End of Year Reading

• Zerohedge summarizes a Bank of America study on the past and upcoming decades of Asian economics and how they impact the US.

  The financial crisis delivered a clear verdict, in our view, on the limits to the Asian growth model. It no longer makes sense to pursue double-digit growth by lending cheaply to the US consumer.
  Yet change would require less reserve accumulation or – put another way – allowing the currency to appreciate against the US dollar, to which it is now effectively pegged. China needs to manage this “exit” carefully. Moving too fast risks a dollar crisis, with a disorderly drop in the US dollar and a spike in US bond yields. Moving too slow risks a boom-bust cycle in China, with capital inflows and strong monetary growth rates putting upward pressure on asset prices and inflation.

• This is an amazing read on China, written by Christopher Hayes at The Nation. One of the summary paragraphs is particularly interesting, and I quote it below, but I strongly recommend you read the entire article.
  

  We tend to view China as posing an alternative and threatening model for the future, one that's by turns seductive and repulsive, the source of envy and contempt. But after a while I wondered if we aren't in some way converging with our supposed rival. China has managed the transition from a repressive, authoritarian, impoverished country to an industrial, corporatist oligarchy by allowing a loud and raucous debate while also holding tightly onto power. Perhaps we are moving toward the same end from a democratic direction, the roiling public debate and political polarization obscuring the fact that power and money continue to collect and pool among an elite that increasingly views itself as besieged on all sides by a restive and ungrateful populace.

• The title says it all: Why market sentiment has no credibility. Good read at FT.
  
• I don't know who John Kozy is, but I like this paragraph he wrote in his article titled, "The Long Decline of the American Economy":
  

  Ideally, companies exist to provide products and services to people. If the products and services are good, the companies prosper; if they aren't, the companies fail. That's risky, so American companies inverted this model. They fed the public the notion, which has rarely been questioned, that a company's responsibility is solely the financial welfare of its stockholders. Products and services are no longer the goal of business; they are merely means to profit. That reducing quality leads to greater profits quickly became evident. One fewer olive in each jar, one flimsy part in a complex device, one inefficient procedure in a manufacturing process, built-in obsolescence, built-in short product life-cycles, engineered high failure rates. The American quality standard became, "Junk"!

• An excellent argument for a surtax on millionaires, which does a good job of countering an argument I myself believe: that unlimited income potential (where a surtax limits said income potential) is a great motivator for innovation, entrepreneurship, and general hard work. Also, I really like the reasons behind the title of the blog.
  

  The third thing it also might change is the pay that CEOs get. For example, if the top tax bracket were 99%, for all income over $5 million, tax opponents always describe this case as having the effect that people will just stop working after they get to $5 million. That's just not an option for the likes of Peyton Manning, however. What Peyton Manning (or any corporate CEO in the same position) would likely do, however, is settle for just $5 million a year, since all income after that goes to the state. Then, once you get a Republican in office, and they cut that 99% top bracket from $5 million-plus to $25 million plus, Peyton Manning will renegotiate his salary up to $25 million, even though he's still playing 16 NFL games a year...
  So, in this case, tax rates down implies total taxes collected from Peyton Manning up but total "production" from Peyton unchanged, but worsening inequality for the economy and less taxes paid for someone else. So, we'd need to look at whether the consumption spending of people like Tiger Woods, CEOs with their corporate jets, and investment bankers is better for long-run economic growth than the spending of the poor, who spend a large chunk of their disposable income on things such as education and health care...
  This is essentially what has happened in the US, and that is why you shouldn't believe it when economists tell you we shouldn't tax millionaires.
  

"Life is pain, Highness. Anyone who says differently is selling something."

Quick one here. The NYT just published a lengthy article detailing highly questionable behavior by GS during the housing bubble/bust. In short, they created C.D.O.'s of large collections of mortgages that they sold to clients. Simultaneously, they shorted them. Thus, their clients paid GS for instruments that GS created and immediately bet against.

The woeful performance of some C.D.O.’s issued by Goldman made them ideal for betting against. As of September 2007, for example, just five months after Goldman had sold a new Abacus C.D.O., the ratings on 84 percent of the mortgages underlying it had been downgraded, indicating growing concerns about borrowers’ ability to repay the loans, according to research from UBS, the big Swiss bank. Of more than 500 C.D.O.’s analyzed by UBS, only two were worse than the Abacus deal.
Goldman created other mortgage-linked C.D.O.’s that performed poorly, too. One, in October 2006, was a $800 million C.D.O. known as Hudson Mezzanine. It included credit insurance on mortgage and subprime mortgage bonds that were in the ABX index; Hudson buyers would make money if the housing market stayed healthy — but lose money if it collapsed. Goldman kept a significant amount of the financial bets against securities in Hudson, so it would profit if they failed, according to three of the former Goldman employees.
A Goldman salesman involved in Hudson said the deal was one of the earliest in which outside investors raised questions about Goldman’s incentives. “Here we are selling this, but we think the market is going the other way,” he said.

The question now should be, did Goldman advise clients of what they were doing? Goldman does claim they did:

The Goldman salesman said that C.D.O. buyers were not misled because they were advised that Goldman was placing large bets against the securities. “We were very open with all the risks that we thought we sold. When you’re facing a tidal wave of people who want to invest, it’s hard to stop them,” he said.

To be absolutely fair, GS is making a good point. There were probably a ton of blind speculators out there who were happily buying these C.D.O.'s up despite being told that the instruments' very creator was betting against them. However, it seems GS and other banks still worked to tilt the field in their favor, as they were in the best position to understand just how awful the underlying securities in their C.D.O.'s were and what was likely to happen (crash).

Banks also set up ever more complex deals that favored those betting against C.D.O.’s. Morgan Stanley established a series of C.D.O.’s named after United States presidents (Buchanan and Jackson) with an unusual feature: short-sellers could lock in very cheap bets against mortgages, even beyond the life of the mortgage bonds. It was akin to allowing someone paying a low insurance premium for coverage on one automobile to pay the same on another one even if premiums over all had increased because of high accident rates.
At Goldman, Mr. Egol structured some Abacus deals in a way that enabled those betting on a mortgage-market collapse to multiply the value of their bets, to as much as six or seven times the face value of those C.D.O.’s. When the mortgage market tumbled, this meant bigger profits for Goldman and other short sellers — and bigger losses for other investors.

This behavior was not illegal, but perhaps it should be illegal. It simply seems wrong that a bank could create, market, and sell an instrument that it is planning to bet against. This kind of pure profit-chasing can have awful consequences, as we all recently witnessed. One thought I had: require that a bank that creates any security it markets to clients must not be allowed to invest in it. A bank could naturally advise clients on what it has created, but at that point it would have incentive to create securities that have a clear chance at good performance. Naturally, they could still go long or short securities created by other banks. I think this seems like a more balanced state of affairs than what was described in the NYT article.

Executive Pay Disclosure

So, the SEC is making some regulatory changes to how executive compensation is disclosed, the idea being to build on regulations from 2006 that help people understand how stock compensation translates to actual dollars.

Under current rules, companies don't have to reveal the full value of stock options they give an executive. Instead, they must disclose in their annual proxy statements only the portion of an options award that vests that year.
The new rule will require companies to show in a summary table the estimated value of all stock-based awards on the day they are granted. The SEC's 2006 rules had relegated those totals to a separate table that investors often overlook or find hard to decipher.
An example is the case of a company that decides its CEO deserves $10 million worth of stock options, to vest in equal installments over four years. Under current rules, the company would have to include only $2.5 million -- one-fourth of the total -- in the summary table.

Well, that sounds nice. Too bad it won't really do anything worthwhile. Back in 1992, the SEC made some moves to improve transparency of executive pay, which was hailed as a good thing. At the time, it was thought that executive compensation was out of hand and needed to be reined in. Transparency was supposed to be a big step in the right direction, as most thought shareholders would complain over excessive compensation and bring things back to some semblance of normalcy. Guess what happened after that? CEO pay increased 400% between 1992 and 2000! Why? I think it was because CEO's got a good look at what their peers were making, and those who were below average complained until their boards gave them more money, which turned into a continuous cycle of companies wanting to pay "above average" for good CEO's, which naturally raises CEO pay. Good stuff eh? Notice shareholders didn't do squat to alleviate anything.
"We learn from history that we learn nothing from history." - George Bernard Shaw.

