Moving the Policy Discussion Forward

Some interesting articles on the state and direction of economic policy:

David Frum challenges fellow conservatives to come up with compelling policy alternatives to Paul Krugman’s recommendations:

 …if Krugman’s direct government expenditure is not a very good policy answer, his dire economic warning remains a haunting policy question. What can we do to accelerate economic growth and job creation? For those of us on the free-market side of the debate, the question is even more haunting: What’s our countervailing idea? And if our countervailing idea is tax cuts, what is our reply to the obvious rebuttal that the Bush tax cuts have been in effect through the whole of this crisis, seemingly without effect?

Marshall Auerback outlines a bevy of progressive policies in response:

…Professor James K. Galbraith sets out some useful criteria for good stimulus:

1. Open-ended support for the current operations of state and local governments…

2. Comprehensive foreclosure relief…

3. Increased Social Security benefits…and a cut in the eligibility age of Medicare…

4. A payroll tax holiday to restore effectively the purchasing power of working families. By setting the payroll tax rate at zero (and letting the government write a check to the Social Security Trust Fund for the uncollected sums), tax relief can be delivered at large scale and with immediate effect…

…And finally deploy government spending in a way which REDUCES unemployment, rather than arises as a consequence of it. We therefore suggest a new approach: a Job Guarantee Program. The U.S. Government can proceed directly to zero unemployment by hiring all of the labor that cannot find private sector employment. Furthermore, by fixing the wage paid under this ELR program at a level that does not disrupt existing labor markets, i.e., a wage level close to the existing minimum wage, substantive price stability can be expected…As we have argued before, the Job Guarantee program should remain a permanent feature of our economy, in effect acting as a buffer stock to put a floor under unemployment, whilst maintaining price stability whereby government offers a fixed wage which does not “outbid” the private sector, but simply creates a stabilizing floor and thereby prevents deflation. [Many on the right might reflexively think of such a program as socialism run amok, but as we've pointed out more than once, an employer-of-last-resort program has been proposed on the right by Nobel economist Ned Phelps. The idea is definitely worth a closer bipartisan look.]

There are good ideas out there, but there is a distinct failure of political imagination and courage to implement them. With any hope Frum’s provocative article will spur a healthy discussion on the possible solutions, rather than a retreat to tired, discredited economic shibboleths.

But Brad DeLong gives little hope that Auerback’s retreat can be avoided:

…Congress is balking. Republican legislators from states with double-digit unemployment have put party above country. Blue Dog Democrats, who think that they can marginally improve their chance of gaining more terms in office if they publicly worry about the deficit to the exclusion of all else, have put self above country and party. And, significantly, the Obama Administration has never offered a grand bargain for tax increases and entitlement caps in the future in return for more spending now to restore full employment.

We’ll toss a few cents into the discussion in an attempt to show that we can and should overcome irrational deficit phobia (yes, there are sometimes rational reasons to fear government deficits), we’re likely to make little progress towards ensuring a strong and durable economic recovery, and ironically, we’re likely to end up in a worse public debt position. 

On Frum’s question, Randy Wray has pointed out (pdf) that an accelerating pace of federal government tax receipts followed the Bush tax cuts and recovery, and may have contributed to the intersectoral strains that eventually resulted in financial collapse (emphasis added):

Every recession since World War II was preceded by a government surplus or a declining deficit-to-GDP ratio, including the recession following the Clinton surpluses. Recovery from that recession resulted from renewed domestic private sector deficits, although growth was also fueled by government budget deficits that grew to 4 percent of GDP. However…the Bush recovery caused tax revenues to grow so fast that the budget deficit fell through 2007, setting up the conditions for yet another economic collapse…

In 2005, tax revenues were growing at an accelerated rate of 15 percent per year—far above the GDP growth rate (hence, reducing nongovernment sector income) and above the government spending growth rate (5 percent)…this fiscal tightening was followed by a downturn—which automatically slowed growth of tax revenue.

Thus, conservatives might not be painted into as severe a policy corner as Frum fears. But that’s true only if they can let go of their (newfound, circa 2006?) deficit phobia and escape the intellectual tyranny of Ricardian equivalence. We think that’s easily done, but there are two basic concepts that need to be framed out before the policy conversation can make any significant progress.

First, we need to frame our modern financial economy as Knut Wicksell did over 100 years ago. There are two ‘interest rates’ at work, one on the credit (financial) side, and one on the real (economy) side. The financial rate (in reality, there are many of them) is determined in large part by the cost of a marginal unit of money. The economic rate (in reality there are many of these too) is determined by the expected return on a marginal unit of investment.

When the financial rate is below the economic rate, the result is inflation (greater expected returns on investment lead to increased demand for credit, and money eventually becomes less valuable relative to real goods and services). When it’s above the economic rate, the result is deflation (negative expected net returns on investment lead to decreased demand for credit and increased demand for saving; money thus becomes more valuable relative to real goods and services).

Wicksell’s original thesis has been tweaked to acknowledge that inflation and deflation are unlikely to persist indefinitely. We also need to incorporate the idea of leverage. Low systemic leverage (the amount of credit relative to money) implies a higher cost of credit and lower inflationary pressures. When there’s a high degree of leverage, inflationary swings can be exaggerated, and can turn sharply and suddenly into deflation (Minsky’s “Ponzi finance” or Austrian’s “crack up boom”, of which 2008-2009 was a prime example).

