Political Coordination

The political game has so many moving pieces and almost nothing is as it seems.  You are always asking yourself, do they mean that or is it just posturing for something else (and what is that other thing).  It is also true that as the number participants in a club increase and more interests are represented it become increasingly difficult to do anything if the participants have true power (ex. veto) and if there is a real conflict of interest on anything (not just the topic at hand).  I stumbled upon what struck me a interesting (unintentionally) visual representation of this.  Enjoy …

Credit and Equity

One very narrow data point that jumped out at me from the 4th quarter flow of fund was the change in security credit being extended by commercial banks.  Now the equity market fell for very fundamental reason but underneath that it seems as if there was a contraction of margin credit.  Now was it people backing away from the equity market because they needed to deleverage or was it the banks calling in margins lines.  The second seems more plausible.  This all seems to suggests that it wasn’t just a flight to safety but also a whipping out of the ability of those who wish to take risk to take it. 

I wanted to see how tight this credit line was with equity price changes.  The correlation has the right sign but isn’t overwhelming (which is what you should expect). 

Revisit Monetary Policy Tools

I recently had a conversation about the problem of zero interest rates and it made we want to revisit the topic of the tools of the monetary policy.  (In the United States this would be the federal reserve)  Typically the monetary authorities around the world try to manage their economies through the use of interest rates.  If they are trying to stimulate the economy they will lower the interbank rate thus pulling down the rate that banks lend to each other which flow through both deeper in the credit markets (pulls down the higher risk credit – because they are priced on spread) as well as pulling down longer term rates (because of the term structure of interest rates).  When this rates drop to zero it is true they can not lower the rate any more but they are not without tools. 

In theory they can change the money supply which can facilitate lending (and push up inflation, which will push down the real rate).  This changing of the money supply can happening through liquidity provision, credit inter-mediation (credit easing) or quantitative easing (increasing the money supply).  Providing liquidity gives the banking system assurances that they will not have a problematic run on their funding thus encouraging lending (the fed is doing this happening).  Credit inter-mediation is when the central bank takes on credit risk itself (it take on the role of the banking system – we are doing this as well).  Lastly quantitative easing is when the money supply is increased.  I interpret this to mean that the central bank would buy assets without funding the purchases (meaning they don’t borrow to buy assets which they are currently doing, but they simply buy the assets).  Up till now they have been funding the purchases via reserve creation (or t-bill issuance via the treasury), unless those reserves increase lending that is going on (are used to credit credit); then I would argue that new money has not been created.  The fed is trying to push out new money but is challenged by a dis-functional banking sector (which is why they are doing some inter-mediation themselves).  The big challenge is that if and when the banking system feels more comfortable and starts to use it excess reserves will the fed be able to walk along the tightrope they have created for themselves without (a) pulling back to much on liquidity and starting a new problem or (b) not pulling back enough and starting a inflation fire (and plausibly a currency problem – although I think the Fed has some ability to fight that with the FX swap lines at the moment). 

Now it is important to note that we don’t have a lot of experience with these tools and thus it is hard to have a lot of confidence in the handling.  In fact I would argue that we (economist) don’t have a precise tool set when working with the concept of money (which I ranted about before).  I think it would be fair to say that we are in a large economic experiment. 

One major risk is that of the political system interfering with independence of the fed; although I think it is still unlikely it is much more likely that at anytime during my life.

Democracy and The Rule of the Stupid

The word democracy makes people feel good.  Just like the ‘Axis of Evil’ sounds bad (however cartoonish).  But hopefully the reasons for our choice of societal organization is based on more then semantics and rhetoric.  I’m not going to try to provide the rational for why democracy is good (justice but also robustness) but I’d like to point out some of its weaknesses and why you should care about them in the context of the economic crisis.  

I’ve ranted about the fact that banks were giving back capital and that our bank bailout plan might retroactively fail because politicians were providing incentives for bankers to treat the capital as a short term loan instead of the equity injection that was needed.  Why would politicians do this?  They care about being elected and they want to keep their job (and increase thier power).  Thus they are pandering to what makes people feel good at the moment.  Which unfortunetly is beating up the financial system instead of fixing the problem.

