Zombie Economics

During his campaign for President in 1980, George Bush famously dubbed Ronald Reagan's platform "voodoo economics." He must have been on the right track for in its wake we now see the mythic creations of voodoo doctors walking among us- Zombies.

We have Zombie Banks, Zombie Corporations, a Zombie currency and, if I may go so far, Zombie Economics.

There is, of course, nothing new in this observation. Others have beaten me to the punch. Banks and other corporations which should be dead are still walking, ergo, they are Zombies- blindingly obvious. Yet, just as a miner skilled in deep extraction might buy a vein most think of as "played out" I'm going to deep mine this well used metaphor.

There are many aspects of Zombie lore, from the aforementioned voodoo doctors to the film genre inspired by George Romero's Night of the Living Dead. In Romero's Mythos, Zombies don't do the bidding of their voodoo masters. Instead, they shuffle around in search of the living- to eat. Further, the living bitten by a Zombie become Zombies themselves.

Combining the two mythic strands, Reagan's Voodoo Economics, which manifested in the mind of Dick Cheney as "deficits don't matter" created, by allowing debt levels to rise beyond that which which could easily be extinguished in a normal bankruptcy, the Zombie Banks and other corporations which don't serve their creators but instead feed, not on people, but capital, creating more Zombies in the process.

Unlike those in Romero's films, however, we are not trying to rid ourselves of these Zombies. We are incorporating them in our economic policies. Thus we have Zombie Economics.

In a recent round table discussion, George Soros opined: There are two features that I think deserve to be pointed out. One is that the financial system as we know it actually collapsed. After the bankruptcy of Lehman Brothers on September 15, the financial system really ceased to function. It had to be put on artificial life support.

The problem with the "artificial life support" of the financial system is that the voodoo doctors (government regulators) decided to play Frankenstein- a violation of the laws of capitalism as profound as re-animating dead flesh is to the laws of biology- instead of transplanting the dead banks' useful parts into living organisms.

In a sense, the problem begins at birth. To incorporate is to embody, or give substance to. Nature both incorporates the living and ensures that they die. Modern Man, however, at least the American variant thereof, seems loathe to allow its creations to follow suit.

The "creative destruction" aspect of Capitalism has been aptly described as an evolutionary process- the strong procreate and the weak are culled. Within a Capitalist framework, then, zombie corporations have as little place as zombie humans would in real life.

In Romero's films the living are eventually consumed by the zombies and if we are not careful the same could happen to us. Financially mediated trade has risen, flourished, and died many times in human history- e.g. Roman commerce gave way to Dark Age feudalism. I often wonder if the much more recent experience of Mao-ism (a taste, if you will, of feudalism) informs the Chinese perspective of the virtues of financially mediated trade. They seem amazed that we would flirt with such an outcome.

American leadership, reminiscent of Kubrick's Dr. Strangelove- perhaps Dr. StrangeCapitalist, or how I learned to stop worrying and love Zombies, would be more apt- now faces the daunting tasks of rewriting the rules of Capitalism and convincing our creditors that Zombies are normal. Most recently, Treasury Secretary Geithner visited China and assured them our Zombie currency (the US$) wouldn't consume the capital they create and store therein.

On the home front, Zombies are not just consuming capital, they are, in a sense, consuming Capitalism.

In an ironic twist worthy of Greek Tragedy, the supposed proponents of free markets who refuse to let bankrupt corporations die are engendering the very regulations they worked so hard to remove. They have forgotten one of the essential aspects of capitalism- free markets cut both ways. You are free to succeed AND free to fail.

Complaints over executive compensation, or even transportation weren't credible until those executives decided to turn their corporations into Zombies instead of letting them die. Bankruptcy and dismemberment are the check and balance of Capitalism. Without that check and balance we are left with Zombie Economics and, apparently ever-increasing regulations. The longer we allow Zombies to walk among us the more intrusive will state regulations become.

There is another, more mundane sense of the word Zombie which also seems to apply to the current situation- a person without an animating force, just going through habitual motions.

This last sense seems to aptly describe the US economy in in the 21st Century. While the Clinton years were not without problems, there was an animating force driving the economy beyond the desire to just "make money"- we were getting on the "information super-highway." Yes, it's a cliché, but it worked. Economic growth was, in a sense, a function of, inter alia, getting the country "wired." While the guys doing the "wiring" were getting rich in the process it, at least to me, seemed as if people were excited about more than just money- they had a dream of a wired world in their minds and they manifested it in the real world.

Could it be that Capitalism which aims solely to make money is indeed soul-less?

I believe so.

This isn't a knock on Capitalism, but rather a recognition that the system is a means to an end, not an end in itself. Policies that aim to re-invigorate growth by re-invigorating growth will likely fail. It seems to me that there needs to be a greater goal to engender durable economic growth, be it the desire to save ourselves from Nazi-ism, pave the country for our new cars or wire it up.

Let me try to explain this view from a different perspective. Finance, per se, creates nothing. Finance used in pursuit of a goal can be extremely helpful so long as the goal is not merely making money (at which point the financial system, as seems obvious, becomes parasitic). Finance, in a sense, is a Zombie requiring an animating force, be it the desire to "go green" (by retooling our transportation and energy production sectors), make America beautiful (by rebuilding infrastructure), or some other desire.

We need, it seems to me, a goal, a dream, or we're just going to keep shuffling around like a Zombie.

The Cult of the Uber-Banker

The tendency in the media and the Congress has been to blame the current depression on "stupid, greedy, and reckless" bankers. I believe that that is a mistake. I know bankers. They are not stupid; most of them are smart, and many of them are brilliant. If they are "greedy," it is largely so in the sense in which most Americans (most anyone, I imagine) could be called "greedy": they like money a lot. I read somewhere recently that bankers (a word I use loosely to cover financiers in general) derive their job satisfaction entirely from their monetary compensation, unlike other workers. But that is wrong. Rich bankers derive satisfaction not only from making a lot of money but also from a sense of outsmarting competitors, and in that respect they are not unlike highly paid athletes; in both cases the money the stars are paid do not merely enhance personal welfare, but also are indicators of relative performance. Money is a scorecard of success. Richard Posner

Rudyard Kipling famously argued, If you can keep your head when all about you are losing theirs....you'll be a man. Of course, it is only in hindsight that one can be sure one is keeping one's head.

Perhaps the Bankers really are Nietzchean Supermen? Perhaps intelligence is no longer manifested by following the wisdom of Daedelus but rather by flying high like Icarus?

Then again, perhaps not.

Richard Posner, whose prose in his new book A Failure of Capitalism: The Crisis of '08 and the Descent into Depression and blog suggests a gifted and learned mind, argues the former position.

Bankers, to him, are akin to athletes richly rewarded to push the envelope- to be reckless.

I agree with the comparison, but will argue that this is NOT a sign of intelligence, but of the ignorance of youth.

When I was a bank options trader in my early 20s I chased profits as ardently I chased women- recklessly and without much thought of consequence. I was Icarus and the fear of falling was obscured by the joy of soaring.

I eventually learned that I could fall.

Our Uber-Bankers have been resistant to this lesson, ably assisted in this regard by the Cult thereof. Otherwise intelligent people cheer our Uber-Bankers on like fans in the stadium.

Mr. Posner claims to know bankers. I wonder if he knows athletes? I wonder if he has really thought through his apology for their actions?

In addition to being a banker, I've been an athlete, albeit one who was never paid. In my youth I played Ice Hockey in front of crowds of 100s and it was quite a rush. While I was never the star player when I played competitively, I know the feeling that comes from a roar of the crowd when scoring a goal or body checking an opponent into the boards. Desire for that feeling drives many athletes to actions a saner man would view as mad.

There is a term for people like this- adrenaline junkies- and while they can excite crowds of on-lookers today in much the same way Gladiators of old excited the Romans, to consider them "smart" or worse, able managers of of a vital social function seems to me a bit strange.

To wit, while we might admire the recklessness of a NASCAR driver, we wouldn't want our cab drivers to follow their lead. While we might admire the nerve of a Chuck Yeager, we don't want our commercial air pilots finding out how fast or how high a 767 can go. Should we equip all seats on commercial airlines with ejector buttons and parachutes? It would certainly extend the obligatory safety instructions- in the event the pilot decides to escape the stratosphere and fails you will be expected to hit the ejector button....please wait to deploy your chute until you are clear of all other passengers.

Banking, and finance in general, despite the efforts of CNBC et. al. is not a spectator sport.

I think the Uber-Bankers Mr. Posner glorifies are not smart, nor, in that regard at least, are those who cheer them on and apologize for their excesses as sports agents apologize for the excesses of the athletes in their "stable." They, like Icarus, don't understand that their function is to ensure a safe flight.