Second, we need to get a better grasp of money — what it is, where it comes from, and how it works. 

Under any type of gold standard, gold is essentially money, and over the long run, gold’s real value is a function of its supply relative to all other goods, services, and assets (gold’s flexibility, durability, and steady long term accumulation rate give it its monetary properties). As long as money is defined as a fixed weight of gold, the value of money will closely track the value of gold. Thus, under a gold standard, the financial rate of interest is determined in large part by developments in the gold industry relative to the rest of the economy (as an aside, Ricardian equivalence might have some merit in that type of system).

However, in a fiat currency system like the U.S. has had (officially) since 1973, money is just money, which the government sector creates at minimal cost (currently the money creation process is controlled by the Federal Reserve through its interactions with member banks and primary dealers). Thus, the financial rate on fiat money is more easily attuned to the economic rate, thereby helping to mitigate the cycles of inflation and deflation that occurred regularly under classical gold (that was Wicksell’s stated intent when he first outlined his monetary theory). Granted, it’s taken policymakers and markets several decades to learn how to run such a system effectively, and there’s still plenty of room for improvement, but that’s to be expected with any large scale innovation.

A key takeaway is that the federal government creates the money used in private sector transactions, satisfaction of tax and other liabilities to the public sector, and demand for goods and services by the public sector. Thus, saving or spending desires of the private sector can only be accomodated by the federal government (leaving aside export income), while under a gold standard, they could only be accomodated (with some qualifications) by the available supply of gold. In other words, despite the widespread belief that they are subject to the same constraints, the federal government’s budget is nothing like households’ or businesses’ budgets, and in fact, in some key respects it is the inverse (just as under a gold standard, the gold industry would need to “dis-save” gold in order to satisfy the desire for saving in other sectors of the economy).

Today, if households, businesses, and state and local governments want to run a surplus, then the federal government must by definition (again ignoring exports) run a deficit. That’s not an ideological statement, it’s a simple operational fact, which is why (we think) it opens up a lot of common ground for policy.

So what role do federal government deficits play in our economy?

Depending on how they come about, they can raise the expected rate of economic return (by increasing aggregate demand), lower the financial rate (by increasing the supply of money), or both (by financing its demand for real goods and services with new money).

Conversely, a budget surplus (or a smaller deficit) can lower expected economic returns, and can also impact the financial rate (under our Wicksellian framework, if money becomes more scarce, then the prevailing nominal interest rate becomes tighter, all else equal).

In certain environments (e.g., Japan 1990’s thru 2000’s, U.S. 2000’s thru 2020), expanded deficits make sense, while in others (e.g., Japan 1970’s thru 1980’s, U.S. 1980’s thru 1990’s), smaller deficits or even surpluses might make sense – albeit with this caveat from Wray:

…the United States has also experienced six periods of depression that began in 1819, 1837, 1857, 1873, 1893, and 1929. Comparing these dates with the periods of budget surpluses, one finds that every significant reduction of the outstanding debt, with the exception of the Clinton surpluses, has been followed by a depression, and that every depression has been preceded by significant debt reduction. The Clinton surpluses were followed by the Bush recession that was ended by a speculative, private debt–fueled euphoria, and was followed in turn by our current economic collapse. The jury is still out on whether we might yet suffer another Great Depression. While we cannot rule out coincidences, seven periods of surplus followed by six and a half depressions (with some possibility for making it a perfect seven) should raise eyebrows…our less serious downturns in the postwar period have almost always been preceded by reductions of federal budget deficits. [Note that all six depressions occurred under a gold standard of some kind, so the direction of causation is open to question.]

Where are we today? U.S. demographic composition (pdf) implies a relatively pessimistic outlook for productivity, saving, and investment, possibly until the end of this decade. Large swaths of the private sector — notably households, but also some state and local governments – are in desperate need of repairing their balance sheets. Many corporations are flush with cash but apparently reluctant to invest it in human or physical capital. In other words, the demand for saving in the private sector remains high, and probably will for some time. 

What’s the proper response?

For households, some combination of fiscal support (e.g., extended payroll tax holiday, financed by money creation if need be) and financial relief (e.g., cleaning up the mortgage mess in as fair and transparent a way as possible, possibly with greater commitment from the federal government, as opposed to the private sector incentives and public-private partnerships experimented with to date) should help.

For state and local governments, direct budget assistance, again financed with new dollars if necessary (which is essentially how it’s now done, except that primary dealer and other banks get to hold Treasury paper for “financing” the federal deficit and earn the spread over the fed funds rate).

For the corporate sector, expanded public sector demand (e.g., maintenance and productivity enhancing infrastructure improvements, R&D into promising areas like energy and health care, etc) and perhaps most importantly, tax and regulatory assurances that will decrease the level of political uncertainty that businesses now face.

All of these would mean higher deficits in the short run, but if we’re right about the underlying state of the economy for the next decade, they will mean lower future debt and deficits than would otherwise occur (unless liquidationists and entitlement cutters were to win in drastic fashion, but in that improbable case the net costs would be much greater than any savings implied by a smaller federal debt).

