, it is much harder for banks to make profits and hence to justify paying large bonuses.

The former IMF economist also calls for a break up of Bank of America into smaller more manageable pieces. There will be resistance obviously. Not only from Bank of America but also from other banks that see it as their birth right to behave as they see fit; even at the expense of taxpayers. Given the systematic risk that the banking system still represents, I would not hesitate to act on this recommendation. It's in the public interest. Yet, the public can't do much about it: the banking lobby is still alive and kicking in Washington and will probably succeed in imposing the status quo.

Here is the piece which was published today on Bloomberg News:

The Obama administration says the Dodd-Frank financial reform law ends “too big to fail,” meaning that no financial institution will ever again need to be bailed out. The promise is alluring, but it’s already proving to be false.

The argument rests on the premise that bank capital is now high enough to withstand serious shocks, so a calamity is less likely. It also assumes that Dodd-Frank’s new resolution authority allows global financial institutions to be wound down in an orderly fashion, and that the law’s call for “living wills” ensures that banks provide all the necessary technical details regulators might need to take prompt pre-emptive action.

Consider the law’s promise in the context of Bank of America Corp. Through the back door, U.S. regulators are facilitating another round of implicit bailouts, putting more taxpayer money on the line in the form of guarantees. Bloomberg News reported on Oct. 18 that regulators have allowed Bank of America to move highly risky derivatives contracts -- and the associated downside risk -- from Merrill Lynch into the insured retail deposit-taking part of the bank.

The move puts the Federal Deposit Insurance Corp. on the hook for any losses. The FDIC’s deposit-insurance funds come from its member banks, but because the agency can tap a U.S. Treasury line of credit if the fund runs dry, taxpayers could be at risk, too.

This condones the continuation, or perhaps escalation, of taxpayer-backed gambling on a grand scale -- and by people who aren’t very good at it. The U.S. is heading in the direction of Western Europe, where state-backed banks repeatedly bring everyone to the brink of disaster. Consider, for example, UBS AG’s recent rogue-trading episode.

Bank of America is a behemoth beyond control. The destruction of shareholder value in its recent history is shocking. The Wall Street Journal reported on Oct. 19 that the bank has spent $148 billion on acquisitions since 1998 and today its market value is only about $65 billion.

Bank of America is also a badly managed bank. In 2008, Ken Lewis, then the chief executive officer, agreed to pay about $4 billion to buy Countrywide, a disastrous foray into mortgage origination and distribution that will probably end up costing shareholders more than $60 billion. Eric Schneiderman, the New York state attorney general, is calling for a full investigation of mortgage abuses; egregious and allegedly illegal behavior at Countrywide must be very much in his sights.

Lewis bought Countrywide after a year’s worth of due diligence -- what was he thinking? -- and then grabbed Merrill Lynch over a weekend in September 2008, apparently without much thought. Significant additional losses were the result.

Why the FDIC would agree to escalate taxpayer subsidies now is a puzzle. According to people familiar with the situation, the Federal Reserve pressed for this move, which required an exemption from the usual rules. This outrage demands immediate congressional investigation.

Does Bank of America have enough capital to avert disaster? From its third-quarter results, it has $2.2 trillion in assets, making it the second-largest bank in the U.S. The book value of its tier-one common equity is about $117.7 billion -- hardly a robust buffer against the shocks that appear likely from mortgage litigation and from the European debt disaster. Investors believe that much of this capital will be wiped out -- hence the lower market valuation.

A large chunk of its most recently reported profit actually turns out to be due to the decline in the market value of its debt, precisely because investors realize it is in so much trouble. This ludicrous application of accounting standards should raise major flags for regulators.

If Bank of America really had enough capital, it wouldn’t have needed to move its derivatives risk onto its FDIC-insured deposit business. Nor would the Obama administration be strenuously resisting the New York attorney general’s efforts to organize a full and fair mortgage settlement based on all the facts.

Could the resolution authority be used on Bank of America? Definitely not in a way that would bring calm to the markets. Merrill Lynch is a global business and the resolution authority is purely domestic. I have discussed this point repeatedly with U.S. legal and financial experts and with members of the Group of20 nations. Their opinion on this point is unanimous: The Dodd-Frank resolution authority doesn’t help manage the orderly liquidation of a global bank.

There could be a conservatorship, but that is just a long word for full creditor bailout. Or there could be a bankruptcy, with the kind of disorganized collapse seen after the failure of Lehman Brothers Holdings Inc. Those are the choices.

Could the living-will provision make a difference? The FDIC claims it would have handled the problems at Lehman differently if the Dodd-Frank powers had been in effect and if it had full and timely information. But the essence of the argument is that the FDIC would have acted before the problems got out of control. Given the politics of the regulatory process and the predisposition of Treasury not to act early, I am skeptical.

So here is a fair test for this part of Dodd-Frank. Bank of America should clearly be broken up into pieces, spinning off Merrill Lynch along with other structural changes. Will the regulators pursue this course of action? Breaking up the bank would be good for the country, should help stabilize the financial system and could even create value for its shareholders.

Such an action would draw support from both the right and the left. Republican presidential candidates should be drawn to this position (apart from Mitt Romney, who has already taken a lot of money from big banks). So far, the only one to have identified “too big to fail” as a problem, and proposed a course of action, is Jon Huntsman.

When will other politicians and regulators awake from their current complacency? Bank of America should be forced to break itself up. Make the pieces small enough and simple enough to fail. Then let the market decide.