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.

Moody's Might Be In Trouble

I've made mention of ratings agencies being one of the core reasons for the recent housing bubble. Although it's of course too late to help with immediate problems, it is important that we understand what they were doing, why it was bad, and how it can be controlled in the future.

Let me provide some background for the larger context of this post. A commenter and I recently had the following exchange in the comments following a post here:

Wanna said...

Philosophically speaking boom and bust are a way of life and that is the way it should be. Fed should not try to anticipate a boom and nip it in its bud. How would the Fed know in advance that a bubble is going to happen. These things are evident only in hindsight (which of course is 20/20 for TV and market pundits). Fed's job as Greenspan and Bernanke have said before should be that of a mopper rather than a boom-breaker.

Adit said...

Why is it that "boom and bust" is the way it should be? Would it not be better to target steady, sustainable growth rather than extreme run-ups followed by sharp letdowns over and over?

Wanna said...

By suggesting that "Would it not be better to target steady, sustainable growth" you are probably saying that Fed knows two things: 1. the number for steady, sustainable growth. Is it 3% per year, is it 5% per year, is it 8% per year? Which number should Fed use? Depending on which number you pick then the next question is 2. How do you know that is a correct number? China is growing at more than 8% per year. Should Chinese Fed have tried to rein in this party long time back because 8% is such a big number?

This is similar to Monday morning Quarterbacking. Most people's hindsight is perfect.

Mopping up post party is much better than reigning in the party prematurely.

I did not answer in the comment section, but I did put the following hasty thoughts together in an email sent to Wanna later:

I think you make a good point that setting targets is difficult, but at the same time, directly reigning in bubble-like growth isn't necessarily the idea. Instead, I go back to regulatory reform. One example: If there was proper oversight on ratings agencies so that they couldn't rate a big collection of junk as AAA quality when it should have been B or worse, much of the rampant real estate speculation and associated market tools could never have been exploited to the degree they were. This would have indirectly limited the extent of the bubble. Perhaps then, the comments shouldn't be aimed at the Fed, but at the government in general. Basically, I don't see how a bubble like the tech bubble could have been prevented: that was pure speculation that I can't think of reigning in, because it was due to an extremely bullish, forward-looking investment sentiment that was just the market being silly. This more recent bubble might have been less bubble-like if regulations were in place to limit financial "innovation" that really just took advantage of bad gov't. Keep in mind that it also allowed banks to reduce capital requirements which is a more dangerous state of affairs than what existed during the tech bubble. So, you're right: the Fed's job is to clean up after the mess and regulation reform is outside Fed purview. But smart regulation could perhaps mitigate *some* bubbles, which is better than letting them all through. I wonder if the S&L crisis was exploitation of similar gov't inadequacy. Let me predict that your counter will be that there will always be loopholes we will only see in retrospect, and the gov't will thus perpetually be inherently inadequate. I hope this is not true, and I wonder if it comes back again to the lack of financial literacy in the public. If this literacy rate was higher, perhaps financial "innovation" would be more transparent and idiocy would be caught more quickly.

p.s. Wanna's response was indeed that gov't will always be inadequate. I can't dispute that. Not all bubbles can be prevented, not all idiocy can be controlled. However, the government has a responsibility to control what it can. One thing it can control is transparency of ratings given by ratings agencies: it can be argued that these ratings fueled much of the equity market bubble by enabling all the exotic "financial innovations" Wall St. put together during that time. Also, buried in the guest post made yesterday, is a paper from the Dallas Fed arguing against Wanna: it is imperative that we not simply sit back and clean up after the party.

As such, there are two solutions that I see: one, as mentioned in other posts in this blog, is financial literacy. This is a topic that probably goes beyond the scope of this blog, as that seems more like educational policy than anything else. The other is regulatory reform, which I've been hammering at for a while. Congress investigating Moody's is a step in the right direction on that front, though Congress should look at regulation of all various financial institutions and do their best to ensure transparency on all issues. Going after ratings agencies should be one step in a larger, broader process.