It’s also important to point out to the Tea Party types that, as Jamie Galbraith and many other economists have noted, only a small percentage of the rise in federal deficit and debt to GDP ratios was driven by increased discretionary outlays by the Democrats. Almost all of the rise is simply a function of counter cyclical measures like unemployment insurance in the numerator and lower GDP in the denominator.

However it turns out, the federal government is not “broke” and never can be. The only true constraint on federal deficits is inflation, and there simply aren’t any signs of elevated inflation risk  today — although USD exchange rate depreciation is a meaningful risk, depending upon the relative movements of fiscal, trade, and monetary policies in different countries and regions. As Wray observes (emphasis added):

…there is no financial constraint on the ability of a sovereign nation to deficit spend. This doesn’t mean that there are no real resource constraints on government spending, but these constraints, not financial constraints, should be the real concern. If government spending pushes the economy beyond full capacity, then there is inflation. Inflation can also result before full employment if there are bottlenecks or if firms have monopoly pricing power. Government spending can also increase current account deficits, especially if the marginal propensity to import is high. This could affect exchange rates, which could generate pass-through inflation. [Viewed in this light, the Obama administration's export initiative might be a wise idea.]

The alternative would be to use fiscal austerity and try to keep the economy sufficiently depressed in order to eliminate the pressure on prices or exchange rates. While we believe that this would be a mistake—the economic losses due to operating below full employment are almost certainly much higher than the losses due to inflation or currency depreciation—it is an entirely separate matter from financial constraints or insolvency, which are problems sovereign governments do not face.

We openly admit that:

• While some of the measures we’ve outlined could be easily implemented, others are much easier said than done.
• All of them are subject to severe agency and other risks. But that’s true for most things in life, not just politics!
• Many of the distortions and perverse incentives that got us here still need to be corrected.
• Many voters may fear — perhaps justifiably, judging by some of the rhetoric on the left — that deficits do indeed imply higher future taxes and should thus be avoided.

We also admit that under certain conditions, fiscal austerity (via higher taxes and/or lower spending) may indeed be supportive of growth. But we do not think those conditions are in play today in most developed nations.

The bottom line is that no meaningful, bipartisan measures capable of supporting of economic growth at a reasonably healthy level can be crafted until we’ve moved beyond irrational deficit hysteria. And that requires a broader and deeper understanding of how modern money and financial economies work.

URLs:

http://theweek.com/bullpen/column/204603/the-krugman-question

http://www.newdeal20.org/2010/07/02/free-market-showdown-david-frum-poses-the-question-heres-the-answer-14105/

http://theweek.com/bullpen/column/204665/keynes-amp-co-have-lost-the-stimulus-argument

http://www.levyinstitute.org/pubs/ppb_111.pdf

http://en.wikipedia.org/wiki/Ricardian_equivalence

http://symmetrycapital.net/index.php/blog/2006/12/committees-vs-markets/

http://symmetrycapital.net/index.php/blog/2010/07/galbraith-blasts-the-deficit-commission/

“Money we don’t have”

Good NYT article on deficit hysteria, with an especially illustrative quote from Rep. Cooper (D, TN):

“We have to stop spending money we don’t have,” said Representative Jim Cooper, a Tennessee Democrat who voted against the bill. “I hope deficit reduction fever is catching.”

The U.S. is in the midst of a balance sheet recession, with demographic ratios shifting an an unfavorable economic direction for several more years.  Under those conditions, deficit reduction fever will lead directly to the dreaded Japanese Disease —  another decade of stagnation, underemployment, and opportunity costs, all of which will impose greater burdens on future generations than expanded federal deficits would.

And policymakers — not to mention most members of the electorate, including analysts and the media — continue to commit two fundamental errors regarding fiscal policy:

1. They believe that all deficit spending must be financed with interest bearing debt, thus competing with the private sector for scarce financial resources.  However, judging by current Treasury rates, there’s still plenty of room for expanded federal borrowing.  And there’s a symbiosis between federal deficits and repair of balance sheets in the financial sector, as evidenced by the perfect quarters turned in by several major investment banks recently.  Politically, that relationship is almost nauseating, as it’s doing very little to relieve distressed households — but it nevertheless makes apparent the  dynamic between public sector fiscal deficits and private sector balance sheet relief.
2. They also believe implicitly that the U.S. is on a gold or similar standard, where fiscal and monetary policies are constrained by the supply of some exogenous factor, and governments can thus literally “run out of money.”  Governments can’t run out of money, as it is ’created’ by nothing more than digital ledger entries.  In other words, government (today, via operations of the quasi-private Fed) is the sole creator and supplier of high powered money.  Thus, the only constraint on money creation is inflation and a loss of confidence in the currency, and at the moment, those forces are emphatically not in play.  This too is symptomatic of Japanese Disease.

The fears of incumbent politicians like Cooper are certainly understandable.  But they’re borne of either ignorance about how these things work, or self-preservation.  Either way, it smacks of lousy political leadership. 