I think the real key to 'curing' executive compensation is to approach things from a different angle. Everyone seems to be focused on how much CEO's get paid. Indeed, these recent SEC disclosure moves only serve to better understand the how much aspect. But what about how they get paid? If we understand the structure of pay, perhaps we could get better compensation practices that might of their own accord bring CEO pay to what it really should be (something that should be left to the market, though so far the market has been inept). Harvard Business Review has some excellent columns on this. I quote from the second link:

Let's look at modern executive compensation in this light. It has become dominantly stock-based, such that the biggest rewards come from an increase in stock price following the establishment of the incentive compensation system. How then do executives reap incentive rewards? The answer is simple. Since a stock price is nothing but the market's consensus of expectations about the future performance of their company, executives can only reap a compensation reward if they increase the expectations of future performance above their current level.
Now apply the first test. To what extent do executives have control over increasing the market's expectations about the future performance of the company? Very little. That is proven by the degree to which expectations fluctuate dramatically more than real results of publicly-traded companies. Real results dropped slightly in the fall of 2008 and expectations plummeted to half their previous level.
Then apply the second test. Do we really want first and foremost the expectations of stock market participants to rise regardless of anything else? I guess one could say the answer is yes if expectations could rise forever. But interestingly, that has never happened with any stock - ever. Expectations fluctuate because they are the product of imagination and speculation, not actual company results. What is more true is that we would wish that real variables, like earnings per share or market share or return on invested capital, would grow from their previous levels. If they grow, then expectations and stock price will grow with a sound underpinning rather than through idle speculation.
Because it's impossible to keep expectations rising forever, executives are smart enough to do so in the short term and get out before expectations fall. The very cleverest CEOs (and those who showed no mercy to their successors) like Coke's Robert Goizueta and GE's Jack Welch were able to manage expectations wonderfully until the day of their retirement. But look at what that personal profit-maximizing behavior did to their corporations, and their hapless successors. By focusing on stock-based compensation, we have caused executives to manufacture stock market volatility rather than build long term value. And it isn't their fault; it is the fault of their boards. It is the boards who swallowed the stock-based compensation fallacy - hook, line and sinker.
Fortunately, there is a simple solution. Scrap stock-based compensation entirely and compensate executives on the basis of improving real measures such as EPS, ROIC, and market share. Those are things over which executives exert significant control and if they improve those real results, stock price will follow. It isn't hard or complicated. It just takes going back to principles.

The hard part will be to break the current system, where prospective CEO's seem to be able to dictate highly favorable compensation packages. I don't know how to get corporations to shift their compensation strategies, but I'd prefer it not be through regulation in this case. Government regulation of pay is something I am not in favor of. Goldman Sachs has taken a small step towards tying their executive pay to company performance, but as HBR points out above, they're unfortunately using the wrong metric for performance.

More Reading

• The WSJ has put together its second annual "Future of Finance" convention. There is far too much to link, but here's the summary and the main page. It was, of course, heavily populated by private-sector representatives, so the summary shouldn't be too surprising:
  

  Their recommendations acknowledge the need for a stronger role for government regulators. At the top of their list was a call for increasing the capital that financial institutions must hold, with higher requirements for institutions posing greater risks to the system. Second on the list was a call for the Financial Stability Board to impose toughened regulatory standards across nations.
  
  The financiers, however, shied away from other, more intrusive government actions. They rejected a proposal requiring institutions to get regulatory approval before selling innovative new products. They steered clear of proposals that would force institutions deemed "too big to fail" to divest certain businesses. And they dodged the explosive issue of compensation.
  
  That led one ex-regulator, former Federal Reserve Board Chairman Paul Volcker, to chastise the group for not going far enough. "Wake up, gentlemen," he said. "Your response is inadequate."
  
  But the prevailing sentiment of the largely private-sector gathering was that, while strengthened regulation is clearly needed, there is also a significant risk of overreaction. As hedge-fund manager and philanthropist George Soros warned: Markets fail, but regulators fail as well.
  

• Thankfully, Paul Volker was there, and he had some (in my view) encouraging things to say:
  

  I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster. Were they wonderful innovations that we want to create more of? You want boards of directors to be informed about all of these innovative new products and to understand them, but I do not know what boards of directors you are talking about. I have been on boards of directors, and the chance that they are going to understand these products that you are dishing out, or that you are going to want to explain it to them, quite frankly, is nil. I mean: Wake up, gentlemen. I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.
  

  Here's my favorite part of what he said:
  

  I think that I am probably going to win in the end.
  

  The Baseline Scenario summarizes his position perfectly: "Volker wants tough constraints on banks and their activities, separating the payments system – which must be protected and therefore tightly regulated – from other “extraneous” functions, which includes trading and managing money." I must add, I am very very encouraged by his statement that he believes he will "win in the end." I very much hope he is accurately assessing his impact on swaying Obama, and politicians in general, to make some more fundamental reform.
• Another interview with Volker, from a German paper. Nice to see an international perspective. Volker says the same as what he was saying in WSJ's conference:
  

  SPIEGEL: You have been clear about your ideas. Do you really believe we have to break up the big banks in order to create a more sustainable financial system?
  
  Volcker: Well, breaking them up is difficult. I would prefer to say, let's just slice them up. I don't want them to get heavily involved in capital market activities so my view is: Hedge funds, no. Equity funds, no. Proprietary trading, no. Trading in commodities, no. And that in itself would reduce the size of the big banks. So you get some reduction in size. Equally important, you make them more manageable and easier to deal with if they do get in trouble.
  
  SPIEGEL: Banking should become boring again?
  
  Volcker: Banking will never be boring. Banking is a risky business. They are going to have plenty of activity. They can do underwriting. They can do securitization. They can do a lot of lending. They can do merger and acquisition advice. They can do investment management. These are all client activities. What I don't want them doing is piling on top of that risky capital market business. That also leads to conflicts of interest.
  

• Financial Times has a really interesting post from GS about China's exchange rate, essentially saying GS is no longer convinced that China is artificailly screwing exchange rates. Also, GS is saying that Chinese domestic consumption is skyrocketing. This is really, really interesting, and flies in the face of popular economic commentary. In the long run, this could be a very good thing, assuming it's correct. I don't know if you guys can read it though - it's probably behind a paywall that I am lucky to bypass: my employer gives me access to FT. I really wish stuff like this was freely available!
• Perhaps we need to change BRIC to BIC.
• There's been lots of talk about regulating, or reducing the power of, the Fed. FT (again, likely behind a paywall) writes that the Fed must be protected. Note that I do not quote this, or the previous FT link, because they are behind paywalls. Again, wouldn't it be nice if it was free? Then I could quote and discuss here properly. This is one of the reasons I rarely link them - why bother when the people I know who read this don't care to pay for access? For the record, one can subscribe free and access a whopping 10 articles a month...
• Krugman writes about Samuelson, who passed away Sunday. He was one of the great theoretical economists. He wasn't a Marx or Keynes, both of whom drove a philosophy that altered the world, but he had a tremendous impact on the field of economics itself. He was one of the first to make economics a quantitative field.
• Not sure if I already posted this: Goldman does something truly interesting. They are giving their top 30 executives bonuses in the form of stock that cannot be exercised for 5 years, amongst other interesting changes. This is a very fundamental change in bonus structure that is being done without any kind of formal regulation or law. I wonder if other banks will follow suit. This would be a tremendous step in the right direction. EDIT: Yes, I posted it in my previous "Reading" post, but it bears mentioning again.
  

Reading

• Krugman made a post recently about how many jobs we need and a promotes a plan to do so:
  
  

  The most specific, persuasive case I’ve seen for more Fed action comes from Joseph Gagnon, a former Fed staffer now at the Peterson Institute for International Economics. Basing his analysis on the prior work of none other than Mr. Bernanke himself, in his previous incarnation as an economic researcher, Mr. Gagnon urges the Fed to expand credit by buying a further $2 trillion in assets. Such a program could do a lot to promote faster growth, while having hardly any downside.
  

