Friday, October 31, 2008

Models cannot replace brains

I liked this article on how the scientific models for cod population were bogus. A friend of mine who studied Earth and Planetary Sciences at a good university left the field because she found the models they used to be totally bogus as well (yes, these are the models used in Global Warming). I developed a computer model looking at proteomics -- it was bogus also. Obviously the risk models used by banks were similarly bogus, although the "Government will bail us out" parameter seems to be working as advertised.

This is not to knock models -- it valuable to make assumptions that are implicit, vague, and inconsistent; explicit, precise, and consistent. But models don't replace brains.

I think a good example is the traditional subprime mortgage: there are people out there with bad credit, but good willingness (and ability) to repay. One test of this willingness and ability is to require a significant downpayment -- if you have the discipline to save for an extended period of time, you will repay your loan. This makes the second part of the test, a low "teaser" rate, make sense: if you can make payments for two years, then your credit score improves and you can escape the reset by refinancing into a regular mortgage. If you cannot make payments, then you are higher risk, and have to pay a higher rate to compensate for that.

This is also why just looking at interest rates does not tell you much about credit expanding or contracting, you also need to look at how the downpayment requirements are changing.

Thursday, October 30, 2008

The World's Central Bank

The dollar is, de facto, the world's reserve currency, which is why we've seen it strength against almost everything else as investors delever and switch to cash.

However, the US Central Bank traditionally only lends to american banks. Thankfully, it is now lending to banks of all nations so they too can borrow the dollars they need. The US Government is now lending directly to commercial banks, investment banks, insurance companies, auto companies, any business large enough to have commercial paper, Japan, UK, Switzerland, the EU, Brazil, Singapore, Korea, and Mexico. This is all well and good, because it formalizes the current state of the financial world: the US dollar is the world's reserve currency, and the Fed is the world's central bank. Some of the nations the US is lending to have a largely dollarized economy anyway: Brazil, and Mexico. The rest should ditch their currency and embrace the greenback too.

The IMF, which is de facto a part of the US Government, has been lending dollars to pretty much everyone else. The US should open up a swap line with the IMF, or even better, just fold that thing officially into the Fed.

It seems that only China and Russia are left out of the party. China's exclusion is particularly interesting because they've been sending us real goods, like TVs, cars, and washing machines, and all they have in return is this pile of US Treasuries! It's like a joke t-shirt.

As Brad Setser has been dutifully tracking for years now, almost all the long term demand for US Treasuries has been coming from the Government of China, who have been buying these things as a matter of policy. In the short term, this policy has stuck China between a rock and a hard place: if they stop buying Treasuries their export industries will suffer, but if they keep buying Treasuries they will be left with ever larger piles of Treasuries that the US can devalue (or not) whenever it wants.

Finally, with housing prices still 30% above historical trends, we have academics like Marty Feldstein saying the Government should prop them up "to prevent overshooting on the bottom". Nice to see that everyone is staying focused on the right things.

My preferred solution is for the Government to just mail everyone a check for $1M. Problem solved. For those who cry that "tax payers writing checks to themselves" cannot work are mistaken -- government money does not come from taxpayers.

Wednesday, October 29, 2008

Red vs Blue

The ongoing financial crises demonstrates that the current banking system, as well as the theoretical frameworks in academic macroeconomics and finance, are unsound. One could even say bogus. The failure of these established modes of thinking has opened the door to new modes of thinking, one of which may be right, and the rest of which may be wrong. That's if we get lucky--all of them may be wrong.

I've linked to Mosler in the past, but it's worth rereading his primer on fiat money economics, and scanning through his ppt on the current crises (here). Of the many provocative things he says, here are a few of my favorite:

- The current downturn was caused by the reduction in the Federal deficit in the Clinton administration
- The best way out of the current downturn is to (temporarily) eliminate FICA taxes, and so increase the Federal deficit while transferring money directly to consumers
- The Euro will totally fail as the spending caps mean EU countries cannot run sufficiently high deficits to support aggregate demand in the face of negative consumer demand shocks
- The point of taxes is to get people to work (so they can earn $ to pay that tax and net save). Unemployment is high because taxes are low.
- Government spending comes from borrowing. It does not come from taxes. Taxes only exist to create demand for currency, and thus reduce unemployment.
- Countries that run current account deficits are king. Countries that run current account surpluses will lose.
- Deficits don't matter.