Sadly, they have been piloting the US$ 767 Jumbo Jet. I hope you remembered the safety instructions. The ejector button is the golden one on the right but they're not enough to go around so you might want to beat the rush.

Hitting the Niall on the head

Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins. Yes, it was all the fault of deregulation.

There are just three problems with this story. First, deregulation began quite a while ago (the Depository Institutions Deregulation and Monetary Control Act was passed in 1980). If deregulation is to blame for the recession that began in December 2007, presumably it should also get some of the credit for the intervening growth. Second, the much greater financial regulation of the 1970s failed to prevent the United States from suffering not only double-digit inflation in that decade but also a recession (between 1973 and 1975) every bit as severe and protracted as the one we’re in now. Third, the continental Europeans — who supposedly have much better-regulated financial sectors than the United States — have even worse problems in their banking sector than we do. Niall Ferguson

I envy Niall Ferguson's command of the facts of history. Reading his books or essays, leavened with historical yeast, reminds me of the limits of my own sense of history.

Yet, for some odd reason, despite the, apparently, appropriate leavening, the "bread" of his arguments never seems to rise, for me. Jumping to a new metaphor, his arguments are like cloth from a weaver with the strongest, most vivid and varied thread, but a broken loom.

The loom on which a storyteller weaves his fact-threads into cloth is his perceived experience. If his experience-loom comports with the reader's the story seems to come alive. If not, the story will prove inaccessible to the reader.

Similarly, arguments in essays require a shared loom of premises, else they too fall short.

To accept Mr. Ferguson's argument the deregulation was NOT the problem, we would have to accept that policy changes 29 years ago alternatively have no impact on today's events or have a negative impact which must be balanced by the intervening good. We would also have to accept that the depths of the current event have been plumbed, else the comparison with the 70s might, in the future, obviate his argument.

In the arena of history, the view that the Treaty of Versailles's punitive imposition of reparations on Germany led, in part, to the rise of Hitler and WWII is reasonably well accepted. Should we, a la Ferguson, deny that a policy choice decades prior can have no effect on today's events, or that the intervening good- no war and a France rebuilt on Germany's dollar (or mark)- negated the flaws in the Treaty?

Has the fraud and theft of Mr. Madoff been negated by the years of income he did provide his investors, or the fact that his choice to "go Ponzi" occurred decades ago?

To me, though, the most egregious error in Ferguson's reasoning is his ridicule of the dollar crashers and sense that the depths of the current crisis have been plumbed.

Reality, it seems to me, has yet to fully unfold on this crisis. When it does, in the event that, as I suspect, the US$ loses it's place as global reserve currency the wisdom of retaining the old (or similar) regulations on finance will become evident.

Borrowing a phrase from his essay, for reasons to do with human psychology, regulations of certain activities has proven effective. These regulations are often capable of significant improvement, but their absence....well, when this story ends we'll find out the true cost of their absence.

You can't get a little bit "fiat"

As you likely know, the administration is proposing to lend $100bn to the IMF, as part of that organization’s increase in resources following the G20 summit. Peter Orszag, head of OMB, argued that there was zero probability of this money being lost, so $100bn should be “scored” for budget purposes as $0bn – which is how this kind of transaction has been handled in the past. As the IMF likes to say, it is “the lender of last resort, but the first to be repaid.”

After considerable back and forth, the scoring issue was referred to the CBO. The CBO has reportedly decided there is a 5 percent probability of default by the IMF. This is an extraordinarily important statement. Most informed people just assume that the risk of IMF default is zero, because that would essentially constitute a complete breakdown of the global economy and payments system. But nothing is zero probability, particularly in a world of massive financial panics, incipient protectionism, and improvised global governance. Baseline Scenario

Another day, another example of monetary confusion.

To what do I refer? I'm (once again) noticing the apparently widespread view that "credit risk" only occurs in the event of default- a view that seems to me a "residual monetary image" from the days of fixed exchange rates to specie.

When money was defined as a fixed amount of Gold or Silver, "credit risk" could be conflated with the risk of default- either you got your specie (or equivalent) or you didn't.

However, we haven't had such a link to specie for decades. The value of fiat money fluctuates, which is both the blessing and curse of that policy. The risk of, say, a default by the US Treasury, which was a concern of France before the link to Gold was severed, is now almost nil because the only obligation is to pay US$s, which the Fed can print.

In other words, the risk of default inherent in a fixed specie exchange system has been replaced- at least for countries that can issue debt in their own currency- by the risk of devaluation.

There isn't, as the old saying goes, any free lunch. To borrow a concept from physics, risk, like matter and energy (combined), is never created nor destroyed, it just changes form.

It seems to me this residual monetary image- the view that money, specifically the US$, is a thing unto itself and not merely a share of output divided by the stock thereof- is the last bit of foundation holding the house of cards together.

Human conception is a curious thing. I can remember quite a few instances when I was sure I knew something only to later find out I did not. I didn't, for various reasons, take in all the consequences. I thought, to use another old adage, one could get a little bit pregnant- an adage that has lost some of its punch with the availability of abortions.

One also can't get a little bit fiat. Either there is a fixed exchange to specie or there isn't. The most pressing risk in funding the IMF is not whether they will be repaid in US$s, on which I agree with the CBO's assessment, but what those US$s will buy when repaid.

When Interests Collide

I followed the rules as I always have. Stephen Friedman, on his purchase and previous holdings in GS

2500 years ago Euripides observed, Whom the Gods would destroy, they first make mad. Having risen beyond the confines of the rules of men, big finance, forgetting that the rules of true finance and economics apply to all, will fall by their own hand.

The case of Stephen Friedman, who, while owning a stake in GS, chaired the NY Fed Board which approved their application to become a bank holding company and thus have access to government bail out funds- a shift denied to Lehman Brothers- is a perfect example of the "rules don't apply to me" perspective.

This perspective doesn't end with Mr. Friedman. Fed Vice Chairman Donald Kohn, according to the WSJ, The Fed's logic was that the conflict wasn't created by any action of Mr. Friedman, the financial system was in crisis, and the New York Fed needed a new president if Timothy Geithner became Treasury Secretary. So Fed officials say Mr. Kohn concluded that the benefit from the continuity of keeping Mr. Friedman outweighed the conflict of interest.

The virtues of continuity outweighed the conflict of interest, eh? In other words, maintaining the status quo- a policy which doesn't seem to comport with creative destruction- is more important than the judgment clouding effects of a large monetary stake in the outcome of a bureaucratic decision.

On the topic of the virtues of continuity, the big banks appeared to pass their "stress tests" with satisfactory grades, although they'll need to raise some extra capital because the rest of the economy isn't pulling its weight. I wonder if the policy of maintaining the status quo in finance, or even more mundane issues like a large financial stake in the outcome, might have influenced that assessment.

To wit, according to the Fed Report: At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one‐half of which were Treasury, agencies, or sovereign securities, or high‐grade municipal debt, and so are subject to no or limited credit risk. This is, I sense we are to assume, a good thing. If there was any credit risk in sovereign securities (including Treasuries), agencies, or hi-grade munis the BHCs would have to raise a couple $100B more in capital. We'll leave aside the obviously silly concern that there actually is credit risk in such securities. No government has ever defaulted or devalued nor has mortgage debt ever led to a loss.

Right?

The other thorny issue of such an assessment- marking to market securities which few apparently hazard to value- was easily ignored with these words: The adherence of SCAP to current practices is important because the majority of assets at most of the BHCs participating in the SCAP are loans that are booked on an accrual basis. As a result of the loss recognition framework for assets in the accrual loan book, the results of this exercise are not comparable with those that would evaluate such assets on a mark‐to‐market basis.

In other words, if we marked these loan books to market the BHCs would need to substantially raise capital levels, far beyond those recommended by the Fed. The virtues of continuity must be great indeed- outweighing the concerns of sovereign credit risk and virtues of marking to market- all in one report, mind you.

I wonder if our foreign creditors are aware of continuity's great virtues. Given recent talk about changing the global financial architecture, I suspect they aren't, mainly because the virtues are not universal.

Sometimes interests collide.

To wit, theft is virtuous for the thief but not for he from whom the goods were stolen. The owner's interests are not aligned with the thief's. Nor, it seems to me, are our foreign creditors' interests aligned with our BHCs'.

Continuity is only in the interests of those within the system in question in the event that different, more efficient modes of thought and action cannot be implemented for less than the cost of maintaining that continuity- a view which seems to have escaped the men at the Fed.

Perhaps the Financial Powers That Be have, as is the wont of those who use econo-metric models, gotten confused by recent history. In the early 90s, during the last reliquification of Big Finance- remember the job-less recovery- Japan was in the role China plays today. If Japan had a Army, instead of a US military base on Okinawa, they too might have called for changes to the global financial architecture.