  When I read this piece, I was a little struck by how casually he used the $2 trillion number. That's a lot of money, and a lot of debt. Thankfully, The Mess That Greenspan Made agrees:
  
  

  Hardly any downside, that is, unless we're in the middle of a long deferred, fundamental change for the U.S. economy in which the credit expansion seen at all levels over the last few decades - government, corporate, and personal - can no longer produce growth.
  
  

• Mish Shedlock points out that the bond market (usually worth keeping an eye on) is starting to worry about our deficit:
  
  

  The so-called yield curve touched 372 basis points, the most in at least 29 years, as the bonds drew a yield of 4.52 percent. The so-called yield curve has widened from 191 basis points at the end of 2008, with the Fed anchoring its target rate at a record-low range of zero to 0.25 percent and the Treasury extending the average maturity of U.S. debt.
  ...
  “The market is continuing to worry about the massive amount of Treasury issuance that’s going to hit the market well into next year,” said Ian Lyngen, senior government bond strategist at CRT Capital Group LLC in Stamford, Connecticut.
  

• JP Morgan is apparently not concerned about anything actually being done with regards to the "too big to fail" issue. No surprise.
  
  

  Overall, we are left with a big bank that is getting bigger.  It has been (relatively) well run by Mr. Dimon, but there are no assurances for the future.  Given that the “Resolution Authority” is at this point a mythical beast – with no potential effect on the problem of “Too Big To Fail” – we should worry a great deal.
  We could set a hard size cap on banks like JPMorgan Chase (e.g., on assets relative to GDP), which could force them to find ways to spin-off businesses – and return to the much smaller and more manageable size of the early 1990s.  There is no evidence this would be disruptive or cause any economic difficulties.  But, for political reasons, this won’t happen any time soon – the size and power of banks like JPMorgan is put to good use on Capitol Hill.
  

• However, Goldman makes a change to its bonus structure. I wonder if this will be beneficial. It's not in line with Dr. Mintzberg's idea of getting rid of bonuses altogether (as the Goldman strategy still presumes stock price is a good measure of corporate performance), but it does feel like a small step in the right direction:
  
  

  With a resurgent Goldman set to award billions of dollars in bonuses — a trove that could rival the record payouts of the bubble years — the bank said that its 30 most-senior executives would be paid in the form of a special stock, rather than in cash.
  

Ratings Agencies Getting Away Clean

The NYT published a pretty scathing article on how Congress is doing just about nothing to the ratings agencies despite their contributions (some of which have been documented on this blog) to the recent financial crisis:

Without question, the credit rating system is one of the capitalism’s strangest hybrids: profit-making companies that perform what is essentially a regulatory role. The companies serve the public, which expect them to stamp their imprimatur on safe securities and safe securities alone. But they also serve their shareholders, who profit whenever that imprimatur shows up on a security, safe or not.
To make matters more complicated, rating agencies are deeply entrenched in millions of transactions. Statutes and rules require that mutual fund and money managers of almost every stripe buy only those bonds that have been given high grades by a Nationally Recognized Statistical Rating Organization, as the agencies are officially known.
But even if there is no foolproof way to reform the rating agencies, the measures that Congress is now backing are strikingly weak, a number of critics say. There is no talk, for instance, about creating a fee-financed, independent credit rating agency, one modeled along the lines of the Public Company Accounting Oversight Board, which was established to oversee auditors after the Enron debacle — an idea floated by Christopher J. Dodd, the Senate Banking Committee chairman as recently as August.
That approach would attack the conflict of interest problem head on.

Double Dip threat is back?

A long while back, I wrote that I believed we would face a double-dip recession, though I certainly got the time-frame wrong.
Krugman just put up a post on the same issue, and it made me think about why we might still be facing this "W" shape recovery. It relates strongly to Brenner's paper below: we're running out of ways to stimulate business activity. There does not seem to be a bubble left to inflate. When government stimulus runs out (and I don't think we'll see another stimulus package - doesn't seem politically feasible right now) next year, who will spend? From Krugman:

Two stories this morning highlight the risks. The WSJ has a report on highway construction titled Job Cuts Loom as Stimulus Fades:

Highway-construction companies around the country, having completed the mostly small projects paid for by the federal economic-stimulus package, are starting to see their business run aground, an ominous sign for the nation’s weak employment picture.

Meanwhile, the ISM for manufacturing suggests that industrial growth is already slowing down.
I’d be more sanguine about all of this if there were any indications that private, final demand is taking off — consumers, business investment, whatever. But I haven’t seen anything suggesting that sort of thing.

Also, deflation is still looming. Japan is already there. America faces the prospect as well, though if the Treasury keeps pumping out dollars, we also face a risk of inflation down the road. Take a look at this, which has more on double-dip risk (emphasis mine):

The Fed has to do one of two things: They either have to pull $1.5 trillion out of the system by June, which would collapse the economy, or face hyperinflation. This is why the Fed has instructed banks to inform them when and how much of the TARP funds they can return. At best they can expect $300 to $400 billion plus the $200 billion the Fed already has in hand.
We believe the Fed will opt for letting the system run into hyperinflation. All signs tell us they cannot risk allowing the undertow of deflation to take over the economy. The system cannot stand such a withdrawal of funds. They also must depend on assistance from Congress in supplying a second stimulus plan. That would probably be $400 to $800 billion. A lack of such funding would send the economy and the stock market into a tailspin. Even with such funding the economy cannot expect any growth to speak of and at best a sideways movement for perhaps a year.

Their belief goes directly counter to my belief that we will not see a second stimulus plan. If we do not, as I believe, we face the deflationary threat and a true double-dip. If, however, another stimulus plan is passed (which seems more and more necessary, though I still think is too politically unacceptable in the short-term), we may be okay for a while yet.

I know this is a highly doom-and-gloom scenario. Hopefully, I'm wrong, and the world economy recovers more smoothly than I expect.

Also, I wanted to post a short follow-up to the Brenner post below. One thing his analysis does is completely destroy the China-decoupling theory. Note that it was a far more popular theory before the recession than it is now, but it does still get some mention. I think the Brenner write-up finishes it off in my mind, but here's some more on it anyway: The China Decoupling Myth.

Robert Brenner Insight

Robert Brenner is a historian at UCLA. My dad recently pointed me to a paper he wrote that has some fascinating analysis of the root causes of where we are today, economically. The title of the paper, in my mind, is somewhat misleading - so for those of you who are sensitive to any perceived attack on modern banking, please keep reading it. Since it's a 74 page paper, however, I would point you also to this article, which does a great job of summarizing Brenner's paper.
My (preliminary and probably poorly thought-out) understanding of his analysis is that we're locked into a strange loop in which East Asian countries have been, since the 1960's, purposefully forcing over-capacity in manufacturing, which causes downward prices, profit margins, and wage pressure internationally. However, this downward pressure affects the very consumers they intend to sell to, so they simultaneously prop up those consumers (mostly, the United States, and I imagine Europe to a lesser degree) by buying up debt (emphasis mine):

Japan had, from the mid 1950s on, deliberately staked its prosperity on the construction of excess global capacity in a series of key industries beginning with textiles and marching up the value-added chain from ship building and steel through machine tools, a wide range of consumer durables, and capital equipment, as well as a host of important upstream components. Japan did not launch industries. Rather, it targeted markets that were already served by existing capacity in other countries. Japanese companies built their own capacity to capture these markets and then, backed by patient financing and enjoying the advantage of an undervalued currency with predictable labor costs and meticulous attention to quality control, flooded global markets with “torrential rain-type exports” to quote a Japanese government term. The result was to destroy profitability in these industries, forcing foreign competitors either to abandon the industry in question or to cut costs drastically – most commonly, by shifting production to low wage, developing countries.

Subsequently, in its momentous shift away from the Stalinist economic model of autarkic industrialization, China would follow the road blazed by Japan: the deliberate creation of overcapacity in targeted industries aimed at the global market and with the necessary cheap financing overseen and/or organized by the state. Deng Xiaoping's visit to Japan in 1978 – the first ever by a de facto head of the Chinese government – may well be the most important foreign trip ever made by a Chinese leader.

