jmkeynes

Lehman's Collapse: Broader Economic Damage Unlikely

Those who obsess over the credit crisis are making three faulty assumptions:

(1) they assume US economy has to be a consumer driven economy,

(2) they assume that the only way to prop up consumer demand is to re-inflate the housing bubble, and

(3) they assume that the only way to avoid another Great Depression is to bail out any bank that would otherwise fail.

We need to examine how these three faulty assumptions are really part of a larger picture. To see the larger picture one needs to understand the link between America's energy policy, its chronic trade deficit, and asset bubbles induced both by the Fed's easy money policy and America's need to borrow from abroad to finance its trade deficit.

America's energy policy has been entangled with our military policy for many years. Even Alan Greenspan admits that the war in Iraq was and is largely about oil.

Unfortunately, those opposed to the war have not insisted that American's must at least pay for the war by imposing a tax on oil consumption. Since the cost of the war is not included in the price of oil, America is subsidizing oil imports.

Taxing oil would help bring down the trade deficit and it would encourage investments in alternative energy. But instead, America borrows money from abroad to pay for the war.

The Chinese, Japanese, Germans, Saudis, and others have been all too willing to loan American money to help stimulate their trade surpluses. In fact, their surpluses are so large and America's deficit is so big that America is allowed to borrow still more to pay for "investments" in housing - hence the housing bubble.

If America could at least stop investing in housing and start investing in windmills (something Al Gore and T Boone Pickens could agree on) we could make a dent in our trade deficit. According to Pickens, we need to spend around one trillion dollars on windmills and another 200 billion dollars on the electric energy grid to bring electricity to the coastal states. In other words, we need to make a massive investment in alternative energy. Given that need for investment spending, a slowdown in consumer demand due to house price deflation may actually be a blessing in disguise for the country (if not homeowners with bad investments).

But politicians know they can't get elected by telling voters they'll need to take some bad tasting medicine for the country to regain its economic health.

So, instead, politicians (such as McCain and Clinton) propose only what they think voters will like - cuts in oil taxes - even though their economic advisers should know this is the opposite of what America really needs to bring down the trade deficit.

To make matters worse, both the Republicans and Democrats push for tax rebates to encourage consumption spending, which further exacerbates the trade deficit.

In an economic downturn, it does make sense to borrow money from abroad to stimulate aggregate demand. But, the government could and should do stimulate demand by spending money on alternative energy infrastructure.

Windmills help bring down the trade deficit, but increased consumer spending at WalMart only drives up imports.

Finally, to top it all off, politicians seeking to capture the home owner vote argue about who has the best plan to re-inflate the housing bubble.

Unfortunately, politicians, voters, and some economic journalists have come to believe that the US economy has to depend on consumer spending.

For some reason, they think the US has to focus on consumer demand and can't get our economy going again by making investments in projects that will reduce our trade deficit.

What's worse, some so called "free market" economists argue that the government shouldn't make or try to promote investments in alternative energy because this would be industrial policy, which they criticize as yet another futile attempt by to government to "pick winners."

Oddly, these same "free market" economists don't see the war in Iraq (a war Greenspan admits is largely about oil) as energy policy or industrial policy. They see war as "military policy" so therefore picking winners in this instance is OK according to the Ayn Rand and Milton Friedman guidebook on what governments should and should not try to do.

So, America borrows money from abroad and lets the Fed run the printing presses to send out tax rebates, bailout banks, and jack up home prices.

These policies may be "good tasting" but they're not good medicine, they're poison.

The medicine America needs to take won't taste good, but there may still be time to save the patient.

America needs to work off its trade deficit. And, to do so, we need to kick both our oil and our house-as-investment habits.

As for dealing with investment banks and other financial institutions that are thought to be too-big-to-fail - as I see it there are three options:

1) a free market approach that lets failing banks fail,

2) a socialism for the rich approach that bails banks out but eventually lets them go back to their high risk behavior that will lead to future bailouts, or

3) a plain old socialism approach that nationalizes institutions that are inherently too big to fail and turns them into highly regulated government agencies.

People keep arguing about whether option (1) or (2) above is better, but they don't give any serious thought to option (3).

The question is whether you want the CEO's and other high ranking executives of these firms to be highly paid, high rollers who earn their fat paychecks by taking big risks. If so, that's great but the taxpayers don't want to get left holding the bag.

Or, do you want the managers of these firms to be competent but rather boring bankers who are heavily regulated and are therefore obliged to follow a script. If so, that's great the taxpayers should be more willing to backup and bailout this kind of operations. But, don't expect much innovative behavior from banks if this is the way we want them to operate.

You can't really have it both ways.

So, if a majority of Americans really want an innovative, high risk banking system, then we need to be willing to let banks fail and suffer the consequences whatever they might be.

On the other hand, if the majority of Americans want a safe, reliable, but unexciting banking system, if we think banks are just too to fail, then great, I say we take banking out of the private sector and make it a function of the public sector.

Lehman Is Just the Thin Edge of the Wedge

The financial press spends 99% of its time debating whether taxpayers should or should not bail out financial institution X.

Despite all the electronic ink that has been spilled, the tax payers have become liable for Fannie & Freddie and we will, no doubt, become liable for more institutions in the future.

So, since it's a given that taxpayers will be required to bail out financial institutions that are too-big-to-fail, too-politically-well-c... or whatever, I say we turn the discussion of WHICH TAXPAYERS should be on the hook.

For example, the Fed is pleading with a number of financial institutions to get them to take over Lehman. And Lehman is just the thin edge of the wedge.

So, instead of pleading with financial institutions, the government should be considering new taxes that will make those responsible for the credit crisis pay up.

Personally, I favor a retroactive financial institution CEO tax. Let's have congress pass new tax legislation that will give the IRS the mission of leveling taxes on financial institution CEOs over the past ten years.

After we've taxed the CEO incomes, we can institute net wealth taxes on everyone who's become rich over the last ten years by running up the housing bubble.

We could start by retroactively taxing the capital gains on home sales over the past ten years. These homeowners have been the principal beneficiaries of the housing bubble, so let's let them pay their fair share for dealing with the financial crisis that has resulted from the housing bubble.

What we shouldn't do is assume that tax payers who have not gained in any way from the housing bubble should be made to pay for the mess created by the housing bubble.

The Nature of Risk

One way to use options to reduce risk (volatility) is to own an index (e.g. by owning an ETF like IWM) and sell short-term, out-of-the-money, covered call options against that index.

Usually short term (one month or less), out-of-the-money options expire worthless unless the value of your underling investment (e.g. IWM) goes up dramatically. The worst case scenario is that you suffer an "opportunity cost" of not gaining everything that you would have gained if you didn't sell the options. This happens if the price of the underlying index goes up past the strike price on the options you've sold. Your underlying investment gets "called away" but you get paid the strike price and you make money some money from the sale of the options as well.

Generally what happens is that you make some money from the sale of the options. Your investment in IWM either goes down, stays the same, or goes up a bit but doesn't cross the strike price.