And given that Republicans are likely to benefit in November, we’d expect the trend towards fiscal conservatism to intensify.  Even President Obama, in a speech yesterday, promised the following:

• A three year freeze on all non-discretionary federal spending beginning in 2011
• Expiration of tax cuts via sunset provisions
• Elimination of 120 federal programs
• Reinstatement of PAYGO
• Higher fees on banks that are expected to lower federal deficits by $90B over ten years

He promised all of this as a way to force the public sector to budget in the same way that families and businesses do.  Again, this is wrong, and is borne of either ignorance or pandering.  And as with Congress, it smacks of crummy political leadership either way. 

The administration’s jawboning is also reminiscent of budget austerity measures touted by the Carter administration in the 1970s in reaction to the “tax revolt” — austerity measures that contributed to its eventual demise, even though they may have been more appropriate to the conditions prevailing at the time (e.g., baby boomers entering adulthood, global trade and financial integration, etc).   Today, austerity is far less appropriate, but even more vigorously pursued.  That almost certainly spells trouble for Obama in 2012 – assuming the GOP can field a worthy candidate and avoid blowing all of its political capital in the intervening years. 

You also have to wonder, were he to experience a change of heart, whether there’s any credible way for him to backtrack from his neo-liberal rhetoric.  The DLC, Brookings, Peterson, and all the other usual suspects have painted the guy into one hell of a corner.

In the meantime, assuming that reality will align with rhetoric, the political climate continues to be favorable to the USD and Treasuries, and rather risky to gold.  A contrarian call? You bet.  But it’s based on what we think is a well-grounded and – just as importantly – non-ideological assessment of the facts. 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC (“SCM”) is a state registered investment adviser in the Commonwealth of Pennsylvania. The views expressed by the author are as of the publication date, and are subject to change based on market and other conditions. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy or a solicitation to sell any security, or to engage in any investment strategy. Investors should not use this information as a basis for any investment decisions without first consulting their own financial adviser. SCM is an Amazon.com associate, and earns a commission on sales generated through links from our website. Some clients of the firm are long GLL and/or long TLT.  At the time of writing, neither the firm nor its principals owned any securities mentioned. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

URLs:

http://www.nytimes.com/2010/05/29/us/politics/29deficit.html

http://www.japanreview.net/review_bsr.htm

http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1125&group_id=1&pageNo=2

http://www.investmentnews.com/article/20100602/FREE/100609973

http://seekingalpha.com/article/208174-how-deficit-hawks-will-keep-cutting-spending-until-we-re-all-on-food-stamps

A brief “Now what?!?”

Equity markets and indices are down over 2% today on worries about what most pundits refer to as the “Greek bailout,” which took its (supposedly) final shape over the weekend, with details to follow from the IMF and other parties. The terms, as currently laid out, are brutal, a fact reflected by the intense street protests in Greece and the government’s loss of union support. The theories and practices underlying them are highly questionable and pitifully anachronistic as well, which make it all the more frustrating.   

There’s no doubt that Greece has made some mistakes, that the lack of accurate fiscal disclosures by its previous government was extremely unethical, and that labor market reforms may be in order. But there are humane ways to approach and work through the entire imbroglio. Unfortunately, neither the IMF nor major eurozone countries seem to be giving that much thought. And as Marshall Auerback has pointed out, Germany’s longstanding inflation paranoia has it behaving as if it’s 1921 all over again; when to us, reality appears to be much closer to the deflationary late 1920s and 1930s.   

We referred to the Greek plan as pitifully anachronistic because it embodies what we might call gold standard era thinking, when the supply of new money was a function of mining output and demand for gold ownership in the private sector. At the turn of the 20th century, economist Knut Wicksell pointed out the need for a “rational monetary system“, while highlighting intellectual obstacles to it:   

It is no exaggeration to say that even to-day many of the most distinguished economists lack any real, logically worked out theory of money, a circumstance which has not, of course, been particularly conducive to the success of modern discussions in this field.   

Wicksell’s sentiments are still relevant today, and (in our view) have been powerfully echoed and expanded upon by proponents of neo-chartalism, also known as Modern Monetary Theory. Bill Mitchell, an occasionally acerbic but ever prolific member of the MMT club, recently posted the following diagram on his website:   

The essential point of the diagram is to illuminate that, under a fiat currency system, the government (whether through its treasury or via a quasi-public central bank) is the sole provider of money. And one of the resulting takeaways of this fact is that under certain conditions, fiscal austerity in the public sector will impose significant costs on the private sector. In turn, that will tend to raise the value of money, all else equal, which is the essence of deflation. And as Wicksell pointed out over a hundred years ago, deflation, like inflation, comes at a cost (emphasis added):   

…when a rise or fall occurs in the money prices of all, or of most, commodities…[a]djustment can no longer proceed through changes in demand or through a movement of factors of production from one branch of production to another. Its progress is much slower, being accomplished under continual difficulties, and it is never complete; so that a residue, either temporary or permanent, of social maladjustment is always left over.   

By linking the inflation boogeyman to public sector debt levels, prevailing economic theory sometimes leads to poor policy prescriptions and outcomes, as we are now seeing in Greece. It also fails utterly to explain the experience of Japan over the last two decades, and it looks set to fail in both the Eurozone and the U.S. in the coming decade.  So far, our contrarian calls for a strengthening USD and a dovish view of long term U.S. Treasury yields has lent support to this thesis.   