These two countries – and the smaller economies of East and Southeast Asia that followed in their wake ¬– could not, however, escape the consequences of their systematic creation of overcapacity and the resultant decline in manufacturing profitability. To save the global system on which they themselves had come to depend, they were forced to turn around and provide the waves of credit that permitted the financial lynchpin of the global capitalist system – the United States ¬– to continue to act as the world's primary engine of demand.

As Brenner notes in discussing how the explosion in deficits by the George W. Bush administration was financed, “... Japanese economic authorities saved the day by unleashing an unprecedented wave of purchases of dollar-denominated assets. Between the start of 2003 and the first quarter of 2004 ... Japan's monetary authorities created 35 trillion yen, equivalent to roughly one percent of world GDP, and used it to buy approximately $320 billion of US government bonds and (the debt of government-sponsored institutions such as Freddie Mac), enough to cover 77 per cent of the US budget deficit during fiscal year 2004. Nor were the Japanese alone. Above all China, but also Korea, Taiwan, and other East Asian governments taken together increased their dollar reserves by $465 billion and $507 billion....”

I want to make it clear that Brenner is not really playing a "blame game", in which he tries to point to East Asia as the bad guy. He spends just as much time criticizing American policy for blatantly encouraging this situation (emphasis mine):

The fundamental source of today’s crisis is the steadily declining vitality of the advanced capitalist economies over three decades, business-cycle by business-cycle, right into the present. The long term weakening of capital accumulation and of aggregate demand has been rooted in a profound system-wide decline and failure to recover of the rate of return on capital, resulting largely—though not only--from a persistent tendency to over-capacity, i.e. oversupply, in global manufacturing industries. From the start of the long downturn in 1973, economic authorities staved off the kind of crises that had historically plagued the capitalist system by resort to ever greater borrowing, public and private, subsidizing demand. But they secured a modicum of stability only at the cost of deepening stagnation, as the ever greater buildup of debt and the failure to disperse over-capacity left the economy ever less responsive to stimulus. ...
To stop the bleeding and insure growth, the Federal Reserve Board turned, from
just after mid-decade, to the desperate remedy pioneered by Japanese economic authorities a decade previously, under similar circumstances. Corporations and households, rather than the government, would henceforth propel the economy forward through titanic bouts of borrowing and deficit spending, made possible by historic increases in their on-paper wealth, themselves enabled by record run-ups in asset prices, the latter animated by low costs of borrowing. Private deficits, corporate and household, would thus replace public ones. The key to the whole process would be an unceasing supply of cheap credit to fuel the asset markets, ultimately insured by the Federal Reserve.
As it turned out, easy money was made available throughout the entire subsequent period. The weakness of business investment made for a sharp reduction in the demand by business for credit. East Asian governments’ unending purchases of dollar-denominated assets with the goal of keeping the value of their currencies down, the competitiveness of their manufacturing up, and the borrowing and the purchasing power of US consumers increasing made for a rising supply of subsidized loans. So the real cost of long term borrowing steadily declined. Meanwhile, the US Central Bank made sure that short term interest rates never rose to such an extent as to jeopardize profit-making in the financial markets by reducing the Federal Funds Rate at every sign of trouble. One has therefore witnessed for the last dozen years or so the extraordinary spectacle of a world economy in which the continuation of capital accumulation has come literally to depend upon historic waves of speculation, carefully nurtured and publicly rationalized by state policy makers and regulators—first in equities between 1995 and 2000, then in housing and leveraged lending between 2000 and 2007. What is good for Goldman Sachs--no longer GM--is what is good for America.

What is missing is a solution. He's a historian, so all he's trying to do is give us the history. Fine. I have to admit, I personally don't see much of a realistic solution. What would probably help is an American acceptance that we've lived well beyond our means and are due for a serious reduction in living standards (completely unacceptable politically, of course). What might simultaneously help is China trying to focus more on domestic consumption as a path to future growth rather than continued exports, but I have no clue what their policies on that are. What will likely happen is we will limp on in this manner for some time yet - Asian exporters will keep flooding us with both cheap goods and plenty of money. I imagine that this can't last indefinitely, but I've no idea what the future really holds.

"The problem isn’t that they are poorly designed. The problem is that they exist."

The title refers to executive bonuses. CD emailed me a great piece from MIT Sloan Management Review. The main purpose of the review is to show that executive compensation is poorly structured. What I really like is that it's one of the first "legitimate" publications (read: not a random angry blogger/talking head) to suggest entirely scrapping executive bonuses. That this school is one of the prominent producers of the very executives they are criticizing only furthers the articles' relevance. It is important to note that the article itself was written by Dr. Mintzberg of McGill University in Montreal, but it isn't being considered an op-ed.

One of the most compelling points is that even bonuses based on "performance measures" are a flawed idea:

How do you assess the long-term performance of a chief executive? Some proposals look at three years, others as many as 10 years. But can we even be sure of 10 years? Is a decade long enough in the life of a large company, with all its natural momentum? How many years of questionable management did it take to bring General Motors to its knees?

Conversely, if a company’s stock price goes up and stays up for several years, does that signify the definitive success of the current chief executive? What if the previous CEO made some good decisions that later kicked in? Don’t we all talk about the long-term influence of executive decisions? Have we forgotten about that?

He concludes with a pretty funny (though thoughtful) bit:

Actually, bonuses can serve one purpose. It has been claimed that if you don’t pay them, you don’t get the right person in the CEO chair. I believe that if you do pay bonuses, you get the wrong person in that chair. At the worst, you get a self-centered narcissist. At the best, you get someone who is willing to be singled out from everyone else by virtue of the compensation plan. Is this any way to build community within an enterprise, even to foster the very sense of enterprise that is so fundamental to economic strength?

Accordingly, executive bonuses provide the perfect tool to screen candidates for the CEO job. Anyone who insists on them should be dismissed out of hand, because he or she has demonstrated an absence of the leadership attitude required for a sustainable enterprise.

Of course, this might thin the roster of candidates. Good. Most need to be thinned, in order to be refilled with people who don’t allow their own needs to take precedence over those of the community they wish to lead.

Accusations Against the Fed

To be honest, I don't quite understand this one. Can someone explain to me whether the conclusion in this article is true (namely, that the Fed is acting in violation of the Constitution)?

It had generally been assumed that the AIG payouts of 100% on credit swaps (when the insurer was under water and bankrupt companies do not satisfy their obligations in full) was the result of some gap in oversight plus traders at AIG exercising discretion (they were unhappy about bonus rows and had reason to curry favor with dealers, who were potential employers).

The article makes clear that AIG had been negotiating to settle on the swaps prior to getting aid from the government, and was seeking a 40% discount. The Fed might not have gotten that much of a discount, but there was clearly no need to pay out at par.
...
After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.
...
As Vickrey indicates, the fact that this was a backdoor rescue means the Fed is acting as an extra budgetary vehicle of the Treasury. This is a violation of the Constitution and shows how patently false the Fed’s claims of independence are.

Onto other reading...

• David Brooks with some more criticism of the idiotic government decision to police pay and whatnot:
  
  

  Now in disgrace, Wall Street firms are rewriting their rules, but the Obama administration has decided it should take control of compensation reform. Nobody seriously believes high pay caused the financial meltdown; it was bubblicious groupthink. But cutting executive pay just polls so well. ...
  Treasury officials are now making individual pay-package decisions across an array of different companies — and they must have really big brains to understand the motivational psychology of all those different people. The Federal Reserve, meanwhile, has decided to police banks and veto pay deals that lead to excessive risk. Those experts must have absolutely gigantic brains if they can define excessive risk years before investments pay off.
  ...
  The best and the brightest in government are now rewriting existing pay contracts and determining that certain firms will be compelled to pay much less than their competitors. They’re not leveling the playing field, as a humble government would do. They’re making it less level in complicated ways.
  
  

• A case for big banks, and a rebuttal.
• A really interesting read on the dollar.
• On the new tools of monetary policy:
  
  

  Participants in this session were asked to address two basic questions. The first is whether the Fed's targeted liquidity operations were necessary and effective. My answer is probably yes, though I would have a hard time persuading someone if they were not already convinced of that. The second question is whether such operations should be considered an important part of central banks' arsenal of tools in the future. To that my answer is categorically no. From virtually any perspective of our current problems, it would have made far more sense to address these problems with proper regulatory supervision prior to the crisis instead of targeted liquidity operations after the crisis unfolds.
  

