Symphonic Chaos

Good Reads

2012-02-03T09:09:00.000-08:00

Here is a list of stories that I found interesting in the last few days:

Antitrust Kills, by Bryan Caplan (01/24/12)
This is a philosophical examination of the human toll of the antitrust case against Microsoft twelve years ago. What is not discussed is that the theory that antitrust law is based on was discredited decades ago. The only sustainable predatory monopolies are those that are protected by the government (i.e., utilities, health insurance, pharmaceuticals) - in the private sector, monopolies that are predatory don't last.

Udacity, by Alex Tabarrok (01/25/12)
This is an anecdote discussing the coming education revolution.

Economists vs Americans, by Sudeep Reddy (01/26/12)
A Survey highlighting the differences in opinions about economic matters between Economists and other Americans.

Why Should We Restrict Immigration? by Bryan Caplan (01/27/12)
A very good article on the inhumanity of US immigration policy. Unfortunately, most people don't think rationally about this issue.

Why the Government Doesn't Innovate, by Alex Tabarrok in the Atlantic (01/29/12)
[That's not the title of the article, but I thought it was more discriptive.] He lays out the reasons why the government has no incentive to fund true innovation.

An Estimate of the Value of Human Capital in the US Economy, by Alex Tabarrok (02/01/12)
The Case for More Skilled Immigrants, by Arnold Kling (02/02/12)
Two articles citing the same statistic - that the stock of human capital in the US is worth $750 trillion (US GDP is about $14 trillion). Nick Schulz actually made the original estimate.

The Real Unemployment Rate, by Tyler Cown (02/01/12)
It's much higher than the official unemployment rate.

Too Many Consultants? by Robin Hanson (01/31/12)
Very interesting analysis of the management consulting industry. I've generally suspected this for a long time.

Two Posts on Charles Murray's new book, by Bryan Caplan and Tyler Cown.
There were many more.

Interesting Stories - Friday 1/20/12

2012-01-20T19:28:00.000-08:00

How relevant is business experience to being president? by Arnold Kling
This article is interesting because it highlights misperceptions about how government works versus how business works.

Is China experiencing a "hard landing" type recession? Part 2. by Patrick Chovanec
One of my information sources on China discusses his opinion about the state of the Chinese economy. His answer is yes, though it is technically not a recession because growth will still be positive. However, low growth in China is bad news.

Behind China's GDP numbers. by Patrick Chovanec
Discussion of the recent Chinese GDP release.

The difference between the My Lai massacre and Hiroshima. by Bryan Caplan
Professor Caplan, a pacifist, explains that the only difference between the killing of innocent civilians at My Lai in the Vietnam war and dropping the bomb on Hiroshima was that the soldiers could actually see their victims at My Lai, while the bomber pilots flew away and never saw the faces of their victims. I would respond to him by maintaining that a lot more was at stake at Hiroshima - the Japanese and the Germans had waged a war of world conquest and genocide. However, his question is thought provoking. In my mind, the justification for war centers on the lessor evil, not the greater good. However, that may still not justify Hiroshima, but it does contrast it with My Lai, which was largely senseless.

A Discussion of Fiscal Multipliers. by Kurt Shuler
A blog fracas has erupted between Sumner and Krugman, among others, over fiscal multipliers. Mostly it's boring and wonky, as I find the concept of a "single" fiscal multiplier to be just political silliness. However, Shuler discusses the issue quite well.

The Top 1% Majors. at Economix
Economics is the second best undergraduate major if you want to be in the top 1%, behind pre-med. Perhaps there is a selection bias at work here...

What I’m Reading

2012-01-10T11:04:00.001-08:00

Eureka! Economic Illiteracy as Mental Substitution, by Bryan Caplan (1/9/2012)

One of the best summaries of human cognitive bias when it comes to evaluating complex concepts. He leaves out the incentive framework, which is also critical to predicting people's belief systems – when an individual has a lot at stake at getting to the right answer, they will exert the mental energy to figure out the truth and are more open to discarding previous prejudice; alternatively when an individual could suffer loss for changing his belief systems, then he will exert the mental energy to defend it even in the face of overwhelming proof.

Just How Scary Is the Gold Standard? By David Glasner (1/8/2012)

The gold standard debate surfaces from time to time because the idea is popular among amateur economists – what is a sort of a "Pop-Austrian" paradigm. I thought this post was a good summary of the debate by someone who has a good understanding of all sides of the debate.

Does wealth equal power? By Tyler Cowen (12/30/2011)

An interesting post critical of the popular notion that money controls the government. I generally agree with him – that the truth is a lot more complicated than the popular beliefs on the subject.

Psychiatry's Disorders, by Bryan Caplan (12/29/2011)

This one is a little off-topic for me, but still an interesting look into the psychiatry profession and the biases inherent in the "expert" consensus.

What went wrong with U.S. health care cost control? By Tyler Cowen (12/14/2011)

I liked this one because it introduced data that I had not been previously aware of. Keep in mind that I believe that the US healthcare system is much closer to the European model than what the popular consensus has allowed, and this data provides further support for my thought process.

Comments on the Employment-Population Ratio. Calculated Risk (12/4/2011)

This data is very important for understanding the unemployment rate and the current/future labor market dynamics. It also has profound implications for the solvency of social security and medicare, as well as for private pension and retirement systems (including 401k's).

Myths of Monetary Policy

2010-07-31T07:46:00.001-07:00

Economics is counter-intuitive, which is why many otherwise well-educated people don’t get it. There are many myths in economics that pervade the populace, and by extension, their elected representatives. For instance, here are a few of the most popular myths that have not only been disproven, but have been known to be incorrect for centuries as the facts overwhelmingly contradict them:

· Economic Myth #1: Free trade between nations is, at best, a zero sum competition. Thus, a free trade agreement will result in a net job loss in one or both countries. Some even take this further and argue that free trade results in exploitation by multi-national companies of poor people in search of profits.

[Free trade, which is embedded in the US Constitution’s interstate commerce clause, results in large net gains for all countries involved, even the “exploited” poor. However, some previously protected interests will lose, and are very effective in exploiting this myth to block movement towards free trade.]

· Economic Myth #2: Immigration into a country is an economic negative for existing citizens, resulting in job losses and greater burdens on social services.

[Immigration is simply free trade in labor, but is actually more economically beneficial than trade in goods and services to the host country. As far as the greater burden argument, immigrants pay taxes but are not eligible for social services except at the most basic level. In fact, immigration laws typically deny immigrants of basic rights, resulting in higher levels of poverty and exploitation than would otherwise exist.]

· Economic Myth #3: Greater government regulation results in better economic outcomes.

[Government regulation is necessary for markets to operate, just as police and jails lower crime rates. However, this is an argument that if a little of one thing is good, than more must be better. Excessive regulation distorts economic activity, raises unemployment, increases economic inequality, increases corruption, and reduces production.]

I could go on, but I don’t want to alienate my readers any more than necessary.

If economics is counter-intuitive, then monetary economics is extremely counter-intuitive, such that most economists who do not specialize in the field (and some who do) don’t get it. Just as pervasive myths exist in popular economics, there are at least two pervasive myths that exist in monetary economics.

Monetary Myth #1: Lower Interest Rates Mean “Easy Money”, or Monetary Expansion

Truth: Lower interest rates – absent Fed intervention – signal declining inflation or deflation.

Why this myth persists among Economists is very mysterious. A recent academic study by prominent economists studied the Great Depression. One of its input variables in determining if fiscal policy was effective was to control for interest rates … except it assumed that low interest rates were a sign of easy money. Thus, it missed the biggest monetary contraction in history from 1929-1933. In fact, one of Keynes’s key mistakes was to make this assumption, as the quote by Milton Friedman on the Great Depression demonstrates:

“To Keynes and many of his contemporaries, this sequence of events seemed a clear contradiction of the earlier theory and of the efficacy of monetary policy. They tended then, as many still do, to regard monetary policy as operating via interest rates. Short-term interest rates in the United States had fallen drastically … Judged in these terms, monetary policy was ‘easy,’ yet it apparently had been powerless…

From another, and I would argue far more significant, point of view, monetary policy was anything but ‘easy.’ That point of view regards monetary policy as operating via the quantity of money. In terms of annual averages, the quantity of money in the United States fell by one-third from 1929 to 1933 [etc.]…” [Friedman 1997]

The nominal interest rate on Treasury securities, as well as on any other security, is calculated by the following equation (absent Federal Reserve manipulation):

Inflation rate + Credit Risk + Term Risk +/- Liquidity Discount/Premium

For Treasury securities, the Credit Risk can be observed by examining CDS spreads or looking at Treasuries in reference to the government bonds of other countries. The Credit Risk has historically been so low as to be assumed to be zero, implying that if it moves, it will move in only one direction (up). The Term Risk can be controlled by comparing bonds of similar maturity (longer maturity bonds should have higher interest rates than short bonds, unless short-term rates are expected to decline in the near future). The Liquidity Premium is not likely to change unless another country suddenly issues a large amount of bonds.[1] Therefore, it is highly unlikely that the last three terms in the equation have budged in many decades for US Treasuries. This leaves only the Inflation Rate as the single determinant in changes in interest rates.

This is the market-based interest rate, and changes are determined primarily by inflation.

Thus, absent Federal Reserve intervention, a declining interest rate signals declining inflation. Yet something interesting happens when inflation goes negative: interest rates cannot go negative, otherwise people would hold currency. Therefore, in a deflationary environment, interest rates drop to zero, or close to it, but don’t decline further.

So what happens when the Federal Reserve intervenes? This is where the confusion comes in. The Federal Reserve can intervene by expanding or contracting the money supply. He usually does this by purchasing T-Bills (expansionary) or selling T-Bills (contractionary). Thus, if he is expansionary, T-Bill interest rates go down, and if he is contractionary, T-Bill rates go up. If you hold everything else constant, then other interest rates would move in tandem. However, Fed moves should be interpreted as relative to the current market-based rate, not in an absolute sense or relative to past rates.

Thus, if the Fed moves interest rates below the market rate, then Fed policy is expansionary relative to the current inflation rate. If the Fed moves rate above the current market rate, then policy is contractionary – relative to the current inflation rate. Note, that I used the term “Fed Policy”, and Fed policy says nothing about the current rate of inflation.

However, there is a problem. If interest rates drop to zero, then we can’t know if Fed policy is expansionary or contractionary by looking at interest rates. For instance, if the interest rate is set at zero by the Fed, but the inflation rate is -5%, that suggests Fed policy is highly contractionary. Except that the Fed has a number of ways to expand the money supply other than interest rates, so we don’t know if the zero-interest rate policy (ZIRP) is expansionary or contractionary.

However, in most instances, ZIRP signals deflation.

In fact, interest rates are just a signaling mechanism that the Fed uses; they are not the only policy tool. It is a policy called “Interest Rate Targeting”, where the Fed announces a target interest rate, and then acts to move the interest rate to its target. However, this policy is meaningless in a zero rate environment. Thus, the “Interest Rate Targeting” regime at the Fed has failed.

Myth #2: An Expanded Federal Reserve Balance Sheet is Inflationary

An expanded Federal Reserve balance sheet is deflationary, unless the Fed acts to offset it.

There are two sides to the Federal Reserve balance sheet: liabilities and assets. Liabilities are the reserves that the banks hold at the Fed. A bank in the Fed system must keep a minimum reserve level at the Fed; it can lend out the rest. Typically, banks hold both minimum reserves and excess reserves. However, until 2008, banks did not hold their excess reserves at the Fed; instead they invested the excess reserves in the market, typically in very short-term highly liquid facilities at other banks, companies, or in Treasuries. Indeed, banks would often invest minimum reserves for periods of less than a day then deposit them back at the Fed in time to be counted. The reason: these investments paid interest, the Fed did not. However, investments outside of the Fed meant the cash was circulating and impacted things like inflation, interest rates, and aggregate demand.

Reserves held at the Fed, however, may or may not be reinvested in the economy – it depends on what the Fed decides to do. Hence, the asset side of the Fed’s balance sheet include all of the investments in securities that the Fed chooses to make. Historically, these investments were T-bills only. This, combined with money creation, is how the Fed increases and decreases the money in circulation.

In 1937, the Fed committed what is now a famous mistake: it doubled the reserve requirements at the banks. In reality, the banks already had over twice the required reserves held at the Fed. Seeing those excess reserves, the Fed decided to formalize what was already an informal reality – moving the reserve requirements up to where the reserves were already being held. Unfortunately, the banks were holding those reserves as a cushion against the Fed’s minimum requirement, and reacted by increasing their reserves further. The economy plunged back into the Depression.

In September of 2008, amidst the chaos of the panic after Lehman collapsed, two things happened. First, the banks (and other financial institutions along with money market funds) holding excess reserves were concerned that they would not get repaid. First, they piled into T-bills, until the interest rate went briefly negative. Then they piled into longer dated Treasuries, until the rates got too low. Then they parked the reserves at the Fed: if they were not going to get paid any interest, they might as well not get paid interest at the Fed. Secondly, the Fed decided to start paying interest on reserves. However, at this time, the Fed Funds Rate was higher than the T-bill rate. The Fed was sensing that it was losing control of monetary policy (the correct intuition). The result was that most of the excess reserves were quickly deposited at the Fed.

This posed a problem: financial institutions and other companies that issue short-term paper could no longer get funding. Nobody wanted to lend, and much of the funds were parked at the Fed anyway. Some, like Goldman Sachs opted to become bank holding companies so they could get access to the discount window (where the Fed lends money to the banks). Others begged the Fed to start buying their paper.

The Fed soon started buying commercial paper and other short-term instruments, and later expanded the buying program to longer-dated Treasuries, high quality mortgage securities and other asset-backed securities. The Fed also lowered their target interest rate to zero the following November.

However, the Fed was not printing money – it was simply re-lending out the reserves that it had borrowed from the banks in the crisis.

Unfortunately, there was a significant lag in Fed actions, resulting in a sharp slow-down in economic activity and a deep recession.

The ECB recently did something similar during the sovereign debt crisis with Greece and other European countries. Interbank lending had dried up, and the banks deposited their reserves with the ECB. The lag time in this crisis was much shorter due to the fact that the ECB was able to learn from our experience.

So why do people continue to believe this myth? Unfortunately, Fed communications have acted to perpetuate the myth. One can only speculate as to why, but I believe that there are several motivations:

The Fed tried and failed to communicate that its bond-buying program was not inflationary and did not constitute “Quantitative Easing”, even coining a new term: “Credit Easing”. These concepts are complicated and difficult to communicate to the public.
The Fed did not want to reinforce deflation expectations, which it believes would be a self-fulfilling prophesy. This is based on the theory of “rational expectations.”
The Fed did not want to shine a light on the fact that its decision to pay interest on reserves and its timidity in lowering interest rates may have contributed to the crisis.

[1] This is a problem for countries such as Spain and Ireland when the United States, Germany, and Japan suddenly run large deficits.

The Problem of Systemic Poverty

2010-01-15T13:46:00.000-08:00

Addressing the problems of poverty in the underdeveloped world is an extremely complex and challenging task. This problem of poverty has been highlighted in the recent earthquake in Haiti, a country that never had a functioning government or a functioning economy. Indeed, it is easy to blame Haiti’s misery on poor governance and/or outside exploitation, but the more complex question is that a symptom or a cause of poverty? Most nations at sometime in their history have been subject to poor governance, exploitation, and even outright conquest. Yet some rise above this into prosperity, while others sink into an abyss of depravation. Other explanations offered sometimes are a lack of resources: resource rich countries have a reserve of wealth to draw upon (this is often offered as an explanation for the wealth of the US). Yet, countries with rich natural resources, such as those in Africa and the Middle East, are mired in destitution while others with little resources, such as Singapore or Taiwan, are a model of modern wealth and prosperity. The modern rise of China, a country conquered and heavily exploited, is another case in point.

While I am by no means an economic development expert, I have done some reading on the subject and I have extensive training and experience in economics and finance. Recently, I read an article on Haiti, called Why is Haiti So Poor? by Bob Corbett, a former director of People to People and lifelong worker in Haiti. On balance, it was a good article and well thought out, though the author makes mistakes typical of a social development worker without formal training in economics. The reason I highlight it is because it triggered a line of thought for me that I believe has been fruitful.

Basically, I have identified four high level themes with respect to economic development: coordination problems, the pace of modern economic change, location/clustering, and war.

1. Coordination Problems: at its root, economics is about coordination and the division of labor. I work in finance, you work in manufacturing, and he works in agriculture. We then coordinate our activities through various means to exchange goods and services. Wealth is created through the specialization of labor and magnified through technology and better ways to organize and coordinate. Education plays a key role, but it is not sufficient and is often overstated.

A key coordination actor is the government and institutional structures. The government in Haiti is so bad as to be legendary. Governments can enhance coordination, as is sometimes the case in Western countries, or they can distort and inhibit coordination, as is the case in most of the underdeveloped world. This is where Western countries have been most heavily criticized: they intervene in ways that are not helpful, either by propping up bad regimes, or directly exploiting and interfering in a country’s development. Such exploitation has occurred by Western governments as well as Western institutions such as multi-national corporations. However, there is also significant evidence that many countries have benefited from Western intervention, both by governments and especially by multi-national corporations. Companies bring know-how and often work to improve economic organization, as it is in their interest to do so.

Often poor countries have multiple barriers to coordination. In Haiti, the aforementioned article mentioned language: the population speaks Creole, yet the language recognized and taught in schools is French. Other countries, such as India or most of Africa have a multitude of native tongues yet use an official language (such as English or French) that is foreign. Language is critical to coordination; without it cooperation is nearly impossible.

Other barriers to coordination include ethnic rivalry and class structures: people unwilling to cooperate with each other, at least on equal terms. A lack of social cohesion: many countries in Africa and the Middle East are not really countries, but merely lines on a map drawn by the British and French after World War II.

2. The Pace of Modern Economic Change: we often forget that economic development is a recent phenomenon. Technology and economics are changing so rapidly that if a country sits out a generation or two, then it will seem like it is so far behind that it can’t catch up. The Soviet Union sat out on technological change basically from the end of World War II until the present. The longer a country sits out, the harder it is to catch up: indeed catch up requires borrowing, stealing, and imitating technology invented by others, and often in the meantime, workers must pay the price in depressed wages. Haiti, of course, sat out on the industrial revolution and all subsequent development.

3. Location and Clustering: It is well known that economic activity clusters together in locations. This physical clustering enables labor mobility, knowledge exchange, and the low cost exchange of goods and services. Trade, of course, facilitates this exchange, but long distance trade is often limited to goods that can be shipped cheaply (which is why coastal areas develop faster and are richer than inland areas). Indeed, urban centers represent clusters, and cities often cluster together regionally. Inland Africa, far away from ports and from any advanced economic activity, thus starts with a significant handicap. Conversely, Singapore has always benefited from its location as a major port along a huge shipping lane, even though it is surrounded by countries that are mired in their own economic misery and it has no mineral resources. Haiti is surrounded on three sides by water, but it is not on a major trade route. It’s location near the US has been both a blessing and a curse: it has benefited from US generosity, but it has also been exploited by US greed, military imperialism, and/or incompetence.

4. War: the devastation that is wrought by war can set a country back several generations. GDP measures income and increase in wealth, it does not measure actual wealth. Wealth is the physical and intellectual resources that generate income and/or can be enjoyed over multiple years. War is often a symptom of poverty as well as a cause.

This is by no means comprehensive, but I think it is useful to think along these lines about economic development. I don’t think it is useful to recycle the common refrain of Western exploitation, even though I mentioned it in one of my bullet points. Exploitation has always occurred and will continue to occur: to point to it as a cause is like saying the sun will rise tomorrow. The purpose of economic analysis is to point to the mechanisms and then examine how those mechanisms can be changed.

Follow me on Twitter

2009-11-10T09:46:00.000-08:00

Recently, I've been posting links on Twitter that is the source material for some of my thinking. I may occasionally post here, too, but Twitter allows me to post some of my thoughts vicariously through other authors.

twitter.com/dcarroll001

What is the Fed Doing, Anyway?

2009-08-07T06:56:00.000-07:00

I continue to be surprised by the level of misunderstanding about the Fed’s actions, especially misunderstanding by professional commentators. Therefore, I feel the need to comment upon them.

For those who have paid attention, the Federal Reserve has dramatically increased its balance sheet. This dramatic expansion took place extremely rapidly last fall, as a plot of bank reserves plods along for years and years and then suddenly leaps like a rocket. Here are some of the charts from last fall.

Many have assumed that this means that we are in for a bout of hyper-inflation. The Fed is printing money, and the printing of money always results in inflation.

There is a famous equation called the quantity theory of money:
MV = PT = GDP [Money Supply x Velocity of Money = Prices x Total Output = GDP].

Thus, a change in the money supply (M) would result in a change in prices (P) if V and T are held constant. The reasoning behind the inflation fears, therefore, is that the Federal Reserve is increasing the money supply (M), and therefore the result will be an increase in prices (P).

However, there is a problem with this reasoning. We can’t just assume that Velocity (V) and Output (T) have remained constant. In fact, we know both quantitatively and qualitatively that Velocity (V) has collapsed as a result of the credit crisis, and Output (T) and Prices (P) have also dropped, resulting in the decline in GDP.

The last time Velocity collapsed like this in the US was 1930-1933, which, incidentally, was the last time we had a major credit crisis. The difference between now and then is that in the 1930’s, the Federal Reserve actually shrunk the money supply, magnifying the collapse.

What is Velocity? A strict definition is that Velocity is the rate at which the money supply is turned over in the economy. Thus, if the a dollar is turned over 3 times in a year, then the velocity of that dollar is 3.

What drives it? I believe that Velocity is an indirect function of the demand for money and the supply of money. In fact, it is linked to the Money Supply and therefore is heavily influenced by the expansion or contraction of M.

What is the Money Supply? Another mistake implied by the inflation fear is the idea that the Federal Reserve’s monetary base (pictured in the charts above) constitutes the money supply. It does not – it is only a fraction of the money supply. The Fed’s monetary base is expanded by a multiplier called credit. The Fed has direct supervision over the banking system, which supplies some of the credit in the overall economy. Until recently, however, there was a “shadow banking system” that also extended credit, most notably in the form of mortgage-backed securities, consisting of Wall Street, AIG, and the Chinese Central Bank. The shadow banking system was largely unsupervised, and the Fed had only a very indirect influence over it in the form of buying and selling short-term treasury bills.

Therefore M = Mb + Cr + Cu [Mb = Fed’s monetary base, Cr = regulated credit, and Cu = unregulated credit]

Thus, if there is a credit crisis, the Credit starts to contract, thus contracting the money supply, assuming all else is held constant. In late 2008, Cu contracted sharply, while Cr also contracted, though at a slower rate. Therefore, the Fed expanded Mb.

In addition, the collapse of Lehman and AIG, among others, led to a sharp reduction in Velocity (V) as the extension of credit promotes an increased rate at which transactions are conducted. Most new loans are spent fairly quickly; thus if new loans are not extended, new money is not spent.

In rapidly expanding the monetary base, the Fed averted what is called a “multiple contraction of the money supply,” similar to what happened in 1930.

I should also note that the charts above mask what is essentially an accounting change: much of the bank reserves pictured above had previously not been held at the Federal Reserve. Instead it was held elsewhere in the financial system, because the Fed did not pay interest on those reserves. When the Fed began paying interest on reserves, financial institutions immediately moved their reserves to the Fed. This gave the Fed the ammunition to begin its quantitative easing program, and, conversely, it gives the Fed more ammunition to prevent inflation from heating up in the future.

What happens if Velocity picks up and credit starts expanding? If that were to happen and if the monetary base was not contracted, we would have inflation. However, there are important reasons why that is not likely to happen quickly: most lending institutions either no longer exist or are impaired. While some banks are lending aggressively, the Wall Street securitization engine has disintegrated. Specifically, much of the lending taking place is either being done directly by the Federal Reserve, or is being subsidized by the Federal Reserve. The Fed can withdraw that lending anytime it wants.

It is for these and other reasons that I believe that the probability of inflation in the next 3 years is pretty low.

Organic Farming?

2009-08-04T05:58:00.000-07:00

An interesting link: http://www.american.com/archive/2009/july/the-omnivore2019s-delusion-against-the-agri-intellectuals

Economics Blogs

2009-07-17T09:05:00.000-07:00

Though I have been tailing off on my blogging activity (not enough life changing economic events in the past months), it appears that economics blogs have taken on a life of their own. The following WSJ article highlights this trend: The New Stars of the Blogosphere (subscription may be required).

I read a number of blogs, and they are typically much more useful than the newspapers. While economics bloggers are biased and opinionated, so are journalists (or at least their sources are). The difference is that economists tend to know what they are talking about. The way to counter that is to read different blogs and get a variety of opinions.

They also tend to write about the trivial as well as the important.

Here is a list of blogs that I read:

Carpe Diem: http://mjperry.blogspot.com/ - very optimistic and very libertarian
Freakonomics: http://freakonomics.blogs.nytimes.com/ - generally non-political issues, but with a liberal bent when mentioned
Greg Mankiw: http://gregmankiw.blogspot.com/ - mostly political commentary and right of center/conservative
Marginal Revolution: http://www.marginalrevolution.com/ - some political and some non-political, with a partial libertarian bent
Calculated Risk: http://www.calculatedriskblog.com/ - very pessimistic (it's basically a short-seller's blog), macroeconomic and financial but largely apolitical, though with a subtle liberal undercurrent
Economist's View: http://economistsview.typepad.com/economistsview/ - Mark Thoma's blog, strongly liberal and mostly political commentary
Market Design: http://marketdesigner.blogspot.com/ - non-political, mostly about various idiosyncratic markets
Paul Krugman: http://krugman.blogs.nytimes.com/ - very political and very liberal, more so than his writings suggest in other forums

I should note that libertarian opinion is generally "conservative" with regards to economic policy, but "liberal" with regards to social policy, where "liberal" and "conservative" are consistent with the label. Libertarians believe that government involvement usually, but not always, is counterproductive and will make whatever problem it tries to solve even worse.

I have a libertarian tilt to my thinking, as I have a healthy respect for the incompetence and pervasive corruption of the government (federal, state and local) and I believe the "market" works much better than most people realize. However, I have an egalitarian bent, as I believe that tax policy should be progressive when implemented and we have an obligation to assist the poor and disenfranchised.

More on Health Care

2009-06-29T07:44:00.000-07:00

An interesting article on health care reform.

http://www.nytimes.com/2009/06/23/opinion/23brooks.html?_r=1

Health Care Reform

2009-06-11T07:08:00.001-07:00

The hot political topic has moved from the financial crisis to the GM bankruptcy now to health care reform. As usual, there are a lot of half-baked opinions from all sides of the ideological spectrum, particularly on the television. Liberals point to the European and Canadian models as examples of functioning health care systems, while conservatives point to the same models as examples of non-functioning health care systems.

The truth is that the European and Canadian health care systems have both advantages and disadvantages relative to the system in the US. The advantage is that health care is universally available and relatively inexpensive in Europe and Canada. The disadvantage is that advanced care is largely unavailable and subject to significant rationing - so much so that private, cash-based health care clinics have arisen to fill the gap and often the sick travel to the United States for care.

Health care is a complex problem in a society, and it doesn't lend itself well to easy solutions. I generally break down the health care problem into three categories, examining the difference between the private and socialized approach, with the socialized model that of a single-payor system. Other government-designed systems exist, but typically represent a hybrid approach.

Revenue collection: Where is the money coming from?

In a private insurance system, revenues are collected on a fixed, flat-rate basis, sometimes (if allowed) priced according to insurability. In the US, employer-based "collectives" have formed to share the costs across many users, flattening out the rate structure. Thus, the healthy subsidize the unhealthy, within that collective. In this kind of system, a certain segment of society will be unable or unwilling to afford the single rate, and will be forced out. This gives rise to the ranks of the uninsured. The US reinforces this system by offering preferential tax treatment to employer-based plans.

In a socialized system, typically, revenues are collected from a tax base tied to percentage of income. Thus, ability to pay is not a criteria for inclusion. In the US, medicare fits this bill, as well as federal and state subsidies to hospitals to treat the uninsured. The downside of this approach is that it is a form of coercion, and it creates a drag on economic productivity.

If we determine that health care is a right and a social good available to all, then the private system is unworkable, and we should opt for a tax-based system. However, this does not necessitate a fully socialized system; it only socializes the collection of revenue.
Treatment: Who will provide the treatment?

In a private system, individual doctors, clinics and hospitals earn income by offering treatment in exchange for payment. Payment is based on the procedures offered. The advantage of this system is that it efficiently matches up demand with supply - if there is a shortage of neurosurgeons, more will be trained to meet the demand. The disadvantage is that by matching up payments with specific illnesses, the burden falls most heavily upon those with expensive ailments.

In a socialized system, the government directly or indirectly hires doctors, clinics, and hospitals to treat all comers, and sets the rules governing treatment. Payment is fixed and not linked to treatment. The advantage of this approach is that it separates the cost from the illness, spreading the burden around. The disadvantage is that supply and demand aren't matched up, and shortages (i.e., long waits, unavailable care) inevitably result.
Payment: How are the services going to be paid?

Separating the payment from treatment is a bit arbitrary, as the who will follow the how. However, it is useful to examine this issue independently.

While fee-for-service clinics exist (a pure example is the market for Lasik surgery), most private systems incorporate a combination of insurance and pre-paid medical plans, which are incorrectly labeled insurance. The definition of insurance is a plan that takes payments from a diversified pool of individuals to protect against risks that are unpredictable, relatively rare, and financially catastrophic. Chronic and fatal diseases as well as accidents fall into the insurance category. Most other medical services fall into the predictable and/or planned category, such as old age and pregnancy. Some, like heart disease, fall into a middle category that doesn't affect everybody, but we can predict who it is most likely to affect. These ailments are usually treated by a form of a pre-paid medical plan, which doesn't save individuals any money but does average out the payments over a lifetime. Sometimes subsidies are used, such as where men's premiums help pay for pregnancies.

In a socialized plan, the government pays for everything.

Which is better, public or private?

The answer depends on what our society is willing to give up.

If we want efficiency, low cost, and innovation, than the closest we get to a private system, the better. A great example is Lasik surgery: this procedure is not covered by insurance, yet it has been increasingly perfected with the costs driven down rapidly by new technologies. The cost is about 10% to 25% of the cost of having a baby (roughly $15,000 to $20,000 before insurance). Yet, arguably, Lasik surgery is more complex and difficult (for the doctor), while having babies is the ultimate standard procedure and a technology that has been around for a long time.

Yet not everybody can afford Lasik surgery. And society has an interest in making sure everybody can afford baby delivery.

Thus, if we want universality, a public plan is pretty much the only way to achieve that.

My recommendation:
Socialize Premiums. The government should collect the revenues, through a payroll tax. This tax would replace insurance premiums paid today, which equal to an average of around $5,000 to $10,000 per year for a family including employer subsidies (not including deductibles, which range from $250 to $2,500). Given a median household income of $50,000 (which, if you add back employer health care subsidies, is about $60,000), that would equate to 10% to 15% of income.