Remember, Mosler talks about fiat vs real currency. Fiat currency gives the Government options that real currency does not. In this other article, Mencius Moldbug lays out Bagehotian vs Misean banking systems. Bagehotian system maturity transforms (borrows short term money to lend long term money) while a Misean banking system does not. While Miseans are often conflated with hard currency advocates, please note that maturity transformation can happen (or not) with hard and fiat currencies alike. While Mosler and Moldbug are miles apart on many issues, neither of them likes MT.

Someone who disagrees about the importance of MT is Michael S., who has a number of excellent comments in Moldbug's post. His central claim is that banks "pay a great deal of attention to the duration both of loans and of deposits and apply sophisticated methods of analysis to balance them". Empirics would suggest that the amount of attention is insufficient, as is the sophistication of analysis, and the quality of balance. Nevertheless, he tells a story of bad regulation, poor decisions by the Fed, leverage, and bank capital.

My feeling is that he is incorrect. A pure "tally" bank, a bank that is simply a ledger matching borrowers with lenders (and matching maturity) can operate on zero reserves and never have a problem. It's "equity" is not a cushion against bank shocks, it's simply the present value of the expected future cash flow it gets from whatever fees it charges for matching borrowers and lenders. The left and right side of the balance sheet increase and decrease together, you don't get a sudden fall in assets which then need to be matched by a sudden fall in the equities side of the liability column. Assets are matched directly to liabilities, with equity simply being the profitability of the rest balance sheet.

I also feel that Michael S remains too focused on the proximate cause of proximate problems (the underlying loans were bad, so mortgage backed securities feel dramatically in value) and ignores the actual problem at hand (why have bad condo loans in Florida and California caused emerging market equity markets to tank 50%, push oil up 50% and then have it crash back down, cause Iceland to go bankrupt, cause the commercial paper market to freeze etc. etc. etc.) There is a difference between asset bubbles (where the value of the security gets unmoored from fundamentals) and a credit crises (where all credit instruments freeze up together) and the mechanism for contagion is the key to understanding the current situation. I have yet to find a better explanation than MT -- and if Mosler and Moldbug agree on something, it's worth thinking about.

Friday, October 24, 2008

Weekend reading

Here are some recommended links for the weekend.

1. Everything you ever wanted to know about Austrian economics, but were afraid to ask.

Heard of Mises? And Hayek? Intimidated by titles like "The Theory of Money and Credit" and "Nation, State, and Economy" but want to know what all the fuss is about? Worry no more -- check out these awesome powerpoints and you will have a good understanding of the Austrian Business Cycle Theory, and a weak understanding of Keynes (who has dominated macroeconomics for 80 years now)

First read this: Austrian Business Cycle Theory (ppt)
Then this: Keynes and Hayek: Head to Head (ppt)

2. Everything you ever wanted to know about fiat money, but were afraid to ask.

Mosler is mad. Fiat money is mad. The combination is delicious. Check this out:
We are now in a position to demonstrate our proposition: the natural rate of interest is zero. First, to reiterate the argument thus far: Under a state money system with flexible exchange rates, the monetary system is tax-driven. The federal government, as issuer of the currency, is not revenue-constrained. Taxes do not finance spending, but taxation serves to create a notional demand for state money. Spending logically precedes tax collection, and total spending will normally exceed tax revenues. The government budget, from inception, will therefore normally be in deficit, which also allows the non-government sector to ‘net save’ state money
It's hard to know quite where to begin with Mosler, so maybe one should just start at the start, and move down. Slowly.

Quick thoughts:
1. As we see firms layoff workers and cut costs in anticipation of difficult economic times, there certainly seems to be something to Keynes' Y = C + I. Being canned does not inspire one to spend, but may result in someone else being canned.

2. That said, viewing cash in the bank as "waste" is looney. People want insurance, and people want to smooth consumption. Savings is it. Seeing all investment be funded by the Government extending a vig to banks is looney.

