Tuesday, October 25, 2011

How to Deal with Financial Tornadoes

Being retired affords me some personal options. For example, I can sleep until noon and Betty dusts around me. It also gives me the flexibility to take on some overseas teaching. I have been fortunate enough to teach for the last two months in an MBA program in Seoul, Korea. My contract provides an unlimited supply of kimche in return for economics lectures. It seems pretty fair to me! Anyway, I am now in Bloomington with great intentions to rake leaves and otherwise be a productive household unit.

While in Korea I read my usual newspapers and watched a little business/political news and tried to write my blogs from afar. I am struck, however, as I sit here in little Bloomington Indiana at how common are the political breakdowns in most countries. The political breakdown and  government malfunction have got to be a defining signature of our times. In my last blogs I nibbled around the edges to try to understand why we get such bad policy and today I try a different angle. This one focuses on the difference between problems and big problems – or dealing with challenges versus emergencies.

Many of the important policies we are dealing with daily have had and will have relatively enduing consequences. The stimulus programs will have effects that last for years. Today we are confronted with a new debate about how best to improve the jobs situation. In parallel is a very heated question of taxation of rich persons. Health care policy and what to do about entitlements require policies and solutions that will be with us for decades. In short, our government is bent on making policies that could not be considered temporary – these are changes whose impacts will last. These are solutions whose effects will endure.

The heft and durability of policies should, I think, reflect the nature of the challenges they seek to resolve. For example, if your kid stole a pack of cigarettes you would probably not send him to prison for 50 years. If your house burns to the ground you would not rebuild your house without a stove. If a tornado destroys your house you would not move to Venice Beach California or a place that almost never has tornados. If you got a stomach ache, you wouldn’t quit eating.

Most experts agree that the financial collapse and the ensuing recession and slow growth period, including the continuing dismal performance of unemployment came about because of a once-in-a lifetime-event.  I would not call it a random event but the swiftness, the depth, and the very sources of problems made it a rarity among economic shocks.  Tornados and fires are tragedies that sometimes unfold for reasons, but the truth is that most people never encounter these problems. If you live through one such event the likelihood is that you will not endure a second one. When someone is unlucky enough to experience one such tragic event, it is reasonable that they wonder what they could have done to prevent the problem and what they should do in the future.

It is equally reasonable to conclude that sometimes because of the severity of the negative consequences of such rare events, that people come to the wrong conclusions and sometimes make tragic decisions about how to avoid them in the future. I am afraid that is what is happening today with respect to economic events since 2007. Let’s go back to the tornado example. Surely moving to Venice Beach seems pretty outlandish unless you always wanted to live near Muscle Beach and were afraid to admit it. Less extreme would be to rebuild a house that has a basement, so you would be safer if another tornado did impact you. In between those extremes might be building a house that could stand the high winds of any tornado. I am guessing that such a house could be very expensive and well beyond the financial resources of most people. No matter which choice is made, however, there are financial consequences.

With respect to our current high rate of unemployment and slow economic growth, it seems to me we are barking up the wrong policy trees, especially if you believe that the economic shocks of 2008 were macroeconomic tornados – once in-a-life-time shocks that may never happen to us again. The negative economic consequences of the financial crisis are all around us and it is easy political picking to find demons and red herrings. Let’s blame it all on the capitalist system. Let’s blame it on rich people. Let’s blame it on China. Let’s blame it on globalization. Let’s blame it on….

If 2008 and thereafter really were the results of a rare event that has some small possibility of returning in the future then it seems to me that we want to do three things. First, realize that nothing you do right now will make the past go away. Second, don’t change things forever that have very little to do with a rare event. Third, whatever you do make sure that you are focused on what really may have caused the problem and attack those causes directly and with a budget that seems commensurate with the probable return of the problem.

So let’s create two lists. First we list all those things that did not cause 2008 and thereafter. Second, let’s list those things that we think did cause it and which could happen again without remediation.
List 1. Did not cause it:  people without healthcare insurance, rich people, insufficient taxes paid by rich people, the capitalist system, unions, worker demands, China, oil companies, inadequate infrastructure, air pollution, unemployed teachers and policemen, a disdain of small business to hire workers, immigrants
List 2. Did cause it: excessive leverage by financial and other firms, households incurring too much debt, governments incurring too much debt, unrealistic expectations about housing prices, corrupt practices among some individuals in financial firms, Fed policy that left interest rates too low for too long, realization that government revenues are insufficient for current and future liabilities, earthquake

Before you get too hot under the collar…note that List 1 does not imply that there are no problems with respect to income distribution, poverty, de-regulation, re-regulation, business costs including employee health and pension benefits. There are problems that need addressing in all those and other areas. But the point is to try to prioritize and to focus on cause and effect .If high unemployment and slow growth are the result of something – then let’s stick to those things. Let’s not use the current economic malaise as a cheap excuse to solve all of man’s ills.

