Weekend Reading

• Ben Friedman, a professor of economics at Harvard, essentially questions the value of financial engineering. Not that this is anything new, particularly since the recent crash, but it is a question worth considering. A lot of his contentions themselves are questionable, but I encourage you to read the entire piece. Some relevant quotes here: "For years, much of the best young talent in the western world has gone to private financial firms. At Harvard more than a quarter of our recent graduates who have taken jobs have headed into finance. The same is true elsewhere. ...At the individual level, no one can blame these graduates. But at the level of the aggregate economy, we are wasting one of our most precious resources. While some part of what they do helps to allocate our investment capital more effectively, much of their activity adds no economic value. ... What makes a more efficient financial system worthwhile is not just that it allows us to achieve greater production and economic growth, but that the rest of the economy benefits. ... Does the increased efficiency our investment allocation system delivers meet that hurdle? We simply do not know. ... It is time for some serious discussion of what our financial system is actually delivering to our economy and what it costs to do that."
• A logical follow-up, though not directly related: Business Week calls for a return to scientific innovation as our primary driver of economic growth. Again, nothing revolutionary, but nice to hear. As an engineer, I naturally tend to agree with such a view. However, IBM is already going international with such efforts, in ways previously unseen.
• The Economist takes a critical look at Chinese stock markets, more or less saying that the market doesn't seem to reflect fundamentals. I have to say, our stock markets don't seem to either.
• Remember when important people said we shouldn't have banks that are too big to fail? Guess what: those banks have grown even bigger!
• Barney Frank and Ron Paul want to audit the Fed, and I'm all for it. It seems to be amazingly difficult to pull off, however. Did you know the Government Accountability Office has no power to do so? What the heck?
• A response to Paul Krugman's claim that $9 trillion of projected debt is not that big a deal. In turn, Krugman respectfully defends his position. At face value, I think $9 trillion sounds pretty scary. Both sides present good arguments as to why it is and is not.
• Solar panels getting more affordable. I think this is an interesting piece: plenty of people could benefit from adding solar energy to their homes when factoring in lowered prices and federal incentives.
• This just can't be good: a state government garage sale. It reeks of desperation, but it's a good idea.

More on Inflation vs. Deflation

Roubini has a great article in Forbes talking about how government policies today can be causes for deflation and inflation. In fact, he discusses what I mentioned in my post on the topic: a fear of short-term deflation and long-term inflation. I'm so proud of myself! .... assuming Roubini's right, that is.

I'm highlighting some relevant passages here, but I would strongly encourage you to read the entire writeup. Any emphasis is mine.


"The fiscal implications of the current policy package are particularly serious. For the time being, fiscal policy has been put at the service of survival, but the current price of survival is that net public debt is going to double as a share of GDP between 2008 and 2014. Even using the very optimistic forecasts of the Congressional Budget Office, which anticipate growth of around 4% over the next few years, the net debt burden will rise from 40% of GDP to 80%--that's an increase in the debt stock of about $9 trillion. The interest charge alone on that increased debt will be in the region of $300 billion to $400 billion a year, which in turn may mean more borrowing to pay the interest if primary deficits are not reduced. When governments reach the point where they are borrowing to pay the interest on their borrowing they are coming dangerously close to running a sovereign Ponzi scheme."
"Ponzi schemes have a way of ending unhappily. To get out of the Ponzi trap, governments will have to raise taxes, or cut spending, or monetize the debt--or most likely do some combination of all three."
"Over time, monetization is inflationary, but the inflationary effect is insidious because it is not immediately visible. In the short run deflation will outplay inflation. In most developed countries today there is so much slack in economies, with weak demand and high unemployment, that prices cannot rise. The velocity of money is also weak, as financial institutions are receiving liquidity from central banks and hoarding it to rebuild their balance sheets, instead of lending it out. But as the economy recovers, these effects will abate, and the growth of the monetary base caused by monetization will eventually drive expected and actual inflation. And once markets start to anticipate that scenario, it may already be too late to avert an inflationary surge."