3. "Stimulus" (inflation) is fine until it is not. Sooner or later, the real economy needs to be rational, and that means that after a boom, malinvestment needs to be shut down and cleared out.

4. Soft money economics sucks for savers. The sooner they can find an alternative, the better. GLD anyone?

5. My belief in the healing power of prices is restored. We're in a situation where things are down from the peak -- leaving bad investors in the hole -- but still too expensive -- keeping good money on the sidelines. A situation which has the government keeping prices in this uncanny valley is a recipe for stagnation. We'll never get back to the top of the bubble, debt just needs to be written off, but we'll never get good money off the sidelines. Stagnation stagnation stagnation.

Tuesday, October 21, 2008

For biotech geeks

Invitrogen has launched a new bottle for its media business. The new bottle is awesome -- back when I worked in a lab, I always struggled when pipetting media into and out of the standard bottles, that looked like they were designed to tip over.

You can check out a standard bottle here.

Sunday, October 19, 2008

Other links

Funny column by Jeremy Clarkson on riding a Vespa

Excellent column by Daniel Davis (who I usually do not agree with) about Federal responsibility for the real estate bubble.

New Regulation, same as the old Regulation

Now that various governments are backstopping all financial activity, it's time for new Regulation to be added to the warehouses of old Regulation that already exist. The excellent Steve Waldman has a good list of some guidance for these additional rules:
Dani Rodrik has asked for examples of good innovations. Here are a few on my list:

* Exchange-traded funds
* The growth of venture capital and angel investing
* The democratization of access to financial information (e.g. Yahoo! finance)
* The democratization of participation in financial markets (e.g. the growth of internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international).

No list of good innovations is complete without a list of bad innovations. Obviously at the top of the list go CDOs, CPDOs, OTC credit-default swaps, the general alphabet soup of the structured finance revolution. (I would not, however, put all mortgage or asset-backed securities on the list. Well-constructed asset-backed securities, those that are transparent and not overdiversified, are very much like ETFs, and if they were more widely accessible I'd place them directly in the "good" column.) But there are many, many more bad innovations that we have yet to come to terms with:

* 401-K plans with limited investment menus
* The conventional wisdom that long-term savings ought by default be placed in passive stock funds
* The conflation of ordinary saving and financial return seeking
* The tolerance, advocacy, and subsidy of financial leverage throughout the economy
* The move towards large-scale, delegated, and professionalized of money management
* The growth of investment vehicles accessible primarily or solely to professional and institutional investors
It's well worth reading the entire post. My disagreement with Steve is that he seems to be trying to eliminate bubbles entirely, and I think that's impossible. We should be able to eliminate credit bubbles -- eliminate self-created risk from the financial system -- but human beings are prone to periods of irrational exuberance and it will always be that way. 

I also think that, in a society where Engineering Wizards keep creating new marvels like Google and the iPhone, we should be able to sit on our duffs and get richer even if we don't buy the new marvels. The money supply should deflate, gently, making money in safes worth slightly more over time. So while I agree that we should separate savings from investment, I don't think that every investor should be active, nor do I believe that savings should lose value. 

Arnold agrees that bubbles are inevitable, and does not like the degree to which the Government can direct investment in this new era. But in a world where there is maturity transformation (MT: short term deposits backing long term loans) the Government must provide FDIC insurance because there will be a systematic bank run. And if Government is essentially backing all loans, it will have a say in where those loans get deployed.

I see no recommendations that say we should just keep MT off, and build a stable system on those new foundations.

Friday, October 17, 2008

Tesla Motors, RIP?

I occasionally see Teslas whizzing about my neighborhood, and even more rarely, stalled (crashed?) and holding up traffic, but I'm not sure if their current difficulties can be tied to the credit crunch.
A blog post by Musk on Wednesday blamed the credit crunch for the decision.

"These are extraordinary times,'' Musk wrote. "The global financial system has gone through the worst crisis since the Great Depression, and the effects are only beginning to wind their way through every facet of the economy. It's not an understatement to say that nearly every business will be impacted by what has unfolded in the past weeks, and this is true for Silicon Valley as well.''
Certainly Detroit's problems began long before this current crises -- they've been spending too much to produce bad cars for decades now -- but Teslas are primarily a toy for the very rich and I don't think equity fueled Silicon Valley has been impacted much by debt deflation. It is possible that the cars just aren't working, and investors are saying that Tesla either needs to get its act together, or they're going to pull the plug.

