Humility of Realism II: Seven Thoughts about Our Whole System 37 comments
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This post is a kind of “catch up” post, where I write about a number of small things that I thought were interesting, but weren’t worth a full post.
1) The government can’t fund everybody. The recent backup in the US treasury note market is a great example of that. As the demands for funds now in exchange for funds later has increased, Treasury interest rates have risen.
I have several biases, but one of them is that the Government can’t unilaterally create prosperity. It can create conditions that encourage economic activity, through predictable and fair laws, but it can’t make us immediately better off through deficit spending, or tax-and-spending. The Government does not know what is needed to a better degree than its citizens do individually.
But let the government fund or guarantee everybody. When they do that, there is just one overleveraged credit that matters, and it will fail, taking us with them.
2) Equity Private is one clever lady. Fair value accounting primarily exists to deal with investments that are as volatile as equities. How are publicly traded equities valued? At market. How about volatile assets where the value is derivable from market prices? They should be valued at pseudo-market. If we were back in the old days, and all of our assets were bonds, we wouldn’t need fair value accounting. Even if we did it, the values would not vary much. But when you slice and dice the various pieces of bonds, the volatile bits jump around a lot. To value them at their initial value is ridiculous, the value is too volatile.
3) Felix is right. There needs to be more of a debate over bank nationalization. I’ve written my pieces there, influenced by the better regulations of the insurance industry, and how they deal with insolvencies. Mark assets to market. Do the triage. Send insolvent institutions to RTC 2, and take stakes in some marginal institutions. That is where the money will do the most good.
4) “We have to buy up assets that are selling at fire sale prices. We will even make money for the taxpayers.” So go the arguments of those that want to create a “bad bank”. Oh, please. Profits are rare in bailouts. They happen by happy accidents, a la Chrysler (80s, not now), which possibly could have made it without a bailout.
Assets are at fire sale prices because there is not enough balance sheet capacity to buy and hold them over a period where the realization of value is likely. I’ve seen structured assets rated AAA where the collateral is okay, and the likely realization of value is in the 90s, if you can hold it for 5 years. Where does it trade? Around $60. Another asset, which would likely be worth $35 if it could be held for 15 years, where does it trade? It doesn’t trade, but you could get rid of it to a broker for zero.
Strong balance sheets can’t be created out of thin air, though. Remember how formidable Fannie (FNM) and Freddie (FRE) used to be, or many of the FHLBs? Strong balance sheets only exist through investments where the cash flows will not be needed for decades, like pension and endowment plans.
5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please. First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation. Our dear government had many lending programs pre-crisis, and even more post-crisis. They further encouraged the increase in debt through the tax code.
Why is debt finance tax-deductible, and equity finance not? What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be? Leverage would have been a lot lower, and the system would be a lot more stable.
Market efficiency means many things. In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way. They reveal problems that need to be solved. Some might call those market failures but they aren’t. In the present crisis, the invisible hand is saying to us: Reduce debt levels; your economic system in too inflexible. The visible hand, the government, says: “Have some more of the hair of the dog that bit you. We need lower mortgage rates. We need more consumer lending. We’re going to borrow more than ever before in an effort to create prosperity.” Caroline Baum takes a similar view, and as usual, she expresses it well.
Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems. Some things become revealed as truly public goods that the government needs to regulate. But that is not the majority of human actions.
6) AIG is one black hole for cash. Selling or IPO-ing units during the bust phase, when valuations are compressed, does not seem to be an optimal strategy here. If all of the assets were sold, would there be enough for the junior debt or preferred shareholders to get paid? (Forget the common.) So, in the face of it, do they IPO partial stakes in enterprises, with an eventual end of IPO-ing or selling the whole thing later? If so, there is little free cash flow being generated to pay down debt.
What this implies to me is that the huge loans that the government made to AIG (AIG) will likely hang out there for a long time. Is this the best use of the government’s credit? I think not. If there are still systemic risk issues, wall those off separately, and send the rest of AIG into liquidation. The insurance units are intact; let others buy and manage them. Speculating on a future boom in asset prices is not a reasonable government policy. Hope is not a strategy.
7) It is simple to blame the US for the current global crisis. Simple and wrong. The US deserves blame, true, but not even the majority of the blame, just a slightly larger than proportionate amount for its size.
