Ben's Bailout Blog

Long Live The Euro!

2011-12-03T11:43:00.000-08:00

As the European debt crisis continues to worsen, a growing consensus seems to be emerging that Europe must either form a fiscal union to rescue countries mired in debt or suffer a devastating dissolution of the currency union. The first choice is unappealing to citizens of wealthy Northern European countries because they do not favor paying for the excesses of foreign governments. And few Europeans seem keen on the idea of surrendering economic sovereignty to foreigners.

The second choice - in which some or perhaps even all Eurozone members would ditch the currency - would cause all sorts of economic hardship. Changing currencies from the Euro to some new national currency would be a chaotic process. A country would most likely need to freeze bank withdrawals and convert the currency denomination of contracts. So, if someone had 30,000 Euros saved in the bank and still owed 9,000 Euros on a car loan, both balances would be legally converted from Euros to the new monetary unit. This new currency would be worth less than the Euro. Families that had been saving money in banks could see the value of their savings slashed. Investors would flee in the short term and quite possibly stay away for years, leading to a dearth of capital to fund investment in new businesses. Because many contracts denominated in Euros involve parties from more than one country, some very thorny legal issues would arise about what currency the contracts should be denominated in going forward.

Throughout the financial crisis, policy makers have employed scare tactics to justify aggressive interventions and bailouts: If the banks are allowed to fail, economic catastrophe would result. If Greece defaulted, the entire financial system would collapse (a contention that seems inconsistent with Europe's latest rescue plan, which calls for banks to "voluntarily" concede a 50% haircut on their Greek positions). I suspect that European leaders portrayal of only two options - fiscal union or Eurozone breakup - is yet another scare tactic. A Eurozone breakup would indeed be chaotic. But it is hardly the only viable alternative to fiscal union.

A country can default within the Eurozone. In reality, Greece already has. Banks have agreed to accept less than they are owed on Greek government bonds. The Euro is still around.

The argument that a country cannot default within the Euro system remains one of the least thoroughly explained notions in current policy debates. Perhaps the best explanation I've seen of such logic appears in The Economist:

If a messy default is forced upon a euro-zone country, it might be tempted to reinvent it own currency. indeed it may have little option. That way, at least, it could write down the value of its private and public debts, as well as cutting its wages and prices relative to those abroad, improving its competitiveness. The switch would be hugely costly for debtors and creditors alike. But the alternative is scarcely more appealing. Austerity, high unemployment, social un-rest, high borrowing costs and baking chaos seem likely either way.

In other words, a country might prefer to simply convert all contracts into a new currency and print that currency to service debts. Unfortunately, this would most likely lead to massive inflation and capital flight, causing families to suffer a severe loss in the value of their savings, among many other unwanted consequences of high inflation. There is little reason to think that citizens would actually be better off.

The fact of the matter is that Greece cannot honor its debts and should haircut them even more than it already has. Owners of that debt will suffer losses. The Greek banking system may need to be recapitalized. All of this can be done within the Eurozone without imposing severe hardship on the Greek people, though they will have to stop spending above their means. By writing down the debt, the amount of austerity required will be greatly reduced.

Banks and politicians are arguing that if the people of Europe do not use their money to avoid defaults and rescue the financial system, calamity will ensue (in the form of a chaotic Eurozone breakup). However, this argument is unconvincing. It is easy to imagine a country applying a haircut to its debt while continuing to use the Euro. Such a result will lead to some bankruptcies and a significant loss to investors. But it need not lead to economic chaos. It has the added benefit of bringing back some level of fairness to the financial system. Investors who chased profits without properly accounting for risks should not be made whole at everyone else's expense.

None of this is to say that a default within the Eurozone will be a simple and painless affair. But for countries that are unable to honor their debts (Greece certainly and maybe Portugal and *Ireland), it is the best path forward.

*Ireland actually entered the financial crisis in decent fiscal shape. Only after assuming the liabilities of financial institutions did the government find itself mired in debt. The people of Ireland would be far better off today had their government not acquired massive debts in order to bailout bank investors.

Occupy Wall Street

2011-10-25T19:31:00.000-07:00

When I take the subway to the office, I get off at the Fulton Street stop in downtown Manhattan and then walk about half a block south to Zuccotti Park, home of Occupy Wall Street. I usually take a quick look at the protesters to see if anything notable is going on. But on most days it is too early for real action. So I cross the street, ascend to the 48th floor of a skyscraper and trade bonds all day. After work, I usually head to a gym on John St., meaning I walk by the Federal Reserve Bank of New York. Located at 33 Liberty Street, the FRBNY is an imposing stone structure built in the 1920's. Its vaults contain $415 billion of gold bullion, making it the word's biggest repository of the precious metal. The most awesome power of the Federal Reserve, however, is its ability to create money. This has enabled the Fed to save banks, prop up the prices of assets held by banks, and lower interest rates across the country. Although Zuccotti Park is only a few blocks away, the area around the FBRNY remains devoid of protesters. And I have not heard much dialogue from Occupy Wall Street about specific changes that the Fed should implement. This daily cycle of walking past the protesters, trading bonds, and then walking past the fortress-like Fed leaves me thinking that the Occupy Wall Street Movement is not on the right track.

The OWS protesters have a diverse array of views, many of which I agree with. But the central thrust of the movement has somehow become about the divisions between what they call the 99% and the 1%. The following is from the main page of OccupyWallSt.org: Occupy Wall Street is [a] leaderless resistance movement with people of many colors, genders and political persuasions. The one thing we all have in common is that We Are The 99% that will no longer tolerate the greed and corruption of the 1%. I believe this is an unfortunate unifying theme. Most of the 1% are not corrupt. And I doubt they are particularly more greedy than the 99%. One datapoint to consider is from exit polls in the 2008 presidential election showing that of voters earning over $250,000 per year, 52% supported Obama. I reject the notion that the 1% is the problem.

OWS is correct that the government's stance toward Wall Street has been too generous. One can make a strong case that Congress and the Federal Reserve have been alarmingly obsequious in their dealings with the financial sector. I have tried to make that case in other posts in this space. But the movement ought to focus on some of the specific policy mistakes that have been made and continue to be made. Ending tax breaks for hedge fund managers, oil companies, and corporate jets would be a great place to start. In order to accomplish policy change within our democratic system, we need to figure out where Americans from across the political spectrum can come together and agree. Polls indicate that abolishing special tax breaks, ending Wall Street bailouts, and raising the top marginal tax rates are all issues where that could happen. But a vaguely defined condemnation of the 1% is not going to attract the support of the many conservative Americans who would also like to make the system fairer.

Occupy Wall Street has the world's attention. It should quickly establish a simple platform of policies that will make the United States a better place. Then it should use its publicity to promote those policies and educate people about why they make sense.

Sheila Bair

2011-07-10T07:51:00.000-07:00

Today's NY Times Magazine has a noteworthy profile of Sheila Bair, the head of the F.D.I.C. during the financial crisis. Bair recently stepped down from her post and now appears more willing to speak openly about her opinions. Bair favored a tougher handling of the big banks than did her colleagues at the Federal Reserve and Treasury. She thought that bank bondholders should suffer haircuts if banks needed government aid. Indeed, that is how the F.D.I.C. handles troubled smaller banks on a regular basis. Depositors are covered by F.D.I.C. insurance and the creditors take a hit. Executive compensation can also be slashed because many of the bank's contracts are rendered null and void due to the insolvency. This occurs just about every week somewhere in America, but financial chaos does not result.

Proponents of the generous bailout terms offered to the biggest banks back in 2008-09 often said that such a process would not have been possible because the appropriate legislation did not exist. However, the government was engaged in various other bailout actions of questionable legality. And Congress was enacting major legislation - such as TARP - on a very tight schedule. Had the administration wanted to be tougher on banks, avoid financial chaos, and maintain market discipline by forcing losses on investors whose firms were insolvent, it could have done so. Unfortunately, Bair never really came out in public during the crisis and spoke as forcefully as she does in this NY Times interview. In the middle of the crisis, she argued that she favored an F.D.I.C style approach to the big banks in the future, but she failed to publicize the view that the government's current policy was deeply flawed, unfair, and unnecessary.

Icesave Referendum

2011-02-21T08:03:00.000-08:00

Iceland does it again. The small country's leaders continue to buck the trend by refusing to force citizens to pay for banks' losses. The latest news relates to the Icesave dispute. When Iceland's Landsbanki went bankrupt in 2008, Iceland declined to reimburse overseas depositors. The United Kingdom and the Netherlands subsequently stepped in and used their own money to reimburse Landisbanki depositors in their countries. They have been pressuring Iceland to repay their costs ever since. In the latest chapter of the Icesave saga, President Ólafur Ragnar Grímsson is putting the decision of whether to reimburse the United Kingdom and the Netherlands to a public referendum in Iceland, thereby giving citizens control over the outcome.

