winterspeak.com

Sense and nonsense about Deflation

noreply@blogger.com (winterspeak) — Fri, 21 Nov 2008 14:49:00 +0000

Deflation, like inflation, is a confusing word that conflates price changes due to a change in money supply, with price changes due to a change in some underlying supply/demand dynamic in the good itself. For example, if the Government prints a lot of money (increases money supply) but new manufacturing technology in China makes TVs cheaper to produce, the net impact on the price you pay for your new flat screen may be positive or negative depending on which effect was bigger. Our past 100 years as seen a massive increase in money supply that has swamped the also dramatic increases in productivity. A bottle of coke that cost 10 cents in 1908 should cost 1 cent in 2008, not $1.50.

When Nouriel Roubini talks about deflation, like most commentators he's referring to the net effect of money supply and underlying supply/demand dynamics on price. If prices are going down, then we're in"deflation". But he brings out the standard canard about why this is bad:

Second, when there is deflation there is no incentive to consume/spend today as prices will be lower tomorrow: buying goods today is like catching a falling knife and there is an incentive to postpone spending (consumption and investment spending) until the future: why to buy a home or a car today if its price will fall another 15% and purchasing today would imply having one�s equity in a home or a car fully wiped out in a matter of months? Better to postpone spending. But this postponing of spending exacerbates the vicious cycle of falling demand and supply/employment/income and prices.

Does this make any sense to you? Does it match your own spending habits over the past 10 or 20 years?

Computers are a product category that experience dramatic deflation. Your $1000 Dell today is worth $500 next year, and $100 the year after that. And while computers continue to become dramatically more powerful and cheaper, and people consider holding off so they can buy that new model, there are still plenty of consumer sales.

Cars are another product category with dramatic deflation. A $25K Subaru WRX today will outperform a $70K Ferrari built in the 1970s. The cars of tomorrow will be even better, and cheaper. But there are plenty of car sales.

Look at other goods categories that have experience dramatic price deflation due to cheap labor in China: clothes, toys, consumer electronics. All of them have become much cheaper through the 90s, and yet people still buy plenty of them.

One area where falling prices might give people pause is housing, but housing remains overpriced in almost all areas in the US (based on equivalent rents) and it should give one pause. The real "problem" with deflation is that it makes the real cost of debt higher. But haven't we been hearing that the US, as a whole, needs to be less indebted?

People aren't buying cars now because cars are a big ticket item that it's easy to postpone for 6-12 months. People aren't buying houses now because houses are still too expensive compared to rents, and without price appreciation to gamble on, it makes no economic sense. This "people won't spend if prices fall" does not fit with empirical observations.

Money's role in plunder

noreply@blogger.com (winterspeak) — Thu, 20 Nov 2008 18:16:00 +0000

I strongly recommend this excellent post by Arnold where he posits how money is intimately intertwined with Government power. Part of me wants to say "duh", but fully embracing the reality of fiat money is hard, especially when our intuitive sense is tied to this atavistic idea of "store of value".

Fiat money comes into existence when it is issued by a Government. First the Government creates the loan, then the loan creates the deposits. Demand for Government money comes from requiring taxes in that fiat currency, and the secondary market comes into existence as individuals exchange goods and services to get the money to pay taxes, and net save. Fiat currency by definition is entirely a creation of the Government.

The role of the banking system is administrative -- someone needs to tally all the credits and debits -- and it should also be to assess credit risk (how likely is this loan to be repaid). The Government creates the money to be loaned out, but it wants an intermediary to decide who should get it and who should not based on their assessment of credit risk.

As Kling says, the standard view is a medium of exchange view, where money makes trade between producers easier. This view gets us to a "money is a store of value" concept, a gold standard, etc. etc. But in fact, fiat money is just willed into existence by a sufficiently powerful Government. The strength of fiat money depends on the strength of the Government's ability to demand and collect taxes.

Arnold seems to find something sinister in this, but it's just the way fiat currency works.

Ouch!

noreply@blogger.com (winterspeak) — Tue, 18 Nov 2008 17:05:00 +0000

Yahoo!'s Jerry Yang seems to be worth -$1.8B. I'm still shocked when anyone who lived through the dot com crash doesn't sell when the sellings good.

The memory hole

noreply@blogger.com (winterspeak) — Thu, 13 Nov 2008 02:15:00 +0000

On Sept 29, Congress voted down the original Paulson Plan, where he sought $700B to buy troubled assets from banks.