Thursday, October 16, 2008

Zeno's paradox

In Zeno's paradox, Achilles keeps gaining on the Tortoise but never actually reaches it. Similarly, economists keep coming closer to the core problem behind this (and all) credit crises, but can never bring themselves 100% there. In this NYTimes piece, Diamond and Kashyap (and Diamond in particular is closest to understanding the problem here) say:
If the remaining investment banks, Goldman Sachs and Morgan Stanley, do not get more secure funding in place, they may be acquired or subject to a run too. In the current environment, relying almost exclusively on short-term debt is hazardous, even if a firm or bank has nothing wrong with it.
The very next paragraph reads:
The inability to secure short-term funding fundamentally comes from having insufficient capital. There are many indicators that the largest financial institutions are collectively short of capital.
Perhaps Diamond and Kashyap could explain in what kind of environment relying almost exclusively on short-term debt is not hazardous, and while they are at it, perhaps they want to explain FDIC, and how sounds the retail banking system would be if FDIC did not exist. And while in this article the say that the inability to secure short-term funding comes from having insufficient capital, perhaps they could explain why the crises happened when it did, and not a year ago (where housing financials were as dubious as they are now)? As Diamond's own freakin' model demonstrates, relying almost exclusively on short-term debt is never a good idea because you can have a bank run at any time, for any reason. The bank run reduces capital, which exacerbates the bank run.

Megan makes a similar error when she talks about the timing of the recession, who called it, and who did not. The only honest article I've seen on this is from the overweight and overwrought Brad DeLong: The Wrong Financial Crises. He straightforwardly admits that academic macroeconomists were focused on trade and current account deficits, particularly between the US and China, and not on the potential for a bank run on the shadow financial system (which is what's happening now). Bank runs happen spontaneously and for no reason -- they cannot be timed or predicted. If you don't see this credit crises as a bank run, then you can make claims about who should or should not have predicted it. Bank runs are unpredictable -- everything works fine until it doesn't. It's a lousy way to run a financial system.

Finally, I would add, that there is still an entity out there who relies almost entirely on rolling over short term debt, and has not yet seen demand for that debt dry up

Does not compute

The amount of drivel poured forth on the credit crisis is astonishing. It is obviously extremely difficult for academic economists to see what is really happening -- their ability to perceive truth is clouded by their training and priors. My alma mater's Greg Mankiw is a case in point: he's a scholar, a gentleman, and a smart guy, but still comes up with craziness like this:
It could work as follows. Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date.

This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control.
His plan has good features, but parse that last idea again: since the Government would take non voting shares, the private sector would maintain control.

With all due respect: what planet is he living on? When the Government had *no* equity stake in the banks, Paulson was able to make them sign on to his plan. The Treasury does not need any stinkin' voting rights. The Treasury already has all the rights it needs. Arguments that the Government cannot influence how banks lend is similarly rubbish. All the have to do is nationalize, and then direct, like they have with Fannie and Freddie. At this point, they don't even have to nationalize.

Alan Blinder and Glenn Hubbard similarly claw around in the dark.
Yesterday, the Treasury and the Federal Deposit Insurance Corporation (FDIC) announced the second broadening of deposit insurance coverage within two weeks -- this time, to unlimited deposit insurance for business checking accounts. Some want to go even further.

Hang on a minute. We think it is time to remember that unlimited insurance coverage for all deposits is not costless. It would not address the main problems now undermining confidence in the financial system. It might not encourage bank lending. In fact, it might even have the perverse effects of undermining confidence in the soundness of the FDIC, increasing moral hazard, and destabilizing the financial system.

It was a bad idea two weeks ago, and now there is an international dimension. Policy makers in Ireland, Germany and elsewhere have given a 100% guarantee to bank deposits in their countries. A few countries have gone even further, insuring nondeposit liabilities as well.