It is important to note that Roubini does say the massive government support was necessary to avert disaster: "This massive escalation of central government spending and borrowing was necessary." He is primarily discussing how the result of that intervention makes for a "damned if you do, damned if you don't" scenario.

Wednesday Reading

• Transcript of Bernanke's speech at Jackson Hole. In case you didn't know, Obama's having him back for another term, with fairly widespread support. The topic's a little too politically sensitive for me to bring up my own feelings.
• One analyst saying we have plenty more bank failures coming.
• Sent by a reader: large-scale agriculture in cities. This could be pretty amazing if it's ever proved to be feasible (economically and practically).
• Mish still banging his looming-foreclosure-disaster drum.
• Despite all the 'green shoots', and announcements that we're coming around, the Philly Fed is showing we still look like we're pretty deep in a recession, and have a ways to go yet. (Speaking of green shoots, this article is linked for no better reason than quoting the great Inigo Montoya)
  
• Perma-bear Nouriel Roubini still making arguments for an ugly U-shaped recovery, and as mentioned here before, is getting more and more worried about W. FT.com requires registration (I've got a free 30-day window through my employer) so I can't say much more. Good read if you do have access.
• A fascinating debate is taking place at The Economist regarding how much population the world can support. Great read.
  
• A little off-topic, for all the engineers out there: Keep It Simple, Stupid!
• Krugman giving further details on his recent opinion that we're in a jobless recovery.
  

Inflation? Deflation? Both?

Of course, not at the same time. However, this question has been on my mind recently.

First, a quick Econ 101 review (I had to look this stuff up, I swear) courtesy Wikipedia:
Inflation: "In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. ... A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time."
Naturally then, Deflation: "In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below zero percent, resulting in an increase in the real value of money — a negative inflation rate. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when the inflation decreases, but still remains positive). Inflation reduces the real value of money over time, conversely, deflation increases the real value of money." (here's another good explanation article on deflation from Inflationdata.com)

One further important point: headline vs. core inflation. Core inflation uses a CPI that excludes food and energy prices. This has, in recent times, been controversially viewed as a more accurate measure of inflation. The argument for it is that food and energy prices are too volatile to be considered as part of CPI. It's important to note that the Fed tends to use core inflation as it's guide, though they've recently had to review that policy. The controversy stems from the fact that, one, consumers *do* need to pay for food and energy, and two, there are more volatile aspects to CPI than food anyway, according to research from the Philly Fed.
Yikes, eh? Makes things pretty complicated. And to make things even more fun, headline inflation is negative while core is slightly positive.

It's important to note that what needs to be avoided is hyper-inflation and deflation (this also is arguable, but let's go with conventional thinking for now). As far as I know, it's generally accepted that moderate inflation is considered the most healthy scenario for an economy. I draw heavily from the SF Fed for the following analysis:

• High inflation is dangerous and prevents economic growth: for example, price change in a product could no longer be easily define by supply and demand if inflation could just as easily be the cause. Also, high inflation tends to have higher fluctuation, which causes consumer and investment uncertainty.
• Zero inflation is dangerous because this usually implies lending rates close to 0, which leaves the Fed very little room for stimulus if necessary.
  
• Thus, you're left with moderate inflation as the safest path. Kinda roundabout, but hey - that's what I've gathered so far.

We also need to address why deflation is generally considered dangerous (again, from SF Fed):

• In deflation, prices are falling throughout the economy - and that actually sounds kinda nice at first glance, from a consumer's perspective. However, keep in mind that deflation increases the burden on borrowers (read: consumers) in the case of a fixed-rate loan, and prolonged deflation can reduce the value of collateral, again making borrowing (credit) more difficult to come by. Lastly, again, the Fed would probably be stuck at 0% interest rates and would be unable to properly stimulate the economy.

Ok. All that's out of the way. I think we have a very rudimentary understanding of what we want, and what we don't. So, what might be coming?