However, given that this would a tax as a percent of income and not a flat rate, the actual tax rate could be less and still collect more than enough. The top 20% of earners account for 80% of income, suggesting that the rate could be around 10%, or perhaps a little less.
Privatize treatment. The government simply is not equipped to administer a health care system, as the costs would spiral out of control, and the quality of care would plummet. Private doctors and clinics would be much more efficient.
Privatize payment systems. Distribute health credits, which could be used to purchase insurance or participate in payment plans. Set up health care savings accounts, which individuals and households could use pretax dollars to save up for future treatments. Implement controls that require insurers to take all comers, charge the same price for everybody, and ignore pre-existing conditions. Structure the health credits so that it is a use-it-or-lose-it system.
Structure a transition plan so that the older generation can do a catch-up on the health care savings accounts, perhaps receiving a payout based on age and health condition. This payout would be "use-it-or-lose-it" as well.

This plan combines the advantages of a government plan with the advantages of a private plan, while substantially mitigating the disadvantages of each. Generally, the government is good at taxation, redistribution, and coercion, while the private sector is good at choice, innovation, and efficiency.

Not that anybody's listening in Washington.

Ranking the Presidents

2009-06-09T14:44:00.001-07:00

This Freakonomics post is an interesting one on evaluating our presidents. Rather than just polling historians and political scientists about who gives them the warm fuzzies, this author suggests that we evaluate them on specific criteria. While one might quibble with the scores assigned, the approach seems reasonably valid.

http://freakonomics.blogs.nytimes.com/2008/10/31/the-presidents-ranked-and-graded-a-qa-with-the-author-of-the-leaders-we-deserved/

I was surprised to learn that some historians regard Andrew Jackson well, since his actions brought about and/or exacerbated one, maybe two, devastating economic depressions as well as the crime against humanity perpertrated on Native Americans (aka Trail of Tears). This author gave him a low rank.

I thought his review of Grant was optimistic given the level of corruption and recklessness that ushered in what was once considered the Great Depression in 1873.

In all, his rankings were reasonably good, though I would make a few adjustments.

What about GW? Here are my thoughts (1-5, with 5 being best):

* Character: 3 (didn't have sex with an intern, but didn't exactly tell the truth)
* Vision: 3 (had vision, but was overly ideological)
* Competence: 1 (hello ... Iraq, economy)
* Economic Policy: 1 (a deer caught in the oncoming train's headlight)
* Preserving and Extending Liberty: 2 (protected the US, but alienated the world and engaged in at least borderline torture)
* Defense, National Security, and Foreign Policy: 3 (see above)

Average: 2.16 (bottom third, but not the worst)

Child Soldiers

2009-06-02T07:36:00.000-07:00

While not economics, I found this interesting, albeit depressing. The following article highlights the facts and myths regarding the use of children in military conflicts.

http://www.foreignpolicy.com/story/cms.php?story_id=4944&page=0

Behavioral Economics

2009-05-21T06:12:00.000-07:00

The field of behavioral finance is fertile with great insights into investor behavior. The following article makes good arguments about the behavior of economic actors - in this case the bankers that helped get us into this mess.

http://www.voxeu.org/index.php?q=node/3572

In her article, her first two points are relatively transparent.

Point one states that humans are prone to cognitive errors when assessing financial risk. We are overconfident weighing our own ideas and have a tendency to ignore contrary information. We also have a tendency to over value our initial conclusions and are unwilling to change our minds when new information arises. This is well established in behavioral finance literature.

Point two cites literature that men are less risk averse (i.e., they take more risk) than women. It also indicates that group dynamics tend to push consensus decisions towards more extreme outcomes than just the simple average of the group. Thus, in a room full of risk taking men, the consensus decision would invovle more risk than the average inclination of each male individually (the reverse would be true if all were risk averse). She points out that the financial industry is overwhelmingly male (where, in her words, lap dancing is considered appropriate corporate entertainment). I would extend this to point out that the financial industry consists of men who, on average, are risk seekers, more so than the general male population and exhibit a high level of overconfidence. While not politically correct, there is actually a lot of evidence to support this hypothesis that an industry full of men will not only tend to take more risk, but will periodically veer towards recklessness.

The last point is a little difficult to ascertain, but it appears to me that she is arguing the following:

· Bonuses, especially short-term oriented bonuses, reward the perception of competence.
· Highly competent individuals are unlikely to question their decisions because their decisions are unlikely to be wrong.
· Less competent individuals seek to mimic the behavior of highly competent individuals in order to be perceived as highly competent, thus not questioning their decisions
· In order to increase the perception of competence, a bias exists among professionals to oversell decisions to coworkers and clients and not seek out information that might contradict prior decisions.
· I would add that the culture of most organizations punishes mistakes, and changing one’s opinion exposes potential mistakes and decreases the perception of competence. Thus, the institutional structure of the economy reinforces this behavior.

Bill Gross's Latest

2009-05-01T10:22:00.000-07:00

Bill Gross of PIMCO has gained a little more fame in the recent years, as he was one of the investors who predicted the current economic malaise, though he was early by a few years. He oversees the management of one of the largest bond investment companies in the world. His most recent newsletter is a general outline for his vision of our collective economic future. I don't recall where the letter can be found at, but I’ll summarize it here (with some interpretation where he was deliberately vague).

Delevering
Consumers and businesses will work to save more and reduce debt. The question is whether it will be destructive and revolutionary, or gradual and evolutionary. For 25 years, growth was powered by, among other things, the issuance of debt which in part drove appreciating asset prices, which was then offered as collateral for more debt. He believes that process will reverse, leading to slower growth, at a minimum.

Deglobalization
Growth was also driven by globalization and the increased free flow of trade. That process will also reverse itself, much as it did after WWI, as countries raise protectionist barriers. This will lead to slower economic growth and higher unemployment, and probably inflation.

Reregulation
Government will seek to regulate private business more extensively, especially financial markets. The extreme is government control or direct ownership of private enterprises.

Gross goes on to examine the impact on asset prices, explaining that these three processes increase the degree of uncertainty, and therefore decrease the prices of risky assets (such as stocks). He highlights the following conclusions:

The Dollar, while currently strengthening, will weaken.
Credit will become more expensive
Equities will sport lower P/E multiples and will emphasize dividends
Emerging markets will find growth harder to come by

My Critique
Bill Gross is known for his pessimism and focus on risk, which is a hallmark of a bond investor. His forecast record is mixed at best, as he is better at identifying risks in the present that at predicting the future. He also comes across as a diehard Keysian (see previous posts) in terms of his policy prescriptions and approach to economic analysis – which only means that he believes that a massive government response is the only real solution to the current crisis.

That doesn’t mean he is wrong. However, I think he is a little less than objective.

Delevering
I agree that the consumer will delever. Businesses will delever to the degree that their profits permanently decline, as it is not clear that businesses were over-levered to begin with. I am looking at a chart that suggests that interest payments on consumer debt in the fourth quarter of 2008 declined to the lowest level since 1980 at 2.15% of disposable income, though still inline with levels seen in the first quarter of 2004 and the third quarter of 1993. It is very likely in the first quarter that interest payments declined further, as they generally continue to decline throughout and past the end of a recession. In the 1960s and 1970s, interest payments hovered around 2.00%, when consumable goods were more expensive. Therefore, the expansion of debt on the consumer balance sheet since 1980 has been driven by a reduction of interest rates.

Interestingly, the recent peak in interest payments in 2005 in the third quarter of 2007 at 2.72% was exceeded by prior peaks in 3Q 2000 at 2.90% and 3Q 1985 at 2.95%.

Since interest rates are about as low as they are going to get for a while, it is not likely that the consumer will take on more debt in the future. The recent reduction in mortgage and rates on other asset-back loans by the Federal Reserve is intended to slow the deleveraging process to make it more orderly, not ignite further expansion of the consumer balance sheet.

The personal savings rate has already moved from 0.2% in Q1 2008 to 5% in January. The last time it was at 5% was in 1995. As I’ve stated in previous blogs, the savings rate was understated, held back by, among other things, capital gains taxes and capital gains related spending. Since capital gains are now losses, the taxes are (very modest) benefits and gains related spending is gone (it probably left in the first leg of this recession in early 2008). The other benefit is the reduction in prices for food and energy, along with an increase in personal income. The following chart outlines some of the sources of the change in savings rate from Q4 2007 to Q4 2008 from 0.4% to 2.8% of personal income:

Personal Savings +2.5%
Personal Income +2.2%
Interest Expense +0.4%
Personal Consumption −0.3%
Personal Taxes +0.2%

The personal savings rate increased to close to 5% in January, with a reduction in personal consumption of roughly 2% to 3% being the primary driver. Some of the offset from personal consumption in Q4 was most likely linked to energy and food prices, which have come down.

What this illustrates is that the savings rate is almost entirely dependent upon increases in income and decreases in personal consumption. However, personal consumption is not likely to decrease as rapidly in the future as it did from November to January. Therefore, going forward, as incomes rise, one would expect the rising incomes to translate into higher savings, not higher spending.

However, incomes don’t usually rise in recessions, though the hardest hit incomes are the high income brackets that tend to be variable. Therefore, I wouldn’t expect savings to rise much further – and may even retrench a little. However, once the recession starts to stabilize (as it appears to be doing now), I would expect the savings rate to start to climb again. Incomes rise on average 5% per year, so one year of “normal” recovery without increased expenditures would push the savings rate to over 10% − higher than the average rate of savings that predominated prior to 1983. It will probably take longer than a year for personal income to rise that much, but I don’t expect the consumer to necessarily cut spending further to get there if incomes don’t rise that quickly. Either way, productivity, which drives income growth, will drive us out of this recession once consumption stabilizes (as it appears to have already done so).

Thus, my prediction is one to three years of anemic (but positive) consumption growth, combined with initially anemic but accelerating income growth. I suspect that the savings rate will climb to 8% to 10% in five years, though there are a number of variables that could throw that prediction off. At that rate of savings, it would take three to five years to work off the excessive debt load of the consumer. This suggests another five to ten years of economic restructuring, which is consistent with forecasts I have made via other methods.

Deglobalization
As Gross notes, globalization can be reversed. While leftist activists will likely be pleased, the result will be higher levels of poverty abroad and higher unemployment and higher prices domestically (along with stagnant income growth).

I hope he is wrong in terms of magnitude, though he appears to be right in terms of directionality. Protectionism is a dangerous game economically and geopolitically. One hopes that the lessons of the Smoot-Hawley tariff have not been forgotten. So far, most of the protectionist sentiments appear to be mostly toothless populism, though he rightly notes that financial and auto sector bailouts are domestic subsidies. Given the circumstances, I think they can be forgiven, even if they are inefficient.

I concede that we will have a rise in protectionism worldwide, but it is not clear that globalization has ended. In some cases, examination of the current international trading system could be constructive, such as the role of the dollar as the international reserve currency and the role of trade imbalances in fueling the current crisis.

Reregulation
This theme is played out so much in the media that I’m not sure Gross has anything to add on the topic. We know regulation is coming. However, what we don’t know is if the regulation will be more or less rational than before, more or less efficient, or more or less captured by special interests.

The lack of regulation is most often blamed as the culprit of this crisis. In my opinion, that is wishful hindsight thinking. If only I had sold my house and my stocks before the crisis hit, I would be a much wealthier man today. Duh.

Will the Dollar Weaken?
The scenario that will cause the dollar to weaken is inflation and/or a loss in the US. Currently, foreign investors have trillions of dollars invested in the US, much of it in US Treasuries (much it formerly in mortgage securities currently effectively guaranteed by the US Government through AIG). If foreigners decide to withdraw into other currencies, then the dollar will fall in value (and inflation will most likely result unless the Federal Reserve raises interest rates).

However, where will foreigners withdraw their investments to? They could put their investments into the Euro, which is the reverse of what has been happening in the last few months. However, the EU has bigger problems than the US. They could put it in their domestic currencies, such as China investing in China instead of investing in the US. That would raise the value of the Chinese Yuan against the US dollar, resulting in lower exports to the US and higher imports from the US. The Chinese clearly don’t want to do that (though I think they will eventually).

In short, I don’t expect the dollar to weaken in the next couple of years due to economic concerns. However, I do expect the dollar to weaken against Asian currencies over time, as that is what must happen if the Asian countries want to grow their economies.

Will Credit Become More Expensive? Will P/E ratios contract?
It already is and they already have. The Baa corporate bond rate went from 6% to 9% in a few short weeks last fall, with the widest spread between corporate bonds and treasuries in the last 25 years. Junk bonds went from 7% to 20%. For Baa companies, that means that the P/E ratio went from 17 to 11, or a 33% decline on top of a decline in earnings (explaining the 50% drop in equity prices). For junk, the P/E ratio went from 15 to 5, or a 67% decline on top of a decline in earnings.

I expect as we work through this economy, that credit spreads and P/E ratios will come back, though perhaps not to the degree that they were before the crisis. My research shows that even after credit crises, P/E ratios return to normal within five years.

Will Emerging Markets find Growth Harder to Come By?
The answer to that is it depends. Eastern Europe is in a lot of trouble, which they will take 10 years to dig out of if their political systems survive (much longer if not). Asia, specifically China, needs to start investing in itself. If so, it will grow after a sharp recession as exports will fall before imports rise. Unfortunately, the political will in China to take that medicine is uncertain at best.

If it's in the ground, it can only go down

2009-04-16T14:36:00.000-07:00

The following article appeared in Newsweek, and is suprisingly good for a mass market news outlet.

If It's In The Ground, It Can Only Go Down

Been a little busy recently ... will get to Part III of my essay on economic schools of thought when I can.

Economic Schools of Thought - Part II

2009-04-03T06:26:00.000-07:00

Keysian Economic Theory:
Keysianism was all the vogue during and after the Great Depression, but has been in decline since the 1970s. The theory has enjoyed a renaissance of late, however, as Keysians have been coming out of the woodwork. Often the Keysians are also quite negative in their assessment, though I suspect some of this stems from their desire to catalyze the general public to go along with their policy prescriptions.

Keysians tend to make good policy-makers, as long as they understand what they are doing (all politicians are Keysians, for reasons that will become obvious in the following bullet points). This is because they tend to be focused on productive use of government resources and often have a long-term point of view. They can be liberal or conservative.

Some of the basic tenants relevant to our discussion are:

* Deep recessions and depressions represent demand shocks, regardless of their source. Trying to identify a source of a demand shock risks over-simplification and inadequate remedies.

* The Government has the resources and capacity to generate a positive demand shock, either through increased spending or tax cuts (liberals like the former, conservatives the latter).

* Therefore the prescription for a demand shock is to increase government spending and/or cut taxes. The idea is to replace lost demand with government demand until private demand recovers, and even catalyze demand by boosting confidence.

* Government programs also have the effect of easing the burden on the population of a recession, but indirectly and directly employing people and providing direct benefits.

The Keysians argue for big government deficits during recessions paid for by surpluses during booms. Paul Krugman, a professor at Princeton and Nobel Laureate, is the most famous modern day advocate of the Keysian response to the current crisis. Others that are Keynsians are (most likely): Prof Roubini and Bill Gross. Even Warren Buffet partly comes across as a Keynsian.

My Critique:
I believe that most of their points are relevant and partly accurate. I believe that a social safety net is important and that over-analyzing demand shocks often do lead to inadequate remedies. However, I think that Keysians miss or underemphasize the costs of government intervention:

* The democratic process is messy and inefficient, usually resulting in wasted spending on non-productive or counter-productive projects. The best government programs are often accidental. In addition, the political process and its proceeds is often captured by “special interests”.

* Government spending represents a reallocation of resources in the economy that is often very inefficient and wasteful. A reallocation of resources often does not result in increased demand, and indeed can result in decreased demand.

* The rise of government in the past half-century has resulted in chronic deficits, not surpluses during times of plenty.

* Government micro-management of the economy is usually counter-productive.

* Governments are not flexible and bureaucracies have difficulty responding to changing economic conditions.

* There is not a lot of evidence that government fiscal intervention during a crisis is effective.

That said, I believe that the government does play a role in responding to an economic crisis. Social safety nets, disaster response, and direct intervention in severe crisis, no matter how inefficient can have very positive responses.

Economic Schools of Thought

2009-03-26T09:44:00.000-07:00

Reading and listening to modern journalism, one could get the impression that there isn’t much debate – things are universally bad, people are afraid, and the world is falling apart. However, the diagnosis of the problem stirs a lot of controversy among economists and professional investors. On the one hand, there is NYU Professor Nouriel Roubini (among others) proclaiming every month that things are only going to get worse, continually downgrading his previous forecasts as things actually get worse. On the other hand, the consensus of economic forecasters have been predicting a turn in the economy by the 2nd half of 2009. What has dismayed many economists was how quickly the economy went south last fall, as economic activity contracted at with an unprecedented suddenness.

So how do we separate out the different comments by different commentators? I’ve been reading a number of different analyses of the economy over the last several months, with a particular focus on the most dire predictions. I figure if I can understand the worst case forecasts, then I can critique it and evaluate the likelihood of the worst case taking place.

What I have found is that economist and investors evaluating the economy fall into three general categories (with variations and hybrids among them). This is extremely useful when evaluating comments made by an individual on television, in print, or at a lecture.

This is the first part of a three part series on the subject.

Part 1: The Austrian School (or classical economists):
This school of economics is most well known for its libertarian ideology and the writings of Hayek. Since libertarianism is not unique to the Austrians, they are often confused with two of the other three general schools of thought. One of the primary defining characteristics – and the most relevant for this discussion - of the Austrians is their advocacy of the Gold Standard for the dollar.

The Austrians, generally, believe that our current system of finance is destined for ruin and collapse. Not, mind you, the collapse we have seen so far, but a total and complete collapse of the dollar and a massive depression exceeding the experience of the Great Depression.

Austrians often make good investors, especially short sellers. This is because they are keenly atune to financial excess and have a deep understanding of the dangers and risks to the financial system.

Some of the primary arguments are as follows:

· The value of the dollar is based on faith and confidence. Once that faith is breached, it will become useless as a form of currency. Gold, however, has worked for thousands of years, and faith will never be lost in it.
· The faith in the dollar is based on the US Federal Reserve.
· The US Federal Reserve will ultimately be unable to defend the value of the dollar because of political pressures, economic complexity, its own mistakes, and/or government deficits.
· The US financial system has built a mountain of debt and credit, which is similarly founded upon faith in trust, which as we have seen recently can be easily breached. This debt must eventually be unwound, which will result in a massive economic collapse.

The Austrians argue for a return to the Gold Standard for international trade because it does not require reliance on the US Government or any other government, and cannot be manipulated. Its supply is relatively fixed, so inflation or hyper inflation is not possible.

The most negative commentators, generally, though not always, incorporate some or all of the Austrian School. Some argue that Armageddon is at hand, while others argue that this is just a precursor of Armageddon.

My Critique:
While I am not an Austrian, most of the points above about faith and trust are definitely valid. However, I differ from the Austrians on several points:

· The Collapse of the Gold Standard in the 20th Century resulted in a Great Depression and ultimately a massive world war. Likewise, history is replete with economic collapses tied to gold as an inadequate measure of value, including, by some counts, the collapse of the Roman Empire. The collapse of the quasi Gold Standard after WWII resulted in the inflationary epidemic in the 1970’s.
· Once inflation was tamed, the world enjoyed an unprecedented period of economic growth, innovation, relative political and economic stability, and expansion of wealth from 1982 to 2000 on the fiat monetary system and a world economy backed by the dollar.
· The Gold Standard can and has been manipulated/changed arbitrarily by governments. Therefore, a return to the Gold Standard will not necessarily avoid Armageddon because government and private market mischief will always be with us.
· The world economy is immensely complex, and a gold standard is inflexible and restrictive.
· The supply of gold is arbitrary and usually fixed, and thus is inherently deflationary. Deflation makes efficient trade difficult and periodically impossible.
· The supply of gold is not always fixed, as its use as currency stimulates the search for new sources. This search is not necessarily a productive use of our resources.
· Gold is actually no different from paper as a form of currency: it has no intrinsic value (aside from a very small number of industrial uses). The value we perceive from gold lies in its continued perception as a reserve currency, even to the extent that we choose to wear our wealth in jewelry.
· Predicting that the dollar will “eventually” collapse and then say “I told you so” when it does is like predicting that a meteor will eventually strike and wipe out life on earth.

I don’t believe it is practical to return to a gold standard. Likewise, I don’t think that Armageddon for the dollar necessarily follows from a credit crisis. Credit crises have hit every thirty to forty years or so for centuries, the gold standard notwithstanding.

Historical Bear Market Research

2009-03-12T07:04:00.000-07:00

I have spent a lot of time in the past few weeks researching various topics, but my most interesting finding is my 135 year review of the stock market. I examined both historical trends and past bear markets.

Bear Markets
You may have heard of the "4 bad bears" charts on dshort.com, here I will highlight "14 bad bears." There have been 14 major bear markets (including the current one) in the last 135 years - with an average decline of nearly 50%.

I used the Dow Jones Industrial Average to run my calculations, which is not as robust an index as the S&P 500. However, it has daily price history dating back to 1900, as the S&P 500 only dates back to 1961. There are several notable problems with the DJIA, two of them are:

1. The Dow Jones does not accurately capture the technology bust of 2000-2001, where the S&P 500 declined 44% and the Nasdaq declined 72%. The DJIA only declined 38%.
2. The DJIA removed IBM from the index in 1938. Had IBM remained in the index, the DJIA would be double the price level it is today.

The worst bear market was the 1929-1932 bear market, with a decline of 89%. The mildest bear market on the list was 1978, with a decline of 27%.

What's so interesting about these findings?
The most interesting thing about these findings is that in every previous case, except for 1932, the market recovered 100% of its original peak within 5 years - and most often with in 2-3 years - of bottoming. In the Great Depression, the market recovered 51% of the previous peak by 1937, 62% on an inflation-adjusted basis, and 100% of the previous peak when dividends are added back. Even the bear markets of the 1970's, when inflation and dividends are accounted for, regained at least 100% of their previous peaks within 5 years.

Thus, if history is any guide, we should return to 14,000 on the Dow and 1,400 on the S&P 500 by, at the latest, 2014 or 2015.

Other Interesting Findings
* On an inflaton-adjusted basis, this bear market has not yet surpassed 1974, although it is close.

* There are very clear trend lines in the pricing data. The trends shift every 15-20 years. There has never been a negative trend. We are at least half way through the current trend, which started in 1999-2000 and is most likely flat or nearly flat. I estimate that the trend value on the DJIA is in the $9,000 to $10,000 range.

* Historically, the variation around the trend lines has been limited 0.67x to 1.45x the trend, with the exception of 1929 and 1932 which were 3.2x and 0.34x the trend. The peaks and troughs tend to be the inverse of each other. The current bear market has, so far, conformed to that rule.

* We have been spoiled by the 18-year bull market from 1981-2000, where bear markets were mild due to a steeply upward slope in equities. Nevertheless, the peaks and troughs even the secular bull markets conformed to the same rules mentioned above.

Housing foreclosure study

2009-03-03T10:35:00.001-08:00

UVA put out a study on housing foreclosures (
http://www.virginia.edu/uvatoday/newsRelease.php?id=7838), and the empirical results are staggering (I got the reference from Carpe Diem).

They conclude that foreclosures and price declines are concentrated in four states and a handful of other counties (Chicago, Minneapolis, and Denver). Even within those states, foreclosure rates vary significantly by location.

They also note that the potential losses in on housing – if they decline to 2000 levels in all 50 states - is less than one-third of the $350 billion disbursed to banks to deal with mortgage-related losses. Thus most of the mortgage losses so far are related to derivatives and illiquidity.

"Damage to the balance sheets of large banks and AIG occurred not mainly from losses on foreclosed residential mortgages, but because of borrowing short-range to buy long-range derivatives and from selling credit default swaps insuring derivatives backed by mortgage payments," Lucy and Herlitz said.

"Weapons of Financial Mass Destruction" … (a quote from Warren Buffett)

This means that most loans carried on the books and in the MBS structure should be valued in excess of 90 cents on the dollar - even under an extreme scenario - but are valued as low as 20 cents due to a lack of a market. The fix then is to establish a market, hence the repeated attempts by the Treasury to do so.

Here are some quotes:

If all the listed foreclosures and preforeclosures became repossessions, then these value reductions would cost $95 billion in California, $10 billion in Florida, $5 billion in Nevada, and $4 billion in Arizona, a total of $114 billion (Table 7). This estimate overstates the crisis dimension of foreclosures. From 1997 through 2006 the average foreclosure rate was 0.42 percent of mortgage loans, about one-third of the 2008 rate (HUD 2008, 73). It had become the normal cost of being in the mortgage business. Consequently, the foreclosure crisis should be considered, at most, the number and rate of foreclosures above the previous decade’s norm.

An extreme perspective on pricing mortgage-backed toxic assets can be acquired by projecting 2008 foreclosure losses if housing prices decline to year 2000 ratios of housing values to family income. Calculating declines in the 34 states above the year 2000 national ratio of house values to family incomes (2.4) in 2007, the loss from lower house values would be about $143 billion. In all 50 states, the decline to year 2000 house values would be about $145 billion, with 87 percent in four states—California $95 billion (66 percent), Florida $18 billion (13 percent), Nevada $6.5 billion (5 percent), and Arizona $5.5 billion (4 percent) (Table 8). Declines of $1 billion or more also would occur in Illinois, New Jersey, New York, Massachusetts, Colorado, and Washington (Table 8).

Traditional banks and investment banks have incurred losses far in excess of these estimates. By May 2008, banks and insurance companies already had written down more than $300 billion in asset-backed losses (Ferguson 2008, 354). Nouriel Roubini, who apparently had the most extreme prediction in February 2009, foresaw mortgage-related lender losses far exceeding $1 trillion (Lohr 2009). Because $145 billion is less than the funds allocated to banks by January 2009 under the TARP (Troubled Assets Relief Program) of the U.S. Treasury, it would be, or would have been, possible to buy up all the toxic mortgages, or to refinance them at lower principal, lower interest rates, or longer terms, with bank funds or TARP funds, if they could be disentangled from MBSs.

These calculations indicate that massive private market failures have occurred. Banks and other lenders have claimed losses on their balance sheets far in excess of the actual reduction in value of the houses on which mortgages have been foreclosed. Moreover, the recorded losses are greater than the house value declines that would occur if the foreclosed properties declined in value to year 2000 levels. It is possible that price reductions to year 2000 levels will occur. But such large price declines can occur as a result of deep and prolonged recession, not because of an excess of supply occasioned by the foreclosures themselves which add to the backlog of houses for sale.

Thus, market failure has two components. The first is that the value of the underlying mortgages has not been disentangled from the MBSs, leading to excessive undervaluing of the MBSs. The second is that accounting rules, so-called “mark to market” requirements forced MBSs to be valued at what buyers would offer for them today, rather than based on the revenue stream that the underlying mortgages would provide.

An obstacle to formulating remedies for the national financial crisis that followed the foreclosure crisis has been difficulty in pricing and accessing so-called toxic assets. Assets are referred to as being toxic if they are worth substantially less than their original valuations by lenders or buyers of repackaged mortgages. As mortgages were purchased from lenders and bundled in MBSs (mortgage backed securities), which are various forms of securities paying a given interest rate, mortgages were separated from the original lender and reallocated in forms that were difficult to disentangle. MBSs limited ability of mortgage servicers to renegotiate mortgage terms with delinquent home owners at risk of foreclosure and repossession. Lacking a market for many bundled MBSs, their value was undetermined. If valued at zero, or some small fraction of their original value, these assets were toxic in the sense that they weighed heavily against the reserves banks are required to maintain against liabilities.

Evaluating the severity of the 2007 to 2009 financial crisis, one should remember that the traditional foreclosure start rate from 1997 through 2006 was 0.42 percent of mortgages. In estimating values of MBSs, a foreclosure start rate in this range should be considered normal for the lending business. MBSs with foreclosure rates above that level, as occurred in 2007 and 2008, should be valued in light of this normal range. This value is not zero, and it is not 20 cents on the dollar, except in highly unusual circumstances. As calculations in this study indicate, the cost of mortgage reductions through repossessions and resales in 2007 and 2008 was much less than losses acknowledged by banks and much less than the $700 billion in TARP funds. Establishing values of MBSs is a challenge, one which the U.S. Treasury is much better prepared to achieve than are private banks which must satisfy skeptical regulators administering the “mark to market” accounting rule.

Therefore, the 10 months’ supply prevailing in 2008 was inflated, because it reflected a lower sales rate, an increase in foreclosures, and persistence of opportunity sales prospects. Production of new housing in 2007 had returned to levels that prevailed from 1998 through 2002. This production level may be sustainable. But it is crucial that new housing is provided where demand is high. In 2008, too many foreclosed houses and other new houses for sale were located where demand was low relative to supply. Foreclosure trends described for 35 metropolitan areas in this study (Appendix 1) indicate a partial mismatch has occurred between where housing is available for sale and where households want to live. In most metropolitan areas, foreclosure rates were highest in a few outlying counties.

The Bailout, the Housing Credit, and The Band Bank Proposal

2009-02-09T06:05:00.000-08:00

There is a lot of news swirling around about the new president's plans, and I thought I would offer some concise observations about them. This is not comprehensive, as I have not studied the plans in detail (the details have not all been disclosed).

TARP
I watched a piece of "investigative journalism" last night ("watching" may have been a stretch - I was feeding my son a bottle and the TV was playing in the background). The piece was investigating what the banks have done with all of the TARP money given to them, and why they weren't lending it out. I thought I would clear it up for the journalists and the high powered Harvard law professor they interviewed:

1. The banks were not "given" the money; they were forced to sell preferred stock to the government, subject to mandatory repayment with interest. While we can debate whether that is a good investment for taxpayers, it was not a "gift."
2. Banks close to (or past) insolvency used the money to plug holes in their balance sheet. That is, they lost a bunch of money and were on the edge of failure, the TARP money was used as a cash buffer against those losses.
3. Banks that are solvent and sound probably lent the money out. Of the major banks receiving TARP money, I can think of only one or two in this category (JPM and WFC). Even those have gotten weaker.

Fiscal Stimulus:
I looked at the fiscal stimulus plan briefly a couple of weeks ago. In general, the debate over fiscal stimulus focuses on two things:

1. The value of the "multipliers". When the government spends money, the value of that money to the economy is some multiple of what is spent. Thus, if the multiplier is 2x, then for every dollar spent by the government, the impact on GDP is two dollars. Unfortunately, there is no agreement over the multipliers for fiscal spending and/or tax cuts - liberals think the multiplier for spending is high and the multiplier for tax cuts low, while conservatives think the opposite is true.

My opinion is that the multipliers vary considerably depending on how the money is spent as well as the economic context for the spending. A significant tax cut right now targeted at indebted households would have a much higher multiplier than one three years ago. Likewise, the multiplier for ethanol subsidies is probably highly negative (instead of creating GDP, it subtracts from GDP).

I'm not picky about how the money is spent right now, because anything that pumps cash into the economy is likely to have a positive multiplier, since I believe that the problem with the economy is that it is starved for cash.