Throughout the financial crisis, major credit-ratings firms were criticized for their overly rosy ratings of complex debt securities, which deteriorated soon after and led to billions of dollars of investor losses.

Despite months of regulatory scrutiny and some internal changes at the firms, a recently departed Moody's Corp. analyst says inflated ratings are still being issued. He has taken his concerns to congressional investigators.

The analyst, Eric Kolchinsky, said Moody's Investors Service gave a high rating to a complicated debt security in January 2009 knowing that it was planning to downgrade assets that backed the securities. Within months, the securities were put on review for a downgrade.

"Moody's issued an opinion which was known to be wrong," Mr. Kolchinsky wrote in a July letter to the rating firm's chief compliance officer, a copy of which was reviewed by The Wall Street Journal. In the letter, Mr. Kolchinsky cited other instances in which he believes inflated ratings were given to securities.

Nice Update on SEC (Rakoff) vs. BoA

Last June, when Bank of America CEO Ken Lewis was asked by a U.S. House committee why the bank hadn't disclosed seemingly important information about its upcoming Merrill Lynch acquisition in a proxy statement last November, he had a ready response:

"I'm not a securities lawyer," he said. "I don't decide on disclosures."

...

But now, thanks to U.S. District Judge Jed Rakoff of Manhattan, the stonewall is crumbling.

...

SEC: We can't prove the individual executives did anything wrong because they tell us they simply delegated to their lawyers the task of handling the disclosure obligations.

Rakoff: Then go after the lawyers.

SEC: We don't know what the lawyers said, since the executives invoked their attorney-client privileges.

Rakoff: If the officers are saying they relied on counsel, they're automatically waiving the privilege. Plus, there's a crime-fraud exception to the privilege, so you could have asked me to order them to answer.

SEC: Not really. We haven't charged anybody with fraud. We just charged a lesser infraction -- filing a false proxy statement -- which does not require proof of a fraudulent state-of-mind, so the officers never had to formally invoke a reliance-on-counsel defense. Accordingly, neither the bank nor Merrill ever waived their attorney-client privileges either.

Rakoff: Why didn't you charge anyone with fraud?

SEC: We couldn't prove fraudulent intent.

Rakoff: Why not?

SEC: They said they relied on advice of counsel.

See why Rakoff got steamed?

This article is a great read on the status of the SEC vs. Bank of America case, mostly for that last segment on 'why Rakoff got steamed'. Hopefully, something will come of this. Transparency at the big banks, and on Wall St. in general, is badly needed. This also plays into a post on corporate governance I still need to do.

Guest Post on Regulatory Reform and Beyond

I'm excited. Guest post! Always wanted to do this.
FYI - any of you readers, if you want to put some thoughts up here, email me. You all know how to contact me.

This post is from Pramod Khargonekar.



Martin Wolf is a highly respected and influential economist who writes a regular column for Financial Times (www.ft.com). A wonderful article, Call of the Wolf, describing on Martin Wolf can be found at http://www.tnr.com/article/economy/call-the-wolf?page=0,0.

In his article in FT on September 15, 2009 (http://www.ft.com/cms/s/0/b24477de-a226-11de-9caa-00144feabdc0.html), he wrote an excellent piece on what lessons we can take away from the fall of Lehman brothers a year ago.

“If the price of oil stabilises, I believe we can weather the financial crisis at limited cost in terms of real activity.” Thus did Olivier Blanchard, newly appointed head of the International Monetary Fund’s research department, describe the prospects ahead on September 2 2008. He was swiftly proved wrong

Few economists then realised how fragile the global financial system had become. The failure of Lehman Brothers just under two weeks later and the ensuing crisis at AIG, the insurance giant, turned complacency into terror. The financial system plunged into an abyss, dragging the economy behind it.

