Marginal Revolution

Ike Brannon, where is my talk?

Tyler Cowen

My Wednesday evening, Washington, D.C. talk on the financial crisis.  Both I and some MR readers would like to know, so please leave the answer in the comments.  If you know Ike, could you please forward this inquiry to him?  My email for him isn't working and tomorrow I am on the road.

And for those of you wondering about my Bloggingheads.TV with Robin Hanson, Robin had a cold and we will reschedule it.

Arnold Kling's alternative: lower capital requirements

Tyler Cowen

My alternative is to encourage new lending by lowering capital requirements at the margin. Tell banks that loans issued after September 1, 2009, require half the capital of similar loans issued before September 1. Some banks are in such bad shape that even with those lower capital standards they will not be able to make new loans. Fine. You don't want those banks to grow. But other banks have room to grow, and you want them to grow more than they would under the existing regulations.

As with changing accounting rules, lowering capital requirements ultimately exposes the government funds that insure banks to more risk. That is the flaw in the idea. However, there has to be some risk exposure to tax payers for any policy that encourages bank lending.

Here is more.  One question I have is how to calculate the existing capital for the very worst, most insolvent, and most corrupt banks.  You don't want them making loans to their uncles, so to speak.  Would requiring 1/2 capital discriminate usefully against such banks or would it in fact select for their relative expansion?  Or do we have this problem in any case?

Via Brad DeLong, here is a summary of the Dodd plan.  It sounds like an improvement over the Paulson plan.

Paul Krugman on why the liquidity trap really matters

Tyler Cowen

Read his latest post, which outlines many key but usually unstated assumptions behind monetary theory and policy.  It is one of the most instructive econ posts to appear in some time. 

That said, on the policy issue I think one of Krugman's earlier posts (I can't find it) is closer to the mark.  With or without a liquidity trap, monetary policy can't fix negative real shocks and -- here is now the earlier Krugman -- monetary policy can't make insolvent (or potentially insolvent) banks whole.  That's my take on why the Fed is relatively powerless, not because of a liquidity trap.  If you believe, as a Keynesian would, that insufficient aggregate demand is the problem in the first place, you will be relatively worried about liquidity traps.  If you believe, as a neo-Austrian would, that malinvestments and coordination problems are the key issues, you will look toward other factors which limit the power of central banks to restore order. 

In my view sometimes the Keynesian perspective is relevant, but not so much today.  As the contraction of credit spreads through the Fed-regulated banking sector, however, and the broader money supply aggregates come under stronger negative pressure, the Keynesian perspective is likely to become more relevant.  That is in fact my major medium-term worry and we probably should be pessimistic in this regard.

There is a separate and very important liquidity issue about restoring the markets and valuations for bank loans, but this is not a liquidity issue in the sense of Keynes's portfolio theory or the traditional liquidity trap.

Addendum: Brad DeLong adds comment.  Another way of putting my point is this: in the situations where a liquidity trap might be binding, there is usually some even worse constraint which is more binding, thereby making the potential liquidity trap not so much a problem at the relevant margin.

Markets in everything, India electoral fact of the day edition

Tyler Cowen

According to the study...almost one in two voters in Karnataka, where assembly elections were held in May, had taken money for voting or not voting.

However, the share of voters is higher among the voters in the so-called below the poverty line, or BPL, category: 73% in Karnataka while the national average is 37%.

And the price?

“The bribe money varies from state to state. It may be Rs100-150 (a voter) in some states and it can go up to Rs1,000 in some constituencies,” said Rao, adding that the CMS study refers to only cash bribes, not the value of liquor or other material inducements being doled out during election campaigns.

The exchange rate is about 45 to 1.  Here is the full story.  It is estimated that one-fifth of the Indian electorate sells its vote in some manner.  I thank Deane Jayamanne for the pointer.

Won't Get Fooled Again

Alex Tabarrok

The regulation of derivatives

Tyler Cowen

Be wary when you hear talk of "derivatives" without further qualification.  They fall into three quite distinct categories: exchange-traded, over the counter (OTC), and swaps.  Here is the best overall paper I know on that division.  Wikipedia is useful as well.

I'll cover swaps in a separate post soon, so for now let's set those aside.

Exchange-traded derivatives include the instruments traded at the Chicago Mercantile Exchange and The New York Stock Exchange.  Their regulation has overall gone well and no one serious has alleged that they are responsible for our current financial problems.  That said, a single regulator is preferable to our current dual SEC-CFTC structure.

Most but not all OTC derivatives are interest rate derivatives.  Equity derivatives fit this category as well and so do credit default swaps (even though they are called "swaps" they do not here fit into the swaps category). 

These instruments are OTC because no clearinghouse in the middle guarantees the deal.  That means more credit risk and that no single middleman is tracking net positions on a more or less real time basis.  Ideally we would like to make OTC derivatives more like exchange-traded derivatives and we should consider regulation toward that end.  (Do note that private swaps regulators have already done quite a bit to clear up the issue of hanging and unconfirmed transactions.)  At the margin the social benefits of such homogenization are higher than what the private swaps regulators will bring on their own accord.  In essence homogenization and trading through a clearinghouse limits the leverage issue to a single, easily-regulated institution and therefore it limits the problem of counterparty risk.

The cost of such additional regulation will be higher transactions costs for the trades themselves and also greater contract homogeneity, which is a requirement for exchange trading, netting, and clearing.  We need to make this move wisely and carefully, otherwise OTC derivatives could move to even wilder and less well regulated markets.  Simply trying to shut down the OTC markets, even if that were the economically ideal vision (unlikely), would in terms of risk prove counterproductive.  But the strong market positions of New York and London do make some effective regulatory action possible for OTC derivatives, especially if done in concert.

The lack of sufficient offset and netting and the inefficient spread of counterparty risk across a large number of institutions is an important issue behind current crises and it does not receive enough attention in most blogosphere discussions.

How about Europe?  The 2006 Markets in Financial Instruments Directive extends traditional European financial regulation to OTC derivatives.  Here is one source: "MiFID expands the definitions of financial instruments to include other frequently-traded instruments, including contracts for difference (CFDs) and other types of derivatives such as credit, commodity, weather and freight derivatives."  Here is one overview of MiFID. 

Implementation and enforcement is on a country-by-country basis and of course the UK is the big player.  Read pp.27-29 in the very first link above and you'll see that overall the UK has a looser regulatory approach than does the United States, though not on every single matter.  For instance the UK is stricter on regulating hedge funds in OTC derivatives markets.

The more important point is that no country uses regulation of the derivatives market as its major line of defense against financial crises.  Rather countries regulate their financial institutions, their risk, their leverage, and their accounting directly, of course with more or less success.  Regulating the derivatives market, as opposed to regulating the institutions, and their possible participation in those markets, simply isn't a very effective instrument.

To sum up: a) we should regulate OTC derivatives more, b) those regulations should aim toward establishing netting and well-capitalized clearinghouses, not micro-management of those markets, which would prove both impossible and counterproductive, and c) regulating OTC derivatives is only a weak substitute for regulating the institutions which trade in them.

The U.S. passed the Commodity Futures Modernization Act of 2000, which, among other things, limited the ability of the federal government to regulate OTC derivatives.  I'll cover that Act in a separate post and yes I do think it should be amended.  But I'll start by saying that most blogosphere critics of the act simply do not know or understand much of the above.

A defence of the Paulson plan

Tyler Cowen

It's always worth hearing from both sides, in this case Nadav Manham:

This [the purchases of the Paulson plan] has the effect of modestly increasing the stated book value of these financial institutions.  More importantly, with the toxic waste off the books, it improves the likelihood that an outside investor--Treasury itself, a sovereign wealth fund, even our man in Omaha--now feels able to value the enterprise.  Hold your nose and admit it:  the relatively few franchises that manage the capital raising and M&A activities of Corporate America are worth a lot.

3) Said outside investors collectively have enough capital to recapitalize the major Wall Street insitutions via injections of new equity.  Here comes the tricky part: In exchange for their largesse, both the outside investors and Treasury (e.g. via warrants struck at the same price as the outside investor) must be allowed to invest on very favorable terms.  In a perfect world existing equity holders and stock options would be essentially wiped out, a la AIG.  In an even more perfect world, existing debt holders (i.e. unsecured lenders to Morgan Stanley, Merrill, etc.) would also take a big haircut, just as they usually do when corporations declare bankruptcy. 

4)  Both liquidity and solvency are restored, credit starts to flow again, and the downward spiral of asset sales is prevented, allowing whatever pain will occur to occur over time, and to be spread widely.

...as far as I can tell, the plan does not specify when Treasury is obligated to buy toxic assets, nor does it prevent Treasury from doing another AIG.  Conceivably it could wait until the maximum moment of pain to get the best price possible for its assets.  Or it could continue to do AIG-style bailouts followed by purchases of the toxic assets, in a sense bailing out itself.

There is more at the link.  A key assumption here is that jump-starting liquidity for bank assets is a big part of the cure; having the government dilute bank equity, as the Elmendorf plan suggests, does not on its own achieve this end.  I do find this a reasonable view, though as Paul Krugman points out it is unlikely that it is only a liquidity issue.  The implicit belief here is that resolving the liquidity issue is needed to make progress on the solvency issue.  Maybe.  But still I do not like the Paulson plan.  It reminds me of everything I dread about unchecked power and the administration's score on this question is very, very bad.

Assorted links

Tyler Cowen

1. Jose Saramago starts blogging; here in Portuguese, here in Spanish.

2. The world's most expensive hotel rooms; via Craig Newmark

3. Milton Friedman YouTube video, from way back when with Milton at his peak.  Black and white, and thanks to Yana for the pointer.

4. 9-minute video of Julian Simon.

5. Frank Partnoy, financial prophet.

Matt Yglesias, drunk

Tyler Cowen

The plan is bad. But bad policies get enacted all the time. But we’re at a point now where congress is, allegedly, in the hands of progressive leadership. Simply put, if congressional Democrats manage to acquiesce in a plan that spends $700 billion on a bailout while doing nothing for average working people and giving the taxpayer virtually no upside in a way that guarantees that even electoral victory would give an Obama administration no resources with which to implement a progressive domestic agenda in 2009 then everyone’s going to have to give serious consideration to becoming a pretty hard-core libertarian.

It’d be one thing for a bunch of conservative politicians to ram a terrible policy through. Then we could say “well, if some progressives win the next election things will be different.” But if this comes through an allegedly progressive congress then the whole enterprise starts looking pretty hollow.

Here is the link.  Personally, I don't get drunk, but there are a number of enterprises -- not just Matt's -- which are looking pretty hollow these days.  And I don't just mean banks.  You can blame lots of the crisis on government -- more than most people think -- but at the end of the day it is hard to escape the conclusion that markets simply have performed horribly in a number of important regards.

As one of Matt's commentators indicates, it is time for both candidates to show up in Washington and start...um...acting like Senators.

Addendum: Via Greg Mankiw, here is a chilling analysis of the bail-out.  Get this line:

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Second addendum: Also via Matt, here is a round-up of critical commentary on the Paulson plan.  Count me in too, among those screaming "no!"  Yet it seems it's going to happen.

And Now for Something Completely Different

Alex Tabarrok

• Philosopher Saul Smilansky says his work is a cross between Kant and Monty Python. I'm not sure I'd go that far but I enjoyed hearing Smilansky and Will Wilkinson on blogginheadstv.  I discussed Smilansky's paradox of retirement argument earlier.  He is now out with a book, Ten Moral Paradoxes.

• Pictures from the most alien place on earth.  Worth a look (scroll down). Hat tip to Craig Newmark.

• The Sarah Connor Chronicles doesn't get any respect but I thought the first season was great in an action-packed, edge-of-your seat, thrill-seeking sort of way.  The second season has just begun.  Summer Glau plays the Spock/Data learning-to-be-human cyborg that John Connor can't admit he wants to interface with.

How big was the Nazi premium?

Tyler Cowen

Every now and then I like to post about history:

Firms connected with the Nazi party outperformed unaffiliated firms massively. Their share prices rose by 7.2% between January and March 1933 (43% annualised), compared to 0.2% (1.2% annualised) for unaffiliated firms. The politically induced change was equivalent to 5.8% of total market capitalisation. This is a high number by international standards. Johnson and Mitton (2003) estimate that revaluation of political connections in Malaysia during the East Asian crisis wiped 5.8% of share values. While comparable in magnitude, it took 12 months for this change to occur.

Here is more, interesting throughout.

Facts about banks

Tyler Cowen

...the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to around 2,000 billion euro, (more than Fannie Mai) or over 80 % of the GDP of Germany. This is simply too much for the Bundesbank or even the German state to contemplate, given that the German budget is bound by the rules of the Stability pact and the German government cannot order (unlike the US Treasury) its central bank to issue more currency. The total liabilities of Barclays of around 1,300 billion pounds (leverage ratio over 60!) surpasses Britain’s GDP. Fortis bank, which has been in the news recently, has a leverage ratio of "only" 33, but its liabilities are several times larger than the GDP of its home country (Belgium).

The Fed has possibly been bailing them out too (not necessarily by intention), as it is likely that some of these institutions had heavy exposure to the weaker U.S. institutions.  Here is the link.  Those failures should also put the U.S. regulatory failures in perspective.  And what would happen if a big U.K. bank were on the verge of failing?  Would the Fed have to step in there too?  Contagion is contagion, as Aristotle once said...

International public goods? Public bads?

Tyler Cowen

Among the potential sources of tension is the Treasury’s ultimate decision on whether it will buy troubled mortgage-backed securities from non-American banks. European banks, like UBS, invested heavily in such securities.

“If Paribas has bought a mortgage-backed security, why can’t they present it to Treasury?” Mr. Truman said. “If the government is going to do it for the American banks, they should do it for everyone.”

But that could provoke a strongly negative reaction from lawmakers on Capitol Hill, who already protested that other countries should chip in for the $85 billion rescue of the insurance giant American International Group, because it has operations in those countries or has insured their banks.

“Are the taxpayers in the United States going to bail out all the banks in the world?” said Allan H. Meltzer, a historian of the Federal Reserve. “I just don’t know how this works out.”

Here is the story.

Markets in everything, literary world edition

Tyler Cowen

Part of this new policing mentality is that publishers are becoming more   risk-averse – children's book authors, for example, are being asked to sign   contracts agreeing to 'appropriate conduct' in their private lives.

Here is much more, mostly a discussion of how digitalization is changing the literary world.

Sentences to ponder

Tyler Cowen

“It’s important to pay taxes if you want to live a normal life,” said ‘Lisa’, a prostitute who spoke with the newspaper.

That's from Sweden (no mention of patriotism), and apparently some social benefits are attracting more prostitutes to the taxed sector.  The record of income creates or enhances rights to sick-leave pay, parental leave benefits, and a pension.  Note that in Sweden it is illegal to buy sex but not to sell it.

Thanks to a loyal MR reader for the link.

Mindles Dreck is the Dreck of my dreams

Tyler Cowen

I'd like to reproduce chunks of his old yet prescient post (or go here and scroll down to 22 January):

Pundits continue to link the Enron debacle to a need for increased regulation, especially of derivatives. What most of these people...don't appreciate is that regulation and/or accounting rules are the most fertile breeding ground for derivatives and synthetic or packaged securities. Regulations and accounting rule-inspired transactions describe the bulk of the well known derivative-related blow-ups of the last two decades. Proscriptive regulation and the derivative trade have a symbiotic relationship.

Investors and operating companies buy derivatives for two basic purposes: speculation and risk transfer. A derivative, (a financial contract based on the price of another commodity, security, contract or index) either eliminates an exposure, creates an exposure, or substitutes exposures. That last one, substituting exposures, is important to heavily regulated investors.

For example, insurance companies were a goldmine for derivatives salespeople in the last two decades, only slowing down in the late 1990s. The fundamental reason for this is not because insurance executives were stupid, but because they manage their investments in a thicket of proscriptive regulation. Insurance companies have to respond to their national regulatory organization (the NAIC), their home state insurance department and the insurance departments of states in which they sell or write business. They file enormous statutory reports every quarter using special regulatory pricing, and calculate complex risk-based capital reports and "IRIS" ratios regularly.

Even though the insurance industry has been heavily regulated throughout the entire post-war era, the incidents of fraud and financial mismanagement have been numerous and spectacular.  Remember Marty Frankel? Mutual Benefit Life? For each of these cases that are in the news, there are many smaller ones you don't hear about. Some of that may be the nature of the industry, but it doesn't make a prima facie case for more regulation...

Insurance companies often need the yield of less creditworthy obligations. So derivative salesmen see an opportunity to engineer around the regulations. They package securities that substitute price volatility for the proscribed credit risk. Then the investor can be compensated for taking some additional risk, and the banker can be compensated for creating the opportunity. A simple example of this is the Collateralized Bond Obligation (CBO). A CBO is created by buying a bunch of bonds, usually of lower credit quality, putting them in a "special purpose vehicle" (SPV) and then issuing two or more debt instruments from the SPV. The more senior instruments can obtain an investment grade rating based on the "cushion" created by the junior debt tranche. The junior bond absorbs, for example, the first 10% of losses in the entire portfolio and only when losses exceed that amount will the senior obligations be impaired. The junior instruments, known as "Z-Tranches" become "toxic waste", suitable only for speculators and trading desks with strange risks to lay off (or, in a famous 1995 case, the Orange County California Treasurer).

A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing - they decrease frequency of loss but increase the severity. So they blow up infrequently, but when they do it's often a big mess. Ratings-packaged instruments are less risky than the pool of securities they represent but often riskier and less liquid than the investment grade securities for which they are being substituted. As a result, they pay a yield or return premium (even net of high investment banking fees). That premium may or may not be enough to pay for their risk. But they pass the all-important credit rating process and are therefore sometimes the only choice for ratings-restricted portfolios reaching for yield.

...[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests that regulation is often the derivative salesman's best friend. Complicated rules encourage complex transactions that seek to conceal or re-shape their true nature. Regulated entities create demand for complex derivatives that substitute proscribed risks for admitted risks. If a new risk is identified and prohibited, the market starts inventing instruments that get around it. There is no end to this process. Regulators have always had this perversely symbiotic relationship with Wall Street. And the same can be said for the ridiculously complicated federal taxation rules and increasingly byzantine Financial Accounting Standards, both of which have inspired massive derivative activity as the engineers find their way around the code maze.

Dreck, in case you don't know, used to blog with Megan McArdle over at Asymmetric Information.  Here is what happens when you enter "Star Dreck" into YouTube.

Luigi Zingales on the Paulson bailout -- Kazow!

Tyler Cowen

He doesn't like it.  And he has another idea:

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture.  But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain.  Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few.

And now come the real zingers:

It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.

Addendum: Here is further comment.

Where we are at

Tyler Cowen

Here is an excellent overview from Arnold Kling, read it.  Soon I will myself cover derivatives in greater detail.

Glass Steagall: The Real History

Alex Tabarrok

Many wise people are now recognizing that the repeal of Glass-Steagall was one of the few saving graces of the current crisis.  Let's thank President Clinton (and Phil Gramm) for that wise bit of deregulation.  The following potted history of the law, however, is all too typical:

Glass-Steagall was one of the many necessary measures taken by Franklin Delano Roosevelt and the Democratic Congress to deal with the Great Depression. Crudely speaking, in the 1920s commercial banks (the types that took deposits, made construction loans, etc.) recklessly plunged into the bull market, making margin loans, underwriting new issues and investment pools, and trading stocks. When the bubble popped in 1929, exposure to Wall Street helped drag down the commercial banks....The policy response was to erect a wall between investment banking and commercial banking.

Given a history like this people wonder how repealing the law could have been a good thing.  But a significant academic literature has investigated these claims and rejected them.  Eugene White, for example, found that national banks with security affiliates were much less likely to fail than banks without affiliates.  Randall Kroszner (now at the Fed.) and Raghuram Rajan found that (jstor) securities issued by unified banks were (ex-post) of higher quality that those issued by investment banks.  A powerful book by George Benston went through the entire Pecora hearings which supposedly revealed the problems with unified banking and found them to be a complete sham.  My colleague, Carlos Ramirez later showed that the separation of commercial and investment banking increased the cost of external finance (jstor).  Finally, my own work (pdf) unearthed the real reasons for the separation in a titanic battle between the Morgans and Rockefellers.

Thus, the history of banking before Glass-Steagall and now our recent experience after is consistent, generally speaking unified banking is safer and repeal was a good idea.

Did the Gramm-Leach-Bliley Act cause the housing bubble?

Tyler Cowen

No.  That is one common myth among the progressive left.  Because it involves financial deregulation and the unpopular Phil Gramm, the Act is vilified and assumed to be part of a broader chain of evil events.  Here are some of the articles which promulgate the myth that the Act caused or helped cause the housing bubble.  One version of the claim originates with Robert Kuttner, but if you read his article (and the others) you'll see there's not much to the charge.  Kuttner doesn't do more than paint the Act as part of the general trend of allowing financial conflicts of interest. 

Most of all, the Act enabled financial diversification and thus it paved the way for a number of mergers.  Citigroup became what it is today, for instance, because of the Act.  Add Shearson and Primerica to the list.  So far in the crisis times the diversification has done considerably more good than harm.  Most importantly, GLB made it possible for JP Morgan to buy Bear Stearns and for Bank of America to buy Merrill Lynch.  It's why Wachovia can consider a bid for Morgan Stanley.  Wince all you want, but the reality is that we all owe a big thanks to Phil Gramm and others for pushing this legislation.  Brad DeLong recognizes this and hail to him.  Megan McArdle also exonerates the repeal of Glass-Steagall. 

Here is a good critique of GLB, on the grounds that it may extend "too big to fail" to too many institutions.  That may yet happen but not so far.   

The Act had other provisions concerning financial privacy.

Maybe you can blame some conflict of interest problems at Citigroup and Smith Barney on the Act.  But again that's not the mortgage crisis or the housing bubble and furthermore those problems have been minor in scale.  Ex-worker has a very sensible comment.  The most irresponsible financial firms were not, in general, owned by commercial banks.  Here's lots of informed detail on GLB and the bank failure process.  Here is another good article on how GLB didn't actually change Glass-Steagall that much.

Here's a Paul Krugman post on GLB; he attacks Phil Gramm but he doesn't explain the mechanism by which GLB did so much harm.  The linked article has no punch on this score either, although you will learn that Barack Obama has scapegoated GLB, again without a good story much less a true story. 

I may soon cover the Commodity Futures Modernization Act as well.

Financial links

Tyler Cowen

1. Very good David Brooks column

2. What would the new RTC look like?

3. When will bank loans fall more?

4. Beating LeBron James at "HORSE"

5. Treasury will guarantee money market funds

The end of central bank independence, a continuing saga

Tyler Cowen

"Why does one person have the right to grant $85 billion in a bailout without the scrutiny and transparency the American people deserve," asked House Speaker Nancy Pelosi (D., Calif) a reference to the loan the Fed gave AIG with the Treasury's blessing.

And:

"No one in a democracy, unelected, should have $800 billion to spend as he sees fit," said Mr. [Barney] Frank.

He was referring to Bernanke's balance sheet and not to Gerald Ford, in case you were not sure.  Here is the link, courtesy of Arnold Kling, who responds: "I just get a chuckle hearing a Congressman complain about someone spending other people's money."  Here is Arnold on RTC-like plans.

Tim Groseclose tells me

Tyler Cowen

Research by UCLA political scientists into the "facial competence" of candidates puts the Republican VP hopeful in the top 5%.

Their paper (http://renos.bol.ucla.edu/AtkinsonEnosHill.pdf ) shows that facial competence explains a significant portion of the vote -- about 4% of independent voters in a congressional election.

Here're some more details: http://renos.bol.ucla.edu/AtkinsonEnosHill.pdf

Elsewhere concerning news events of the day, Megan McArdle covers money market funds here and here.

Links to cheer you up

Tyler Cowen

1. "Crows seem to be able to use causal reasoning to solve a problem, a feat previously undocumented in any other non-human animal, including chimps."  Here is more.

2. "I, Crayon," so to speak, a video.

3. Should libertarians migrate to Canada?

4. Treadmill desks.

Sarah Palin and John McCain on AIG

Tyler Cowen

This was "unscripted", from Sarah Palin:

Disappointed that taxpayers are called upon to bailout another one. Certainly AIG though with the construction bonds that they’re holding and with the insurance that they are holding very, very impactful to Americans so you know the shot that has been called by the Feds it's understandable but very, very disappointing that taxpayers are called upon for another one.

That's via Andrew Sullivan.  It's the phrase "very, very impactful" I object to.  The point about construction surety bonds is actually correct, as indeed AIG did issue them and it doesn't seem that any regulation or state authority will make good those guarantees (readers, correct me if I am in error but I can find no record of such guarantees).  That means a lot of people bought insurance against adverse construction events and will be left without that protection.

Of course this matters less at lower levels of construction.

The real lesson of this quotation is that the Republicans have no good language for discussing recent events.  They're not allowed to say anything that sounds like "showing sympathy for Wall Street," so they have to find someone else to show sympathy for but they can't turn to traditional Democratic rhetoric about how an unregulated capitalist economy is failing us.  Citing the construction bonds is like worrying that the financial crisis will postpone the retirement of many professors.  Yes that is true but it's odd (though not unprecedented) if that's the first thing that comes to your mind or for that matter to your talking points.

Here is John McCain on the crisis, again unscripted, from The Today Show:

LAUER: So if we get to the point middle of the week as we heard in that report where AIG might have to file for bankruptcy, they're on their own?

McCAIN: Well...quote, "on their own"...we have to - we cannot have the taxpayers bail out AIG or anybody else...this is something we're gonna have to work through -- there's too much corruption, there's too much access, we can fix it, I believe in America - we can have a 9/11 commission such as we had after 9/11, 'cause this is a huge crisis and we can come up with fixes and we can make sure that every American has a safer future and that is to make them know that their bank deposits are safe and insured.

Here is more of the session.  He did worse than she did and that's after decades on the national scene.

Should we worry about liquidity traps?

Tyler Cowen

Well, short-term T-Bill rates were very close to zero yesterday.  But I've long felt that the liquidity trap argument is overrated in its import.  Here is my previous post on the topic.  (As you may know, I don't like "re-runs" but I've received many requests for this.)  Here's one bit from the post:

Open market operations, when tried, seem to have worked in 1932. Was Japan in a liquidity trap in the 1990s?  They could have printed more money and given it to me.  With an interpreter at my side, I would have spent it right away.  Who knows, maybe you could have helped me. Here is a good critique of Krugman on Japan.

...What is the evidence for a liquidity trap?  Low nominal rates and the absence of a recovery?  That's not much evidence.  I suspect real coordination problems are at fault in most of these settings, and hoarding is at most a secondary issue.  Few serious economic problems are purely monetary in nature, yet the liquidity trap encourages us to embrace that dangerous idea.

By the way, some sources (now verified) claim that Treasuries "traded negative" for a brief while yesterday.  T-Bills are standard collateral for many kinds of transactions, so for very brief periods of time they can have a shadow value higher than that cash, even apart from the possibility of earning a nominal interest rate.

The liquidity trap is most likely a problem when the Fed is restricted to open market operations, namely trying to trade cash for T-Bills.  A less orthodox Fed (and yes, that is what we have) has many ways around the trap, if indeed it was ever a trap in the first place.

The culture that is French, a continuing series

Tyler Cowen

“I fear the government has passed the point of no return,” said Ron Chernow, a leading American financial historian. “We have the irony of a free-market administration doing things that the most liberal Democratic administration would never have been doing in its wildest dreams.”

While they acknowledge the shock of the collapse of Lehman Brothers, the bailout package for A.I.G. on top of earlier government support for Bear Stearns, Fannie Mae, and Freddie Mac has stunned even European policy makers accustomed to government intervention in the economy.

“For opponents of free markets in Europe and elsewhere, this is a wonderful opportunity to invoke the American example,” said Mario Monti, the former antitrust chief at the European Commission. “They will say that even the standard-bearer of the market economy, the United States negates its fundamental principles in its behavior.”

In France, where the government has long supported the creation of national champions and worked actively to protect select companies from the threat of foreign takeover, politicians were quick to point out the paradox of what is essentially the nationalization of the largest American insurance company.

“Today the actions of American policy makers illustrate the need for economic patriotism,” said Bernard Carayon, a lawmaker of President Nicolas Sarkozy’s center-right governing party, UMP. “I congratulate them.”

Here is the story.  Since I am not a policy maker, I cannot claim that I am being congratulated personally.  Still, I believe I am receiving a kind of indirect congratulations.

The economic fallout from these events is dominating the headlines.  The intellectual and ideological fallout we are just beginning to contemplate.

The good news

Tyler Cowen

There is some.  First, it seems (knock on wood) the Fed and Treasury may make money off the AIG deal, at least over a time horizon of one to two years.  Felix Salmon explains some detail.  The company has assets and if it needs to borrow money it is paying the Fed at Libor plus 850 (!). 

Second, the size of a guarantee does not represent the cost of the bailout.  I have been getting many emails about "the cost of the bailouts" and in truth we still don't know what those costs will be.  But think in terms of balance sheets to start on the problem, not numbers in headlines. 

Third, if the Fed needs to "print money" to make good on various guarantees (NB: this has not been the case), this need not be as disastrous or as inflationary as it sounds.  If it came to this, the Fed is creating money to protect against potentially deflationary events so the inflationary impact of that money creation is blunted.  (That said, you don't usually want to trade in bank-created higher monetary aggregates for an increase in borrowed reserves.)

You might wonder if AIG is (possibly) a money-making deal, why no one else wanted in on the action.  Think of it as a prisoner's dilemma among the lenders.  No one of them wants to put up money at non-exorbitant rates and so the company -- which has partially illiquid assets and profit-maximizing, weakly capitalized shareholders determined to take advantage of lenders -- fails.  But with the guarantee the company can borrow cheaply and the lending continues.  The company can continue and oversee an orderly liquidation.  That's not a pretty picture and it does mean that, in the bad world-states, losses continue to stack up precisely because the guarantee was extended.  But the good world-states are there too and the expected value of the guarantee and purchase may well be positive.  To give an example, Argentina in its crisis days had net positive value but no one wanted to lend to them either.

Recent events remind me of the arguments against free capital movements for developing countries and whether those capital movements boost economic stability and growth.  Well, we have free capital movements for investment banks and insurance companies and of course the losers get hit by whipsaw effects.

Did you notice that short-term Treasuries have been trading at rates close to zero?  That's not good news. 

In presenting all this "good news," I don't mean to communicate a pollyannish attitude.  The bad news is indeed very bad but let's understand it in its proper context.

I'd like to stress again that I remain worried about the rule of law in all these events.  First, the referee is on the playing field.  Second, while Dodd and others are on board, basically we have the executive branch of our government -- the Treasury -- operating without formal checks and balances.  (Does that sound familiar?  Would this administration do that?)  That's why it is all being done through the Fed.  Fortunately the Fed is also a competent technocracy (as is the current Treasury) but the broader implications here are very worrying, both for governance and for the future of the Fed itself.

Maybe there is no better alternative, but these developments are a sign of just how dysfunctional American government has become.

Is central bank independence gone?

Tyler Cowen

It's another bail-out of sorts today, although you won't hear it described as such:

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

Here is the link.  How long will it take to win back Fed independence?  There used to be talk that "The Paulson Plan" would centralize various kinds of financial regulation in the Fed.  But, as it turns out, under the "beta" version of the plan, the Fed goes hat in hand to...Paulson.  I guess that's why they call it The Paulson Plan.

The legal status of the takeover

Tyler Cowen

Here is one opinion:

I imagine that the legal answer to that question depends on a nice distinction between practice and plain language. Under the plain language of the statute, interpreted imaginatively, the Fed can extend credit, upon the right showing, to any company or individual, and so why not insist on conditions on the loan?  Heck, why couldn't EPA, in the name of fishable swimmable rivers (that's Clean Water Act language), ban all pesticides, including dishwasher detergent, or nationalize water users like the steel industry?  Maybe it can!  Which might be good news for environmental activists.

I thank David Zaring for the pointer to this very interesting analysis.  So far I haven't seen a more detailed post, nor has Google, but please let us know in the comments if you are aware of other serious treatments of the question.  The question is justifying the ownership, not the lending.  I'll update this post if I learn more of relevance.  I've also posed the query over at Volokh.com.  Marty Lederman adds comment.  Eric Posner thinks it is fishy and that the "collateral" for the loan would legally count as a sale.

...are doomed to repeat it

Tyler Cowen

Systemic risk can render drastic action necessary.  But what about the prospects for the long term?  Will they truly look up?  David Leonhardt writes:

The Chrysler bailout may have saved the company, but it did nothing, after all, to stop Detroit’s long, sad decline.

Barry Ritholtz — who runs an equity research firm in New York and writes The Big Picture, one of the best-read economics blogs — is going to publish a book soon making the case that the bailout actually helped cause the decline. The book is called, “Bailout Nation.” In it, Mr. Ritholtz sketches out an intriguing alternative history of Chrysler and Detroit.

If Chrysler had collapsed, he argues, vulture investors might have swooped in and reconstituted the company as a smaller automaker less tied to the failed strategies of Detroit’s Big Three and their unions.

...Speaking of which, Detroit’s Big Three have come back to Capitol Hill lately, lobbying for billions of dollars in handouts. This time, their executives insist, they’ll use the money to solve their problems.

Google Heads to Sea, Will You?

Alex Tabarrok

The NYTimes Bits Blog reports:

The search and advertising company has filed for a patent that describes a “water-based data center.” The idea is that Google would create mobile data center platforms out at sea by stacking containers filled with servers, storage systems and networking gear on barges or other platforms.

This would let Google push computing centers closer to people in some regions where it’s not feasible, cost-effective or as efficient to build a data center on land. In short, Google brings the data closer to you, and then the data arrives at a quicker clip.

Perhaps even more intriguing to some, Google has theorized about powering these ocean data centers with energy gained just from water splashing against the side of the barges.

Hmmm, do I spy the work of Patri Friedman, libertarian, Googler and seasteading proponent?  Perhaps the seasteaders are ensuring that they have good internet access.  As you may recall, Paypal entrepreneur Peter Theil is backing the seasteaders so there is more than one Silicon Valley entrepreneur with an eye on the sea.

By the way, the First Annual Seasteading Conference will be held in Burlingame, CA on October 10.  The conference is sure to be interesting but shouldn't it have been held here? 

The Federal Reserve now has commercials

Tyler Cowen

Really.  View it here.  This one is even better.  Here is the Fed on risk protection.  And here: "The Greatest Risk is Not Taking One."  Here is Fed Karaoke.

The sad saga of Almaz Moges

Tyler Cowen

The National Bank of Ethiopia (NBE) has sacked Almaz Moges from her post as General Manager of the turbulent Nile Insurance.

Getahun Nana, Banking and Insurance Supervision Department head, wrote a letter to Nile on June 19, 2008, informing them that her deputy, Dawit G. Amanuel, would take over the post. It is alleged, however, that she refused to hand over the office to her successor. The central bank subsequently shut down the office on Thursday, June 26, 2008.