You can read more about the Icesave dispute at Wikipedia and Bloomberg

During the last few years of financial turmoil, Iceland has tended to protect taxpayers while forcing bank creditors to suffer losses. The economy has suffered, but has not been the victim of the sort of crippling collapse that leaders in Europe and the United States continue to insist would occur if we did not bailout banks. Unemployment in Iceland is still lower than it is in Ireland, where politicians have imposed severe hardship on taxpayers to keep banks afloat.

Costs of the Fed, Part 2

2011-02-12T22:37:00.000-08:00

In the previous post I discussed how lowering interest rates adversely affects people with money in savings accounts. I argued that because savers receive less interest income, they have less money to spend, which dampens economic activity. In this post I will return to the idea that lowering interest rates can cause consumers to spend less money. But whereas Part 1 discussed how a decline in interest income affects people who have already saved money, this post will examine how the Fed's actions can change the behavior of people who are trying to build savings.

Economists often teach that lowering interest rates causes consumers to save less and spend more. "Low interest rates provide a powerful incentive to spend rather than save," declares one Federal Reserve publication. The logic underlying this assumption is straightforward: When rates are lower, saving is less attractive and spending is more attractive, so people save less and spend more. If true, this makes Fed policy more effective because when people spend more, the economy grows. And growth is exactly what the Fed is hoping to achieve by lowering rates.

But there is another way to look at this. Consider a family that is trying to save $25,000 for college and $250,000 for retirement over the next 20 years. If interest rates are 5% for the next 2 decades, the family will need to save about $547 per month. With rates at 2%, they will need to set aside $762. The lower the rate, the more they have to save. This runs counter to some of the dominant thinking about lowering interest rates.

Lowering rates probably does cause some people to save less, especially people who are deciding what to do with money that they do not need for basic expenses (ie., rich people). The thinking might go something like: "Should I buy a new Mercedes now or earn 5% for a year and then get the Mercedes with a moon roof? I'll earn the 5%. But if rates are only 2%, it's time to shop." Makes sense. Of course, that is not how a household of limited means and specific financial goals should go about making decisions. For the vast majority of Americans, lowering rates should cause savings rates to increase and spending to decline.

None of this is to say that there are not other factors that might cause people to save less when the Federal Open Market Committee lowers interest rates. When the stock market goes up, people feel richer. I do not dispute that, though I do intend to address some problems with the phenomenon in a later post. Additionally, if the economy does better, confidence rises, prompting people to spend more. However, Federal Reserve publications and Ben Bernanke's many recent statements would have us believe that monetary easing (lowering rates and printing money) categorically stimulates economic growth as long as inflation is not a problem. There has been very little discussion by Fed officials of the ways in which Fed policy causes some pockets of the economy to contract. A cost-benefit analysis that models who wins and who loses - and how much they win or lose - is sorely needed.

Costs of the Fed, Part 1

2011-02-12T20:34:00.000-08:00

The U.S. Federal Reserve has created trillions of new dollars in the last few years. This has been controversial. Opponents of this policy usually argue that creating so much money could lead to massive inflation. However, as more and more time passes without any serious bouts of inflation, the Fed increasingly seems to be winning the debate. But what if the Fed is doing other sorts of damage to the economy? What if inflation is not the only metric by which we should judge Federal Reserve policy?

There are many other costs to the Fed's recent radical interventions - costs that deserve a lot more attention. I intend to write a series of posts on this topic, starting today.

Costs of the Fed, Part 1:

One of the most obvious costs of increasing the money supply and decreasing interest rates is that people who save money in interest-bearing accounts earn less money. The elderly and people without significant wealth often suffer the most from low returns on savings accounts and CD's. Because these savers are not able to bear the risks associated with stocks and bonds, they put significant amounts of their savings into safer interest-bearing accounts. When the Fed floods the banking system with money, banks have less need for deposits, deposit rates go down, and depositors receive lower returns. Obviously, this is bad for people with money in interest-bearing accounts.

But there are other consequences as well. If these savers have less money, they will probably spend less, hurting the entire economy.* According to data from the Federal Reserve of Philadelphia, American households' annual interest income has declined by 150 Billion dollars since 2008. That amounts to over a full percentage point of U.S. GDP. This does not mean that lowering interest rates caused GDP to shrink. Reduced rates can help borrowers. Indeed, the same data that shows households earned less interest income also shows that households paid less interest on their debts. Unfortunately, the decrease in interest income was over twice as large as the decrease in interest expenses, so American households were net losers in this regard.

The Fed contends that the benefit to borrowers leads to increased economic activity in aggregate. However, the Fed has not done a good job of proving this. A publication by the Fed's St. Louis branch entitled "Low Interest Rates Have Benefits . . . And Costs" provides a sensible list of some of the benefits and costs of lowering rates. Lacking from this paper is any attempt to quantify the benefits or reach a conclusion about the net effects on the economy. Have lower rates caused borrowers to increase economic activity enough to offset the loss of income suffered by savers? The right answer is probably that it depends on an array of factors including the outlook for business, economic expectations, and household financial health, among other things.

The Fed does not seem to be calibrating its policy to these ever shifting variables. Rather, the Fed seems anchored to the notion that decreasing rates increases economic activity as long as inflation is not a problem. Consider a scenario in which a country had invested too much in housing and households had not saved enough. It is possible that under those circumstances, decreasing savers' income in order to increase investment is the wrong response and will not lead to a stronger economy. If it is indeed true that lowering rates can consistently be relied upon to stimulate the economy, then the Fed ought to better job of proving it.

*Many economists often argue that lowering interest rates causes people to spend more and save less because the return on savings is less attractive. I will address some complications with this theory in the next post.

Krugman blames the Euro

2011-01-17T20:13:00.000-08:00

In this weekend's New York Times Magazine, Paul Krugman offers his views on the European debt crisis. The thrust of his argument is that because Europe cannot devalue its currency - a point which is not altogether clear - its options are "Toughing it Out", "Debt Restructuing, "Full Argentina," and "Revived Europeansism." He concludes that Europe ought to seek a "Revived Europeansism," which means richer countries should give money to poorer countries. This seems unlikely given in current political climate. So, he seems to think that Europe will suffer some combination of debt restructuring and "Full Argentina." I will not attempt a full critique here - it would take too long. But I will highlight two major flaws in the Nobel Laureate's analysis. I believe Krugman's criticism of the European Currency Union is misguided and his assessment of how painful a European restructuring would be is exaggerated.

Krugman's comparison of Europe's monetary situation to that of Argentina at the turn of the century is unfair. Argentina had pegged its currency to the U.S. Dollar, meaning that it was essentially unable to control its own monetary policy. Krugman suggests that by adopting the Euro, member countries have likewise ceded their control over monetary policy, and are therefore unable to devalue their way out of the crisis. It is correct that countries that have adopted the Euro cannot unilaterally print Euros, but the European Central Bank can do just that. In fact, it has already done so, though not to as great an extent as Krugman probably prefers. Argentina, on the other hand, had no pragmatic means for creating U.S. dollars. Another crucial difference between Europe and Argentina is that the latter had promised the world that its currency could be exchanged for dollars at a fixed rate. As investors began to question its credibility on this promise, a run on the currency unfolded. Compounding Argentina's difficulties, the South American country had issued billions of bonds denominated in U.S. dollars. Europe has not fixed its currency to the dollar and most of its debt is denominated in Euros. Krugman's use of Argentine history to bolster his opposition to the European Currency Union is flawed.

Krugman also errs in his treatment of events in Iceland as they relate to Europe. Iceland decided not to bailout its banks during the current crisis. Investors suffered serious losses, but the economy did not collapse and appears to be rebounding quite well. At the same time, Iceland devalued its currency. Krugman says that the Icelandic path is appealing, but is unavailable to Europe because Europe cannot devalue its currency. However, he offers little evidence that devaluation of the currency has been important to Iceland's quick rebound. Although he claims that devaluation led to an increase in exports, the evidence does not support this conclusion. According to statistics at OECD.org, Iceland's exports did not expand any more than the exports from Eurozone members expanded. Iceland's recent success is a result of its refusal to save a banking sector that was too large for such a small country to bailout. Its ability to print money was of lesser consequence. The Icelandic path does indeed remain open to some European countries, particularly Ireland.

The Economist Recommends Restructuring

2011-01-17T11:49:00.000-08:00

In this week's Economist, the publication concludes that Europe's ongoing attempts to solve its sovereign debt crisis "are failing." The article continues by arguing that unless rich countries become more willing to pay for the fiscal problems of their debt-ridden neighbors - a prospect the Economist deems a "political non-starter" - then the only reasonable alternative is to restructure debts. And the Economist believes this should all be done sooner rather than later.

I wholeheartedly agree.

However, the article goes on to argue that Europe's hitherto failed attempt to avoid default "was worth trying" and that "the dangers from debt restructuring have diminished." Because "Banks have had time to build up more capital - and palm off some of their holdings of dodgy sovereign bonds to the European Central Bank," restructuring will be a much more decent affair now, the magazine contends.