But when China blames the US, it goes too far. In the era of neo-mercantilism, China had political goals to achieve. Industrialize the country. Get surplus workers off of the farms and into the cities. Keep the currency undervalued to support export-led growth. Force savings through restrictions on imports. As a result, suck in developed country debts and companies where strategically desirable and possible. Do these deals in their currencies because of the need to keep the Yuan cheap.
China made its bed, let it sleep in it. They knew that they were lending to the US in its own currency; it was a necessary part of the bargain to achieve their own goals. Just as the mercantilists sucked in gold, and then found it to be less valuable than they imagined when they had to draw on it, so it will be when nations want to draw on the US dollar assets that they have hoarded.
=-=–==-=-=-=-=–=
My phrase “the humility of realism” is meant to get us thinking about the system as a whole, and about the long-term consequences of societal actions, whether by the government or private parties. Humility says that sometimes we have to say, “No, we can’t.” It also says that we should think carefully about major policy actions, and not let ourselves get bullied by those who rush, shouting “crisis, crisis,” while quietly angling for their favored pet projects to get swept in while no one is looking. Realism sometimes means the government has no good solutions, so it should inform the public that it isn’t omnipotent, and humbly say the crisis must be borne with grace.
The problems generated by the short-termism of the past three decades will not get solved by more short-term thinking. The present rush to assure prosperity will not end well, in my opinion.
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I do disagree with your concept that the Chinese government forces its citizens to save by restricting imports. True, the yuan is undervalued, but the Chinese save because the traditional way of retirement in China - the young take care of the elderly - is unable to function after a generation of one-child families. The Chinese social security system will keep you from starving, but it won't pay for a place to sleep, or anything else. So if you live in China and you don't want to live in the streets in your old age, you save all that you can.
Americans get so caught up in current events that we miss long term trends that will change present circumstances. Most Americans were surprised how quickly the Japanese economy slowed down as its population median age grew older. The same will happen to China, but even faster than it did to Japan. As China's GNP becomes the largest over the next 15 years, be prepared to be inundated with news stories about how China is 'overtaking the USA', etc...Fact: the Chinese labor force probably peaked in 2007, continuing growth in China will come from utilizing the unemployed and the masses of 'under-employed' for the next 15-20 years, after that the Chinese economy can only really grow through productivity gains.
nobody knows how to get us out of it. The dislocations are too many and too complex to fix with any simple solutions. Watch out below we still have a long way to go to bottom out. Get your apple cart painted and your victory garden going...these might be your next food source...MarvinMBA
"I have several biases, but one of them is that the Government can’t unilaterally create prosperity." -so the premise of running deficits (as during the Reagan/Bush I &II ) era's created no wealth -even if you look at GDP?
"Fair value accounting primarily exists to deal with investments that are as volatile as equities. " All investments are risk. Even bonds as Orange County and MBS securities have shown. What you seem to say is that assets backing the underlying bonds should be ignored and they should not be marked to market? This is ludicrous. Fair Value should not be restricted only to equities - it is clear that all investments are risk - the return is based on the appetite for risk. High yield bonds have risk -shouldn't they be evaluated at Fair Value -when adverse events affect the issuer- oh -they are!
The 'free market' thing is and has always been a farce. Even Adam Smith has acknowledged this -as he implored the use of morality. In short - the premise goes someting like this: Foxes will always realize that it is better to eat only one chicken a day if all safeguards to chicken's are removed. Also -as has been increasingly pointed out vy Steve Keen and Nassim Taleb -the premises upon which the foundations of economics rest are flawed. To assume static, equilibrium models as the keystones to complex models in a dynamic, multivariate situation is bound to be doomed. While many can profit with this in the extreme short term -as a system in the long term it has been proven time and again to be a colassal failure and make economists one of the most irrelevant social scientists of our time.
"It is simple to blame the US for the current global crisis. Simple and wrong. " -Perhaps but who are you going to blame when your platoon leader walks you into an ambush -yourself?
"Realism sometimes means the government has no good solutions, so it should inform the public that it isn’t omnipotent, and humbly say the crisis must be borne with grace."
Actually realism means that good safeguards and solutions have been bypassed through campaign contributions. That the omnipotent public would do well to emulate the riots in Greece, Ukraine, Latvia, France and now Britain. What is needed is for the public to acknowledge that we are on a ship of fools -and to ruen the ship around.