On Sept 30, the responsible media, and Brad DeLong blamed the subsequent drop in the stockmarket (which was not even that subsequent) on Congressional Republicans, and declared the vote to be a terrible mistake.

On Oct 2 (approx) TARP was finally passed, and there was wide rejoicing, as the responsible media declared it a victory for right thinking people.

On Sept 30, the day after TARP 1 was killed, the S&P opened at 1164. It has since fallen to 850 despite TARP 2 being passed. Moreover, Paulson has abandoned the plan behind TARP 1, and instead is doing what TARP 2 enabled him to do but TARP 1 did not.

I have yet to see a single story retracting any of the pieces of received wisdom that were widely distributed by the responsible media on Sept 30.

1) The stock market decline on Sept 29 had nothing to do with TARP 1 failing.
2) TARP 1 was a bad plan, and it was good that it failed.
3) The original Congressional vote against TARP 1 was correct.

Note that all of this happened two months ago, and yet the recorded history is completely different from actual, easily recalled events.

Money Supply vs Real Goods and Services

noreply@blogger.com (winterspeak) — Tue, 11 Nov 2008 12:41:00 +0000

On the road this week, so blogging will be light.

There was a great article yesterday (Monday) in the WSJ describing how the Fed and Treasury made decisions through the crises. It was a realistic portrait of decent people, doing their best, in difficult, harried times. Sadly, I cannot find it, but if you have the link, please email me and I'll put it up.

It was also clear that Bernanke and Paulson are fundamentally stumbling around in the dark, being purely reactive, and focusing on making things "go back to the way they were." Even though the "way things were" was suboptimal.

A moment now to talk about money supply and inflation.

Suppose an economy has a money supply of X. Suppose it also has a supply of real goods and services, Y.

If X increases by 10%, and Y increases by 10%, there should be no change in aggregate price indices since you have (proportionally) the same amount of money, chasing the same amount of goods and services. Note that anyone saving money in X has been diluted by this 10% increase in X. I used to think that a perfect, globally balanced basket of currencies would be perfectly hedged against inflation but I was wrong -- it does not protect you from dilution.

Alternatively, suppose X increases by 20%, and the supply of real goods and services increases by only 10%. Here you have dilution as before, and you will also have rising prices show up in the CPI, and thus be termed "inflation" by economists and the press.

The fall in real estate prices and other asset classes has shrunk X. The supply of real goods and services has contracted also, but not as much. So, X has decreased more than Y has decreased. This is why we are in deflation and the economy is also shrinking.

The Government is printing a huge amount of money and giving it to financial institutions. They may also start giving it to automakers. Since both industries are a net destroyer of value, this means that the increase in X will not be met by a concomitant increase in Y. If they "stimulate" too much, then X > Y and we'll get inflation. Maybe a lot. If they "stimulate" too little, then money supply will continue to fall, and we will stay deflationary. If they "stimulate" just right, then any increase in X will be met by an increase in Y, and we won't see a change in prices, but the supply of goods and services will increase.

Please note that all of these scenarios will result in "dilution" and punish anyone holding dollar bills. The Press and economists seem to think that China's current account surplus with the US means that China is in a better position than the US, but they've been exporting real, useful good and services in exchange for paper. I know which I would rather have.

Also, please note that the majority of Government actions to date have focused on supporting particular industries, which guarantees that in the increase in money supply will exceed the increase in real good and services. State owned enterprises that continually hemorrhage money (AIG, Fannie, Freddie, GM, Ford, Chrysler, Citi, Goldman, JP Morgan, AMEX etc.) are inflationary in that the money they get from the Government goes into general circulation, increasing supply, while the goods and services they produce are not commensurate to that increase in supply. This will be dilutive and inflationary (X increases, and the increase in X is greater than the increase in Y).

When is unemployment not unemployment?

noreply@blogger.com (winterspeak) — Fri, 07 Nov 2008 17:27:00 +0000

It's interesting to compare these two pieces on what to count as unemployment. First Tabarrok:

So why are there multiple series on unemployment for the 1930s? The reason is that the current sampling method of estimation was not developed until 1940, thus unemployment rates prior to this time have to be estimated and this leads to some judgment calls. The primary judgment call is what do about people on work relief. The official series counts these people as unemployed.

Rauchway thinks that counting people on work-relief as unemployed is a right-wing plot. If so, it is a right-wing plot that exists to this day because people who are on workfare, the modern version of work relief, are also counted as unemployed.

