Saturday, June 26, 2010

Financial "reform" bill a dud

Yves is merciless about the Obama administration's financial "reform" bill:
I want the word “reform” back. Between health care “reform” and financial services “reform,” Obama, his operatives, and media cheerleaders are trying to depict both initiatives as being far more salutary and far-reaching than they are.

So what does the bill accomplish? It inconveniences banks around the margin while failing to reduce the odds of a recurrence of a major financial crisis.

The only two measures I see as genuine accomplishments, the Audit the Fed provisions, and the creation of a consumer financial product bureau, do not address systemic risks. And the consumer protection authority was substantially watered down. Recall a crucial provision, that banks be required to offer plain vanilla variants of products, was axed early on. In addition, the agency, initially envisioned as independent, will now be housed in the Fed, which has never taken any interest in consumers (witness its failure to enforce the Home Owners Equity Protection Act, a rule which would have limited subprime lending) and has a long standing hands-off posture towards its charges.

Most of the rest is mere window dressing.
I have a lower opinion of the bill than Yves, since I don't like the consumer protection agency. I see that as to households what the bond rating agencies are to corporations -- third parties with no skin in the game whose job it is to keep you "safe" by making credit decisions for you. Not only did the ratings agencies fail, they actually made things worse by enabling bad credit to pass as triple-A. A loan is not a product, it is a combination of a financial instrument and a borrower, and treating it as if it were a product, "good" or "bad" by itself, misses the fundamental nature of a credit transaction, which is a promise between a lender and borrower.

I also don't like the "audit the Fed" provision. What are they going to do? Send Bernanke to jail? Which leaves nothing in the "good" column.

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Friday, June 25, 2010

So Lost

I am so late in reviewing Lost, but heck, I reviewed Easy Rider a couple of weeks ago. Anyway, I watched Lost from beginning to end over about 4 months. Reactions:

The word for "laundry" and "landscape" come from the same root. "Landscape" is what you get when you take wilderness (land which has not been "cleaned") and you "clean" it. The resulting "landscape" is synonymous with "civilization".

By contrast, wilderness is wild and unclean. It is dangerous and mysterious, wonderful and terrible things can happen out there at any moment. You might be eaten by a wolf. You might find a Gingerbread cottage and be eaten by a witch. You might fall in love with the first living thing you see upon awakening. Characters who live at the interface between civilization and the wilderness, like woodsmen, are dark, mysterious individuals.

The island, in Lost was the very personification of this old notion of "wilderness". It was filled with magic, mystery, and danger. When the show focused on the effect Wilderness had on normal people, it was interesting. When the show focused on the mechanics of the Wilderness itself, it was terrible. I want to know how the island works as much as I want to know about the mitichlorians in Puck's "love-in-idleness" juice. But that was what we got.

The entire story arc dealing with Jacob and his brother, the source below the island, etc. left me cold. The characters ultimately were not interesting because backstory alone does not create interesting characters. I tired of Sawyer's scowls, Jack's disbelief, Kate's heels, and Hugo's amiable shrugs. Locke was the most interesting to me, until he became the smoke guy. I also liked Ben Linus for most of the series, and Mr Eko. The flash-sideways effect sort of worked because it promised to highlight the impact the island had on the characters. But that payoff never really came.

The first season remains fantastic. The rest of it is addictive and not-annoying if you can watch them back to back on DVD. Most of the disappointment comes from how well it began.


The Case for Austerity

I support larger stimulus and greater deficits. This is because the private sector is still overleveraged, and wants to increase its net financial assets. The deleveraging process is reducing aggregate demand, and getting to a debt level that the sector can service out of income via default will bring with it massively higher unemployment, and thus real output losses. Our current 10% unemployment rate is already too high, and the real output losses acute. So, let's stimulate through higher deficits.

Let me now try to make a case for Austerity.

The credit crises exposed distribution that seems unfair to the electorate. Or at least grossly inefficient. For example, the financial sector is remunerated multiple times above the non-financial private sector, and yet, once you factor in the cost of bailouts, seems to net destroy wealth. This seems unfair, or at least, grossly inefficient. Much of the Obama administration's stimulus has benefited the financial sector directly, supporting and extending this practise.

Public sector unions such as the SEIU and the teachers union, especially in California, have lavish benefits and retirement packages that they can juke to increase to obscene levels. At the same time, they enjoy extreme job security in a system that does not seem to reward competence or productivity. In California, young promising teachers are fired while teachers on probation (and therefore, not teaching) get paid full salaries for years. Again, this seems unjust, or at least, grossly inefficient.

