Learning from Dogs

Learning from Dogs muses the new book from Yves Smith

ECONned, by Yves Smith

In Econned, Yves Smith, founder of Naked Capitalism, argues that the economy was doing just fine in the regulated environment up to the 1970s.  Then began the work of the Chicago economists who challenged Keynesian economics and touted the benefits of deregulation which eventually led to the financial crisis we have today.

Yves argument is internally consistent and well researched, but ignores some factors that I think would change the conclusions drawn from her work.

Yves Smith, author and founder of Naked Capitalism

First, Yves notes that the primary reason that economists are not useful to the real world is that economic research presumes equilibrium.  Smith misses the point here, but it is understandable. It took me years of study and contemplation to fully appreciate that an equilibrium simply gives economists a point of reference, a common base, from which to study shocks and movements. In and of itself, equilibrium is not interesting or important.   But movements to and from equilibrium are of real interest because they enable us to study and try to predict how individuals will react to incentives and changes in market conditions.

Second, we have to put the contributions of the Chicago economists of the 1970s into context.  Up until that time, the only real school of thought in macroeconomics was based on Keynes, who presumed that markets fail and that the government must play an active and large role – primarily through government spending and taxes — for the economy to perform well.  Keynes’ work was a reaction to the Great Depression.

Friedman’s monetarism also sought to explain the Great Depression, but focused on the role of monetary policy on the economy. This work showed that the missteps of the Federal Reserve was the primary cause of the depth and length of the Great Depression, and that long-term accommodative monetary policy causes inflation.  This body of work did not stress deregulation, although it did lean more heavily on enabling private market solutions than on replacing them with government solutions.  Neither theory is complete; Keynes focused on the short run (“In the long run, we are all dead” is a rather famous Keynes quip) and Monetarism focused on the long run.

There was a second large body of work that came out of the University of Chicago during the late 1960s and 1970s.  This research documented the tremendous costs of regulation. I know this literature personally and believe that its conclusions are very sound:  it shows that any effective regulation limits either the quantity or price of a good or service away from what it would have been without the regulation.  In fact, in my view, it was the passage of regulations requiring certain lending behavior that set off the series of events that led to the crisis, which is the exact opposite argument from what Ms. Smith makes.

By Sherry Jarrell

Growth in final GDP hides disturbing weaknesses in economy

The U.S. GDP grew at an annual rate of 5.9% in the last quarter of 2009 which may look good at first glance, but when we dig a little deeper, we find some concerns about the implications for sustainable growth.  A large fraction of this reported growth came from businesses selling off accumulated inventories, which has more to say about past production than current. Exports were also a significant source of fourth quarter growth, driven in large part by a weak dollar.

Weak dollar both helps and hurts the economy

Of course, a weak dollar is a very mixed blessing for the economy, and is hardly a sign of a strong or recovering economy.

Real residential fixed investment increased 5.0 percent, helped along by the extension of the home purchase tax credits from the federal government.

New housing helps spur growth in GDP

Real nonresidential fixed investment increased 6.5 percent. This figure nets out nonresidential structures, which decreased at a troubling rate of 13.9 percent, and equipment and software, which increased 18.2 percent. Investment in equipment and software consists of capital account purchases of new machinery, equipment, furniture, vehicles, and computer software; dealers’ margins on sales of used equipment; and net purchases of used equipment from government agencies, persons, and the rest of the world. Own-account production of computer software is also included, which is production performed by a businesses or government for its own use.

Again, the underlying figures show that those variables most associated with building a sustainable productive capital base for the economy – nonresidential fixed investment –are declining at an alarming rate. This, combined with a 9.7% unemployment rate and the specter of rising debt levels, energy prices, and taxes, paints a picture of a slow to non-existent recovery to a robust economy any time in the next year.

http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

by Sherry Jarrell

A Magic Pill for Everything?

I am always struck by Man’s desperate groping for a Magic Solution to each and every problem. It is a bit pathetic but also of course rather funny, especially if one tries to see things from the perspective of a visiting alien from outer space.

Looking for a Magic Pill?