This is only partially true. People like Roubini, Schiff, and many others did warn of the troubles quite accurately. But the larger point that the collapse stunned most of the people is quite true.

What lessons are we to learn from this shock, a year later?

Above all, the true insurers of the financial system can be seen in our mirrors. According to the IMF’s Global Financial Stability Report of April 2009, total support for the financial system from the governments and central banks of the US, the eurozone and the UK has amounted to $8,955bn (£5,436bn, €6,132bn) – $1,950bn in liquidity support, $2,525n in asset purchases and $4,480bn in guarantees.

These numbers should be etched on a large stone on Wall and Broad Street. To put these numbers in perspective, US annual GDP is around $14,000bn. So, we have spent close to 60% of US annual GDP to support the companies in the financial sector.

These sums are misleadingly precise. The painful truth is that the incomes of taxpayers were put at the disposal of the financial sector’s creditors. When finance ministers and central bank governors of the Group of Seven leading developed countries met in Washington last October, they decided to “take decisive action and use all available tools to support systemically important financial institutions and prevent their failure”. Desperate times; desperate measures.

Since large financial institutions are most likely to fail during a crisis, this amounted to an open-ended government guarantee. What makes the decision quite unbearable is that it was, in my view, also correct. The risk of a cascading failure of the good, the bad and the ugly among financial institutions was apparent. Given what had happened after Lehman’s failure, only fools would have run this experiment. We were not that foolish.

This is the key argument --- the bailout was necessary. There is the other side of the argument which says we should let companies fail. It is impossible to know which would have been the better choice: bailout as was done or let them fail. At this point, it is an academic issue. Indeed, what has been done to deal with this crisis will be used to draw lessons when it comes to future crises which are bound to happen. In this sense, Ben Bernanke, Hank Paulson, Tim Geither, Larry Summers are writing the book which will be studied by future economists and policy makers.

Thus, the lesson learnt from Lehman’s failure was the precise opposite of what many had hoped on the day it was announced: it is that every systemically significant institution must be rescued in a crisis. That lesson is reinforced by Wednesday’s agreement that the rescue, buttressed by unprecedented monetary and fiscal stimulus, has worked: the panic is over and the world economy is on the mend.

We still have so many systemically important institutions. So, there has been no change in the “too big to fail” situation.

Indeed, one can argue that the Lehman failure was necessary. Without such an event, there was no chance of obtaining the resources needed to resolve the crisis, above all from the US Congress. This is what the Harvard historian Niall Ferguson argued in the FT on Tuesday. It is likely that he is right.

Everything, in short, has been for the best in the best of all possible worlds. In retrospect, it was right to let Lehman go, because it caused such a disaster. That then forced a public sector resolution of the crisis and taught that such a failure must never be allowed again. If these are indeed the sorts of lessons we draw, we are making huge mistakes.

We are now getting to the punch lines of the Wolf article:

First, we cannot let stand the doctrine that systemically significant institutions are too big or interconnected to be allowed to fail in a crisis. No normal profit-seeking business can operate without a credible threat of bankruptcy.

Thus, President Barack Obama is correct to call for the “most ambitious overhaul of the financial system since the Great Depression”. The communiqué of the Group of 20 finance ministers and central bank governors outlines the current agenda for reform. It is quite sensible, so far as it goes.

The question, however, remains whether enough will be done to eliminate the present incentives to game the system. It must be possible to wind up institutions without the damage we witnessed after Lehman’s collapse. This has come to be called a “living will”. A better term would be “assisted euthanasia”. Should that be impossible, these institutions must be under the sort of regulation that we normally apply to utilities.

I have previously talked about the “public utility” model for the financial sector. (ed. note: I summarized some of his thoughts on this idea in this post.) It is great to see that Wolf also advocates the same notion. The only other way is to have a well designed system that eliminates the very notion of too big to fail.