And Greece has a large public sector, which draws the best and the brightest for its generous compensation and job security, while the Germans work hard, save, and export all the fruits of their labor so they can save some more. The Germans tighten their belts, while the Greeks strike so they can keep retiring at 60. This may seem unjust, or at least grossly inefficient, to the Germans.

And, at ground zero, irresponsible homeowners took on massive loans they could not afford, which inflated the price of housing leaving the prudent "priced out forever". An ocean of tax breaks, bailouts, hand outs, ZIRP, etc. have all focused on helping the irresponsible homeowner, keeping house prices high, and the prudent stuck on the sidelines.

All of these situations are political, and as Rahm noted, you need a great crises to tackle them. So far, stimulus has taken the form of extending and further entrenching the inefficiency and malinvestment. All of this has real cost, in badly allocated resources, lost opportunity, and a further corrosion of the polity (such as it is). If this be "stimulus", the Austerians might say, then maybe it is time to "purge the rot from the system".

If stimulus took the form of flat rate, per capita transfers, then we could purge the rot while protecting employment. But unfortunately, academic macroeconomics does not understand that Government deficits fund net private savings, and so it managed aggregate demand for savings through unemployment and not through appropriate fiscal policy.


Tuesday, June 15, 2010

Bernanke cannot do Accounting

Bernanke demonstrates the squalid state of Economic Theory:
debt-deflation represented no more than a redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups, it was suggested, pure redistributions should have no significant macroeconomic effects. Bernanke (1995, p. 17)
Voila -- Bernanke does not understand the difference between assets (which really is just a transfer, ie the Internet bubble) and debt.

Banks do not loan out deposits. Savings do not get given, by banks, to borrowers. Investing in a mutual fund, there the fund manager doles out your cash to a company, is nothing like putting your money in a bank, where the bank manager certainly does not dole our your money to a borrower.

Banks create loans by expanding their balance sheets. The money is created as an asset and a liability, simultaneously. Therefore, debt deflation is not a simple transfer, where balance sheets stay the same size, but a contraction, where balance sheets shrink as assets and liabilities are both written down.

We are two years into this crises, and the basic mechanism for bank lending remains opaque to the Chairman of the Federal Reserve.

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Religion, the University, and Economics

I don't have anything to say about the conclusions or politics of this individual (whom I suspect is this person) but I did want to call attention to one dynamic she highlights:
Ed schools don’t get much respect within the university, and even less in the political arena. But they are the gatekeepers of elite credentials within the education community. These credentials don’t matter so much for teaching jobs per se, but do matter for educational policy jobs and doctoral program applications that come after teachers "do their two" in public schools and move on to jobs in which they can influence policy.

It’s much easier to move from teaching to an education think tank or a doctoral program if you’ve got a degree and credential from, say, Columbia Teacher’s College than if your degree has the local state diploma mill stamp. Elite ed schools use the one area where they reign supreme to withhold legitimacy from dissenters.
I think this explains why the University system seems to be so much less capable today of revealing truth than it was back when the Academy was distinct from the Government. So we have an Economics discipline that does not understand double entry bookkeeping.


Tuesday, June 08, 2010

To what end?

It should be obvious to the most casual observer that the financial industry is not part of the private sector. The charter it gets from the Federal Reserve, and the role it shares in the payment system with the US Treasury, means that it is a public/private partnership.

Access to reserve accounts at the Fed mean that banks can print money, just as the Government can. The reason they exist at all is so the State can have investment decisions made by the private sector, with private capital being in first-loss position before (ultimately) public capital. The actions of the Geither, Summers, and Obama perverted the role of the financial sector by putting public capital in first loss position before private capital.

The public/private nature of the financial industry also means that regulation should be focused more on the "why should we allow it" rather than the "why shouldn't we allow it"? just as, when setting up a new Government department, we should ask "why" rather than "why not?"

Here is an excellent discussion on high-frequency trading which illustrates this point. The Exchanges -- shockingly in my opinion -- sell information that can be used to front-run trades. Kid Dynamite takes the "why not" perspective:
someone will always have the data first, and someone will always have the data before you. It's a fact of, well, data transmission.