2. The political process: the concern around any fiscal spending centers around a political process that is fraught with indirect corruption. Anytime you let Congress have its way with the taxpayer's purse, it is likely to blow most of it on a trip to Vegas, so to speak. Another word for this is "feeding the pig." This is the true cost of the bailout.

I feel that there are times when it is worthwhile to risk Congressional lagresse, but those times are few and far between.

Housing Credit
One proposal that has received a lot of attention is the $15,000 tax credit for the purchase of a home. It is sold as a bid to reverse the decline in housing prices by stimulating demand for homes. It has broad bipartisan support, despite the fact that many economists (liberal and conservative) oppose it.

I doubt it will do much for home prices, especially in areas where the inventory of homes is very high (California and Florida). At the margin it will stimulate demand, and inject cash directly into the housing market (where it is needed most). I suspect the impact will be felt the greatest in markets where inventory is not too high and prices have not declined significantly. It may have the benefit of improving housing turnover, which has gotten stuck as a result the credit crisis.

Thus, I'm not opposed to it; I just wouldn't expect miracles.

Bad Bank Proposal
The bank bailout should have the following goals:

1. Provide liquidity for loans and securities that have been impaired - setting a price for the "toxic assets". This one is the most difficult, because liquidity is a self-fulfilling prophesy - the reason we don't know what they are worth is because nobody is willing to price them.
2. Recapitalize and restructure the banks - many banks are insolvent because the value of their assets (the loans) is less then the value of their liabilities (deposits and bonds). Therefore, the banks need to be recapitalized and restructured by injecting cash directly into them. But, unfortunately we don't actually know the value of their assets until we solve #1.
3. Recapitalized and restructure the borrowers - the banks are insolvent because many of their borrowers are insolvent.

The bad bank proposal emphasizes #1, but is unclear about #2. #3 is a political football, but probably the most important.

That's my two cents.

Glimmers of Light in the Darkness

2009-02-06T06:17:00.001-08:00

The stream of economic news coming out these last few months has certainly been bleak. Will it ever stop? Are there any glimmers of light?

Actually there are. First, it's important to know that most of the published economic numbers are lagging indicators - indeed, often changes in the economy do not show up in direct measurements until months later.

For instance, the inventory numbers embedded in the GDP figure for December showed a rise in inventories. That despite the fact that inventories were down 10% to 30% for many retailers and manufacturers. Why the discrepency? Aside from the fact that early GDP releases involve a number of guestimates by government statisticians, commodity inventories are still stacking up as producers are still getting paid inflated prices to produce, and the measured inventories are still priced at the inflated prices. It's also likely that the inventories of commodities was vastly understated last summer, when prices peaked, and now are magically showing up in the numbers as holders dump product on the market (through forced and/or panic selling).

Since I follow certain companies very closely, are are a few glimmers of light coming from the front lines:

* Mortgage applications are so high that lenders are backlogged up to 60 days (they fired their mortage underwriters last year, so they are now understaffed). Most of these applications are for refinancings, but that's not necessarily a bad thing either. Buyer interest in the house we are trying to sell was the higher in January than it was at the (local market) peak.
* Inventories are extremely lean in many parts of the food chain as companies have taken inventories down 20, 30, and 40% on a 5-10% drop in demand. Early signs of shortages have already cropped up, suggesting that in certain sectors we are setting the stage for a sharp inventory snap-back.
* Janaury retail sales, as bleak as it was, defied predictions of an inventory blowout. Many retailers beat expectations, something they weren't doing in November and December. Profit margins have started or are at a minimum set to start improving.

While the fundamental economic problems remain unsolved, it appears that we are setting the stage for an inventory snap-back. We had originally believed wouldn't come until the 3rd quarter, but there appears to be indications that it might come sooner.

Of course, if it comes, that raises the risk of a double-dip recession - growth improves in the 2nd half because the economy overshot in the first half, but the underlying trends are still bad, causing the economy to slide again in 2010.

Update on Ethanol

2009-02-04T12:35:00.000-08:00

It seems that the ethanol problem is abating. In one of my earliest posts, I lamented the crime that the ethanol subsidies were perpertrating on the world - the US was subsidizing the conversion of corn into fuel. This had the net result of removing a large amount of arable land from the food chain, consumed energy in the conversion process, had dubious value as an actual fuel (studies indicated that gas mileage went down for cars burning fuel with ethanol mixed in), and drove up the price of food around the world.

Recent articles have indicated that the collapse in the price of fuel has made the production of ethanol unprofitable, even with the massive subsidies.

From the Kansas City Star: Instead of making ethanol, let's make a profit

From the Rolling Stone Magazine in 2007: The Ethanol Scam: One of America's Biggest Political Boondoggles

The Chickens are Guarding the Coop

2009-02-04T06:04:00.000-08:00

Markopolos testimony before Congress on the Madroff fraud:

Markopolos Testimony

Highly sobering.

Link on the Bailout

2009-01-14T15:02:00.000-08:00

This is a good perspective: Is the BailoutWorking? by Steven Pearlstein, Washington Post

.

2009 Economic Forecast

2009-01-12T08:36:00.000-08:00

My Crystal Ball

Economic forecasting is notoriously unreliable, but that never stopped anyone before. The primary problem with most economic forecasting is the precision assumed within the forecasts and the tendency to exclude exogenous and/or unexpected factors. Most economists are paid to make specific forecasts, meaning precise forecasts, and exogenous/unexpected factors are by definition impossible to predict. Therefore, they give their customers, employers, and the public what they want: precise forecasts that exclude the impact of unforeseen events.

As an investor, I am forced to make investments whose value will be determined in the future. I am not, however, forced to make decisions based on precise forecasts, even though such decisions would be made easier. This forecast is the decision framework I am currently operating under.

I do not base my understanding of the future on precise econometric models (they are just as unreliable as rule of thumb forecasts), and I try not to ignore the impact of exogenous events. First, I’ll review the available literature on the subject:

· The consensus of the economics profession is that the current recession will bottom sometime in the 2nd and 3rd quarter in 2009, with unemployment peaking late 2009 or early 2010. Generally speaking, that means a three to five percent total decline in GDP and eight to ten percent unemployment. Most assume that the recovery will be slow and uneven.

· Some more pessimistic scenarios push out the bottom and recovery by six months.

· Others predict similar levels of unemployment accompanied by rising inflation

· The optimists predict a strong recovery by the second half of 2009, possibly accompanied by inflation

In my opinion, they are all right and wrong. Each of those scenarios is possible. The outcome is more of a distribution of several scenarios with probabilities attached. The framework outlined below groups the scenarios into three broad categories.

Decision Framework:
· Snap-Back (35% probability): strong recovery by second half of 2009 as the monetary influx rejuvenates the economy and the fiscal spending restores confidence. The consumer balance sheet repairs itself more rapidly than expected. The Fed is forced to pull liquidity out of the system to curtail inflation, dampening the rate of recovery. Unemployment peaks closer to 8%, and GDP falls by less than 3% in quarters 4 through 2.
o Housing prices bottom and start to recover in the first half of 2009
o Risk of inflation in 2010 and 2011, forcing Fed to withdraw liquidity.
§ Fed overshoots, sending economy back into recession in late 2010
§ Fed undershoots, sending inflation above 5%, forcing a deeper recession in 2011-2012

· Bad Recession (50% probability): work-outs continue throughout 2009, but the economy bottoms some-time in 2009. The recovery is slow and consumer spending does not return to previous levels. However, investment spending here and overseas rejuvenates employment and exports rise fueled by a recovery in Asia. Unemployment peaks at around 10%, GDP falls around 5% in quarters 4 through 3 before leveling off, beginning growth sometime in 2010.
o GM and Chrysler go bankrupt, Ford teeters
o Additional bank bail-outs required, especially for Citigroup and possibly Bank of America. The Home Loan Banks require bail-outs. This could come in the form of TARP-2 or massive debt guarantees as have already been provided to Citigroup and AIG.
o Housing prices bottom in 2nd half of 2009, start to recover in 2010 – with California recovering first, Florida second, and a decline in New York and possibly elsewhere extending into 2010.
o States of California, Florida, and Alabama, along with the City of New York require federal funds to avoid running out of money

· Depression: (15% probability): monetary and fiscal policies are insufficient to the task, or an exogenous event sinks the economy into a depression. While the likelihood of a severe depression is small, it cannot be ruled out. There is really a continuum from the recessionary scenario outlined above and the worst case scenario outlined below:
o GDP falls by more than 10%; unemployment peaks at over 15%; a quarter to a third of US households are insolvent
o Oil prices go under $20 per barrel. The S&P sinks to $500.
o All three car companies go bankrupt and only one emerges
o Real estate prices decline across the country, especially in high-priced markets
o TARP-2 required for the banking system, as defaults climb. GE requires a bailout.
o Several major retailers go bankrupt, including Macy’s
o Many of the states need a Federal bailout.
o The Federal debt balloons to over 100% of GDP from a current 63% of GDP.
o The Euro collapses, as Italy and Eastern Europe go bankrupt. Japan and the UK teeter.
o China descends into chaos due to social unrest. India and Pakistan go to war. War erupts in the Middle East. Russia and the Ukraine collapse and disintegrate, with war erupting in some of the farther flung provinces.

In the above scenarios, I have mentioned the possibility of exogenous events. These are events that cannot be predicted, but will have a negative impact on the economy. As a result, the better scenario has a lower probability and the worse scenarios have higher probabilities than would otherwise be indicated based on the data. An exogenous event is an event outside the realm of prediction: such as major war, a natural disaster (i.e., global warming in the form of a sudden shift in the oceanic currents), or another sudden shift in investor and consumer sentiment.

An example of an exogenous event was the sudden shift in consumer sentiment in October that cut aggregate demand in the US economy by roughly 5% over the course of one single day (October 16). This created a huge backdraft throughout the supply chain as companies were forced to not only defer orders but liquidate existing inventories in the system. Thus, factories have idled while businesses try to "right-size" their inventories to match the current demand level.

As long as we don't get another step down in aggregate demand (we have not had one since October 16, nor have we had any indications of a resumption of demand), the inventory liquidation should be completed by the end of 2Q.

Economics of Deflation - Updated Draft

2009-01-08T07:59:00.000-08:00

Introduction
The world has changed, in ways both profound and subtle. Each day, we see news reports of more layoffs, declining production, lower or negative profits, and more bailouts. Comparisons with the Great Depression are proliferating. How do we make sense of these events, as unprecedented as they are?

As we navigate these uncharted waters, we have prepared some of our thoughts and a summary of our research about the current state of affairs. The good news is that we believe that comparisons to the Great Depression are greatly exaggerated, and that policymakers have taken the needed steps to avoid a similar fate. The bad news is that the economy is nevertheless in bad shape, and the waters as treacherous as any we have seen in our lifetime.

Deflation
Until the middle of 2008, the primary concern in the financial community and the general media was inflation. This was logical because the primary indicators of inflation, commodity prices, were rising rapidly. Oil prices had risen to a level of $147 from a low of under $10 a decade earlier, and we had seen similar rises in a host of other commodities. The value of the dollar was falling relative to other currencies.

So were we facing inflation? In retrospect, it is now clear that we weren’t. In a newsletter that we were in the process of writing at the time, however, we argued that inflation was not a risk, and that, indeed, the primary risk was actually deflation. Deflation is the opposite of inflation – a general decline in prices and wages. Unfortunately, we were right, but much more so than we realized.

In September and October the world economy was hit by a severe deflationary shock, and economic activity and the stock market subsequently took a nosedive. So, we rolled up our sleeves and did more research. The media, of course, went into a frenzy describing the bad news – and generally doing a very poor job.

So what is deflation? The US has not experienced sustained deflation since the Great Depression, though it experienced it fairly often in the 19th and early 20th centuries. In addition, deflation was a fairly common occurrence throughout the world prior to World War II. Since WWII, deflation was thought to be banished and as a result there is scant discussion of it in college economics courses. Inflation, the scourge of the last four decades of the 20th Century, has been the source of most economics research.

There are two types of deflation: real and monetary. Real deflation results from improvements in productivity, derived from technological change, advances in industry organization and practices, and improvements in asset utilization. This is good deflation – mostly good, since some companies and industries necessarily suffer when competitors improve and technology changes. It is good because real incomes rise, profits go up, and the standard of life improves.

Monetary deflation, however, is a different animal, and is usually very bad.

Monetary deflation is similar to monetary inflation, but instead is caused by a decline in the total outstanding balance of currency, which in the case of the US is dollars. Think of dollars like any other commodity – the price of one US Dollar depends on supply and demand for US dollars. Thus, just as a loaf of bread is priced in dollars, a dollar is priced in terms of the number of loafs of bread it will buy. In aggregate, for all products and services offered in the US economy, the price of the dollar is expressed in terms of inflation. Inflation is, in turn, a function of the number of US dollars in circulation and the level of demand for those dollars.

The outstanding balance of currency – the number of US dollars in circulation – consists of cash, deposits at banks, deposit-like instruments, and loans and debt securities outstanding. The Federal Reserve is the institution responsible for managing the first three and a small portion of the fourth, which is defined as the monetary base. The financial system – banks and bank-like institutions – multiplies that base by extending loans and debt to expand the overall monetary base.

In the past prior to World War II, monetary deflation was often intentional – the central bankers often wanted to reverse inflation that had built up so they revalued the money supply and prices downward. In the pre-World War II era, money was usually backed by gold at a fixed ratio and exchange rates were fixed. However, during times of war, governments would go off of the gold standard and inflate the economy. At the end of the war, they would attempt to go back onto the gold standard, usually at prewar ratios, resulting in deflation.

In other circumstances, deflation was caused by a credit boom that led to excess capacity in one or more industries, which in turn led to a bust and a resulting collapse in credit. Often, the bust was caused by crop failure. Since money was tied to the gold standard, central bankers were powerless to prevent either the boom or the bust. This type of deflation can be especially severe, because it can be very sudden and a collapse of credit results in a collapse of the multiplier effect on money – credit is often cut off, with the balance of loans and debt contracting rapidly.

Sometimes capital flight was the culprit. In the past, capital flight was when money in the form of gold left the country to be deposited elsewhere, resulting in a decline in the money stock in one country and an increase in another. This would result in a balance of payments imbalance – current account deficit combined with a capital account surplus. Thus, the monetary base in one country would decline while the base in another would increase, resulting in deflation in one country and inflation in another. Today, since we are not on the gold standard, the deflationary impact of an imbalance of the trade and capital accounts is messier, though just as profound.

Most often, all three were to some degree the combined culprit. A slow deflation can lead to a credit boom, as individuals and businesses are not aware of the deflation, driving down interest rates and borrowing money to finance spending. An intentional deflation can lead to capital flight, which can be slow or fast, resulting in a credit boom elsewhere as capital is injected into another country’s financial system.

There can be many scenarios that lead to deflation, but the reason it is rare in modern times is because central bankers have every incentive and, without gold, have an infinite war chest with which to battle it. More on that later. However, we have a series of live experiments from the past in which we can study the causes and effects of deflation.

The Effects of Deflation
We know from both economic theory and empirical studies that wages and prices are “sticky”, that is, they don’t change quickly. In fact, they resist downward adjustment much more rigorously than upward adjustment. In addition, debt balances don’t adjust downward, and neither do cash balances. However, if there is a reduction in the volume of dollars chasing goods, services, and assets, something has to give.

In a credit crisis, banks that had been lending freely will often see the value of the loans impaired. This is the result of excess capacity in one or two areas of the economy (which today is real estate), and the inability of debtors to pay their debts. Banks then repossess and sell the assets. Unfortunately, when there is excess capacity, the assets are usually worth a lot less than when they were purchased. With loans impaired, the banks are unable to continue lending, and therefore reduce the availability of money in the system.

With a balance of payments problem, capital flows out of one country into another. Sometimes this is fast, as is the case of Britain after World War I. Sometimes it is slow. If the money stock leaves the country, and it is not replaced quickly enough, then that puts deflationary pressure on the country in question.

When deflation sets in, prices resist decline. This results in reduced demand for products and services. The reduced demand creates an inventory buildup, which reduces cash holdings at businesses. Businesses then start liquidating both assets and inventory, which is fine if they do it one at a time. However, usually everybody liquidates at once. When this happens, prices plunge.

However, businesses have fixed costs: wages, factories, and debt are costs that are sticky. Thus, if prices plunge, margins collapse and cash drains out of the business. As a result, businesses move quickly to cut costs – laying off workers, closing factories, and if all else fails, declaring bankruptcy.

With employment falling, pressure begins to build on wages. However, wages typically do not fall, because deflation is usually seen as temporary and workers typically have significant political clout. This accelerates the process of rising unemployment and bankruptcies.

With rising unemployment, demand falls further, and the cycle repeats itself. Furthermore, as assets are liquidated to pay off debts, prices descend further defeating the purpose of paying off the debt, and debt actually increases relative to the value of the assets. This is referred to the debt-deflation spiral.

When does it end? It ends when shortages arise due to the destruction of industry, and the money stock hits a bottom. The magnitude of the fall depends on the debt and leverage multiplier. In modern times, that multiplier is quite large.

Thus, debt and leverage are the great magnifiers of deflation, and that can invariably leads to depression if intervention does not occur.

Can it be prevented? Fortunately, yes, though not without avoiding a recession. Generally, the initial onset cannot be prevented due to the excesses built up that must be reversed. However, the multiplier effect can be muted by flooding the economic system with liquidity – i.e., putting cash in the hands of consumers and businesses, cash that is printed by the central bank. This is not possible in a gold standard currency regime, but it is possible in a fiat money regime like what we have today.

The preventative for depression is government intervention, and is one of the few examples of where government intervention is absolutely necessary. Only the government has the capacity to re-inflate the economy and take debt off of the hands of individuals and businesses without causing prices to crash.

The Panic of 2007 – 2008
Why do we have a deflationary shock in the modern era when we have the capacity to print money at will?

We believe that we have had multiple sources of modest real deflation over the last 30 years. Technological advancement, globalization, and improvements in industrial organization all have driven down the cost of production and improved productivity and the quality of life. These sources of deflation are not necessarily bad, since they are slow and measured, and generally provide improvements to our economic life.

Another source of deflation, one less positive but just as pervasive, has been the demographic changes occurring in all developed countries. We are all familiar with the baby boom that occurred here in the US. In the US, as the baby boom ages, it would result in a decline in population if immigration did not occur. Even with immigration, population growth in the US has slowed. Declining population has been occurring in Japan for over a decade, and has begun to occur in Western Europe. China, too, has a large and more pronounced population bubble, but it is younger and thus population decline is twenty years into the future.

A declining population is deflationary and contractionary: fewer people to demand goods and services and fewer people to produce them. In industries where the costs are variable, that wouldn’t be as big a problem. However, costs are often fixed, especially debt. This problem is most obvious in the case of real estate: it is easy to increase the supply of housing, but not as easy to reduce the supply of housing.

While the effect is slow and largely hidden, we have seen this effect before. Japan is the most obvious example, but the Northeastern US and the Upper Midwest have all experienced declining population at some point in the last 30 years, and in each case it has been accompanied by housing price declines and economic stagnation. Of course, the economic stagnation often causes the population declines through migration, thus creating a vicious cycle.

However, in 1998 an event variously called the “Asian Contagion” occurred. At the time, there was a sudden reversal of fortune for the “Asian Tigers”, where countries that had borrowed extensively in dollar-denominated debt and misallocated those funds suddenly found themselves with severe excess capacity. In many cases high inflation accompanied the crisis, which was combined with foreign debt obligations inflating with the currency and sudden capital flight. The result was a long severe recession.

As is usually the case, most policy makers are busy fighting the last war and learning the wrong lessons from past crisis. In Asia, central banks incorrectly concluded that the debt crisis was caused by insufficient monetary liquidity, a conclusion borne out of the fact that they were unable to defend their currencies against collapse. The Asian defaults were actually caused by an expansion of dollar-denominated debt combined with domestic inflationary policies and misallocation of capital. This led to excess capacity combined with rampant inflation against falling real asset prices. Since the debt was dollar-denominated, it inflated with the currency, while the purchasing power of domestic businesses and individuals collapsed.

The right lesson to be learned from that crisis would be to pursue stable prices without excessive debt-financed expansion. However, the lesson actually learned was that the central banks needed ample dollar reserves to defend against an attack on the currency. To accumulate those reserves and provide a subsidy to domestic export industries, the countries held their exchange rates at an artificially low rate, creating a balance of payment imbalance, causing reserves to flow into Asia and out of the West. The reserves were then reinvested in US debt instruments. Thus, the central banks accumulated US Treasuries and Fannie Mae securities. This flooded the West with low priced goods (modestly deflationary) and drove down interest rates on dollar-denominated debt (initially inflationary, until it goes bust).

Specifically, China played a key role in exasperating the credit expansion in the US and Europe. China legally required excess private saving to be invested in a government-run fund, so that the government could keep the currency cheap and promote exports. The excess dollar reserves created from sales to the US were reinvested in US Treasuries and mortgage backed securities that helped finance both the real estate bubble and the Iraq War. China got what it wanted (more exports to fuel economic expansion), US consumers got what they wanted (lower prices that raised their standard of living), the Bush Administration got what it wanted (cheaper debt to finance a war without raising taxes), Congress got what it wanted (cheaply financed housing for otherwise unqualified homeowners) and local governments got what they wanted (more property taxes to fuel larger government largesse). Normally such a huge credit expansion would create inflation that would force the Fed to raise rates. However, cheap goods from China and Asia offset most of the potential consumer inflation. Instead of Chinese savings flowing into consumer prices, it flowed into American real estate and other asset classes (commodities, hedge funds, private equity LBOs, etc.).

The net result was that the deflationary effect of a strong dollar was offset by the inflationary effect of excessive credit and low interest rates. Capital flowed out of the real economy in the US, effectively reallocating it to the financial sector, resulting in the massive expansion of credit in the US. A similar effect was occurring in Western Europe, though with slightly different allocations.

Fast forward to 2002, and the US was facing the potential for modest deflation after a collapse of the Nasdaq Bubble (which itself was partially fueled by the same imbalances). The Federal Reserve, rightly fearing such an episode, drove down interest rates to 1% and kept them there. This added gasoline to the fire: igniting a massive credit bubble, mostly funneled into real estate, though later it fed into commodities. Here, the Fed attacked the right problem with the wrong tool, in our opinion. In an environment already primed for credit expansion, lowering the cost of credit was not the best move.

This Fed’s decision was rooted in a 30-year philosophy of interest rate targeting as a means of managing the money supply, and an exclusive focus on cost inflation (the CPI) instead of broader measures of money growth to include asset prices. The Fed did not act sooner to prevent the real estate bubble because it was focused on using the money supply (as defined by the M quantities) to prevent inflation in the CPI, and was not concerned with asset inflation. The FRB assumed that any asset bubble would be self-correcting because markets are by definition “efficient” (according to most academic economists). They did not see a relationship between these bubbles and the overall economy. The bursting of the Internet bubble and its limited effect on the economy tended to confirm this thesis. Bernanke was one of the few to see the potential dangers of the Chinese “excess savings”, but either couldn’t or didn’t act soon enough to prevent many of our current problems.

The truth is that the Fed has a multitude of tools with which to manage the money supply. It can buy Treasuries (which it has been doing for a long time), it can manage lending by managing reserve requirements at banks (something it hasn’t done since the 1950’s), or it can lend directly to banks (which it just started doing in a big way recently). In addition, it can buy any number of securities, such a money market debt, corporate debt, stocks, bonds, futures, derivates, etc. It can intervene directly in currency markets by buying and selling dollars. In theory, it can even buy houses, though this presents logistical problems. This can be done by issuing Treasuries (called sterilized intervention), or printing money (called unsterilized intervention).

However, it is also important to point out that the Federal Reserve is limited in its scope – it does not have global reach. Debt markets evolved from multiple systems that work within the control of central banks to a global shadow system that easily allows arbitrage between markets. A good example is the Japanese carry trade that allowed many asset managers to leverage up by borrowing in cheap Yen and convert to other currencies, using derivatives to control currency risk. This allowed asset managers to take an end run around Central Bank constraints embedded in the conventional monetary base and banking system leverage restrictions. Thus, much of the excessive speculation was being fueled through securitized assets sponsored by investment banks and non-bank financial institutions that could leverage 20 or 30 to one. Effective unmeasured money “velocity” (the speed at which currency circulates) skyrocketed while the velocity as measured by Central Banks was more subdued. Thus, neither Central Banks nor the investment community saw the degree of leverage embedded in the system as a whole. Those that did see the leverage assumed that it was restricted to certain asset classes and that diversification among asset classes would offset most of the risk. The leverage was seen as a local rather than as a global problem.

In 2002, the Fed probably should have used other means to offset deflation. Primarily, in a deflationary environment, the remedy is to put printed cash in the hands of individuals and businesses. The Fed tried to do this by lowering interest rates and expanding lending. However, the Fed probably should have directed it to a basket of securities, excluding ones purchased by the Asian Central Banks. Combined with brakes on lending, we could have had a sustainable recovery. But, then, hindsight is always 20-20.

Therefore we had a double dose of central bank intervention: the Federal Reserve and the Asian Central Banks acted independently but not cooperatively to drive down interest rates in the US, creating a massive monetary stimulus. Combined with new, creative, and hidden sources of leverage (securitized loans, derivatives, off-balance sheet investment vehicles, private equity, and hedge funds), we had a massive credit bubble which funneled capital into residential real estate, mostly in Florida, California, and New York where, due to local tax and zoning laws, prices are more volatile and periodic speculative profits therefore more attainable.

A global financial juggernaut was accelerating blindly towards its day of judgment.

A Classic Banking Panic
Thus, we had the ingredients for a modern bank panic. Unfortunately, it was masked by a combination of hubris and a limited monetary philosophy. A combination of rising interest rates and the laws of gravity punctured the real estate bubble, causing prices to fall precipitously. Deflation in a heavily leveraged sector such as real estate is not a good thing. While real estate bubbles and busts are relatively common, this one dwarfed any that had preceded it and was global in scale. With prices declining but loan balances remaining fixed, the only thing standing in the way of a crisis was default rates.

Mortgage defaults traditionally depend on two things: the price of the house relative to the mortgage, and the ability of the household to pay the monthly payment. The first domino started falling in late 2006. Unfortunately, as with any credit bubble, lending standards had been relaxed, and mortgages were extended to households and speculators with limited ability to pay and limited money down. Thus, rising interest rates and a softening economy led to a snowball effect of defaults.

The snowball gathered as the debt-deflation spiral accelerated. Until September, the problem had been largely contained to the housing, financial, and retail sectors. But September was an inflection point.

Another critical element in any economy, but especially in the banking and financial system, is the element of confidence. If people believe the future is good, they are less likely to save and more likely to borrow. Likewise, if the future looks bleak, people will save more, spend less, and borrow less. Confidence represents people’s willingness to take risks and conduct business, and it includes people’s willingness to predict the future. As long as those perceptions don’t shift suddenly, the system remains in balance.

In September, a rapid succession of events led to a sea change in confidence. Starting with the Lehman bankruptcy, investors, not wanting to be caught by the next domino, fled the financial sector to safe haven investments. Thus, banks and financial companies suddenly found their primary costs – the cost of money – skyrocketing. The weakest companies and the ones with the most exposure were the hardest hit – AIG, Merrill Lynch, and Wachovia – and all three experienced some kind of failure. The crisis exploded onto the national stage with the congressional debate over a bailout and a stock market collapse.

Everybody changed their behavior all at once. Businesses immediately drew down lines of credit to conserve liquidity at the same time banks were unable to obtain financing to provide the lines of credit. Consumers, seeing their investments in stocks and real estate halved and realizing that the future was now much more uncertain, slashed spending and began liquidating assets to raise cash. Businesses, anticipating a slowdown, began liquidating inventories, slashing spending, and laying off employees in a bid to conserve cash.

The race to cash was ignited – the key ingredient to a global deflationary spiral and a global financial meltdown.

Zeit Geist
In college, I had a history professor that wrote about an idea he called Zeit Geist, after the German phrase loosely translated, “The Spirit of the Times.” His point was that history is inherently unpredictable, and that change typically occurs suddenly and violently, instead of in the way we desire – measured and predictable. (He spent the entire semester talking about this concept instead of the listed topic of the course – Medieval History.) Both then and now I found the concept extremely salient. His primary example at the time was the fall of the Berlin Wall and the collapse of the Soviet Union.

The reason this is true is because of two interchangeable factors: the world is extremely complex with the behavior of entire populations unpredictable, and we humans suffer from a tendency to reduce the complex into simple narratives that are as easy to understand as they are wrong. We suffer from the assumption that the world is inherently rational – and, of course, we like to define what is rational. And we suffer from the tendency to adopt the opinions of other experts, even if we ourselves are experts. The media, of course, reinforces this behavior.

This is not to say that problems can’t be identified – the subprime crisis and real estate crash was predicted by many. However, an extremely trivial number of experts (indeed mostly by only those that had access to inside or privileged information) predicted the October crash. Not that the Armageddon predictions did not exist, but there were no more than usual, and no more coherent than usual. As always, the media is now highlighting the ones that made the right call. Most experts, however, were as shocked by it as the rest of us.

For example, the prevailing narrative in the media and in the investment community in first nine months of 2008 was accelerating inflation with oil prices skyrocketing due to dwindling supplies. $200 oil was the prediction in June, with some numbers even higher. In fact, many of the experts predicting Armageddon were doing so via an inflationary spiral and advocating investment in commodities, including oil. However, the air came out of the oil bubble in record time, with a peak-to-trough return of -75% (so far).

We (as well as many other equity managers) underestimated the depth of this bear market. We believe that we missed this because we were focused on stocks, which were reasonably priced based on estimated future earnings for most of this year, rather than the bigger picture. Because we were not involved in commodities, private equity, and direct real estate investments, we failed to realize the magnitude of the leverage. Indeed, most of this leverage was unreported and in many cases indirect. We—like many others—took it for granted that the money markets would be open every day and that solid companies (like GE) would be able to roll over their short-term debt without problem.

The sudden and cataclysmic loss of confidence in all financial markets was caused by two salient events. The first was the seize-up of the money market and the collapse of securitized loan market (securitized mortgages essentially dried up) in July-August 2007. The Fed was able to use its liquidity to quickly deal with this first crisis, but buyers of securitized assets were spooked and never fully returned to purchasing securitized instruments. Thus a major source of financing was lost and the velocity of money began to decline, causing a credit contraction, which was partly offset by continual Fed intervention and the reduction of interest rates. Those that could not refinance loans began selling assets, resulting in an asset deflation. This continued through September of this year with several close calls for a collapse, as major counterparties (mostly investment banks such as Bear Stearns) either failed or teetered on the brink.

However, the second major shock was the demise of Lehman Brothers in September. This caused asset managers to lose all faith in counterparties. The money market evaporated completely for several weeks and only government-guaranteed money instruments have induced institutional investors to take risk in commercial paper or asset backed securities. Lehman’s demise also caused a tidal wave in the banking system as many smaller banks had preferred shares in the company. Overnight they saw their balance sheet contract.

Looking Forward
Despite the fact that predictions are inherently unreliable, we are forced to make them. We make them with the understanding that we might be wrong and that we do our best to mitigate our errors.