China, unlike Japan, has an Army. Like Japan, China sees the virtues of trading internationally in one's own currency. Unlike Japan, whose talk of "internationalizing" the Yen never came to much, China is internationalizing the RMB.

Returning to the early 90s experience, the resolution had 3 main facets: 1) raise capital 2) use the capital to take non-performing assets off bank balance sheets 3) maintain a large spread between short and long rates for an extended period of time to raise bank profits. In my view, global economic growth during that period was sluggish, in part, because the banks increased the "vig."

I suspect a similar strategy is in play in the sense that the BHCs will need a wide spread for an extended period of time. Thus the key question arises. Will our foreign creditors, who might (or might not) be willing to purchase an equity stake, also agree to pay the increased "vig" in the form of a wider than normal spread, to use US$s?

Side note: Would we be willing to sell an equity stake big enough to make a difference, can sufficient capital be raised without loss of control?

Perhaps, but only if the Fed is right about the lack of credit risk in Treasury Securities. If inflation returns, as I suspect it will, the cost benefit analysis of continuity in the global financial system changes radically.

At some point the cost of a devaluation would exceed that of creating a new system, although the cost of creating a new system increases dramatically if a war is required to "align everyone's interests."

I truly hope the powers that be can manage this mess, for it seems to me a collision of interests is imminent. The more success China has in RMB based international trade, the less willing they will be to use US$s and thus the longer will recovery take. In a sense, expansion of US$ use in the 90s dug the BHCs out of a hole. A decline in US$ use while trying to dig out of a much deeper hole seems to me a desperate situation.

Losing the Exorbitant Privilege

I don't think there's any prospect of any big shift in portfolio preferences of foreign investors right now. Ben Bernanke

The bank stress tests are beginning to create a perception problem, but not – as you might think – for banks. Rather the issue is top level Administration officials’ own optics (spin jargon for how we think about our rulers).

At one level, the government’s approach to banks – delay doing anything until the economy stabilizes – is working out nicely. This is the counterpart of the macroeconomic Summers Strategy and in principle it is brilliant. “Don’t just do something, stand there,” is great advice in any crisis – eventually everything bottoms out and you can take the credit, justified or not (unless an election catches up with you first; check with Herbert Hoover.) Simon Johnson

Harry Truman, who famously wished for a one-handed economist, would, I suspect, be quite pleased with Mr. Bernanke and Mr. Summers, both of whom, according to the passages above, are singularly concerned with restoring US citizen's faith in finance.

Summers and Bernanke seem to have forgotten the wisdom of Machiavelli; For a prince should have two fears: one, internal concerning his subjects; the other, external, concerning foreign powers. These princes of finance apparently have no fear of external powers.

The America Economy is, I believe, a wondrous thing, a powerful engine of production. Despite what I believe to have been a lack of need, the US added a turbo-charger to the economic engine- the, in the words of Valery Giscard D’Estaing, exorbitant privilege of issuing debt to foreigners in our own currency. The exorbitant privilege will not be retained by restoring US citizens' faith in finance, but rather by restoring the faith of external powers.

Without the exorbitant privilege the US would already be deep in the throes of a currency crisis familiar to many banana republics. Without the exorbitant privilege big finance would have no bargaining chip with the state and as President Obama is reported to have said, My administration is the only thing between you and the pitchforks.

While it might be fear of the pitchfork wielding public that drove Summers and Bernanke to one-handed-ness I suspect a bigger factor is residual self-image from the heady End of History days. Summers' Don’t just do something, stand there policy implicitly accepts what Bernanke explicitly stated, no prospect of shifts in foreign investors' portfolio preferences. I can almost imagine these two advising the Pope during Martin Luther's time- "there's no prospect of a shift in sinners' desires to buy indulgences from us."

The genius of Paul Volcker, informed by current problems, becomes clearer by the day. Mr. Volcker didn't just break the back of inflation, at great risk of angering the pitchfork wielding public, he maintained the exorbitant privilege. He understood that one needs to compete to stay at the top. With Russia (in 1979) flexing its muscles and Iran breaking free of US control, US$ dominance wasn't assured, as Volcker learned during an IMF meeting in Belgrade that year. US policy needed to ensure the $ was a solid store of value.

Sadly, the Obama administration seems to be listening to Mr. Summers rather than Mr. Volcker. The most recent G20 meeting was, in my view, another Belgrade- a warning that US$ dominance is not a given.

I think we, and even his backers in big finance, will greatly regret this summer with Summers. The recovery for which he waits might be driven by China, and the pitchforks his backers fear might yet be brandished- made in China and purchased with RMB.

Bank Stress Test Results Released

US Treasury Department Recommendation: Economic growth must be lifted slightly (but not too much) to validate bank balance sheet solvency

What a pleasant surprise to read an interview with President Obama this weekend which contained the following:

What I think will change, what I think was an aberration, was a situation where corporate profits in the financial sector were such a heavy part of our overall profitability over the last decade. That I think will change. And so part of that has to do with the effects of regulation that will inhibit some of the massive leveraging and the massive risk-taking that had become so common.

Now, in some ways, I think it’s important to understand that some of that wealth was illusory in the first place.

If he could just share this view with Mr. Geithner and Mr. Bernanke who, according to the WSJ, have a different view: the news [of the stress tests] sparked concern among investors and depositors that the results would be used to shut down or nationalize some of the country's weaker institutions. But Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner assured investors that none of the banks undergoing stress tests would be allowed to fail and that all would have access to government funds if needed.

If, as President Obama argues, some of the wealth created by the financial sector was illusory, financial sector profits need to shrink relative to the rest of the corporate sector and leverage in the sector must be reduced, why won't banks be allowed to fail?

For how much longer will the economy be the tail wagged by the financial sector dog- a tail, mind you, which can only wag in ever smaller amplitudes to avoid overturning that dog? If the Auto sector was viewed as the Financial sector is the response to their troubles would have been a $20K stimulus check such that each family could buy a new car.

Stressing the Banks

What Is a Stress Test?

At its simplest, a stress test is a way of revaluing a portfolio using a different set of assumptions. The results of a stress test show the sensitivity of the portfolio to a particular shock. Stress tests can be useful because for most asset markets, the history of returns does not provide sufficient information about the behavior of markets under extreme events. Stress tests complement traditional models with estimates of how the value of a portfolio changes in response to exceptional but plausible changes in the underlying risk factors. IMF

A long time ago in a galaxy far, far away (it sometimes seems to me) I used to work in one of the big banks now undergoing stress tests. As an FX Options trader I had access to some fairly advanced (for the time) software that allowed me to examine the changes to my portfolio under a variety of different conditions. I very quickly learned that unimaginable scenarios were not just more plausible than I thought, they were actually happening.

When I started trading I would run a few simple "ladders"- calculations that would tell me my spot, forward, theta, and vega positions over a sequence of spot, interest rate, volatility and time changes. As time went on and my sense of the possible changed- hard lessons indeed- I learned the value of knowing how my book would change under a much wider set of assumptions than was normal practice at the bank. Informing me of how my book could change over the course of a few days was the goal of this process.

Before I left the bank I felt reasonably assured that my "doomsday" assumptions would cover all but the most dire of possibilities. Before I list them here's a few words on the US Treasury Department's assumptions in the current stress tests: According to the new Treasury Department guidelines, the banks would have to assume that the economy contracts by 3.3 percent this year and remains almost flat in 2010. They would also have to assume that housing prices fall another 22 percent this year and that unemployment would shoot to 8.9 percent this year and hit 10.3 percent in 2010.

My assumptions, and the experiences on which they were based, were:

1) short term interest rate changes of 5% (as I traded currency pairs, this covered both countries raising rates by 5% or one country raising by 5% while the other lowered 5%): Britain raised rates by 5% during the ERM crisis of 92

2) spot FX changes of 10%: The GBP fell 10% over a few days in 1992 (as did the A$ a few years earlier)

3) implied volatility changes of 10% in the front months and 3% in the back end: The A$'s volatility curve exploded in Feb '89, as did that of the GBP in '92. When the GBP entered the ERM the volatility curve for GBP/DEM collapsed

Armed with the information I then calculated the trades I would need to do to negate my risk as quickly as possible. As time went on and the book got bigger- 20 years ago when such things were many orders of magnitude smaller than currently- I found that the trades I would need to do couldn't be done in a short period of time, under normal market conditions. In other words my book grew big enough such that I had to be right, for I couldn't change things quickly enough if I wasn't.

This problem today is orders of magnitude larger.

If I was in Geithner's shoes, I would want to know how the big bank's positions would change if:

1) China didn't show up at a Treasury Auction and bond rates jumped 3-5%
2) China started dumping US$s on the open market and our exchange rate dropped 10%
3) The Fed, under such conditions, had to raise the Fed Funds rate by 5% quickly
4) An act of war or natural disaster struck one of the big coastal cities, putting it entirely out of commission thus pushing GDP down 6-10% quickly

Now that would be a stress test.