Again, the important fact is that this data is open to anyone who is willing to make the investment in it - not just a secret cool kids club that requires you to work for a specific blue blooded Wall Street firm. Anyone can do it - if they are willing to invest in the business.
Rajiv takes the "why" counter-perspective:
Generally speaking, stability in financial markets depends on the extent to which trading is based on fundamental information about the securities that are changing hands. If too great a proportion of total volume is driven by strategies that try to extract information from market data, the data itself becomes less informative over time and severe disruptions can arise. Banning specific classes of algorithms is unlikely to provide a lasting solution to the problem unless the advantage is shifted decisively and persistently in favor of strategies that feed information to the market instead of extracting it from technical data.
He also notes that HFT does not add liquidity, in fact it destabilizes it (as the "flash crash" showed) and it may not be profitable, as tail risk may destroy all profits just as the credit crash of 2008 consumed all the profits made from 2000-2008, if not more.

If the financial sector was purely private, I would take Kid Dynamite's "why not?" position. As it's a public/private partnership, I am taking Rajiv's "why?" position, just as I would any other Government program.

Monday, June 07, 2010

The Cleanest Race

I love this crazy interview about North and South Korea, in part because Myers looks a little like Karl Lagerfeld. I'd love to see a Japanese interpretation of Japan, both politically and economically, from their housing crash to today


Friday, June 04, 2010

Accounting for Loans, deposits, and equity

winterspeak reader TH asks:
There's just one part of introductory MMT that I can't quite figure out: why, if loans create deposits, can a banking system have a loans-to-deposits ratio other than 1? Do some loans somehow not
create deposits in equivalent amounts?
Bank loans, of course, are not the only thing that creates deposits. Deficit spending creates deposits with their being no private sector loan associated with that.

Non-bank elements of the private sector can also, of course, extend credit -- for example, by issuing bonds. Here, the borrower expands its balance sheet just like before, but the non-bank borrower does not, he just changes the composition of his assets.

Here are some related threads that happened to be going on elsewhere. First, from Mosler:
“He seems correct to me — can you take us through t-tables to show how deposits increase when private credit is extended in this way?how deposits increase when private credit is extended in this way?”

Deposits don’t need to increase as a result of this. That’s orthogonal, unless you are defining “credit” to be solely deposits, in which case you need another word for equity, bonds, money market mutual funds, and commercial paper. As well as repos and other credit-market instruments I must have missed. :P It’s good to stick to standard usage, as all of these are considered to be “credit market instruments”, and an increase in any of these corresponds to an increase in “credit”.

I think, if you want to only talk about deposits, then say “deposits”, or “bank credit”, if you prefer.

Just as with bank loans, the supply of credit market issues expands and contracts as return prospects change, and as a result, the quantity of deficit spending increases and decreases, causing the quantity of cash-flow surpluses to increase and decrease (which helps or hurts the thirsts of savers for more and more and more financial assets :P)

Any liquid IOU takes on the characteristics of money or “credit-money”, and the stock of these IOUs contribute to the stock of financial assets held by households. If the issuer of the credit market instrument is outside the household sector — say in the business sector, which would be typical for corporate bonds or equities, then an increase in these assets causes an increase in household net financial assets.

“So, the firm has a larger balance sheet, but the household has a balance sheet the same size.”

Yup. The borrower’s balance sheet is key. The borrower incurs a liability — to repay the loan, or to repay a bond — as well as an asset — a deposit, or money market fund, however he decides to park his short term assets while he goes about deficit spending.

But the point is that the borrower does not hang onto his asset. The loan is used to buy a house or car, and the bond is sold to expand industrial production. So the borrower then turns around and spends the asset (technically, he sells it for cash, pays the cash to someone else, and that person buys some financial asset with the cash — maybe a deposit, maybe a money market fund, maybe a bond — who knows?).

The bank borrower pays the homebuilder or the car maker, who in turn supplies wages and capital income to *someone* in the household sector, increasing that person’s financial assets. In the same way, the bond-seller turns around and invests in productive capacity by paying employees and parts suppliers, etc, and that ends up also increasing the wages and capital income of some households.

In both cases, investment is self-funding, and the “savings” of the fortunate workers or capital owners whose financial assets increased as a result of the deficit spending ends up being the accounting record of borrowing — whether that borrowing takes the form of selling bonds or borrowing from a bank.

As an aside, you can look at the various forms of credit market borrowing in table F.4 in Z.1. Hope that helps
Also, an oldy but goodie from JKH regarding equity (comment 188):
This is a response to Mahaish’s questions # 134 and # 151. It is a macro accounting explanation of the concept and measurement of household net worth, in the context of the Chartalist accounting model. It is not intended to address issues beyond that.