The idea seeks to collapse the period of time to which a more predictable and reliable flow of capital through our system can be arrive at; it cannot in and of itself resolve all systemic problems. The limited and uncertain access to capital has in large measure hobbled our collective economic system; interested parties to productive assets have been beset by a vicious cycle of pessimism and diminishing valuations, many times leading to a complete loss to owners and counter parties. The recommendation is designed to impose upon the banking system requirements to fully deploy their capital, with the aim of arresting this downward cycle and arriving at the nexus where collateral valuations are affirmed and once again become a measure of strength and not weakness.
The basic tool and in this solution is taxation. A new piece of legislation is to be formed in which banks are taxed when not meeting the required leveraging minimums, and somehow rewarded when they demonstrate full leveraging deployment. Despite the cajoling of the Feds and Treasury after massive capital injections and asset swaps, the banking industries collective uncertainties are preventing their raison d'être, banks continue to under deploy and hoard capital, this is where we are collectively bogging down.
As commercial banks comply with new leveraging requirements, they deploy capital to the most favorable credit risk. A new competitive lending environment will spring forth; banks will compete with other banks to actively seek out the best risk reward borrowers for their offerings, or be subject to this new Federal tax or penalty. This new velocity of money will energize our economy, restore asset predictability and grow balance sheet valuations without further deficit spending.
This novel catalyst along with other primers will reduce the distance and time that the wheels of Capitalism need to travel before growth and optimism is restored; preventing unneeded failures, losses, and human hardship due to degrading asset valuations and capital deprivation.
Let the chip fall where they may there after, a force new beginning will have started.
That leads to the next matter: do Americans still have access to jobs that pay them a "living wage"? Not all Americans (in fact, very few) have the ability or drive to write new operating system software or invent something. They need access to jobs that will pay them enough to live on.
In the last 20 years, we have flooded the labor market with illegal and legal immigrants. This injection of low-skilled labor in the labor market has wreaked havoc and hastened the "globalization" process.
Dirk is right. But the problems do not end at an exhortation to "get to work."
On Jan 30 11:39 PM John Lounsbury wrote:
> David - - -
>
> Thanks for sharing your thoughts. I would try to emgage in some discussion
> but I doubt that discussion is what many of the angry people in this
> comment stream want. I guess anger is the stage after denial? <br/>
>
> Please keep writing.
You mention government mismanagement, Are we on the wrong side of the Laffer curve or not? And wouldn't that be the biggest mismanagement of them all?
On Jan 31 01:13 PM johnny g wrote:
> I have an idea that can help resolve the problems facing both our
> economy and financial industry. Front lines reports from academia,
> government, and the media explain in good measure that banking industries
> uncertainties and fears regarding asset viability on their own and
> others balance sheets have created immovable road blocks to reasonable
> distribution and capital access.
>
> The idea seeks to collapse the period of time to which a more predictable
> and reliable flow of capital through our system can be arrive at;
> it cannot in and of itself resolve all systemic problems. The limited
> and uncertain access to capital has in large measure hobbled our
> collective economic system; interested parties to productive assets
> have been beset by a vicious cycle of pessimism and diminishing valuations,
> many times leading to a complete loss to owners and counter parties.
> The recommendation is designed to impose upon the banking system
> requirements to fully deploy their capital, with the aim of arresting
> this downward cycle and arriving at the nexus where collateral valuations
> are affirmed and once again become a measure of strength and not
> weakness.
>
> The basic tool and in this solution is taxation. A new piece of legislation
> is to be formed in which banks are taxed when not meeting the required
> leveraging minimums, and somehow rewarded when they demonstrate full
> leveraging deployment. Despite the cajoling of the Feds and Treasury
> after massive capital injections and asset swaps, the banking industries
> collective uncertainties are preventing their raison d'être, banks
> continue to under deploy and hoard capital, this is where we are
> collectively bogging down.
>
> As commercial banks comply with new leveraging requirements, they
> deploy capital to the most favorable credit risk. A new competitive
> lending environment will spring forth; banks will compete with other
> banks to actively seek out the best risk reward borrowers for their
> offerings, or be subject to this new Federal tax or penalty. This
> new velocity of money will energize our economy, restore asset predictability
> and grow balance sheet valuations without further deficit spending.
>
>
> This novel catalyst along with other primers will reduce the distance
> and time that the wheels of Capitalism need to travel before growth
> and optimism is restored; preventing unneeded failures, losses, and
> human hardship due to degrading asset valuations and capital deprivation.