As with our recent “What Happened?!?” piece, we also think it’s important to tie the Greek “rescue” package to the current U.S. policy outlook. Today, speaking to the Business Council, President Obama once again invoked our “unsustainable fiscal deficit” and argued for immediate reimplementation of PAYGO. Looked at in terms of Mitchell’s diagram above, that implies that at best, the federal government is unlikely to add to the supply of vertical money.  It’s also important to realize that a concept like PAYGO essentially restricts the vertical money supply function to the central bank. And yet, according to recent testimony from Fed Chairman Bernanke, the Fed is targeting roughly a 50% contraction in its balance sheet, which also implies a contraction in narrow or vertical money supply (though rising velocity could give the Fed some room to work with).  Similarly, it was over tightening in both the fiscal and monetary spheres that led to the 1937 recession after several years of economic recovery.

The upshot of all this is that leaders in the public sectors of both the U.S. and the Eurozone are clearly signalling their intentions to “crowd out” private sector saving and, potentially, income. And unfortunately, electoratal majorities in key countries seem to support this direction. Normally, we expect electoral outcomes to approach optimal, but in this particular case, we suspect that the historic lack of economic and financial education might steer us wrong. Then again, voters with incomes might be making some rational inferences about deficits, austerity, and taxes. If so, the burden of adjustment could rest even more heavily on the on the un- and under- employed (believe it or not, that’s something that a handful of policy pundits have advocated, and that at least one senator briefly pursued).   

Either way, deflation will be the inescapable result of excessive restriction or contraction in vertical money.  We’re currently getting slight whiffs of it from credit markets and price indices (although the latter are still positive); cooling measures in China are also likely to help it along. As noted in our “What Happened?!?” piece, we don’t expect it to manifest in an economic downturn until 2012 or 2013, but it could show up in market prices before that. We’ll be watching commodity markets closely, as a broad decline in those prices would provide an especially powerful confirming signal.  Stay tuned…   

URLs:   

http://www.newdeal20.org/2010/03/30/greece-and-the-eurozone-angie-aint-it-time-to-say-goodbye-9235/   

http://www.newdeal20.org/2010/04/12/the-piigs-problem-maginot-line-economics-9697/   

http://en.wikipedia.org/wiki/Inflation_in_the_Weimar_Republic   

http://en.wikipedia.org/wiki/File:GDP_depression.svg   

http://mises.org/books/interestprices.pdf   

http://bilbo.economicoutlook.net/blog/?p=7864  

http://www.econlib.org/library/Essays/wcksInt1.html   

http://symmetrycapital.net/index.php/blog/2010/04/a-brief-what-happened/ 

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

Good column by Ron Rhoades

 Good column by Ron Rhoades on RIABiz.com, in which he predicts what types of financial reforms might come out of Congress in the current session. He echoes some concerns we’ve raised (emphasis added):

There are many parts of the overall financial services reform legislation that are incremental improvements over what we have today, and which should be supported. I hope the upcoming amendments will address “too big to fail” and reduce the perverse compensation incentives which tend to drive improper risk-taking activities.

I am deeply troubled, however, by the lack of oversight of all credit default swaps and other forms of derivatives. There are likely to remain many gaps in regulation which can continue to be exploited.

Additionally, much of the bill appears to fragment, rather than to consolidate, banking regulation. Regulation needs to be robust – to paraphrase James Madison, if securities industry participants were all angels, regulation would not be needed. But regulation also needs to be efficient. Our country cannot afford inefficient regulation of the same functional areas through duplicative, often over-lapping agencies.

This point, on disclosure as panacea, was particularly interesting, and lends some support to our call (and others’) for bringing basic financial education (legal might be a good idea too) into primary education:

The fundamental problem is that the SEC continues to emphasize disclosure above all else. While I support better disclosures of compensation practices and conflicts of interest, we must be realistic in what disclosure can accomplish. Disclosures are usually ineffective, as research into behavioral biases has demonstrated.

Today the financial world is far more complex for consumers than it was in 1940. Hence, disclosures utterly fail to overcome the huge “knowledge gap” between financial advisors and their clients.

The full column is available here: http://www.riabiz.com/a/748005?subscribed=true

Crisis, regulation, vigilance & cynicism

A cynical take on Sen. Dodd’s financial regulatory reform bill by Matt Koppenheffer for Motley Fool:

We can probably point to plenty of regulatory failures in the lead-up to the financial crisis. But I hardly think that they’re regulatory failures stemming from lack of regulators. As Valukas noted in his report, regulators were swarming on Lehman well before its collapse…

It seems to me that the issue never was whether there were people trying to address the problem, but rather that they were trying to regulate on a fuzzy mandate of not letting something bad happen within the bounds of a very permissive system. For the same reason that we have speed limit signs posted in our residential neighborhoods, we need to give regulators a clearer, tougher set of standards that they can impose on financial companies.

First and foremost, those standards need to address the lunatic business model that Lehman Brothers — and, really, most of the big financial companies — was operating on at the time of its demise.