The top-down Chartalist sector balance sheet decomposition is that of government and non-government sectors. Although this breakdown could be applied globally, one typically would choose a particular national balance sheet to model, and then anchor the model with the corresponding government sector.

So let’s take the United States and the US government.

The entire United States balance sheet can then be modelled according to government and non government sectors.

The non government sector decomposes further into the private sector and the foreign sector. We can alternatively refer to the private sector as the domestic private sector, or the domestic non government sector.

The private sector decomposes further into the household sector and the non household sector. The non household sector is mostly incorporated and unincorporated business, including financial institutions.

The US household sector balance sheet as at June 30, 2009:

(Numbers rounded)

Total assets $ 67 trillion
Tangible assets 25 trillion
Financial assets 42 trillion

Liabilities 14 trillion
Mortgages 10.5 trillion
Consumer Credit/other 3.5 trillion

Net Worth $ 53 trillion

Household tangible assets of $ 25 trillion include about $ 20 trillion in real estate and $ 5 trillion in consumer durable goods.

Against financial assets of $ 42 trillion we net $ 14 trillion of liabilities (which are of course financial) to arrive at:

Household Net Financial Assets $ 28 trillion

This household net financial asset total is significantly larger than the total level of non government net financial assets for all sectors. The conceptual and numerical difference is explained below.

Any household financial asset that is not a direct obligation of the government must by definition be the obligation of another non government entity.

E.g. a corporate bond held by the household sector is the liability of the corporate sector.

Therefore, although the corporate bond contributes to both the gross and the net financial asset position of the household, it does not contribute to the net financial asset position of the entire non government sector, due to cancellation of the household asset against its corresponding representation as a non government liability.

This relationship holds for all financial claims of non government entities on other non government entities.

Importantly, this includes equity financial claims. This can seem a bit counterintuitive. Equity claims represented in the usual way on a balance sheet are not categorized as liabilities. However, the essential double entry book keeping characteristic is that they are on the right hand side of the balance sheet. The right hand equity entry directly offsets the corresponding asset entry on the balance sheet of the equity claim holder.

E.g. common stock held by the household sector is that sector’s financial asset. It is not technically a liability of the corporate sector. Nevertheless, it is a financial claim issued by the corporate sector in the sense that the owner of the stock has the right to benefit from all cash flows and valuation effects that accrue directly to the stock (dividends and marked to market stock price changes). This benefit reflects a comprehensive valuation of the operation of the issuer, including its deployment of real assets, its use of liabilities, and its ability to generate profits, etc. The point is that even though common stock is not categorized as a balance sheet liability, it is a financial claim issued by the corporate sector and a financial asset held in this case by the household sector. Common stock and equity claims in general are treated as a financial asset of the holder and a financial obligation of the issuer (cash flow and marked to market evaluated), and because of that essentially net to zero when consolidating the net financial asset position of the non government sector. The residual as a result of this equity netting includes the real assets of the issuer that are instrumental to the generation of such gross equity value. Depending on the objective of a given measurement exercise, those real assets obviously can also be valued separately from their representation as value embedded in the liability and equity structure of the issuer’s balance sheet. They are excluded from direct representation in the measure of net household worth because their implicit valuation has already been transmitted via the direct debt and equity valuation of the enterprise.

The household sector, in addition to holding direct financial claims in such forms as bonds and stocks, also holds financial assets in the form of mutual funds, pension funds, life insurance, and unincorporated business equity. Again, these positions are all represented as obligations of the issuer, and therefore all net out on consolidation with the household sector’s corresponding assets in the calculation of non government net financial assets. From the asset perspective alone, they constitute a large component in the gross financial asset position of the household sector.

One could similarly work through the balance sheets of the non household domestic private sector (incorporated and unincorporated business, including financial institutions) and the foreign sector. The business sector has a substantial net negative financial asset position, reflecting the corresponding net tangible or real asset position referred to above. The foreign sector has a positive net financial asset position, reflecting the result of a cumulative US current account deficit, with certain balance sheet items valued on a marked to market basis.