I wholeheartedly disagree.

Transferring the costs of a debt restructuring from bank investors to the citizens of Europe is hardly a good thing. Rather, it represents yet another forced expropriation of wealth from taxpayers to benefit the financial system.

European leaders seem reluctant to stick banks with the losses associated with sovereign restructurings. It is true that a good deal of financial turmoil would result if banks were made to suffer the full extent of the losses on their sovereign bond holdings. But there are far superior - and less costly - ways to avoid a major collapse of the European financial system than just transferring the losses to the public. For instance, the European Central Bank could recapitalize failing banks in exchange for massive equity stakes in any institutions requiring funds. These equity stakes might later be sold for a profit. Such a system is hardly ideal; it is a violation of free market principles and bails out failing institutions. But it is fairer and cheaper than the approach suggested by the Economist.

End The Fed?

2011-01-01T18:27:00.000-08:00

I just finished reading Senator Ron Paul's "End The Fed." The book outlines the controversial libertarian's reasoning for wanting to shut down the Federal Reserve. Headed by Ben Bernanke, the Federal Reserve has the power to print U.S. dollars - a power the Fed has been using frequently in recent years. Paul argues that this is a form of tyranny enabling the Fed to covertly tax Americans by devaluing their money. And he believes the Fed uses this power to serve the interests of "the banking cartel" and "the most powerful politicians in Washington."

Perhaps Paul is correct that our central bank's manipulation of the money supply, interest rates, and asset prices does not benefit our economy. And perhaps it is true that the Fed enables a few powerful interests to enrich themselves at public expense. I increasingly suspect that he is onto something. But surely lowering interest rates does benefit some parts of the economy and can lead to growth and job creation in some industries, even if only temporarily. Paul would have us believe that the costs of monetary stimulus are higher than the benefits. Unfortunately, "End the Fed" provides little concrete evidence to support these conclusions.

Paul's best argument against the Fed is that it has a dangerous power in its ability to print money with little oversight by Congress. This does seem inconsistent with democratic values. But this is not new information. Americans appear willing to grant the Fed this power if the result is a stronger and more stable economy. Supporters of the Fed contend that the ability to change interest rates, help the financial system, and control the money supply is of great value to all Americans. After reading "End The Fed," I am not better able to rebut such assertions.

Paul deserves much credit for raising questions about the merits of our monetary system. His book has at the very least prompted more Americans to begin questioning the status quo. However, he fails to offer sufficient evidence to convince us that the Fed does more harm than good. We need to see some data showing that any gains are offset by economic losses elsewhere. The book does not even provide a theoretical explanation as to why any investment and spending spurred by monetary expansion is bad for the economy. More analysis is needed.

The Irish Bank Bailout

2010-11-26T15:50:00.000-08:00

Authorities in Europe are scrambling to put together a bailout for Ireland before financial markets open on Monday. However, the circumstances of this latest bailout are perhaps the most interesting - and eyebrow raising - of the many rescue schemes launched in recent years. Unlike the banks and Greece, Ireland does not actually need any money in the immediate future. The country has already borrowed all the money it will need until the middle of 2011. And unlike most other bailouts, the terms of this bailout will cause the Irish economy to contract because of spending cuts. It is also likely to damage the fiscal position of the government. So what is going on?

Ireland's banks are in trouble. And they need money soon. It is difficult to ascertain how much the banking sector needs to stay afloat, but news sources have been reporting numbers ranging from about 30 to 60 billion USD. Controversy, of course, abounds about the wisdom of bank bailouts. But the logic of supporting the banks in this instance appears especially weak. The standard argument in support of bank bailouts usually goes something like: credit is vital to keeping the economy moving; if banks fail, lending will grind to a virtual halt. In Ireland, this line of reasoning does not hold water. In order to keep the economy moving, the country is giving a bunch of money to banks. In order to bailout banks, taxes are going up and government spending is being severely slashed. The effect of this massive fiscal tightening is to slow down the economy. It just does not make sense.

This looks nothing like the bank bailout in the United States, in which the American government has thus far been able to provide massive fiscal stimulus while also rescuing banks. In that scenario, one can at least argue that the government is trying keep the economy moving. But one cannot convincingly purport that the Irish are trying to stimulate their economy by raising taxes and cutting government spending to fund Irish banks.

Perhaps the more convincing argument in favor of another Irish bank bailout is the notion that by providing liquidity to Irish banks, Ireland and the rest of Europe can avert any further "contagion". If Irish banks fail, investors may next lose confidence in Portugal or Greece. But we have heard that argument before. Just this summer, politicians argued that Europe must save Greece so that other countries do not suffer from a lack of confidence. So Greece was bailed out. But today confidence in Ireland, Portugal, Spain and Greece is nowhere to be found.

Forcing Irish bank bondholders to suffer losses will indeed cause financial turmoil around the world. However, that turmoil will cause less real economic pain than would be caused by forcing European taxpayers to foot an ever growing bailout bill.

Krugman Laments Austerity

2010-06-06T10:53:00.000-07:00

Krugman's Sunday blog post is entitled "Lost Decade, Here We Come". In this post he laments that many members of the G-20 have abandoned fiscal stimulus and commenced with fiscal austerity (ie., cutting deficits). He argues that governments should be pouring money into economies now and cutting deficits at some future date. Of course, anyone who has been following the recent travails of Greece, Spain, and Portugal can tell you that things are not so simple: Investors are reluctant to lend money to countries with excessive debts and deficits. Sometimes fiscal stimulus is not an option. Krugman seems to suggest that if countries had only outlined credible deficit reduction policies for the future, then markets would be more forgiving. I am skeptical of this view. Greece did exactly that to no avail, though perhaps Greece's extreme indebtedness makes it a special case. The American stimulus bill already accomplishes what Krugman is talking about: it stimulates the economy now, and automatically reduces spending in the future as it naturally expires.

Krugman, however, wants even more stimulus. He condemns "deficit hawks" who want near-term spending cuts as guilty of "utter folly." Europe's debt crisis is not a harbinger of things to come in the United States, Krugman asserts. Rather, he attributes the European turmoil to the unfortunate condition of being part of the Euro-zone. It is true that until a few weeks ago, being a member of the Euro-zone did present a special challenge: individual members could not just print Euros to solve fiscal problems as the United States and Japan can do. However, the E.C.B. rendered that point irrelevant when it began creating Euros to buy European government debt a couple weeks ago. Europe can print money too, it turns out, but is still mired in fiscal and economic problems. Krugman's argument that Europe is some sort of especially tough case that is not relevant to the United States is unconvincing. A loss of investor confidence in America's willingness and ability to repay its obligations could be catastrophic for the global economy. We should proceed very cautiously going forward. Deficits should be reduced and spending should be focused on areas that will lead to long-term economic growth: infrastructure, energy independence, and research and development would be good places to start.

Don't Blame the Germans

2010-04-30T22:04:00.000-07:00

Greece's financial problems have shaken world markets over the last month. Each time the likelihood of a bailout seemed to increase, stocks rallied around the globe. And each time someone – usually in Germany - suggested that money might not be readily available, stocks sank and Greek bonds plunged. Recent market movements do suggest that a failure to rescue Greece would lead to some sort of sharp downturn in financial markets. But it does not follow, as many commentators assert, that the best policy is therefore to bailout Greece with all due haste. Germany's Chancellor Angela Merkel has taken flak from politicians and media outside of Germany because she has been slow to lend her taxpayers' money to the Greeks. The Economist chastises her:

“The chief culprit is Germany. All along, it has tried to have it every way- to back Greece, but to punish it for its mistakes; to support the Greek economy, but not to spend any money doing so; to treat this as just a Greek problem, when German banks and German citizens, who lend to Greece, stand to lose money too. German voters do not favor aiding Greece. But rather than explain to them why it is in Germany's interest, the chancellor, Angela Merkel, has run scared of upsetting them before a big regional election on May 9th.”

This is a flawed analysis. It fails to account for what would have happened had Germany just offered the funds promptly. Consider the situation a few weeks ago: Greek Finance Minister George Papaconstantinou attempted to allay investors' concern about Greek indebtedness by trumpeting a 3% cut in the deficit and the Euro region's vague “commitment” to offer 45 billion Euros in loans should funds be needed. Meanwhile, large numbers of Greeks took to the streets to protest such draconian thrift. But the harsh reality is that to lend money to a country with a shrinking economy, a deficit of over 10% of GDP, and a debt of over 115% of GDP would solve nothing. In a matter of months, if not days, investors would realize that Greece was still hurtling towards default. And then where would Europe be? They would be 45 billion Euros poorer and Greece would have an even bigger debt problem to deal with. And the political will to pay for yet another bailout would surely be much abated.

That Germany chose another path should not be written off as mere political political posturing. Rather, Germany demanded that Greece submit to an I.M.F. austerity program. Involving the IMF has two major advantages that greatly increase the probability of Greece avoiding default – though some sort of eventual restructuring will still be hard to avoid. The first advantage is that the I.M.F. has expertise in lending to distressed countries and designing austerity programs. The E.U.'s initial attempt to rescue Greece by itself suffered from a lack of coordination and clarity of purpose. The I.M.F., on the other hand, seems to know exactly what it is doing and how it is going to do it. The second advantage of bringing in the I.M.F. is that unlike European politicians, the organization is known for tough quantitative assessments of what is really needed to bring foundering countries back to fiscal self-sufficiency. It now appears that in conjunction with the IMF, Germany will demand a much more drastic 10% cut in Greece's deficit. If this can be accomplished without causing the economy to contract too severely, Greece might just be able to pay its debts. Surely a plan in which Greece's debt will not continue to explode is superior to a scheme that would merely delay and exacerbate the current fiscal crisis.

Yes, it is true that a consequence of delaying the Greek aid package was increased uncertainty and volatility in markets. But that is a cost worth bearing. By delaying the package, involving the I.M.F., and demanding serious deficit reduction, there is now some chance that Greece escapes economic catastrophe. Had Germany not delayed its package, Greece's fiscal situation would have continued to deteriorate, necessitating more bailouts and causing even greater uncertainty and volatility at a later date.

NY Times Inconsistency

2010-03-23T17:55:00.000-07:00

When talking about government debt, commentators often make a distinction between total government debt and net debt held by the public. Total government debt includes monies owed to other government organizations of the same country. For example, the Social Security trust fund owns billions in treasury notes. These billions are included when discussing total debt. But many commentators think that when talking about the size and sustainability of debt, it is more useful to net out such debt. It is the amount of debt the government owes to the public that matters, they say.

Ok, boring, I know. But here is why it matters:

Yesterday the New York Times ran a piece on Social Security that included the following statement:

By 2016, Social Security will begin paying more in benefits than it collects in payroll taxes, according to the annual report of government trustees; reserves in the form of government i.o.u.’s will be exhausted by 2037, after which incoming taxes will cover three-quarters of benefits.

The problem with this statement is that it makes it seem like there is some sort of massive trust fund that will help us straggle along to 2037. And as far as I can tell, a problem that is not a problem until 2037 is not really a problem at all, at least in Washington.

However, the majority of commentary about America's debt does not count money owed to social security as real debt. The thinking is that since the government owes itself the money, it doesn't count. Using this logic, America's total debt of over 100% of GDP is made to look like the much more manageable sub 70% of GDP often cited in the press. I don't have a strong opinion on the right way to classify debt owed to social security and other government agencies. But I do know that you cannot have it both ways. If you think social security has enough money to get us to 2037, then America's government debt is a Greek-like 100% of GDP. If, on the other hand, you think the debt is closer to 70% of GDP, then social security will most likely be broke within 6 years. The NY Times and other media outlets should address this inconsistency in their reporting so that readers can better understand America's budget problems.

The Debt Debate

2010-03-13T12:32:00.000-08:00

A debate is raging about government debt. On one side, economists like Paul Krugman argue that large deficits and debt levels above 100% of GDP are nothing to be too alarmed about. This camp cites historical examples of nations successfully clawing themselves back from massive national debt burdens by combinations of tax increases and spending reductions. Of course, for every example of success, an example of failure can also be found. A new book entitled 'This Time is Different,' by Reinhart and Rogoff, chronicles the surprisingly long historical record of debt defaults and introduces its chapter on Sovereign Default on External Debt with the following note:

Policy makers should not have been overly cheered by the absence of major external sovereign defaults from 2003 to 2009 after the wave of defaults in the preceding two decades. Serial default remains the norm, with international waves of defaults typically separated by many years, if not decades.

Reinhart and Rogoff also point out that defaults frequently occur at ratios of external debt to GDP much lower than 100% - indeed, developing countries typically default long before debt reaches 70% of GDP.

What emerges from this debate is that the focus on debt to GDP ratios as a measure of a country's likelihood to repay is misguided because the record is very mixed. A variety of other factors need to be considered: The household savings rate, ease of cutting government spending, demographics, ability to inflate, liabilities not counted in national debt figures (ie. Fannie Mae and social security), state debts, and municipal debts seem like good places to start.

Readers should therefore find little comfort when they encounter claims that if Japan, the United Kingdom and Belgium have historically been able to handle massive debt burdens, so can Greece or the United States. Likewise, they should not conclude a massive default wave is approaching just because current debt ratios exceed those of countries just before they defaulted. Each country is unique and the focus on debt to GDP ratios is woefully narrow-minded.

Consider the United States, for instance: Our debt hole is really much bigger than the 60% debt to GDP ratio often cited. Medicare, social security, municipal pension obligations, and low household savings rates all make the true debt burden much heavier. On the other hand, we have been able to print over a trillion new dollars without causing significant inflation (so far), a long record of political and financial stability, a history of entrepreneurship, and the strongest military on Earth. The question of how much debt a country can handle is extremely complex. Economists and policy makers need to conduct a much fuller analysis as soon as possible so that we can develop a wiser fiscal policy.

Unintended Consequences

2010-02-25T20:48:00.000-08:00

The Senate on Wednesday passed a $15 billion jobs bill that offers a tax break to companies that hire people who have been unemployed for at least 60 days. This should help create some jobs. But it will probably also have unintended consequences. Unfortunately, the legislation actually encourages companies to fire existing employees and hire unemployed people to capture the tax credit. This problem will particularly afflict unskilled laborers who require little training and are easily replaced, but have managed to avoid the chopping block despite the current downturn. The tax credit may even trigger layoffs: companies often delay layoffs as long as possible because the costs of rebuilding a workforce once demand picks up in the future are substantial at many firms. By making hiring so much more attractive, this bill likewise makes firing much easier for firms. The Senate ought to have just lowered payroll taxes for all Americans, but by a lesser amount.

Bank Busters

2010-01-23T14:25:00.000-08:00

The Obama administration's schizophrenic affair with investment banks took another unfortunate turn this week. While Wall Street has been busy doling out compensation packages that rival the bonuses of the frothiest days of 2007, the White House has been busy trying to position itself as the avenger of Main Street. A hundred billion dollar bank tax is now on the agenda for debate (see recent post). But the proposal that has the greatest potential impact on finance as we know it is a prohibition on banks using customer deposits to finance trading operations.

While I support some sort of special tax, I do not support the proposed ban on risky investing by banks that accept customer deposits. It is clear that the government does not want banks to stop investing and trading altogether. Despite the tumult of the last two years, it is important to remember that the core business of finance is actually good for the world: moving capital from lenders to borrowers does wonders for real economic development. The difficult problem we face is how to regulate that process so as to foster economic growth, create fair outcomes, avoid systematic meltdowns, and keep taxpayer dollars out of Wall Street's hands.

Separating deposits from banks' trading operations would not improve the financial system. It might very well make it worse. Recall that in the Fall of 2008 firms with large reservoirs of customer deposits were best able to ride out the storm. Bear Stearns, Lehman Brothers, and A.I.G., on the other hand, did not have significant customer deposits. This is because F.D.I.C. insured deposits were a remarkably stable source of capital for banks. As the financial world unraveled, customers happily left their deposits in their accounts at J.P. Morgan Chase, Citi and Bank of America. Other sources of bank capital - the repurchase market, the commercial paper market, and the bond market - dried up. Without access to capital, banks were forced to sell assets at fire-sale prices to repay their obligations as they came due. The result was a market collapse and trillion dollar government interventions. One of the major lessons of Fall 2008 is that banks were buying risky assets with capital that could dry up very quickly. Customer deposits were a bright spot on banks' balance sheets; they were a source of stable capital throughout the crisis.

So why would the administration want to discourage banks from using a more stable source of capital? I don't know. Perhaps they believe that by taking away one source of capital they can reduce the amount of investing that investment banks do. This is probably correct. But surely we would want to restrict the sources of capital that are least stable first. And remember that we do indeed want banks to take some risk; investment is a good thing. Cutting off deposits from investment banking removes a stable source of capital. Such a policy could increase risk while decreasing investment and economic growth. Obama's team needs to go back to the drawing board.

Also check out this Bloomberg article about the proposal.

Obama's Bank Tax

2010-01-16T16:58:00.000-08:00

President Obama this week unveiled a plan to raise about 100 billion dollars by taxing big banks. The overall thrust of the plan - replenishing government coffers with a slice of the profits made by institutions that were saved from destruction by government largesse - seems fair. And the U.S. Treasury could surely use the cash. So I support this effort to get taxpayers some of the money that is rightfully theirs.

However, this tax is far from ideal and raises some troubling questions about the future role of government in the financial sector. A system in which politicians run about deciding which industries they like and which they would like to tax is a bad one. Tax policy should be predictable so that investors can confidently invest without fear of retributive taxes. And taxes should not target certain industries; targeted taxes interfere with the free market and hinder economic growth. Another unfortunate consequence of a system in which Congress picks winners and losers in business is that such a system encourages lobbying and tends to corrupt the political process. Perhaps worst of all, this tax does little to remedy the hyper-leveraged risk taking that brought down the financial system in the first place. In fact, the tax has the unfortunate consequence of increasing leverage by reducing the firms' equity.

One desirable feature of the tax is that it hits bigger firms harder (the amount of tax owed is a percentage of certain types of assets and only kicks in if a firm has 50 billion in such assets). This may in some small way reduce the too big to fail problem, but the benefits of being big will still outweigh the costs of the tax. Other than that, the proposed levy does little to reform the financial system to make it more stable in the future.

A variety of superior alternatives exist. The first that comes to mind is an F.D.I.C. controlled investment bank bailout fund modeled after the current F.D.I.C. deposit insurance program. Firms would contribute to an annual fund that would be used for future problems and the amount contributed would be based both on a firm's size as well as an estimate of its risk. An important feature of an F.D.I.C fund would be the orderly wind-down of any firm that needed assistance. The F.D.I.C. has already successfully wound down hundreds of failed deposit banks and could extend this expertise to the investment bank behemoths. Funds would not be used to keep the firm alive or to bail out investors. Only customers would get bailed out and even they might be forced to take a haircut on their assets.

Another alternative would be a tax that accounts for leverage as well as size. Banks' excessive leverage was a much more significant factor in the financial meltdown than was size.

It is also worth quickly reviewing some T.A.R.P. history to point out how this tax is inconsistent with earlier theories used to justify the terms of the bailout. Many argued - including myself - that the terms of any bank bailouts should be much harsher for the banks' investors. Paulson - in conjunction with a Congress controlled by Democrats - doled out cash on generous terms. They argued that they were not trying to punish banks, but to encourage lending. Despite the fact that Warren Buffet was simultaneously extracting much better terms for his investment in Goldman Sachs, Paulson believed that he should not do so on behalf of the taxpayers who employed him. Had the government demanded much larger equity stakes and/or concessions from bondholders, taxpayers would have fared much better and banks would have learned a much sterner lesson about the dangers of excessive risk.

Obama is doing the right thing by trying to capture some of the profits that were made possible by taxpayers. But his tax proposal is a blunt tool that undermines political integrity and confuses investors. It also fails to discourage the types of behavior that caused the financial crisis in the first place. It would be easy to improve this bill.

How Much Debt Is Too Much Debt?

2009-10-28T20:01:00.000-07:00

Just about everyone in Washington seems to agree that the U.S. deficit is large and unsustainable over the long term. But there are few signs that Congress has the discipline to reduce the deficit anytime soon. The Obama administration and many Congressman talk about deficit reduction. It remains unclear how they aim to achieve it. It will be especially difficult to cut the deficit if the economy does not recover as Washington is hoping; another downturn could make it tricky for politicians to cut popular - and expensive - stimulus programs. Keep your eye on how Congress handles the upcoming expiration of the $8,000 first-time homebuyer credit for early indications about how much willpower exists to reduce spending (there has been a lot of chatter about extending and/or expanding the program).

Policy makers have a difficult balancing act: cut spending too much and economic activity could plummet; spend too much and the United States could have a fiscal crisis replete with inflation, high interest rates, and a weakening of the dollar. Both scenarios could be disastrous to Americans' well being. But there has not been a thorough public discussion about how close we are to the latter outcome. How is Congress supposed to balance these monumentally important constraints when so little is understood about how much debt is too much debt?

Recent articles in the Economist and the New York Times have examined this question. The Economist suggests that the high amount of government debt may weigh on growth in the future, but will not cause a crisis. This thesis largely rests on a comparison of the United States with Japan. Japan's government debt to GDP ratio is actually much higher than America's ratio. The Times makes a similar comparison, but raises questions about how useful such a comparison will be in reality. The Times correctly points out a crucial difference between the United States and Japan that the Economist failed to mention:

One hugely important difference is that Japan is rich in personal savings and assets, and owes less than 10 percent of its debt to foreigners. By comparison, about 46 percent of America’s debt is held overseas by countries such as China and Japan.

In other words, Japan owes Japan money and the United States owes other countries (including Japan, incidentally) money. By some measures, America actually looks much worse than Japan. A useful statistic that receives insufficient attention in discussions about debt is the net international investment position. The NIIP of the United States measures the value of foreign investments held by Americans minus the value of investment in the United States owed to international holders. This accounts for all types of investment (stocks, bonds, and direct ownership) by all sorts of entities (government, businesses and consumers). Japan has a positive NIIP, meaning that other countries owe Japan more money than Japan owes the rest of the world. The NIIP of the United States, on the other hand, is negative.

Considered in this context, it appears incorrect to find comfort about America's debt levels by comparing them to Japan's debt levels. So how much debt is too much debt? I don't know. But the current plan of spend now, figure it out later, and don't worry because our government debt to GDP ratio is lower than Japan's seems dangerous and ill-informed. Economists and Congress should be scrambling to determine just how much debt the United States can sustain without triggering a new financial crisis. Armed with a better understanding of how much debt is sustainable, policy makers will make much smarter choices about spending.

Home Prices Should Not Go Up

2009-06-26T16:39:00.000-07:00

The collapse of home prices in the United States is a major cause of the financial sector's current woes and the severe economic decline we are currently suffering. I do not dispute that. But I do dispute the notion that using government money to attempt to stabilize or increase home prices is the correct policy response.

Home prices declined because they were far too high to begin with. They got so high because fancy mortgage products enabled people to buy homes that were more expensive than they could actually afford. And people bought homes that were more expensive than they could afford because they assumed (wrongly) that they could refinance on more advantageous terms sometime later or sell the house at a price higher than they paid for it. The government exacerbated the bubble by encouraging the GSE's (Fannie Mae and Freddie Mac) to subsidize the mortgage market, thus making it easier to borrow money for a home purchase.

There are many reasons why government policies designed to prop up home prices are a bad idea. The first one is that low home prices are a great thing. Like milk, gas, and healthcare, housing is something everyone needs. The lower it costs, the better. It is pretty straightforward to understand why the approximately 1/3 of Americans who do not own homes would benefit from lower housing prices. Of course, many Americans own their homes. And they seem to want their homes to be worth more money. But if you think about it, the vast majority of homeowners do not realize any benefits when home prices rise. Higher home prices mostly make people feel wealthier; owning a more expensive house does not result in more money in someone's bank account unless she is willing to sell that house and begin renting or buy a smaller house. Most homeowners, however, aspire to live in their homes for a long time or to move up to a bigger and better house when they can afford to do so.

The government has enacted many policies designed to make home ownership more affordable: tax credits for first-time home buyers; an aggressive policy of printing money to buy mortgage-backed securities from financial firms designed to drive down mortgage rates; and propping up Fannie Mae and Freddie Mac to make it easier for Americans to obtain mortgages. These policies may make homes more affordable for people in the near term. But they also create more demand for housing and result in higher home prices: people are willing to pay more for houses because interest payments on their mortgages are lower and they can receive tax incentives for buying.

Unless the government is going to continue to plow money into the housing industry forever, these policies are creating future problems. If the government cuts these subsidies, housing prices could fall, perhaps drastically. Because current policy encourages people to buy homes today at artificially high prices, we might have a whole new wave of people who owe more on their mortgages than their houses will be worth in the future. This might create yet another economic crisis. And it would ensnare a whole new group of homeowners who managed to escape the current crisis and are fortunate enough to be able to buy a new home today.

Another unfortunate consequence of policies that prop up home prices is that they result in resources being diverted from more economically productive industries toward home construction. Building bigger and better homes is nice. But it does not result in a more productive economy. (It does lead us to consume more energy, however). By increasing the demand for homes - and the resources that go into home construction - we take resources from other industries that create economic progress and make America more competitive.

The dangers of a housing bubble are clearer than ever. The United States needs to stop feeding a new one and let housing prices decline to a natural equilibrium. Although this may upset some banks and those homeowners who are planning to sell, it will benefit the broader economy by reducing the risk of a future housing collapse and increasing our economy's productivity.

TARP Repayment: Good News, But Banks Still Have Government Money

2009-06-09T15:42:00.001-07:00

Today the Treasury announced that 10 large banks would be allowed to repay funds they received under the T.A.R.P. program. This is good news for the American taxpayer. However, it hardly signals some sort of "all clear" for these institutions. Banks that repay T.A.R.P. money are not necessarily operating without massive amounts of government financial assistance. Remember that the T.A.R.P. represents only a fraction of total government support to the financial sector. The Federal Reserve, through a variety of other bailout programs, has lent billions of dollars to Wall Street. Perhaps this has received less attention because reporting on it is so difficult: the Fed refuses to disclose who it has loaned to and on what terms. Meanwhile, the F.D.I.C (and ultimately the taxpayer) continues to guarantee billions of dollars of debt issued by some of the very same banks that have repaid T.A.R.P. funds.

If every single bank were to repay every dollar ever lent through T.A.R.P., Wall St. would still have lots of government money. And the government would still be on the hook for massive amounts of bank liabilities if some of these institutions ever become insolvent in the future. It remains unclear when and how the Fed and the F.D.I.C. will untangle themselves from these arrangements.

Usury

2009-05-13T15:26:00.000-07:00

To a foreigner you may charge interest, but to your brother you shall not charge interest, that the LORD your God may bless you in all to which you set your hand in the land which you are entering to possess. (Deuteronomy 23:19,20)

I usually try to avoid Biblical quotations, but this time I just could not resist. To be honest, I do not really agree with the quote. I am, after all, a fixed income trader whose career hinges on the usefulness to society of lending money at interest. I include it here to make a point: throughout history, the charging of interest has been a controversial topic. Some argue that it leads to investment and progress. Others argue that it is immoral and contrary to scripture. I would argue that the controversy stems from the fact that while it does lead to economic progress in the majority of instances, there are also times when lending can be predatory and immoral. Lending money to a small business at 9% sounds like a good deal for everyone. But lending money at an annual rate of 25% to a single mother who is struggling to put food on the table does not result in economic progress. Rather, it results in richer guys getting richer and poorer people staying poorer.

So, I was quite disappointed today when the Senate killed a proposal by Senator Bernie Sanders, Independent from Vermont, to put a cap on the rate banks charge credit card customers. Unfortunately, Congress lacks the will to inhibit the type of irresponsible lending that financially cripples families and leads America further down a seemingly never-ending hole of bad debt.

In general, I oppose Congressional interference in business matters. But today an exception to that rule should have been made. Taxpayers are currently propping up Wall Street banks for the good of the country, or so we are told anyway. It is perfectly reasonable for that assistance to come with some strings attached. One very good string would prevent bailout recipients from engaging in a practice (usury) that exacerbates the very same problem (a debt crisis) that the bailout money is intended to resolve.

I would have liked Sander's proposal even more had it only applied to bailout recipients. That way the problem of interference with free markets would be irrelevant. But either way, it is very disappointing that our government has again failed to protect American families because the interests of banks got in the way.

Breaking the Law

2009-04-29T18:26:00.000-07:00

I finally got around to reading some of the Emergency Economic Stabilization Act of 2008. I was a bit surprised - even a little impressed - by the level of specificity written into the bailout legislation. Yes, Congress did grant wide discretion to the Treasury Department. But the discretion was not boundless. The law does not give the executive branch of government the authority to spend $700 billion as it wishes; Timothy Geithner cannot go around buying whatever he wants. Rather, "The Secretary is authorized to establish the Troubled Asset Relief Program (or "TARP") to purchase . . . troubled assets from any financial institution on such terms and conditions as are determined by the Secretary, and in accordance with this Act . . ."

That may not sound like much, but in light of recent actions by Treasury, I would like to delve a little deeper into that straightforward instruction. Anyone who has taken a basic accounting class can tell you that an asset is something a company owns. It is worth something greater than zero. It can be a factory, a troubled mortgage bond or a patent. But it cannot be a liability. An asset cannot be something that will result in the company having less money in the future. (I apologize if this sounds obvious, but I promise I am going somewhere here.) When a company issues a share of stock, a preference share, or a bond, then a new liability is created. That LIABILITY is not an ASSET. Indeed, an asset is the opposite of a liability.

Ok, now take another look at the excerpt from the TARP law. It gave Treasury the authority to purchase assets. But not liabilities. So then how in the heck did we taxpayers end up spending billions of dollars on common shares and preference shares? The best answer I can come up with is that the Treasury Department decided it was above the law. I will refrain from expounding on the importance of democracy and adherence to the system of government outlined in the American Constitution. Suffice it to say that certain Treasury officials apparently believe they have more important concerns and that I respectfully disagree.

The law does contain a definition of the term "troubled assets." They are assets related to mortgages or "any other financial instrument." I'm sure the Treasury Department could find a lawyer to argue that therefore assets can be liabilities. However, even if that argument were to succeed, the Treasury would still be operating outside of the law because Congress specified how the Secretary must go about acquiring these assets (also know as liabilities to creative types). The Treasury is instructed that any publicly traded institution that sells assets to Treasury must also give the government a warrant or equity stake designed "to provide additional protection for the taxpayer against losses from sale of assets." In other words, the government must demand equity stakes as an additional compensation for buying troubled assets. But if the government is only buying equity stakes, then it would be impossible to receive any "additional protection" from equity stakes. It is therefore impossible to adhere to the law without the government acquiring more than just preferred shares or common stock. Any way you cut it, both former Treasury Secretary Hank Paulson and current Secretary Timothy Geithner broke the law by using TARP money to buy equity stakes instead of troubled assets.

The Asset Allocation Question

2009-04-28T23:21:00.000-07:00

For years, many of the most trusted experts in personal finance have instructed American families to allocate their savings to a mix of stocks, bonds and money market instruments. The percentage that should be allocated to each sector, according to widely accepted theory, mostly depends on the investor's age, wealth, willingness to accept risk, and expected future income stream. But one factor has been conspicuously absent in the determination of investors' asset allocation decisions: valuations are not considered. If stocks are bubbly and bonds are cheap, the investor still funnels as much money into stocks as he would if the valuations were reversed. Two assumptions that underlie this approach to investing are that markets are generally efficient (meaning stock and bond prices are close to fairly valued given the amount of information available to the investing public) and that the average investor cannot beat the market.

Recent events have got me thinking a lot about this. This approach has wreaked havoc on the retirement savings of millions of Americans. So I took out a book I had not read since college: "A Random Walk Down Wall Street," by Princeton economist Berton Malkiel. The book is one of the most influential arguments for the efficient markets theory and the implications for personal investors. The basic message is that investors should not attempt to pick stocks or time the market.

Most of the research I have seen supporting the efficient markets theory (and the notion that the average investor cannot beat the market) focuses on the futility of stock-picking. "A Random Walk Down Wall Street" is no exception. It convincingly argues that people should not attempt to pick which stocks will go up and which will go down; they should just buy index funds with low fees. A small number of experts keep stock prices in line and earn profits doing so; but most people should not attempt to beat the market.

However, Malkiel only touches on the subject of asset allocation. Malkiel cites data showing that equity only mutual funds hold a larger percentage of their funds in cash (mutual funds almost always have a fraction of their funds in cash to meet liquidity requirements) at precisely the wrong times. He concludes that "mutual-fund managers have been incorrect in their allocation of assets into cash in essentially every market cycle during this period [1970-2002]." This is a weak argument. Equity only mutual fund managers are not in the business of allocating assets between equities and cash (and are often legally prohibited from investing significant amounts of money in bonds). They are in the business of buying stocks.

Consider the state of affairs in the United States. The vast majority of Americans and institutions invested a relatively fixed percentage of their savings into equities regardless of valuations. Despite the advice of people like Malkiel, a lot of that money is invested in funds with flexibility to pick stocks (as opposed to index funds). So, there are a lot of dollars out there chasing "cheap" stocks. Because so many people are chasing the same cheap stocks, it is very difficult to outperform the maket. But very few funds are able to sell stocks and buy bonds. Most of the money is literally stuck in the equity markets because investors believe they need to allocate some fixed percentage in stocks. There might just not be enough money out there that is actually managed by people with enough flexibility to keep stocks at fair levels relative to other asset classes.

I suspect that the very good research about the efficiency of the stock market has been wrongly applied to asset allocation in general. Although it may be difficult to pick which stocks are winners, it may be possible to intelligently allocate more or less money to certain sectors of the financial markets based on valuations like yields and P/E ratios. Much more research needs to be done on this point. But many studies have suggested that simple metrics like P/E and P/B ratios can be used to beat the market.

For years Americans have been instructed to invest with a blind faith in the ability of the stock market to turn money into more money when given a long enough time horizon. Recent events ought to at least trigger a serious academic reevaluation of the notion that Wall Street is able to keep the markets near their fair values. Perhaps it is time to rethink the philosophy of investing so much of our savings in the stock market regardless of fundamental valuations.

Equity Stakes

2009-04-21T19:29:00.000-07:00

Speaking to a Congressional panel today, Treasury Secretary Geithner advanced the idea of converting the government's preferred equity stakes in banks into common equity. Preferred stock is actually more like debt than stock because companies pay a fixed coupon to holders of preferred shares. By converting preferred shares to common equity, the Treasury hopes to reduce the liabilities of troubled banks and thus improve their capital position. The media, along with many politicians, have correctly identified this as a risky idea. But most of the scrutiny has focused on the thorny issue of how the government can effectively control large ownership stakes in corporations. Fears of nationalization and government interference in private markets have been at the heart of the debate about converting government stakes to comon equity.

Such fears are valid. But they should not be the focus of the debate. First of all, the government already has control over bailout recipients. Many banks would be bankrupt without government assistance. If the government wants to interfere, it can already do so simply by threatening to cut off funding. So fears of nationalization or excessive government interference are moot. Second, and most importantly, the real problem is that common equity is much riskier than preferred equity. A preferred share must pay a fixed coupon to the investor unless the company suspends the dividend it pays to common shareholders. In other words, preferred share holders get paid before common equity holders. Preferred stock holders also fare better if bankruptcy occurs and the firm is liquidated. Congress and the media should be giving more attention to how the conversion would increase the government's probability of losing money. The Treasury has already put trillions of taxpayer dollars at risk to help banks. Converting preferred shares to common equity will exacerbate the problem.

A Better Plan

2009-03-31T19:23:00.000-07:00

The American economy is going through a profound restructuring. Less money will be spent on home construction in the future. American car companies will be smaller in the near term. The financial sector will employ fewer people. Such restructurings are painful because they are associated with layoffs and bankruptcies. But there are many ways for the government to mitigate the effects of this economic correction without risking trillions of dollars on bailouts. Below I outline a 5 part approach to coping with the current economic crisis and the financial sector's problems. Compared to the Obama administration's approach, this plan devotes less money to the financial sector and more money to the social safety net and job creation.

1) Restore Confidence: The most efficient way to restore confidence is to greatly expand unemployment benefits and the affordability of health care. Compared to many other developed countries, the United States has a weak social safety net. Parents who are worried that their children may lose access to medical treatments have every reason to drastically cut spending, causing an especially severe economic contraction. If Americans were more confident that they could maintain a decent standard of living, economic activity would be higher. This policy does not mean that we have to adopt a European style economy. The U.S.A. can skip the restrictive labor rules found across the pond because they hamper economic growth. We should just borrow the good stuff (the safety net) and we should do it as soon as possible.

2) Fight Unemployment: There are millions of unemployed Americans out there right now who want to work. Many businesses are shrinking. Eventually, other businesses will expand to fill the gap. But that can be a slow process. In the meantime, the government should use this excess supply of labor to modernize American infrastructure so that the country enters the next global economic expansion on a competitive footing. We need more stimulus money.

3) Maintain Price Stability: The Federal Reserve has done a good job fighting deflation so far. Under Bernanke's direction, the Fed has expanded the monetary base to help prevent a dangerous drop in prices. However, the Fed should be more cognizant of inflation risk. Bernanke ought to be more conservative in the assets he acquires during this monetary expansion because he may need to sell the assets quickly - thereby reducing the monetary base - to fight inflation. The Federal Reserve should conduct monetary policy. It has no business assuming massive credit and interest rate risks.

4) Ensure That There Is A Viable Financial Sector: This does not mean that huge banks need to be bailed out. The economy will benefit if a competitive group of healthy financial institutions exist to provide credit to people and businesses. The government can intervene if such a group does not exist. But that intervention should not take the form of pumping cash into failing banks. Rather, the money should be used to better capitalize the healthiest banks. Such a policy has a higher chance of ending in full repayment to the government and in an expansion of credit.

5) Impose Harsher Terms On Bailout Recipients: Many commentators argue that some banks are too big to fail. One argument for saving failing financial institutions is that their failure would be catastrophic to other institutions, setting off a dangerous chain reaction. I would like to see more evidence on this point. But even if one does assume that a firm's failure would be intolerably harmful to the economy, it does not follow that the government needs to spend billions of dollars to save investors in the firm. The government can guarantee the failing firm's obligations to customers and counterparties, but allow bondholders and equity investors to suffer losses. While discussing such an approach, market commentator and fund manager John Hussman wrote:

"Ultimately, if a financial institution is not capable of surviving without large and constant infusions of public capital, the stockholders and bondholders of that company – not the public – should be responsible for the losses incurred. . . . [T]his can be achieved without customer losses or a disorganized Lehman-style unwinding." (Here's the link.)

In conclusion, the Obama administration needs to rethink its approach to the current economic crisis. More money should be spent on the social safety net and building infrastructure. Less money should be spent on saving investors in financial institutions. Both can be accomplished without stifling the free market and without financial market chaos.

Bernanke's Gamble

2009-03-22T14:31:00.000-07:00

Most Americans have heard of the Federal Reserve (often referred to as "the Fed"). And most Americans probably know that the Fed can influence interest rates. But I suspect that many people are unaware of the Fed's most awesome power: The Federal Reserve can create U.S. dollars without the consent of even one democratically elected official. Recently, Ben Bernanke has created an astounding number of U.S. dollars. In fact, the monetary base (the sum of U.S. dollars in circulation plus banks' deposits at the Federal Reserve) has nearly doubled since the economic crisis began. In layman's terms, the Federal Reserve DOUBLED the amount of money out there. Earlier this week, the Fed announced that it would create another 1 trillion dollars and use that money to buy U.S. Treasuries, mortgage bonds and agency bonds. It seems that within a few months, the monetary base will have at least tripled. If the T.A.L.F. becomes a 1 trillion dollar program, as Geithner has suggested, the monetary base might just quadruple.

Printing money is risky business. Many countries that have tried to print their way out of economic trouble have suffered economic collapse. So far, Bernanke has managed to get away with it. The sharp economic contraction has counteracted the inflationary effects of the greatly expanded monetary base. And the global perception that the U.S. dollar is safe has helped to keep the dollar strong vs. other currencies. However, there are signs of weakness. Since Bernanke announced that he would create another 1 trillion dollars on Wednesday, the U.S. dollar has taken a bit of a beating in foreign exchange markets and commodity prices are higher.

Bernanke argues that if inflation becomes a problem, he can reduce the monetary base. This is true. When the Federal Reserve creates and then disburses money, it acquires financial securities (like mortgage bonds and U.S. Treasury bonds) in exchange. The Fed also makes short term collateralized loans to banks. Bernanke believes that it will be a straightforward affair to sell these securities and to terminate loans to banks if the dollar begins to weaken. When the Fed sells those securities or terminates the loans, it will get its greenbacks back. And the monetary base will shrink again.

Bernanke is counting on the theory that if the economy improves and lending increases, it will be easy to unwind the Fed's expansive new programs. However, another scenario is possible. The economy could begin to improve while a group of healthy financial institutions could help increase the use of credit in the country. But at the same time, the deficit could continue to run at a record high. Meanwhile, a group of unhealthy financial institutions might continue to depend on Fed lending. If that happens, it would be quite problematic for the Fed to reduce the monetary base because yields on treasury bonds and mortgage bonds would probably be much higher than they are today. (The yields on treasuries and mortgages usually increase during economic expansions and when governments need to borrow a lot of money. And when yields increase, the prices of bonds go down.) The Fed would have to sell the Treasuries and mortgage bonds for less than it paid. So it would be impossible for Bernanke to sell the assets and get back all the money he printed. And terminating the bank loans to unhealthy banks could bankrupt those institutions, meaning the Fed would be repaid with collateral as opposed to cash. Then the Fed would need to sell even more securities at a discount in order to reduce the monetary base. But it would not be able to get all the money back if it were selling them for less than it paid. Yet another scary prospect is that political factions try to influence Fed decisions, which seems increasingly likely given recent behavior by Congress. Anything is possible there.

The point here is not that Bernanke has made a mistake by increasing the monetary base. Rather, there is a strong case for increasing the monetary base during severe economic contractions. However, the methods Bernanke is using to accomplish monetary expansion involve more risk than he would have us believe. A more realistic assessment of the risks involved might lead to a safer course of action by the Fed. For instance, Bernanke could focus his purchases on securities with shorter maturities, which have less risk. He could also require banks to post higher quality collateral on their loans. Hopefully, Bernanke is correct and the U.S. Dollar is not at risk. But it is unsettling to hear him gloss over the risks as minimal.

To learn what Bernanke has to say on this matter, follow the link below. The sections titled "The Federal Reserve's Policies and its Balance Sheet" and "Credit Risk and Transparency" focus on the issues discussed above.

Bernanke discusses the risks of recent Fed actions

Two Observations On The A.I.G. Bonus Circus

2009-03-17T21:01:00.000-07:00

Congress and the Obama administration seem to be in a bit of a tizzy over the $165 million of bonuses being handed out to A.I.G. employees. How a measly $165 million managed to garner quite so much attention in times like these is beyond me. Nonetheless, there are two important points that I found myself pondering after reading a few of the articles on the bonus scandal.

1) Bankruptcy is very useful. The problem with not letting firms like A.I.G. go bankrupt is that they are still bound by their contractual obligations, even when that means paying lavish bonuses to executives. Had the government allowed A.I.G. to go bankrupt, such contracts could have been suspended. And the government could still have stepped in to pay those of A.I.G.'s obligations that it deemed important to the American economy.

2) Treasury Secretary Geithner is willing to stretch the truth pretty far. In his March 17 letter to Nancy Pelosi regarding the Treasury's handling of the bonus situation, he proclaimed, "We also want to insure that taxpayers are compensated for any monies we cannot recover. Therefore, as part of our provision of recently announced taxpayer funds, we will impose on AIG a contractual commitment to pay the Treasury from the operations of the company the amount of the retention awards just paid." Am I taking crazy pills? The United States government owns A.I.G. And the company has just received another government lifeline. So, a candid translation of Geithner's statement would be something like: In order to pay back the taxpayers, we will take money from the company owned by the taxpayers (which, by the way, does not have any extra money) and give it to the taxpayers. Nonsense.

The Bonus Problem

2009-03-15T10:52:00.000-07:00

Many Americans are enraged that the same Wall Street firms that received infusions of taxpayer dollars continue to dole out huge bonuses. In January, President Obama remarked that the large amount of bonus dollars handed out this year is the "height of irresponsibility. It is shameful." Strong words. But we have not seen much strong action.

Perhaps this is because the administration largely accepts what Wall Street says about its compensation practices:

1) Some bonuses are contractually required.
2) Employees will underperform and even quit if not properly incentivized.

These arguments are valid, but they do not imply that the Obama administration should forgo a much tougher stance on Wall Street bonuses. The first point probably has the most validity. It is difficult to get out of a contract without filing for bankruptcy. It should be noted, however, that the government was not too shy about forcing the auto companies to renegotiate compensation contracts with their employees as a condition for aid.

The second point, however, seems to be the hardest to swallow. There are many steps the government could make that would better protect taxpayers without obliterating the incentive structure on Wall Street. An easy first step would be the establishment of a tougher vesting schedule for bonuses. Rather than just handing over so much money to wealthy finance guys, the bonus money should be locked in an account. Bonus recipients should not be able to withdraw from that account until they have stayed at their firms for at least one year. What is the point of paying people handfuls of cash if they are just going to quit a few days later? If bonuses are really required to keep people working, the administration should require bailout recipients to structure bonuses so that people are incentivized to actually stay at their firms. Another option would be to lock up at least a portion of those accounts until the government is repaid.

Thus far, it seems that the Obama administration has really just paid lip service to this issue. We have heard some tough words from the president. And a few rules have been implemented regarding compensation for the top five executives at some firms that receive government money. But we could be doing much more to protect taxpayer interests without causing irreparable harm to Wall Street's incentive structure.

Portfolio Update

2009-03-03T18:22:00.000-08:00

Proponents of the various Wall Street bailout schemes often make the point that the American government is not just giving all the money away. Rather, the Treasury is buying stuff with the billions of dollars it disburses. American taxpayers now own mortgage backed securities, common stock, preferred shares and many other financial instruments. In order to help quell opposition to the bailouts, many of our Congressional leaders insisted that we might actually be able to make some money on such investments.

Last September, for instance, Nancy Pelosi insisted that the $700 billion dollar T.A.R.P. "investment" would "protect taxpayers" and provide "upside" (Pelosi Clip). Representative James Moran of Virginia went even further, explaining that "this is the time to be buying, when everyone else wants to sell." He also proclaimed that "the taxpayer is likely to recoup a 25 - 30% capital gain." (Moran Clip, starting around minute 33). I figured it was time for a portfolio update.

The news is not good. Let's start with our investment in Citigroup. Back in October, we paid $25 billion for preferred shares in Citi. A few days ago, the U.S. Treasury converted our preferred shares into just over 7.69 million shares of common stock. As of the market close on March 3, those shares are worth less than $9.5 billion. So we are down over 60% on that trade.

The Treasury owns billions of preferred shares in other financial firms. This investment has not fared well either. Obtaining precise numbers is difficult because the shares we own do not trade in the open market. But calculating a rough estimate is straightforward: The S&P Preferred Stock Index Fund is down over 30% since mid October, when the government began purchasing shares. And we know that the government paid an above market price for its shares. So, we probably lost over 30% on our preferred equity stakes.

I do not know how to go about valuing America's $163 billion investment in A.I.G. Despite receiving such a large cash infusion, the firm continues to deteriorate. A near total loss of our investment should not be ruled out.

In sum, our investment portfolio has done very poorly. Many supporters of the bailout used assurances that taxpayers would be protected and that they could expect substantial gains to help get the $700 billion T.A.R.P. through Congress. Thus far, the government has suffered losses upwards of 30% on its portfolio.

A great radio show about the housing debacle

2009-02-24T16:19:00.000-08:00

If you are looking for something to listen to while cooking your frank and beans or cabbage stew, this is a good:

(to access the episode for free, click "Full Episode" in the sidebar under the picture of the crumpled dollar bill)

http://www.thisamericanlife.org/Radio_Episode.aspx?sched=1242

What Credit Crisis?

2009-02-19T19:02:00.000-08:00

The current economic turmoil is often described as a "credit crisis." The term implies that financial institutions are increasingly unwilling or unable to lend money to companies and individuals. The unfortunate result is that because borrowing money is more difficult, consumers spend less on items like new cars and companies spend less on investment. This causes the economy to contract, causing layoffs and losses in financial markets. This is a reasonable line of thinking. And it is probably the most important argument used to justify the use of trillions of taxpayer dollars to bailout Wall Street. The theory that Main Street will suffer if Wall Street does not extend sufficient credit to borrowers has been the central tenet of recent economic policy. It explains why our deeply indebted government has given trillions of dollars to failing financial institutions staffed by some of the world's wealthiest people. It is the heart of the reasoning behind the bailout.

But there is a problem with this analysis. The "credit crisis" does not exist, at least not in the way many politicians suggest. Everyone talks about the credit crisis. I know. Surely there is a credit crisis, right? It turns out that for many people and companies, borrowing money is not especially difficult these days. In fact, many borrowers can access money at lower interest rates than has been possible for many years.

Here are a few quick facts about credit:

- Mortgage rates for borrowers with good credit are exceptionally low. Since 1992, mortgage rates have only been as low as they are today for a brief few months in 2003.

- The yields paid by corporations to borrow money in the credit markets are not especially high. According to data on long maturity AAA-rated corporate bonds from the St. Louis branch of the Federal Reserve, yields averaged above 6.50% for the decade starting in 1990. At times they were above 8%. Today they are under 6.50%. This is higher than they have been in recent years (when credit was especially easy), but it is hardly unprecedented or inconsistent with periods of economic growth. Much attention has been given to the spread between the yields on ultra-safe investments like U.S. Treasury bonds and riskier corporate bonds. This spread is indeed quite high. But such analysis ignores the fact that treasury yields are near record lows. It does not mean that corporations must pay a high rate to borrow money.

- It is true that the use of credit is declining. Households and companies are borrowing less, which results in less spending and investment, causing the economy to slow. However, this cannot simply be attributed to a credit crisis stemming from Wall Street's toxic assets. Rather, a recent Federal Reserve report indicates that demand for credit is sharply lower (http://www.federalreserve.gov/boarddocs/snloansurvey/200902/default.htm). Consumers and companies do not want to borrow as much money as they have in the past.

So, it is not especially difficult to borrow money these days. For some borrowers, credit is tighter than it has been in recent years. For others, money comes cheap. But to describe the current situation as a "credit crisis" is to gloss over important facts. Money is available to many borrowers on very reasonable terms. And the slowdown in borrowing and economic activity has a lot to do with a decline in demand - as opposed to just the troubles on Wall Street. The policy implications of these facts are important. If credit is indeed available to borrowers, why are we risking so much taxpayer money to help certain financial institutions on such generous terms? Furthermore, almost everyone seems to agree that our economic troubles stem from a frenzy of irresponsible lending and borrowing. Isn't a contraction in credit therefore a good thing?

Introduction: If I Had a Trillion Dollars

2009-02-18T22:53:00.000-08:00

If I had a trillion dollars, I would not give it to Wall Street.

Until a few months ago, such an introduction would seem ridiculous because it was so obvious that it need not be stated. In February 2009, however, opposing trillion dollar handouts to the financial industry is the work of rebels. The mainstream debate in Washington and on CNBC is not about whether giving Wall Street so much money is a good idea. Rather, the debate centers around the question of how we should give Wall Street the money. It is all but given that we are supposed to hand over the cash. In just a few months, the obvious has become the preposterous.

In subsequent posts I will offer my perspective on the government's various Wall Street bailouts. Hopefully, this perspective will help people to challenge the notion that we should be pumping so much money into Wall Street on such generous terms. At times, I will veer off course and comment about other economic events.

A few words about myself: I am a fixed income trader. I graduated from Princeton University in 2004 with an undergraduate degree in American history. Barack Obama got my vote. And I live in Philadelphia, PA.

Nothing written here represents the views of my employer.

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