Moreover, it's quite reasonable to count people on work-relief as unemployed. Notice that if we counted people on work-relief as employed then eliminating unemployment would be very easy - just require everyone on any kind of unemployment relief to lick stamps. Of course if we made this change, politicians would immediately conspire to hide as much unemployment as possible behind the fig leaf of workfare/work-relief.

But if the Government did have a large work-relief person, there would be no unemployment. If someone gets up in the morning, goes to an office building, does activity for 8 hours, collects a paycheck and goes home, that's employment whether it's part of a work-relief person or not. If we're going to stop counting people who work for the Government as employed, then the US has a 40% unemployment rate, not a 6% rate.

Compare and contrast with the Employer of Last Resort proposal from Mosler:

The U.S. Government can proceed directly to zero unemployment by offering a public service job to anyone who wants one as a supplement to the current budget. Furthermore, by fixing the wage paid under this ELR program at a level that does not disrupt existing labor markets, i.e., a wage level close to the existing minimum wage, substantive price stability can be expected.

The ELR program allows for the elimination of many existing government welfare payments for anyone not specifically targeted for exemption, as desired by the electorate. Minimum wage legislation would no longer be needed. Labor would welcome the safety net of a guaranteed job, and business would recognize the benefit of a pool of available labor it could draw from at some spread to the government wage paid to ELR employees. Additionally, the guaranteed public service job would be a counter- cyclical influence, automatically increasing government employment and spending as jobs were lost in the private sector, and decreasing government jobs and spending as the private sector expanded.

The ELR proposal also has characteristics similar to the current Federal unemployment compensation policy. There are, however, significant differences as unemployment is 1) compensation is payment for not working, 2) temporary, 3) does not cover everyone, and, 4) is less than the proposed ELR wage.

If the Government steps up as Employer of Last Resort, giving anyone a job who wants one, then involuntary unemployment -- by definition -- goes to zero. Such a program would dramatically increase the Federal Deficit, but Mosler does not care about deficits.

Tabarrok, however, did not raise deficits as his objection. His problem was that politicians would conspire to hide unemployment behind work relief, but nothing would be hidden! Work relief numbers would be public just as unemployment numbers are now! Moreover, if the price of work relief was appropriately set, it would not take skilled workers from the private sector. Mosler calls this work relief pool a "buffer stock" of workers, a buffer stock superior to unemployment (which is the current buffer stock). He is certainly correct in this. He also says that government deficit to pay this buffer stock does not matter, and people can disagree with him there.

90 day moratorium

noreply@blogger.com (winterspeak) — Thu, 06 Nov 2008 17:14:00 +0000

Our very own Arnie is proposing a 90 day moratorium on foreclosures in California. John Dizard thinks this is a terrible idea:

Let's take the 90-day moratorium idea. There are about 3m houses in the foreclosure process. During that 90-day moratorium, the mortgage servicing companies - that is the people who make the collection calls, do the restructuring and forward the payments to the mortgage securities owners - would have to continue to make up the missed payments. They would need to finance those payments by issuing notes, typically 360-day paper. Those servicers that were not bank-owned, and could not be financed by a parent holding company, would have to raise money at rates that are already high - say 600 basis points over Libor - and rising. If they could get the money at all.

If one of the non-bank servicers were to go bankrupt during the 90-day moratorium - a distinct possibility - the trusts holding the mortgages it was servicing would have to find new servicers. There would be a time gap during which no calls would be going out to delinquent homeowners. Past experience indicates that during the servicer disruption the foreclosure rate on a troubled pool would rise from 25 per cent to 35 per cent.

The key element that took Japan's equity and real estate collapse, and turned it into two decades (and counting) of economic stagnation was eliminating price discovery. In the US, housing has to come back inline with incomes before economic growth can resume. Right now, prices are below peak (leaving recent buyers and aggressive HELOCers underwater) but still above rent-equivalent levels. So there is financial pressure to sell, but a financial disincentive to buy. Keeping prices above their market clearing rate will just drag this crises on.

Towards a new financial system

noreply@blogger.com (winterspeak) — Thu, 06 Nov 2008 06:30:00 +0000

First, congratulations to Barack Obama! And good luck -- he'll need it.

Second, two interesting articles about a new financial system. In the first one, Steve Waldman yearns for a financial system that actual pairs investors with investment opportunities, instead of taking "savings" and using it for anything but. Be sure to read the comments too.