If one then nets the net financial asset positions of all these sectors against each other, the result will be an aggregate net financial asset position equal to the government net liability position, as per the Chartalist overview. Financial claims between non government entities net to zero. But government to non government financial claims don’t. The primary reason for this is that governments tend to issue more claims to non government than vice versa. The latter direction is quite possible of course. That is what has happened to a limited degree in the case of the US Federal Reserve accumulating private sector credit assets, and in the case of the US Treasury injecting TARP capital into the banking system. But such unusual US government financial asset activity has been mostly offset at the same time by the issuance of additional excess reserve base money by the Fed and additional bonds by the US Treasury. Beyond that is the aspect of outstanding and expanding US Treasury debt that reflects the more typical creation of net government liabilities due to government deficit spending. It is this latter net mismatch that results in the corresponding vertical net financial asset accumulation of the non government sector.

Two concluding points:

First, the net worth of US households was calculated at $ 53 trillion as at June 30, 2009. This includes “real” assets of $25 trillion and net financial assets of $ 28 trillion.

This net financial asset measure of $ 28 trillion is one of deceptively wide scope.

One may ask where the real assets of business can be found in this calculation. Where is the measure of plant and equipment investment value in the United States? Where is the left hand side of the business balance sheet?

The answer already alluded to above is that the real assets of businesses are reflected implicitly in the value of their financial obligations, which are included comprehensively in the value of household and foreign sector gross financial assets. This includes as well business liabilities and issued equity claims that are held indirectly through such household financial assets as mutual funds and pension. All business assets are reflected in this way. This is double entry book keeping hard at work.

Second, although this describes the connection between non government net financial assets and household net financial assets, one must delve deep into the various sector gross positions in order to extract the exact location of government issued liabilities held as assets by the non government sector. It’s there. You just have to look for where the government bonds are, as well as Federal Reserve currency, and finally central bank reserve balances.

(BTW, those who are interested in the consolidated treasury/central bank government position can find expert commentary from the various Chartalist oriented economist bloggers, including Scott Fullwiler, Randall Wray, Warren Mosler, and of course Bill Mitchell. But in summary, the net balance between government and non government includes the gross effect of central bank reserve balances issued to the banking system, central bank currency issued to the non government sector, and treasury debt issued to the non government sector.)

The bonds in particular are all over the place. For example, foreign central banks own trillions of US treasury bonds and bills, most prominently in China and Japan. Those central bank bond holdings are part of the gross US financial assets held by the foreign sector. In turn, the foreign sector in total has a net positive financial asset position with the US as counterparty (again the result of the cumulative US current account deficit).

The foreign sector thus includes a net asset position with the US government sector, embedded within its larger gross financial asset position with the US, and in conjunction with its total net financial asset position with the US. When one recognizes that the net horizontal asset position of the non government sector must sum to zero, one can then attempt to identity the location of the net vertical asset positions embedded in each defined horizontal sector. The foreign sector clearly has a net positive vertical position according to its bond holdings and some currency. The household sector actually has a modest vertical position relative to its size, consisting of bonds and currency. The rest of the vertical position exists in the non household private sector. Ironically, although this sector has a large net negative financial asset position, most of the net positive vertical position can be found in the gross assets of financial institutions and pension/life insurance investment funds. Against this would be netted the effect of Fed Reserve private sector credit and Treasury TARP funds. Thus, one may decompose sectors according to their positions in net financial assets, as well as their positions in net government assets. The sum in both cases will be the same, according to the overarching Chartalist axiom of aggregate net financial asset equivalence, with the government deficit equal to the non government surplus.


Thursday, June 03, 2010

The Work Rules are worst

The NYTimes decides to take another swing at a public sector union, the MTA.
One of those workers, a Long Island Rail Road conductor who retired in April, made $239,148, about $4,000 more than the authority’s chief financial officer, according to payroll data released on Wednesday.

In fact, more than a quarter of the Long Island Rail Road’s 7,000 employees earned more than $100,000 last year, including the conductor, Thomas J. Redmond, and two locomotive engineers — who were among the top 25 earners in the entire transportation authority.
Although the numbers are pretty eye-popping, from my experience, I think the real stories are in the work rules. I did a project that involved a unionized work force, and they earned a lot for very basic work, but what really impacted the company were the plethora of work rules that made it impossible to improve performance in any way. The article hints at some here, but never really delves deeply into, what I am sure, are a bunch of nutso restrictions:
He also received $94,600 in “penalty payments,” which railroad officials said stemmed from a contractual rule that requires engineers who work in a storage yard to be paid extra if they are assigned to move a locomotive to a nearby maintenance facility or if they are asked to operate a train outside of the yard.
I'm not sure what the difference is between operating a train inside a yard and outside a yard, but it may just be a matter of feet.