Specifically, Lehman was increasingly building up large, illiquid, proprietary investments while primarily financing itself through very short-term agreements. What it became was a massive, teetering Jenga game right smack in the middle of our financial system that could be toppled in the blink of an eye if it lost the confidence of major counterparties…

That last paragraph echoes a beautiful turn of phrase by Bill Bernstein in the most recent Financial Analysts Journal, in which he refers to ”leveraging so unstable that it could not survive the slightest of economic breezes, let alone a 100-year storm.”

Koppenheffer continues:

…the bill includes the Volcker Rule the way Cocoa Puffs include well-balanced nutrition. Little actually gets implemented in the text of the bill. Rather, specific regulations are supposed to come from a study on the rule’s potential impact. Not only is this likely to maximize the squishiness of the eventual rules, but it also gives lobbyists plenty of time to work their magic.

In the end, I don’t see the Fed folks as a bunch of incompetent bumblers. But when it comes to smothering the next Lehman, Fannie Mae…or AIG…I do think they’ll fail miserably because they’re being given a butter knife to regulate with when what they need is a buzzsaw.

A tangential riff: If we aren’t going to impose a hard, fast cap on leverage and other risky behaviors, then perhaps the power of network effects and private sector vigilance (vigilantism?) can help fill the gaps in our financial regulatory structure. For example, it seems reasonable to expect (OK, hope) that the next Harry Markopolos will be taken more seriously.

But when the issue is not fraud by a single market participant, but rather systemic levels of leverage and risk, then it seems unlikely that any kind of enforcement powers could be brought to bear if regulatory bodies haven’t purposefully enlisted private sector assistance beforehand. 

I suppose we’re a bit cynical too.  

URLs:

http://www.fool.com/investing/general/2010/03/24/why-the-fed-will-fail.aspx

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1553816

http://en.wikipedia.org/wiki/Internet_vigilantism

http://en.wikipedia.org/wiki/Harry_Markopolos

Smart Money: Credit Card Companies

Smart Money magazine has a great long running feature, “Ten Things.” Their latest is “Ten Things Your Credit Card Company Won’t Tell You,” a rather timely dissection given passage of the CARD Act.

URLs:

http://www.smartmoney.com/spending/rip-offs/10-things-your-credit-card-company-wont-tell-you-18808/?cid=1230

How do you spell W-I-M-P-Y?

First Congressional jobs bill of 2010 has cleared the Senate:

Senate Democrats Wednesday delivered the first of several promised election-year jobs bills, passing a measure blending tax breaks for companies that hire unemployed workers with highway funding eagerly sought by the states.

The bipartisan 70-28 vote to pass the bill sends it to the House, where many Democrats say it is too puny…

We tend to agree with the House Dems. Among the bill’s measures:

Democrats promise additional measures to create jobs, promising help for small businesses having trouble getting loans, aid for cash-strapped state governments, and subsidies for people who make their homes more energy efficient…

The bill contains two major provisions. First, it would exempt businesses hiring the unemployed from the 6.2 percent Social Security payroll tax through December and give them an additional $1,000 credit if new workers stay on the job a full year. The Social Security trust funds would be reimbursed for the lost revenue.

Second, it would extend highway and mass transit programs through the end of the year and pump $20 billion into them in time for the spring construction season. The money would make up for lower-than-expected gasoline tax revenues…

And the reason it is so wimpy:

But budget deficits are a worry, and future measures are going to be more difficult to pass — especially since a top Senate Democrat has blocked unused authority from the Wall Street bailout program from being used to “pay for” jobs initiatives…

Sen. Judd Gregg of New Hampshire, top Republican on the Senate Budget Committee, blasted the measure for increasing the budget deficit to fund highway and transit programs. He said the measure made a joke of Democratic promises to adhere to “pay-as-you-go” budget rules requiring new spending programs to not increase the deficit.

“I don’t think you get people back to work in this nation by loading more and more debt onto the next generation,” Gregg said.

Sen. Gregg seems like a good man, but he just doesn’t get the underlying economics (unless he believes that the private sector is in robust shape and capable of standing on its own, which means he’s looking at different data than we are). And as we continue to point out, if he and other budget hawks are wrong about the underlying economics, then they are actually going to leave “the next generation” in even worse shape than they would be with more concerted stimulus.

Mark Zandi is cited as estimating that the Senate bill will create roughly 250,000 jobs. That number is unlikely to even make a perceptible dent in structural unemployment. By our back of the envelope calculations, the Senate bill will add about half a percentage point to GDP under the most optimistic assumptions.

We’ll close by calling again on correspondent J. Wellington Wimpy:

“You will gladly pay me today for a job that might be created tomorrow.”

URLs:

http://news.yahoo.com/s/ap/20100224/ap_on_bi_ge/us_congress_jobs

http://symmetrycapital.net/index.php/blog/2010/02/the-hawks-are-circulating/

Miller & Chevalier Tax Policy Forecast

Miller & Chevalier’s 2010 tax policy forecast survey is out (TOH WebCPA), and it starts with this rather gloomy preface:

Although Congress and the Administration continue to focus their attention on health care reform and the continuing economic downturn, the business community can expect that there will be a significant focus on tax policy issues in 2010, including the potential for the consideration and enactment of proposals that increase the corporate tax burden.