Admittedly, the Treasury is more interested in a longer view than I was, although given the highly leveraged derivatives positions, they might be well served to also inquire about substantial, discontinuous price changes.

I'm troubled that they don't test for what the past suggests is possible.

What if Unemployment goes to 30% as it did in the 30s?

What if Inflation falls to -5% or rises to 12%?

What if Fed Funds goes to 17% as it did in the early 80s?

What if we can't roll-over our foreign held debt, as has happened to most nations which have run up as large an external debt position as ours?

You Can't Handle a Recovery!

You can't handle the truth!

Son, we live in a world that has walls. And those walls have to be guarded by men with guns. Who's gonna do it? You?

I have a greater responsibility than you can possibly fathom. You weep for Santiago and you curse the marines. You have that luxury. You have the luxury of not knowing what I know: That Santiago's death, while tragic, probably saved lives. And my existence, while grotesque and incomprehensible to you, saves lives......

I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of the very freedom I provide, then questions the manner in which I provide it. A Few Good Men

Before our economy, generally, and financial sector, specifically, became so "resilient" and "robust", interest rates had to be raised significantly and for long periods to slow credit and economic growth and thus inflation. Over the past 2 decades, however, the same damping effect could be achieved by much more modest and shorter duration tightenings. Unlike previous decades, it seems as if credit can only flow under an ever narrowing set of conditions, with change in flow acting digitally- on today, off tomorrow.

In the late 60s, before we dropped the Gold standard, Fed Funds was raised from just under 4% to over 9%. As we were dropping the Gold standard, in the early 70s, Fed Funds was raised from under 4% to well over 12%. During Volcker's term, Fed Funds rose from an already elevated 9.5% to almost 17%, admittedly during a period when interest rates weren't the fulcrum of monetary policy.

Since the Volcker peak, as noted, and as can be seen in the graph below, a few percentage points increase in the Fed Funds rate has been sufficient to "cool" the economy. Moreover, over a few cycles now, what had previously been considered a normal level for rates, like the 5.5% level during the mid 90s, becomes too high during the next recovery- 5.25% was the peak in late '06 through summer of '07.



The reaction, with respect to employment, of the real economy to the financial has also changed. The pattern of employment growth- with each cyclical trough being much higher than the previous peak- evident from 1962-200 has also changed. For the first time in decades, the trough (thus far) of employment is almost equivalent to the old peak- i.e. the current level of employment is roughly equal to that of early '01. By contrast, the '03 trough was 20M jobs higher than the '90 peak and the '91 trough was 16.5M jobs higher than the '81 peak.

The current pattern of employment growth more closely matches that of 1942-1962 with the caveat that median income gains were substantially higher in the earlier period.

The reaction, with respect to real median household income, of the real economy to the financial has also changed. For the first time in decades, real median household income in a recovery failed to exceed the previous cycle peak- the recovery under Bush the younger was restricted to the upper income class.

The above is a long "winded" (byted might be better given the medium) way of noting increasing income inequality. The quality of US recoveries has changed from one which benefited the middle and upper classes to one which only benefits the upper classes, and given the recent declines in real estate and equity based wealth, many of the upper class are finding that GDP gains may not translate into their gains. Increasingly the beneficiaries of recovery are restricted to the top tier of finance. The trickle down which was used to justify the shift to a financially centric economy in the 80s and 90s has become a trickle up in the 21st Century. To paraphrase Abraham Lincoln, policy increasingly aims to ensure that government of the financial oligarchs, by the financial oligarchs and for the financial oligarchs, shall not perish from the earth.

The question then arises, "why have we forsaken the old faith, which carried us through the tumultuous 60s and 70s, that a robust middle class is good for the stability of the state?" Have we forgotten the lessons of Aristotle's Politics (Book 4: Part XI)? Is it simply a case of self-interest run amok, or are their other reasons behind trickle down becoming trickle up?

On a related note, I wonder how different the results of the '08 election would have been if the trickle had been down rather than up under Bush the younger. The Democrats might want to take note, pandering to the financial oligarchs does not ensure electoral success.

Returning to the main point, why has policy allowed the quality of recovery to change so significantly? It is almost as if the financial oligarchs fear an old style recovery to maintain their grip on power. This fear would not be without precedent in human history. The European Nobility feared the rise of their middle class, fortunately for the Burghers, they often found a friend in the King or Queen.

I suspect, however, an additional reason behind the policy shift- a most insidious reason. As the wealth of the nation has shifted from production to financial it has, as noted above, become increasingly fragile and sensitive to changes in financial variables.

During the 70s the price of oil rose by a factor of 10, settling, if you will, in the 80s at about a 6 fold increase. Interest rates, as noted, fluctuated wildly, ending the decade at double digits across the board. Equity markets too fluctuated wildly, although the Dow Jones was at roughly the same level in 1982 as it was in 1968. While the 70s were no picnic, as I recall, the wealth of the nation, and the well being of many improved.

Back then though the wealth was of a different sort- we made, mined, and grew things. Changes in financial variables were onerous, but they didn't cause the world to stop turning. Even the financial world seemed to take the 70s somewhat in stride, despite the Fed funds rate moving from a low of roughly 3.5% to a high of roughly 16%.

I doubt our supposedly much more resilient current financial system could survive in that environment, perhaps it would be more accurate to say that few of the top tier financial firms would make it through a decade like the 70s. So long as fear of loss of financial wealth drives policy, policy will fight to ensure that discounting (i.e. interest rates) remains minimal. Few changes kill a leveraged long bond position than a hike in rates. Restraint of the middle class then is, in modern terms, collateral damage.

And that, it seems to me, is the insidious problem that trumps all else. We can't handle a broad based recovery because if we do we'd get significant inflation and eventually, substantial increases in interest rates. Just as it isn't the fall that kills you, it's the sudden stop at the end, for the highly leveraged financial oligarchs, it isn't the inflation that will kill them, it's the substantial hike in interest rates at the end. For my money, wealth that cannot survive necessary changes in interest rates isn't wealth at all, it's just a mirage.

George Friedman, of Stratfor, recently argued that the US is worth some $340T (a bold assertion, but let's go with it for the sake of argument) and thus our debts are trivial in comparison. As with any corporation, however, that depends on how the assets are managed. Nonproductive asset is a contradiction in terms. Iraq, too, is, in theory, a wealthy nation. Alas it was and still is crippled by poor management.

We too, it seems to me, are crippled by poor management. The financial oligarchs fear a recovery that would make real world assets, which the US has in abundance, productive. The path to such a recovery does not go through them. It goes through a financial system that is thought of as Alfred Marshall thought of a mature industry- like a forest where individual trees come and go but the forest remains. Forests, by the way, are not a few big trees, but many middle sized (OK sometimes they are all big, like the Sequoia, but they need forest fires to propagate) ones. Currently, a few big trees are seeking protection from a cull.

Seeking the safety of power, the financial oligarchs have made what I see as one last gamble- one that, it seems to me they will soon lose- they are channeling flows into government bonds, after taking a nice chunk off the top, for their trouble. So long as the state can borrow cheaply, the financial oligarchs will be safe. Sadly, for them, decades of open capital markets and chronic deficits means that they are not the final arbiter of price in their last hope market. When the BRICs (Brazil, Russia, India and China) discover (and act thereupon) that real world investments offer greater and more durable returns than US Bonds, the financial oligarchs will lose the protection of the state.

It seems worth noting the example of Russia. They too had their state protected oligarchs, until government finance could not be found. But a few short years after they defaulted on their debt and the oligarchs were removed from power, Russia, whose real sector, due to its reliance on resource exports, is not nearly as vibrant as ours, recovered stronger than it had been in decades.

If Russia can do it.....

Is that an echo?

How funny to come across a similar view.

The late twentieth century was the heyday of deductive economics. Talented and facile theorists set the intellectual agenda. Their very facility enabled them to build models with virtually any implication, which meant that policy makers could pick and choose at their convenience. Theory turned out to be too malleable, in other words, to provide reliable guidance for policy.

In contrast, the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants. Work in economics, including the abstract model building in which theorists engage, will be guided more powerfully by this real-world observation. It is about time.

Prof. Barry Eichengreen

Perhaps Einstein put it most aptly: As far as the laws of mathematics refer to reality, they are not certain, as far as they are certain, they do not refer to reality.

Induction is all about checking to see how, why and where the rubber of an idea hits the road of reality.