This other article is a discussion on how payout structure can dramatically alter people's behavior wrt to saving. The effect can be large -- individuals can forgo increasing their consumption by 21 times in 30 days just because it is so difficult for them to resist small temptations and save.

Of course, Keynesians would have you believe that saving is the problem.

IDEO to go

noreply@blogger.com (winterspeak) — Wed, 05 Nov 2008 23:59:00 +0000

For those of you who have never been in an IDEO (or IDEO inspired) office, they're pretty awesome. There is now a company offering IDEO-style offices for very-short-term lease. Cool!

Hyde Park

noreply@blogger.com (winterspeak) — Wed, 05 Nov 2008 17:48:00 +0000

Slate's Megan O'Rourke has a partial description of Hyde Park, Chicago -- a place where I spent a very happy couple of years in my yoot. She talks about how it's economically and racially integrated, and mentions some local restaurants like Valois and Medicis. And of course, the presence of the most intellectually rigorous university in the US, the University of Chicago.

But the reality of life in Hyde Park is not the bucolic neighborhood that Megan describes. The University is part tower, part fortress, and it shields its nervous students from an area that is riddled with crime and murder. Walking around Hyde Park at night was scary, and I'm a fairly tall guy. Chicago proper is also scared of Hyde Park, as there are is no metro link between the neighborhood and the city. I was told that the green line extended down there once, but it was taken down to keep the two areas separated. South Side Chicago was, before the 1960s, a nice place with restaurants, and fantastic jazz clubs, but after the Civil Rights movement it descended into the hell hole it is today. And unlike Harlem, there's been no gentrification to turn things around.

Hyde Park has more Nobel Prizewinners than restaurants, and two bars -- one of which is student run. In my time there, the greatest recreational innovation was a bowling alley burger place. While Hyde Park is not the worst managed ten square miles in the US, it is governed appallingly. One hopes that this does not foreshadow the Obama administration, but the article might foreshadow how it will be covered in the responsible press.

A tip for those living there: under no circumstances take a bus from Hyde Park to Midway Airport. It will take so long that you will miss your flight. You may also be murdered on the way.

Excellent analysis of election results

noreply@blogger.com (winterspeak) — Wed, 05 Nov 2008 16:20:00 +0000

I really liked this analysis of the election results. Basically, there was a small, but broad, shift towards the Democratic party. Youth turnout was the same, but skewed more heavily Democratic. Ethnic minorities across the board also shifted to Obama.

In Praise of Savings and Deflation

noreply@blogger.com (winterspeak) — Wed, 05 Nov 2008 00:15:00 +0000

Dean Baker, whom I like, has a post where he gets very confused about deflation. This is understandable -- the thinking around deflation is very confusing. After all, if iPhones go from being $500 to $200 we are all happier (and richer) but this contributes to deflation. If flying from San Francisco to New York goes from costing $20,000 to $200 (someone invented Southwest) again, this would contribute to deflation, but we would all be happier (and richer). How can something that makes us all happier (and richer) be bad? How can something that impoverishes us all (inflation) be good in small doses, but bad in large doses. If this strikes you as a kind of economic homeopathy then you are not alone.

But first, to Dean:

There is no need to look to credit crunches or deflation. The problem is quite simply a massive lost of housing wealth, compounded by the recent loss of stock wealth. The only cure will be finding alternative sources of demand. In the short-term, government will have to fill the gap. In the longer term, it will be necessary to get the dollar down so that the country's trade is closer to balance.

Housing is a levered instrument, which means that prices are a function of financing. For a long time I believed that financing should have no impact on prices but I was wrong -- for goods purchased primarily with debt, price is directly driven by the cost of that financing. Houses would cost much more if you needed to pay in one lump sum. Since credit is money, a collapse in the price of housing is a reduction in the amount of money in the world. When the amount of money in the world goes down, the value of the remaining money goes up -- the money has been concentrated. The $20K you have in the bank is looking much better now that houses cost $100K instead of $300K.

Alternatively, when money (credit) expands, the value of the money that was there to begin with goes down (the old money is getting diluted). Houses now cost $300K again, and your $20K savings account is too puny again. D'oh!

This expansion/dilution of the money supply can be hidden by changes in demand or technology. Money supply may increase (dilution, causes prices to go higher) but some engineering mastermind figures out how to make an iPhone for 50% less. Prices stay the same, the CPI shows no change, but savers have still been robbed because instead of having access to a $100 iPhone they still have to pay $200 for it. D'oh indeed.