  
  
  
  

This Isn't Needed Regulation

I'm appalled by what the government is up to right now.
In case you haven't heard, the Pay Czar, Kenneth Feinberg, just started instituting pay cuts at Wall St. firms that used TARP money:

Mr. Feinberg, the Treasury Department's special master for compensation, will lower total compensation for 175 employees at seven firms including AIG, Citigroup, Bank of America and GM, by an average of 50%, people familiar with the matter said. He will also demand a series of corporate-governance changes at the firms, including splitting the positions of chairman and chief executive officer; requiring boards of directors to create a committee to assess risk, and eliminating staggered boards.

Some of that actually sounds not so bad, such as splitting the positions of chairman and CEO. However, this is not the way to go about fixing anything! What is Feinberg trying to accomplish? Here's the best I've found:

Summers said Feinberg's rulings -- which are expected to be publicly released in the coming days -- will ensure taxpayers' interests come before those of shareholders and incumbent management at the beleaguered firms.

Let's do a quick history. First of all, lest we forget, the government forced these companies into accepting bailout money. Some argue that hey, if you take public money, you have to be prepared for public oversight ... but they didn't have a choice! Beyond that, it's not as if there were any particular requirements associated with the TARP money. For example, one way to look out for taxpayers might have been to get the banks taking TARP money to lend more, during a time when credit was/is tight. Did that happen? No. "Geithner did not require the Big Banks to loan money for commercial loans as a prerequisite for additional borrowings from the Fed."
And now Obama & Co. start trying to trim their pay? What are they accomplishing?? All that I'm seeing here is this: Dear Big Banks, if you get in trouble, we'll give you tons of money. In fact, we might even force it down your throats, but at least no matter how bad you screw up you know you won't go under. Then we'll let you do whatever you want with that money and achieve mind-blowing profits during a recession, which will naturally lead to fantastic compensation and plenty of public outrage. And since we used to work on/with Wall Street, we could basically predict all this would happen. And it's kinda messed up that we used to work with you and now we're giving you more-or-less free public money, but hey, that's what friends are for! But look, we'll have to pretend to be totally bewildered and fake some anger at you so the public doesn't tar-and-feather us.
Honestly, as far as I can tell, that's more or less the story so far. Ugh. Instead of focusing on useful policies that might prevent future issues (such as reinstatement of the Glass-Steagall Act, or something similar, which is sadly looking like it won't happen), they do worthless stuff that won't even really have a lasting impact:

Pay is the wrong way to tackle this problem. It’s a lazy, crowd-appeasing, intellectually dishonest approach. The out of line pay is a symptom, and any attempt to treat symptoms as causes is likely to be ineffective, more likely dysfunctional.
...
Now why is trying to control this through pay not such a hot idea? First, one hundred years of performance appraisal systems have proven them to be abject failures (aa 1992 paper by
Patrick D. Larkey and Jonathan P. Caulkin, “All Above Average and Other Unintended
Consequences of Performance Appraisal Systems,” did a brilliant job of dissecting why, but it was too heretical to get published. You can read a few key points here in the section “The Illusion of Meritocracy”). Second, comp systems are supposed to solve what is called a principal-agent problem. You the person hiring someone to work on your behalf wants to make sure they are operating in accordance with YOUR best interests in mind, not theirs.
But what did we learn from 20 years of executive rewards schemes that had lots of equity incentives that would supposedly align the interest of top brass with that of shareholders. We got instead an explosion of CEO pay and companies that are so fixated on quarterly earnings that they are reluctant to invest in growth. How did that come to pass?
BECAUSE THE AGENTS AND NOT THE PRINCIPALS DESIGNED THE PAY SCHEMES!  The foxes were running the hen house. Oh, sure, we had some fig leaves, it was the HR department that hired the compensation consultant, and the board (nominated by the incumbent management) that signed off on it, but it is pretty clear that a comp consultant that did not deliver a CEO-wallet-fattening plan was unlikely to get much repeat business.
And is anything going to be materially different? No. The conventional wisdom is that having employees take a high level of pay as equity is a magic solution, conveniently forgetting that Bear and Lehman both featured very high levels of shareholding among its top management and employees. Feinberg is only intervening in outliers, to collect a few scalps. He is in a very difficult position and is trying to make the best of it.
The financial services industry now has an unimaginably rich deal: privatized gains and socialized losses, and with tons of leverage too, which amps up the apparent profits and hence the pay levels these looters can claim they deserve. The way to attack this problem is to constrain the level of risk assumption. That in turn requires understanding the products and the markets, something the authorities have completely abdicated. With so much “talent” looking for jobs, now would be the perfect time to invest in catching up.

Sorry for the angry, poorly-written rant. And please keep in mind, I'm not exactly trying to defend banks here. In fact, I think I've been quite open on this blog about how immoral they've been and how dangerous they are to our country as they're currently constructed. The point here is, nothing useful is being done to correct this! All this Pay Czar junk is just political maneuvering. Real reform is not happening.

Lots of Reading

• A new book by the authors of Freakonomics, unsurprisingly called SuperFreakonomics, is reviewed by John Mason at Seeking Alpha and Krugman in multiple parts. I have not read Freakonomics, though I should. I believe the main premise is a study of how people respond to incentive.
• The Mess That Greenspan Made points us to "The Warning", a documentary by PBS about how a potential whisteblower on the financial crisis was shut down by figures such as (naturally) Greenspan, Rubin, and Summers. A damning preview:
  

  At the center of it all he finds Brooksley Born, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008. ...
  

  Greenspan, Rubin and Summers ultimately prevailed on Congress to stop Born and limit future regulation of derivatives. "Born faced a formidable struggle pushing for regulation at a time when the stock market was booming," Kirk says. "Alan Greenspan was the maestro, and both parties in Washington were united in a belief that the markets would take care of themselves."
  

  Now, with many of the same men who shut down Born in key positions in the Obama administration, The Warning reveals the complicated politics that led to this crisis and what it may say about current attempts to prevent the next one.
  

  "It'll happen again if we don't take the appropriate steps," Born warns. "There will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience."
  

  
  
• An interesting interview with Eric Maskin, the Albert O Hirschman Professor of Social Science at the Institute of Advanced Study in Princeton. Woo titles. He's also a Nobel Prize winner, though the legitimacy of that prize is a little questionable right now. Anyway, the interview talks mostly about regulation and the need for it through brief reviews of various papers and books. It's a good primer for those who want a really simple, layman's overview of banking, regulation, etc.
  
• Must read.
• In an about-face from his role as described in "The Warning", Summers calls for banks to accept more stringent regulation. I think the real issue, beyond even accepting regulation, is that the government needs to enforce them. This is a problem that I don't see a solution to yet.
• Problems and Solutions. I like the Solutions part.

Why Are We In A Recession?

A paper was recently published which I found very interesting. Written by Ravi Jagannathan, Mudit Kapoor and Ernst Schaumburg (of Northwestern Kellogg, Indian School of Business, and the New York Fed respectively), it attempts to analyze the true cause of the recession.

...why are we in such a great recession? What is the cause?
According to folk wisdom, the financial crisis caused the recession. That leads to the question, what caused the financial crisis? The standard answer is, easy credit and lax regulation led to the crisis. But then, what caused easy credit and lax regulation? According to popular press it is due to the savings glut in Asia, and a major part of that savings flows into the the US with the result that there is too much money in the US financial system chasing too few opportunities. Why is there too much savings in Asia and why those savings flow to the US? Asians just like to save and Americans just like to consume more! According to this logic all that is needed to remedy the situation is to require Asians to save less and consume more.
In this paper we argue that this logic is misleading. All these phenomena – savings glut, easy credit and lax regulation, and financial crisis – are closely interlinked and there is a deeper driving force. While each piece is well understood, our focus here is to emphasize how a common driving force is linking them all together.
...
In what follows we argue that this huge and rapid increase in developed world’s labor supply, triggered by geo-political events and technological innovations, is the major underlying force that is affecting world events today. The inability of existing financial and legal institutions in the US and abroad to cope with the events set off by this force is the reason for the current great recession: The inability of emerging economies to absorb savings through domestic investment and consumption caused by inadequate national financial markets and difficulties in enforcing financial contracts through the legal system; the currency controls motivated by immediate national objectives; the inability of the US economy to adjust to the perverse incentives caused by huge moneys inflow leading to a break down of checks and balances at various financial institutions, set the stage for the great recession. The financial crisis was the first symptom.