The Road to Hell

Hell is full of good intentions or desires. Saint Bernard of Clairvaux

In a recent post at The Baseline Scenario, a blog by Simon Johnson I find most interesting- gotta love financial blogs that reference Baudrillard, I came across the following:

I don’t know Tim Geithner. But I have no reason to believe he is corrupt. Instead, the simplest explanation of the Times article is that he has internalized a worldview in which Wall Street is the central pillar of the American economy, the health of the economy depends on the health of a few major Wall Street banks, the importance of those banks justifies virtually any measures to protect them in their current form, large taxpayer subsidies to banks (and to bankers) are a necessary cost of those measures - and anyone who doesn’t understand these principles is a simple populist who just doesn’t understand the way the world really works.

In other words, according to the author, with whom I agree on this point, Mr. Geithner is well intentioned. Sadly, as St. Bernard, in more modern vernacular would say, "the road to hell is paved with good intentions."

Mr. Geithner suffers from a common phenomenon observed by William James who famously quipped, "most people think they are thinking when they are merely rearranging their prejudices."

Reasoning, or the generation and affirmation of propositions (perhaps induction would be more apt), differs from rationalizing, or the defense, explanation or excuse of an already accepted proposition. To paraphrase Mr. James, most people confuse rationalizing with reasoning in part because rationalizing and deductive reasoning- the type of reasoning most easily and thus often taught in schools- are often indistinguishable....until you wonder if the given propositions are, indeed, true.

Deduction, as the word implies, assumes the truth of given propositions and logically infers, or takes from them, other, non-contradictory propositions as in the classic- if you ever found yourself in a logic class, that is- all men are mortal, Socrates is a man, therefore Socrates is mortal.

Deducers tend to do well in school, and work well in institutions, like banking, where the given truths are not questioned. Inducers, like myself, who question tenets, do not work well in institutions. We wear pajamas all day and blog.

But, enough pedantry. The reason for the post was to suggest, assuming Mr. Geithner's prejudice is wrong, that we stand at the precipice of a Kuhnian revolution.

There are a great many people who believe propositions about political economy which, in my view, are not supported by the facts nor by theories of Capitalism itself, to wit, when did finance become exempt from creative destruction?, but as there are far fewer inducers than deducers, especially in long extant institutions, these propositions will not die easily.

The likelihood of a graceful resolution- say by putting most of insolvent Wall St. in receivership and granting more power in international finance to China, et. al.- to the current financial crisis has, in my view, became very small indeed. Substantial, discontinuous changes in financial prices are the fruit of non-graceful resolutions.

Hang on to your hats (and wallets).

Bankers hate Golden Rules

The groups that are leading the charge against me on this are familiar names on Capitol Hill. The Mortgage Bankers Association, the people who brought us this wonderful subprime mortgage crisis. The Financial Services Roundtable, the biggest names in financial services in this nation, the ones that have had their hands out for federal money, opposed this idea of helping people facing foreclosure. And the American Bankers Association. What a disappointment. What a disappointment that a great association like that, representing so many good banks, would not even sit down at the table to discuss this provision. It's a source of great disappointment to me because as a congressman and senator I work with them on so many issues. Sen. Dick Durbin

The Banking Industry, having dispensed with the Gold Standard, now takes aim at the Golden Rule of doing to others as you would have them do to you, or, if you prefer, the more modern, Rawlsian formulation, don't enact laws you wouldn't want imposed on you.

If, as the Bankers assert, current bankruptcy procedures are "written in stone" why then are the big banks not in receivership?

Oh well, as the saying goes, those who live by the sword, will die by the sword. When credit conditions fail to recover, due to the banks' lack of capital sufficient to cover unprofitable investments, and the Banks are once again called to Congress to explain, will the Grand PooBahs of Finance appreciate the delicious irony of being hung on their own expressed views about the sacrosanct nature of bankruptcy procedures?

Time, Power and Money

When you are courting a nice girl an hour seems like a second. When you sit on a red-hot cinder a second seems like an hour. That's relativity. Albert Einstein

Late in the 16th Century, Pope Gregory XIII stole 10 days, declaring that October 4, 1582 would be followed by October 15, 1582. After 12 centuries of use, the extra 11 minutes per year relative to the vernal equinox cycle assumed by the Julian Calendar had pushed the date of the spring equinox back about 10 days. The Vatican wanted the vernal equinox to occur on the same calendar date as that of the First Council of Nicea in 325, Mar 21, thus the decision to "steal" 10 days.

This Gregorian Calendar and its intercalations has (not without dissent, e.g. the British didn't adopt it until 1752) become the (for the most part) global standard for commercial purposes.

As you might surmise, such a significant change caused great consternation. Some thought the reform a plot by landlords to cheat them of 10 days rent- no doubt some clever insiders bought property to capture this free rent prior to the calendar's adoption in each country. A counter argument that, relative to the new calendar, renters had been cheating landlords out of 11 minutes of rent per year for centuries would likely have fallen on deaf eras.

Fortunately the Julian Calendar Year wasn't 11 minutes less than the vernal equinox cycle, thus requiring an addition of days. Stealing days from the poor and padding the accounts of landlords was a much easier "sell" than the reverse would have been.

The word, time, as Einstein reminds us, refers to an idea. It is one of man's greatest conceptual tools to impose order on our sometimes chaotic perceptions. Seconds, hours, days and years might feel alternatively long or short but the choice to apply- perhaps "submit to" would be more apt- real world standards of time keeps us on the same page. Were we not all on the same temporal page, modern finance, given its reliance on time based interest, would never have been developed.

Imagine, perhaps in an attempt to ameliorate the effects of the current financial crisis, a government loosening the standards by which time was measured. Adding days to a few months would certainly make debt service easier, assuming one's income flow was based on a non-monthly standard.

Financiers, correctly, in my view, would argue against loosened standards of time. "How," they might ask, "can we calculate asset worth, determine net present value, or estimate risk in a world where the month of April refers to this amount of time today and a radically different amount of time tomorrow?"

Given current conditions, however, one could respond by noting that despite rigid standards for time, such calculations are obviously difficult for the financial world. "It wasn't," the imagined retort might be formulated, "a change in any temporal standard that destroyed the value of my retirement investments or that of US mortgage securities."

Indeed, it wasn't a change in temporal standards that led to the current financial disorder. Rather, inter alia, it was, I believe, a loosening of monetary standards. If standards of time are crucial for accurate financial calculation so too, it seems, should be standards for money. These standards for money go beyond the basic decision to, for instance, set a fixed exchange rate to specie or some other method to ensure that no more money is created than there are goods and labor to buy with it. They would include restrictions on securitization and credit, and procedures for liquidation. The idea of unrestricted finance seems to me about as absurd as unrestricted time....how many seconds in a hour?...however many you prefer.

The calendar reform noted above can perhaps be seen as a lesson in compounding- error, that is. Eleven minutes is but 0.002% of a year, yet, over time such a seemingly trivial error- certainly one that went unnoticed by most people on earth- eventually pushed back the date of the vernal equinox by 10 days.

At least the error was constant. What if temporal standards had been "elastic?" Imagine the confusion that would result from days being 25 hours one year and 23 the next. Imagine, instead, the increased confusion that would result if the elasticity of temporal standards varied per individual. Tax payers might wish for years of 500 days while mortgage bond holders might wish for months of 10 days. Such mortgage bond holders, if they were able to implement this "short month" policy, would see the value of their assets, at least on paper, rise dramatically.

Of course, under such conditions, it wouldn't be long before the whole system of temporally based payments collapsed. If the desired changes in standards were less radical- call it the Fabian approach to loosened standards- the collapse would take longer to manifest. In any event, the lesson is clear, standards that vary over time and individual (or group) inevitably create confusion and discord. In the highly ordered modern world my month must be the same as everyone else's month.

Equally, in the modern world, my money must be the same as everyone else's money. There must be some standard of reference if calculations today are to have any merit tomorrow.

To illustrate, let's return to our mortgage bond holders wishing for a short month to increase the value of their assets. How many mortgagees, once the short month policy was adopted, would be able to make payments after 10 days? or after 3 short months? In the event, the paper gains mortgage bond holders loudly proclaimed as their path to permanent prosperity wouldn't manifest, for they would be but an illusion. No doubt those who expected to benefit from such a scheme would consider both the scheme, and those who devised it, brilliant. Expected beneficiaries would quickly become mesmerized by the proverbial "pies in the sky" and give these brilliant people the benefit of the doubt and more.

And so they were, and so they have.

As former IMF Chief Economist Simon Johnson recently wrote:

A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan’s pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him, said in 2006: “The management of market risk and credit risk has become increasingly sophisticated. … Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.”

Of course, this was mostly an illusion. Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible.

Wall Street’s seductive power extended even (or especially) to finance and economics professors, historically confined to the cramped offices of universities and the pursuit of Nobel Prizes. As mathematical finance became more and more essential to practical finance, professors increasingly took positions as consultants or partners at financial institutions. Myron Scholes and Robert Merton, Nobel laureates both, were perhaps the most famous; they took board seats at the hedge fund Long-Term Capital Management in 1994, before the fund famously flamed out at the end of the decade. But many others beat similar paths. This migration gave the stamp of academic legitimacy (and the intimidating aura of intellectual rigor) to the burgeoning world of high finance.

"Hang on a second, Dude," you might be thinking, "I get the bit about time, but you haven't explained how variations in monetary standards caused the current confusion. Mr. Johnson doesn't mention it."

True. I haven't and he didn't.

Let's begin with a review. We use conceptual standards to ground our ideas through time and space and thus make them useful. We improve the utility of our ideas by choosing the best standard available.

While lunar cycles seem to have been the first choice of temporal standard some cultures- the early Egyptians and Britons are two that come to mind- discerned that annual rhythms more closely matched solar rather than lunar cycles. These "sun worshipping" cultures tended to outperform their moon worshipping, a.k.a. "lunatic" rivals because their expectations of the future, grounded by wise standards, tended to be more accurate.

The idea of time is regulated- in ancient times it was regulated by priests. The modern world, however, having settled on temporal standards, and having reduced the mysteries of time to a science no longer worships the sun, or moon. We self regulate using accepted technology- modern governments have no ministries of time.

We do, however, have ministries of money and "priests" whom, we hope, understand this new mystery. In a sense, we worship money. Sadly the priests of the new temple have gone pagan, by which I mean forsaken the old teachings, and the Great God Money is angry.

Like time, the word, money, refers to an idea- one that measures value and thereby facilitates trade and projections thereof through time and space. In our highly ordered modern world with its complex division of labor, my plans of the future are based on my trade of labor for, initially, money, and then the share of goods and labor produced by the cooperative effort it represents. It is vital, given our increasingly complex division of labor, that my work is productive. If it doesn't add to the cooperative effort I'm diluting the value of money- not just mine, but everyone else's.

Pause, if you will, and reflect on this idea a moment.

Each day hundreds of millions of people spend hours typing, talking, thinking, planting, calculating, transporting, managing, and building to cite a few jobs. This cooperative effort produces the things we need to survive (or would just like to have). In certain occupations, such as farming, productivity is easy to measure. In others, such as government or finance, productivity is usually much more difficult to measure because it tends to flow from labor freed for more useful purposes.

What's a good government or stable financial system worth? Ask those from a country in crisis, like Iraq. Productive governments, inter alia, maintain civil order and thus reduce fears of loss of life and goods that would otherwise increase the labor burden on others. Productive financial systems allow savings to be channeled to productive uses. Although these 2 occupations add nothing directly to the stock of available goods, when they are working well, by facilitating cooperation they add to total output.

This last point is key. The economic value of government and finance, among other occupations, can only be calculated indirectly as some segment of total output of the economic unit in question. It then follows that the value of an existing government and financial system can never be greater than total output. It also follows that neither government nor finance are the sine qua non of economic output.

Because their economic value is a function of total output, during periods of increased productivity in the rest of the economy, government and finance may overstate their contribution in somewhat similar fashion, I imagine, that the Egyptian Priests of Ra sometimes overstated theirs. Productivity increases flowing from, for instance, the use of iron had little to do with the rites of the Priests of Ra.

As Simon Johnson notes: From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent.

What did the financial world do such that its share of corporate profits should nearly triple? It didn't invent the computers and networking technology that gave rise to Greenspan's tech boom, although it did use them to reduce its labor force and improve their bottom line. It didn't optimize manufacturing techniques or improve mine or oil drilling extraction rates, although it helped finance the research and implementation. Outside of asset securitization, most of the "innovations" in finance, like futures and options, would have been familiar to early 17th Century Dutch Bankers- yes, the one's who fomented the Tulip Mania.

Finance, despite numerous attempts to enforce the label, refuses to accept that it is a mature industry, in the main, because mature industries, like electricity production, aren't growth industries- they are expected to provide their service flawlessly and get paid a regular but small profit for their efforts.

As a student of the physical sciences I find electricity generation and transmission fascinating. It must have been a marvel for the late 19th Century man to witness a machine creating and harnessing the power of lightning. Fortunately, we do not worship electricity. Thanks to Science we realize that a generator transforms mechanical energy into electrical for ease of transmission, inter alia. The process is not seen as mystical, it is considered a natural process that follows laws which can be understood by any reasonably competent person who cares to study. The industry is considered mature and its leaders not irreplaceable. Bankruptcies in the industry are, correctly, in my view, seen as management failures. Electricity generating CEOs could not go to Congress and ask for 100s of billions of $s with no questions asked. There is no mystique to the process.

A few years ago, however, one natural gas mining company got into the electricity generating and transmission business and created a mystique about its practices. Enron became a financial industry favorite by posting profits far in excess of similar companies in the field- profits which came, as time passed, less and less from its core businesses and more from arcane financial transactions. As we now know, these profits were fiction. When the fraud was exposed, shareholder equity was wiped out and management was prosecuted. Enron's attempt to mystify the utility industry and thus justify higher profits failed. Their failure was only a catastrophe for their shareholders and workers. Electricity and natural gas continued to flow.

Where Enron failed, finance has succeeded. Modern finance, which has been around longer than electricity use, has, I believe, mystified its procedures- think Greenspan speak. Banking, which had, in the 50s and 60s, been a boring business for older, sober men, became, as monetary restrictions were cast aside, exciting, new and mysterious. General Electric, the company founded by Edison, and which still builds electricity generators, doesn't have a TV station devoted to the marvels and mysteries of electricity, it has one devoted to the marvels and mysteries of finance- CNBC. This mystique stands in the way of finance receiving the Enron treatment. We do not fear a stoppage in the flow of electricity if large utility companies are bankrupted but we do fear a stoppage in the flow of funds if large finance companies are bankrupted.

A child who wished to radically increase the flow of electricity (amperage) in a wire would rightly by admonished by an adult who knew the wire would heat up and fail. Yet there are seemingly no adults to admonish the children who radically increased the flow of credit thus halting that flow.

China's Vice Finance Minister recently called for reform of the world's monetary system. Like Pope Gregory XIII, this minister sees that our ideas are not working as we wish, but with money instead of time. Reforming the world's monetary system means, to me at least, stripping the subject of its mystique. There is a science of money as there is a science of electricity and it seems to me man would be well served by remembering this. This isn't, as Jon Stewart remarked to Jim Cramer, a %&$#% game. Money is the tool which allows our complex division of labor to work.

Bretton Woods Gets Off to Unfortunate Start

Today the representatives of more than forty nations will gather at Bretton Woods to open a monetary conference. In several respects the conference will get off to an unfortunate start. Important as the problem of stable exchanges and world monetary soundness is, it would be impossible to imagine a more difficult time for individual nations to decide at what level they can fix and stabilize their national currency unit. NYTimes July 1, 1944

I've been reading the NYTimes archive of Bretton Woods articles from 1943-1946 to remind myself how murky history can be in real time, and thus how wrong "expert" opinion is often, in hindsight, shown to be.

Here's a link to the London G20 site readers might find of interest.

Icarus and the Death of Nations

In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen orso panics and recessions; virulent inflation that led to a 211⁄2% prime rate in 1980; and the Great Depression ofthe 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.

Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – thereal standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow JonesIndustrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during whichhumans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economicsystem has worked extraordinarily well over time. It has unleashed human potential as no other system has, and itwill continue to do so. America’s best days lie ahead. Warren Buffett

Of late I've been encountering quite a few declarations similar to that from Warren Buffett above- our economic system works well, is the best ever devised, etc. Yet I take no comfort from such declarations, which seem to me, increasingly with the frequency of repetition, like whistling past the graveyard. The question I would pose to anyone making such a statement is simple- what system?

While I don't dispute Buffett's facts, I think there are additional causal factors behind the rapid rise in Americans' standard of living than the choice of industrial capitalism (which was imposed on the South during the Civil War) or the adoption of the Federal Reserve System- winning a few wars springs to mind. Victories against the British and Spanish Empires and the Native Americans gave us much of our land. Victory in WWII led to our role as monetary sovereign for much of the world.

Less than desirable outcomes in Vietnam and now Iraq increased our debt with little to show, in an economic sense, for the effort. If one considers military conflict as an element of economic policy, the return on investment of these relatively recent losses is extremely negative.

Yet, I suspect war as tool for economic gain was not what Buffett had in mind when writing his letter to shareholders. However, as Bertrand Russell argued in Icarus, a polemic on scientism, written in 1924, Economists have underestimated the part played by military prowess in the acquisition of wealth. The economic effect of the spoils of war, such as becoming the issuer of the world's reserve currency, a status neither Bernanke nor Geithner, according to recent comments, wish to lose, is the dirty secret of the Wealth of Nations.

Over the past few days the world has come to what can either be seen as the edge of a precipice or a golden road to another generation of economic growth- true globalization. For decades, commercial and financial corporations have organized themselves to take advantage of such a transition. Yet, two key issues need to be resolved before further gains can be generated from globalization- 1) the creation of a multi-national court to resolve disputes 2) a global currency.

After the implosion of the Soviet Union, the US$ was assumed by many to become that global currency. Unfortunately, a quarter century of expanding external deficits, accelerating since the Soviet collapse, has reduced US bargaining power. Neither Russia nor China seem keen to globalize so long as the US continues to abuse its position as issuer of the global reserve currency.

The emergence of a stumbling block on the road to globalization would not be a surprise to Bertrand Russell. In the aforenoted Icarus, Russell argues: Rivalry is, with most well-to-do energetic people, a stronger motive than love of money..... This rivalry has attached itself to nationalism, and enlisted the support of the ordinary citizens of the countries concerned; they seldom know what it is that they are supporting, but, like the spectators at a football-match, they grow enthusiastic for their own side. The harm that is being done by science and industrialism is almost wholly due to the fact that, while they have proved strong enough to produce a national organization of economic forces, they have not proved strong enough to produce an international organization.

After pondering Russell's views, I've come to think the quantum in Smith's Wealth of Nations needs to be expanded- the issue in a globalized economy is the Wealth of the World, and consequently the Death of Nations.

This perspective is a radical break from the past in that, inter alia, the virtues of war shrink dramatically. From a nationalist perspective, new territory gained comes ex nihilo, foreign destruction of capital infrastructure is not a loss but an opportunity to profit during rebuilding.

From a global perspective nothing comes ex nihilo. There are no spoils of war, just potential productivity gains arising from what is assumed to be a more efficient organizational form. From a global perspective, channeling the benefits of seigniorage to a single (or small group of) nation(s) is absurd.

Economics has come to a fork in the road. I believe a decision to take Frost's road less travelled by and expand the quantum of economics offers the potential for another generation of growth. If Nationalist concerns are not overcome, resource wars seem almost certain.

According to Politico, US Treasury Secretary Geithner, in response to China's call for a new global currency said, The continued use of the dollar as a reserve currency, depends..on how effective we are in the United States...at getting our fiscal system back to the point where people judge it as sustainable over time.

In an update to the story, Politico reports, Evidently sensing a gaffe, moderator Roger Altman told Geithner that it would be "useful" to return to the question, and asked if he foresaw a change in the dollar's centrality.

"I do not," Geithner said, adding several forceful promises, including, "We will do what's necessary to say we're sustaining confidence in our financial markets."

Mr. Geithner, it seems to me, is caught in a Catch-22. The only thing standing between further substantial deterioration of US financial markets is the US$'s position as global reserve- any normal currency under similar conditions would long ago have lost much of its value. Yet, US finances are such that the US$ shouldn't be that global reserve. Heck, if one applied the Maastricht criteria, the US couldn't even get into EMU.

The idea that the Wealth of the World requires the Death of Nations has been depressing me for weeks. Perhaps I'm wrong (it certainly wouldn't be the first time) but it seems to me that current conditions are similar to those of a century ago. Then, as now, the commercial world was about to globalize but satisfactory agreements could not be reached, Nationalism ruled the day and two World Wars followed.

A line from the movie, The Matrix comes to mind, You've been down there, Neo. You already know that road. You know exactly where it ends. And I know that's not where you want to be.

Why "Stimulus" is Wrong

A strident response from an adherent to the Austrian School of Economics to my last post, Multipliers, Imbalances and Weights, Oh My!, suggests to me that choosing the terms of debate is at least as important to the outcome as choosing the field of battle. In this case, the term "stimulus" is a poor choice as it has become "loaded." It connotes the worst elements of Keynesian Economics- that the state should "goose" the economy to increase stalled growth through unproductive, make-work jobs.

Decades ago the preferred term for such policies was "intervention" perhaps with the hope that the state could be conflated with the divine- a conflation which acted as stimulus to the polemics of the Austrian School, notably from Mises: in face of the modern tendencies toward a deification of government and state, it is good to remind ourselves that the old Romans were more realistic in symbolizing the state by a bundle of rods with an ax in the middle than are our contemporaries in ascribing to the state all the attributes of God.

Even von Mises, however, did not fall into the trap of assuming that all state actions were "interventions" or "stimulus" and thus doomed to failure. Mises was no anarchist, he merely wished to find an intermediate position from which to argue the virtues of limiting the scope of government action: But he who correctly perceives the impracticability of anarchism and seeks a state organization with its apparatus of coercion in order to secure social cooperation is said to be inconsis­tent when he limits government to a narrow function.

Mises' argues, and I agree, that the state should operate within the structure of the market, and not try to impose its "will" thereupon. This was the thrust of my endogenous vs. exogenous conceptions of government. An intervention, as Mises argues in his Critique of Interventionism: is a limited order by a social authority forcing the owners of the means of production and entrepreneurs to employ their means in a different manner than they otherwise would.

We must distinguish between two groups of such [limited] orders. One group directly reduces or impedes economic produc­tion (in the broadest sense of the word including the loca­tion of economic goods). The other group seeks to fix prices that differ from those of the market. The former may be called “restrictions of production”; the latter, generally known as price controls, we are calling “interference with the structure of prices.”

Mises goes on to detail what qualifies as an "intervention" (in our case "stimulus") and what does not:

Measures that are taken for the purpose of preserving and securing the private property order are not interventions

Partial socialization of the means of production is no intervention in our sense. The concept of intervention as­sumes that private property is not abolished, but that it still exists in substance rather than merely in name. Nationaliza­tion of a railroad constitutes no intervention; but a decree that orders an enterprise to charge lower freight rates than it otherwise would is intervention.

Government measures that use market means, that is, seek to influence demand and supply through changes of market factors, are not included in this concept of intervention. If government buys milk in the market in order to sell it inexpensively to destitute mothers or even to distribute it without charge, or if government subsidizes educational in­stitutions, there is no intervention.

In more concrete terms, Eisenhower's Interstate Highway Project was not, with some exceptions, an intervention or stimulus. Laborers were paid the going wage, supplies were purchased at market prices, most (but not all, thus creeps in an intervention) land was purchased at going rates. To the extent that Obama's infrastructure projects are implemented with the same philosophy, they too would not constitute an intervention in the Misesean sense.

Historically, such projects often, but not always, prove wildly profitable. Persian Qanats and Roman Aqueducts are early examples of state driven projects with huge multipliers on growth (we'll leave aside the issue of Roman slave labor, which would constitute an anachronistic intervention). The point being, so long as the state facilitates projects the private sector is happy to supply and work on, this is not an intervention.

Bridges to nowhere would be an intervention, profitable high speed rail would not. We will see where the Obama plan falls between these 2 extremes.

In my next post I'll turn to the interventionist aspects of Obama's plan, much of which deals with finance.

Multipliers and Imbalances and Weights, Oh My!

By the way, these days everybody thinks they're an economist. President Obama

It's Friday the 13th. Centuries ago a group of Monks/Warriors turned Bankers known as the Knights Templar were arrested on secret orders from King Philip the Fair on a Friday the 13th in October, 1307. Philip owed the Knights quite a bit of money- what better way to cancel a debt than to outlaw your banker- and besides, their raison d'être as warriors and bankers, the Crusades and the financing thereof, had ended in failure.

Another dream of Globalization bites the dust. I suspect today's Bankers are hoping they are treated somewhat better than the previous financiers of Globalization. Imagine what one could discover from the CEOs who just visited Washington if they had faced a Medieval Inquisition?

Today's Bankers are made of much softer stuff. I doubt one would need waterboarding to get them singing, a simple threat of making them ride the NY subway to work each day would likely be sufficient.

But enough of the trip down history's lane, today's post is about the perils of economic debate in the public arena- like the scene from the Wizard of Oz, pundits are faced with the terrors of the unknown on a dark road, but instead of Lions and Tigers and Bears, it's Multipliers and Imbalances and Weights.

Take the debate between the Left and Right in America on tax cuts vs. increased spending. The Right, despite evidence of the past 8 years (which, as an aside does not debunk any theoretical argument in favor thereof, more on that later) would have us believe that tax cuts are the true Yellow Brick Road, while the Left would have us believe that all public spending is stimulus.

While past results are no guarantee of future returns, as I had to learn to pass my Series 3 exam- humans, after all, are not stones- the multiplier effect of the Bush era tax cuts has been limited mainly to increased building of economically unproductive mansions in Greenwich, Connecticut, exorbitant payments to prostitutes- haven't these guys heard of Bangkok?- and increased profits for Caribbean Junkets. Tax reductions on the upper class would have been much more simulative if today's rich had behaved more like the Protestant Ethic imagined- live frugally and reinvest.

This behavior could, of course, change and the upper class could dispense with their retained income in accordance with the Protestant Ethic derived assumed weights in Right Wing econometricians' imagination. The theory behind the virtue of tax cuts rests on the assumption of wise dispostion of the additional funds they control.

While I agree in principle, given the dire need for US infrastructure improvement, and the lack of initiative shown by the private sector in that regard of late, with the decision to shift the flow of funds away from the upper class and towards such projects, the returns from such spending will depend on the guiding vision and the efficiency with which the funds are spent. If the Left Wing fund distributors prove as greedy as the Right Wing Financiers, the effects wil be the same.

Funds spent to rebuild and improve suburban roads and malls will, in my view, have a much lower multiplier on growth than funds spent on more energy efficient goods and people transportation. Funds spent to construct new schools with lots of new technology will, in my view, have a much lower multiplier effect than funds spent on attracting and retaining better educators. More teachers, fewer bankers is my motto in that regard.

Alas, economic debate in the public arena is driven more by dogma than empirically based multipliers.

The final boogeyman on the dark road of depression is Imbalance (External)- a condition which arises when a nation imports far more than it exports. Recall the cries of outrage from our foreign trading partners occasioned by the phrase "Buy American" in the stimulus legislation.

To the extent that one cause of the financial malaise is the burden of funding the US Current Account, "Buy American" could be just what the economic doctor ordered.

Alas, a reduction of that imbalance (as occurs with any major shift in the flow of funds) will lead to profit reduction for some. Thus do recessions become depressions. The need for change becomes obvious and yet few want to change- trading a few extra quarters of profits for the life of the corporation.

Oh well, as Dorothy learned on her way back home, this too shall pass. Perhaps, to expedite the process, we could throw a bucket of water on the Bankers on their next trip to Washington.

Economic Recovery Plan: Analysis and Suggestions

Despite hitting a few bumps in the road, President Obama's plan for Economic Recovery is almost ready to be enacted. The plan has two main features; 1) a Treasury-led rescue of the financial sector (Financial Stability Plan) 2) substantial public works spending (American Recovery and Reinvestment Act of 2009).

In toto the Economic Recovery Plan will add more than $1T to the already rapidly increasing Federal Deficit and given the rather short duration of US Federal Debt, one key issue will be finance.

Last week's release of the quarterly refunding details explains how the Plan will be financed; 1) by increasing the quarterly refunding amounts 2) adding a monthly 7-year note auction 3) reopening the 30-year Bond in the month following the quarterly auction.

It's a quarter later than I expected (if you recall I argued that the November Refunding could be the straw that breaks the US$'s back- I was surprised by Paulson's decision to finance TARP with bills) but the effects will be similar- substantial increases in longer dated Treasury issuance will lead to higher rates and a weaker $ over time. Additionally, the risk of a "failed" auction on other markets will grow. While today's auction of 3-yr Notes went reasonably well (99.87, 2.67 Bid-to-Cover ratio, $14.3B to indirect bidders) weak foreign demand for longer dated issues, like this week's 10 and 30-yr and the monthly 7-yr will be ominous signs. With petro-$ recycling, thanks to the crash in oil prices, not a large factor, Asian demand for US Debt becomes paramount.

The Financial Stability Plan, as described by Treasury Secretary Geithner has four steps:

1) Clean and strengthen banking sector balance sheets by initiating more consistent, realistic and forward-looking risk assessment practices and providing additional capital support to banks in need thereof.

2) Establish a Public-Private Investment Fund whereby the Treasury will partially finance private sector purchases of so-called "toxic debt."

3) Work with the Fed to buy newly securitized loans in the small business, student, consumer, auto and commercial mortgage markets from the banks

4) launch a comprehensive housing program- details to be released later.

As best I can tell, Mr. Geithner's plan is merely a combination of the two approaches Paulson considered and will leave us, the tax paying public, with both toxic banks and toxic debt. I suspect a less ethically challenged Treasury Secretary would have devised a plan that apportioned more of the losses to bank shareholders.

To digress a bit, appointing Mr. Geithner to Treasury given his tax issues is akin to appointing an old Dead Head like me to the Office of National Drug Control Policy. Methinks Mr. Geithner is already learning the difficulties of cleaning house with dirty hands.

As a shareholder of a local bank I'm talking my book here and suggest a better plan would be to treat the big banks which failed to assess risk properly as failed ventures, wipe out their capital and use the funds to finance the expansion of regional banks with a better track record of risk assessment. Let's do some creative destruction and clear the financial decks, so to write.

Comparisons have been made between the US response to the current crisis and Japan's response to the crisis which emerged in the early 90s to the effect that the US response is (and needs to be) more "expeditious and forceful," by which is meant quicker and more expensive. I think we will find that greater speed and more capital will not be the answer. Japan's problem is our problem- bloated financial corporations which have gained power and are reluctant to relinquish it.

In a sense the same argument which put Geithner at Treasury despite his tax problems is that which informs his plan- just as he, despite his shortcomings, was supposed to be the best man for the job, so too are the current leading financial institutions, despite their obvious shortcomings, supposed to be the best for their job. This has little to do with Capitalism but much to do with Cronyism.

In sum, while I think real sector conditions, barring a "failed" auction (not a small probability event) will improve marginally in the spring, I suspect, as was the case in Japan, it won't be too long (late summer/early fall of '09) before debate begins on another Financial Stability Plan- one which will hopefully lean more on the wisdom of Volcker and less on that of Summers and Geithner.

In blunt terms, the "changing of the guard" the election of President Obama was heralded to bring has yet to manifest in Finance. As Einstein argued, insanity is defined as doing the same things and expecting different results.

Let's do something different.

Let Capitalism work.

On Confidence

A lack of confidence is one of the few causes of the current and all previous economic crises with which most economists agree. "Restore confidence," they argue and recovery will soon follow.

This leaves open the question of how confidence is "restored," and to what one refers when one uses the word, "confidence."

Is confidence that which is measured by consumer confidence surveys or is it something else?

The English word, "confidence" comes from the Latin confidentia, which translates literally as, "with faith," or more colloquially, "to trust fully." This definition begs the question, faith (or trust) in what? In the arena of economics, to be confident is to have faith (or trust) that one's actions will lead to the desired effects- a confident employee has faith that his employer will deliver the agreed upon wages and/or other benefits in trade for their labor, a confident investor has faith that his investment will generate the expected returns.

More generally, confidence in an economic sense is faith in the economic system, be it socialist, capitalist or other variant.

Under that head, confidence of economic participants will rise when the actions of the faithful are rewarded, and will fall when the actions of the faithful are not rewarded. If, for example, one sees others who labor faithfully get their promised rewards, which might include a pension for many years of service, one will come to believe that they too can be so rewarded.

Consumer confidence, perhaps confidence of the masses might be better, is, under this head, a widespread belief that the system works as promised.

Currently, consumers, i.e. the masses, are said to lack confidence. I agree, in a sense, but suggest that a different, and pernicious confidence is growing- the faith that the system works, not as promised, but as revealed. Idealism is being replaced by pragmatism, which makes restoring the beneficial confidence that much more difficult.

The system, as revealed, seems only to work for a small class of people, for whom the rewards are many, regardless of transgression.

A laborer who fails to pay taxes may well lose his home and perhaps be jailed while others who fail to pay get posts in the new Cabinet because they are allegedly the "best people for the job"- a sorry commentary on the quality of US administrative personnel.

A laborer who faithfully works for a business for many years may well find that, for no fault of his own, his promised pension will not be paid in full (or at all) while a CEO who runs a business into insolvency retires with millions.

A small business which fails to properly forecast future economic conditions is forced to liquidate and fire its employees while a large bank or other favored financial institution which fails to properly forecast future economic conditions is bailed out and gets to give its employees bonuses, or other perks.

While there may be hidden issues which rationalize such events to some, I suspect these rationalizations will fail to sway those whose trust in the system they were promised was broken. Indeed, the rationalizations may only serve to increase confidence in the system as revealed, which is a cynical system.

To the extent that the ideals of America are virtuous, which is to say that non-meritorious aristocracy and monopoly do not lead to the best economic outcomes, restoring the confidence of the increasingly pragmatic masses in those ideals will only happen when the facts on the ground match the ideals.

Trust repaid is trust increased and trust broken is trust decreased.

Sure it's obvious, but that doesn't mean it's easy.

I am asked to speak from time to time at the local Rotary Club and during my most recent visit I found, for the first time, a not-so-silent majority express the view that the system was predatory, not participatory. Restoring their confidence will not be easy.