Washington Still Doesn't Understand Finance

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 |  Includes: AGG, DIA, SPY
by: John M. Mason

The President and Congress just don’t get it!

Financial reform is in the air. The bad guys did it and they need to be brought to account! Protect Main Street and go after those that are on Wall Street.

Unfortunately, this is not going to produce the results that the President and Congress want.

We are not going to get helpful results until the President and Congress develop an understanding about finance and what their current philosophies about economic policy are doing.

Unfortunately, I don’t see this happening in the near term.

Just two points this morning, but points that I have made before.

The first point pertains to the understanding…or misunderstanding…of what finance is all about. This misunderstanding is captured in the lead editorial in the New York Times this morning titled “After Goldman.” In this editorial we read: “The Goldman deal was nothing more than a bet on the mortgage market…WITHOUT ‘INVESTING’ ANYTHING IN THE REAL ECONOMY.”

Guess what? That is what finance ultimately is. Finance is nothing more than information, and millions and millions of people operate with this kind of information every day.

What is your dollar bill? A piece of paper…a piece of information.

Well, but it is legal tender!

Right, according to the government you have to accept a dollar bill in payment for debt. What has this got to do with THE REAL ECONOMY?

And, what about the demand deposit account you have at your commercial bank? It is just 0s and 1s in some computer. What has this got to do with THE REAL ECONOMY?

By the way, you are betting that you will be able to access that money when you need it? Is it safe?

Well, you say, the deposit account has insurance on it, doesn’t it? The Federal Government has guaranteed that you will not lose these funds and will not be inconvenienced by a delay in access to them. You have a promise! But, what has that got to do with THE REAL ECONOMY?

What are loans? Well, they are cash flows. Say, an initial cash outflow to the borrower and then a series of cash inflows back to the lender. Just 0s and 1s through bank accounts.

But, I put up a house to back the loan, didn’t I? The house is a real asset.

Yes, but the loan agreement is in terms of cash flows and the house is there for security in case you don’t pay the returning cash flow. Furthermore, that house is 25% underwater now, another piece of information, so how does this impact the cash flows?

Furthermore, it was the government that showed us how to “slice and dice” cash flows in order to tailor cash flows so that potential purchasers would find those “new” cash flows more attractive and purchase them. The first mortgage-backed security was issued by the Federal Government in 1970. The mortgage market went from playing a zero role in world capital markets to becoming, by the middle of the 1980s, the largest component of world capital markets. (See Michael Lewis’ “Liar’s Poker”.)

Thank you Washington for teaching us that cash flows are just bits of information. No real world here.

Now Washington wants to bring the herd of cats it has unleashed under control. Good luck!

The second point has to do with government policy and how it creates the environment for all else that goes on in the economy. Some of this discussion can be related to the David Wessel’s column in the Wall Street Journal this morning, “Mapping Fault Lines of Crises.” Wessel, in his column, discusses the work of Raghuram Rajan, a professor at the University of Chicago and former chief economist at the International Monetary Fund.

Rajan argues that, “The U. S. approach to recession-fighting and its social safety net are geared for fast recoveries of the past, not jobless recoveries now the norm. That puts pressure on Washington to do something: tax cuts, spending increases and very low interest rates. This leads big finance to assume that the government will keep money flowing and will step in if catastrophe occurs.”

This philosophy of government was first incorporated into government policymaking in the early sixties and has continued as the foundation for economic policy ever since. A consequence of this has been that the purchasing power of the dollar has gone from $1.00 in January 1961 to $0.15 in 2010. And, as we know, a sustained inflationary environment is one that produces massive debt creation and increasing financial leverage along with extensive amounts of financial innovation.

This leads us to another part of Rajan’s argument: “As incomes at the top soared (in the last half of the 20th century), politicians responded to middle-class angst about stagnant wages and insecurity over jobs and health insurance. Since they couldn’t easily raise incomes, politicians of both parties gave constituents more to spend by fostering an explosion of credit, especially for housing.” And, Wessel states, Rajan goes back in history to support the fact that this is not an atypical reaction.

The latter move not only contributed to general inflation, but eventually led to asset price bubbles in specific sectors of the market which could not be sustained. Hence the financial crisis!

Finance has never really been connected to THE REAL ECONOMY. Take a look at Niall Ferguson’s book “The Ascent of Money.” (See my review here.) This is especially true since the growth in finance and financial innovation, historically, has been connected with government’s financing of wars and, in the 20th century, the social system.

Furthermore, finance, in the future, is going to be even more connected with the idea of information and the exchange of information. For example, see the book “The Quants” (reviewed here). And this concept is spreading beyond financial markets. An amazing amount of research efforts and publications are connected with “Information Markets” which are not related to financial markets. Bob Shiller of “Irrational Exuberance” has produced a lot in this area: see his books “Macro Markets” and “The New Financial Order.”

The point is, again, that the President and Congress are fighting the last war. But, the last war is history!