When Greenspan, the great Monetarist, talks about whether or not to factor bubbles into interest rate decisions, I shake my head in disbelief. Credit bubbles are, by definition, an uncontrolled increase in money supply. For a Monetarist, who (correctly) believes that inflation is always and everywhere a monetary phenomenon, ignoring credit growth is like an oncologist ignoring a group of uncontrollably dividing cells. There are clear grounds for a malpractice suit. Also note that there is more to credit than interest rates -- there are down-payments, prepayment penalties, rate resets, subsidies, etc. etc etc. A central banker who thinks he can control money supply (credit) just by controlling interest rates is wrong, he's wrong when the economy is in a liquidity trap, and he's wrong when the economy is in a credit bubble.

Let's take a moment to consider just how much of the economy a central bank needs to control given our current credit infrastructure.

Keynes gives us no clue

noreply@blogger.com (winterspeak) — Sat, 01 Nov 2008 15:09:00 +0000

Megan doesn't understand why David Brooks' NYTimes column makes no sense. Brooks calls for infrastructure spending as "stimulus" and Megan thinks this is reasonable:

For starters, Brooks's statement about stimulus doesn't strike me as particularly controversial. The point of stimulus is to use the government to artificially expand aggregate demand by borrowing at fairly low interest rates and spending the money. The problem is, if you send out checks, most of the checks seem to get saved, which creates a closed, useless cycle.

Keynes, the father of the idea of economic "stimulus" tells us nothing about the mechanism for that stimulus

C+I+G = Y

GDP simply equals consumption plus investment plus government spending, but the mechanism by which increased government spending leads to increases in GDP is buried in the type of aggregation that Keynes is fine with, but drives Austrians up the wall. It also provides little guidance of policy makers -- if you want to stimulate, how best to do it?

Megan is too dismissive of mailing checks to consumers. Most of the checks might get saved if they are $1000, but $50,000 would soon find it's way into the economy, and do so in less distortionary (and therefore inflationary) mechanism than simply increasing G.

Keynesians, and "real goods" economists, argue that an increase in money supply is not inflationary so long as it funds projects that are at least equal in worth to that monetary expansion. Money supply can increase by X% so long as the economy also increases by X% and produce no inflation. This is, unfortunately, not the right way to think about it, but it is the dominant paradigm so let's run with it.

Giving money to consumers -- lots of money -- will be spent (at least in part) on stuff that consumers actually want. Increasing G will go to the usual suspects involved whenever G gets larger. Increasing the stock of useless expenditures (Bridges to Nowhere, or the concrete meadow that is modern Japan) grows the economy by less than the increase in money supply, and will so ultimately result in more inflation. At the same time, maintaining this useless stock will be a drag on the economy, reducing growth. And this is how Keynesians take us to the land of stagflation. Next: how Monetarists do not give us a clue either.

Models cannot replace brains

noreply@blogger.com (winterspeak) — Fri, 31 Oct 2008 23:15:00 +0000

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.

The World's Central Bank

noreply@blogger.com (winterspeak) — Thu, 30 Oct 2008 16:48:00 +0000

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.

Red vs Blue

noreply@blogger.com (winterspeak) — Wed, 29 Oct 2008 16:36:00 +0000

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.

Weekend reading

noreply@blogger.com (winterspeak) — Fri, 24 Oct 2008 22:35:00 +0000

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.

For biotech geeks

noreply@blogger.com (winterspeak) — Tue, 21 Oct 2008 22:41:00 +0000

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.

New Regulation, same as the old Regulation

noreply@blogger.com (winterspeak) — Sun, 19 Oct 2008 15:54:00 +0000

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.

Tesla Motors, RIP?

noreply@blogger.com (winterspeak) — Fri, 17 Oct 2008 16:13:00 +0000

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.

Zeno's paradox

noreply@blogger.com (winterspeak) — Thu, 16 Oct 2008 18:31:00 +0000

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

noreply@blogger.com (winterspeak) — Thu, 16 Oct 2008 17:53:00 +0000

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.

The Japan Experience

noreply@blogger.com (winterspeak) — Sun, 12 Oct 2008 22:35:00 +0000

To those of you all excited about buying on the dip

(Thanks to Angry Bear for the graph)

Financing and prices

noreply@blogger.com (winterspeak) — Sat, 11 Oct 2008 22:02:00 +0000

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 Amazon.com 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.