It's good to get a review of what can actually cause inflation and deflation.

What can cause inflation:

• Increasing supply of money
  
• Decreasing supply of goods
  
• Increasing demand for goods
• Decreasing demand for money

Deflation is the opposite:

• Decreasing supply of money
  
• Increasing supply of goods
  
• Decreasing demand for goods
• Increasing demand for money

The inflation-is-coming faction bases their claims on the Fed's liberal pumping of money into the economy (first bullet for inflation). Though CPI has been falling, many attribute this to dramatic falls in food and energy prices, as well as dramatic falls in rental and property prices - and despite all this, notice Core CPI never went negative!. When these factors begin to recover, inflation will jump with it.
The deflation-is-coming camp, however, notes that there has indeed been negative Headline CPI, and that there is no guarantee prices will recover. Even despite the recovery in energy prices, which will force headline CPI back up, rent and wages are still falling and will be much more serious components of the measure.

I'm leaning towards the deflation camp in the short term. Layoffs are on-going, and though they're slowing, they're still happening! This means lots of people with less purchasing power, which will force rents down and the price of goods down, based on decreasing demand. The Fed already has interest rates at 0 - if things go bad, they won't be able to easily stimulate things again, which is further danger of deflation. And yes, I believe we're not out of the woods and that we are likely in line for a U- or W-shape recovery.
In the long-term, however, the picture is more murky. The Fed has pumped a LOT of money into the system (take a look at their balance sheet! I link to that in the Econbrowser article below) and if/when recovery occurs, that increased supply could make for serious inflation.

Here are some good reads on the topic:

• Krugman (deflation-oriented)
  
• David Rosenberg (deflation-oriented)
  
• Seeking Alpha (inflation-oriented)
• Econbrowser (inflation-oriented, very very good read)
  

Lastly, I'm no expert on ANY of this stuff. I hardly know monetary policy. Please, if anyone has more insight, feel free to comment and criticize. I would love to understand this better.

A few follow-up points I think are important:
1. It's unclear that deflation is necessarily bad. Many tend to use the Great Depression or Japanese experience as examples of why deflation is bad; in fact, it can be argued deflation occurred during the Industrial Revolution (supply of goods increased dramatically) and this was a good thing. So, deflation could be good or bad depending on the situation. This is taken from the Inflationdata.com article linked earlier in this post.
2. There are many debatable measures of inflation. I tried to stay with mainstream analysis for this post.
3. This is all based on the conventional definition of money supply where money is currency. I didn't discuss money supply enough in this post, but it is very important in understanding inflation.

**UPDATE** The market and the Fed seem to disagree on where interest rates are headed, which implies differing views on coming inflation (the market seems to think it's more likely than economists do).

Sunday Links

• Paul Krugman defining post-1990 recoveries from recession.
• The past few decades have seen the "rise of the super-rich". Might that era be over for the forseeable future? Personally, I doubt it.
• Sent to me by readers: British government seems far less enthusiastic about the current recovery than American, and why the recent crisis was more economic than financial.
• U, V, or W? The Economist thinks U.
• A must read: is the efficient-market hypothesis dead?
• Lastly, I want to post on this in more detail later, but here's a heads up: inflation vs deflation. Which do we face, and on what timeline?

More Random Reading

• Warren Buffett at the NYT, discussing our rapidly-increasing national debt.
• A reminder that we still may need more bank regulation. Remember how in the immediate aftermath of Lehman/Bears, everyone was crying out for more regulation? Now some are claiming that the government simply dropped the ball, and that sufficient regulation already existed. I've linked to an article of that opinion before in this post.
• Perhaps free-market health care is the answer (in two parts: part 1, part 2). Part 2 is the more interesting segment. I think the author is not adequately dealing with underprivileged kids and the elderly; otherwise, he makes a pretty good case that a free-market system may be best assuming we as a society take care of 'pre-existing conditions'. Also, as pointed out by a reader with whom I discussed this article earlier, he does not deal with tort reform.
• More on healthcare: an article that talks about why Obama is struggling to convince people to work with him on reform. Note that the article is focused on why he's struggling; there does not seem to be much of an opinion either way on free-market vs universal care. More importantly, it contains 20 links (count it, 20!!) to different articles, ranging from conservative to liberal. I still haven't read through all 20, but it seems like a nice resource. *UPDATE* I was wrong, he does lean to universal care. I missed that in my first read-through.
  