Let’s take “The Fat Pill”. What we really want is not to eat properly and cut down our vast consumption of just about everything but especially burgers, chips, popcorn swamped in sugar, honey or chocolate, giant steaks and pizzas, crisps, candy, and of course alcohol and simultaneously combine this with a healthy lifestyle involving regular exercise that makes us pant (to get the heart going – nothing to do with sex, though Tiger Woods is clearly pretty fit)!

No, what we prefer is to keep on stuffing ourselves and then take a FAT PILL! Whoever invents this is going to make Bill Gates look like a starving rickshaw- puller in India.

Then there is the ALCOPILL. Rather than drink in moderation to the benefit of all and sundry many of us prefer to binge ourselves to the point of death and then, just before hitting the sack (if we make it that far), grope for the magic pill. I believe pharmaceutical companies worldwide are working furiously on this in the hope of hitting the jackpot. Much more profitable than boring old stuff with malaria, which kills millions every year.

It may be cynical old age, but I’m currently off magic solutions. As a language teacher, I saw the desperate scrambling for nirvana when language laboratories came in. Every school had to have one; every timetable was hacked about; teachers would become redundant ….. Oh dear … most language labs are now broken-down, dusty and abandoned piles of junk at the bottom of some rubbish tip somewhere.  Are wind-turbines in the same category?

dot.com? This was the magic pill of the late 1990s! The new paradigm. Everything would be different; billions could be made without doing any real work. Oh, and does this remind us of the banker’s world? Of course, they are an exception because DESPITE everything they can STILL make billions for doing no real work.

As for government finance (a quite different animal), the current British magic pill is to print money and bung it into the economy in the hope of stimulating “growth”. None of this “living within our means”, taking “a bit of strong medicine” stuff. No, we’ll go for the magic pill so we can get back to normal levels of debt and spending. Patience, virtue, moderation and commonsense are much less fun than the magic pill of printing money.

And there is a VERY GOOD reason for this of course: the GENERAL ELECTION is around the corner and we don’t want any pain BEFORE then, do we? After, of course – if we get the right result – we will have a bit of commonsense back. Not that we want to, but it’ll be forced on us by the markets … but then we can blame it all on someone else. In Britain’s case, Mrs. Thatcher will probably still come in for considerable stick, even though she left power nearly twenty years ago.

Magic? Sadly, one can see the same desperate groping for the easy solution in religion. We are metaphysically, morally, spiritually and practically lost, so let’s look for some magic to provide a solution, even if there is not the slightest proof of the existence of God that would stand up in court.

Our epitaph may well be: Homo Sapiens – the Magic Species. Unfortunately, magic is best left to conjurors; it is not a recipe for managing society.

by Chris Snuggs

Could the U.S. government default on its bonds?

I’ve been asked many times over the years for advice on investing. “What is the market going to do?” “Should I be invested in stocks or bonds?” And, especially in the last few weeks, “Should I hold U.S. or foreign government bonds?”

A U.S. treasury bill

Those are some good questions!  The answers are not as “good.”  The factors that drive the yields on treasury bills and bonds are complex and, despite Ben Bernanke’s pronouncements to the contrary, less well understood than stock returns, and I don’t have a crystal ball, but I can at least begin to frame an answer to these questions here.  I will come back to expand on this topic over time, as markets, economies, and world events evolve.

The return on both bonds and stocks is measured as the percent change between the market price today, and the cash flows received later.  The cash flows of a bond, namely coupon payments and principal, are specified in a contract; if they are not paid, the issuer is in default, and the bondholder has the right to take them to court.  The cash flows on stock, dividends and capital gains, are residual; they are discretionary, and are paid out only after debt payments and other obligations are paid.  For this reason, bonds are considered to be less risky than stocks, and the nominal yields on bonds are generally lower than those of stocks.   The risk-adjusted returns on stocks and bonds may be the same, but the nominal yields on bonds are typically lower.

There is an important distinction between the nature of the returns on bonds and stocks. With bonds, the future cash flows are known.  Movements in the bond’s yield are determined simultaneously with movements in the bond’s price. Once a bond is issued, only changes in interest rates (yield, risk) drive unexpected changes in its price.  Stock prices, on the other hand, fluctuate as either risk or residual cash flows change.  As a result, changes in a bond’s price, hypothetically at least, are a much cleaner indicator of the market’s expectations of future market rates of interest than a stock’s price.