The second big potential mistake is to return to the old doctrine that it is better to clean up after a crisis than to take any pre-emptive action. Yet, the more effective the present clean-up seems, the more likely is it that central bankers will draw that lesson. They can argue that, if we have been able to survive such a huge crisis, no changes in the policy orthodoxy are needed.

This would be a huge error, as William White, formerly chief economist of the Bank for International Settlements, argues in a thought-provoking paper.* Mr White, one of the few economists in the official sector to warn of a looming crisis, argues that the “macroprudential” approach, now increasingly accepted, cannot rely on regulation alone. It is almost impossible for such regulation to offset the powerful incentives for credit creation produced by expansionary monetary policies. Thus, argues Mr White, “pre-emptive tightening” should replace “pre-emptive easing”. If we look back at the past two decades of ever more desperate efforts to clean up after crises, the wisdom of this “belt and braces” approach will seem evident.

I think it is an interesting intellectual problem. Can one design a system to detect bubbles? Can one create numerical measures of “bubbliness”? It sounds like an engineering or machine learning problem. It may be hard, possibly impossible, since the system may change over time making the measures designed on the basis of past data inadequate or useless. (ed. note: a commentor on this blog has argued against the idea of preemptive bubble killing in the comments in this post.)

The third big mistake is more immediate: it is to assume that we are already well on the way to a healthy recovery. The financial panic is indeed over, as it should be, given the scale of government guarantees. The economic dangers are not.

The recovery has been fuelled by the bail-out of the financial system and by extraordinary fiscal and monetary policies, particularly in the countries with the highest private-sector leverage. For good reason, the private sectors of such countries are likely to save more and pay down debt for years to come. This, in turn, now necessitates a big swing in the balance between supply and demand in export-dependent economies.

Mr Blanchard has set out the post-crisis macroeconomic agenda in a recent article.** As he puts it, we must manage delicate “rebalancing acts” – first, “rebalancing from public to private spending”; second, “rebalancing aggregate demand across countries”. Unless and until both are managed, the recovery is built on quicksand.

Only the future will tell whether the recovery is sustainable or built on quicksand. It is amazing how the stock market anticipated the current recovery. As it happens, real economy responds to perceptions of people (which in turn are influenced by the stock market and jobs and the real economic conditions. (Soros calls this reflexivity. It is also related to the idea of animal spirits, currently championed by Akerloff and Shiller.)

Letting Lehman go was not our biggest mistake. That was letting the economy and financial system become so vulnerable. Equally, the past year has restored neither the financial system nor the economy to health. We have avoided the worst. That is good. It is not enough.

There it is. A multi trillion dollar question is: will we really make any substantial changes in response to this major collapse which has led to near 10% unemployment rate!

More On Fed-Induced Boom-and-Bust Cycles

The Baseline Scenario adds to the chorus of economists discussing two issues: one, how the Fed has perpetuated the boom-and-bust cycle over the last few decades; two, that serious regulatory reform is needed.
Again, I don't think anything will come of this. However, it's still worth reading and understanding how things work, because if the system remains as is, we're virtually guaranteed to have another great bubble and another great crash. The reason it's worth understanding is because one can at least profit from all this mess by playing the market correctly. Understanding macro cycles is helpful in that regard.

A couple nice paragraphs from the article:

In successive financial boom-busts over the past 30 years, the Fed undertook smaller versions of what Ben Bernanke did over the past 12 months. In the Latin American debt crisis of 1982, the savings-and-loan crisis of the late 1980s, the Asian financial crisis and the collapse of Long-Term Capital Management in 1998 and during the bursting of the dot-com bubble in 2001, you saw the same pattern: First, of course, the financial system grew rapidly, bank profits were large and a bubble emerged. At a certain point, we reached the market peak and stared down the mountain. Bankers frantically called the Fed, and it dutifully stepped in to prevent an economic collapse — by lowering interest rates and providing credit to “maintain liquidity.”
...
In today’s nascent global recovery, we are already seeing bubble-like rises in the prices of real estate and assets, from Hong Kong and Singapore to Brazil. And many more emerging markets will likewise soon boom. The details of who makes which crazy loans to whom will no doubt be different from what they were from 2002 to 2007, but the basic structure of incentives in the system is unchanged. The same people are running the American banks, and the same regulators are regulating them, so you can easily get the same outcome here as we have just seen.