• A representative saying Social Security could default within two years!
• PIMCO on the dollar, both valuation and as global reserve currency. Plenty of re-hash of popular, recent economic commentary, but a nice summary nevertheless.
  

I Love NPR

Yes, they're pretty openly slanted to the left. However, so am I! As such, I don't mind that public money is used to support their operation (I know that rightfully bothers quite a few people).
Two of their regular segments, Fresh Air and All Things Considered, are the only reasons I bother turning the radio on anymore. Yesterday, Fresh Air had an excellent piece on newspapers and democracy in an interview with Alex Jones, a Pulitzer Prize winner. I'm sure this argument has been made before, but I'll repeat here: as we know, newspapers have been under tremendous financial pressure over the last decade or so, as the advent of the internet has replaced newspapers as the primary source of information for many people. Many newspapers across the country have closed down - and newspapers are, according to Jones, by far the largest provider of investigative journalism. This NPR piece discusses Jones' contention that democracy functions best when there is an excellent core of true investigative journalism that covers everything from international to national to local news and issues. He's naturally biased to this viewpoint, but I think there's a strong case to be made for his side. Indeed, evening news is now dominated by personalities rather than reporters, and it's important to remember that these personalities often offer opinions rather than simply facts. I would encourage everyone who reads this to listen to the segment, which is linked above.
I bring this issue up in this blog because of the recent controversy over health care, an economic issue that affects us all. As you might know, costs of health care have been skyrocketing recently, and are projected to continue doing so, which is why reform has become such a huge and necessary issue. Here is one summary of the cost aspect that was emailed to me. The numbers in that article are frightening. What is just as interesting is the final paragraph:
It is a pity that this central issue seems to have been shoved aside by mendacious distortions from Sarah Palin, Betsy McCaughey, Rush Limbaugh and other extremist commentators seeking to frighten Americans with their prattle about "death panels" and "pulling plugs on granny" that no bill before Congress even remotely envisions.
This seems directly related to the Fresh Air piece above: talking heads who aren't necessarily reporting the facts are screwing up the democratic process: the recent outrageous town-hall protests are evidence that dialogue is not taking place; instead, angry and misinformed people are drowning out useful debate on the issue. And it may be that the slow death of newspapers, which naturally kills off investigative journalism, will only exacerbate this problem (along with others) over time. Unless someone steps forward to pay for investigative journalism, the beliefs of the general public may be more easily swayed by TV personalities than their own opinions based on the evening news.

If anyone has articles or their own opinion to share, on either topic, please do send them my way. Health care in particular is an issue that I have very little understanding of, and this is something I need to fix as it seems to now be one of the bigger economic issues in this country.

**UPDATE** I realize that I criticize talking heads for providing opinion-based journalism despite earlier saying I love NPR despite it's leftist slant. I want to make it clear that I do not listen to NPR for news, but rather for special programs like Fresh Air, with the express intent of hearing out opinionated discussions on, often-times, esoteric topics. News for me generally comes from CNN and the NYT (both of whom, usually, openly distinguish news reporting from their op-ed pieces).

Monday Reading

• Forget the coming commerical real estate crisis; we may not yet be done with the residential crisis. (more at Mish's)
  
• Nouriel Roubini, a well-known perma-bear, has long been claiming this would be a 24-month U-shaped recession (for the record, his 24-month period is coming to a close at the end of this year). He is starting to worry about a W-shape recovery now.
• Hussman discussing limited Potential GDP, in line with Roubini's fears of an anemic recovery.
• Apologies for such a bearish post, but I do not believe we're out of the woods yet, despite the positive sentiment evidenced by the enormous market rally over the last 3 months.
• Lastly, on the healthcare side: Obama giving up on the public option?
• *UPDATE* I felt guilty about putting up all those downer articles. Here are some encouraging articles. One, from Roubini himself, highlighting some potential bright spots! Also, New York state is reporting the best business conditions for manufacturers since mid-07.
  