We believe that the path out of the current crisis lies through Washington DC. Policy-makers, especially the Federal Reserve, need to pump cash into the economy, including pumping cash into the banks.

* The regulated banking system needs cash. Traditional banks are regulated by the FDIC and the Federal Reserve, and operate to access sources of cash (deposits, commercial paper, bonds, and securitization, along with the Fed’s discount window) and lend that cash out to businesses and individuals. If a bank runs out of cash, either through defaults on loans or having its access to cash cut off, it will fail. October saw a modern day bank run, except this time by investors in commercial paper, bonds, and securitized loans. Fortunately, the Fed and the Treasury responded by opening the discount window, buying commercial paper, mortgage securities, and ultimately preferred securities issued by the banks.

* The non-regulated (“shadow”) banking system needs cash. Shadow banks, like Fannie Mae, Morgan Stanley, Lehman Brothers, Goldman Sachs, and General Electric operate much like traditional banks, except they don’t have access to FDIC deposits or the discount window, and they operate with fewer regulations regarding capital adequacy. They also experienced a bank run in October by investors. The Fed’s response here was also aggressive: buying commercial paper and securitized loans and allowing several companies to convert to traditional bank holding companies, stabilizing the situation.

* The Fed is also injecting cash into other lending companies attempting to support auto loans, credit card lending, and commercial lending.

* The government should provide fee-based catastrophic re-insurance to the financial system, including to banks, financial service companies, and insurance companies. FDIC is a limited example of this, as is the ad hoc guarantees provided in the last several months to Citigroup, JP Morgan, Fannie Mae, and Freddie Mac. We all know these companies are too big to fail anyway, providing such insurance would shrink risk premiums and reduce uncertainty, and could be applied evenly. The fee is just an acknowledgement that such insurance isn’t free. A Stanford economist has proposed this idea.

* Provide inflationary support for prices by pumping liquidity into the general economy. The Fed’s primary avenue here has been driving down interest rates on both Treasuries and securitized mortgages. A credit bubble like the one ignited in 2002 is unlikely, due to the fact that lending is currently impaired. However it will provide support for existing loans and underlying assets (principally houses) where the underlying debtor is still solvent.

* Provide inflationary support for asset values, principally those being liquidated. This is more difficult to accomplish, given that physical assets don’t lend themselves well to government ownership. However, it can be accomplished indirectly by the purchase of securities and by passing cash through fiscal stimulus to businesses and individuals. The quickest fiscal stimulus is a tax cut combined with a reduction/rebate of prior year taxes. This could be sterilized (though the issue of Treasury bonds) or unsterilized (by printing money). Ironically, the much-maligned tax rebate in May of 2008 may have delayed the onset of the liquidity crisis, even though it was relatively small and non-recurring.

Generally speaking, all of these actions have been implemented or (in the case of fiscal stimulus) contemplated. The question is, has it been enough? Most of the indicators are that more needs to be done.

Our position is that the Federal Reserve and the European Central Bank both understand clearly the danger we face, but I am more concerned about Congress and the public. Congressional leaders are not well versed in economics, and face considerable political pressure to “punish” the perceived evildoers – usually corporate bad guys – not “bail” them out. Unfortunately, if we try to educate the public about the danger, we are more likely to scare the hell out of it without actually achieving a degree of understanding, which could prove even more costly to the economy.

The dance of the last several months between the Fed, the Treasury, and Congress is that the first two have acted with implicit approval of Congress, but without explicit approval or legal cover. Thus, Congressional leaders take few political risks while enjoying the benefits of the aversion of the crisis and even economic recovery when the new regime takes power in January. As the crisis over the TARP legislation proved in September, public debate over such arcane and complex financial concepts can prove costly – to Congress’s political clout, to the taxpayer, and to the markets.

However, we believe the risk of a severe depression is small – we have the tools and the willpower to avoid it. Furthermore, the Obama administration seems to understand most of what needs to be done. The risk lies more in how deep the fall goes, how quickly the situation will stabilize and recover, how much damage will be incurred in the meantime, and how much time and money will be wasted on distractions.

However, the recovery will be unpredictable. It is not likely to look like any we have experienced in recent memory. It could be slow, it could be uneven, and we could even have a double-dip recession. It is not likely to be financed with debt. Investors, businesses, and consumers will probably be slow to take risks, quick to raise cash. However, some sectors will rebound quickly, while others will not recover.

Is Inflation Still a Risk?
We believe that inflation is not as big a problem as many are predicting. Yes, the monetary base has expanded tremendously, but this has not prevented a contraction of credit as velocity has collapsed. It is always possible that velocity could quickly rebound and create a new credit bubble, but this is unlikely for the following reasons:

* Major money managers have been burned twice by ABS and commercial paper problems and will be slow to return.

* Banks have been burned by real estate declines and will be extra conservative in their reserves—because they fear further declines that would force them to sell assets.

* A deflationary mindset has overwhelmed the world. Why make a purchase today, if the price will be less tomorrow? Also, if one believes that the future is bleak, then one is tempted to hoard cash.

* Because of the conservatism that will remain in the banking system, and continued employment declines even when the economy recovers, economic recovery will be slow and gradual. We are now in a global economy, but national economies are not all in sync. The US will be the first to recover because most nations depend on exports to the US to drive economic growth.

* It will take time for legislators around the world to establish new rules for the financial markets. In the meantime institutions will tend to remain conservative to make sure that they are not hurt by the new rules.

* The Fed could quickly reduce its balance sheet by selling assets as the credit markets improve. If inflation was really bad, they could easily kill credit expansion by temporarily raising reserve requirements. Some inflation is likely because the Fed will error on the side of too much credit (inflation) rather than too little (deflation). But this inflation is unlikely to exceed 3-4% before the Fed intervenes to prevent a future bubble.

Rebuttals of Prevailing Media Narratives
Simultaneous Inflation and Depression, and whether the Fed has run out of ammunition

The most common narrative I see circulating in the news media and among “experts” is the idea that the Fed’s actions won’t work and are highly inflationary. They base this on the idea that banks won’t lend, and that lending is necessary to restart the economy. But the Fed is printing money which “always” leads to inflation. Generally speaking, we believe this argument is confusing several interrelated ideas in contradictory ways.

Basically, the problem we are facing is debt-induced deflation. Since most of our debt is denominated in our local currency (unlike the Asian crisis in 1998), when prices go down, the real value of debt goes up. Ironically, if we had issued debt in another, non-deflating currency, we would be in less trouble. Thus, consumers face rising real debt values in the face of falling asset prices and falling wages. Therefore, if the Fed’s action doesn’t work, it won’t lead to inflation, instead deflation will set in. If the banks hoard the cash and refuse to lend, then they will sit on the cash, and the cash won’t circulate. Non-circulating cash is the equivalent to non-existent cash, and doesn’t cause inflation.

But banks are in the business to make money, and sitting on cash earning zero percent doesn’t make any money. They too have bills to pay.

The idea that the Fed has run out of ammunition reflects a lack of understanding of the power of the printing press. Interest rates are simply a tool of the Fed – they are one barrel in which the Fed uses to shoot bullets, they are not the bullets themselves. The bullets are cash.

Printing Money Will Cause the Dollar to Crash
Printing way too much money will certainly cause the dollar to crash, as the value of US cash holdings will depreciate. But that will only occur if inflation results, and if inflation results, then the specter of deflation will have been defeated.

One scenario is that investors could sell dollars issued by the Fed and buy foreign currencies, putting downward pressure on the dollar. That would also require them to sell US Treasuries, driving up yields. This scenario is not as bad as it sounds: the Fed is buying Treasuries, so yields would stay low as he gives cash to investors and receives Treasuries. Then investors sell the dollars on the FX markets, pushing down the value of the dollar, and sending those dollars back into the economy. Sooner or later, the cash will find its way into the hands of consumers and businesses, which is what we want. Thus, a weaker dollar is inflationary, which is what we need in a deflationary scenario.

Basically, we can’t have inflation and deflation at the same time. Besides, what currency will they buy? The rest of the world is in as bad or worse shape than the US. Would you buy Rubles now? In a deflationary environment, investors keep money in cash, and the cash of choice is US dollars.

It is also important to remember that the dollar is a relative measure of inflation, not an absolute measure. If the Euro is deflating while the dollar remains stable, then the dollar will decline relative to the Euro (all else equal). We believe that until 2007, the dollar was over-valued for about a decade, and that over-valuation was a key contributor to the current crisis.

One critical element to watch is the specter of wealth transfers. When the economy is out of balance, wealth is transferred between parties. This occurs when we have speculative bubbles – wealth is transferred from buyers to sellers. In extreme bear markets, wealth is transferred from sellers to buyers (from the weak to the strong). The more extreme this event, the more damage is done to the economy.

Bailouts Reward Bad Business Decisions – The Moral Hazard Argument
Generally speaking, the government picking winners and losers is not a good idea – decisions will be made based on political expediency, not on what’s best for the country.

Many advocates of free markets extend this to all situations – the government should never intervene in the markets, since the markets are self-correcting. Indeed, we can read this almost every day on the Wall Street Journal Opinion page. They argue that government interventions introduce distortions and that recessions are times when excesses are purged and the economy is cleaned up. Bailing out businesses picks winners and losers, rewards excessive risk-taking, and prevents the economy from correcting. I should note that this school of economics generally rejects the deflationary spiral theory, and rejects the existence of extreme events.

The problem with this argument is that free markets don’t always punish wrongdoers, but almost always punish the weak. Businesses are not people, and therefore do not behave like people. Efficiencies are driven by healthy competition, innovation, and strong underlying economics, not by allowing the economy to self-destruct.

I agree that most fluctuations in the business cycle are self-correcting, but not all. I agree that the government should generally follow a policy of allowing markets to work freely and competitively (and allowing businesses to fail), and only intervene in extreme cases. I also agree that such intervention will never be perfect or efficient, and will produce significant distortions.

However, if I am correct about the deflationary spiral – and I believe there is a lot of historical evidence to back me up – then intervention is absolutely necessary, despite the cost. There is always a case for intervention when the benefits outweigh the costs.

We are Headed for another Great Depression
There have been a number of references and comparisons to the Great Depression in the media. Indeed, in early 2008 I myself was in a debate with another analyst who was comparing the conditions at the time to the Stagflation of the 1970’s, and I pointed out that a more apt comparison was the Great Depression, though I was only using it to emphasize the point that inflation was not a long-term risk.

There are many similarities between the current crisis and the start of the Great Depression. There are, however, many differences.

The Great Depression could be described as the “Mother of All Deflations”, as the world experienced a massive debt-deflation spiral reinforced by a virtual halt of world trade via tariffs, an extensive and devastating drought in the farm belt of the US, and a massive people migration from the countryside into the cities. The Federal Reserve and the US Treasury, following the then popular economic theory, stood by and did nothing, preferring instead to let the system self-correct and purge itself of excesses. The Federal Reserve was also decentralized, and therefore its responses uncoordinated.

President Hoover, much maligned, oversaw a massive expansion of government spending in a largely blind attempt at fiscal policy. Historians describe Hoover as someone who was actually a very compassionate person, but was given poor advice by his Treasury Secretary about the appropriate response to the crisis.

The dollar was linked to the gold standard in a fixed exchange rate.

The deflation spiral was halted and began to reverse in March of 1933, when the new president Roosevelt declared a bank holiday and devalued the dollar relative to gold. The devaluation flooded the system with liquidity, and the deflationary spiral was broken. But not after a lot of damage was done.

Roosevelt also went on to implement his New Deal, for which he is famous, and historians ever since have been debating its effectiveness.

In 1937, the country was beginning to pull out of the Depression, until two things happened. The Federal Reserve doubled the reserve requirements on the banks, effectively pulling the plug. And the Roosevelt administration pulled back on fiscal spending and raised taxes severely. The country plunged back into the Depression.

When the US entered World War II, the country was effectively broke, and had a small and obsolete military. Within a year of the war, we had suffered a series of defeats, a madman was in charge of Europe, and the Japanese military machine was rolling over Asia. We couldn’t find buyers for US Treasury bonds – who would buy our bonds when it looked like the world was going to end? So the Treasury was forced to print money. Inflation resulted, and the country pulled out of the Depression.

Fast forward to 2008. At the initial onset of the recession last year, the Fed cut rates rapidly and intervened both quietly and publicly in the failures of Bear Stearns and a handful of lending institutions. The October collapse provoked a massive response by the Federal Reserve, the US Treasury, the European Central Bank, the Japanese Central Bank, and the European governments to inject over $2 trillion of cash into the world’s financial system – some of it borrowed, some of it printed. Rates are now at all-time lows across the globe.

There is no drought, no trade war, no evil dictator bent on world domination and the annihilation of other races (no, Osama Bin Laden is not in the running). We have had the most massive response to a credit crisis in history – and there is a lot of precedent for it working.

The Debt Leverage of the Last 30 Years Needs to be Undone
There is a school of thought that argues that the prosperity of the last 30 years has been driven by an expansion of credit. The officially reported savings rate for the consumer was slightly negative in 2006, while household debt (including mortgages) reached nearly 13 trillion in 2007, or 97% of GDP. In the 1970’s, the savings rate was nearly 10%, while household debt was around $1 trillion, or 20% of GDP. For a comparison, gross government debt is about 63% of GDP, up from 50% in the late 70’s.

Thus, they argue, we need to reverse the debt load. I’ll revisit later whether or not 97% of GDP is “too much” debt. However, this argument omits certain key facts.

First, interest rates on US Treasuries in the late 70’s were 15%. In 2007, they were raised to around 4%. So, in terms of debt service cost (interest expense), the rise is real but more modest: an increase of roughly 25% to 35%, with most of that increase coming in the last few years as a result of the real estate bubble. The relative debt service costs for the US Government has declined by roughly two-thirds. This does not take into account the recent interest rate declines nor the recent government bail-out expenses. It also excludes unfunded Government liabilities like Social Security and Medicare.

Second, the savings rate is absurdly understated. Consider that, while the savings rate has averaged in the low single digits as a percent of GDP, households have added anywhere from $2 trillion to $4 trillion per year to their balance sheet, or 15% to 25%, with about a third of that borrowed. Thus, we are saving a lot more money than we are saving, according to official statistics.

The answer to this paradox lies in the way the savings rate is calculated. Say I start a business with a $100,000 investment. That $100,000 counts as negative savings – an expense with no income. While I operate the business, my reported profits count as income, but would count certain items that would normally classified as investments as expenses. Twenty years later, I sell the business for $10,000,000, pay a capital gains tax and other taxes of $2,000,000 and buy a yacht for $1,000,000. My official savings rate in the year of the business sale is a negative $3 million.

The savings rate does not include capital gains, but includes capital gains taxes and spending resulting from the capital gains. It does not include private investment in private businesses or investment in long-lived personal property (such as houses). There are a number of other items it excludes as well.

Estimates of the actual savings rate ranges from 8% to 15%, versus around 10% in the 1970’s and 1980’s. The divergence between the actual savings rate and the reported savings rate widened significantly in the 1990’s.

Because it includes capital gains, the actual (unreported) savings rate is more volatile than the reported number: it declines when asset values decline, and rises when asset values rise. So when we see a significant destruction of value like we have seen in 2008 or in 2002, it goes negative. When it goes negative, households and businesses cut back on spending.

But let’s address the question of whether or not debt levels are too high. The individuals making this argument are making the implicit assumption that debt “should” be at the same level it was in the 1970’s. Yet, in the 1970’s, the US monetized most of its debt by igniting inflation – the Federal Reserve expanded the money supply (by printing too much money), causing inflation, depreciating the value of debt and cash. So, one could argue that debt was “too low” in 1980 since much of it had been inflated away.

However, there is a deeper philosophical problem with this argument: “too low” and “too high” are value judgments. Lending is simply one way to transfer money from savers to borrowers, and interest is the return on investment given to savers. Other ways include venture capital, stock investments, private equity, and investments in private businesses, to name a few. Therefore, savers have a variety of places to choose to invest their money.

The key distinction between debt and other investments is the fixed nature of debt: the interest is fixed and the principal is fixed. This provides a level of convenience for both borrowers and lenders, as it provides predictability and at least the appearance of safety.

The problem with debt lies less in its magnitude than in the fixed nature. In a stable environment, particularly in a stable monetary environment, the fixed interest rates and fixed principal are not a problem. However, inflation hurts lenders and deflation hurts borrowers. Deflation is more corrosive because it forces behavioral changes that result in a collapse of asset values.

If we think borrowing is too great, then we need to find a way to shift financing flows from fixed charge debt to variable charge forms of financing (equity and hybrid). Currently, the US, through tax policy, subsidizes debt and penalizes equity financing. Therefore, that magnitude is unlikely to shift anytime soon, though there are early precursors of it with some of the “mortgage modification” programs being proposed.

In general, debt is only bad if we experience deflation or inflation. However, in such an environment, any form of debt is bad.

More on Why We Take Too Much Risk

2009-01-05T09:41:00.000-08:00

A reader of Thoma's blog added a fifth source of risk; one I will loosely characterize as "Keeping Up With the Joneses" (he uses a lot of technical gobbly gook, so I'll try to distill it as best as I understand it). It took a Ph.D. in psychology for him to come to terms with why former colleagues of his - very intelligent and very sophisticated financial professionals - failed to see the obvious signs and heed the warnings of the impending tech bubble crash in 1999. He concluded that they were under social pressure continue making profits while their friends and classmates were making profits, and thus their perception of risk and judgement were clouded.

Comment: I think this is very real, though more subtle than he proposes. Instead, I tend to believe we are subject to a number of biases, including a tendancy to ignore the probability of events occurring outside of our experience or observation. I also believe that the pressure to perform in the short-term is more than just social; it is institutional and structural. We get paid or fired in the short-term, but success and profitability can only be properly measured over a long time horizon.

Why People Take Too Much Risk

2008-12-30T08:41:00.000-08:00

Or Why We Have Speculative Bubbles and Excessive Bear Markets

Mark Thoma in his economics blog highlights models that characterize excessive or incomplete risk-taking. Each of these models have been cited as playing a role in the current financial crisis. Here I have described them, and then commented on them with my opinions (Thoma is a liberal commentator, so he has his own opinions).

Misperception of Risk: Economic actors do not perceive risk correctly, as a result of incomplete information and/or fickle human nature. The misperception of risk causes people to either take on more risk than they can handle, or take on too little. The vernacular for this is the “greed-fear” analogy.

Comment: In political discourse and economic theory, this model is typically ignored or under-represented. I would expand this further to incorporate the “herd instinct” and the “madness of the crowds” often observed in financial markets and economic behavior. Regulating this behavior is extremely difficult, but is best accomplished through better and more thorough disclosure.

Misrepresentation of Risk: Economic actors are lied to. Sellers of risk represent the risk as lower than it really is, either though intentional deception or negligence. The extreme case is fraud. In the case of selling insurance, often the reverse is true: sellers use fear to over-represent risk.

Comment: This model always occurs and while it can be limited, it cannot be eliminated. The problem occurs when it is systemic, and tends to occur in parallel with the “market failure” model below. Misrepresentation is a difficult and complex problem when it comes to financial reporting.

Misallocation of Risk: There are two strands of risk misallocation:

1. Moral Hazard – the government will step in and cover any catastrophic losses (risk is reallocated from the private to the public sector). This model has been emphasized by critics of the government bailout and more generally by critics of all government intervention.

Comment: I generally think this problem is over-emphasized in financial and economic theory, as it personifies institutional entities. It is a problem, but the problem emerges as structural shifts in industry organization as weaker poorly managed entities are allowed to continue to operate. The bailout is a form of government insurance against extreme and systemic risks, and the weaker entities have generally been eliminated.

2. Market Failure – This model characterizes principal agent problems (i.e, mortgage brokers get paid by volume of loans, not quality). Excessive risk taking occurs when the agent gets the full upside but only limited downside. Also known as agency costs.

Comment: Agency costs are mentioned in economic theory, but typically only when referring to the separation of management interests from shareholder interests. However, agency costs occur throughout any organization and all industries, as individuals have divergent incentives and interests from organizations and society overall. Liberals like to cite this as an excuse for regulation, but fail to realize that regulators and politicians are also subject to agency costs, and indeed political agency costs are the reason regulation often fails to prevent market failure.

Forced or Subsidized Risk-Taking: This model is a variant on the misallocation model mentioned above. The government, through regulation, subsidies, and/or political suasion, forces or encourages risk-taking for political ends. An example often cited is the actions by Congress to encourage lending to minorities and expand homeownership to lower income classes (subprime lending). Another example is the corn ethanol subsidy.

Comment: This model is a political hot button, as conservatives use it to attack government intervention. I tend to think this is a big problem, but not in the way that conservatives or liberals think. Generally, politicians – liberal and conservative – use government regulation and subsidies as a way to buy votes and get elected, which is another way to characterize agency costs. The CRA/expanded lending to minorities issue was, in my opinion, at best a minor contributor to the lending boom: the government didn't force companies to make bad loans.

A Working Paper Analyzing the Crisis

2008-12-26T12:59:00.000-08:00

Deflation Defined

Until the middle of 2008, the primary concern in the financial community and the general media was inflation. This was logical because the primary indicators of inflation, commodity prices, were rising rapidly. Oil prices had risen to a level of $147 from a low of under $10 a decade earlier, and we had seen similar rises in a host of other commodities. The value of the dollar was falling relative to other currencies.

In a newsletter that we were in the process of writing at the time, we argued that inflation was not only not a risk, but the primary risk was actually deflation. Deflation is the opposite of inflation – a general decline in prices and wages. Unfortunately, we were right, but much more so than we realized.

In September and October the world economy was hit by a severe deflationary shock, and economic activity and the stock market subsequently took a nosedive. So, we rolled up our sleeves and did more research. The media, of course, went into a frenzy describing the bad news – and generally doing a very poor job.

So what is deflation? The US has not experienced sustained deflation since the Great Depression, though it experienced it fairly often in the 19th and early 20th centuries. In addition, deflation was a fairly common occurrence throughout the world prior to World War II. Since WWII, deflation was thought so much to be banished that there is scant discussion of it in college economics courses, which instead focus on inflation – the problem of the last 40 years.

There are two types of deflation: real and monetary. Real deflation results from improvements in productivity, derived from technological change, advances in industry organization and practices, and improvements in asset utilization. This is good deflation – mostly good, since some companies and industries necessarily suffer when competitors improve and technology changes. It is good because real incomes rise, profits go up, and the standard of life improves.

Monetary deflation, however, is a different animal, and is usually very bad.

Monetary deflation is similar to monetary inflation, but instead is caused by a decline in the total outstanding balance of currency, which in the case of the US is dollars. The outstanding balance of currency consists of cash, deposits at banks, deposit-like instruments, and loans and debt securities outstanding. The Federal Reserve is the institution responsible for managing the first three and a small portion of the fourth, while the financial system multiplies that “base” through loans and debt.

In the past, monetary deflation was often intentional – the central bankers often wanted to reverse inflation that had built up so they revalued the money supply and prices downward. In the pre-World War II era, money was usually backed by gold at a fixed ratio and exchange rates were fixed. However, during times of war, governments would go off of the gold standard and inflate the economy. At the end of the war, they would attempt to go back onto the gold standard, usually at prewar ratios, resulting in deflation.

In other circumstances, deflation was caused by a credit boom that led to excess capacity in one or more industries, that led to a bust and a resulting collapse in credit. Sometimes the bust was caused by crop failure. Since money was tied to the gold standard, central bankers were powerless to prevent either the boom or the bust. This type of deflation is especially severe, because it can be very sudden and a collapse of credit results in a collapse of the multiplier effect on money.

Sometimes capital flight was the culprit. In the past, capital flight was when money in the form of gold left the country to be deposited elsewhere, resulting in a decline in the money stock in one country and an increase in another. This would result in a balance of payments imbalance – current account deficit combined with a capital account surplus.

Most often, all three were to some degree the combined culprit. A slow deflation can lead to a credit boom, as individuals and businesses are not aware of the deflation, driving down interest rates and borrowing money to finance spending. An intentional deflation can lead to capital flight, which can be slow or fast, resulting in a credit boom elsewhere as capital is injected into another country’s financial system.

There can be many scenarios that lead to deflation, but the reason it is rare in modern times is because central bankers have every incentive and, without gold, have an infinite war chest with which to battle it. More on that later. However, we have a series of live experiments from the past in which we can study the causes and effects of deflation.

We know from both economic theory and empirical studies that wages and prices are “sticky”, that is, they don’t change quickly. In fact, they resist downward adjustment much more rigorously than upward adjustment. In addition, debt balances don’t adjust downward, and neither do cash balances. However, if there is a reduction in the volume of dollars chasing goods, services, and assets, something has to give.

In a credit crisis, banks that had been lending freely will often see the value of the loans impaired. This is the result of excess capacity in one or two areas of the economy (which today is real estate), and the inability of debtors to pay their debts. Banks then repossess and sell the assets. Unfortunately, when there is excess capacity, the assets are usually worth a lot less than when they were purchased. With loans impaired, the banks are unable to continue lending, and therefore reduce the availability of money in the system.

With a balance of payments problem, capital flows out of one country into another. Sometimes this is fast, as is the case of Britain after World War I. Sometimes it is slow. If the money stock leaves the country, and it is not replaced quickly enough, then that puts deflationary pressure on the country in question.

When deflation sets in, prices resist decline. This results in reduced demand for products and services. The reduced demand creates an inventory buildup, which reduces cash holdings at businesses. Businesses then start liquidating both assets and inventory, which is fine if they do it one at a time. However, that usually doesn’t happen. Usually, everybody liquidates at once. When this happens, prices plunge.

However, businesses have fixed costs: wages, factories, and debt are costs that are sticky. Thus, if prices plunge, margins collapse and cash drains out of the business. As a result, businesses move quickly to cut costs – laying off workers, closing factories, and if all else fails, declaring bankruptcy.

With employment falling, pressure begins to build on wages. However, wages typically do not fall, because deflation is usually seen as temporary and workers typically have significant political clout. This accelerates the process of rising unemployment and bankruptcies.

With rising unemployment, demand falls further, and the cycle repeats itself. This is often called a wage-price death spiral. Furthermore, as assets are liquidated to pay off debts, prices descend further defeating the purpose of paying off the debt, and debt actually increases relative to the value of the assets. This is referred to the debt-deflation spiral.

When does it end? It ends when shortages arise due to the destruction of industry, and the money stock hits a bottom. The magnitude of the fall depends on the debt and leverage multiplier. In modern times, that multiplier is large.

Thus, debt and leverage are the great magnifiers of deflation, and that invariably leads to depression if intervention does not occur.

Can it be prevented? Fortunately, yes, though not without avoiding a recession. Generally, the initial onset cannot be prevented due to the excesses built up that must be reversed. However, the multiplier effect can be muted by flooding the economic system with liquidity – i.e., putting cash in the hands of consumers and businesses, cash that is printed by the central bank. We must emphasize, however, cash, not more debt. This is not possible in a gold standard currency regime, but it is possible in a fiat money regime like what we have today.

The preventative for depression is government intervention, and is one of the few examples of where government intervention is absolutely necessary. Only the government has the capacity to reflate the economy and take debt off of the hands of individuals and businesses without causing prices to crash.

The Panic of 2007 – 2008

Why do we have a deflationary shock in the modern era when we have the capacity to print money at will?

I believe that we have had multiple sources of modest real deflation over the last 30 years. Technological advancement, globalization, and improvements in industrial organization all have driven down the cost of production and improved productivity and the quality of life. These sources of deflation are not necessarily bad, since they are slow and measured, and generally provide improvements to our economic life.

Another source of deflation, one less positive but just as pervasive, has been the demographic changes occurring in all developed countries. We are all familiar with the baby boom that occurred here in the US. In the US, as the baby boom ages, it would result in a decline in population if immigration did not occur. Even with immigration, population growth in the US has slowed. Declining population has been occurring in Japan for over a decade, and has begun to occur in Western Europe. China, too, has a large and more pronounced population bubble, but it is younger and thus population decline is twenty years into the future.

A declining population is deflationary and contractionary: fewer people to demand goods and services and fewer people to produce them. In industries where the costs are variable, that wouldn’t be as big a problem. However, costs are often fixed, especially debt. This problem is most obvious in the case of real estate: it is easy to increase the supply of housing, but not as easy to reduce the supply of housing.

While the effect is slow and largely hidden, we have seen this effect before. Japan is the most obvious example, but the Northeastern US and the Upper Midwest have all experienced declining population at some point in the last 30 years, and in each case it has been accompanied by housing price declines and economic stagnation. Of course, the economic stagnation often causes the population declines, thus creating a vicious cycle.

However, in 1998 an event called the Asian Contagion occurred. At the time, there was a sudden reversal of fortune for the “Asian Tigers”, where countries that had borrowed extensively in dollar-denominated debt and misallocated those funds suddenly found themselves with severe excess capacity, in many cases high inflation, combined with foreign debt obligations inflating with the currency and sudden capital flight. The result was a long severe recession.

As is usually the case, most policy makers are busy fighting the last war and learning the wrong lessons from past crisis. In Asia, central banks incorrectly concluded that the debt crisis was caused by insufficient monetary liquidity, a conclusion borne out of the fact that they were unable to defend their currencies against collapse. The Asian defaults were actually caused by an expansion of dollar-denominated debt combined with domestic inflationary policies. This led to excess capacity combined with rampant inflation against falling real asset prices. Since the debt was dollar-denominated, it inflated with the currency, while the purchasing power of domestic businesses and individuals collapsed.

The right lesson to be learned from that crisis would be to pursue stable prices without debt financed expansion. However, the lesson actually learned was that the central banks needed ample dollar reserves to defend against an attack on the currency. To accumulate those reserves, the countries held their exchange rates at an artificially low rate, creating a balance of payment imbalance, causing reserves to flow into Asia and out of the West. The reserves were then reinvested in US debt instruments. Thus, the central banks accumulated US Treasuries and Fannie Mae securities. This flooded the West with low priced goods (modestly deflationary) and drove down interest rates on dollar-denominated debt (initially inflationary, until it goes bust).

It also pulled capital out of the real economy, effectively reallocating it to the financial sector, resulting in an expansion of credit in the US on the top of modest deflationary pressures.

Fast forward to 2002, and the US was facing the potential for modest deflation after a collapse of the Nasdaq Bubble. The Federal Reserve, rightly fearing such an episode, drove down interest rates to 1% and kept them there. This ignited a massive credit bubble, mostly funneled into real estate, though later it fed into commodities. Here, the Fed attacked the right problem with the wrong tool, in my opinion. In an environment already primed for credit expansion, lowering the cost of credit was not the best move. This decision was rooted in a 30-year philosophy of interest rate targeting as a means of managing the money supply, and an exclusive focus on cost inflation instead of broader measures of money growth.

The truth is that the Fed has a multitude of tools with which to manage the money supply. It can buy Treasuries (which it has been doing for a long time), it can restrict lending by increasing reserve requirements at banks (something it hasn’t done since the 1950’s), or it can lend directly to banks (which it just started doing in a big way recently). In addition, it can buy any number of securities, such a money market debt, corporate debt, stocks, bonds, futures, derivates, etc. It can intervene directly in currency markets by selling dollars. In theory, it can even buy houses, though this presents logistical problems. This can be done by issuing Treasuries (called sterilized intervention), or printing money (called unsterilized intervention).