Weekend Reading

As usual, bold highlighting in quotes is my own emphasis.

• Firstly, a great article on Regulatory Arbitrage (which is something all the big banks pulled off during the recent bubble). It was written back in May 09, but it's a great primer for those who want to understand what exactly all those banks were doing with CDO's and why they were created: so that banks did not have to hold much capital. Here's a quick quote to give you a taste: "How does regulatory capital arbitrage work? ... the most straightforward to describe and to implement is securitization. Recall our bank earlier that had $100 in mortgages, for which it had to hold $4 in capital. Let’s say it creates a simple collateralized debt obligation out of these mortgages. It sells them to a special-purpose vehicle (SPV) that issues bonds to investors; these bonds are backed by the cash flows from the monthly mortgage payments. The bonds are divided into a set of tranches ordered by seniority (priority), so the incoming cash flows first pay off the most senior tranche, then the next most senior tranche, and so on. If these are high-quality mortgages, all the credit risk (at least according to the rating agencies) can be concentrated in the bottom few tranches (because it’s unlikely that more than a few percent of borrowers will default), so you end up with a few risky bonds and a lot of “very safe” ones. The magic is that by getting sufficiently high credit ratings for the senior tranches, the bank can lower the risk weights on those assets, thereby lowering the amount of capital it has to hold for those tranches. The risky tranches will require more capital, but it is possible to do the math so that the lower capital requirements on the senior tranches more than outweigh the higher requirements on the junior tranches. So you end up with lower total capital requirements – in some cases, 50% lower – simply through securitization." Thankfully, those ratings agencies are starting to come under fire, an interesting story in and of itself. Look at this ridiculous exchange between two S&P Execs (S&P is one of the big ratings agencies). That old defense of free speech is looking a little less plausible...
  
• Janet Yellen, President of the San Francisco Fed, presents her outlook on the economy: "I am hugely relieved that our financial system appears to have survived this near-death experience. And, as painful as this recession has been, I believe that we succeeded in avoiding the second Great Depression that seemed to be a real possibility. Much of the recent economic data suggest that the economy has bottomed out and that the worst risks are behind us. The economy seems to be brushing itself off and beginning its climb out of the deep hole it’s been in. That’s the good news. But I regret to say that I expect the recovery to be tepid. What’s more, the gradual expansion gathering steam will remain vulnerable to shocks. The financial system has improved but is not yet back to normal. It still holds hazards that could derail a fragile recovery. Even if the economy grows as I expect, things won’t feel very good for some time to come. In particular, the unemployment rate will remain elevated for a few more years, meaning hardship for millions of workers. Moreover, the slack in the economy, demonstrated by high unemployment and low utilization of industrial capacity, threatens to push inflation lower at a time when it is already below the level that, in the view of most members of the Federal Open Market Committee (FOMC) best promotes the Fed’s dual mandate for full employment and price stability. As a result, monetary policy makers will continue to face a difficult task in the years ahead."
  