>
>
> Let the chip fall where they may there after, a force new beginning
> will have started.
Free-market capitalism is as good as it gets, as close to perfection as is possible within a world of imperfect people. But life is inherently cyclical and so is the free market. Whenever the free market enters into a downward phase of the cycle, the ignorant masses whine that the free market has failed and government must step in to fix the problems, to eliminate forever the downward part of the cycle. Government is never a real solution to economic problems.
Government is a necessary evil, the sole legitimate purpose of which is to protect the rights of its citizens to life, liberty and the pursuit of happiness as long as they do not seek to infringe the rights of their fellow citizens. Lacking the profit-loss discipline, government will always be incompetent (i.e., lacking cost effectiveness) in whatever tasks it takes to itself. All actions that expand the role of government will be destructive in the long run. Social Security and Medicare are indeed Ponzi schemes that make Bernie Madoff a "piker" by comparison.
Rahm Emmanuel recently put the cynical liberal agenda into words by saying that "A crisis is a terrible thing to waste." Rarely do political leaders state the ugly truth so blatantly.
If we really wanted to get this country back on the right track, we would open our borders to almost anyone who would commit to buy a house, we'd elimate the vote from anyone who doesn't pay taxes and relies on the dole for subsistence, we'd do a lot of things that would be politically incorrect today but would be well understood by the Founding Fathers.
On Feb 01 01:46 AM 1RuleNoRules wrote:
> Excellent idea, use taxes to punish or discourage bad or undesirable
> behavior. Democrats fight this idea because it goes their philosophy
> of taxation, maximize revenue. If you can use taxation to get beneficial
> results you won't need government to fix all problems. Smaller government
> is not the goal of Liberals. Unfortunately it was not the goal of
> the Republican congress under Bush.
>
On Jan 30 04:57 PM LITHGOWK wrote:
> It is certainly true that the demi-gods in charge of our economy
> lack humility. They have analyzed the Great Depression and decided
> that if the government had acted quicker and with ample size, the
> Great Depression could have been avoided. This dubious line of thinking
> is producing our present spending spree that has all conservatives
> frowning or in tears. The problem may be that leadership is following
> two lines: one they are attempting to prevent deflation (construed
> as keeping housing prices from eroding more than they have) and two,
> to stimulate through keeping interest rates low and banks solvent.
> While these goals seem consistent, both may be beyond the power of
> government. Is it arrogance or ignorance to think government can
> control or even influence housing prices? Recognizing the losses
> for what they are, recapitalizing the banks that can survive such
> write-downs and let housing sort itself out would seem the more modest
> and perhaps wiser approach.
>
> The percentage of our economy related to housing was excessive. It
> may now be time to realign our economy into more productive sectors.
> I would suggest ground transport via light rail. A huge investment
> in this sector would be a long term investment in transport, in energy
> efficiency an in reducing carbon emissions. If most of our spending
> was directed into long-term productivity it would not seem so irresponsible.
>
>
> But it takes leadership to change direction. Congress, defenders
> of the status quo, and beholden to labor unions, will fight for funds
> for those industries that lead us into the present mess- autos and
> houses and the associated debt that over financed those sectors.
>
>
> Our manufacturing sector should be recognized as being more important
> than housing. Housing is overbuilt.
> It is time to concentrate energies on different sectors, sectors
> that can led us in new directions.
Clearly many others have a long way to go to get to this point, and judging by the increase in general anger ( and yes - starving is a good reason to be angry) we have a lot of troubles to work our collective world through. I hope we make it through the angry stage - I not really sure I want to be too close if China, Iran, ...( add whoever is your personal bogeyman country) gets angry as the USA cops it for "stealing" their money, even if they made bad investments choices.
For me - I 'd like to know where all those lawyers are that normally chase ambulances - have I got a clean up job for them, but then again I already know the bankers will have paid them off as well. I guess the natural reaction is to blame someone to justify your own anger, and getting the bankers to cough up their ill-gotten gains would be my preference.
Having said that, it would be no solution as then by the looks of things there would be no one left to do anything at all, as the lot of them appear collectively very guilty of a minimum of greed to outright fraud and theft.
Getting past my own personal blame preferences, letting the whole system naturally reset to the worst lowest common denominator position seems so excessive, but I have to agree with David that the prognosis for any other solution does not seem that good right now. Maybe hope has to be a strategy choice after all.