Yes, we want to reassure depositors -- and we have. But we need to look before we leap. A country can get in trouble by guaranteeing more than it can afford. Iceland may be in that situation already. Since FDIC insurance has been the rock of stability up to now, the U.S. government should never do anything that calls into question the viability of the FDIC. Just yesterday, it was asked to do more than it has ever done before.
All of the banking system "maturity transforms" (ie. uses short term deposits to make long term loans). Therefore, all of the banking system is subject to bank runs. Only part of the banking system, though, is covered by FDIC insurance. The rest of the banking system, is experiencing one enormous bank run. The US Government is retroactively, and in fits and starts, extending FDIC insurance to this exposed part of the banking system, which is good, because an MT system must have FDIC insurance in the same way a fission reactor must have control rods. The fact that these did not already exist demonstrates the complete ineptitude and incompetence of the macro and finance branches of economics. The awful scenario that Blinder and Hubbard describe is reality as it has existed for about 350 years.

Sunday, October 12, 2008

The Japan Experience

To those of you all excited about buying on the dip

(Thanks to Angry Bear for the graph)

Saturday, October 11, 2008

Financing and prices

A while ago I asked: to what degree should financing impact the price of an asset? Should I be willing to pay more for a share of because my broker offers me a generous margin account?

The answer is: to the degree that the price of the asset is determined by financing, financing can effect it a great deal. As we are seeing, the value of a 30 year debt instrument depends monumentally on whether it's being financed by rolling over short term debt, or whether it acts as a very long CD. Similarly, we saw how mortgage financing drove up the price of housing, even us underlying rents barely moved. George Soros, of all people, makes this point in an interview with Bill Moyers:
And that actually was based on a false idea. This namely, the markets self-correcting because the market moods have a way of affecting the fundamentals the markets are supposed to reflect...

Banks give you credit based on the value of the houses. But they don't seem to somehow understand that the value of the houses can be affected by the amount of credit they are willing to give. Now, we've developed these fabulous new ways of securitizing mortgages, which has made credit much more amply available.
Also a while ago, I wondered how the Treasury would act, as I understood the people who made up the Fed (academic economists) but did not understand the Treasury. Now I know -- it's ex-bankers, so you should expect them to do what they can to save banks. This explains why the original Paulson Plan was such a stinker, and the shift to Plan B: (partially) nationalizing banks etc. Zingales his a Plan B here:
Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property. Why? Because there is no reason to give a break to inhabitants of Charlotte, North Carolina, where house prices have risen 4% in the last two years.

How do we implement this? Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level. Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property. Exactly like in my hypothetical example above.

In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder. It seems a strange contract, but Stanford University successfully implemented a similar arrangement for its faculty: the university financed part of the house purchase in exchange for a fraction of the appreciation value at the time of exit.
I didn't think much of Zingales' Plan A and have mixed feelings about his Plan B. The key problem is that it tries to prop up house prices, which are still too high. As we learned in the Great Depression, keeping a market from finding its clearing price is the best way to halt economic activity, which extends and deepens recessions. The Stanford University plan was put in to protect the University in case prices declined -- they wanted the owners to have some skin in the game, which a traditional debt subsidy did not give them. One of the broader issues in the economy is that the American consumer is finally tapped out, has stopped taking on debt, and is working to rebuild the household balance sheet. Keeping the price of housing inflated at current unaffordable levels will be as beneficial in this environment as adding a $10 tax to every gallon of gasoline.

Friday, October 10, 2008

Buell in Time

And now for something completely different. An inside look at Buell, the most innovative motorcycle company on the planet. Hearing about their non-automated assembly line helps me understand why their bikes are so unique, but have such a reputation for reliability.

Thursday, October 09, 2008

Sour Season

Quote of the day:
Yet today the cry, accompanied by visions of catastrophe if it is not forthcoming, continues for still more easy money. I am really not sure what world these mad voices are living in that they consider the actual state of affairs non-catastrophic but here is a small observation: the wheels already fell off. Iceland, for Heaven’s sake, is short of the foreign reserves necessary to import food.
Looks like it's time to get back to Hákarl.

Wednesday, October 08, 2008

Policy blunders

At this juncture, it's worth pointing out that not only has the US not re-capitalized financial firms in return for equity stakes (apparently never having heard of the expression "nothing for nothing") but they have also failed to start sifting the wheat from the chaff. Headlines make us think otherwise, but not all financial institutions are in distress, there are good actors out there as well as bad, but so far the Fed's actions have been to broadly support the market as a whole, and Goldman Sachs in particular. The problem is not confined to the US either. An excellent synopsis by Yves on the poor quality of government interventions to date is here.