• Calculated Risk presenting a couple bullish views on the economy. The author of the post disagrees with those views. (edit: My wording in the previous sentence is ambiguous. "The author" refers to Calculated Risk: the link goes to a CR post that presents two articles with bullish views, and then refutes them. I did not mean to imply I had a personal opinion either way. Sorry for any confusion.) Good points on both sides. Personally, I'm just wondering if the stock market is going to keep going up...
• Remember the earlier point (4th bullet in my previous post) about how GDP might be overused in measuring the state of a nation? The Economist follows up!
• More from The Economist, on an interesting new investment playground: patents.
• Stephen Roach updates his views on the BRIC's. "'It's a myth that the baton of economic leadership is being seamlessly passed to the BRICs, in particular China. My premise is there is still a lot of work to be done,' says Roach." For those who don't know: Stephen Roach is a highly respected analyst and economist for Morgan Stanley, who is now their top executive in Asia. The BRIC's ... well, that's a must read, perhaps the most influential and widely accepted modern paper predicting the changing world landscape. Goldman Sachs' Global Economic Paper No. 99: Dreaming With BRIC's.
• Peter Schiff revisits the demise of Lehman.
• Will Flash Trading be banned? Wow, this would be remarkable. I'd prefer to see more efforts at fundamental regulatory reform, but realistically, this is more than I was expecting.
  
• Dubuque, Iowa: America's first truly "Smart City"?
  

Regulatory Reform Is Wishful Thinking

Sorry for not posting all of last week - I was extremely busy. I'll attempt to make up for it here with some worthwhile reading, though I still have some posts with content I want to do. Hopefully, I'll get to them sometime soon.
As usual, in quotes below, any emphasis in bold is mine.

• An excellent read on the history of the Fed and why it perpetuates our boom-and-bust cycle: "We have seen this spectacle--the Fed saving us from one crisis only to instigate another--many times before. ... The fault, to be sure, doesn’t lie entirely with the Fed. Bernanke is a prisoner of a financial system with serious built-in flaws. The decisions he made during the recent crisis weren’t necessarily the wrong decisions; indeed, they were, in many respects, the decisions he had to make. But these decisions, however necessary in the moment, are almost guaranteed to hurt our economy in the long run--which, in turn, means that more necessary but harmful measures will be needed in the future. It is a debilitating, vicious cycle."
  
• Serious doubts we'll see any useful reform: "Let's be clear: The Street today is up to the same tricks it was playing before its near-death experience. Derivatives, derivatives of derivatives, fancy-dance trading schemes, high-risk bets. "Our model really never changed, we’ve said very consistently that our business model remained the same,” says Goldman Sach's chief financial officer...The only difference now is that the Street's biggest banks know for sure they'll be bailed out by the federal government if their bets turn sour -- which means even bigger bets and bigger bucks."
• More doubts. This article has a real gem in the conclusion: "One solution ...: break up big banks. Citigroup is splitting itself up after years of empire building that created a company many considered to unwieldy to manage effectively. But that won't really fix things. Lehman was far from the biggest Wall Street bank, in fact it was the smallest of the big four still standing after the collapse of another relatively small firm, Bear Stearns, in March. Interconnectedness was the problem. And in our increasingly sophisticated and complex global financial system, it still is. How to eliminate that risk? This may be tough to swallow, but the truth is that you can't."
  
• An argument against making GDP too important in measuring societal well-being. This is a point I've debated before (not on this blog as of yet). I think there's been a problem over the past few decades in that we've come to view economic growth as the end instead of the means. Keep in mind that GDP growth is really supposed to be a way of improving quality of life; in other words, a means to an end. However, recently, we've been so wrapped up in maximizing growth and GDP and profit margins and whatnot, that *that* has become the end. The article suggests that had we paid more attention to indicators like median income, we would have had a better measure of societal well-being and things might not have looked so (artificially) rosy during the bubbles.
• As mentioned before, banks too big to fail are even bigger.
• BoA may not get off so easy after all!
• Krugman defending himself from criticism of his article. As mentioned before, I strongly encourage everyone to read his piece.
• Funny stuff.

The Onion Is (sometimes) Awesome

Gotta love it: Nation's Unemployment Outlook Improves Drastically After Fifth Beer

I'm going to be fairly busy over the next few days, but I do have a couple posts planed and hope to get to them. In the meanwhile, hope everyone's enjoying the long weekend.