According to survey respondents:

An increase in the U.S. taxation of international operations (74 percent), increased taxes on capital gains, dividends and interest (67 percent) and codification of the economic substance doctrine (61 percent) are named as the leading tax revenue sources to be tapped to fund Congressional initiatives in 2010.

We sure hope they’re wrong. As we’ve noted elsewhere, if the federal government makes a concerted effort to finance its spending from current and short term revenues, then economic outcomes are sure to disappoint. In the wake of a financial crisis, money is in relatively short supply (high demand), and the last thing the public sector should be doing is competing for savings.

URLs:

http://www.webcpa.com/news/Execs-Concerned-about-US-International-Tax-Policy-53296-1.html

http://tinyurl.com/miller-chevalier-2010

The hawks are circ(u)l(at)ing

Two interesting and somewhat discouraging trial balloons have been floated by the Senate recently:

Schumer-Hatch payroll tax break

First, in a NYT op-ed, Sens. Schumer and Hatch propose a payroll tax credit for employers who hire someone who’s been out of work for 60 days or more. This is intended to be a much simpler approach than the disastrous jobs tax credit of the 1970s:

…any private-sector employer that hires a worker who had been unemployed for at least 60 days will not have to pay its 6.2 percent Social Security payroll tax on that employee for the duration of 2010. The Social Security trust fund will then be made whole with spending cuts elsewhere in the budget between now and 2015. That’s it. Simple to understand, and easy to explain.

Simplicity is a reasonable objective, but as described, the proposal is NOT going to stimulate a return to full employment, because it’s fiscally hawkish, i.e., it aims for budget neutrality. Thus, the net economic effect is likely to be somewhere around nil, give or take.

It also gives no payroll tax break to the newly hired employees! That is NOT likely to play well to a frustrated electorate. Warren Mosler’s version of a payroll tax holiday would be fairer and much bolder. As he framed it at a recent Tea Party get together:

I believe that the surest engine for full economic recovery is a full payroll tax holiday. Payroll taxes take away over 15% of everyone’s paycheck, from the very first dollar earned. This is big money- about $1 trillion per year. Half comes from the employee and half from the employer. A payroll tax holiday does not give anyone anything. What it does is stop taking away $1 trillion a year from working people struggling to make their payments and stay in their homes, and businesses struggling to survive. A full payroll tax holiday means a husband and wife earning $50,000 a year each will see their combined take home pay go up by over $650 a month, so they can make their mortgage payments and their car payments and maybe even do a little shopping.

In their op-ed, the Senators also claimed:

Our two-pronged approach would be a far more efficient use of taxpayer dollars than other proposals under discussion, all of which could cost many times more with very little guaranteed improvement in unemployment. [emphasis added]

Taking care to use taxpayer dollars efficiently is a wonderful thing when resources are fully employed and there are sufficient dollars in circulation. But in the prevailing environment, it’s far too hawkish. As some have noted, the key factor that will incentivize hiring is for businesses to see signs of improving demand; tax breaks like this one are unlikely to have more than a marginal effect. And as long as Congress is stingy about deficits and about where taxpayer dollars come from, it could merely reallocate existing resources, rather than raise overall employment.

The entire idea brings to mind the old Hefty Bag jingo: WIMPY WIMPY WIMPY!!!

Senate jobs bill

Second, Senate Democrats have been circulating a comprehensive jobs bill that includes the Schumer-Hatch proposal. Positive features include extension of unemployment benefits and subsidies. More questionable are the extensions of various expired tax provisions through the end of 2010. Like financing federal expenditures with existing “taxpayer dollars”, sunset provisions will tend to offset any stimulative effects of ’stimulus’.

From the proposed measures in the bill, it looks like members of Congress, especially Senators, believe that their reelection prospects hinge on budget and debt hawkishness. That might well be true, given that our educational system has done a lousy job teaching economics for generations. If that’s their angle, then they’re as bad as their policy ideas: WIMPY WIMPY WIMPY!!!

It’s estimated that the bill would create 80,000 to 180,000 new jobs in the coming year. We would need 180,000 or so per month to meaningfully reduce unemployment. Taking secondary effects into account, the typical employment multiplier falls in a range of roughly 2 to 4. That means that the overall impact on employment would range from 160,000 to 1.44 million new jobs in 2010. This would make less than an 18% dent in the number of jobs lost in this recession! [We've assumed that multiplier effects are not accounted for in that number; if they are, the package is even more pathetic.]

Admittedly, we’re leaving out private sector employment and the related multipliers, and 1.44 million new jobs would still be a good thing. But the glaring problem is that policymakers seem to believe that the real economy is in the kind of shape it’s been in since the mid-1980s, and that it will do just fine with the federal government contributing a net 20% or so to economic activity. We strongly disagree, and would point out that policymakers in Japan made the same error over their two lost decades. Policymakers need to dramatically raise expectations in the private economy, whether it’s through spending, tax cuts, or a combination of both. Wimpy proposals are not going to get it done.  

If the Senate bill is as good as we get, then our strong dollar call remains in place, and incumbents could face some rough sledding in November. The Obama administration is reportedly trying to work some better features into the bill, but most of them have an undeniable fiscal wimpiness to them, and thus won’t do much to alleviate the stubborn shortage of dollars, income, and employment in the real economy.