(Also, I recommend the comment thread on Arnold Kling's post on monetary institutions. Excellent discussion on maturity transformation, the difference between asset bubbles and credit bubbles, and the difference between liquidity risk and solvency risk.)

Tuesday, October 07, 2008

Struggling with Term Transformation

I'm glad to see that the Fed is now lending directly to businesses. In a world with maturity transformation plus FDIC, deposits are essentially kept under a mattress, and all loans are made directly by the Government. This credit crises is essentially a bank run on non-FDIC insured banks, and it's nice to see the US Fed (slowly) remove the ambiguity in the situation by taking over most of the world's financial system.

Given that the financial system has revealed itself to be one enormous Government Sponsored Enterprise, I'm amused to hear that the solution is "more regulation". I assume that that's the solution to FEMA as well.

Arnold Kling continues to struggle with the notion of "term transformation" or "maturity mismatch". This makes it very difficult to understand this, actually any, credit crunch or liquidity crises. Essentially, when an intermediary uses short term deposits to finance long term loans, it always runs the risk of a bank run, as those short term deposits can choose to withdraw their money at any time, and the intermediary cannot call in the long term loans to make up the short fall. This is your classic "bank run" and it has no solution. The Government can step in and simply guarantee some short term deposits, and add reserve requirements, but as we've seen in practice, during an actual bank run the Government will simply extend it's guarantee to all deposits, and the bank will use off balance sheet vehicles to get around reserve requirements. Better to simply put your money under the mattress and borrow directly from the Government (which is what is happening now) but it also might be nice to experiment with this thing called "banking".

Arnold reasonably becomes confused between three concepts: fiat money, fractional reserve banking, and maturity mismatching. He also asks for a "theory of how long-term lending emerges". I will clarify the first three, and offer the fourth.

Fiat money is essentially any medium of exchange that can be increased at will by the Government. The dollar is exhibit A. Ultimately, all fiat money will become debauched and valueless through inflation (monetary dilution).

Fractional reserve banking essentially gives banks the ability to increase the money supply by extending credit. So they have mini printing presses of their own, just like the Treasury. Fractional reserve banking means that a bank can make a loan without needing to have the money on hand. It can conjure the money out of thin air -- which is pretty cool. Note, that in a fiat money system, this now means the central bank has much less power over monetary expansion because there are so many new entities that can extend credit by using their own little printing presses. You get a credit bubble when banks print too much money using the fractional reserve system.

Finally, maturity mismatching means using short term deposits to make long term loans, a system which is intrinsically unstable and subject to bank runs.

You can maturity mismatch with any kind of currency. The bank will still be subject to runs, but the currency will not lose value. As the issue of the day seems to be an enormous bank run, maturity mismatching is the culprit at its heart.

As for Arnold's "theory of how long-term lending emerges", I would suggest that you have someone who wants to borrow money for a long period of time, and he finds someone to lend it to him.

Monday, October 06, 2008

Cross-border contagion

Krugman has a model of the contagion episode of the financial crises here. My reactions:
But we’ve known for some time that trade flows aren’t the only source of international interdependence. The Asian financial crisis of 1997-1998 was notoriously marked by “contagion,” the spread of crisis to economies with seemingly weak links to the original victims. In particular, the most severely affected nations were small economies that were not each others’ major trading partners, yet they experienced a dramatically coordinated slump...