I should note that I've heard this argument before, although not so formally researched and argued. It is a very interesting piece of analysis and points to us being in the midst of a much larger correction that is taking place. One question to be asked, assuming the analysis is correct, is what is the solution to our problems here? They draw an interesting historical parallel to a rapid increase in labor supply that was solved as follows:

When millions of World War II soldiers returned home that increased the US labor force of about 60 million workers by almost 25% within a very short period of time. At that time the Department of labor, which certainly had no cause to accentuate the negative, predicted that 12 to 15 million workers would be unemployed. That did not happen! We managed that problem well leading to prosperity instead of doom, thanks in no small part to the GI Bill and other governmental fiscal intervention. We can manage this one as well.
For that to happen, the first step is to recognize the problem for what it is. A solution may well require actions similar in scope to the GI Bill and require a national debate.

This seems to be support for serious government intervention, which has already started.

But there's no sugarcoating of how America must deal with things. The authors definitively state that consumption must go down and competitiveness must go up. In other words, less shopping and more education. I'm sure kids around the country will just love to hear that.

A few more random quotes from the paper that are interesting:

As housing prices decline and the charade of cheap credit is lifted, there will be a severe contraction in consumption levels... We should therefore be prepared for a permanent 3% drop in consumption levels. This number does not account for the brewing trouble in the commercial real estate markets where many regional banks may yet be in trouble due to excessive exposures to bad loans which could further delay the recovery in the real economy.

It is likely as recovery takes hold, the value of the U.S. dollar will decline substantially, and that alternative reserve currencies will begin to emerge.

Clearly China’s export led growth strategy of the past cannot continue indefinitely and domestic consumption must be allowed to grow as a share of GDP. At the same time, Western economies must adjust to a new equilibrium in which commodities are scarcer and households will face stiffer competition for jobs.

Reading

• In defense of Geithner's phone calls.
• More reasons on why a weaker dollar isn't all bad. Some interesting points here:

  A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ. ...The sensible goal of a more balanced world economy is entirely consistent with a weaker dollar and a stronger euro. I am not trying to make a short-term prediction. Foreign exchange markets are crazy, and I have been wrong too many times. But what persuades me that the dollar has further to devalue is the observation that, for once, politics and economics are pushing in the same direction.
  

  
  
• And immediately, a rebuttal to the weaker dollar argument:

  ...a certain amount of dollar weakness is a good thing and consistent with global rebalancing. On one level, this is a sensible and defensible view. But this view is implicitly based on the idea that the dollar will somehow find its “correct” level, more or less. ...But currencies are known for their propensity to overshoot and stay for long periods at levels not warranted by fundamentals.
  

  
  
• An argument for why fiscal stimulus is the right way to go, and worries about debt are misplaced:

  The textbook argument for fiscal stimulus still applies. We face a large output gap -- the difference between the amount the economy could produce and the amount it is producing -- because demand from households (for consumption) and companies (for investment) is low. The government should therefore increase spending in order to increase demand and help close the output gap. This should be balanced by lower spending or higher taxes when the economy has recovered. The fact that our baseline amount of debt has changed does not affect the validity of this principle.
  

  
  
• Of course, it's not clear that the fiscal stimulus has been executed properly. Good read at Models & Agents.
• More from Models & Agents (neat new blog I just discovered) ... a proposal for bank reform. It also includes critiques of other proposals. Really great read. Her proposal follows:

  So here is an idea: Extend the FDIC’s deposit-insurance framework to the entire financial sector. In other words, get financial institutions (i.e. not just commercial banks) to pay a fee to a dedicated FDIC-like fund, which would be financial subsumed to the Treasury. This fund would be available to cover the liabilities of a financial institution (i.e. its creditors, up to a given amount and level of seniority), if that institution failed.
  ...
  Importantly, the scheme could be so designed to address the need to discourage excessive risk-taking as well as a heavily procyclical behavior on the part of financial institutions: For example, the fee could be a function on an institution’s leverage, appropriately defined; and it could also be time-varying, in tune with the business cycle, to discourage heavily procyclical behavior.

  
  
  
  
  
• Not sure I totally follow this one, but here's an argument that M&A will make for a new bubble.
  

BlackRock's Potential Conflict of Interest

This is a somewhat alarming report.
From the WSJ:

BlackRock Inc., which scored multiple government assignments during the financial crisis, is a contender for another prestigious gig: helping state regulators size up risks in insurers' investments.
The money manager and risk-advisory outfit is among a handful of firms that have talked with officials from the National Association of Insurance Commissioners lately about possibly taking on a slice of work now done by the major ratings firms, according to regulators and an official at the NAIC.

Why is this alarming? From POGO:

Another company that is reportedly under consideration for the contract is PIMCO...
To understand why hiring a company like BlackRock or PIMCO could raise the risk for conflicts of interest, just take a look at BlackRock’s latest quarterly SEC filing. As of June 30, 2009, BlackRock is managing a whopping $1.37 trillion in assets, including $510 billion in bonds, $317 billion in cash products, $330 billion in stock funds, and $52 billion in alternative investments such as hedge funds. The company also advises clients on $166 billion in assets, including many of the same types of assets that it would be evaluating for the NAIC. And these numbers will soon be increasing thanks to BlackRock’s recent acquisition of Barclays’ investment unit, which, according to Bloomberg, will create a “company overseeing $2.7 trillion in assets—more than the Federal Reserve.”

To be fair, BlackRock told the WSJ that the company has “very strict policies and procedures in place to protect confidential client information and manage any potential conflicts of interest.” However, there's still potential for abuse if they get such a contract.

It's important to note that this is a severe strike against traditional ratings agencies, who have been increasingly viewed as major culprits in the recent crisis. However, I don't think the solution is to simply ignore them. Consider the fact, instead, that ratings agencies are for-profit institutions, which in and of itself raises conflicts of interest. A hypothetical: suppose JPMorgan goes to Moody's to ask for a rating on some assets they want to securitize. Moody's comes back with a bunch of poor grades. Well, Standard & Poor's could easily jump in with its own 'research', claiming they are able to rate the assets at a higher level which would allow JPM to create a more stable security, though in reality the assets are now of unclear strength. S&P, looking for customers, has every incentive to do something like this when regulatory enforcement is weak. That link has an SEC report about how much conflict of interest exists for ratings agencies, and how the SEC did absolutely nothing about it. All bark, no bite.
One possible solution (and I'm just throwing something out there) is for all ratings agencies (at least, all of the Big 3, or perhaps some combination of the Big 3 and other smaller firms) to be required to independently rate assets when any one of them is asked, and investors be required to use the 'average' of the three ratings. The problem there is increased cost to investors, but perhaps that would give investors incentive to do a little research of their own and not waste time on potentially risky assets. Does this make any sense?

Update: Good read from Fortune on the current state of affairs with ratings agencies.

Criticism and Solutions

I've read a lot of articles about the crisis over the past year. Lots and lots of articles. I've started to notice that the vast majority of them (including my own, to be fair) tend to be focused on criticizing mistakes. What bothers me is that articles providing solutions, not just criticism, are few and far between. I'm going to try to focus future posts, both links to articles along with my own thoughts, on solutions. Criticism leads to pointless debate; proposals lead to useful debate. Granted, the tiny debates that occur here are hardly meaningful, but I'm doing my best!

Anyway, sorry for the rant. On to some good reading:

• An article from the Economist, pointing out that the failure of regulators in this past crisis may have been due to a lack of incentive to regulate. Interesting, though not particularly novel, insight. Thankfully, in line with my earlier diatribe, there is a proposed solution in the article (though I think it's a weak solution, in that there's not much substance offered):
  

  Incentives also help explain why regulators resist the delegation of powers to supranational institutions. Supervisors may wish to protect the local industry or secure a competitive edge over other financial centres. Even without a protectionist agenda, supervisors are prone to capture: because they talk to local institutions on a daily basis, they are likely to empathise with the competitive pressures that those banks face. Pay is also a problem. In most countries compensation structures for national supervisors will involve low salaries, no bonuses and small rewards for doing a good job. Supervisors get into trouble if they go out on a limb and make a technical mistake (and a bank sues), but face fewer problems if everybody makes the same material mistake and the system goes down. It does not help that officials are repeatedly told that the smartest people go where the money is—into the banks, in other words, not the agencies that regulate them. ... The solution to the problem of local regulatory capture would be to rely more on supranational authorities. ...And beyond Europe, too, policymakers ought to match their new-found focus on incentives in the private sector with more attention to their own.

• Geithner has been known to be very close with top banks on Wall St. This AP article shows just how close using phone records obtained via FOIA:
  

  After one hectic week in May in which the U.S. faced the looming bankruptcy of General Motors and the prospect that the government would take over the automaker, Geithner wrapped up his night with a series of phone calls. First he called Lloyd Blankfein, the chairman and CEO at Goldman. Then he called Jamie Dimon, the boss at JPMorgan. Obama called next, and as soon as they hung up, Geithner was back on the phone with Dimon.
  While all this was going on, Geithner got a call from Rep. Xavier Becerra, a California Democrat who serves on committees that help set tax and budget policies.
  Becerra left a message.
  In the first seven months of Geithner's tenure, his calendars reflect at least 80 contacts with Blankfein, Dimon, Citigroup Chairman Richard Parsons or Citigroup CEO Vikram Pandit. Geithner had more contacts with Citigroup than he did with Rep. Barney Frank, the lawmaker leading the effort to approve Geithner's overhaul of the financial system. Geithner's contacts with Blankfein alone outnumber his contacts with Sen. Christopher Dodd, D-Conn., chairman of the Senate Banking Committee.
  

  This is pretty disturbing stuff. The Baseline Scenario points out that it wasn't even that he was calling the biggest or most troubled banks. He was calling his friends. Although that's fine when one is in the private sector, I think it's quite wrong for a public servant. Then again, who really thinks of Geithner as a public servant after how he bailed out the banks?
  
• The NYT talks about how the debt-securitization market is still pretty frozen:
  

  Many investors have lost trust in securitization after losing huge sums on packages of subprime mortgages that had high default rates. The government has since spent more than $1 trillion trying to restore the markets, with mixed success.
  Until more of the securitization market revives, or some new form of financing takes its place, a wide range of loans needed to secure a lasting economic recovery will remain elusive, experts said.
  

  The question here is, why should we want to return to securitization? Naked Capitalism and Krugman both comment on this. I like that Krugman offers a solution, though an oft-repeated one.
  NC:
  

  What is intriguing about these comments is the tacit assumption that we have to go back to status quo ante, of having a significant amount of loans on-sold into credit markets rather than retained on bank balance sheets. Yet we have seen the superficial appeal of that system comes at considerable cost. Securitization allows for more “efficient” banking, in the sense that banks can operate with far less equity than if they conducted banking the old-fashioned way, by holding the loans they originate.
  But this prized efficiency comes at high social cost. First, the idea that these loans were really off balance sheet in many cases was spurious. For some types of conduits, like credit card trusts and SIVs, banks did intervene when the supposed off balance sheet vehicles got in trouble. Indeed, credit card receivables could not have been off-loaded absent parent support. So the supposed efficiency gain was phony; the banks were simply using off balance sheet vehicles as a way to run with less equity than they actually should have had, but the regulators accepted the charade and looked the other way.
  Second, as we know, securitization reduces the incentives to do proper borrower assessment and even worse, means no one is monitoring the borrower on an ongoing basis.
  

  Krugman:
  

  But here’s my question: why does it have to be a return to shadow banking? The banks don’t need to sell securitized debt to make loans — they could start lending out of all those excess reserves they currently hold. Or to put it differently, by the numbers there’s no obvious reason we shouldn’t be seeking a return to traditional banking, with banks making and holding loans, as the way to restart credit markets.
  

Quick Links

Sorry for the lack of posts recently - been quite busy. Here are a few articles I think are worth reading:

• The Baseline Scenario writes about monetary policy, taking a look at hawks vs. doves in the Fed. I never quite thought of hawks or doves in monetary policy, but it's a neat take.
  
  

  Hawks also like to talk a lot about “credibility,” which means a reputation for being willing to fight inflation. People use the word credibility in this context because the conventional wisdom used to be that national governments would not be willing to take tough steps (raising interest rates) against inflation because that would cost jobs, and hence votes in the next election. So central banks had to prove that they were willing to raise interest rates and put people out of work, even though that might be politically unpopular. Now that our Fed governors and bank presidents are accountable to just about no one, beating on their chests and proclaiming how willing they are to be tough in the face of the political winds rings a little hollow to me — especially in a “middle-class” country that considers inflation to be a greater evil than unemployment. Arguably, the situation has reversed; it has become so accepted that the primary job of a central bank is to fight inflation, despite the Fed’s dual mandate (to both fight inflation and promote stable economic growth), that fighting inflation has become the politically safe thing to do.
  

• This is interesting, and for Americans, potentially alarming: China, Russia, Japan, France, and some Middle Eastern countries are planning to "end dollar dealings for oil." There's been quite a bit of noise over the past months about shifting away from the dollar as the main international currency, but (at least in articles I read, which I must note tend to be written by Americans) such talk has been largely dismissed. Apparently, we shouldn't dismiss so easily. The dollar is already weak in value, and such a move only further hurts its reputation. If this is actually going to happen, it will increase tension between China and America. It is also interesting that Japan, who has been a pretty close trade partner and ally since WWII, is part of this non-dollar alliance.
• A profile of Larry Summers and his team.
  
• Mish arguing that deflation is no longer a looming threat, it is here. Furthermore, he argues that it's a good thing! Take a look:
  
  

  Deflation is not a threat because deflation is here by any practical measurement. Deflation is also here by impractical measurements such as falling prices. See Humpty Dumpty On Inflation and Daniel Amerman vs. Mish: Reflections on the Great Inflation/Deflation Debate for a further discussion of a practical definition of deflation, a contraction of money supply and credit marked to market, not falling prices.
  
  Moreover, deflation is not a threat in a second sense. Deflation is needed to purge the excesses of the last credit cycle. Attempts to defeat deflation by force will only prolong the agony while accumulating government debt, just as happened in Japan's two lost decades.
  
  Finally, deflation is not a threat in a third sense. Falling prices are a natural state of affairs because of rising productivity over time.
  

  
  
  
  
  

The Weak Dollar Policy

I received an email from a friend, Nicholas Kreifels, recently. He reads this blog on occassion and wanted to send some thoughts on what he thinks is a "weak dollar policy". I got his permission to post his thoughts here:

...in regards to the Fed's current solution to the crisis.  I think of it like this, they are pouring all the water on the floor (i.e. liquidity flood) and not mopping it up.  Big banks continue to devour smaller, weaker banks, consolidating capital, posing an even larger systemic threat to the global economy.  The dollar weakens each day, which poses a severe threat to the U.S. economy in the long run by depreciating our currency and threatening our reserve currency status.  After all the liquidity floods the market, are we any better off?  I see one of two things happening, domestic companies mop up the liquidity, fueling the inflation of another bubble (think 90s S&L crisis), or inflation balloons and foreign investment, already declining, packs its bags and heads for the hills.  The U.S. has carried a trade deficit since I was born.  I think it's time to realize we need to raise interest rates and let the export industry take it on the chin in order to help the majority (companies that import).  The trade deficit partnered with our currency deficit increases the problems for the U.S.  What will we do when China stops borrowing?  Or, when the dollar is no longer the reserve currency?  I think the negative implications of a weak dollar policy far outweigh its benefits.

I asked for further clarification on what he meant by "I think it's time to realize we need to raise interest rates and let the export industry take it on the chin in order to help the majority (companies that import)." Here is his followup:

The sentence about "taking it on the chin" references basic strong/weak dollar policy.  If the dollar is weak, compared to foreign currencies, this proves to be in an exporter's advantage because he can sell his goods cheaply, due to the fact that foreign countries' purchasing power increases as the dollar weakens.  We know that the U.S. maintains a trade deficit, which signals that our economy is IMPORT heavy.  Hence, it appears, based on trade, that the U.S. has more domestic companies that import than export, making the majority of domestic companies importers and the minority exporters.  By instituting a strong dollar policy, the export companies take a direct hit (also known as taking it on the chin) because they cannot sell their goods as cheaply as before.

My argument is to institute a strong dollar policy to benefit the majority (importers), instead of the minority (exporters).  Not only does the weak dollar policy hurt the majority of the companies, it harms the status of the dollar as the reserve currency because weak dollar policy promotes inflation.  The Fed has expanded its balance sheet by 2 trillion dollars, and it currently practices a weak dollar policy.  Inflation, if not monitored closely, can flame up quickly.  I understand the Fed's motive to promote and thaw the credit markets; however, the liquidity in the market is there, the banks simply are not lending it.  So, the question becomes: when will the Fed cease to flood the market with liquidity?  I don't see an end in sight, and that is discouraging. 

Does anyone have thoughts on this? I have not thought about the strength of the US Dollar, and how that affects our country, much at all. However, at first glance, it's not clear to me that having a weaker dollar is all bad, at least in the short-term. First of all, I don't see any other currency that can legitimately replace the US Dollar as the global reserve currency. Though some countries may diversify into Euros, or other globally respected currencies, the dollar is in my mind still the safest play due to the position of the US economy. This economy is the largest and strongest in the world despite the downturn, and no other country is as of yet ready to take that role. Also, might it not be a good thing for us to start exporting more? This may lead to job creation in manufacturing or services industries, providing both blue- and white-collar jobs that would greatly help the middle-class.
I have written about the inflation scare potential, and it indeed lurks on the horizon. In this, I feel Nick is correct: we will eventually see inflationary issues from all the money the Fed has pumped into the system (note: I wrote that the short-term worry is actually deflation. I should revisit this topic at some point.). That is intentional, as Nick articulates: the Fed is purposefully practicing a weak dollar policy. I also feel the long-term dangers are severe. Though in the short-term, this policy could help alleviate the recession, a long-term weakened dollar doesn't help our country.
I'd love to get some opinions on this weak dollar policy business. Is Nick's premise correct? If so, are the repercussions he envisions, and his preferred response, with merit? Does my response have any merit? Any thoughts on Bernanke's policy in general?

Weekend Reading

I meant to publish this last evening (see title), but I completely forgot to actually hit the publish button. Oh well... here's some interesting stuff from the weekend:

• My dad sent me this bit from Richard Russell of Dow Theory Letters fame. He writes about the world deflation story, based primarily on the fact that U.S. consumption has decreased while emerging market consumption is not increasing. The most interesting paragraph, to me, is quoted below (can anyone confirm if this is true? It's a fascinating little piece of information):
  

  Do you know the “why” of the Chinese wok? Fuel is scarce in China, and if food is diced and sliced and placed in a wok with a bit of oil, it will cook in a minute or so over a small fire. As soon as the food is cooked, the fire is put out and the remains of the fuel are saved for the next meal. Talk about fast food, wok-cooked food is the original fast food. Wok food is cooked as quickly and as inexpensively as possible.
  These are the billions of people we are dealing with. They live to work hard, and save — and to sell to the West, specifically to US consumers. And we wonder why there is world deflation.
  

•  Harvard Magazine with a neat bit of historical analysis that I've shown before through many other articles. When we deregulate, we lose:
  

  Of course, financial panics and crises are nothing new. For most of the nation’s history, they represented a regular and often debilitating feature of American life. Until the Great Depression, major crises struck about every 15 to 20 years—in 1792, 1797, 1819, 1837, 1857, 1873, 1893, 1907, and 1929-33.
  But then the crises stopped. In fact, the United States did not suffer another major banking crisis for just about 50 years—by far the longest such stretch in the nation’s history.  
  

  Calm Amidst the Storm: Bank Failures (Suspensions), 1864-2000
  

•  I like the title of this article: "It's Hard Being a Bear". That's part 5! I need to find and read parts 1-4. 5 shows, with a whole bunch of fancy charts and analysis, that the stimulus plan is failing to increase the broader money supply, which goes counter to classical economic theory. Summary: when the stimulus program runs out, we're going back to recession. This is assuming that the stimulus can't go on forever, though an IMF article recently mentioned an interesting tidbit. The IMF projects that the future cost of 'entitlements' (health care, social security, etc.) is 10x the future cost of stimulus. I'm not sure how accurate that projection is, but hey, it's the IMF. I'll trust them for now. The takeaway is that by reducing entitlements, the government may be able to continue stimulus for longer than one might expect. We're now getting dangerously near politics, so I'll leave it at that for you to chew on.
• Krugman on Skidelsky on Keynes. Here's a really interesting quote from that review:
  

  Most strikingly, Skidelsky declares that the traditional division between microeconomics and macroeconomics, which is based on whether one focuses on individual markets or on the overall economy, is all wrong; macroeconomics should be defined as the field that studies those areas of economic life in which irreducible uncertainty, uncertainty that cannot be tamed with statistics, dominates. He goes so far as to call for a complete division of postgraduate studies: departments of macroeconomics should not even teach microeconomics, or vice versa, because macroeconomists must be protected "from the encroachment of the methods and habits of mind of microeconomics".
  

• Was the G-20 summit dangerous? This article claims that there are fundamental differences between American and European banking that should really make for different solutions on either side of the Atlantic. Obama's drive to have a common solution might actually make for more harm than good:
  

  Obviously, raising capital standards in the US is going to be a long and drawn out fight.  The G20 could help, if it set high international expectations, but the opposite is more likely.  As Nocera suggests this morning, the inclination of the Europeans – largely because of their funky “hybrid” capital, but also because they have some very weak banks – will be to drag their feet.
  Why should we care?  This administration seems to think that we need to bring others with us, if we are to strengthen capital requirements.  Our progress will be slowed by this thinking, the glacial nature of international economic diplomacy, and the self-interest of the Europeans.
  

Keynes Is Popular Again

I pointed to this trend in a previous post: the work of John Maynard Keynes has been largely disregarded for the past 50 years as out-dated. Recently, however, people are starting to take his work seriously again. Here is another excellent column on why Keynes seems valuable again. The key point (behavioral economics strikes again!) is quoted here, and as usual, emphasis in bold is mine:

The General Theory is a hard slog, though not because it is mathematical. There is some math, but it is simple and, with the exception of the formula for the "multiplier" (of which more shortly), it is incidental to Keynes's arguments. A work of elegant prose, the book sparkles with aphorisms ("It is better that a man should tyrannize over his bank balance than over his fellow-citizens") and rhetorical flights (most famously that "madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back"). But it also bristles with unfamiliar terms, such as "unit-good" (an hour's employment of ordinary labor), and references to unfamiliar economic institutions, such as a "sinking fund" (a fund in which money is accumulated to pay off a debt). ...

It is an especially difficult read for present-day academic economists, because it is based on a conception of economics remote from theirs. This is what made the book seem "outdated" to Mankiw--and has made it, indeed, a largely unread classic. (Another very distinguished macroeconomist, Robert Lucas, writing a few years after Mankiw, dismissed The General Theory as "an ideological event.") The dominant conception of economics today, and one that has guided my own academic work in the economics of law, is that economics is the study of rational choice. People are assumed to make rational decisions across the entire range of human choice, including but not limited to market transactions, by employing a form (usually truncated and informal) of cost-benefit analysis. The older view was that economics is the study of the economy, employing whatever assumptions seem realistic and whatever analytical methods come to hand. Keynes wanted to be realistic about decision-making rather than explore how far an economist could get by assuming that people really do base decisions on some approximation to cost-benefit analysis.

The General Theory is full of interesting psychological observations--the word "psychological" is ubiquitous--as when Keynes notes that "during a boom the popular estimation of [risk] is apt to become unusually and imprudently low," while during a bust the "animal spirits" of entrepreneurs droop. He uses such insights without trying to fit them into a model of rational decision-making.