In 2002, the Fed probably should have used other means to offset deflation. Primarily, in a deflationary environment, the remedy is to put printed cash in the hands of individuals and businesses. The Fed tried to do this by lowering interest rates and expanding lending. However, the Fed probably should have directed it to a basket of securities, excluding ones purchased by the Asian Central Banks. Combined with brakes on lending, we could have had a sustainable recovery. But, then, hindsight is always 20-20.

Therefore we had a double dose of central bank intervention: the Federal Reserve and the Asian Central Banks acted independently but not cooperatively to drive down interest rates in the US. Thus we had a massive credit bubble which funneled capital into residential real estate, mostly in Florida, California, and New York where, due to local tax and zoning laws, prices are more volatile and periodic speculative profits therefore more attainable.

A Classic Banking Panic
Thus, we had the ingredients for a classic banking panic. Unfortunately, it was masked by a combination of hubris and a limited monetary philosophy. A combination of rising interest rates and the laws of gravity punctured the real estate bubble, causing prices to fall precipitously. Deflation in a heavily leveraged sector such as real estate is not a good thing. While real estate bubbles and busts are relatively common, this one dwarfed any that had preceded it. With prices declining but loan balances remaining fixed, the only thing standing in the way of a crisis was default rates.

Mortgage defaults traditionally depend on two things: the price of the house relative to the mortgage, and the ability of the household to pay the monthly payment. The first domino started falling in late 2006. Unfortunately, as with any credit bubble, lending standards had been relaxed, and mortgages were extended to households and speculators with limited ability to pay and limited money down. Thus, rising interest rates and a softening economy led to a snowball effect of defaults.

The snowball gathered as the debt-deflation spiral accelerated. Until September, the problem had been largely contained to the housing, financial, and retail sectors. But September was an inflection point.

Another critical element in any economy, but especially in the banking and financial system, is the element of confidence. If people believe the future is good, they are less likely to save and more likely to borrow. Likewise, if the future looks bleak, people will save more, spend less, and borrow less. Confidence represents people’s willingness to take risks and conduct business, and it includes people’s willingness to predict the future. As long as those perceptions don’t shift suddenly, the system remains in balance.

In September, a rapid succession of events led to a sea change in confidence. Starting with the Lehman bankruptcy, investors, not wanting to be caught by the next domino, fled the financial sector to safe haven investments. Thus, banks and financial companies suddenly found their primary costs – the cost of money – skyrocketing. The weakest companies and the ones with the most exposure were the hardest hit – AIG, Merrill Lynch, and Wachovia – and all three experienced some kind of failure. The crisis exploded onto the national stage with the congressional debate over a bailout and a stock market collapse.

Everybody changed their behavior all at once. Businesses immediately drew down lines of credit to conserve liquidity at the same time banks were unable to obtain financing to provide the lines of credit. Consumers, seeing their investments in stocks and real estate halved and realizing that the future was now much more uncertain, slashed spending and began liquidating assets to raise cash. Businesses, anticipating a slowdown, began liquidating inventories, slashing spending, and laying off employees in a bid to conserve cash.

The race to cash was ignited – the key ingredient to a global deflationary spiral and a global financial meltdown.

Zeit Geist
In college, I had a history professor that wrote about an idea he called Zeit Geist, after the German phrase loosely translated, “The Spirit of the Times.” His point was that history is inherently unpredictable, and that change typically occurs suddenly and violently, instead of in the way we desire – measured and predictable. (He spent the entire semester talking about this concept instead of the listed topic of the course – Medieval History.) Both then and now I found the concept extremely salient. His primary example at the time was the fall of the Berlin Wall and the collapse of the Soviet Union.

The reason this is true is because of two interchangeable factors: the world is extremely complex with the behavior of entire populations unpredictable, and we humans suffer from a tendency to reduce the complex into simple narratives that are as easy to understand as they are wrong. We suffer from the assumption that the world is inherently rational – and, of course, we like to define what is rational. And we suffer from the tendency to adopt the opinions of other experts, even if we ourselves are experts. The media, of course, reinforces this behavior.

This is not to say that problems can’t be identified – the subprime crisis and real estate crash was predicted by many. However, an extremely trivial number of experts (indeed mostly by those that had access to inside or privileged information) predicted the October crash. Not that the Armageddon predictions did not exist, but there were no more than usual – and as always, the media is now highlighting the ones that made the right call. Most experts, however, were as shocked by it as the rest of us.

For example, the prevailing narrative in the media and in the investment community in first nine months of 2008 was accelerating inflation with oil prices skyrocketing due to dwindling supplies. $200 oil was the prediction in June, with some numbers even higher. In fact, many of the experts predicting Armageddon were doing so via an inflationary spiral and advocating investment in commodities, including oil. However, the air came out of the oil bubble in record time, with a peak-to-trough return of -75% (so far).

Thus, beware of easy narratives (including the one proffered here).

Looking Forward
Despite the fact that predictions are inherently unreliable, we are forced to make them. We make them with the understanding that we might be wrong and that we do our best to mitigate our errors.

I believe that the path out of the current crisis lies through Washington DC. Policy-makers, especially the Federal Reserve, need to pump cash into the economy, including pumping cash into the banks.

1. The regulated banking system needs cash. Traditional banks are regulated by the FDIC and the Federal Reserve, and operate to access sources of cash (deposits, commercial paper, bonds, and securitization, along with the Fed’s discount window) and lend that cash out to businesses and individuals. If a bank runs out of cash, either through defaults on loans or having its access to cash cut off, it will fail. October saw a modern day bank run, except this time by investors in commercial paper, bonds, and securitized loans. Fortunately, the Fed and the Treasury responded by opening the discount window, buying commercial paper, mortgage securities, and ultimately preferred securities issued by the banks.

2. The non-regulated (“shadow”) banking system needs cash. Shadow banks, like Fannie Mae, Morgan Stanley, Lehman Brothers, Goldman Sachs, and General Electric operate much like traditional banks, except they don’t have access to FDIC deposits or the discount window, and they operate with fewer regulations regarding capital adequacy. They also experienced a bank run in October by investors. The Fed’s response here was also aggressive: buying commercial paper and securitized loans and allowing several companies to convert to traditional bank holding companies, stabilizing the situation.

3. The Fed is also injecting cash into other lending companies attempting to support auto loans, credit card lending, and commercial lending.

4. Provide fee-based catastrophic re-insurance to the financial system, including to banks, financial service companies, and insurance companies. FDIC is a limited example of this, as is the ad hoc guarantees provided to Citigroup, JP Morgan, Fannie Mae, and Freddie Mac. We all know these companies are too big to fail anyway, providing such insurance would shrink risk premiums and reduce uncertainty, and could be applied evenly. The fee is just an acknowledgement that such insurance isn’t free. A Stanford economist has proposed this idea.

5. Provide inflationary support for prices by pumping liquidity into the general economy. The Fed’s primary avenue here has been driving down interest rates on both Treasuries and securitized mortgages. A credit bubble like the one ignited in 2002 is unlikely, due to the fact that lending is currently impaired. However it will provide support for existing loans and underlying assets (principally houses) where the underlying debtor is still solvent.

6. Provide inflationary support for asset values, principally those being liquidated. This is more difficult to accomplish, given that physical assets don’t lend themselves well to government ownership. However, it can be accomplished indirectly by the purchase of securities and by passing cash through fiscal stimulus to businesses and individuals. The quickest fiscal stimulus is an across-the-board (corporate and individual) tax cut combined with a reduction/rebate of prior year taxes. This could be sterilized (though the issue of Treasury bonds) or unsterilized (by printing money). Ironically, the much-maligned tax rebate in May of 2008 may have delayed the onset of the liquidity crisis, even though it was relatively small and non-recurring.

Generally speaking, all of these actions have been implemented or (in the case of fiscal stimulus) contemplated. The question is, has it been enough? Most of the indicators are that more needs to be done.

My position is that the Federal Reserve and the European Central Bank both understand clearly the danger we face, but I am more concerned about Congress and the public. Congressional leaders are not well versed in economics, and face considerable political pressure to “punish” the perceived evildoers – usually corporate bad guys – not “bail” them out. Unfortunately, if we try to educate the public about the danger, we are more likely to scare the hell out of it without actually achieving a degree of understanding, which could prove even more costly to the economy.

However, I believe the risk of a severe depression is small – we have the tools and the willpower to avoid it. Furthermore, the Obama administration seems to understand most of what needs to be done. The risk lies more in how deep the fall goes, how quickly the situation will stabilize and recover, how much damage will be incurred in the meantime, and how much time and money will be wasted on distractions.

However, the recovery will be unpredictable. It is not likely to look like any we have experienced in recent memory. It could be slow, it could be uneven, and we could even have a double-dip recession. It is not likely to be financed with debt. Investors, businesses, and consumers will probably be slow to take risks, quick to raise cash. However, some sectors will rebound quickly, while others will not recover.

Narrative Rebuttals
Simultaneous Inflation and Depression, and whether the Fed has run out of ammunition

The most common narrative I see circulating in the news media and among “experts” is the idea that the Fed’s actions won’t work and are highly inflationary. They base this on the idea that banks won’t lend, and that lending is necessary to restart the economy. But the Fed is printing money which always leads to inflation. Generally speaking, I believe this argument is confusing several interrelated ideas in contradictory ways.

Basically, the problem we are facing is debt-induced deflation. Since most of our debt is denominated in our local currency (unlike the Asian crisis in 1998), when prices go down, the real value of debt goes up. Ironically, if we had issued debt in another, non-deflating currency, we would be in less trouble. Thus, consumers face rising real debt values in the face of falling asset prices and falling wages. Therefore, if the Fed’s action doesn’t work, it won’t lead to inflation, instead deflation will set in. If the banks hoard the cash and refuse to lend, then they will sit on the cash, and the cash won’t circulate. Non-circulating cash is the equivalent to non-existent cash, and doesn’t cause inflation.

But banks are in the business to make money, and sitting on cash earning zero percent doesn’t make any money. They too have bills to pay.

The idea that the Fed has run out of ammunition reflects a lack of understanding of the power of the printing press. Interest rates are simply a tool of the Fed – they are one barrel in which the Fed uses to shoot bullets, they are not the bullets themselves. The bullets are cash.

Printing Money Will Cause the Dollar to Crash
Printing way too much money will certainly cause the dollar to crash, as the value of US cash holdings will depreciate. But that will only occur if inflation results, and if inflation results, then the specter of deflation will have been defeated.

One scenario is that investors could sell dollars issued by the Fed and buy foreign currencies, putting downward pressure on the dollar. That would also require them to sell US Treasuries, driving up yields. This scenario is not as bad as it sounds: the Fed is buying Treasuries, so yields would stay low as he gives cash to investors and receives Treasuries. Then investors sell the dollars on the FX markets, pushing down the value of the dollar, and sending those dollars back into the economy. Sooner or later, the cash will find its way into the hands of consumers and businesses, which is what we want. Thus, a weaker dollar is inflationary, which is what we need in a deflationary scenario.

Basically, we can’t have inflation and deflation at the same time. Besides, what currency will they buy? The rest of the world is in as bad or worse shape than the US. In a deflationary environment, investors keep money in cash.

It is also important to remember that the dollar is a relative measure of inflation, not an absolute measure. If the Euro is deflating while the dollar remains stable, then the dollar will decline relative to the Euro (all else equal). I believe that until 2007, the dollar was over-valued for about a decade, and that over-valuation was a key contributor to the current crisis.

One critical element to watch is the specter of wealth transfers. When the economy is out of balance, wealth is transferred between parties. This occurs when we have speculative bubbles – wealth is transferred from buyers to sellers. In extreme bear markets, wealth is transferred from sellers to buyers (from the weak to the strong). The more extreme this event, the more damage is done to the economy.

Bailouts Reward Bad Business Decisions – The Moral Hazard Argument
Generally speaking, the government picking winners and losers is not a good idea – decisions will be made based on political expediency, not on what’s best for the country.

Many advocates of free markets extend this to all situations – the government should never intervene in the markets, since the markets are self-correcting. They argue that government interventions introduce distortions and that recessions are times when excesses are purged and the economy is cleaned up. Bailing out businesses picks winners and losers, rewards excessive risk-taking, and prevents the economy from correcting. I should note that this school of economics generally rejects the deflationary spiral theory, and rejects the existence of extreme events.

The problem with this argument is that free markets don’t always punish wrongdoers, but almost always punish the weak. Businesses are not people, and therefore do not behave like people. Efficiencies are driven by healthy competition, innovation, and strong underlying economics, not by allowing the economy to self-destruct.

I agree that most fluctuations in the business cycle are self-correcting, but not all. I agree that the government should generally follow a policy of allowing markets to work freely and competitively (and allowing businesses to fail), and only intervene in extreme cases. I also agree that such intervention will never be perfect or efficient, and will produce significant distortions.

However, if I am correct about the deflationary spiral – and I believe there is a lot of historical evidence to back me up – then intervention is absolutely necessary, despite the cost. There is always a case for intervention when the benefits outweigh the costs.

We are Headed for another Great Depression
There have been a number of references and comparisons to the Great Depression in the media. Indeed, in early 2008 I myself was in a debate with another analyst who was comparing the conditions at the time to the Stagflation of the 1970’s, and I pointed out that a more apt comparison was the Great Depression, though I was only using it to emphasize the point that inflation was not a long-term risk.

There are many similarities between the current crisis and the start of the Great Depression. There are, however, many differences.

The Great Depression could be described as the “Mother of All Deflations”, as the world experienced a massive debt-deflation spiral reinforced by a virtual halt of world trade via tariffs, an extensive and devastating drought in the farm belt of the US, and a massive people migration from the countryside into the cities. The Federal Reserve and the US Treasury, following the then popular economic theory, stood by and did nothing, preferring instead to let the system self-correct and purge itself of excesses. The Federal Reserve was also decentralized, and therefore its responses uncoordinated.

President Hoover, much maligned, oversaw a massive expansion of government spending in a largely blind attempt at fiscal policy. Historians describe Hoover as someone who was actually a very compassionate person, but was given poor advice by his Treasury Secretary about the appropriate response to the crisis.

The dollar was linked to the gold standard in a fixed exchange rate.

The deflation spiral was halted and began to reverse in March of 1933, when the new president Roosevelt declared a bank holiday and devalued the dollar relative to gold. The devaluation flooded the system with liquidity, and the deflationary spiral was broken. But not after a lot of damage was done.

Roosevelt also went on to implement his New Deal, for which he is famous, and historians ever since have been debating its effectiveness.

In 1937, the country was beginning to pull out of the Depression, until two things happened. The Federal Reserve doubled the reserve requirements on the banks, effectively pulling the plug. And the Roosevelt administration pulled back on fiscal spending and raised taxes severely. The country plunged back into the Depression.

When the US entered World War II, the country was effectively broke, and had a small and obsolete military. Within a year of the war, we had suffered a series of defeats, a madman was in charge of Europe, and the Japanese military machine was rolling over Asia. We couldn’t find buyers for US Treasury bonds – who would buy our bonds when it looked like the world was going to end? So the Treasury was forced to print money. Inflation resulted, and the country began to pull out of the Depression.

Fast forward to 2008. At the initial onset of the recession last year, the Fed cut rates rapidly and intervened both quietly and publicly in the failures of Bear Stearns and a handful of lending institutions. The October collapse provoked a massive response by the Federal Reserve, the US Treasury, the European Central Bank, the Japanese Central Bank, and the European governments to inject over $2 trillion of cash into the world’s financial system – some of it borrowed, most of it printed. Rates are not at all-time lows across the globe.

There is no drought, no trade war, no evil dictator bent on world domination and the annihilation of “inferior” races (no, Osama Bin Laden is not in the running). We have had the most massive response to a credit crisis in history – and there is a lot of precedent for it working.

The Debt Leverage of the Last 30 Years Needs to be Undone

There is a school of thought that argues that the prosperity of the last 30 years has been driven by an expansion of credit. The officially reported savings rate for the consumer was slightly negative in 2006, while household debt (including mortgages) reached nearly 13 trillion in 2007, or 97% of GDP. In the 1970’s, the savings rate was nearly 10%, while household debt was around $1 trillion, or 20% of GDP. For a comparison, gross government debt is about 63% of GDP, up from 50% in the late 70’s.

Thus, they argue, we need to reverse the debt load. I’ll revisit later whether or not 97% of GDP is “too much” debt. However, this argument omits certain key facts.

First, interest rates on US Treasuries in the late 70’s were 15%. In 2007, they were raised to around 4%. So, in terms of debt service cost (interest expense), the rise is real but more modest: an increase of roughly 25% to 35%, with most of that increase coming in the last few years as a result of the real estate bubble. The relative debt service costs for the US Government has declined by roughly two-thirds. This does not take into account the recent interest rate declines nor the recent government bail-out expenses. It also excludes unfunded Government liabilities like Social Security and Medicare.

Second, the savings rate is absurdly understated. Consider that, while the savings rate has averaged in the low single digits as a percent of GDP, households have added anywhere from $2 trillion to $4 trillion per year to their balance sheet, or 15% to 25%, with about a third of that borrowed. Thus, we are saving a lot more money than we are saving, according to official statistics.

The answer to this paradox lies in the way the savings rate is calculated. Say I start a business with a $100,000 investment. That $100,000 counts as negative savings – an expense with no income. While I operate the business, my reported profits count as income, but would count certain items that would normally classified as investments as expenses. Twenty years later, I sell the business for $10,000,000, pay a capital gains tax and other taxes of $2,000,000 and buy a yacht for $1,000,000. My official savings rate in the year of the business sale is a negative $3 million.

The savings rate does not include capital gains, but includes capital gains taxes and spending resulting from the capital gains. It does not include private investment in private businesses or investment in long-lived personal property (such as houses). There are a number of other items it excludes as well.

Estimates of the actual savings rate ranges from 8% to 15%, versus around 10% in the 1970’s and 1980’s. The divergence between the actual savings rate and the reported savings rate widened significantly in the 1990’s.

Because it includes capital gains, the actual (unreported) savings rate is more volatile than the reported number: it declines when asset values decline, and rises when asset values rise. So when we see a significant destruction of value like we have seen in 2008 or in 2002, it goes negative.

But let’s address the question of whether or not debt levels are too high. The individuals making this argument are making the implicit assumption that debt “should” be at the same level it was in the 1970’s. Yet, in the 1970’s, the US monetized most of its debt by igniting inflation – the Federal Reserve expanded the money supply (by printing too much money), causing inflation, depreciating the value of debt and cash. So, one could argue that debt was “too low” in 1980.

However, there is a deeper philosophical problem with this argument: “too low” and “too high” are value judgments. Lending is simply one way to transfer money from savers to borrowers, and interest is the return on investment given to savers. Other ways include venture capital, stock investments, private equity, and investments in private businesses, to name a few. Therefore, savers have a variety of places to choose to invest their money.

The key distinction between debt and other investments is the fixed nature of debt: the interest is fixed and the principal is fixed. This provides a level of convenience for both borrowers and lenders, as it provides predictability and at least the appearance of safety.

The problem with debt lies less in its magnitude than in the fixed nature. In a stable environment, particularly in a stable monetary environment, the fixed interest rates and fixed principal are not a problem. However, inflation hurts lenders and deflation hurts borrowers. Deflation is more corrosive because it forces behavioral changes that result in a collapse of asset values.

If we think borrowing is too great, then we need to find a way to shift financing flows from fixed charge debt to variable charge forms of financing (equity and hybrid). Currently, the US, through tax policy, subsidizes debt and penalizes equity financing. Therefore, that magnitude is unlikely to shift anytime soon, though there are early precursors of it with some of the “mortgage modification” programs being proposed.

In general, debt is only bad if we experience deflation or inflation. However, in such an environment, any form of debt is bad.

FRB Paper on Classical Deflation Theory

2008-12-22T09:38:00.001-08:00

The Federal Reserve Bank publishes research and other articles on varous topics in economics. I generally pull in the RSS feeds from their website, this one from the FRB in Richmond (http://richmondfed.org/publications/research/working_papers/index.cfm?cc_view=rss). Unfortunately, it is in PDF format, which my blog doesn't let me attach, so my notes are below.

The paper examines classical theories of deflation posited by six thinkers in the 18th and 19th centuries, who had observed the effects of deflation in their home countries. I found it interesting because given that in the modern era economics education has focused mostly on inflation and its effects, and it seems that many of the authors I read are either perplexed by deflation or very incomplete in their analysis. Below are my notes:

Hume (1711-1776) – a short-term deflationary monetary shock combined with sticky wages and prices brings about rising unemployment, rising inventories, and a decline in economic activity. However, the result is temporary, as economic activity resumes once prices adjust, though a wealth transfer from debtors to creditors occurs. Continuous deflation in a closed economic system has similar results, due to incomplete information. However, in an open system, continuous deflation results in a rebalance of trade flows.

Hume analyzed countries on a metallic monetary standard and fixed exchange rates.

Christernin (1725-1799) – he analyzed the effects of deflation on fiat monetary standards and flexible exchange rates. He also emphasized wage-price stickiness. He added that rising real debt and tax burdens along with the higher rate of return on cash balances creates cash hoarding. All inhibit real spending and create bankruptcies. In the export sector, higher exchange rates shifts demand toward imports away from exports, resulting in a further fall in production.

He also hypothesized that the wage-price stickiness is greater for deflation than for inflation. “Rising inventories of goods and labor constitute the signals that trigger reductions in prices and wages”. He talks about a debt-deflation spiral as “all debtors … wish to sell all they had in order to pay off their debts before prices fell further … Sellers hoping to beat the price fall flood the market with goods only to find that consumers would not buy except at a low price – and even if they did buy (and the debts at the bank were repaid) the refunding of the principal to the bank would cause a new reduction in the circulation of money”. “The result would be nothing short of a complete credit breakdown as creditors would not dare to loan their money for fear of debtors’ inability to pay.”

Thornton (1760-1815) – he argued that persistent long-term inflation is the only sufficient evidence to blame a central bank for the inflationary episode, as short-term real shocks could precipitate temporary inflationary pressures that soon reverse themselves. He also highlighted the fact that a sharp contraction in the money stock causes businesses to experience a sudden drop in cash balances or an increase in cash demands, requiring them to delay purchases and stop production, both to reduce inventory and raise cash. He indicated that wage stickiness is the result of workers belief that the deflation is temporary. Finally, he notes that price falls result in excess capacity, resource misallocation, value destruction (through layoffs, factory closings, and obsolescence) of otherwise productive resources, as well as the dumping of inventory.

Ricardo (1772-1823) – advocated modest (less than 5%) and gradual deflation after inflationary episodes, but argued against severe deflation, for many of the same reasons. The application today is the inflation-targeting versus price-level targeting policies of central banks. He is known for his advocating the elimination of gold coins and using instead issue paper currency backed by gold, thus relieving the central bank of holding large reserves and eliminating the need to acquire large reserves, thus not influencing world gold prices.

Attwood (1783-1856) – argues that full employment was the overriding policy goal, and price increases was the way to secure it. Deflation must be avoided at all costs. Deflation was “harmful because it worked its way slowly, unevenly, haphazardly, and disruptively through the price structure.” If price falls take place “in an obscure and unknown way, first upon one article and then upon another, without any correspondent fall taking place upon debts and obligations, it has the effect of destroying all confidence in property, and all inducements to is production, or to the employment of labourers in any way.” A deflationary wage-price spiral ends only when a shortage of goods caused by the destruction of industry results in rising prices.

Torrens (1780-1864) – argued that tariffs imposed by one country create deflationary pressures on another. His analysis being in a gold-standard regime, he argued that the imposition of unilateral tariffs resulted in a reduction of imports and a balance of payments surplus, resulting in a currency drain from the import source country. The currency drain, being gold, resulted in deflation. This analysis has implications for the modern Asian policies of maintaining undervalued currencies relative to the dollar and the Euro, creating an artificial trade surplus with the West. It also has implications when combined with game theory – that a free trade system is politically unstable, as nations will always have an incentive to try to game the system. He actually advocated trade reciprocity, a position generally opposed by both classical and modern economists.

Conclusion
These writers predicted the Great Depression when European central bankers attempted to reverse the inflation of the GreatWar by reinstituting the gold standard at prewar levels (especially the bank of England), the effects of which were delayed by the expansion of credit, then refused to adjust the standard until well into the Depression. To make matters worse, they closed their economies off to trade, reinforcing the real economic effects of deflation. The writers failed to differentiate between beneficial, productivity-induced deflation and harmful monetary-induced deflation. However, they offer interesting insight into the current deflationary crisis.

I should also note another effect borne out of observation: that private debt expansion likely precedes and delays deflation, as the decline in interest rates on the back of inflexible expectations results in greater borrowing to finance consumption. This magnifies the deflationary impact once it occurs. This has interesting implications regarding the policy of interest-rate targeting versus other means of managing the money supply: how does the central bank limit debt explosion while preventing deflation?

The Black Swan

2008-12-12T12:46:00.001-08:00

There is a book published in 2007 called the Black Swan by Nassim Taleb that I just started reading. In the 17th century, it was believed in Europe that all swans were white, since nobody had ever seen a black swan. Indeed, it was taken as a scientific fact. Until black swans were discovered in Australia.

This book talks about how world events are shaped by highly improbable events that have a significant impact. They are events that no one could reliably predict (aside from the ones predicting Armageddon each year), yet they have the power to transform and even revolutionize the world - for better or for worse.

Yet, unfortunately, our experts have made a science out of excluding the extreme event. They use mathematical models to examine historical data and make a range of predictions that will come true 95% of the time. The problem? It's that other 5% that is most important.

Quote 1: "I disagree with followers of Marx and those of Adam Smith: the reason free markets work is because they allow people to be lucky, thanks to aggressive trial and error, not by giving rewards or "incentives" for skill."

You can find the book on Amazon.

Consumer deleveraging, deflation, confidence, and the facts

2008-12-10T08:24:00.001-08:00

I read a lot of stuff about the state of the economy, and over time it ranges from Armageddon (currently) to Pollyanna (two years ago). Every argument has both truth and oversimplifying assumptions. The truth is, almost every forecast is speculation, because there are too many variables that could change over the next few months. However, the current fashionable argument is deflation resulting from consumer deleveraging – both very real, but, in my opinion, poorly understood.

Consumer Deleveraging:
The officially reported savings rate for the consumer was slightly negative in 2006, while household debt (including mortgages) reached nearly 13 trillion in 2007, or 97% of GDP. In the 1970’s, the savings rate was nearly 10%, while household debt was around $1 trillion, or 20% of GDP. For a comparison, gross government debt is about 63% of GDP, up from 50% in the late 70’s.

So the fashionable conclusion is that our economic growth has been driven by a borrowing spree that is now reversing. But is this really true?

The usual argument omits certain key facts.

First, interest rates on US Treasuries in the late 70’s were 15%. In 2007, they were raised to around 4%. So, in terms of debt service cost (interest expense), the rise is real but more modest: an increase of roughly one-third to one-half, with most of that increase coming in the last few years as a result of the real estate bubble. The relative debt service costs for the US Government has declined by roughly two-thirds. This does not take into account the recent interest rate declines nor the recent government bail-out expenses. It also excludes unfunded Government liabilities like social security and medicare.

Second, the savings rate is absurdly understated. Consider that, while the savings rate has averaged in the low single digits as a percent of GDP, households have added anywhere from $2 trillion to $4 trillion per year to their balance sheet, or 15% to 25%, with about a third of that borrowed. Thus, we are saving a lot more money than we are saving, according to official statistics.

The answer to this paradox lies in the way the savings rate is calculated. Say I start a business with a $100,000 investment. That $100,000 counts as negative savings – an expense with no income. While I operate the business, my reported profits count as income, but would count certain items that would normally classified as investments as expenses. Twenty years later, I sell the business for $10,000,000, pay a capital gains tax and other taxes of $2,000,000 and buy a yacht for $1,000,000. My official savings rate in the year of the business sale is a negative $3 million.

The savings rate does not include capital gains, but includes capital gains taxes and spending resulting from the capital gains. It does not include private investment in private businesses or investment in long-lived personal property (such as houses). There are a number of other items it excludes as well.

Estimates of the actual savings rate ranges from 8% to 15%, versus around 10% in the 1970’s and 1980’s. However, the divergence between the actual savings rate and the reported savings rate widened significantly in the 1990’s.

Because it includes capital gains, the actual savings rate is more volatile than the reported number: it declines when asset values decline, and rises when asset values rise. So when we see a significant destruction of value like we have seen this year or in 2002, it goes negative.

So why is the consumer deleveraging when it doesn’t appear that the consumer needs to deleverage? The answer to that is more complicated than it appears.

Four key factors determine household (or business) behavior: income, value of assets, performance of assets, and uncertainty or volatility in the first three factors. During times of strong performance of assets and low volatility, households increase spending and reduce cash balances. During times of poor asset performance and high volatility, households reduce spending and increase cash balances. These are rational responses.

For example, take the case of my wife and myself. For years, my wife was a public school teacher (before she stopped to raise a family). She worked very hard and was underpaid and underappreciated. However, her job and career was virtually guaranteed. The state basically can’t fire her unless she has sex with a student or sets fire to the building. She had no incentive to build up cash, except in the case of an emergency. In fact, school teachers are notorious for spending their next paycheck before they receive it. I, on the other hand, also work hard but make much more than a school teacher. However, my job could be gone tomorrow – indeed, I lost a job a few years ago after six years of excellent measurable and verifiable performance. As you can guess, maintaining a large cash reserve is a high priority for me.

Today, households are deleveraging because uncertainty is very high, asset performance has been abysmal, and this is the complete reverse of the environment of two years ago. Stockpiling cash is a rational response to the current state of the economy.

However, this presents a big problem. If there is a fire in a crowded movie theater, everybody panics and tries to exit at once. When that happens, only a few people escape and everybody else dies. When everybody raises cash at the same time, reducing spending and selling risky assets, asset values decline further and faster, causing the cycle to repeat and sometimes resulting in more leverage as asset values and incomes decline faster than debt.

This is called a liquidity trap, and it is highly deflationary.

The only feasible solution to a liquidity trap is for the government or some other very large entity to take the opposite side of the trade. That is, the government should supply liquidity when liquidity dries up. And this is why the government has been doing exactly that: bailing out banks and car companies, and buying a variety of securities with printed money. The question is, is it enough and will it succeed?

Since the perception of a crisis can precipitate an actual crisis, the success of the government response will depend a lot on restoring confidence in the system and in the economy. Like it or not, our economy is predicated on confidence: in the financial system, in the government, and in the future.

How to help the auto industry

2008-12-08T08:01:00.000-08:00

I’ve been thinking about the ailing auto industry and how and whether it should be helped. There is no doubt that the failure of the auto industry would be very costly to the US and to the US Government, but the question is whether keeping them around would cost more. There isn’t really any hard data either way, so most of what I read is conjecture. Most economists appear to oppose a bailout on the grounds that the long term cost would far outweigh any benefits of a short-term bailout – indeed that any bailout would likely be good money after bad.