Let me end this with a few words about the recent protests.  Those who have lost their jobs, houses, retirement incomes, and other means of living in the last several years have a right to be disappointed and angry. They have a right to peacefully protest and make their grievances known. There is much wrong with this country and we should all demand better solutions. But it helps no one to throw the baby out with the dirty bath water. What we all want is for things to get better. To do that with limited resources we have to focus and we have to be logical. Capitalism has served this country and most of the world well. Just imagine how the world has changed in the years since I was about 14 years old walking around Miami as Kennedy faced down the Soviets over rockets in Cuba. Since then country after country gave up central planning for some form of capitalism. It hasn’t been perfect and there are many things we can do to improve capitalism as it serves people of all incomes – but surely if we have learned anything it is that central planning is not a superior system.  We already have a mixed capitalist-socialist system. The financial crisis and resulting global slowdown will not be improved by radical departures from capitalism. Let’s keep our eye on the ball and not be diverted by people who are just using this crisis as a means to their own ideological ends.

Tuesday, October 18, 2011

Howling Wolf

On October 13 Martin Wolf wrote a column in the Financial Times called Time has Come for Intelligent Policy Making (http://www.ft.com/intl/cms/s/0/f4d3fdce-f42f-11e0-bdea-00144feab49a.html#axzz1auKt9tCY ). He ends the article with the following quote:
There are two big points here. First, fiscal and monetary policy converge when interest rates are close to zero. The authorities have to co-operate closely, to prevent an unnecessary disaster. As Deng Xiaoping said: “It does not matter if a cat is black or white, so long as it catches mice.” Who cares if a policy is called fiscal or monetary, so long as it works? Second, without economic growth, it is almost impossible to deleverage an economy. The prime minister revels in his pre-Keynesian views. When weak demand is the immediate constraint on output that is simply terrifying.
What is terrifying is that Wolf, a very influential writer, fails to recognize facts and continues to render advice that will truly harm the world for many years to come. He makes two important errors. First he believes that the present macroeconomic problem is deficient demand. Second he thinks that if past stimulus policies have failed then it behooves government to try them again – now with bigger doses of policy and with more coordination between the government and the central bank.
His belief that the main macro problem is a deficiency of demand or spending is like believing that driving accidents involving drunk drivers result from speeding. It is true that these accidents are correlated to driving speeds just as economic malaise is heightened by under-spending. But correlation is not causation. The accidents were caused by people drinking too much. Our lack of spending derives from very specific causes like years of unsustainable debt, a housing and financial crisis, a European sovereign debt crisis, and the attendant effects these trends have had on both Wall Street and Main Street. Calling for policy to induce people to spend more is like putting up new speed limit signs for drunks. Neither of these solutions addresses the root problem and the result is that neither will work. To the extent that Wolf continues to advise governments to focus on deficient demand means policymakers who follow his advice continue to avoid progress on true causes and thus threaten to make things worse.  
It is interesting that Wolf does not appear to read Wolf. In other columns he is quite lucid about the financial roots of our problems and is instructive on the need for private investors and tax payers to share in the solution burdens. Why he avoids his own advice and keeps coming back to strongly advise stimulus policies aimed at deficient demand is an interesting question. Maybe he doesn’t understand cause and effect? Maybe he believes the situation is so dire that cause and effect seem to be less important than trying ANYTHING to solve the problems. This is not 2008. I just don’t understand why he is so willing to throw caution to the wind and grab at straws.
This brings me to my second point. Wolf wants to see more stimulus and he wants a coordinated monetary and fiscal policy. Apparently the past programs were not enough. But Wolf doesn’t really say how much would be enough. By most measures the past fiscal and monetary injections were huge. And while there may not have been explicit coordination, the Fed and the US government were doing plenty without sending texts or tweets to each other. In theory a solo fiscal policy might lead to higher interest rates as government borrowing crowds out private borrowing. But that didn’t happen this time. I have read nowhere that rising interest rates have prevented recovery. Wolf seems to believe that if the Fed buys the government bonds that will somehow provide even more spending oomph. But does he really believe interest rates are not low enough now for people to want to buy a home or for firms to buy another machine? Does he really believe that the simple announcement of a new, large, and coordinated stimulus will cause people to run in droves to Amazon.com and Walmart with confidence and zest?
Much of Wolf’s conclusions derive from his belief that deflation is a bigger problem than inflation. I will give him that. I do not see imminent inflation for the world economy. But I see that fact different from him. This higher probability of deflation today stems from a belief that monetary and fiscal policy are spent and are NOT the right way to solve our macro problems. The more people listen to Wolf the more worried they become. This worry shows up in uncertainty and a desire to retrench. They don’t spend more when stimulated. The more the government tries to help, the more it nibbles off its own foot. I suggest we keep this Howling Wolf out of the hen house. More stimulus and more coordinated stimulus are going to scare the Hell out of people. What we need is for government to address the causes of housing and financial distress. Only then will we see a resumption of growth in output and employment. A wolf howls at the moon to no avail. I hope the same is true for the Wolf named Martin.