The proposed channel that seems most relevant, however, seems to have been originally proposed by Calvo (1998): contagion through the balance sheets of financial intermediaries. Loosely, when hedge funds lost a lot of money in Russia, they were forced to contract their balance sheets – and that meant cutting off credit to Brazil.
This is entirely true, and was obvious to anyone actually working in the field at the time (which I was). The role of financial intermediaries has grown since then, but no regulatory framework was put in place based on what was learned (or not) in 1998. His model has two lenders: the general public, and highly levered institutions (HLIs). HLIs use leverage, and are their demand for the risk asset is driven by the equity on the balance sheet. Therefore, they have an upward sloping demand curve. Sadly, Krugman does not take this upward sloping curve to its logical conclusions:
As drawn, the supply curve from the general public is flatter than the demand from HLIs; this is the case in which equilibrium is locally stable, because a rise (fall) in q will lead to an excess supply (demand), pushing the price back to its original level. It’s clearly possible in this model for the equilibrium to be unstable instead; in that case we’ll have the possibility of vicious circles that drive the asset market to a low-level equilibrium, virtuous circles that drive it to a high-level equilibrium. My reading of developments so far does not seem to require multiple equilibria – notably, house prices are still above the levels that you can justify in terms of traditional fundamentals. In any case, for current purposes I’ll focus on the case in which pure self-fulfilling crises are not the problem.
So, in the middle of the largest bank run ever, Krugman decides to ignore the fact that there are two equilibria in a world of term transformation. Given these assumptions, it's trivial that the model recommends equity injections in HLIs.

Friday, October 03, 2008

Apocalypse Now -- the Happy Friday version

Just some quick links for Friday.

Nouriel Roubini talks about the generalized run on the financial system, as maturity matching is "turned off", the quantity of money is shrinking, and long term debt is valued at its true, stable, market price (which is much lower than the term transformed unstable market price). Many smart economists, such as Megan McArdle, think term transformation is a good idea. I think it is the Shiva that will, ultimately, unseat the current global financial system. Borrowing short to lend long is inherently unstable.

For more thoughts on the instability of term transformation, I point you to this grim post by Mencius Moldbug on why term transformation is bad, and where this generalized run will end up. To those who don't think FDIC insured banking is equivelent to holding deposits in a vault, and borrowing directly from the Government, I refer you to Recent Events.

And finally, one possible end game which is so ludicrous and mad, that I shall say no more about it here, nor ever refer to, or link to it again.

- Housekeeping note

My ancient custom Blogger template stopped being compatible with the system sometime in late '06, so archives and permalinks stopped working. Also the email list has been defunct for a while, and needs to move entirely to an RSS system. I'm working to move all posts over to a new system while not losing anything. Fingers crossed.

Thursday, October 02, 2008

Memory hole revisited

It looks like I was not the only one who finds the story of Sept 29, 2008 on Oct 1-2, 2008, beardy.
First off… let me make a couple of observations. If you watch the financial news, you would get the impression that without the Paulson Plan, (of whoever's name is on it now) the entire financial system will come crashing down. If you watch the network nightly news, the Financial Crisis of 2008 is just another news item. When I first saw the original hearings and House members didn't sound sold, the people I talked to in the markets told me I was wrong… this is just for show to the voters back home… I was told. Passage is a done deal. Then the bill failed. Wall Street was shocked and mortified at the initial defeat. And now they are now saying yesterday's rally was on news of the resurrection of the Plan in some other form. If you ask me, equity prices were already recovering BEFORE House members tried to resurrect the "Plan". Maybe there was some talk going around on Monday night to try again, but from what I saw, Asian and then European markets were stable to higher well before there was serious talk that the Plan could still be passed. Besides, if the rally were really based on a resurrection of the plan… why was the dollar up so sharply with gold lower in the aftermath of the defeat? My conclusion; we are dealing with heavily tainted news and analysis from Wall Street.

Situation normal

I hope the events of the past seven days have cleared up any remaining confusion about who runs the USA. Paulson is a creature of the Treasury, and the Treasury is a creature of the banks. TARP will help banks by transferring Government money to them, but its impact on the broader economy will be negligible. Or negative.

As home prices return to historical norms, the money supply in the US shrinks (ie. the US is in deflation). While the Fed has printed money through low interest rates and a variety of other new mechanisms (all of which are inflationary), deflationary forces are still more powerful than inflationary forces. The US is in a liquidity trap (although I hate the term) as the economy needs to delever, but the monetary system does not have a good way to accommodate that. This is a fundamental failure of fractional reserve banking: it's a ratchet that can increase money supply (inflation) but cannot gracefully decrease money supply (deflation).