But my thoughts center around the practical instead of the theoretical. Politically, the government is going to step in one way or another. The most likely outcome is that the taxpayer will pick up the tab for pensions and healthcare, and probably for unemployment and re-employment. These commitments, of course, are the fundamental reasons for the auto companies’ inability to remain competitive with Toyota and Honda, or even with BMW and Mercedes. The subsidies that various auto companies receive around the world (including GM and Ford) also result in perpetual excess capacity, meaning that too many cars chase too few buyers.

My thought process is this: since the taxpayer will take on the pension and postretirement commitment, why not simply take those plans off of their hands (and freezing future commitments). In exchange, the taxpayer assumes ownership of the companies, wiping out existing shareholders, and a portion of the bonds get converted into equity as well. The government owned shares would be then be apportioned out to employees and retirees in exchange for a reduction of the existing pension and postretirement commitments, and in exchange for severance pay.

These are principles, and the devil is in the details. But the approach attempts to deal fairly with all parties involved, including with other car companies that didn’t mismanage their operations.

The Mother of Bear Market Rallies

2008-12-02T13:51:00.000-08:00

The following articlae appeared just before thankgiving:

The mother of bear market rallies is on the horizon @ By Barton Biggs
Published November 25, 2008 in the Financial Times.

Before we are all swept away into total despair, let's take a step back and imagine what could get stocks round the world going up for a while. Before I start, bear in mind that I am a hedge fund manager, have been wrong on the severity and duration of this panic, and that at this moment I am
close to shore. I have little risk on, in other words.

First, let me point out that by definition the bottom of a bear market has to be the point of maximum bearishness. Thus sentiment becomes a crucial indicator.

The systematic work that we do on measuring sentiment (and we monitor about 20 indicators for the US and a dozen or so for other equity markets) show very extreme and in many cases record levels of bearishness. Obviously not every indicatoris at an all time high, and in some the history is short- but the message is powerful. Furthermore, there is compelling evidence that investors, hedge funds, pension and mutual funds, and the public are not just talking bearish, they have raised astounding amounts of cash. I am chastened by the fact that all tha data we look at are from the past 40 years, which was really just one great magnificent secular bull market of wealth creation marked by periodic bears that were opportunities to buy. No one knows what levels of pessimism were necessary to spawn the 40 per cent 1929 rally during a massive secular bear market. Nevertheless, I' ve never seen capitulation and despair like this. We must be pretty close to maximum bearishness.

Second, valualions are cheap. There's no point in going into an elaborate dissertation; it 's an inexact science. Using the best historic measures, normalised earnings, book value, and free cash flow, stocks are very cheap, but not as cheap in absolute terms or versus interest rates as they were in the 1930s or at the 1974 bottom. Nevertheless, the 4 per cent dividend return on the S&P 500 exceeds the yield on the 10 and 3O-year Treasury bonds for the first time in 50 years. lf emerging market equities, where the growth this, at six to eight times earnings are not cheap I don't
know what is.

Third, stock markets have been oblileraled and are deeply oversold. Even dead cats bounce. The Dow has had the steepest decline since the 1930s, and the spread between the price and the 200 day moving average at 34 per cent is the greatest since July 19, 1932. The US market is down
almost 50 per cent from its highs, Europe is off 55 per cent, and emerging markets 65 per cent with some unfortunates, such as Russia, off 70 per cent. History shows that even in enduring, secular bear markels there are not just 20 per cent bounces but usually one 30-50 per cent rally. We
should be due.

As far as the economic fundamentals are concerned, investor and consumer confidence have been ravaged by the sudden violence of the global recession. It is going to be deep and it may be long lasting. The bears say at best it will be like Japan's slow death. At worst, it will be a replay of the
1930s. I think both these outcomes are highly unlikely. The so-called authorities have learned from the policy errors of the past, and the response this time, while not perfect, has been faster and far bigger. The effects are just beginning to be felt. In fact, the stimulus has been unprecedented and there is almost sure to be more on the way beginning with the new obama administration. The authorities seem to understand that they have to risk overkill.

And the fabric for economic healing is developing. In the US, average hourly earnings are rising at a 3 per cent annual rate and the consumer price index is probably declining at 5 per cent thanks to the fall in petrol, fuel and food prices, so real average hourly earnings are rising at a rate of 8 per cent. The savings rate is rising. The sharp collapse in the price of oil, while hurtful to parts of the world, is very beneficial to the US, Europe and Asia. The consumer spending collapse we are experiencing may be short lived but that doesn't mean a boom is coming.

Finally, my guess - and it's nothing more than a guess - is that the deleveraging that has caused such heavy selling is two-thirds done. In listed equities it may be 80 per cent finished. Hedge fund redemptions are substantial and will continue into next year, but hedge fund liquidity is at a record high and hedge funds' gross exposure and net long is at a record low. Conversely, investor liquidity is at a record high. All are good contrary indicators.

If I'm bullish why am I not in there now? Because I would like to see credit markets unclog and spreads come in more. At the bottom of a panic, the news doesn't have to be good for stocks to rally, it just has to be less bad than what has already been discounted. I want the markets to stop going down on bad corporate and macro-economic news.

The fact that it still does shows the bad news has not yet been fully discounted. I have no idea when the next bull market starts, but I do thinkwe are setting up for the mother of all bear market rallies.

The writer is managing partner at Traxis Partners, a New York hedge fund, and author of Hedgehogging.

Can GM Be Saved? Should They Be?

2008-11-18T06:51:00.000-08:00

We are hearing increasing noise out of Congress and Detroit about a possible bailout of GM, Ford, and Chrysler. The Democrats are pressuring the administration to use TARP funds (originally designated to save the economy), while the Republicans are threatening to derail passage of anything.

GM, Ford, and Chrysler, meanwhile, are hemmoraging billions every month, fast running through their saved cash holdings. Without intervention, and assuming the current rate of auto sales holds (about 12 million annually), first Chrysler, then GM, and then Ford will be forced into bankruptcy.

The purpose of this post is not to discuss whether there will be a bailout. As a student of the political process, I think that a bailout is a foregone conclusion. The market seems to think so too, or else the stock prices of GM and Ford would be barely above $0.25.

This is just an exercise in thought. Should be we bail out GM and Chrysler? Will it do any good?

The question is more complicated that it might seem. A bailout of the big three will most likely not save them, and only delay the inevitable. While it is true that the current vehicle sales rate of 12 million annually is unsustainebly low (the normal rate is between 14 and 16 million), it is also true that GM, Chrysler, and Ford have an unsustainable business model.

They produce millions of cars that they make no money off of and have no prospect for profit. Thus, they invest no money into the design and manufacture of those cars, resulting in cars that consumers disdain and a huge quality/cost gap with Toyota and Honda.

Why do they do this? For three reasons.
1. They are required to maintain vehicle emissions standards that are based on fleet averages. This means that small low emission cars offset the large high emission SUV's. SUV's make money for US car makers, small cars lose money. US carmakers have never specialized in small cars - their cars have always been large.

I am not against vehicle emission standards. I am only against poorly designed and irrational vehicle emissions standards, like the CAFE.

2. GM and Ford have huge pension and postretirement obligations to retired and older workers. This means that they need to pay those obligations. Thus, the two are willing to continue to sell unprofitable products because those products help to offset the cost of meeting these obligations. Even if the Ford Tauras has a pile of manure in the back seat when sold, selling some helps pay retirees, while selling none does not help.

The pension commitments were negotiated years ago with the UAW. Both the managements and UAW were complicit in a bargain where they would make promises to workers that they might not be able to keep instead of paying cash to workers in the form of wages.

Promises are cheap. Cash is not.

3. It is very expensive to shut down a manufacturing line. Not only do the unions not like it, but politicians get mad. Even more importantly, they are required to pay out significant cash to every worker terminated.

Sometimes it is cheaper just to keep the lines running.

Should we fix this?
So now we know why they are going bankrupt. They made their bed. Make them lie in it.

Unfortunately, it is not that simple.

A lot of people will get hurt. The employees. The retirees. The banks that lend to the companies. The suppliers. The dealers. The hairdresser that cuts the hair of the employees. The housing market in Detroit. The list goes on.

Bankruptcy does not necessarily mean the companies go away, though it might mean that. It usually means that unprofitable lines are shut down, employees laid off, wage contracts voided, and pension obligations dumped onto the taxpayer.

There is no question that the country will be better off in the long run with a reorganized or liquidated Big Three. The problem is that cure may be worse than the disease. It most definitely is for the employees.

A Bailout?
A bailout is unlikely to fix the problem, unless it is essentially an alternative form of bankruptcy. Indeed, much of the reorganization of the financial sector in the last year has been essentially a new bankruptcy workout process. Unfortunately, I do not believe that there is the political willpower do do what is necessary to fix the problem.

A bailout will probably involve some form of cushion: a cushioning of the blow of the failure of these companies. The initial loan will be an attempt to avoid the problem in pray for a quick economic recovery. When that fails, then the government will face a choice: let the firms fail and bail out the employees and surrounding communities, or bail out the firms and wait for the next time.

Post Script:
After I wrote this, I came accross this quote from Marginal Revolution:

Yermack estimates that the aggregate capital investment in GM and Ford since 1980 has led to a net reduction in capital of $465 billion...This is what I find particularly disturbing: with that $465 billion, “GM and Ford could have closed their own facilities and acquired all of the shares of Honda, Toyota, Nissan, and Volkswagen.” Here is more. And here are facts about GM wages .

Is it the End of the World?

2008-11-13T07:25:00.000-08:00

I took a short respite to get the root drilled out of my front tooth. The tooth was dead, so I didn't feel it; however, I did feel the infection surrounding the tooth. I'm better now.

It is easy to feel panic given the market sell-offs - it feels like it will never stop. Research has shown that investors feel and remember the pain of losses on stocks vastly more than they feel the pleasure of gains (though history has also shown that collective investor memory is still short). It is also well known that fear feeds on itself, and that combined with a massive global margin call, the markets make a departure from reality like we have witnessed in the last two months.

Departure from reality? Aren't we in for a long-term severe recession with the twin potential for deflation or inflation (or both)? Yep.

I don't know if the market has bottomed. I just looked at a company that will likely report earnings in 2009 that are down 55% from 2006. Yet the stock is trading at 8x, or a 12.5% yield. So on very depressed earnings in the worst environment they've witnessed at least since 1982 (probably longer), I can still get a 12.5% annual return with no growth. What if the economy eventually recovers? If that happens, earnings will at least rise 75% - to the average level over the last 25 years. That is, the stock is trading at 4.5x average earnings, or a 22% yield.

Here are excerpts from an article a colleague sent to me, written in November 1974:

Perspective on the market’s upheaval, offered by Jim Fullerton, former chairman of the Capital Group — on November 7, 1974, in the latest newsletter from American Funds

One significant reason why there is such an extreme degree of bearishness, pessimism, bewildering confusion, and sheer terror in the minds of brokers and investors alike right now, is that most people today have nothing in their own experience that they can relate to, which is similar to this market decline.

Each economic, market and financial crisis is different from previous ones. But in their very difference, there is commonality. Namely, each crisis is characterized by its own new set of nonrecurring factors, its own set of apparently insoluble problems, and its own set of apparently logical reasons for wellfounded pessimism about the future.

Today there are thoughtful, experienced, respected economists, bankers, investors and businessmen who can give you well-reasoned, logical, documented arguments why this bear market is different; why this time the economic problems are different; why this time things are going to get worse — and hence, why this is not a good time to invest in common stocks, even though they may appear low.

Today people are saying: “There are so many bewildering uncertainties, and so many enormous problems still facing us — both long and short term — that there is no hope for more than an occasional rally until some of these uncertainties are cleared up. This is a whole new ball game.”

In 1942 everybody knew it was a whole new ball game. And it sure as hell was. Uncertainties? We were all in a war that we were losing. The Germans had overrun France. The British had been thrown out of Dunkirk. The Pacific Fleet had been disastrously crippled at Pearl Harbor. We had surrendered Bataan, and the British had surrendered Singapore. The U.S. was so ill-prepared for a war that the cavalry school at Fort Riley was still teaching equitation, and I would guess that probably 75% of our field artillery was equipped with horse-drawn, French 75mm guns, Model 1897 (including the battalion in which I was then serving).

In April 1942, inflation was rampant. A Federal Reserve bulletin stated: “General price increases have become a grave threat to the efficient production of war materials and to the stability of the national economy.”

Today there is concern about the slump in housing construction. On April 8, 1942, the lead article in the Journal was: “Home construction. Total far behind last year’s; new curbs this week to cut further … Private builders hard hit.”

But on Saturday, April 11, 1942 (remember when the exchanges were open on Saturday?), the Wall Street Journal stated: “Brokers are certain that among the factors that are depressing potential investors are, (1) widening defeats of the United Nations; (2) a new German drive on Libya; (3) doubts
concerning Russia’s ability to hold when the Germans get ready for a full-dress attack; (4) the oceantransport situation with the United Nations, which has become more critical; and (5) Washington is again considering either more drastic rationing with price-fixing or still higher taxes as a means of filling the ‘inflationary gap’ between increased public buying power and the diminishing supply of consumer goods.” (Virtually all of these concerns were realized and got worse.)

On the same day, discussing the slow price erosion of many groups of stocks, leading stock market commentator said: “The market remains in the dark as to just what it has to discount. And as yet, signs are still lacking that the market has reached permanently solid ground for a sustained reversal.”

Yet on April 28, 1942, in that gloomy environment, in the midst of a war we were losing, faced with excess-profits taxes and wage and price controls, shortages of gasoline and rubber and other crucial materials, and with the virtual certainty in the minds of everyone that once the war was over we’d
face a post-war depression in that environment, the market turned around.

What turned the market around in April of 1942?

Simply a return to reality. Simply a slow but growing recognition that despite all the bad news, despite all the gloomy outlook, the United States was going to survive, that strongly financed, well-managed U.S. corporations were going to survive also. The reality was that those companies were far more valuable than the prices of their stocks indicated. So, on Wednesday, April 29, 1942, for no apparent visible reason, investors again began to recognize reality.

The Dow Jones Industrial Average is not reality. Reality is not price-to-earnings ratios and technical market studies. Symbols on the tape are not the real world. In the real world, companies create wealth. Stock certificates don’t. Stock certificates are simply proxies for reality.

More on Stock Market Valuation

2008-11-07T07:09:00.000-08:00

In a recent review of the market, Michael Mouboussin makes the following observations (quoted in excerpts):

One of the offshoots of this crisis has been a sharp rise in volatility. We know from empirical finance that volatility comes in clusters—low-volatility regimes alternate with high-volatility regimes. We have transitioned from one of the lowest-volatility periods in the mid-2000s to one of the highest today. To give you some sense of the numbers, during the weeks of October 13 and 20, 2008, the VIX (Chicago Board Options Exchange Volatility Index, a proxy for the annual standard deviation of S&P 500 returns) hit an intraday level of nearly 90, implying monthly volatility of over 25 percent. In the past 80 years or so, the annual volatility has averaged about 20 percent. (See Exhibit 1.) We last saw monthly volatility readings this high for a very brief period in 1987 and again in the 1930s. (See Exhibit 2.) People keep talking about how unusual this period is, and they are right. And you should expect volatility to remain elevated for the near term.

Finally, you can make a decent case for the market based on dividends alone. The current dividend yield on the S&P 500 is only about 25 basis points below the yield on the 10-year Treasury note (see Exhibit 3). You have to go back to the early 1960s to find a similar relationship. 6 If you add in share buybacks, the yield is about 400 basis points above the 10-year note yield, and that’s with buybacks down sharply this year (see Exhibit 4). And excluding the financial sector—and that’s a big exclusion—corporate balance sheets remain in decent shape.

One of the ways to think about environments like today is to step back and take a normalized view of things. Exhibit 5 shows the rolling 10-year returns for large-capitalization stocks. Over the past century-plus, the market has tended to bottom out around zero percent rolling ten-year returns. That happened in the 1930s and 1970s, and that is where we are today. The rolling 10-year figure is worth examining for psychological reasons, too. If the average investor is in a mutual fund, they have lost money after taking fees into consideration. Further, most investors lose an additional 200 basis points due to bad timing. So the bottom line is on a dollar-weighted basis, the average investor has been down substantially in the U.S. stock market in the past decade. That is very psychologically damaging.

To finish, here are a couple of observations from behavioral finance. The first relates to a great piece of research that is very relevant today. In this study, normal people were pitted against people with brain damage in a contest. The brain damage had nothing to do with mathematical or logical abilities, but dealt with the emotional seat—ability to feel fear, greed, anxiety and so forth. The contest was simple. Each participant was given 20 dollars, and for 20 rounds had a choice to do one of two things: they could either keep their dollar or hand the dollar to the researcher who then flipped a coin and paid $2.50 for a win and zero for a loss. So the expected value of handing over the dollar was $1.25. The bottom line is the brain-damaged participants ended up with 13 percent more money than the normal players. The reason is how frequently people were willing to gamble. Everyone understood that playing made sense, and almost all players started off handing over their dollars. But when the normal people lost a round or two, they often chose to hold on to their dollars in the next round. In other words, normal people forgo explicitly net present value positive bets after they have lost.

The second behavioral observation deals with stress. The whole story of how humans deal with stress is really interesting, but there’s one facet worth emphasizing. 10 When people get stressed, they tend to dramatically shorten their time horizons. If you’re a zebra being pursued by a lion, turning off systems for digestion, reproduction, immunity, and growth makes all the sense in the world because the chase will be done, or you will be done, in short order. But humans, who have many of the same physiological responses, are not dealing with a short-term threat, but rather a long-term system called the stock market. So taking a long-term view is absolutely crucial, although really hard.

In summary, we are in the midst of a massive deleveraging process, but governments are acting proactively, even if clumsily, to mitigate the impact. Equities, after suffering a tough period, look attractive for the long haul. But psychology tells us that stepping up in these types of market environments is really tough.

Michael J Maubossin, "Where from Here: Long-Term Opportunities Amidst the Fear", October 29, 2008

A Couple of Good Articles

2008-11-04T06:56:00.000-08:00

Economists Who Don't Have a Clue:
Robert Shiller explains why Economists and the Fed are not very good at anticipating bubbles and subsequent recessions. His basic point is that challenging the consensus can get you fired or ostracisized (or, as an aside, if you are essentially among the 10 most highly qualified candidates for admission to PhD programs, why you can't obtain admission anywhere in the country due to the fact that you have a relatively unorthodox background and perspective). He also notes that most Economists are trained mathmaticians, and are not well versed in psychology, tending to reject some basic observations about human behavior that are relatively well known. The article is in the NY Times.

http://www.nytimes.com/2008/11/02/business/02view.html?_r=1&partner=permalink&exprod=permalink&oref=slogin

What does this say about the current consensus that we are facing a severe deflationary recession, despite huge increases in the Fed's monetary base and collapsing commodity prices (which are mostly imported to the US and serve as a cost to the economy, not a form of revenue)?

Why People Don't Vote
Blogger and Economist Greg Mankiw discusses why people don't vote and why that might be a good thing. His basic theory is that people who don't vote are generally not well informed about the candidates and therefore would add random noise to the outcome. We would rather have voters well informed about the issues and not have people vote who have no idea what they are doing.

http://gregmankiw.blogspot.com/2006/11/election-day-approaches.html

A question: do people who are deemed "well informed" have any idea what they are doing?

Is the Stock Market Cheap?

2008-11-03T07:49:00.001-08:00

Generally speaking, there are two general investment strategies (and limitless variations):

1. Momentum: buy stocks that are rising, sell stocks that are falling - ride the trend up, avoid the trend down. Generally, this strategy is only concerned about the short term trends, and is unconcerned about the long term.
2. Value: buy stocks that are cheap, sell stocks that are expensive. Usually, this strategy is concerned with the long term, and, to be successful, must be willing to ignore short-term volatility (that is, be willing to suffer short-term price declines after purchase).

Both strategies have their strengths and weaknesses - risks and rewards - though I would argue that the momentum strategy is usually much more difficult to succeed at on a consistent basis.

As a value investor, the pertinent question is always: are stocks cheap?

There are two arguments I have seen regarding stock market valuation:

1. Historical absolute P/E ratios: here the analyst looks at P/E ratios and compares them to history. So, for instance, in the 1970's, the P/E ratio of the S&P 500 was in the upper single digits, whereas in the late 1990's, it was around 35. That would imply that stocks were cheap in the 1970's and expensive in the late 1990's. Currently, it is in the mid-teens (depending on one's estimate and definition of S&P earnings).

There are two problems with this approach.

First, the absolute (unadjusted) P/E ratio is not a good measure of value. Earnings from year to year is volatile and cyclical. Big write-offs in, say, the banking sector, can depress earnings for the year, which might be offset by, say, unusually fat profits in the commodity sector. One would hope that banks are not going to continually write off hundreds of billions in capital year after year. Thus, P/E ratios actually go up in recessions, despite stock price sell-offs, and go down in booms, despite extra-normal profits. Analysts using this method argued that the stock market was not yet chep in the summer of 2002, despite the fact that many companies were reporting unusually low earnings.

Second, interest rates are a critical component of valuations. Which leads to the second method of measuring value:

2. Measuring average S&P earnings over a cycle and linking the normalized P/E ratio to normalized interest rates. While this doesn't necessarily tell one when to buy or sell, it does give an indication of expected returns embedded in the market. Most analysts who use this method would prefer to use normalized cash flows for industrial companies and price/book for financial companies, but P/E is a useful short-hand.

Currently, the "consensus" S&P earnings figure for 2008/2009 is around $90. But, of course, we know that that is probably overstated. The most conservative figure I've seen is $70, though extreme bears might argue $50 is more likely. That, of course, depends on whether you are using operating earnings or actual earnings (including write-offs). If you want to predict next year's earnings with precision, then actual earnings are more relevant. If you are doing valuation work, then operating earnings are more relevant.

Then, we look at "normalized" interest rates. There are a couple of approaches: one could use US Treasuries (preferably 10-year or 30-year) and add a risk premium; or one could use Corporate Bond averages, and add a risk premium.

What's tricky about this is that "normal" depends on your inflation/ deflation outlook. If you believe inflation is in our future, you would use a higher interest rate. If you believe deflation is in our future, you would use a lower interest rate, but add a higher discount rate.

Generally, I have used a 5% 10-year treasury and a 6% 30-year. In a normal environment, a 6.5% corporate bond is typical. For stocks, you use a 4-6% risk premium to the 10-year (historically, it has averaged 4% to the 30-year), and subtract the nominal growth rate of 5%, for a net discount rate. That translates to roughly a 5% rate.

To get the ratio, you use the inverse of that, or 1/0.05 = 20x earnings.

For those not versed in the basics of finance, this is called the simple DCF model, except applied to the P/E ratio. Since the DCF is typically applied to cash flows and not to earnings, and cash flows are typically lower than earnings, an adjustment is needed.

Therefore, 20x cash flow typically equates to 16-18x earnings. This implies an annual return of 10% on average.

However, that should be applied to "normal" or average earnings.

While $50 earnings might be accurate for next year (2009), it would be a stretch to argue that $50 is normal. More likely, $100 is normal. But for our purposes, we will haircut the $100, owing to the fact that we are probably facing either a mult-year recession or multiple years of subpar growth. So, we will use $80 (20% is a pretty big haircut on "normal" earnings).

So, conseravately estimated, the S&P is valued at $1,350. That's 40% higher than where it was trading at recently, though well below the peak of $1,576 on October 11, 2007.

Again, this is not a forecast, nor does it tell you when to buy and when to sell. It is important to remember that mispricings can persist for years at a time, and the spread between the price of an asset and the value of that asset can widen before it narrows.

The scenario that undermines this estimate is a true depression-era deflation that would cause many companies to go bankrupt, and thus never be able to return to "normal" earnings once the economy recovers.

Liquidity Traps and the Federal Reserve

2008-10-31T07:40:00.000-07:00

As the focus on the national scene moves from how to prevent a collapse in the financial system to addressing the recession, much of the discussion now seems to be focused on dealing with what is called a "liquidity trap".

A liquidity trap is the reverse of what happened in the 1970's, when American's began to expect prices to rise every year and built those expectations into their spending and living habits. That inflation was primarily caused by expansionary monetary policy by the Federal Reserve in the 1960's and 1970's under pressure from the Nixon Administration and under a then-prevailing belief that the role of the Fed was to stimulate the (real) economy. It was an unlikely alliance between Federal Reserve chairman Paul Volker and the Reagan Administration that brought an unceremonious end to inflation with the 1982 recession.

Many have pointed to the Fed's expansionary monetary policy from 2002-2004 as the cause for the credit bubble and subsequent bust, but I am not convinced. While inflation did pick up a little over the past 12 months, significant monetary expansions always result in inflation, and we simply didn't see enough of it. It is more likely that a surplus of worldwide capital (savings) combined with distortions introduced by both the public and private sector led to excessive risk-taking, resulting in poor capital allocation decisions (sub-prime lending and the like). The collapse in the housing sector punched a hole in the financial system, reversing the capital flows away from risk towards safety.

This has the potential to lead to a liquidity trap: lenders won't lend because they don't have the capital. Borrowers won't borrow because they fear that prices will decline further (expectations of further declines). Demand dries up and prices then decline further, leading to further defaults and further capital destruction. Price declines spread from the initial source due to constrained capital. Individuals and businesses hoard cash because cash has the highest (non-negative) return. The decline in prices is accompanied by a decline in the aggregate money supply, because cash has no multiplier effect when it is not lent out.

This is the death spiral that took place in the Depression, though housing was not the primary source. A liquidity trap can be a self-fulfilling prophesy.

This spiral also took place in Japan as a result of their real estate bust, though Japan did respond by injecting liquidity into the system. However, it is now believed that they were not aggressive enough nor targeted enough.

How does a country escape a liquidity trap?

In most recessions, demand and lending does pull back, but the usual monetary policy tools are sufficient to counteract that. The Fed lowers interest rates, thus effectively injecting cash back into the system. He then raises interest rates when the economy recovers to prevent inflation. Lower interest rates help borrowers and hurt savers.

However, sometimes a liquidity trap is so severe that the usual tools aren't enough. If deflation erupts, then low interest rates aren't enough to help borrowers - interest rates can't go below zero. The Fed then injects liquidity through other means, and the focus then shifts to its balance sheet.

In this latest crisis, the Fed combined with the Treasury has so far: lowered interest rates, arranged bank takeovers by guaranteeing debt, lent directly to banks through the discount window (not often used in normal times), lent directly to other financial institutions by purchasing commercial paper, injected capital directly into banks, made arrangements with Latin American central banks to stablize their currencies, nationalized mortgage securitization, and partly nationalized debt default insurance (called Credit Default Swaps).

All of these actions are targeted at stabilizing the financial system and containing the damage from falling housing prices. However, these actions do not target damage already done by falling housing prices, namely falling commercial real estate, credit card defaults, and falling asset prices elsewhere in the economy. In addition, the Fed has not contained directly the fall in housing prices, and debate is emerging over this issue.

If commercial real estate continues to fall, then the Fed may need to step in again to limit the damage to the financial system, which I suspect he will do if necessary.

However, more controversial is the prospect of intervention directly in the real estate markets. This would involve, either directly or indirectly, the purchase of distressed real estate, thereby adding demand. However, this presents a problem: what would the government do with the real estate? The government is ill-equipped to manage physical assets dispersed throughout the country.

The most likely answer is that the purchased property would be bull-dozed, leased out, and/or sold on a clearing house (would you be interested in buying a vacant lot next door at a deeply discounted price?).

How would this be financed? That would depend on the monetary response: the Fed could finance it by printing money, or the Treasury could finance it by issuing debt (aka, raising future taxes).

An alternative would be to offer various incentives to private capital to purchase distressed homes. These incentives would raise the effective return and reduce the risk, and should include subsidies for maintenance and upkeep. Private capital could then lease the homes or simply sit on them, waiting for better times. Since population growth in the US is positive (1.5% to 2.5% per year), any excess capacity in housing could be absorbed in a 3-5 year time period - people gotta live somewhere. This would preclude the need to destroy houses, since homes will likely be needed at some point in the future.

It would not be costless - these subsidies could deprive the Treasury of future tax revenue, but it wouldn't necessarily require borrowing in the present.

Mr. Market

2008-10-29T13:50:00.000-07:00

Amid investors rushing for the exits in recent weeks, here some interesting observations about the market.

On many days in the past few weeks, the market has sunk as much as 5% in the last 30 minutes of the day. What is causing this?

Mutual funds generally do their trading at the end of the trading day. They do this because it allows them to price the trades at close to the NAV (net asset value) of their funds, giving them predictability as to the funds available for their investors to withdraw (or contribute). In addition, they receive liquidation orders throughout the day (to be executed at the day's end NAV), so by the end of the day they know what their funding requirements are.
Short sellers have almost certainly noticed - an easy trade is to short the stock at 2 PM and then buy back at 9 am the next day. This increases the volatility - and hurts the mutual funds doing the trading.

Another phenomenom is the "global margin call" effect: hedge funds are receiving both liquidation calls as well as calls for more collateral on their margin loans.

Hedge funds are one category of investors that engage in significant borrowing and/or use derivative leverage to establish positions in all kinds of assets (including stocks). With banks reluctant to lend and with asset prices falling, hedge funds are being forced to put up more collateral or liquidate positions.
Hedge funds investors are only periodically allowed to withdraw funds, usually the end of the year. This year, hedge fund losses on average exceed the losses on mutual funds (which is a pretty tall accomplishment). Investors accross the board are calling in to withdraw their funds. Thus, these leveraged hedge funds are forced to liquidate to meet redemptions.
For a fund leveraged 4:1, every dollar of redemption or every dollar of margin call forces another $3 to be withdrawn from the portfolio. So, if Mr. Hedge Fund investor withraws $1, then $4 is liquidated from the portfolio and thus from the overall market.
While this is a big problem in the US, it appears to be a much bigger problem in emerging markets.

FW: It Could Be Worse, A Lot Worse

2008-10-29T13:00:00.001-07:00

Talk about bad governance ...

Feed: CARPE DIEM
Posted on: Tuesday, October 28, 2008 11:37 PM
Author: Mark J. Perry
Subject: It Could Be Worse, A Lot Worse

Now here's a real financial crisis: 231 million percent inflation and 80% unemployment rate in Zimbabwe.

Heading to the grocery store:
The Z$1.243 billion dinner bill:
Paying the bill:
See more pictures of Zimbabwe's monetary and inflation crisis.

HT: Ben Cunningham

View article...

Economics & The Debate over the Impact of the Crisis

2008-10-24T11:57:00.001-07:00

I have come accross several articles debating the impact of the crisis on the real economy. I can't figure out how to attach them to this blog, so I will summarize them.