Wednesday, October 12, 2011

Haircuts, Hazards, and Hand-Grenades

I need a haircut. It has been more than six weeks since my last visit to the Crosstown Barber Shop and the little hairs on the back of my neck are looking unsightly.  But the market’s down and I was hoping to get a little more mileage on the last haircut. And there is the odd chance that government, feeling sorry for old people like me, might come to my rescue with a haircut subsidy.

While the above sounds really silly it is not a bad description of what is happening today around the globe.  Today we use the term haircut to describe the ability or willingness of the private sector to share at least part of the credit losses that have occurred in the last several years. A haircut means that a creditor agrees to take less than the promised or expected return on an asset. When it comes to housing in the US, Ireland and a few other places the haircut has to do with financial institutions that hold bad mortgage loans and/or derivatives tied to these loans. When it comes to European and other banks it has to do with banks and other financial institutions that are holding sovereign debt or the official government debt of Greece and other European nations.

We are not used to talking about haircuts in this manner. In the past, banks and financial institutions that held bad investments were seen as poor decision makers and we generally believe they needed to take care of their own business problems.  If they made bad investments and could not stand behind their debts then they should go into bankruptcy or go out of business. One such institution might try to sell its investments and willingly take a price reduction or haircut in order to maintain cash flow. But this decision was a private one – taken by a troubled financial institution to resolve its difficulties. It was not a matter of public policy.

Today things are different. Today we are in a financial crisis in which the proportions of the problem go well beyond a few firms, a few industries and beyond a few countries. The proportions also go well beyond an amount of debt which could easily be paid with government assistance from a single country or even a consortium of countries. Simply put, the financial crisis has most of us in a very deep hole. If it was not such a deep hole, we would have been out of it by now. If it was not such a deep hole, we would not have so much discussion and such little real action. This is not only a deep hole but it is a new one. Financial crises have come and gone. But most of these past financial crises have been limited to one or a few countries. 

These crises came before the age of GLOBALEV. GLOBALEV is a time when leverage became excessive. GLOBALEV is a time of global interconnectedness that turned the financial industry into a highly interdependent organism.  GLOBALEV is a time when housing and financial market bubbles burst and the negative impacts were quickly transmitted to financial institutions in most countries.

In short, we find most countries of the world sharing a very large financial burden. While bankruptcy and debt reneging/renegotiation might have been appropriate in the past, these solutions won’t work in GLOBALEV. There is too much money involved and too many countries that would be part of a downward cycle of default. Asking private investors to assume the whole load of this debt crisis is like asking me to lift a building. A more relevant question, however, is to ask HOW MUCH of the current debt crisis could realistically be carried by the private sector. That is, how much of a haircut are private financial institutions able to take? One might argue that they should take 100% of the burden. This is the way things ought to work in more normal times. But in GLOBALEV it is not possible.  If we asked all financial institutions to clear their nonperforming debt by tomorrow, the world’s financial system would grind to a quick halt.

Many are quick to point out the phenomenon of moral hazard. And they are correct to do that. If you do not make private financial firms assume the full burden of their investments, then they will assume that they will never have to do that in the future. Whatever harmful practices got them into the current problem would surely continue in the future. So the moral hazard issue is real and worth considering when determining the size of the haircut. With the financial crisis so deep and wide, a moral hazard cannot be avoided.
So if the private financial firms cannot withstand full responsibility for their bad investments, then they must be assumed by society.  GLOBALEV implies there must be a shared responsibility. 