One problem that distorts the information about expected future interest rates that is revealed by changes in the bond’s price is that bonds are less frequently traded than stocks, so the price data on bonds is less comprehensive and complete. In addition, the reported price data that form the basis of bond yield models often diverge from actual market-clearing prices, so that bond pricing models may not describe actual market behavior. Lastly, there is such a tremendous volume of economic and policy information, some of it conflicting, that is crammed into this one variable, the bond price which, given the coupon and principal, summarizes the market’s referendum on future interest rates.

by Sherry Jarrell

Next time: Sources and types of risk in U.S. and other bond prices.

A very good idea from the Canadians

Read this quote:

“Time and again we see behaviour by people – we are talking highly educated, high income people – who are making less than ideal financial decisions for themselves and their families,” said one source. “Other countries that have developed a strategy have focused on education in high schools. This task force has come to the early conclusion that, while enhanced financial education is vital over the long term, it is insufficient.”

The first sentence is so important, to my mind, that it is worth repeating, “Time and again we see behaviour by people – we are talking highly educated, high income people – who are making less than ideal financial decisions for themselves and their families,”

This comes from a piece published by the Canadian newspaper, The Globe and Mail, about a Canadian taskforce that is

Group will be headed by Sun Life's Don Stewart

looking into ways of making Canadians “more savvy” about their personal finances.

The financial industry is very adept at producing complex financial products that are almost beyond the limits of the understanding of good common people.  We, the people, need to be much smarter and that’s why this initiative from the Canadians seems, on the surface, to be such an excellent idea.

By Paul Handover

Looking more closely at the implications of changes in the Fed rate

Fed Funds rate influences consumer and business interest costs

Does the Fed Funds Rate, the rate charged by the Federal Reserve to make short-term loans to banks, directly influence the interest rate consumers and businesses pay on credit cards, mortgages, and consumer and business loans?  If you took the word of the average business news commentator, you would think not.  But the answer, of course, is yes.

One way to view the market rate of interest, although certainly not the only correct or useful way, is to think of it as a base rate that represents the risk-free rate, a rate that compensates the population for its impatience to consume the goods it would have consumed had it not lent the funds out in the first place. This risk-free rate is also influenced by the efficiency and functioning of the capital markets that bring borrowers and lenders together.

A risk premium is then added to this base rate of risk-free interest, one that varies depending on the degree of uncertainty of the lender getting repaid.  The risk of default, the risk of prepayment, the risk of political uprising, exchange rate risk, and many other sources of uncertainty — including the risk of inflation — raise the level of the risk premium commanded by lenders in the market.  As an example, over the last 100 years or so, the average annual risk-free rate in the U.S. has been about 4%, and the average annual risk premium for equity securities has been about 8%, bringing the average annual observed interest rate or rate of return to about 12% on these securities.

So what happens to the interest rate charged to consumers and businesses when the Fed raises the fed funds rate?  Basically, the level of the risk-free rate in the economy rises and, as debt contracts expire or new lending takes place, this higher base rate gets factored into the market rate of interest charged.

Overall, the demand for loanable funds falls, the aggregate demand curve for the economy falls, and equilibrium output and employment fall, RELATIVE to where they would have been without the rate increase. The bright side is that a reduction in the money supply that accompanies an increase in the fed funds rate is absolutely essential to curtailing inflation, which drives the risk premium, and represents a much greater cost to the economy.

By Sherry Jarrell

Here’s one person who doesn’t agree with the President.

The President seems to believe that he can say whatever he wants and no one will hold him accountable. He now claims that “every economist, from both sides of the aisle, believes that the stimulus program created jobs.”

I am an economist, Mr. President, and I know, based either on simple first principles of economics, or on a more rigorous controlled study of labor markets in each major sector of the economy, that the unemployment rate would have been much lower today had the stimulus program never occurred.

You are either woefully unaware of the facts, Mr. President, or are purposefully distorting the facts. Neither is good.  When are you going to realize that just because you say something does not make it so? The world does not contort itself to support your version of the truth.

Do not put words in my mouth, sir.

By Sherry Jarrell

When is a freeze not a freeze?

President Obama’s proposal to freeze parts of federal government spending over the next three years is a lot like a smoker buying a truckload of cigarettes one year before promising to “freeze spending” on cigarettes the next.  He can keep smoking for years to come without spending another dime.

Federal government spending has increased so much over the last year — by some estimates at a rate of 34% — that in December of 2009 the debt limit had to be raised to $12.4 trillion to help absorb a record-shattering $1.4 trillion deficit.

The promise to freeze spending is actually a guarantee that spending will remain at record high levels for the next three years.  It effectively prevents a reduction in federal spending.

How disingenuous of our President.

By Sherry Jarrell

Foxes and hen-house?

I’m not quite sure how I feel about this yet.  The Fed recently announced that it has appointed a long-time staffer with the New York Fed to head a newly created branch to oversee the the parts of its balance sheet acquired in efforts to bail out firms like AIG.

These massive asset purchases, orchestrated by Timothy Geithner, the current Treasury Secretary and former New York Fed official, ballooned the Fed’s balance sheet from $800 billion in primarily government bonds to $2.3 trillion in toxic assets.

Now the New York Fed is overseeing the assets brought into the Fed by the Treasury Secretary as he moved from the New York Fed to the Treasury.  All while the Treasury functions are supposed to be isolated from the Federal Reserve’s role in its implementation of monetary policy.

Smacks of the fox watching the hen house….

By Sherry Jarrell

It’s more than semantics to understand what we mean by The Fed’s profits.

The Federal Reserve, it has been reported, earned record “profits” of over $46 billion in the year ending December 31, 2009.  The previous record profit was $34.6 billion in 2007. The Fed earned $31.7 billion in 2008. The financial crisis has apparently been very good for the Fed, although, as a non-profit entity, all its profits are turned over to the Treasury.  As an aside, I wonder what the Treasury plans to do with its windfall?Reduce taxes? Hmmm.

Be careful, however.  ”Profits” are a bit of a misnomer for the Fed’s activities, because they pay for what they do by creating money out of thin air.  To buy a financial instrument such a treasury bill or mortgage-backed security, which is added to the left-hand-side of their balance sheet as an asset valued at cost, they create (and I do mean “create,” in the true sense of the word) an equivalent amount of deposits on the right-hand-side of their balance sheet. It does not “cost” them resources as it would you, or me, or a business.  The “expense” is deducts from revenues to arrive at this period’s profits consist mainly of employee salaries.  

So if the Fed purchased a bunch of assets with reserves that they created, where do the “profits” come from?  Keep in mind, there are two major drivers of profits.  One is efficiency, or doing more with your resources. The second is pricing power, being able to charge an above-competitive price for a good or service either because you own something scarce or you make up the rules of the game.

First, two minor sources of income to the Fed are the interest and fees it charges for operating the financial system, such as check clearing and interbank electronic payments, and those it charged participants in the emergency loan programs it undertook to support credit cards and auto loans.

By far the largest source of revenue to the fed, however, came from its open market operations and the purchase of toxic assets.  The Fed had about $1.8 trillion in U.S. government debt and mortgage-related securities on its books by the end of 2009, four times the level in 2008, and the interest payments it collected on this huge pile of assets generated much of their (so-called) profits.  But interest payments are only one source of returns on financial assets. The other is “capital gains” or “price appreciation.”  If and when the Fed sells these assets, some of them considered “toxic,” there is a real risk that they will incur significant capital losses.   For example, the central bank recorded a $3.8 billion decline in the value of loans it made in bailing out Bear Stearns and AIG.

So the Fed’s profits are this period’s interest income minus the Fed’s minimal operating expenses; the capital base on which it earns income is basically “free.”  And all of these figures focus on one-period accounting entries, ignoring the huge potential negative stock of value the Fed’s activities are generating.

Don’t misunderstand. The Fed provides an invaluable service to the national and world economies, and they generally execute those services very well.  But when they begin to try to act like a business, replacing existing investment banking with their own activities, and parade around profit figures as if they meant the same thing as private industry profits, we must step back and take a moment to understand that Fed profits mean something entirely different from corporate profits.

By Sherry Jarrell