The Minneapolis Fed put out a research paper arguing, basically, that the crisis has not had much of an impact on nonfinancial firm’s access to credit. The author cites four popular myths not supported by the data:

Bank lending to nonfinancial corporations and individuals has declined sharply – it has not (except for low credits, which is normal in a recession)
Interbank lending is essentially nonexistent – it exists at rates below what prevailed in 2006
Commercial paper issuance by nonfinancial corporations has declined sharply – it has actually remained steady (this myth’s source is probably the misclassification of GE as an industrial company)
Banks play a large role in channeling funds from savers to borrowers – borrowers obtain funds from a variety of sources, including their own savings

The debate focuses on whether firm’s are fast drawing down existing lines of credit either because they need the money or because they fear the line will be cut off. Is this phenomenon masking the actual decline in credit? The answer is that we don’t know because we don’t have the data, though one author did cite surveys that indicate that it is more difficult to get credit today than a year ago (is comparing today versus a time of easy credit a compelling argument?). Another author argued that drawing upon lines of credit is not "masking" credit declines - it's still a form of borrowing and it may actually be partly contributing to the tight credit elsewhere.

It's also important to remember that credit tightening should be expected in industries like home construction - we don't want lenders lending to home builders right now.

Tyler Cowen wrote a commentary in the NYT attributed the current mess to three fundamental sources:

The enormous growth in global wealth over the last decade created a savings glut, something often missed in the discussion on excess liquidity. There has been too much capital to be efficiently allocated.
Decreased risk aversion (and “collective delusion”), where investors are willing to take improper risks in the search for better returns.
Weak governance and oversight at all levels both public and private. He argues “that both government and markets failed miserably – at the same time and on the same issues.”

The WSJ today wrote a short piece about the increase in volumes of home sales against a backdrop of continuing price declines. I saw another article today on the influx of vulture investors into the most depressed parts of Miami condo market. This is the sign of a turn - when volumes spike on lower prices, it means the market is beginning to clear and is moving towards stabilization.

What are Bubbles and Why do they Form?

2008-10-22T07:17:00.001-07:00

Forbes published a series today on market bubbles (Why Do Markets Create Bubbles?), which points to an interest phenomenon: asset bubbles. Incidentally, the author cites a famous book on the subject: Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay (1841).

The definition of an asset bubble (also called a speculative bubble) is the subject of debate. Academics like to claim that bubbles don't exist; they are simply the rational reaction of underlying market distortions usually caused by misguided government policies. However, that explanation, at best, only partly explains the persistence of bubbles: if markets were efficient, they would recognize the policy distortions and adjust to reflect them, thereby diffusing the bubble before it emerges.

I would define a bubble thus (albeit vaguely): an asset bubble is when the price of an asset or asset class rises suddenly and rapidly, without any rational and concrete link to the underlying value. Several factors are enablers of bubbles, including most importantly the availability of excess liquidity (either through easy lending policies, government subsidies, market manipulation, or easy monetary policies). This excess liquidity infuses into the market too rapidly for it to be absorbed and allocated efficiently, especially if the institutional structure of a market prevents it from adjusting prices across asset classes (as it does in the US).

Prices of assets are set at the margin: the purchases of an asset relative to the sales of an asset; prices are not set based on the value of the holdings in the asset. For instance, if 100 people own an asset, but only one is buying and one selling, the price is set by the buyer and the seller, not the other 99 holders. That price is temporary, subject only to the momentary transaction. Thus, if someone offers me $200 for a pencil, and I sell, the price of pencils goes up to $200 - temporarily. But if everyone tries to sell all of their pencils for $200 all at once, there won't be enough buyers with enough cash willing to buy all of the pencils. Prices will then decline.

The value of an asset is a function of its underlying usefulness. In the case of pencils, whether the pencil can write relative to its cost and relative to alternatives (i.e., pens, highlighters, blood, etc.). In the case of stocks, the value is a function of the company's ability to generate profits to shareholders (since that is the only function of stock).

In a bubble, a sudden influx of capital into an asset or asset class often outstrips the sale (or supply) of the asset. The resulting rise in prices sets off the psychological reaction described in the article above.

The bubble ends when the liqudity dries up. But sometimes not before it sucks liquidity from other markets, driving down prices in those markets in order to support the continuing influx of capital into the original asset class. When lending is the enabler, as opposed to cash, the shift in liquidity can be accross a time spectrum as opposed accross asset classes.

In one of the recent examples, a bubble in oil and foreign (non-US) currencies sucked the capital out of the US and out of the real estate bubble that had preceeded it. The end of the housing bubble, therefore, primarily was the oil bubble. The oil bubble is now giving way to a US treasury bubble and "safe asset" bubble, as capital flees from risk (the hallmark of a bear market), buying into US Treasuries.

Therefore, the US Government's bail-out of the banking system represents a kind of arbitrage: selling overpriced US Treasuries and US Dollars and taking that capital and reinvesting it into underpriced risky assets.

A bear market or a market crash is the opposite of a bubble, and is often the result of a bubble's end. In a bear market, investors flee assets, as sellers outnumber buyers, driving prices into a downward spiral - again prices are set at the margin. The decline in prices immediately take on the psychological element, in reverse to the asset bubble.

All of these effects are temporary - unless a feedback loop develops. By temporary, I mean 2 to 5 years for a bubble, and 1 to 2 years for a bear market. However, when a feedback loop develops, the bear market can be extended for a much longer period of time.

The market serves a vital function in the economy: it finances economic activity. When liquidity is too high in a specific sector, economic activity exceeds what is sustainable and excess capacity results. Thus, we have too many houses that have been built over the last 4 years, and the technology industry suffered from excess capacity for several years after the 2000 bubble. When liquidity is too dry, economic activity cannot occur, and industry is impaired. Thus, a recession results. The problem occurs when permanent damage is inflicted on the economy due to the loss of liquidity - a bubble generally affects one sector, but a bear market can affect many sectors.

Another good article in Forbes is Surviving Until Next Time.

I'm not a big fan of technical analysis, except in the case of market extremes (like now). The following article compares the current market with the 1974 bear market: Starsky & Hutch.

What Would Friedman Say?

2008-10-21T07:21:00.000-07:00

A good perspective on the current economic situation.
http://www.forbes.com/2008/10/16/milton-friedman-meltdown-oped-cx_pr_1017robinson_print.html

Buffett on the Stock Market

2008-10-17T11:53:00.001-07:00

Warren Buffett wrote an editorial in the NY Times this morning on the stock market.

http://www.nytimes.com/2008/10/17/opinion/17buffett.html?_r=1&partner=permalink&exprod=permalink&oref=slogin

Economic Gangsters

2008-10-17T11:16:00.000-07:00

There is a new book on economic gangsters - those who operate illegally and the economics of illicit trade. I haven't read it, but it looks interesting. Supposedly it is highly readable.

The website: http://www.economicgangsters.com/thebook.php

Capitalism at Bay

2008-10-17T07:31:00.000-07:00

The Economist had a good editorial on where we go from here, called "Capitalism at Bay". Since a subscription may be required, I have put excerpts here.

Intervening to prevent banking crises from hurting the real economy has a strong pedigree. Wilson’s son-in-law, Walter Bagehot, recommended that the Bank of England lend generously (but at a penalty rate) to illiquid banks (but not to insolvent ones). In modern times governments of every political stripe have had to step in. Ronald Reagan and Margaret Thatcher oversaw the rescues of Continental Illinois and Johnson Matthey. In the 1990s the Finns and Swedes nationalised banks—and privatised them again later...

Even if it staves off disaster, the bail-out will cause huge problems. It creates moral hazard: such a visible safety net encourages risky behaviour. It may also politicise lending...

Capitalism’s defenders need to deal with two sorts of criticism. One has much more substance than the other...

The weaker, populist argument is that Anglo-Saxon capitalism has failed... In fact, far from failing, the overall lowering of “barriers to intercourse” over the past 25 years has delivered wealth and freedom on a dramatic scale. Hundreds of millions of people have been dragged out of absolute poverty. Even allowing for the credit crunch, this decade may well see the fastest growth in global income per person in history. The free movement of non-financial goods and services should not be dragged into the argument—as they were, to disastrous effect, in the 1930's...

A second group of critics focuses on deregulation in finance, rather than the economy as a whole. This case has much more merit. Finance needs regulation. It has always been prone to panics, crashes and bubbles (in Victorian times this newspaper was moaning about railway stocks, not house prices). Because the rest of the economy cannot work without it, governments have always been heavily involved...

Without doubt, modern finance has been found seriously wanting...

Yet the failures of modern finance cannot be blamed on deregulation alone. After all, the American mortgage market is one of the most regulated parts of finance anywhere: dominated by two government sponsored agencies, Fannie Mae and Freddie Mac, and guided by congressional schemes to increase home-ownership. The macro economic condition that set up the crisis stemmed in part from policy choices: the Federal Reserve ignored the housing bubble and kept short-term interest rates too low for too long. The emerging world’s determination to accumulate reserves, especially China’s decision to hold down its exchange rate, sent a wash of capital into America. There was something of a perfect storm in which policy mistakes combined with Wall Street’s excesses...

Sadly another lesson of history is that in politics economic reason does not always prevail—especially when the best-case scenario for most countries is a short recession...

Selling or Giving Away

2008-10-16T12:43:00.000-07:00

"Those who sell investments in this environment are, at best, giving money away. At worst, they are allowing their money to be stolen."

In 1999 and early 2000, stock prices on technology related stocks, especially Internet stocks, departed from reality. They were being priced at the margin: too many buyers and not enough sellers. Then the buyers dried up and the sellers were left with nothing.

Today, in 2008, stock prices have yet again departed from reality. This time there are too many sellers and not enough buyers. The sellers are being forced to sell, short sellers are feeding, and buyers are waiting. At some point, however, sellers will disappear, and reality will set back in.

The market can be irrational, but only for a limited time. We can debate the value of any one stock, but once the price moves outside of the legitimate range of debate, the price has disconnected itself from reality.

However, reality always wins.

If you have cash, your cushy retirement fund is waiting. It won't be there for long, though.

The Great Liquidation

2008-10-15T18:42:00.000-07:00

This is not a Great Depression, it is a Great Liquidation. Reviewing some of our holdings with a colleague today, an obvious pattern emerged.

The most irrationally and bizarrely priced stocks are held by gigantic mutual funds most likely in the throes of massive withdrawals due to greater than usual abysmal performance: Dodge & Cox, Chris Davis, Legg Mason. This means that they are forced to sell off their holdings, and some of these guys are prone to hold very concentrated positions.

Up til this point, we have assumed that leveraged hedge funds were the primary victims of forced liquidation, but the mutual fund industry is much huger than the hedge fund industry, and is very prone to panicked withdrawals by retail investors. Investors typically redeem their worst performing funds first.

This post might also be called the "Death of Value", though an explanation of what that means will take much longer than I have tonight.

It was late in the day, so I didn't have a chance to investigate further, but I intend to see if there are other very large liquidators in the shadows and determine what kind of impact they are having.

Seth Klarman Conference Notes

2008-10-15T11:34:00.000-07:00

from colleague, Wes Goebel:

Seth Klarman at CIMA Conference 10/2/08

1. Biggest fear was buying too soon and on way down, from up in over-valued levels. Knew market collapse was possible and sometimes imagined I was back in 1930. Surely there were tempting bargains and just as surely would have been crushed after decline of next 3 years. A fall from 70 to 20 and fall from 100 to 20, would feel almost exactly the same. At some point being too early becomes indistinguishable from being wrong.

2. Getting in too soon brings risk to all investors. After a stock market has dropped 20% – 30% there is no way to tell when the tides will change. It would be silly to expect that every bear market will turn into a great depression. Yet fair value from under-valued can't be predicted, and would be equally wrong.

3. As market descends you are tempted with purchasing companies. You will be bombarded with tempting opportunities. You never know how low things will go. When credit contracts and tide goes out on liquidity. At these times recall the wisdom of Graham and Dodd. At this time, you should not market time, but stick to your value convictions. You will see tempting bargains and value imposters. Ignore macro and look to buy cheap.

4. In a market like we have been experiencing. Most investors lose their rudders. They become unwilling to part with cash. They start working on macro economic level. Investors look to pull out of market and wait for a clear signal of change. Value investors should be able to keep their focus and remember Graham and Dodd of 1934.

5. If you can maintain your focus, resist business pressures and have a multifaceted tool kit, you can expect to prosper, even in difficult times.

A. Always recall road map of Graham and Dodd. Revisit this road map when times get difficult. Maintain discipline and value with a margin of safety. This doesn't mean you won't lose money. It means if there are drops in price, you have even more of a bargain.

B. Avoid highly leveraged stocks, junk bonds and shaky financials.

C. Look for bargains in various industries and nations.

D. Look at value, not great companies and great management.

E. Listen to Warren Buffett when he states you should buy a stock as if the market would close for a long period of time after you bought the stock.

6. Remain focused on the long run. Graham and Dodd motivate our diligence. They are like silent sentinels. Navigate the best you can and Graham and Dodd are the North Star for value investors.

7. Stand against the prevailing winds, selectively and resolutely. Yet for a while a value investor will under-perform. Interim price declines allow you to average down. Do not suffer the interim losses, relish and appreciate them.

8. Value investing at its core is the marriage between a contrarian streak and a calculator. Buying what is in favor is ensuring long-term under-performance.

9. It is critical to remind your clients, investment team and as often as necessary yourself, that you can only control your process and approach. Understand that you cannot control or forecast the vagaries of the market. Then you should invest in what you believe and what your research dictates. Be indifferent if you lose your short-term oriented clients, remembering that they are their own worst enemies.

10. Controlling your process is essential.

A. Be focused on process, not outcome.

B. Do not judge a decision based on its outcome.

C. During periods of under-performance it is easy to change your process.

D. When a firm is worried about tempers, second-guessing and fear, the process will fail. Look for long-term results; anything else will corrupt the process.

11. Value investing is an art and not a precise science. It is dealing with the fact that we do not work with perfect information.

12. Mechanical rules are dangerous. Graham and Dodd principles should serve as a screen.

Q&A

1. How do you see current investment climate?

A. James Grant - Look at some MBS and beaten down bonds. Some are priced to yield teens. They are priced for a further 25% decline. Also unsecured debentures of nations top retailers. These are priced at 5% to 7%. Hence, short the retailers at 6% and go long the beaten down mortgages.

B. Seth Klarman - Unusual amount of forced sellers, via margin calls. This could breed opportunity. Sees a lot of money managers staying on the sideline. He finds this as an opportunity to buy. Buy when others react to news or false news. His experience is when people give away stocks out of need, due to fear or margin calls, that sounds like a great buying opportunity. In this environment you are playing against very smart people.

C. Bruce Greenwald - Take a deep breath. All the doomsday talking is not being reflected in stock prices. Stocks are basically down 25%, but unemployment is not great like early 1940's. You need to put this into perspective like 1991 or 1982.

2. Klarman discussed buying one security at a time. Not everything is a bargain out there. Be selective. Many of us have seen opportunities now, and history says to buy them. We bought knowing that banks are going to fail, that real estate would drop, but that certain mortgage backed securities were under-valued. Never leverage, where you can have an opportunity to buy and not be able to take advantage of it because of leverage.

3. James Grant - Treasuries are yielding less than expected future CPI. Treasuries are now being priced as a macro-economic play. Treasuries are not intrinsically safe. They are not safe based on valuation.

4. What factors do you look at in sizing a position?

Seth Klarman - He thinks this has been missed over the last 15 years. Most of the diversified risk is done via 20 to 25th position. We have had a 10% or so concentrated position about a dozen times over the last 20 years. Most of the time we have 3,5 and 6% position. We will take it higher if we see a catalyst for increased value. We would not own 10% position in a common stock, only because it seemed under-valued. We would have a greater than 10% position if there was a margin of safety. I see managers make mistakes with concentrated positions in similar industries. Small positions of say 1% are nonsensical. We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges.

A Very Good Explanation

2008-10-15T08:49:00.000-07:00

The following link is to the Freakonomics collumn on the financial crisis. It is a very good explanation of the current crisis and the government's plan to recapitalize the banks:

http://freakonomics.blogs.nytimes.com/2008/10/15/everything-you-need-to-know-about-the-financial-crisis-a-guest-post-by-diamond-and-kashyap/

Not a Great Depression

2008-10-15T08:06:00.000-07:00

A post on Carpe Diem on why we are not facing another Great D:

http://mjperry.blogspot.com/2008/10/another-great-depression-not.html

Another Bankruptcy

2008-10-15T07:39:00.000-07:00

Jefferson County, the home to Birmingham, Alabama is days away from a bankrupty (Chapter 9) filing. Here is a good article on it:

Birmingham on the Brink (Fortune)

Car Crash

2008-10-15T07:18:00.000-07:00

It's no secret that the Big 3 carmakers are in trouble. GM is burning $1 billion a day in cash, and it only has $20 billion in cash its the balance sheet. This is a crash everybody saw coming, but nobody - least of all GM, Ford, and Chrysler - did anything to prevent. Bankruptcy is almost inevitable, and according to one auther, preferable.

http://money.cnn.com/2008/10/14/news/companies/gmwoes_taylor.fortune/index.htm?postversion=2008101509

Punctuated Equilibrium

2008-10-14T06:38:00.000-07:00

The prevailing theory in academic finance about markets is called "market efficiency" - namely that asset prices efficiently incorporate all available information about those assets. Thus, price movements reflect a "random walk", incorporating new information as it flows. Price volatility is assumed to follow a normal distribution of returns (aka, "bell curve"), and assets are assumed to maintain various levels of correlations (degree to which prices of different assets move together). Upon these assumptions sophisticated models of diversification and statistical risk are built.

The problem is that they don't work.

Financial market history is replete with spectacular "model failures" - the crash of 1987, the Long-Term Capital Failure of 1998, and most recently the failure of VaR ("Value-At-Risk") and the sub-prime securities (which were based on models derived from academic theories). In some cases, they not only didn't prevent the crisis, they actually contributed to it.

Where have they failed?
1. Asset price movements only follow a normal distribution over short periods of time.
2. Asset price correlations are not stable - in times of crisis, all assets move in lockstep. Therefore, diversification doesn't protect a portfolio from a crisis.

What we observe in financial market history is that it is marked by periods of relative stability. These stable periods are punctuated by periods of crisis and chaos, or crashes. Some crashes are small, some are large. Indeed, if we observe human history, we find similar patterns - long periods of relative stability punctuated by shorter periods of chaos and rapid change as society searches for a new equilibrium.

The basic principle of this "punctuated equilibrium" is that a system of finance is put into place that functions to enable growth and prosperity over a period of time. However, that same system creates or masks imbalances and pressures that also build up over the same time period. Once the pressure reaches a breaking point, the system "blows up" resulting in a crisis, crash, or chaos while the markets find a new equilibrium. Much like an earthquake.

Some Long Term Solutions

2008-10-13T15:30:00.000-07:00

There are plenty of articles out there on how to solve our current banking crisis. Most of them involve some kind a recapitalization of the banks: i.e., injecting money directly into the banks so they are able to start lending again. This is a necessary step, but a short-term solution.

However, our financial system is broken. The conduit of financing home purchases for the last 30 years has been securitization, and currently only guilded prime borrowers are getting mortgages because nobody will buy securities that are backed by anything else. All of those homes built in the far flung suburbs purchased by middle income households need to be purchased by somebody.

The problem with the system of mortgage lending is, of course, the implicit put option. This means that if a homeowner takes out a mortgage, and the house price goes up, he gets all of the profit on his initial investment. So, if he puts $20,000 down on his $100,000 house, and the price goes up 10%, he pockets the profit of $10,000, or a 50% return on his investment.

However, if the price goes down 25%, then the house is worth only $75,000 - less than the value of the mortgage. At this point, he must decide if his credit rating is worth the $5,000 he is underwater - because if he mails in the keys and walks away, then his losses are limited to the initial $20,000 down. This is what we mean by the put option - he can "put" the house to the bank.

Now, if we change the numbers to the following: $3,000 down, 10% interest rate, and a 50% decline in value. What do you think his incentives are now? Who wins and who loses in this scenario? In short, this is what has caused the subprime meltdown.

So how do we fix this? Well, we can go back to 20% down for super-prime borrowers only, but that doesn't fix the problem because we are still swimming in houses.

Here are my proposals:

* Provide tax credits and deductions to households that choose to rent. This would put renters on par with homeowners, bid up the rental rates, and deleverage (reduce the debt of) existing households. With rental rates higher, investors and property management companies would begin snapping up the existing vacant homes. People gotta live somewhere. Congress could give a tax break to lessors to jump start the process. Why are renters subsidizing homeowners anyway?

* Restructure mortgage terms to convert them into equity. A homeowner could buy 20% of a house, and the bank would buy 80%, leasing out the remainder to the owner as "interest". The homeowner would have control over the property, and could buy out the bank at anytime at the prevailing home price. If the price goes down, both the bank and the homeowner would lose money in proportion to their stake. If the price goes up, both the bank and the homeowner would make money. The price would have to be determined according to a fair, transparent and objective process. The bank would then sell the stake to (equity) investors in the form of standardized and aggregated securities. The tax incentives would need to be changed to accomodate this.

These approaches would not eliminate the price volatility associated with houses, but they would neutralize the effect of leverage on the individual and, if structured correctly, on the economy. They are not perfect solutions, but they would improve the structure of the industry today.

Barnanke Can Make it Work

2008-10-13T07:16:00.001-07:00

Fortune had a good article on the current crisis:
http://money.cnn.com/2008/10/10/news/economy/fox_great_depression.fortune/index.htm
(subscription not required, but user sign-in might be required)

What Did I Miss?

2008-10-13T06:49:00.000-07:00

As a value investor, I specialize in spotting risks - specifically valuation-related risks. Here is a short list of risks I have spotted and avoided in my career (since 1998):

Tech-Stock Bubble: 1997-2000 and subsequent bust: 2000-2002
US Dollar Currency Slide: 2000-2008 and rebound: 2008-
Real Estate Bubble: 2002-2006 and bust: 2007-2008
Commodity & Oil Bubble: 2005-2008 and bust: 2008

In several cases, I was not in a position to profit from those events, though in several cases I was in a position to lose money from them. However, there was one bubble and bust I did not spot clearly enough:

The credit bubble of 2005-2007 and bust of 2008

And it has cost me (though not as badly as it has cost some others). So what did I miss?

That is a question I am still asking myself, and there are two answers I have so far:

1. The credit bubble was deeply enmeshed in our financial system, and I did not have specific knowledge of financial companies (only general economic knowledge). In retrospect, I should pay closer attention to banks and credit markets, since that is where most of the leverage is in our economy.

2. The credit bubble was linked to the real estate bubble, and the bust is really a blowback from the real estate bust. I could spot the real estate bubble because I can evaluate the prices and determine that they do not reflect reality. However, credit is not priced in that sense, and therefore cannot be compared against reality in the same way. Therefore, I need to find ways to examine capital flows and determine when and where imbalances are building up.

Some Good Articles on the US

2008-10-13T06:11:00.000-07:00

In the WSJ today:

Burton Malkiel (author of Random Walk Down Wall Street): http://online.wsj.com/article/SB122385741803727333.html

Are we headed for Depression?

2008-10-10T07:57:00.000-07:00

That's the trillion dollar question. It all depends on the policy response.

I don't believe we are headed for a Great Depression, as I have said in previous posts. The policy response then was non-existant, and what policies were implemented greatly magnified the damage: up until Roosevelt's inauguration, government policies wraught incredible damage to the economy. Roosevelt did some things right and many things wrong. At the end of the day, however, the most destructive policy was to allow massive deflation.

Currently we are witnessing a massive public policy response, which will not prevent recession, but will do much more than the policies of the 1930's. Some policies will do damage. Some will help.

Also at issue is the definition for depression. Many economists feel that we experienced a depression from 1973 to 1982, masked (or caused) by inflation.

So, we have two examples of economic depressions in the US. One is massive deflation; the other massive inflation. (Prior economic depressions in the US were deflationary.) Both were the result of misguided policies as a cause and a lack of understanding as to the solution. Indeed, a look at history indicates that depressions occur with regular frequency in the US and elsewhere. Perhaps systematic imbalances regularly build up in an economy over a period of 20 to 40 years through a combination of misguided policies and inherent human nature, only to correct suddenly and violently.

The policy response either contains the damage, misses the mark, or magnifies it.

Either way, our economy is about to undergo a massive restructuring of the financial sector. Let's hope what emerges on the other side is better and more stable than what went into it.

Panic?

2008-10-10T07:09:00.001-07:00

I believed we have moved past the panic phase and are now in the portfolio liquidation phase. Hedge funds and mutual funds that have performed poorly this year are being forced to liquidate their portfolios to meet redemptions and margin calls. There are some very big ones that are facing these kinds of liquidations. Another word for this sell-off is called a "capitulation." Historically, it has been the final phase in a bear market - when buyers are selling indiscriminantly because they are forced to, not because they want to. It is usually followed by a bounce, another sell-off, and then a sustainable rally.

A quick glance at the bear market of 1974, and we find that the chart looks almost identical.

When will it end? I would be much wealthier if I could make that call. It is important to remember, however, that just as prices don't grow to the sky, they don't fall through the floor. Just as a hyperbolic curve signals the end of a speculative bubble, the same hyperbolic curve in reverse signals the end of a panicked market. Sooner or later, reality forces itself back upon the scene.

A History of Banking in the US

2008-10-10T07:03:00.000-07:00

The Wall Street Journal today had a good article on the history of banking in the US: http://online.wsj.com/article/SB122360636585322023.html.

Another article by George Soros: http://online.wsj.com/article/SB122360660328622015.html

An Paul Volcker:
http://online.wsj.com/article/SB122360251805321773.html

Subscription might be required.

Stagnant Household Income?

2008-10-09T15:24:00.001-07:00

"There are lies, damned lies, and statistics!"

The skeptical optimist writes about income growth.

The article points out that, yes, it is true that the median household income in the US has been stagnant since 2000, but it is also true that the median earner income has risen on average about 3.5%. He writes,

Did household income stagnate or decline for households with no earners at all? YES. How about for households that had a decline in the number of earners? YES. How about those that had the same number of earners? NO. How about those that had an increase in the number of earners? NO.

The middle class is disappearing... The middle class of yesteryear is indeed disappearing: it is getting squeezed, like toothpaste from a tube, into the income category labeled "greater than $100,000."

Of course, we may see a dip in the coming year.

Interesting Article

2008-10-09T09:17:00.000-07:00

In the LA Times On abolishing the Vice Presidency: http://www.latimes.com/news/opinion/la-oe-ackerman2-2008oct02,0,2539877.story

The numbers behind the current banking panic: http://www.themoneymeltdown.com/

Interesting Information on the Crisis

2008-10-08T15:40:00.000-07:00

In some of the research I’ve done recently suggests that most sub-prime and many Alt-A loans default by design (though not necessarily by intent) when prices decline, effectively making them a form equity investment in the home after the default. Most of these loans were issued by securitizers – Countrywide, Ameriprise, etc. These were mostly what was issued in 2005-2006. I find it interesting that in a WSJ article, 64 million owners still have equity in their homes, roughly 60% of households, which is a figure slightly below where historical home ownership rates held before the housing boom.

The initiatives to modify the mortgages on the remaining homeowners amounts to essentially turning these owners back into renters, except with a rent-to-own option built in. I suspect the safest long-term policy out of this mess is for Congress to offer tax credits to renters comparable to the tax and other subsidies offered to borrowers (and a comparable tax credit to owners with equity built up in their house). That will accelerate the conversion of these properties into rentals, rather than dumping them onto the market as sales (some buyers will redirect to leasing as well, but investors would step in to more than fill the gap). As it stands now, households face a high marginal tax rate when switching to rent or to lower LTV ratios.

I have also realized the reason Texas bypassed both the boom and the bust: high property tax rates and high insurance rates. Property taxes in Texas used to be 3% (in Houston), reduced last year to 2.5%, minus the homestead exemption. Insurance rates add another 1%. Subprime loans are designed to be sensitive to home prices but are also highly sensitive to the monthly carrying cost of the house. For borrowers on the edge, the unique design of subprime loans usually does not to work in Texas. Saved by taxes ...

The Panic of 2007

2008-10-07T07:55:00.001-07:00

A recent technical paper on the origins of the credit crisis can be accessed here: http://www.kc.frb.org/publicat/sympos/2008/Gorton.08.04.08.pdf

I should note that the definition of a sub-prime mortgage is one that is extended primarily to low income borrowers as well as some first-time borrowers. I should note that Congress spent the last 20 years pressuring banks and lenders to increase their lending to low income households, and the industry response was a unique form of financial innovation, which as we now know, didn't work as intended.

His basic premise is this: subprime mortgages were securitized and structured so as to mitigate and diversify the risks. However, the structure became so complex that nobody understood them, and therefore nobody knew where the risks were. Therefore, they could not be valued, which resulted in a collapse of the market for these securities. This set off a chain reaction in the financial industry, which itself is highly leveraged, and ultimately bringing the mess to the doorstep of the US Government.

As I have said in previous posts, people panic when faced with a threat they don't understand. Lenders don't extend loans if they believe that there is a heightened risk that they won't get paid back, or they will demand a higher rate for that loan.

Here are some quotes from the research paper:

“This nesting or interlinking of securities, structures, and derivatives resulted in a loss of information and ultimately in a loss of confidence since, as a practical matter, looking through to the underlying mortgages and modeling the different levels of structure was not possible. And while this interlinking enabled the risk to be spread among many capital market participants, it resulted in a loss of transparency as to where these risks ultimately ended up.”

“When house prices began to slow their growth and ultimately fall, the bubble bursting, the value of the chain of securities began to decrease. But, exactly which securities were affected? And, where were these securities? What was the expected loss? Even today we do not know the answers to these questions.”

“The ABX information together with the lack of information about the location of the risks led to a loss of confidence on the part of banks in the ability of their counterparties to honor contractual obligations.”

“The assets of SIV’s and conduits were absorbed back onto bank balance sheets … Absent reliable market prices, accountants forced firms to “mark-to-market” causing massive “write-downs” and resulting in reduced GAAP-based capital."

“Financial firms had to issue securities (at unfavorable terms) and sell assets, with the latter causing a further decline in prices – and subsequent write-downs.”

“Meanwhile, underneath all of this, millions of Americans face foreclosure on their homes due to being unable to refinance their mortgages or to make payments on their current mortgages.”

“The sell-side of the market (dealer banks, CDO and SIV managers) understands the complexity of the subprime chain, while the buy-side (institutional investors) does not. Neither group knows where the risks are located, nor does either group know the value of the every link in the chain. The chain made valuation opaque; information was lost as risk moved through the chain. The introduction of the ABX index revealed and aggregated values of the subprime bonds with centralized prices, until a breakdown in the index.”

“At the root of the information story are the details on the chain … the uniqueness of these designs is at the root of the panic. No other securitization asset class works like subprime mortgages, that is, no other asset class (e.g., credit card receivables, auto loans) is linked so sensitively to underlying prices.”

President's and Politics

2008-10-06T13:50:00.000-07:00

An interesting article on how presidents influence the economy:

http://gregmankiw.blogspot.com/2008/10/predicting-election-outcomes.html

When there is Blood in the Streets

2008-10-06T09:03:00.000-07:00

Or, Should I Sell or Should I Buy?

I work at a firm that manages money for individuals (mostly wealthy individuals). In times like these, we often get fearful clients calling up and asking whether they should sell their portfolio and go to cash. There is a lot of fear out there, and as professionals, we feel it too.