Random Reading

• Op-Ed by Obama on healthcare
• Causal analysis and instrumental variables: "Cause and defect"
• Commerical real estate is a looming issue. Might it affect pensions?
• I do not ever wish this blog to be used for investment advice. In fact, I need to put up a disclaimer on that topic: anytime I post on the market, or post articles related to it, please don't assume it is meant as advice! And with that out of the way, we're seeing some insider selling.
• At least he can get a cab!
• Lastly, a passing thought: it occurred to me that much of the most recent crisis in residential real estate might have been averted if people had a stronger grounding in personal finance. I need to research and eventually post on this, but do we need to make personal finance part of high school education? So many young entry-level workers I know hardly know what a 401k or mutual fund is, let alone sub-prime or adjustible-rate mortgages.

Mark-to-Market Accounting

I was reading a list of 10 unresolved economic issues by David Merkel and #4 caught my eye (if anyone has anything to add on the other issues, please do so):"On a mark-to-market basis, market values for commercial real estate have fallen dramatically. Neither RIT stocks nor carrying values for loans on the books of banks reflect this yet. Many banks are insolvent at market-clearing prices for commercial real estate."

I've read a little bit about mark-to-market accounting and it seems an interesting topic. Wikipedia defines mark-to-market, or fair value, accounting as "the accounting standards of assigning a value to a position held in a financial instrument based on the current fair market price for the instrument or similar instruments." Since the early 1990's, this has been considered a standard accounting practice by GAAP. Interestingly, there are some who use this standard as a scapegoat for the real estate housing crisis, and they make a fair point: it is one thing to value actively traded securities at market value, but a loan made for a house may see its current value swing in the short-term though the long-term value may eventually justify the loan. Is it fair to allow short-term swings in the value of a simple loan to significantly affect the books of a bank?

As of July, accounting rules were a mess, according to The Economist: "The existing standards are a shambles, a patchwork of inherited rules riddled with escape clauses. They mix mark-to-market values with the more traditional practice of carrying assets at their cost and impairing them only when managers and auditors think fit. There are also several different ways of recognising losses. The result is that the balance-sheets of different banks are not always directly comparable." The article goes on to discuss am IASB-proposed change to the standards that makes a lot of sense to me, namely that simple loans be written at cost while more complicated securities that are actively traded, such as derivatives and other mortgage-backed securities, be marked at market value.

Now, FASB is thinking about tightening the standards. I disagree with this idea, and much prefer the July IASB proposal referenced in The Economist article linked above: "Loans and securities which share the characteristics of loans—in other words, assets that derive their value only from interest and repayment of principal—will be held at cost, provided banks can show they will hold them for the long term. Everything else, including equities, derivatives and more complicated securities, will be held at fair value." (emphasis mine)

I think that some of these banks are only insolvent *at this time* due to the pricing bust in real estate; if the economy turns around as we all hope, these assets may increase in value to the point where the loan originator is no longer under water. It is more than fair that banks be required to price some of the complicated instruments they developed at market value, as they are actively traded. However, to be forced to price loans that derive value from repayment of original principal and interest at current market value is unfair. In my mind, tightening these standards would unnecessarily exacerbate an already miserable situation. Note that it is imperative that banks, or some agency, attempt to report what all assets might currently fetch in the market. Also note that I do not have a strong opinion on whether mark-to-market accounting did indeed force the current crisis. I am only focused on how I believe the rules should be written. By following the IASB proposal, Merkel's point #4 may not be a huge problem.

One thing that is clear, however, is the need for accounting standards to be set independent of political pressure, which too often is a short-term response to whatever the current crisis may be. The Economist writes about this quite well: "standards-setters must rebuild their independence after the political assault they have faced in both America and Europe. The best way to do this is to continue to merge their standards, including those for financial firms, into one global rulebook. That should help restore confidence by preventing regulatory arbitrage between jurisdictions and diluting the voices of powerful national lobbies. Investors need not trust in God, but they must be able to trust accounts."

Should commercial banking be treated as a public utility?

Credit for this goes to my dad, who first brought this idea up to me. For the record, I don't think it will ever happen, but the idea is very much worth thinking about. I've captured the conclusion of an interesting article written by Numerian at The Agonist in this blog, but it's worth reading in its entirety:

"In fact, it sounds more and more like commercial banking, in a world where risks are priced and capitalized properly, is a world of modest profit and modest returns for shareholders. Doesn’t that sound like a utility to you? ..."

"... The Treasury and the Fed are propping up so many different markets that it is estimated some 30% of all finance comes from Washington now. Chase is one of the selected vehicles for channeling all this money, and it is allowed to take a generous transaction fee on every dollar. This is no longer banking, but rentier finance for a few institutions granted monopoly rights – again, the classic definition of a public utility."

What is called for is a highly regulated industry considered critical to common good that is in return guaranteed monopoly: essentially the concept of a public utility. It is worth, then, providing a related piece that is opposed to the idea that regulation is lacking. This piece is of the opinion that regulation was in place to deal with the instruments that led to the crisis; instead, what was lacking was enforcement of these regulations, which resulted in fraud.

Initial Stuff

In this first post I want to put up links to some of the more fascinating articles/issues I've tracked since the start of this recent recession and market crash.

1. Michael Lewis is a pretty famous guy at this point. He is the author of Liar's Poker, which was one of the defining chronicles of Wall Street excess in the 1980's. He's still of course well connected and wrote this piece: The End of Wall Street's Boom
2. Zerohedge is a website I follow regularly, though it's clearly a little more conspiracy-oriented than the mainstream. It does, however, bring to light some very interesting issues: it's efforts have highlighted the issue of high frequency trading and flash orders, for example. One aspect on the 'conspiracy' side that has been echoed by a few others is the number of Goldman Sachs alumni in influential government positions. At the very least, there's some moral hazard, no?
3. I need to make a separate post on the more fundamental issues that I think led to this recent crash: lack of adequate government regulation, greed by financiers and bankers, and greed by regular people. All three are to blame, in my mind, though Wall Street seems to take the brunt of the anger. Hopefully I'll get around to posting more on that at some point.

**UPDATE 08/16/09** It has been pointed out to me that I used moral hazard incorrectly, or at least unclearly, in the 2nd item in the list above. Please see the comments here. What I meant to say, based on those comments, is that GS alumni in influential government positions may have a conflict of interest, and also may be able to provide 'insurance' for risky bets made by the bank in the form of bailouts, thus creating moral hazard.

Intro

Background: as most of you who currently read this thing know, I'm absolutely not an economist. All I really have going for me are some undergraduate introductory courses and a hobby of investing and tracking markets.
That hobby is what I'd like to expand on with this blog. The recent financial meltdown has generated a great deal of interest in understanding economies and markets of all scales. This has become one of my pastimes recently: I spend a couple hours daily, if not more, trying to educate myself on what's going on in the world of money.
I'm hoping to use this blog to post the articles I find interesting, along with my thoughts on them. I would very much hope for comments and feedback; if any of you who actually bother to read this have suggestions on topics to research and write about, please do let me know: this would be of great help! You know how to contact me. I would prefer this *not* become too political a blog, but I do realize that politics and economics are pretty closely tied together, and one cannot easily be discussed without the other.
I tried posting a little bit on a blog owned by a friend I met in Chicago, but I would prefer to control my own now so as to give me more flexibility with content. I hope this effort turns out to be useful, both for myself and anyone interested.