This issue reminds me of people who live in flood plains whose property is destroyed by over-flowing rivers and oceans. Whether they were insured or not, it always seems to be the case that society ends up sharing the costs when homes are destroyed by flooding waters. I always gripe that this is unfair to those of us who do not live near water. But it seems to go on and on. After the waters recede people rebuild in the very same places. It sounds crazy but I think about the outpouring of both private and public relief that is mobilized every time there is severe human misery inflicted by Mother Nature. If tax-payers are unable to protect themselves from irrational home location decisions, it seems that we are equally impotent when it comes to deep financial crises.

Some of you are grinding your teeth right now. But I think it is unavoidable that a financial bailout will be part of the solution to our financial crisis. It will send the wrong signal to bailed-out firms and it will not prevent future disasters from happening in the future, but it will be part of a solution that might work.  It might work because the problem is so deep and it requires more assets than the private sector can now provide.  GLOBLEV requires a tax-payer contribution and the only question is HOW MUCH of the total amount is paid through government. Many options are possible. At one extreme the government can shoulder 99%.  At the other tax-payers might fork over 1%. But more than likely, the amount paid by tax-payers will be somewhere in between. 

Unfortunately HOW MUCH the taxpayer pays has become a political/ideological stick of dynamite. Inasmuch we are several years beyond the beginning of the financial crisis and we have little in the way of policy progress. Much has not been legislated and much of what has been legislated has not been put into practice. Stalling, or not deciding HOW MUCH the taxpayer contributes, is the one and only reason why we are staring down the barrel of a double-dip shotgun and why we have made little or no progress in employment.

Right now most of the news is about Europe and the lack of progress on their sovereign crisis. This negative cloud is hanging over all of us. Why? This cloud exists because Germany leads a group of countries that insists on a larger haircut and a small government contribution. France is part of a block that thinks a larger social portion must be paid. In Europe the usual problem of who pays gets even tougher and more political because it not only pits the creditors against the tax-payers but it pits country against country. If most of the debtors are in southern countries and the richer tax payers are in the north, then it is much more difficult to find a sharing solution that seems fair.

What’s happening in Europe is no different than our experience in the US. We continue to have a huge overhang of mortgage debt. We continue to have banks that sit on a razor’s edge of financial stability. We wonder why housing prices keep falling and no clear end to the housing crisis is in sight. But our politicians, like their cousins in Europe, do not want to admit or deal with deciding on the private haircut and the public split. Conservatives want the market to bear the full brunt.  Liberals want the tax-payers to pick-up a larger share of the debt.  Yet nothing will be accomplished until they admit the reality of the situation and get on with a compromise. In the meantime no jobs bill will restore demand or supply to a nation that sees no solution to GLOBLEV. So long as GLOBDEV remains, banks will not lend and houses will not sell.  Firms will continue to have less than sanguine expectations and will see no need to expand employment.

I personally have no frog in this race when it comes to deciding the size of the private haircut. As I said above, the smaller it is the bigger is the problem of moral hazard. Furthermore, the more tax-payers bear the burden the more our national debt increases and the more our financial reputation is a stake. Shifting the burden of finance from the private to the public therefore has its risks. But then the bigger you make the private haircut, the larger the risk you take with respect to the crumbling of global financial markets. This is a deep hole and there is no free lunch. But the more we pretend this is an ideological problem the more we stall a solution and the longer we languish in economic purgatory. We need some experts to decide the proper ratio of public to private responsibility and then we need politicians to bring home the solution. I am not optimistic we will get what we need anytime soon.

Wednesday, October 5, 2011

Currency Manipulation and the Wrong Super Hero

This week our US Senate is taking up the issue of China’s currency manipulation. It appears that we have an almost bi-partisan attempt to create even dumber international trade policy. The stock market hasn’t fallen enough – so our Senate has decided it can do even more to impoverish Americans. Way to go Reid! The Republicans who normally wouldn’t go along with this kind of stupidity (since they have their own kind of stupidity) seem to be worried that they need to play this populist card too.  Let’s blame everything on China. China– you bad. US Congress – we good.  So much for intelligent representation and policy!

What do these guys want to do? While the exact legislation is changing each day, the basic idea is that China depreciates its currency to create a competitive advantage for its exports. So we have legislation that would ask someone to calculate the degree of advantage China gets from currency manipulation and that would be fed into a Robot that would spit out the size of a tariff to apply to some or all of China’s imports into America. Sounds easy, right? Sounds fair, right? Sounds like it will save American jobs, right? Sounds like it will make 65 year old men more potent and attractive, right?