But, if we think about it rationally - which I know is hard when your life savings is dropping every day - we will ask ourselves these questions:

* Do you need the money? If so, you shouldn't own stocks.
* If we think the market is too risky now, will we think so in 5 years if it is 25%, 50%, or 100% higher than now?
* Do we think stocks are going to zero? Do we think the US economy is going to zero?
* Have you sold your house?

A house with mortgage debt and a significant portion of our life savings is a much riskier investment than stock holdings. If you have a $250,000 house with $200,000 mortgage, your net investment is $50,000. If your house price declines by 25%, your investment is now worth -$12,500. If you lose your job, you still owe that amount.

If you have a $50,000 portfolio, and the portfolio declines by 25%, you still have $37,500. If you lose your job, you can still use that to pay bills.

Yes, you still need a place to live. However, it's much easier to downsize (or move into your mom's basement) when renting than it is while owning.

Losing money on your portfolios is much more painful because the prices are published on a second-by-second basis. However, just because you can ignore price movements on a house doesn't make it less real.

I am not suggesting one sells his or her house. Nor am I suggesting one should buy or sell stocks. I'm just pointing out that our fears are not always rational.

The Debate Over the Bail-Out: Will It Work?

2008-10-03T09:24:00.000-07:00

In much of the reading I’ve done this week, I have come across two basic arguments about the bail-out bill. One is the “mainstream” point of view (mainstream among economists and industry experts), and the other I find on various blogs by individual economists and in opinion pages on the Wall Street Journal (which I will call the “minority view”).

The Minority View is espoused essentially by what I would describe as “hyper-libertarians”, that is individuals who truly believe in the supremacy of the markets. In this view, largely informed by certain academic hypotheses, the financial markets are going through a necessary, though painful, adjustment. The world has changed, and many assets held by financial institutions are not worth what they were paid for. The “25 cents on the dollar” price that these assets are selling for is the best and most accurate reflection of their value. Price reflects risk; if the institutions can’t handle the risk, then they shouldn’t buy these assets in the first place. The policy response should be one of recognition of reality, not attempting to change it; otherwise it encourages further reckless risk-taking in the future.

This view has several key assumptions:
* Prices as they are currently trading are “efficient” or indicative of value.
* Price volatility is a natural part of markets and the key measure of risk
* Investors cannot accurately predict future prices
* Only those that can suffer volatility should buy assets that are volatile.
* Systems should be designed to manage that risk, not run to the government every time a bet goes wrong

In this view, the government bail-out as it is currently proposed amounts to either:
1. Handing cash to banks and financial institutions, though indirectly. This amounts to a subsidy for bad behavior, which while recapitalizing the failing banks, it creates a bigger problem in the future.
2. Buying the troubled assets at market value, which is pointless. Essentially, the government becomes another hedge fund, except one that is likely to be less intelligent than other participants and therefore the taxpayer will get taken for a ride.

The problem with this view is that the Market Efficiency Hypothesis has never and can never be proven. And it is almost universally rejected by market practitioners, based simple observation and experience with actually buying and selling securities.

Mainstream View:
The alternative view, which is the Mainstream View among industry experts and has even made inroads among academicia is that markets are in essence social and human institutions. Markets are experiencing a sort of trauma brought about by panic and a sudden reassessment of prospects. Two things are happening: one is that leveraged homeowners are dumping houses on the markets and leveraged financial institutions are dumping linked financial products on the markets, irrespective of value. They are doing it all at once in such a way that buyers are demanding steep discounts to take the assets off of their hands. Essentially, selling is distressed, or “forced”, while buying is optional. In addition, buyers are reluctant to step in for two reasons: prices may go down further, and this kind of panic may be self-fulfilling – the panic actually causes default rates to rise, unemployment to rise, and general economic collapse.

In particular, the assumptions and conclusions are (written point-for-point with those above):
* It is impossible to conclusively link price with value, since value is subjective and subject to arbitrary assumptions. Therefore, that link cannot be proven. However, we can examine various different measures of value (DCF, etc.) and compare them to price, and conclude, anecdotally, that price and value often diverge – sometimes to extremes and sometimes in unpredictable ways.
* Price volatility is natural, but is a key measure of liquidity risk, not valuation risk.
* Prices are unpredictable, but that doesn’t mean one can’t make money off of them.
* Institutions exposed to liquidity risk are prone to collapse at inopportune times (specifically institutions that depend on the markets to fund their operations, which usually are institutions that rely on debt or leverage to operate their business; i.e., banks)
* While it would be nice to operate banks in such a way that they are not exposed to liquidity risk, that’s not really practical.

*** There are very serious and broad ranging externalities associated with the collapse of a bank, such that collapse on one can bring about the collapse of others and can dramatically affect individuals in a negative way – individuals and institutions that did not make bad decisions or were otherwise unrelated to the original boom and bust.***

In this narrative, the government bailout is just what the doctor ordered (though it does have its flaws). The government steps in as a buyer of last resort, supplying liquidity with, theoretically, unlimited funds. The government purchases put a floor on pricing of these assets, such that buyers can then feel confident enough to step in and start their own purchases. At 25 cents on the dollar, these assets are “steals” – that is, even under recessionary conditions, buyers can expect to triple their money.

Recapitalization of the financial system will still be necessary (as is currently ongoing), in addition to this program, but will be made much easier as a result of the program. The taxpayer may still be required to step in to offset some of the costs of the recapitalization. Recovery will not be immediate and, it may get worse before it gets better.

Debating Taxes

2008-10-03T08:01:00.001-07:00

It's nice to know that our politicians act like politicians:

http://www.taxfoundation.org/blog/show/23713.html

Economists Rate the Presidential Candidates

2008-10-02T12:52:00.001-07:00

The Economist did an informal survey of economics professors on the presidential candidates, and surprisingly, Obama beat McCain handily. The profs rate Obama's economic expertise higher and more moderate, though they rate his views of trade lower. Bush, of course, gets the lowest rating of all - and that is not a surprise.

The article, which might require a subscription, can be found at: http://www.economist.com/world/unitedstates/displaystory.cfm?story_id=12342127

What is a Banking Panic?

2008-10-02T12:37:00.000-07:00

Banking panics were considered an anachronism until 2008, with the last one having occurred in 1933. A total of 10 panics occurred in the US prior to the creation of the Federal Reserve in the period from 1819 to 1907 (including four that were forestalled by the New York Clearing House), and then five occurred regionally from 1930 to 1933, after the creation of the Federal Reserve, excluding one forestalled by the New York Federal Reserve Bank in New York in 1929.

Therefore, few Americans alive today have any idea what one is. According to the Elmus Wicker of Indiana University (http://eh.net/encyclopedia/article/wicker.banking.panics.us),

“A banking panic may be defined as a class of financial shocks whose origin can be found in any sudden and unanticipated revision of expectations of deposit loss where there is an attempt, usually unsuccessful, to convert checking deposits into currency … . more recently they have been treated as a rational depositor response to an asymmetric information deficit.”

“episodes of banking panics were accompanied by money market stringency, a stock market collapse, loan and deposit contractions, runs on banks, bank failures, the issue of Clearing House certificates, and in the case of the three major banking panics the partial suspension of cash payment … The proximate effects of partial suspension of cash payment included: 1) difficulties encountered by business firms in meeting payrolls, 2) dislocation of the domestic exchanges, 3) an increase in hoarding, and 4) the emergence of a currency premium. This disruption of the payments mechanism led to an increase in real transactions costs, temporary factory closings, layoffs, and the creation of currency substitutes. The domestic exchanges were disrupted because bankers were reluctant to make remittances. Failure to remit on time encouraged firms to demand cash payment, thereby reducing real transactions.”

According to Ben Bernanke in a 2002 speech, “Before the creation of the Federal Reserve, Friedman and Schwartz noted, bank panics were typically handled by banks themselves--for example, through urban consortiums of private banks called clearinghouses. If a run on one or more banks in a city began, the clearinghouse might declare a suspension of payments, meaning that, temporarily, deposits would not be convertible into cash. Larger, stronger banks would then take the lead, first, in determining that the banks under attack were in fact fundamentally solvent, and second, in lending cash to those banks that needed to meet withdrawals. Though not an entirely satisfactory solution--the suspension of payments for several weeks was a significant hardship for the public--the system of suspension of payments usually prevented local banking panics from spreading or persisting...”

In the pre-1914 era, the New York Clearing House (NYCH) had the tools and often the knowledge to forestall panics, and did so on four occasions. However, after the panic of 1873, “that knowledge seems to have faded from the collective memory of the Clearing House.”

The Federal Reserve was created in 1914 to address the problem of banking panics and prevent future economic depressions that often resulted. However, 1930 brought on the worst depression in history, with severe rolling banking panics throughout the country. That has led many to conclude that the Federal Reserve was a primary cause, because it not only failed to act but acted in ways that brought on the crisis of confidence. The banking panics of the Depression occurred primarily outside of the New York money center banks, in a departure from history, and except in 1933 did not result in a suspension of cash payments.

According to Bernanke, “It was in large part to improve the management of banking panics that the Federal Reserve was created in 1913. However, as Friedman and Schwartz discuss in some detail, in the early 1930s the Federal Reserve did not serve that function... At the same time, the large banks--which would have intervened before the founding of the Fed--felt that protecting their smaller brethren was no longer their responsibility. Indeed, since the large banks felt confident that the Fed would protect them if necessary, the weeding out of small competitors was a positive good, from their point of view.”

Bernanke again, “In short, according to Friedman and Schwartz, because of institutional changes and misguided doctrines, the banking panics of the Great Contraction were much more severe and widespread than would have normally occurred during a downturn. Bank failures and depositor withdrawals greatly reduced the quantity of bank deposits, consequently reducing the money supply. The result, they argued, was greater deflation and output decline than would have otherwise occurred.”

Wicker offers an alternative explanation to the theory that the Federal Reserve personalities were responsible for the crisis:

“There were at least three important structural flaws in the 1913 Federal Reserve Act: l) membership was not compulsory for all banks; it was mandatory for national banks and optional for state banks and trust companies thereby restricting access to the discount window; 2) paper eligible for discount by member banks was too narrowly defined; and 3) power was decentralized among the twelve Federal Reserve Banks and the Federal Reserve Board making consistent and effective policy action difficult. These combined structural weaknesses hindered policymakers' efforts to respond quickly at the onset of banking panics. When four out of five bank suspensions during the three panics of 1930 and 1931 were nonmember banks, it is time to reconsider the membership question as a cause of the Great Depression panic.”

However, it should be noted that the Federal Reserve could have asked for and probably would have received the power to intervene in the case of nonmember banks.

There are two leading theories on the cause of banking panics: Random Withdrawal Theory and Asymmetric Information Theory. “The random withdrawal hypothesis attributes bank suspensions to bank illiquidity induced by a contagion of fear. The asymmetric information approach assigns a key role to bank insolvency induced by asset shocks due to weak management, fraud and malfeasance, or persistent adverse economic conditions in a particular sector. This classification does not preclude that both may be at work simultaneously.”

Wicker concludes, “The long era of banking disturbances finally ended in 1933 due partly to the introduction of deposit insurance, improved performance of the Federal Reserve, and a better understanding of the sources of systemic banking unrest. Knowledge alone, we have learned, is not a sufficient guarantee to forestall banking panics. Leadership and policymaker competence are important as well.”

Past and Present – What’s Going on in 2008?

If the establishment of the Federal Reserve and responsible leadership are present, why are we having a banking panic? After all, one of the foremost experts on the Depression is in charge and we haven’t had one since 1933

First, one could argue that a panic in the US was averted in 1983 (Latin American debt crisis), 1989-1995 (S&L failures), and 1997-1998 (Asian and Russian debt defaults).

I would make the argument that while the banking system has been buffeted by the Federal Reserve, significant “deposits” exist outside of the banking system in a way that they did not exist in 1930. These deposits include the obvious money market instruments, but increasingly over the last 40 years other debt instruments and even stocks have played the role that traditional savings accounts played in years past. The stock and bond markets have replaced America’s banks, and, until recently, were not part of the Federal Reserve System.

The stock market is a different animal, and is designed to withstand shocks even as large as the Nasdaq bubble collapse of 2000 to 2002 without serious repercussions for the overall economy. Indeed, absorbing risk is one of the stock market’s primary functions. This is why shareholders have been the first ones to get wiped out when a bank goes bust.

However, commercial paper, money markets, asset-backed securities, and other fixed income instruments are the primary financing and savings vehicle for large sections of the US economy. These markets are not designed to withstand massive shocks to the system.

Much like the argument that when regional and local banks did not participate in the Federal Reserve system in 1930, thus did not have access to the discount window, until 2008 significant swaths of savings and lending instruments were outside the purview of the Federal Reserve.

That, of course, has changed in the last six months.

Warren Buffett on Charlie Rose

2008-10-02T11:59:00.001-07:00

A great interview with Warren Buffett on Charlie Rose:

http://www.charlierose.com/shows/2008/10/1/1/an-exclusive-conversation-with-warren-buffett

My Opinions

2008-10-01T08:19:00.000-07:00

I've cited many articles on this post - as it is quicker and easier to cite others work than to write my own. However, many of those articles have political slants and biases that I may or may not share, or that I haven't yet processed or come to an opinion on. Given the nature of my profession, most of the opinions I read are of the conservative variety.

So what are my opinions? My opinions evolve and change as I acquire more information. While I have training in economics and finance, and understand many of the macro issues, I do not specialize in banking or investment banking (my specialty is the finance of technology companies, telecommunications, media, newspapers, retail, and other consumer). Therefore, I don't always have all of the specific facts.

While I have a philosophical predisposition to trust free markets more than government, I recognize that the line between two are often indistinguishable, so much so that government policy can help or (more often) hurt the economy. My cynicism stems from the fact that I see so much economic destruction from bad policies on a daily basis. The destruction is magnified when applied to strongman governments and "communist" governments of "developing" countries.

As an economist and an investor, I am a student of human behavior, which happens to be why economics and investment tend to be so difficult. Humans are unpredictable. If experts can't predict human behavior, then why should we trust government regulators or politicians, especially when their behavior can be just as unpredictable.

As to who is to blame for this crisis? Blame is a political word - people are "blamed" when they do things we don't like. As an economist, I look at incentives (financial or otherwise) and institutional structure, and try to determine if behavior can be predicted.

So, when I think that Fannie Mae and Freddie Mac shoulder a large portion of the blame, I am not necessarily blaming the employees (misdeeds of the CEO's aside) nor absolving other players, private and public. I am saying that these institutions created severe distortions in the economic system that could have been and was predicted.

I admit that I sometimes get angry at our politicians, but the truth is that they are humans who respond to the incentives laid out to them. Our political system, for all of its strengths, also has systematic flaws that lead to periodic crisis.

Another economist, Tyler Cown on his blog Marginal Revolution introduced a well-reasoned perspective on his opinions.

Understanding a Financial Crisis

2008-10-01T07:37:00.000-07:00

The following article articulates well what is going on in our financial markets:

http://www.nytimes.com/2008/10/01/business/economy/01leonhardt.html?_r=1&partner=permalink&exprod=permalink&oref=slogin

Lending and Home Ownership

2008-10-01T06:57:00.001-07:00

This article in the WSJ is really good (though he strays a little towards the end):

http://online.wsj.com/article/SB122282719885793047.html
(subscription may be required)

He essentially says that the bailout is necessary, but not enough. We need to recapitalize the banks and change the incentive structure of the banking industry by refocusing lending away from "home ownership" and towards business and innovation.

What About the Glass-Stegall Repeal

2008-10-01T06:37:00.001-07:00

Some are blaming the repeal of the Glass-Stegall act for this crisis. I haven't come accross these arguments myself, because I read technical stuff (which says the opposite - the repeal actually has partially mitigated this crisis), but mythology sometimes trumps reality. The WSJ summed it up well in the following article (warning, it too is partisan):

http://online.wsj.com/article/SB122282635048992995.html
subscription may be required.

Basically, the act legally separated investment banking from commercial banking, such that a company couldn't do both. The repeal allowed commercial banks get into investment banking, and the reverse.

As to how its repeal could have caused the current crisis is beyond my ability to grasp, but we do know that allowing commercial banks to become investment banks has allowed things like Bank of America to buy Merrill Lynch, Citigroup to buy Wachovia, and JP Morgan to buy Bear Stearns and Washington Mutual. All of these actions staved off a far worse crisis.

In addition, Bank of America, JP Morgan, and Citigroup are in far better condition than their non-integrated couterparts as a result of the repeal of the act. So much so that Morgan Stanley and Goldman Sachs decided they were better off becoming commercial banks.

What is an MBS?

2008-10-01T06:14:00.000-07:00

At the heart of all of our financial problems is an "exotic" security called a "Mortgage Backed Security", or MBS. MBS's are part of a class of securities called "Asset Backed Securities". So what is this thing?

I'll start with an analogy: imagine you are baking a pie. You gather the ingredients of fruit, sugar and flour (I'm not really a cook, so bear with me). You mix them all together, throw them in an oven, and out comes a pie. You then divide the pie in pieces and serve to different people.

An MBS is similar.

Four people decide they want to buy a house, John in Arizona, Joe in Pennsylvania, Sarah in Alaska, and Barack in Illinois. They go to their respective banks and take out a mortgage. Traditionally, the bank would have to wait thirty years before getting repaid, but would collect the interest on the loan in the meantime. So, once the bank ran out of money to lend, it would stop lending.

In comes Barney from a strange company called Fannie Mae. Barney offers to buy the four loans from the bank, for a price. The bank gets its money back, but collects a fee for making the loan, and sometimes a fee for servicing the loan (servicing means sending out bills and collecting payments). Now Barney owns all four loans, and the bank is free to lend again.

Barney has two options. He can continue to hold the loans, but he must borrow money to do it. Or he can resell the loans. But Barney has a secret weapon: he has a rich uncle, named Sam, who cosigns all of the money Barney borrows. So if Barney holds the loans, he gets the interest at a rate of, say, 5%, and borrows at a rate of 4%. So, he can make a 1% spread with virtually no money down.

But let's say Barney decides to sell the loans. There aren't many investors out there willing to buy individual loans. So, Barney decides to package all of those loans together in a pool, like baking a pie. Then he divides them up into individual securities, called MBS's, and sells them to investors.

As it turns out, the bank above has run out of customers who want to borrow money. So he decides to buy the MBS's and hold them in his portfolios.

The problem is that Barney won't sell the MBS's unless he can get a good price: remember he can make a profit by holding them.

A Trillion Dollar Government Sponsored Mess

2008-09-30T15:27:00.000-07:00

There is an increasing amount of literature placing the epicenter of the mortgage earthquake at the doors of Fannie Mae and Freddie Mac. These are (were) government sponsored enterprises that bought mortgages from lenders and then repackaged them for resale to the investing public. The following lengthy article by the American Enterprise Institute describes the rise and fall of these behemoths (note, the article is admittedly partisan, though the Democratic congressional support for subprime mortgage train right up to the end is undeniable):

The Last Trillion Dollar Commitment

Part of the Republican revolt against the bailout legislation can be attributed to the fact that they felt that they were shouldering the blame for this, when in fact the Republicans can credited for at least intermittant efforts of limiting and regulating the two.

New Investment Newsletter

2008-09-30T10:34:00.000-07:00

My employer has published a newsletter (dated September 19), which can be found on the website (www.centman.com) - click on the upper right hand corner on "download it here". In the coming days, another shorter letter will be posted as well commenting on the bailout package and the vote.

Wipe Out

2008-09-30T08:14:00.000-07:00

Yesterday, $1.2 trillion of shareholder wealth evaporated. This compares with the $700 billion "cost" of the bailout. This morning, the Fed Funds rate spiked to 7%, which equates to the rate on a mortgage of somewhere between 11% and 15% (assuming, theoretically, you could get one). It will settle down, but I've never seen that before.

The stock market is up, which is driven by sentiment on a day-to-day basis (the credit markets are driven by liquidity needs), and thus equity investors are assuming that a deal gets done.

The "No" Vote

2008-09-30T06:34:00.000-07:00

Congress delivered up another shock to the financial system yesterday with a "no" vote on the rescue package. Almost to a person, the "no" votes were for legislators facing a contested re-election next month, and the public backlash against this package is very real, though probably exaggerated in their email boxes.

Blame is shared all around, from the idiots who put their reelection bids over the future of this country, to the idiots (i.e., Paulson, Pelosi) who insulted the idiots who are worried about their reelection.

I believe the package is necessary, even if imperfect. I am usually not an advocate of government intervention, because usually it does more harm than good. Indeed, government intervention is partly to blame for getting us into this mess. Yes, there are other alternative plans, with costs and benefits, but something is needed now and something is needed quick.

It may not work. But doing nothing is certain to not work.

Human beings suffer from a certain psychosis: the wiring of the brain is a "fight or flight" mechanism. When faced with a serious threat, we panic. This panic is made worse when we are faced with a threat we don't understand. Unfortunately, our financial system is based on trust - and is terribly complex - and trust is the opposite of panic.

When panic engulfs a market, the market ceases functioning. Businessweek had a good article today, titled "Wild Times in the Credit Markets", highlighting that this difficulty started with the banks, not the stock market. If the markets cease functioning, businesses can't operate, GDP takes a nosedive, and unemployment spikes.

An essential role of government is to provide safety - to be an insurer of last resort. We expect the government to insure our beach houses against hurricanes, to insure our health against illness, and to insure our wages against unemployment. Congress voted a 9 trillion liability into existence so we can buy prescription drugs when we get old. I think it is a much smaller thing to ask the government to insure the economy against collapse - insurance that might actually net a profit to taxpayers.

Think of it as an investment in our future - an investment that will pay dividends one way or another.

What are the consequences for doing nothing? Nobody really knows. A Great Depression II might be extreme, though GD I was primarily caused by a massive credit crisis and a do-nothing government. (There are big differences between 2008 and 1930, however.) A recession is a given, regardless of what Congress does. The question is how deep does the rabit hole go? Do we really want to know?

Thus, the problem with doing nothing is not the certainty of what will happen - that will be debated ad infinitum. It is the risk of what could happen. Do we want to roll the dice on our future?

As to voter opposition, voters have a right to be angry. But most voters don't have Ph.D.'s in economics or finance. Indeed, even the doctors of finance are having trouble grasping this. Voters want our politicians to be adults and do the right thing. They will be disappointed by the spectacle seen yesterday.

I believe a deal will get done. Because without it, Congress will face a wrath of voters that will pale in comparison to what they saw in their email boxes yesterday. Voters get really angry when they go hungry.

However, with each passing day, a bailout gets more expensive.

Populist Backlash

2008-09-29T08:25:00.000-07:00

Fortune had a good article on the populist backlash against the bailout proposal. Interesting to note is that it is a backlash not only against the market elites, but also against the government and media elites.

http://money.cnn.com/2008/09/26/news/economy/easton_backlash.fortune/index.htm

Will the Government Make a Profit?

2008-09-29T07:37:00.000-07:00

Barron's Cover says the government bailout will likely make money for taxpayers (subscription may be required)

summary by John Bator
The cover story goes through the numbers for the mortgage bailout plan and says that many people believe the U.S. government will end up making money on the deal. Pimco's Bill Gross has offered to work for free with other managers for the government to decide what to buy. There is a $1T difference between face value and current market price of these securities. The actual losses on these securities should only be about $250B. Because the government can buy with a hold to maturity attitude, it stands to make money, even with draconian assumptions of default because the paper sitting on banks' books are not the lowest rated paper but actually fairly high up the chain. Firms that have securities that could be sold to the government include Citigroup (C), JPMorgan Chase (JPM), Bank of America (BAC), Wachovia (WB), Wells Fargo (WFC), HSBC North America (HBC) and U.S. Bancorp (USB

Wachovia goes to Citigroup

2008-09-29T06:24:00.000-07:00

My betting was on Wells Fargo, and apparently they will still negotiating early this morning, but the headline says Citigroup got it. Not much in the way of details though.

Lehman and the Crisis

2008-09-29T06:04:00.000-07:00

The Wall Street Journal had an interesting article on the Lehman bankruptcy: Lehman's Demise Triggered Global Cash Crunch (subscription may be required - it's too long to reproduce here).

The basic gist is that the Lehman bankruptcy spooked the markets and shut down the credit default swap market, the commercial paper market, and the prime brokerage business, and sparked a run on other investment banks.

What it implies but not states is that lack of a consistent and predictable system to work through bankruptcies of major financial institutions created chaos among investors who had no idea what to expect. In addition, it is clear that our financial system lacks basic safeguards against risks that are relatively forseeable - a bankruptcy of a major financial institution should not be this shocking to investors.

But, then, I am an equity investor, and I deal with volatility and risk every day.

Progressive Taxation

2008-09-26T10:37:00.000-07:00

An interesting article in Barron's this week on the virtues of a progressive tax system. (subscription may be required). He highlights principles that I have not considered carefully about the impact on taxation on individual behavior.

Progressive Taxation Without Apology
By JONATHAN LIPOW
Let the rich pay more.

ALTHOUGH IT IS WIDELY ACCEPTED THAT TAX SYSTEMS should be simple, efficient and fair, it is more controversial to assert that tax systems should be designed so that the burden of taxation falls disproportionately on the wealthy.

Opponents of progressive taxation believe that it is unjust or at least unfair to expect the rich to pay for government services that ultimately benefit all citizens. They argue that the high marginal tax rates engendered by progressive taxation encourage tax avoidance, both legal and illegal, and that high marginal rates also might discourage some people from working.

The standard case for progressive taxation is that it enhances social equity. This is unfortunate and misleading. The genuinely poor earn so little that they are largely unaffected by the tax system in the first place. To argue that taxes should be progressive in order to achieve a more equitable distribution of income is to completely ignore the needs of those in most urgent need of more equitable treatment.

It is impossible to redistribute income to genuinely poor people via progressive taxation, because they are earning little or no income and are probably not paying any taxes. But there is a good reason why taxes should be progressive anyway. To some degree, progressive taxation can actually enhance, rather than erode, economic efficiency.

To understand why, consider the financial markets, which are supposed to facilitate the management of the risks inherent in capital investment. One of the rules of proper risk management is to diversify. Common sense and formal theory show us that we shouldn't put all of our eggs in one basket. Diversification makes it likelier that investors will earn an average return, rather than all-or-nothing results on their investments.

THE RETURN ON INVESTMENT in human capital is every bit as uncertain as the return on investment in physical capital, so the same logic that applies to physical capital applies to human capital: We would benefit if we could diversify human-capital risks. Of course, there is no vibrant market for swapping the risks associated with the return on our human capital.
The main reason is that human capital comes in packages too small to be efficiently traded. The costs of converting future wages into a tradable asset are simply prohibitive.

Because people cannot sell the rights to a portion of their future wages and swap their wage risk with others, they bear more human-capital risk then they should. This lowers their appetite for expensive and risky activities, such as taking off a couple of years to earn an advanced degree, or moving from a salaried job to riskier activity like entrepreneurship.

Taxation, however, makes us all part owners of each others' wages just as the stock market allows us to share ownership of each others' physical capital. Society gains tax revenue when anyone makes more income; it loses tax revenue when anyone loses income. As a result, income taxes lead to some diversification of our human capital risks by forcing us to share them with others.

As taxes become more progressive, the degree of diversification achieved goes up. Just as portfolio diversification lowers the probability that we will earn much more or less than the average return on our investments in physical capital, progressive taxation lowers the probability that we will earn much more or less than the average return on our human capital.
BETTER DIVERSIFICATION OF HUMAN-CAPITAL risk via progressive taxation seems consistent with vibrant economic activity. Sweden, for example, has an extremely progressive tax system, but there is no sign that this deters risk-taking or economic activity. The most recent World Economic Forum survey of global competitiveness ranked Sweden as the fourth most competitive economy in the world. To be sure, the U.S. was ranked highest in this survey, but Sweden was far ahead of most other countries, almost all of which have less-progressive tax regimes.

There are, of course, limits to how progressive a tax system should be made. The return on human capital depends not only on luck but also on hard work. If taxes are excessively progressive, then the incentive to work or study hard is eliminated. The trick is to find the level that is "just right."
Under today's conditions, the U.S. might well benefit from making its tax system a bit more progressive than it currently is. And implementation of the tax proposals of either John McCain or Barack Obama would do just that. Obama's approach to enhancing tax progressivity is to raise marginal tax rates on high income brackets. McCain's approach is to eliminate large tax deductions that benefit higher-income earners -- in particular the deduction for employer contributions to health insurance.

Based on other economic considerations, McCain's is the better approach. Higher marginal tax rates really do result in more tax-avoidance behavior -- which benefits no one except tax lawyers and accountants. The tax deduction for health insurance, however, creates an incentive for the wealthy to pressure their employers to splurge on excessive insurance, something that artificially drives up the price of health care.

JONATHAN LIPOW is an associate professor of Economics at Oberlin College in Ohio. He is also the portfolio manager of the Forum International Equity Fund, an offshore fund listed on the Irish Stock Exchange

Inflation, Deflation, Stagflation

2008-09-26T07:19:00.000-07:00

For the past year, many of the headlines have declared that inflation is heating up and that the economy was headed for a bout of "stagflation". Indeed, many financial professionals and hedge funds were betting on it. But is this really the case?

Stagflation occurs when inflation and high unemployment occur simultaneously. It happened once in our history, during the decade of the 1970's.

Generally, however, there is much confusion over what causes inflation. Recently, the rise in commodity prices (mostly food and energy) has ignited fears of inflation, as sometimes commodity prices are a harbinger of inflation to come.

However, I believe the opposite is what we are facing: not inflation but deflation.

It is now well understood among economists that inflation is entirely a function of the money supply. That is, if the money supply increases faster than economic activity, then prices and wages go up.

The money supply can be thought of in two categories: cash and equivalents, and loans and credit. The US financial system is called fractional banking: cash is held in reserve as a fraction of overall credit (usually 10%). Therefore, the sum total of all credit and cash and other forms of deposits equals the money supply that directly influences inflation.

The Federal Reserve effectively controls the cash component through a variety of tools, but specifically the setting of short-term interest rates. The financial system takes that and multiplies it by 10 (actually a lot less, but it is true in theory).

A credit crisis occurs where sum total of credit has been reduced by losses, and therefore cash reserves must be reduced one-for-one, with the multiplier effect reducing the overall money supply by a factor of 10. This is called a multiple contraction of the money supply.

It is what caused the Great Depression, the Japanese deflation of the 1990's, and most recessions and depressions throughout history.

The Federal Reserve was created to counteract this: reduce the supply of money during booms and increase it during busts. In the case of the Great Depression, they did the exact opposite: decreased money during a severe banking crisis.

Nevertheless, a decrease in the money supply results in deflation, not inflation. Personally, I would rather have inflation - when prices decline all kinds of bad things happen.

What about commodities? Commodity price rises of the past two years were primarily a function bad policies limiting supply (in the case of food) and the movement of large amounts of investment capital into an otherwise illiquid market. In other words, it was a speculative bubble - there are a number of viable causes (China, peak oil, etc.), but none that explain the vertical rise in prices.

The good news is that Bernanke is an expert on the Great Depression, and is doing everything he can to avoid the mistakes of his predecessors.