Bernanke knows how to stop deflation and get out of the liquidity trap: the Government simply prints money and gives it to consumers (thus the moniker "Helicopter Ben") but you'll notice that so far, the US has not done this. Most of the transfers have gone to banks, and banks are using the money to plug up the holes in their balance sheets caused by bad mortgages. So, new money is created, but banks don't lend it out. Paulson hopes that by giving banks a huge plug of money, they will finally start to lend.

I think he is certainly wrong here. His gift of $700B is not enough to plug the holes in the banks balance sheet, and it does nothing for the household balance sheet, where consumers are deep in hock and have recognized the need to pay down debt. This is Nouriel Roubini's point when he argues for a new HOLC.

Instead, Paulson's gift will create Zombie banks -- no longer insolvent (since they now have positive equity) but still not lending (as consumers cannot and will not borrow). Japan went down this path, and the result was two decades of stagnation and decline.

The one area where liquidity (the ability to roll over short term deposits to support long term debt) is really important is in the commercial paper market, where businesses take out temporary loans (30 to 90 days) to make payroll while waiting for accounts receivables to arrive. When folks talk about the Great Depression, they are talking about this market ceasing to function, and otherwise healthy businesses having to shut down. The CP market is struggling, which is the focus of all those NYTimes and NPR stories which magically began to appear, like mushrooms after the rain, on October 30th, the day after the House voted down the Paulson Plan on Oct 29th. The moral of those fables was that unless the Paulson Plan is passed, more business will struggle because they cannot borrow money from the commercial paper for their working capital. I'm sure that the Times' reporters' sources in the Treasury were very clear about how this worked. Certainly the press know how to do their job, as each headline said that it was the House that "failed", and not that a "stupid idea" had been "correctly rejected". It's great to see a plan come together.

Unfortunately, the NYTimes' sources in the Treasury are almost certainly wrong, as the Fed and the Treasury really have no idea what they are doing. This point is made clearly on Yves' blog here and here:
The bailout, I mean rescue plan, can be seen as nothing less than a new Ponzi scheme. It works like this:

Fed as only lender, in an attempt to keep the financial system from imploding;

TARP needed to keep Fed balance sheet intact so that it can continue as only lender;

Treasury will need to significantly increase the amount of Ts (public money) auctioned to fund TARP;

Panic serves to encourage T. buyers, especially for bills;

This represents a liquidity trap: TARP recipients of Ts will hoard cash to buy Ts: rinse and repeat.

This results in drying up of lending to corporations/crowding out private capital - no new credit lines;

The Fed becomes a holder of private capital, the later of which is now frozen to protect that capital from deteriorating, The rollover scheme will restrict even more lending in the private sphere for purposes of keeping the financial sphere on life support, but with the consequence of furthering the deterioration of the 'real' economy.
So, once the Fed uses TARP to buy bad bank assets, it will issues an equivalent number of treasury bills to pay for those assets, and so the quantity of treasury bills available goes up. Treasury bills are close substitutes for commercial paper, and buyers have increased demand for the safety of Treasuries anyway, so the few remaining commercial paper buyers will switch to Treasuries also (as there are enough of them to go around). This shrinks the market for commercial paper further, which starves business of working capital even more.
The problem we're having is that people are fleeing commercial MM for treasury MM. Those are buying treasuries and thus converting the money to the desirable medium duration BUT that money is loaned to the Fed, and the Fed doesn't make working capital loans. So the deposited money that had been made into working capital has been diverted into the Fed and lost to working capital.
This is one reason I hate all the metaphors swirling around the discussion of the financial crises -- it obfuscates the actual mechanisms in play. Paulson has given no good reason why his plan should work, and how it will benefit Main Street.

My prediction: deflation will continue through 2008 and 2009. The economy will continue to contract as consumers reduce consumption (and increase saving, which they must do) and businesses scale back operations so they fit the new, lower personal consumption environment. This will be a slow process, though, as the Fed and Treasury have worked mightily to obfuscate prices, and drag out the bubble deflation. Eventually, Helicopter Ben will say enough is enough and start to (finally) mail freshly printed greenbacks to households. Now we will switch from a deflationary environment to an inflationary environment, China will complete it's transition out of the dollar, and we will get real, honest-to-God 70s style stagflation. And then we will wait for the next Volker.