So then the ignoble question is ‘are the legislator evil or stupid?’  Many politician basically understand the banking crisis (if not I’d be happy to explain it to them) and they know that paying back the capital is not entirely desirable.  If it all just about being elected how do they reconcile with thier conscious.  They tell themselves that if they are not reelected they won’t be able to do any good down the road and if they could just get a supermajority then they could do so much good.  So they justify foolishness now in order to allow them selves to do good in the future.  Of course it is important to note that they are nearly always in the short run and thus never get away from foolishness to go ‘good’.  But it seems weak to argue that politicians should not behave politically.  Politicans will be politicans. 

This policy vs. politics problem – the inability to do the right policy even when smart people agree about what it should be because of the political element – is always a popular conversation among wonks.  But it is not a new problem.  Aristotle wrote about the problem of the rule of the masses (or more bluntly the rule of the stupid) would be mitigated by the rule of the wealthy.  He also argued that one of the keys to a healthy democracy is a large middle class because they will be able to balance the rule of the stupid and the rule of the oligarch.  This could be because they view themselves as possibly being in each of those classes in the future and want the rules of the game (how society works) to be tolerable in both states of the world.  I tend to think that the truth to this argument is not about a large economic middle class but a large educated class.  Eduated voter use thier minds to make decisions based on reality and not a fantasy that a policitcan may be selling. 

From this educated middle class perspective some policy issues have a more substantial middle class than in other policy areas.  To be honest I suspect that people are more in tune with education, military, and health care issues than they are with macro economic issues.  Nearly everyone has experienced the education system, many people know someone who is in the military and most of us interact with the health care system.  And although I’m not a strong proponent that experience makes one an expert it does help increase understanding.  Many macro economic issue are simply not understood by the public and thus the rule of the stupid is risking poor policies that will compound the economic crisis. 

We’ve seen the enemy and he is us.

We don’t want them to give the capital back, yet.

Some of the banks have started to pay backthe government capital that they recieved just a few months ago.  At the surface this seems like a good thing.  The tax payers are getting back thier money.  I would argue that this is a big mistake and a function of political foolishness.  (Most are sending it back because of rules that were tagged on about salary which are politically popular but foolish because they make solving the underlying problem harder (Update: And now with the new tax law more will try to send it back)). 

First if you understand the banking crisis dynamic (if not read the primier)  you know that capital provides balance sheet capacity and can help slow or reverse the liquidation process.  Capital (think foundation) is necessary if the banking system is going to grow credit and the economy is to right itself.  We know that if capital is sent back the banking system balance sheet capacity is going to drop.  The scarier part is that if banks are all treating the capital as a ST loans that artificially raises their capital ratios and that they need to pay it back as soon as possible then all the capital that the US taxpayer has sent out is not doing what we hopped it would.  If it is only fake capital it is holding up the banking system in an artificial way and will only drag out the problem.  This ‘pay me back now’ attitude of our legislature is risking creating zombie banks that don’t lend.  (ala Japan).

I would argue that what the legislature should be doing is saying to the banks that all of you are not allowed to pay the capital back until the banking system is in aggregate working (based on measure of broad credit extention).  This means (1) no dividends, (2) no share buybacks, and (3) the gov’t capital stays in the banks.  Remember that if a firm is drowning in under utilized capital they will want to put it to use.  This can be risky if the sector has excess capital.   At the moment we don’t have that problem.

Bonus?

Everyone is up in arms about the AIG bonuses.  The story goes if the company is not making any money why should there be any bonuses.  I see the emotional appeal of this logic but it is off.  We must deal with reality (how the world is) not fantasy (or how the we would like the world to work).  The fact is that if AIG staff walked out the door it would have been the equivalent of failure this would have been a disaster (see LEH – Letting AIG fail would have been a number of time worse and basically would have broken society.  Is making sure companies that should fail worth causing a second great depression and risk the geopolitical consequences?).  Could they have been retained via moral suasion or less money?  Maybe but walking out the door to another HF and use their knowledge of the AIG book would likely have been profitable so they could have found a home and finding new people and getting up to speed would have been a large risk; paying them a market wage seemed to make sense.  If we don’t want flexible capital market we could make that policy choice but it would be much more costly than these bonuses. 

I suspect we don’t like hearing this but once again…we must deal with reality (how the world will work), not fantasy (or how we would like the world to work). 

Another point.  It doesn’t make sense to pay bonuses simply on absolute performance.  It should be given with respect to relative performance.  Saudi Aramco (Saudi Arabia oil company) will make tons of money regardless of who is the head.  Airlines struggle to make money year after year due to a competitive environment.  An airline that stays out of bankruptcy due to a wise leader has a much more valuable CEO than the head of SA.  In fact a company in a tough spot, if they could find talent, to help them achieve their goal (wind down or recover) should pay well for it. 

Note: Willing the taxation of the retention bonuses be remembered by the next team that finds itself this situation?  I suspect it will and thus we are crippling ourselves by ensuring that the rats will run from the ship and simply let it crash into the harbor instead of trying to mitigate the damage.

Update: I should make it clear that all this analysis offers is clarity regarding choice; it doesn’t tell you what to do.  If you want you could choose to not pay the bonuses and take that cost.  Also an interesting historical comparison is LTCM.  They had the advantage of bring in high ranking risk managers from all the banks that had pooled capital to bailout LTCM (the government doesn’t have this staff); but they choose to retain the LTCM staff to help bring them up to speed.  I don’t know what the LTCM guys were paid but it provides a comparison.

Update 2: Simon Johnson and James Kwak wrote and op-edin the New York Times which compares AIG to the late 1990 Asian financial crisis.  The basic message is that bankers will tell you what is most profitable for them.  They are the only one who can close deal XYZ.  We’ll it will be always true that the banker who know about the deal, in fact know most about the deal.  The question should be is it worthwhile given my new evaluation of competence of that banker to bring in someone else and bring them up to speed and what is the risk in doing that.  There is a BIG difference between the problem in 98 and the securities book that AIG is unwinding.  The banker is South Korea could not take advantage of his knowledge of the deal except to help close the deal (or at least not in the same way the AIG guys can).  Thus it just the question I laid out above, but the boys at AIG could have walked out the door, walked down the street to trading company ABC and started trading because they had tons of information about the book that was about to be dumped on the market.  This would be profitable for the former AIG workers and they would get paid but it would also be very very expensive for the taxpayer trying to clean up the AIG mess.  This gets back to my basic point from above.  When making decisions we must choose between two realities (and in this case two bad realities) not between reality and fantasy.  And thinking you can take away the pay from the AIG guys and ruin the way contract works (and continuously change the rules of the game after the game way played) without some bad consequences (like a decrease in enterprunrialship) is like crossing the street blindfolded to win a 5 dollar bet.  Of course it might work but why would you risk it.

Stewart vs. Cramer

Most of you have seen the Stewart vs Cramer interview.  Stewart did a good job bringing the financial news media to task with regards to if his show was commentary or entertainment (and why that should be clear up front).  (Read Chompsy’s Manufacturing Consent; although I’m not the biggest Chomsky fan I do think it is thought provoking with regards to how the media works).  I think people should consider all ‘news’ as degrees along an entertainment spectrum and thus treat each medium with the right lens of skepticism. 

I also think Stewart was wrong about his claim about the real market and the fake market and that practitioners knew what was going on and choose not to tell the public.  The claim that some people knew oversimplifies a complex world and does not give the audience the right mindset to thinking about finance (or anything else). Simply the world is not discrete or deterministic.  Thinking about finance probabilistically and considering the various paths which could play and then making decisions based on the likelihood and payout of each is a sensible framework.  During the past crisis systematic financial failure was under-weighted and the cost of that failure was underestimated.  The system was not prepared to handle failure of institutions and at a household level many families were not prepared for the current housing or job market. 

Calling out Cramer is not wrong (Note: he is an entertainer – I don’t find him entertaining although that is just a personal taste), but suggesting that a group of people knew is both inaccurate and inappropriate because it suggest the world operates in a way that it very rarely does and will prompt a ‘lot lock them up’ response. 

It may be scary to think this but really, no one knows, at least not for sure.  And once we acknowledge that we can make better decision to handle an uncertain world.

More of the Same

The Fed’s Flow of Funds came out last week.  For the most part it wasn’t particularly surprising but in a way this seems like a misstatement because it was what one would expect it was also extreme. 

(1) Federal Deficit Grows – Federal Debt grew at an annualized rate of 37%. The government (in a extremely useful way) moved to fix the banking system and facilitating the deleveraging process (and will continue for years – although this growth rate will likely drop, but the $ amount will remain high).  The federal government doesn’t usually have large net financial investments (buying of financial assets) for the last 2 quarters it has run at an annual rate of 1.3 trillion dollars.  While the increase in debt has run at an annual rate of over 2 trillion (2.35 trillion in 4 Qtr). 

(2) Monetary Authority – The central bank has taken over the banking system.  Expanding its liabilities in the 4th quarter, on an annualized basis, by 2.2 trillion dollars (nearly half of that going direct into the credit market and a quarter doing to foreign central banks and bank loans). 

(3)De-leveraging – Household debt dropped by 2% and business debt grew by a anemic rate of 1.7%.  HH saving has jumped from 32.5 Bill (2005), to 70.7 billion (2006) and 57.4 billion (2007) (read as no savings) jumped to 343.2 billion in the 4th QTR on an annualized basis.  This has likely accelerated into 2009 (assuming income haven’t fallen hard enough to induce the real paradox of thrift).  The way in which they saved (or what they did the savings) was also interesting.  Instead of buying more financial assets they tended to pay down debts.  Not surprising given the environment but not usual. 

(3) Financing – Credit markets continued to be ravaged by the collapse in the securitization market.  Home mortgages credit dropped by 248 billion on an annualized rate.  ABS issuers withdrew 371 billion and finance companies withdrew 102 billion.  Commercial Banks did not help in the 4th quarter withdrawing 144 billion.  The only provider of credit was the GSE and GSE backed pools which provided 86 and 287 billion respectively. 

Small Note: Security credit tanked in the 4th quarter, contracted by over 1 trillion on an annualized basis.  It could be interpreted as margin credit being bulled from small investors.  Was it due to margin calls due to falling equity prices or did brokers tighten credit and cause sales which hit equities.  Can’t tell just from that line but it is an interesting small note.

The Bracket

The NCAA brackets are out and although filling out the bracket for an office pool is a favorite past time of many people I want to argue that we should change the way we play the pool.   Does it always surprise you who wins…you think ‘they don’t follow basket ball.’  We’ll first off don’t pump yourself up to much, you might not be that smart, but part of the reason that seemingly unknowledgable people do well is they pick things that others don’t and the distributions of their results are larger. Note when a game is winner take all, increasing your volatility is a good thing.  But what if you got a group togther had a selection party and with a fixed buy-in auctioned off the teams and then assigned point values to each round.  I tend to believe (for good reasons, but I’ll let you think about that) that this would be a much more interesting pool because the result would be more connected to skill.  Although if you are one of those ill informed players who won their pool last year you might disagree. 

And for all of you out thier who are disappointed that your team did not make the cut consider the following quote…’You’ve heard me say from time to time if you torture the numbers long enough, you can get them to confess to anything’ – Gary Walters, NCAA Committee Chair.

Update: Ran a fun auction and the result came out surprising close to what the expected value of those ranks (used the aggregated ESPN brackets to give me estimates of team performance).  Underpaid for 1 and 2 were cheap 3 , 4, and 789 were expensive….

The Art of Freedom

Something fun for the weekend.  This is a picture of freedom ranking; the lines are countries, the date range goes from 1975-2008.  You can clearly see the fall of the soviet union in the early 90s.  It is not insightful but I like the way it looked.