As J. Wellington Wimpy might say, “You will gladly pay me today for a job created tomorrow.”

Update 2/14/2010 – Perhaps this description of neo-Keynesian economics explains the cruelty of Hatch-Schumer:  “Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures.”  Good grief. The honorable gentlemen should note that this is just economic theory, which is far from settled (and that economists are probably not a good source of reelection advice). 

URLs:

http://www.nytimes.com/2010/01/26/opinion/26hatch.html?scp=2&sq=orrin%20hatch&st=cse

http://moslereconomics.com/2010/02/04/dallas-address/

http://www.webcpa.com/news/Senate-Democrats-Jobs-Bill-Includes-Tax-Breaks-53257-1.html

http://news.yahoo.com/s/ap/20100210/ap_on_bi_ge/us_what_jobs_11

http://www.newyorkfed.org/research/staff_reports/sr402.pdf

Shovel-ready news bits

It’s another shovel ready snow day in the mid-Atlantic, with our second two footer in five days. Too bad we can’t ship the stuff to Vancouver efficiently. A couple of interesting things on the wires today:

The Fed’s exit strategy

Ben Bernanke outlined the Fed’s game plan for tightening monetary policy when the time is right. In our judgement he said the right things for the most part. The relatively new policy tool that is getting the most attention is the payment of interest on excess reserves that member banks have on deposit with the Fed (“IOER”).

Our initial take on IOER when it was legislated in 2008 was that it offered a way around the zero bound on the Fed’s interest rate target, but that was wrong. We overlooked that (1) the interest is not necessarily paid with new USDs, but could be paid out of cash flows earned on the voluminous assets that have been taken onto the Fed’s books and (2) the incentive effect of the interest payments is to “tie up” banks’ reserves outside of credit creation channels.

Fortunately, the Fed’s current interest rate is not competitive with spreads on public and private sector credit; instead, it appears to compete solely on the basis of risk, as banks don’t have to worry about mismatching assets and liabilities (borrowing short term and lending long term). But overall, it’s hard to see how those two effects of IOER support economic activity in the present. Apparently we’re not the only ones trying to get our heads around this.

ABC News poll

Headline numbers from a recent ABC News poll look bad for President Obama and Democrats, but there are some interesting things under the hood. First the headlines:

• Trust in Democrats’ ability to handle critical policy issues such as the economy and terrorism gave decline steadily since last year, with the overall gap versus Republicans falling from roughly 25% to 5%. 
• Obama’s approval ratings are below 50% on creating jobs, the economy, health care, and the deficit (his approval on terrorism is a very healthy 56%).

Some of the nuances that should be very relevant for political strategists include:

• While the margin has dropped considerably from 13%, 49% of independents lean towards Dems, 45% towards the GOP (p.5).
• While respondents viewed the loss of the Dems’ Senate super majority positively, 58% view the GOP as obstructionist, and 68% say that obstructionism should only be used infrequently (p.4).
• 48% describe themselves as “anti-incumbent”, below the 54% and 53% that preceded the “throw the bums out” elections of 1994 and 2006.

Health care reform is especially interesting; while most respondents view the present outcomes negatively:

• 80% support banning limits on pre-existing conditions.
• 56% support a personal health insurance mandate, including public assistance.
• 65% say the current approach is overly complicated, and 59% say it’s too expensive.
• 74% of those with private insurance trust their carrier to handle claims fairly, and more of these folks oppose the current reform packages.

One takeaway is that there’s plenty of room for strategic and tactical maneuvering by both parties in the quarters ahead.

Another, based on that last bullet point on health care, is that there appears to be a powerful asymmetry at work, one that I’m much more sympathetic to nowadays: people who have satisfactory health coverage are going to have a harder time empathizing with the challenges faced by those who don’t. That seems pretty rational, if not a little cut throat – if it ain’t broke for me, why should I have to pony up for your troubles?

My wife, who has worked in architecture for almost twenty years, was out of work for most of 2009. If not for the COBRA subsidy, we would have been in a much deeper financial hole, to the tune of about $600+ per month. When the subsidy was set to expire in December, we applied for coverage with the carrier we had through her prior employer, but were denied coverage for preexisting conditions, namely minor wear and tear to one of my knees and heightened anxiety in a person who had just lost her job and income. Huh??? 

And if you’ve ever tried to purchase a policy as an individual, you know how frustrating it is to try making comparisons between apples, oranges, cumquats, dragon fruit, and a bunch of others (let alone issues like financial strength and ratings). You also have to be a very savvy insurance consumer to detect the coverage gaps at work in different kinds of policies.

The family’s now fully insured thanks to good news on the employment front, but this is an issue that we have a whole new perspective on — one that’s firmly supportive of well designed health care reform.  

URLs:

http://news.yahoo.com/s/ap/20100210/ap_on_bi_ge/us_bernanke_exit_strategy

http://www.ny.frb.org/newsevents/speeches/2009/dud090729.html

http://www.newsneconomics.com/2008/12/why-exactly-does-fed-pay-interest-on.html

http://abcnews.go.com/images/PollingUnit/1102a22010Politics.pdf