This reminds me of that cold day back in the 1970s when a car-full of Indiana University economists slid off a snowy highway between Terre Haute and Indianapolis and found themselves in a ditch wishing that a truck driver would stop and help them. We had a lot of PhDs in that car but no one who actually could figure out which end of the car to push. Luckily a truck driver did stop and offered some advice. He suggested that we push the car down further into the ditch and then floor it enough to drive out of the ditch. We concluded that this particular truck driver must have gotten his license from Purdue University and that there was no way in H___ that we were going to push the car down further into the ditch.  That was really stupid advice and even a bunch of professors knew it. We convinced the brawny driver to help us push the car upward and we were soon out of the ditch and on our way to Indianapolis. 

The point is that sometimes you really want to be rescued but sometimes you get a super-hero who just isn’t up for the task. In the case of China we in America feel threatened. We worry about China taking away our jobs and companies. So it is not wrong that we worry about how to better compete with China.  But this idea to tie US import tariffs to an estimate of Chinese currency manipulation is impossible to implement, will not increase US jobs and competitiveness, and will more than likely than not be counter-productive.

First, it is impossible to do. While we may have lots of theoretical models that might tell us how much China’s currency is under-valued, there are so many different ways to calculate this number that even a robot named Curly-Larry & Moe might sputter around in endless loops of break dancing. Then there is the small issue that implementing increased tariffs based on this number is not only novel but is illegal within the rules of the WTO. There is no precedent for this. While it sounds like a desirable thing to treat currency manipulation as a trade barrier worthy of reacting against, the WTO has not sanctioned this kind of retaliation. 

Then there is the question of other countries that routinely depreciate against the dollar to gain competitive advantage. Would it be proper and fair to only single out the Chinese? So are we really going to work Curly, Larry & Moe overtime on Brazil, and the others too? Do we really want to risk a global trade war right now?  In short it is really hard to find any way to actually implement this policy. It’s like making it illegal for Martians to own homes in Nevada. It sounds good to try to keep them out of Nevada – but I am not sure we have a good way to do this.

Second, this policy is not going to work. Notice that over the last years the Chinese currency has appreciated against the dollar. While it might have appreciated somewhat more, it is not the case that Chinese policy has been to reduce the value of yuan.  Other developing countries have done more.  Note also that these increases in the value of the yuan have not worked to reduce the US-China trade imbalance. So why would more work?

The answer is that it won’t work and it is because there are more fundamental factors at work causing the US to have a large trade deficit with China. Simply put, we in the USA make Miss Piggy look anorexic. We don’t save. We consume. The trade deficit is an expression of this imbalance. We buy from China and what we don’t buy from China we buy from other countries to meet our ever growing appetite for goods. If somehow we reduced our trade deficit with China, the spending would show up as a deficit with another country or countries. Of course China has a similar but opposite imbalance – they consume less and save more. This is perfect for us. We want to buy and they want to sell. Currency manipulation has very little to do with this. The problem is saving/spending and not currency values.  Altering fundamental attitudes and habits with respect to saving and spending is not something that can be done easily or quickly. Thus, our politicians would rather grasp at populist policies that do not work instead of doing the hard work of focusing on the real problems and solutions.

Finally is the recognition that it is counterproductive to focus our policy so strongly on currency manipulation and trade protection. Rome is burning and we throw gasoline on the fire. If this legislation were actually to be passed and signed by president Obama, we would not only be not addressing the real problems but we would be inflaming China and other countries. They know about our imbalances and they fully recognize protectionism when they see it. Other countries will not sit around and wait for us to focus on them next. Other countries are experiencing the continuing painful global slowdown and there is much populist demand for more protectionism in countries all over the world. 

Of course China has plenty of weapons beyond a simple trade war. How will we have served our own interests when China reacts by buying fewer US government bonds as the US government is trying to sell another $1.5 trillion of them? Or what happens if China aggressively sells the government bonds it already holds. W should not stir up trouble if there is nothing to gain. We should not stir up trouble if there is so much to lose! Instead, we should be the leader. We should be the leader for the right policies. We should not be the leader of a downward spiral of devastating protectionism.  If there are any real leaders in Congress we can only hope they will quickly step forward and put a quick end to this very harmful legislation.