Other Friday Reading

Please do see Krugman's piece in the previous post: by far the most interesting reading I've come across recently. However, there's other stuff worth reading, as always:

• Many people have been using the Great Depression of the 1930's as a comparison to today's crisis. My dad pointed me to the Pragmatic Capitalist, who links to a more interesting comparison: 1873. There is very interesting point in that article beyond just a comparison of crises: namely that the rise of great nations generally came about during a time of turbulence and ultra-protectionist measures. China, anyone? "Moreover, it was during the 1870s that the USA entered global markets for the first time as a major exporter of agricultural and manufactured goods. The USA had by then become the low-cost producer of a wide range of products and in the 1870s began to flood Europe with cheap commodities (agricultural goods, minerals, timber) as well as manufactures. The economic effect on Europe was devastating. The existing international flows of production and consumption were rendered instantly obsolete, unemployment soared and there was widespread and lasting hardship."
• The worst of the slump is yet to come?
• Joseph Stiglitz, Nobel-Prize winner, doesn't think we're out of the woods either.
• Florida's rising taxes are badly straining the middle class, and as a result, it is seeing the first net population loss in many years, according to this Time article.
• Another topic I want to make a more detailed post on: broadband in America. How does broadband affect the economy, and how will current and future policy impact this effect?
  
• The Real Regulatory Revolving Door: "The most important aspect of this is that the “revolving door” problem is most acute, not with the actual regulated firms, but with the professional firms that provide services to regulated entities, especially law firms..."

A must-read

Krugman put up a must-read piece at the New York Times. I think it is slanted to the Keynesian school of thought, but it is also an excellent history of modern macroeconomics and how we got to where we are. There are a few paragraphs I want to quote and discuss, but please do read the article in full. It is particularly good for those who want a quick grounding in economic history.

Any emphasis in the quotes below is mine.

1. The birth of modern economics and the Efficient Market Hypothesis
"The birth of economics as a discipline is usually credited to Adam Smith, who published “The Wealth of Nations” in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market. Yes, economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” — costs that people impose on others without paying the price, like traffic congestion or pollution. But the basic presumption of “neoclassical” economics ... was that we should have faith in the market system."
This is foundational. Note that it relies on rational individual decision-making.
"There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.”"
Krugman details much more, but essentially, makes clear that the belief in Efficient Markets had taken hold to such a degree amongst mainstream thinkers and policy-makers, that any thought to the contrary was dismissed out of hand.
"By October of last year, however, Greenspan was admitting that he was in a state of “shocked disbelief,” because “the whole intellectual edifice” had “collapsed.” Since this collapse of the intellectual edifice was also a collapse of real-world markets, the result was a severe recession — the worst, by many measures, since the Great Depression."
I linked an Economist article on this a few days ago. I think what one can see here is the beginnings of a fundamental questioning of Milton Friedman's faith in rational markets. This is a very, very serious question, as a reversion back to Keynes would be greatly at odds with what we've been used to for nearly 20 years now (it's arguable that Bernanke's stimulus is Keynesian, but I do still think that the core belief system of key modern policy-makers leans towards deregulated markets). Also, this is why I have the blog The Mess That Greenspan Made in my list of favorite blogs. =)

2. The Stock Market
It is generally accepted that the goal of a public corporation is to maximize value for its shareholders. This is a principle that I, at least, have never questioned. I am beginning to, however:
"By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a “casino.”"
I find this very interesting. How did corporate leaders view the stock market prior to 1980? Was it simply a means to raise cash - in other words, allowing the stock to fund your activity and judge your value rather than forcing your activity so as to increase the stock price? The former seems far more rational to me.
My dad, Pramod Khargonekar, with whom I discussed parts of this article, brings up further points and questions on this topic:
There are some really fundamental questions: Consider a public company such as IBM.
Who owns the company? Legal answer: Stockholders (there are many classes of shares which makes this a little more nuanced. There are also debt holders who have a higher priority in terms of ownership which makes this answer even more complicated. Finally, taking into account externalities, society where the company operates have a legal and societal stake in the company. This is not always acknowledged.)
What is the role of mgt? Flip answer: maximize the value of the company. But what does this mean? Stock price in the next day, week, month, year, ...? Not all stockholders have the same view on this. BoD is supposed to represent the interests of the owners but they are often beholden to the management. Often CEO is also the Chairman of the BoD. The entire area of corporate governance is supposed to deal with this but has been quite dismal in this regard.
Where does the larger society fit into this? Flip answer -- no role. But then when the company creates toxic dumps, we the society pay for it and thus it becomes a subsidy from the nonowners to the owners. Unless the cost of externalities is fully reflected in the taxes paid, this is often in favor of the management of the company.
It is critical to realize that the corporate/government structure is constructed by us: it is not ordained by nature. It operates in the physical world and has humans as players. Behavioral finance, economics is probably the best direction for understanding how these things work and what to do about them for the long term good of the society.

3. Keynesian Economics
Back to quoting more Krugman:
"I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.
This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time. Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.
Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . .
In short, the co-op fell into a recession."

4. No one could have predicted this!
"Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”
... there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”
Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified.
...In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place."

I leave the rest of the article to you. It makes for great reading.
The key points this article brings up:

• Lack of faith in the Efficient Market Hypothesis (I've brought this up before, and am wondering if we're beginning to see a more serious questioning).
• Too much belief in mathematical models that make for an ideal world rather than modeling the real world.
• A need to incorporate Behavioral Economics more strongly as the field moves forward.

I want to make a post later in further detail on the principle of maximizing shareholder value, how that's currently defined, and how it should be defined. I will quote my dad's note in that again, but expand on some points it makes brief note of (corporate governance and behavioral economics).

Wednesday Reading

Never mind that bit about this being a slow news week. Plenty of good reading.

• Too early for talk of bailout returns.
• A discussion on how Ben Bernanke is using inflationary monetary policy to combat the recession. This is a good read, and again seems in line with some of my recent posts: long-term, we're headed for inflation, and it will hurt. However, it would be nice to get someone else to judge this piece - it's a bit above my head. Also, more in line with my recent posts: short-term deflation already starting to take place? More in that vein.
  
• $9 trillion? Not even close! Try $14t.
• Nice read on the recent history of large-cap companies. They're back, apparently, though they were never truly gone. Yeah, okay, that sounds dumb, but it's still a good read: "Two further developments are shifting the balance of advantage in favour of size. One is a heightened awareness of the risks of subcontracting... A second is the emergence of companies that have discovered how to be entrepreneurial as well as big." It's the second point, particularly among large-cap tech, that I think is most relevant.
  
• Further proof (furthering the Hussman commentary linked yesterday) that this recession is simply not in line with previous post-war recessions.
  

Tuesday Reading

Been a slow news week so far, and I've been too busy for a lengthy post. However, here are a few good reads:

• Amazing Vanity Fair profile on Henry Paulson, built up over 15 months of regular interviews. I haven't finished the whole thing, but it looks quite intriguing. Some telling quotes about our lawmakers: "“There’s a great lack of financial literacy and understanding in this nation, even among college-educated people.” ... As his tenure wore on, Paulson confessed, “I amuse myself a lot by sitting there (Capitol Hill) sometimes and thinking what would happen if I said, ‘Do you realize what an idiotic question that is?’" This goes back to something I've mentioned before: there's a serious, serious lack of financial education in this country, despite the fact that financial literacy is required in so many aspects of our lives.
  
• Speaking of Paulson, his brainchild, TARP, is showing some early returns.
• Deflation in Spain.
• FDIC is in trouble.
• One more: Hussman showed an interesting chart in his weekly market commentary (sent to me by a reader. Reader, you know who you are - I'll keep you anonymous unless you wish to be known =) ). All I want to focus on is that the recent crash, and the steps the government has taken, are unprecedented in the post-war era: