winterspeak.com

The Arnie-dollar lives

2009-07-07T15:33:00.001-07:00

It seems that California is on the verge of turning it's IOUs into real currency:

The Business and Professions Committee unanimously passed the bill by Assemblyman Joel Anderson during its first legislative hearing Tuesday. The bill requires the state to accept its own IOUs as payment for money owed to the government.

The Arnie-dollar (almost) lives!

Inflation 2.0

2009-07-06T10:02:00.000-07:00

Long time reader MP asks:

I have been an avid Winterspeak reader for a few years now and given your track record on the housing bubble (we corresponded in the past about that) I figure it pays to follow your analysis closely. I’m pretty sold on the Mosler stuff you summarize but the one area where I haven’t seen a concise explanation is that of inflation. Is the argument that inflationary pressure just isn’t a factor, or that money through a payroll tax holiday has no more impact than the money being thrown into the system via the stimulus plans, or something else? I know this isn’t a very precise question…but basically how does the concept of inflation play into this theory? What is the endgame on that?

Excellent question.

"Inflation" is a slippery topic -- the standard definition is an increase in price levels across a broad basket of goods (Consumer Price Index: CPI). The CPI has all sorts of problems with how it is calculated, and how meaningful it is, so I'm not a big fan.

Most importantly, CPI conflates two different factors and gives us a net result which hides more than it reveals: "dilution" (through the creation of more money, which chases goods) and "technological change" whereby new technologies reduce prices. So, someone comes up with a more efficient way of making cars, and cars get cheaper. The Government prints a lot of money, creating inflation, and cars get more expensive again. The net result is that prices stay the same, but the benefits the non-Governmental sector would have received from cheaper cars was taken by the Government printing dollars. In a world of technological process, and constant money, you should see continual, mild, deflation. The more progress there is, the more the Government can take by printing money, without it showing up as higher prices -- you just get the absence of lower prices. This is the typical Austrian view, and it has a lot going for it.

However, adding Mosler's insight from the fiat money world changes how this works. The amount of money in the world is flexible, and most of the "printing" happens via extension of bank credit, not Government printing. Money, like all financial assets, exists as both an asset and a liability, whereas in the "gold standard"-centric Austrian interpretation, money is an asset to its holder and a liability to no one. Financial assets must, by accounting, net to zero. Money supply can increase as balance sheets expand, but they must always net to zero. So the culprit of dilution is credit, not the Fed or the Treasury.

More importantly, the "too many dollars chasing too few goods" is the best definition of inflation -- dollars have to chase goods for inflation to be an issue. If the Government prints money, and it just gets saved, then, although the money supply has been "diluted" (a la that Austrian school) from a practical perspective, it's like the money doesn't exist at all, since it just sits in checking accounts. Does the presence of all that checking account money mean that banks can lend more? No -- bank lending is constrained by capital requirements and demand for credit by creditworthy borrowers, not deposits, and not reserve requirements. If the Government prints money that just gets saved, it's like the proverbial tree falling in the woods: there is no inflationary impact.

Public debt (the deficit) must, by accounting, equal private savings. If the Government spends more then it taxes, that spending bids up the price of whatever the Government is buying. Taxation "sterilizes" the impact of that spending by taking that money out of the private sector. If the private sector naturally saves a lot (like Japan) then it "self sterilizes", enabling the Government to spend more (run higher deficits) without triggering an increase in the CPI. The mystery of Japan, with its sky high savings rate and 30 years of decline, is why the Government bothers to collect any tax at all.

If the private sector, as a whole, decides to save more, you'll see a fall in overall spending, reduction in incomes, debt default, inventory liquidation, and deflationary spiral current in effect in the US. The private sector, as a sector, cannot increase its savings. For one sector to increase its savings, another sector must decrease its savings. Assets must balance liabilities. The Federal deficit must fund the private demands for savings, or you will simply see debt default, lower aggregate demand, and unemployment as incomes keep falling as household try (in vain) to increase savings. Similarly, if the private sector wants to net dis-save, the Federal Government must run surpluses (tax more than it spends) to keep that private credit expansion from creating inflation.

You get inflation whenever you have too many dollars chasing too few goods, ie. too much Government or Private spending not sterilized by taxation or credit restriction. The desire for private sector savings is exogenous, it is Keynes' "animal spirits" and it ebbs and flows based on mass whimsy. When the desire to save is low, or negative, the Government must run surpluses to net destroy money, and/or throttle private (bank) credit extension, to control inflation. If the private desire to save is high, the Government must run deficits to fund that demand, it cannot rely on private (bank) credit extension because that is pro-cyclical. The current monetary response has not stopped deflation because lowering interest payments destroys private aggregate demand, and enriching banks "pushes on a string". The only thing holding up aggregate demand right now is unemployment, as unemployment drives higher deficits, and thus funds private sector savings. It also reduces the private sector demand for savings, as those without jobs run through their savings and/or spend what public transfers they receive.

Inflation control requires counter-cyclical fiscal management, nothing more, nothing less.

The Problem with the Obama Non-Stimulus

2009-07-05T19:59:00.001-07:00

Straight from the horses mouth:

BIDEN: Well, look, we have increased the amount of money unemployed -- those on unemployment rolls have gotten, 12 million are getting more money because of the stimulus package.

We've increased the number of people eligible by 2 million people. We've given a tax cut to 95 percent of the people who get a pay stub. They have somewhere -- $60 bucks a month out there that's going into the economy.

There is a lot going on, George. And I think it's premature to make the judgment?

STEPHANOPOULOS: So no second stimulus?

BIDEN: No, I didn't say that. I think it's premature to make that judgment. This was set up to spend out over 18 months. There are going to be major programs that are going to take effect in September, $7.5 billion for broadband, new money for high-speed rail, the implementation of the grid -- the new electric grid.

$60 a week for *some* American families. As pathetic as 10% unemployment.

Fix the economy to fix the banks

2009-07-02T22:26:00.000-07:00

A great post by Mosler that encapsulates exactly what is wrong with the Obama administration's approach to the crises, and by extension, academic economics. To paraphrase:

The problem with the banks is all the bad loans on their books. But why are those loans bad? What makes any loans bad? Just one thing makes good loans go bad, and that’s people who can’t make their loan payments. Bad loans are loans where people aren't making their payments. If you can make your payments, the loans are good loans, and banks have no problems.

It’s that simple.

So what’s the Obama administration doing about all this? They are keeping the banks alive with trillions of dollars of funding. Yes, throwing trillions at the banks keeps them alive, but it doesn't help anyone make their payments. So the loans are still bad, and the economy is still terrible

Now you know why this crises seems to complicated. When put simply, it makes a mockery of academic economics, and by extension White House policy. Mosler continues:

the States have their own crisis going on.

You’ve all heard about California about to go bankrupt, and lots of other States in big trouble as well. In fact, when the Federal Government let the economy fall apart last year, all the States saw their incomes collapse. And now they are all cutting their essential public services, including police, motor vehicle services, health care services, and even university classes. So what does the Obama administration do? They tell the States to submit lists of thousands of what’s called 'shovel ready projects' to Congress. And then Congress decides what to fund. The States need money to keep the hospitals and the highway patrol open, but Congress will only give them money for new public works projects.

As the private sector increases net savings, aggregate demand falls, and the deficit increases to fund that savings only through unemployment. But Obama funnels money to banks, as the US is now about three months away from double digit national unemployment.

The solution? A payroll tax holiday will fund private savings, and make loans good as workers will remain employed, and have extra take home income to pay their mortgage. A per capita grant to States will keep hospitals open, and let roadworks be postponed for another day. The private sector needs jobs, as the gap between potential output, and actual output, continues to grow. The States need money to continue providing services their constituents actually need. The Federal deficit must grow, by accounting, for the private sector to save. The worst way to grow that deficit is through unemployment.

California scrip

2009-07-02T08:37:00.001-07:00

California is about to create printing presses and start producing it's own scrip... almost. Unfortunately, the California IOU does not seem to be capable of extinguishing a California tax obligation. I'm not sure why this is the case. If it was, a simple step, then the ArnieDollar would be a full fledged currency, and put paid to all those silly arguments about "what is money". Money has the ability to extinguish a tax obligation. A tax obligation is a creation of a sovereign entity. You charge a hut tax, and then invite the natives to work your fields in return for scrip which will, magically, if returned, keep their huts from burning down. The only requirement is that you can, honest to goodness, burn down huts at will. Does this sound like a "store of value" to you?

Global Savings Glut

2009-06-30T10:18:00.000-07:00

Brad Setser has a good point on the Global Savings Glut controversy. How anyone can still give any credence to this notion is beyond me. How on earth can "excess savings" trigger massive de-leveraging?

Few topics are quite as polarizing as the “savings glut.” The very term is often considered an attempt to shift responsibility for the current crisis away from the United States.

That is unfortunate. It is quite possible to believe that the buildup of vulnerabilities that led to the current crisis was a product both of a rise in savings in key emerging markets, a rose that with more than a bit of help from emerging market governments – produced an unnatural uphill flow of capital from the emerging world to the advanced economies, and policy failures in the U.S. and Europe.

I can see how this idea might seem plausible in 2005. But in 2009 the fact that it is nonsense is quite clear.

By accounting, an increase in surplus (savings) in one area must be matched by an decrease in savings (deficit) in another area. Every asset must have a liability. So, it is true by accounting that an increase in debt in the West must have had an increase in surplus elsewhere (China, oil exporters) but events have made the causality clear: Western debt drove surpluses elsewhere. Private sector debt, unlike public sector debt, must be financed out of income, and it is clear the US debt levels cannot be supported by current levels of income. The credit expansion that fueled this increase in debt was bogus, banks stopped lending money and instead gifted it. China can impoverish it's people and trade their income (output) for US dollars (FX savings) to whatever degree it wants. This benefits the US, but does not work well for China. It is, however, sustainable, and it it unwinds it will only be good for China. But debt that cannot be serviced out of income will catastrophically collapse.

Smartest man at Chicago

2009-06-28T07:15:00.000-07:00

Great interview of Kevin Murphy, the smartest person I met at Chicago (and that's saying something). Every time I listen to him, I learn something new. Latest learning (re: healthcare):

What really does matter is the cost of treatment. If treatment costs are $10 trillion, the project has a negative net present value even if the research is free. With $2 trillion in treatment costs, the net gain from success is $3 trillion, so that we would get a good return even if the probability of success was one in 30. So when you think about research, it’s not the dollars you spend that matter—what matters is the cost of implementing the treatment that might be discovered. The downside to research is not failure, but unaffordable success.

I think the following message comes out of that exercise: Cost containment and health progress are complementary. That is, if we can control costs, that makes research a much more attractive option.

New Deal 2.0

2009-06-26T16:30:00.000-07:00

I liked this article which points out that the Obama administration has transfered money to rich bankers, when it should be transferring money to households.

State and local governments have been forced into draconian budget cuts, firing workers who are among the most reliable in making their mortgage payments–when they have jobs: firemen, policemen, teachers, civil servants.

Yet the Obama administration won’t spend even a small fraction of what it has wasted on the banks to cover state shortfalls. The guarantee of $5.5bn in short term notes for California was deemed to be fiscally irresponsible, yet hundreds of billions have already been allocated to the likes of Citigroup, AIG, and Goldman Sachs, all of whom have already beefed up salaries and bonuses as they emerge from the embrace of the federal government.

Good for the banks, bad for the economy

Banks are also benefiting from lending programs that effectively allow them to borrow at zero and reinvest in Treasuries at around 3%. A bank doesn’t have to do anything to make money. The banks’ return on equity is going to be very good. They are going to be able to restore their finances.

While this is good for banks, is it good for anyone else? The problem is the government’s “free money” program means banks have little or no incentive to do any actual lending. Combined with rising unemployment and the ongoing housing crisis, this means any recovery is likely to be muted, at best, especially given the ongoing weakness in the real estate market.

Giving money to banks does not help fund higher consumer savings and support aggregate demand. The increase in household savings, and subsequent fall in aggregate demand, is what is driving the recession. Thank goodness for unemployment -- that's the only thing driving the Federal deficits needed to fund private savings and stabilize AD, but unfortunately, at a low level. The Obama administration could have taken a "float all boats" approach by cutting payroll tax, and funding private savings that way, but instead chose to enrich bankers and put labor on sale. Banks are pro-cyclical, a strengthening economy will get them to lend, nothing else.

...Except maybe for Federal dictat. Nice post on how the 1970s Community Reinvestment Act, and subsequent legislation and regulatory enforcement, contributed to the housing bubble after all. At the time, I'm sure no one understood how the pieces would come together and create this disaster. Same thing is happening now.

There is all this confusion about banking which I do not understand. I would have thought that this crises would make certain point completely obvious:
(1) Banks are pro-cyclical, the amplify what's going on in the broader economy, not drive it
(2) The liability side of a bank's balance sheet is no place for market discipline
(3) Financial regulation fails
(4) Banks should focus on making loans that will be paid back (credit risk)
(5) Banks are public-private partnerships
(6) The current banking system net destroys value

From this, the core of a new banking structure seems straightforward. The Obama administration does not realize any of 1-6.

Why Japan has spent a generation in the doldrums

2009-06-24T10:57:00.001-07:00

From The Times:

With recovery elusive, a population doddering into old age and perhaps a decade of deflation in prospect, Japan may start mulling the most radical monetary policy of all — the abolition of cash.

Unorthodox, untried and, said one Bank of Tokyo Mitsubishi strategist, “in the realms of economic science fiction”, the recommendation has nevertheless begun floating around Tokyo’s corridors of power and economists have described Japan as particularly suitable as a testing ground.

If you want to witness the lunacy of monetarism, this is it. The argument goes like this: monetary policy is zero bound since you cannot have negative interest rates, people will just switch out into cash. Therefore, if we eliminate cash and force all money to be held electronically, we can decrement accounts and have negative rates.

It's utter rubbish. Suppose your dollar account was being decremented, and you were not allowed to hold dollar bills. Would you begin spending, or would you rush your savings into another currency, or maybe even gold?

A high savings rate means that the Government can buy more economic output without having to sterilize that fiscal action through taxation. The real question isn't why does Japan have cash, it's why does Japan bother to tax? Answer: it has no clue what it's doing.

How Investment Creates Savings

2009-06-08T13:33:00.000-07:00

In the standard identity, Savings (S) = Investment (I). The typical causality associated with this: people save, and those savings are parceled out as investment, comes from the gold standard world and, as such, is non-operative in today's fiat world.

It took me a long time to think through why this was the case, but you can see me work through it in this old Interfluidity comments thread.

Briefly:

1. In a given period, an economy produces a certain amount of stuff. This quantity of stuff is that economy's real income.

2. Some of that production (real income) is consumed in the same period. The rest of it is not consumed, and is, instead saved/invested.

3. If you look at it in nominal terms, then income not spent is saved. If you look at it in real terms, production rolled over to be available for consumption in the next period (either in capital stock, or inventory) is investment. Thus savings and investment and flip sides of the same coin. If you don't consume all of your real output in a given period, then someone, somewhere, must have consumed less than they produced (saved). Real investment is recorded as nominal savings. Savings is how we account for real production that's been made available (via investment) for a subsequent period.

The sorry state of officialdom

2009-05-28T15:19:00.000-07:00

Ezra Klein asks:

Recently, I asked an administration official which government program we'd remember as making the most difference in averting catastrophe. Where will the history books place the credit?

"It'll be the Federal Reserve," he replied. "It'll be their decision to increase the size of their balance sheet from whatever it was before the crisis to whatever it is now."

The Fed stepped in to do the intermediation that the banking system was failing to do. By buying longer term government bonds (issued by the Treasury) the Fed decremented one number in their spreadsheet, and incremented another number in their spreadsheet by the the same amount. By substituting one financial instrument for another financial instrument, they "averted catastrophe".

I see this as instituting FDIC insurance where there was none before. If you insist on a system that has built in bank runs, then you need to take market discipline away from the liability side of the ledger.

But the "green shoots" we may or may not be seeing right now come from unemployment, high taxes linked to income, and Federal unemployment insurance. The Federal Government has swung massively to deficit, and begun to undo some of the harm done by the surpluses of the Clinton years. It's still too soon for Obama's fiscal "stimulus" plan to kick in, so the deficit has grown through automatic stabilizers: when people lose their job, they stop saving, stop paying taxes, and start getting fiscal transfers from the Government. Unemployment reduces demand for savings. There was no need to do it this way, it converts a nominal problem into a real one. Savings are easy and free to fund.

If Obama gets serious about shrinking the deficit, through a VAT or higher marginal taxes, then we'll see aggregate demand fall again and the economy slump back into recession, requiring higher unemployment rates to once again increase the deficit, and fund the private sector's demand for savings. We may also see the Fed getting even more active as they uselessly and impotently move a number from one cell in their spreadsheet to another.

Public Service Announcement

2009-04-30T21:00:00.000-07:00

This is for everyone who is flooding my wife's ER:

http://doihavepigflu.com

Please pass this on to your friends and family members.

Automatic destabalization

2009-04-29T13:08:00.000-07:00

From the Economist:

The restructuring of Dubai Inc has begun. Nakheel shed 15% of its staff in December and has continued to pare its numbers since. Sheikh Muhammad’s own Dubai Holding has also cut staff. “Last year, people would talk about how many houses they owned,” says one Dubai veteran. “Now, they talk about how many friends have lost their jobs.” Other economies benefit from automatic fiscal stabilisers as the unemployed stop paying taxes and start spending welfare benefits. The UAE suffers from an automatic destabiliser: 30 days after a foreigner loses his job, he loses his right to stay. Once they leave, Dubai’s ex-expats will spend nothing in the economy they leave behind.

It is true that the West, particularly the US post 1930s, has automatic stabilizers that increase the size of the Federal deficit when aggregate demand falls. In this way, unemployment triggers fiscal expansion, which funds net private sector savings and stabilizes aggregate demand. It could be done through simply cutting taxes, but Govts prefer to do it the hard way (exhibit A: the Obama administration).

Dubai runs net surpluses, is a currency user, and has Abu Dhabi who, as an oil exporter, can sort of print dollars but sort of not. I need to think through whether reducing population is the right automatic stabilizer for that kind of economy.

Mankiw's basic accounting error

2009-04-20T14:38:00.001-07:00

We live in a fiat world, where assets and liabilities have to balance, but Harvard econ profs seem to think we are still on some gold standard, where money is an asset to its holder, and a liability to no one. Greg Mankiw's misconception is clear:

If we want to prop up aggregate demand to promote full employment, what is the alternative to monetary policy aimed at producing negative real interest rates? Fiscal policy. Essentially, the private sector is saying it wants to save. Fiscal policy can say, "No you don't. If you try to save, we will dissave on your behalf via budget deficits." That fiscal dissaving would push equilibrium interest rates upward. But is that policy really welfare-improving compared to allowing interest rates to fall into the negative region?

Private sector savings is funded by Federal deficits. If the private sector wants to save, it will either shrink aggregate demand and fail, or it will be generate larger deficits and succeed. Greg's fiscal policy makes no sense. For the private sector to save the public sector *must* dissave, the same way every asset must be balanced by a liability. It's an iron law of accounting. Public deficits, far from thwarting a private demand to save, are necessary and sufficient to enable that saving.

As for whether fiscal dissaving pushes equilibrium interest rates upwards, surely the example of Japan shows that interest rates respond to whether fiscal deficits are large enough fund private savings demand. Japan's been at ZIRP for years, and public debt runs at 250% of GDP.

How Unemployment Stops Deleveraging

2009-04-10T14:29:00.001-07:00

Equity Markets have bounced into spring, and Barak Obama sees "glimmers of hope" in the economy. News follows prices, so we shall see where prices end up in the coming months, but the economy seems to be falling more slowly.

Unemployment figures show why this is:

In the US, aggregate demand (the sum of Government spending, private spending on consumption and investment, and the current account surplus) has been falling, primarily because the private sector has stopped taking on more debt and is paying down the debt it already has. It has had to do this because it had burdened itself with more debt than it could support out of income, and asset appreciation has to end eventually.

When one sector delevers, another sector has to lever up in order to support aggregate demand. As consumers stopped spending, business stopped booking income, which lead to falling profits, increased unemployment, lower spending, etc. etc. This is Keynes' "paradox of thrift". The Government can step in and lever up to counteract this delevering, but Obama, not wanting to let this crises go to waste, picked slow Government spending increases over fast tax cuts to increase the deficit. The federal deficit funds private savings, the Government needs to spend in order to give us the money we need to pay taxes and net save. If Obama had reduced the fiscal drag the Government imposes on the private sector, by suspending the payroll tax, we would have seen aggregate demand remain up, banks remain healthy, etc. etc.

Thankfully, there are automatic stabilizers in the economy that work through employment. When someone because unemployed, they start eating through their savings, stop paying taxes, and draw on Government unemployment benefits. All of these "automatic stabilizers" reduce private sector savings, and increase the Federal deficit, thus supporting aggregate demand. It's doing things the ugly way, but when the administration picked a slow fiscal stimulus instead of a payroll tax holiday, unemployment was the only thing left to drive up the deficit in the short term.

So, unemployment is good for the economy so long as it drives up the federal deficit, and the economy is faltering through increasing private sector savings reducing aggregate demand. There are much easier ways to get to this nominal result so it's hard to say too much good about it, though.

Horror at Central Bank ignorance

2009-04-06T17:12:00.000-07:00

Both Paul and Brad are horrified that advocates of Ricardian equivalence do not understand the implications of their own model. Fair enough. Others may be horrified that macroeconomists, operating on the global stage to influence policy, do not understand how Government spending and taxation works. Here's Paul:

If the government introduces a new program that will spend $100 billion a year forever, then taxes must ultimately go up by the present-value equivalent of $100 billion forever. Assume that consumers want to reduce consumption by the same amount every year to offset this tax burden; then consumer spending will fall by $100 billion per year to compensate, wiping out any expansionary effect of the government spending.

Nope. Government is a currency issuer. Non-Government is a currency user. Government spending creates money, Government taxation "uncreates" it. The Government never needs to tax in order to spend. If the Government spends an extra $100B a year forever, with no increase in taxes, it will inject an extra $100B/year into the private sector, which may trigger inflation, or it may not, depending on what the private sector does with that money. Right now, money is being saved, so it will not trigger inflation, although it may help support aggregate demand and employment. If the Government increases taxes by $100B/year, that will sterilize the impact of the spending, and thus reduce the money the private sector has available to save. In inflationary times, this will reduce inflation. In deflationary times, it will further reduce aggregate demand, and increase unemployment.

"Ricardian equivalence" is based on the gold standard notion that the Government needs to tax first in order to spend. This is non-operative in the fiat world we live in.

Advocates of Government spending should understand how Government spending works.

Gaming PPIP for fun and profit

2009-04-06T10:21:00.000-07:00

Just two strategies. Jeffrey Sachs:

Consider a toxic asset held by Citibank with a face value of $1 million, but with zero probability of any payout and therefore with a zero market value. An outside bidder would not pay anything for such an asset. All of the previous articles consider the case of true outside bidders.

Suppose, however, that Citibank itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total.

Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank's net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K.

Rortybomb:

Let’s say you are a bidder for Bank A. You know your banking asset is worth $50, and you also know the asset Bank B has is worth $50. You call your buddy up, the trader at B, and make a deal. Happens all the time. You go to bid, and you bid $80 for B’s asset. Then you wait. If B doesn’t come through, you are screwed out a lot of money. And hey, isn’t this wrong? Well, you are pretty sure one of those Rubin-protégé government whiz-kids has given someone who knows someone you know a wink-wink about this. You take a drink, steady the nerves. Then, the bid comes back for your asset - $80 from B. You have each bid up each others assets and traded them. And now the government is screwed.

At Enron, they called that something like the Death Star. Or Ping Pong.

Getting it backwards

2009-04-06T08:23:00.000-07:00

I like Megan, but this article made me laugh:

If you can't or won't read the notes to a 10-K or 10-Q, you should not be investing in bank stocks. Let me put that another way. IF YOU CAN'T OR WON'T READ THE NOTES TO FINANCIAL STATEMENTS, YOU SHOULD NOT BE INVESTING DIRECTLY IN STOCKS.

Cool, we are on the same page. Next:

But we are not doing this to fool investors; we're doing it because of regulatory capital requirements. The problem with things like reserve ratios is that while in theory they should be countercyclical, in practice they aren't.

By reserve ratios, she almost certainly means capital requirements. The notion that reserves somehow constrain lending is completely wrong, and is at the heart of all the ineffectual monetary policy littering the financial landscape today. Bank lending is constrained by capital requirements on the supply side, and quality borrowers on the demand side, with the driving factor today being on the demand side.

Also, capital requirements (what Megan means when she says "reserve ratios") are NOT countercyclical in theory. They are PRO-CYCLICAL in theory, which is great because they are also PRO-CYCLICAL in practice. The notion that credit extension drives the economy is the biggest fraud that the financial sector has perpetrated on us, and has everyone from the Obama administration on down believing that you need to FIRST fix the banks to THEN fix the economy, whereas in real life, restoring aggregate demand to the economy FIRST would "magically" "fix" the banks. "Magically" because no one would understand how helping consumers save will help restore aggregate demand, and "fix" because banks aren't broken, they're just pro-cyclical and the cycle is against them right now.

Maybe you need to understand banking, capital requirements, reserve requirements, and aggregate demand as well as reading 10-Ks and 10-Qs to the necessary qualifications for investing in banking stocks.

Social Security: Real vs Nominal

2009-04-03T08:56:00.000-07:00

Mike Shedlock has the usual complaints about social security, but his arguments reveal that he does not understand the difference between "real" and "nominal".

'The U.S. recession is wreaking havoc on yet another front: the Social Security trust fund.

With unemployment rising, the payroll tax revenue that finances Social Security benefits for nearly 51 million retirees and other recipients is falling, according to a report from the Congressional Budget Office. As a result, the trust fund's annual surplus is forecast to all but vanish next year -- nearly a decade ahead of schedule -- and deprive the government of billions of dollars it had been counting on to help balance the nation's books'....And given that every cent of the fund has been spent, exactly how is the treasury supposed to repay that fund in light of $9.3 trillion (with a T) budget deficits when the "surplus" is a mere $16 Billion (with a B)?

Finally, why does everyone continue the charade of calling Social Security a "trust fund" when it's clearly not a fund and there cannot possibly be any trust in it?

Think about it -- the Government is a currency issuer, it has no need to "balance its books", nor will it ever bounce a check. Ever. Even Zimbabwe does not bounce cheques (although with it's recent move to the dollar, that might change). He is correct that there is no "fund", as SS obligations are merely part of the Government overall obligations. It certainly makes no sense for a currency issuer to keep a reserve of its own currency. Does American Airlines need to keep a reserve of it's frequent flier miles?

I first heard this analogy from Mosler, and it's extremely helpful. Imagine that the US as 300M retirees, and only one worker. Those worried about the SS "shortfall" (whatever that means) are concerned that the 300M retirees will not have enough money to pay the one worker for all the stuff that they want. This is the "nominal" view, and it is clearly ridiculous -- the problem is not how much money the retirees have or do not have, the problem is whether the worker is productive enough to make all the stuff the 300M retirees want.

The Obama Administration is bumping it's head against the same invisible wall. Take a walk outside -- you will see that the US has plenty of stuff. It also has plenty of needs, and plenty of idle resources to put to work. The problem of falling aggregate demand is entirely *nominal* -- people do not have enough zeros after whatever number is in their bank account. Solution: add a zero to every bank account. Or stop uncreating money through a payroll tax holiday. Whatever, it's a nominal problem, not a real problem. If you go to a third world country, you'll see real problems there.

Instead, the Obama administration, keep engaging in a number of increasingly expensive and deceitful practices to increase the number of zeroes in the accounts of bankers. This is because they think bankers are as important to the economy as bankers think. They are wrong. Banks are pro-cyclical, and will turn once the economy does. Banks are in the business of making loans that will be paid back, although they exited that business from 2000-2007. Once the non-bank private sector is able to pay back loans, and is interested in taking on debt, banks will revive. The Obama administration remains focused on the wrong part of the nominal economy -- it should just help the non-bank private sector save by running up its deficit.

On this crises, Michael Lewis said:

Since the beginning of the crisis I’ve wondered why the government has found neither the will nor the way to attack the root of the problem -- the people who borrowed money to buy homes they shouldn’t have bought.

Now I think I understand. It would be too simple. People would understand a lot of small payments to the guy down the street who doesn’t deserve them, and become outraged. Far better to throw trillions at opaque corporations, the inner workings of which no one still really understands.

He's wrong. People would be OK if the Govt gave a small payment to the guy down the street who doesn't deserve them so long as they get the same payment. One is a transfer, while the other simply raises all boats. The problem is that the transfer is not going to the financial industry.

Quick posts

2009-04-02T17:08:00.001-07:00

Excellent, illustrated explanation of the put options embedded in the Obama Administration stealth bank recapitalization program (PPIP). BofA and Citi are the primary beneficiaries, but the way PPIP is structured, it's a big hand out to the whole industry.

The big G20 news is the $1T funding of the IMF. The key element there is "$", as this facility essentially means that the US Gov is making unsecured dollar loans to other countries. (Well, the loans might be secured with pesos and stuff, but who cares). I cannot tell the difference between this and the swap lines the Fed opened up last year, except the swap lines were transparent and this facility is patently not.

I don't know how the US Gov is setting up this $1T facility. If it deficit spends to fund it now, that will be OK, but to the extent it increases demand for US$, it will undo the stimulative effect that high unemployment is having domestically. Aggregate demand is falling because the US is not creating money (deficit spending) fast enough to supply the demand for private dollar savings. To the extent that the IMF increases or supports demand for private dollar savings, it sterilizes the effect of the deficits the US decided to grow through unemployment. Michigan -- we need another 10% in the bread line!

Maybe the bankruptcy of Chrysler and GM will finally create enough unemployment, and deficits, to stimulate the economy and put a floor under aggregate demand. Obama decided to go ugly, and he's getting there!

In other news, Obama's shadow Treasury Secretary seems to have nigh bankrupted Harvard. They had too much money anyway.

AIG as beard

2009-03-31T14:27:00.000-07:00

AIG passed on most of the bailout money it received to twenty large banks, Deutsche Bank and Goldman Sachs being the top two recipients. I argued that AIG was kept alive so it can act as a beard and enable the Obama administration to continue recapitalizing financial firms covertly, because overt recapitalization would require creditors to take a haircut, which seems to be unacceptable to the Govt.

A slightly old, but good, post on Calculated Risk shows other ways that AIG is acting as a beard, enabling the Obama administration to continue to try and recapitalize by stealth:

What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were 1) one-time in nature due to wholesale unwinds of AIG portfolios, 2) entirely at the expense of AIG, and thus taxpayers, 3) executed with Tim Geithner's (and thus the administration's) full knowledge and intent, 4) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

Don't look for it in the NYTimes though.

Adam Posen puts it well from the bully pulpit:

What the Obama team is proposing is disconcertingly similar to the actions of Japanese Prime Ministers Hashimoti, Obuchi, and Mori in 1995 and 1998: Rather than ask the legislature for straightforward recapitalization money, you have the political leadership preferring to risk overpaying current owners of toxic assets rather than forcing sales. For all of Japan’s supposed intervention in markets, its government still lacked the stomach for taking over banks, let alone closing them.

The IMF's advice to America

2009-03-27T13:10:00.000-07:00

I have no idea how good the IMF's advice has been to developing countries historically, certainly Paul Keating didn't think much of Geithner, but it's still worth reading Simon Johnson's account of what the IMF would tell the US if the US needed money from the IMF (which it does not). Market's are up, and things are looking sunnier, but it's hard to disagree with this:

The conventional wisdom among the elite is still that the current slump “cannot be as bad as the Great Depression.” This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big.

We really don't know. And a great deal depends on what politicians decide to do. Japan, again, is instructive:

But the U.S., of course, is the world’s most powerful nation, rich beyond measure, and blessed with the exorbitant privilege of paying its foreign debts in its own currency, which it can print. As a result, it could very well stumble along for years—as Japan did during its lost decade—never summoning the courage to do what it needs to do, and never really recovering.

Japan's been stumbling for 25 years now, trapped in deflation as public debt -- running at about 250% of GDP -- is still not large enough to meet the Japanese demand for savings. Why does the Japanese Government tax at all? It truly boggles the mind. It also does not make me feel better about the US. Johnson again:

“It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

See that -- two sentences back to back, written by someone who claims to be free of the "jedi mind control" the financial industry is able to exert over politicians and academics alike. "No one is going to lend a nickel until the economy turns"... "the economy can't recover until the banks are healthy and willing to lend." If the US Govt stopped draining private spending power through taxes -- not spending anything more, just reducing the fiscal drag it casts every week through FICA, and every April 15th -- the economy would turn. Loans would be paid down. Defaults would fall. Layoffs would taper. Spending would increase. Incomes would increase. Banks would lend. It isn't complicated, but when Simon Johnson cannot see the connection between two sentences, that he wrote, right next to each other, it does not give one much hope.

The banks have made the world believe that the economy needs them to recover. The truth is that banks aren't nearly as important as they think they are. Well capitalized banks cannot help a broader economy trapped in debt deflation. Rising aggregate demand will make whole any bank, regardless of its capital adequacy.

Watchmen

2009-03-27T11:46:00.001-07:00

Totally rocked. Removing the squid was a huge improvement. Didn't miss the pirates. Loved the sound track.

Very slow links

2009-03-26T10:11:00.000-07:00

Nothing about these four links is quick.

Download the word doc Seven Deadly Innocent Frauds of Economic Policy and spend some time with it. It's Mosler's clearest entry level explanation of post-Keynesianism I've seen, although maybe I'm just used to it by now. The comments are also very good.

From the comments, see what happens when post-Keynesianism meets extreme Monetarism here and here. At the margin, they are not so different, but I'll write soon about why quantitative easing has been such a bust so far, and why it will continue to be a bust.

Finally, I recommend both the post, and the thread, on Interfluidity. Maybe we can help James Surowiecki (whom I've enjoyed reading for years) understand that loans create deposits, not the other way around.

Why you don't need banks for the economy to recover

2009-03-25T08:31:00.000-07:00

The Economy drives Banking, Banking does not drive the economy

It is an article of faith that you need healthy banks for the economy to recover. The logic goes that if banks aren't healthy, they won't make loans, and if they don't make loans, the economy cannot grow. A bank is "unhealthy" if it is undercapitalized -- that is to say that it does not have enough equity to meet capital requirements, and therefore cannot engage in additional lending. (Under law, this condition would also trigger FDIC receivership, but that law does not seem to apply today.) If a bank was to write down the value of its assets, then it would also need to write down the value of its equity, and thus put itself into FDIC receivership. Etc.

While the mechanics of the above are true, it is not true that restricted bank lending is causing this "crises". Although it is called a "credit" crises, it is in fact a fall in aggregate demand. Aggregate demand is consumer spending plus consumer investment plus government spending minus taxes.

When the private sector, as a whole, wants to spend less and save more, aggregate demand falls. This increase in savings shows up as an increase in inventory, which gets counted as investment but is nothing like what we would imagine true investment to be (factories, bridges, etc.) Moreover, you will also see credit fall, as instead of taking out money to buy things, people simply pay down existing debt or hoard cash in the bank. The causality is backwards: lower aggregate demand is reducing credit, lower credit is not reducing aggregate demand. Similarly, the cycle will turn the same way: higher aggregate demand will increase the demand for credit, more credit availability will have no impact on aggregate demand if the private sector is still in the midst of deleveraging.

Moreover, falling aggregate demand reduces the private sector's ability to service debt loads, which is what reduces the asset (receivable) quality of banks balance sheets. If you lose your job, you're more likely to default on your mortgage. Again, the received wisdom gets things backwards: bad balance sheets are not harming the economy, the bad economy is harming balance sheets. Once aggregate demand begins to grow, balance sheets will "magically" fix themselves.

Banks are not nearly as important to the economy as they claim they are.

Obama's Bank Bailout enriches Bankers, but does not help the real economy

Obama claims that the banking bailout is critical to get the economy back on track. He is wrong. The banking bailout is critical to lining bankers' pockets, but no more. A growing economy will fix banks, just as it will generate additional lending, which will create more deposits, and additional (real) investment, which will create more savings. Sound lending is important to an economy, but banks are procyclical, and a lagging indicator, not a leading one.

When Regulation cannot work, Fear must

This self-serving "logic" is clear in this resignation letter, which somehow found its way into the NYTimes: AIG: I quit. It will be interpreted as the reason why the US Govt should not claw back the absurd bonuses given to bankers by those who believe that banks are critical to getting the economy back on track. If a regulatory system is continually and systematically gamed, as the financial system clearly does, then the answer is never more regulation (which will simply be gamed around), but retroactive penalties on bad actors. If you cannot set up the right rules in advance, then you must move the goal posts after the fact.

People who claim that the AIG bonuses are small potatoes miss the point: they are very big potatoes to the actors who received them and incentives are a critical factor behind all of this.

The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money.

Because he got lucky. Or not. The point is that in every other business, firm profitability impacts individual and group level compensation. If your firm makes net minus infinity, you don't get anything.

The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats — even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.

Also wrong. In a word where regulations exist only to be "innovated" around, fear must be the prime motivator, as rule of law cannot be. The CEO should be afraid that all of his money will be confiscated if he blows up the world financial system. He must create compensation structures that massively impoverish people if they blow up the world financial system. Employees must keep a close eye on each other, in case someone is doing something that will blow up the world financial system. This is called "risk management" and it is something that the financial industry should try.

Tax Payer "Profit" is an Oxymoron

Taxpayers, aka the Government, can print all of the money they need, anytime they want. The very concept of "profit" to a currency issuer is completely nonsensical. Their only goal should be maximizing the quantity of real goods and services in the economy, long term.

Some Government actions may cause a higher budget deficit, but put in place better incentive structures to prevent capital misallocation and financial blowups in the future. The true cost of this crises is not just the trillions going down the drain now, but also the trillions misspent on McMansions in the middle of nowhere, empty shopping malls, and office buildings that no one will ever fill. Those represent real opportunity cost. Moreover, the double digit unemployment rate, shuttering factories, and collapsing businesses are real capital destruction too. It is completely worthwhile to run a higher deficit, get capital reallocated correctly, and have a banking system in perennial morbid fear of blowing up.