The letter came a week after the central bank declined to approve two of the seven newly elected members of the Board of Directors. Almaz had been advised by officials at the NBE that the insurance company needed better management. Currently, the company is in debt for more than 50 million Br following various business deals.

Yes the company had excess debt.  Here is the story.  Here is a picture of Almaz Moges.  Here, in black and white, is the authorized role of the bank in regulating insurance companies.  Here is Megan McArdle and here.  Read Felix Salmon.  Here are some cautionary words about strangers.  So can New York State now regulate the Fed?

There is more toast

Tyler Cowen

Russia suspends trading with stocks down 17 percent.  There is a financial crisis and much of it is energy-related:

“The fundamental issue is oil. Russian oil companies are not producing more so their earnings are dependent on a rising oil price,” said Daniel Salter, analyst at ING. If the oil price falls, then earnings downgrades are in the pipeline for these stocks, he added.

State-backed bank VTB tumbled 33 per cent to Rbs0.03 and Volga Telecom sank 28 per cent to Rbs37.

Here is a recipe for Russian toast.  The price of oil was down to $91 a barrel last I looked.

AIG is Toast

Alex Tabarrok

So says Felix Salmon:

AIG's $2.5 billion of 5.85 percent notes due in 2018 plunged 19.5 cents to 33 cents on the dollar as of 9:55 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

(quote from here).  33 cents on the dollar? The message is loud and clear: AIG is toast. This is the massive counterparty failure everybody's been scared of, and frankly I'm astonished that the broader stock market isn't plunging as a result. No one is prepared for the repercussions here: the failure of AIG is likely to be an order of magnitude more harmful than the failure of LTCM would have been. And it's not even happening on a Friday, where we could have yet another Emergency Weekend to try to work things out.

Small thoughts, from the little people

Tyler Cowen

It's a little scary that the world's largest insurance company hasn't planned for a rainy day.

Dilbert's poll of economists on Obama vs. McCain

Tyler Cowen

Obama wins, 59-31 percent, here is the story.  The individuals responding to the poll had this distribution of opinion:

48 percent -- Democrats

17 percent -- Republicans

27 percent -- Independents

3 percent -- Libertarian

5 percent -- Other or not registered

In other words, Obama didn't do as well as I would have expected, relative to the survey group.  There is much more information in the article, such as this:

On the issue of international trade, only 42 percent of our Democratic economists support Obama's plans, with 34 percent favoring McCain. Independents favored McCain on this question by 63 percent to 16 percent, while favoring Obama overall.

Another indicator of objectivity is that the income levels of the economists have little impact on their opinions. The economists with lower incomes are no more likely to favor taxing the rich than the rich economists favor taxing themselves.

Likewise, economists in the academic world were largely on the same page as the nonacademic types in predicting which candidate would be best for the long term.

I thanks Alice Miller for the pointer.  And if you do leave a comment, note that the marginal return to being partisan in this setting is very low or even negative.

Public libraries for tools?

Tyler Cowen

Noah writes to me:

Big fan of the blog.  I was wondering whether there's a reason other than historical accident why the public library model only exists for media like books and music.  I understand the argument that books produce a social benefit that the government should be in the business of subsidizing, but surely there must be other goods with that kind of benefit that can be similarly lent out.  Take the example of tools, most of which are rarely used.  Is there a public good in having a mechanically-fluent citizenry that would justify a system of public tool libraries?  Or is there anything else you think it would make sense to build libraries around?

Reserves, it would seem, and maybe they will waive the overdue fines as well and perhaps even the lost reserves fines.  Mark Thoma ponders an AIG bail-out.

The countercyclical asset, a continuing series

Tyler Cowen

A sale of pickled sharks, butterfly paintings and other pieces by the provocative British artist [Damien Hirst] has raised more than US$125 million — a record for an auction of works by a single artist. And there is more to come Tuesday.

Here is the story and I thank Chris F. Masse for the pointer.  Here are previous installments in the series, including dirt for dinner in Haiti.

China wailing market of the day, a continuing series

Tyler Cowen

I entered the mourning profession at the age of twelve.  My teacher forced me to practice the basic suona tunes, as well as to learn how to wail and chant.  Having a solid foundation in the basics enables a performer to improvise with ease, and to produce an earth-shattering effect.  Our wailing sounds more authentic than that of the children or relatives of the deceased.

Most people who have lost their family members burst into tears and begin wailing upon seeing the body of the deceased.  But their wailing doesn't last.  Soon they are overcome with grief.  When grief reaches into their hearts, they either suffer from shock or pass out.  But for us, once we get into the mood, we control our emotions and improvise with great ease.  We can wail as long as is requested.  If it's a grand funeral and the money is good, we do lots of improvisation to please the host.

"How long can you wail?  What was your record?"

Two days and two nights...Voices are our capital and we know how to protect them...

...Frankly speaking, the hired mourners are the ones who can stick to the very end.

That is from Liao Yiwu's excellent The Corpse Walker: Real-Life Stories, China from the Bottom Up.  Here is a previous installment in the series.  Here is an out of date book, by comedian Eddie Cantor.  Here is a photo: