As I listen to, and read about, the debate about raising the debt limit, I am stuck by the fact that we making the same mistakes that got us into the financial crisis of 2008. That is, we are under playing the downside risk that comes from being wrong. A good chunk of the problem that led to the financial meltdown resulted from the assumption that housing prices could not fall; therefore, it was not necessary to measure the downside risk that would come from falling house prices. People therefore invested in dubious financial instruments that could only cause problems if real estate prices dropped.
Tea Party members of congress have essentially said the same thing about default. They are saying that any negative would be short term. They believe that the market knows that USA credit is sound and there would be no consequences from default. What they fail to see is that the world and the markets may not act the way the Tea Partiers suppose. Lets look at some potential consequences of default:
1. The Government could still borrow to replace debt that is maturing as long as it does not exceed the debt limit. This will lead to:
A. Buyers demanding higher interest rates because they are
unsure of the payment of interest.Increasing the deficit.
B. Because the debt sells at auction this higher interest
means that the actual collection from the auction could be
substantially less than the debt being incurred.Increasing
the deficit.
C. To offset this the government could put a higher coupon
rate on the debt. But this will result in higher annual
interest payments. Increasing the deficit.
D. Most of the debt is short term and is sold at discount.
Higher interest rates mean the discount is deeper, interest
payments are higher, and the deficit increases.
2. Rating agencies lower the rating on US debt to AA from AAA. This leads to further increases in the interest on US debt because:
A. Many Fixed Income mutual funds require that they have a
certain percentage of their portfolios in AAA debt. This
means that they would have to dump some of their USA
Securities onto the market thereby lowering the price
of US debt and raising interest rates.
B. Many insurance companies are under similar NAIC rules that
would cause similar restructuring.
C. Many countries have their reserves in U.S.Dollars that
are invested in U.S. Government Securities. They might be
tempted to move to the Euro, the Pound, or the Yen.
D. Oil and many other commodities are priced in U.S. Dollars.
If these move to other currencies, the price effects for
U.S. consumers could be extremely uncomfortable.
E. All of the preceding items 2 A - D would lead to negative
effects on the U.S. economy. A shrinking economy means
automatic decreases in tax collections and automatic
increases in other programs. All leading to an increase in
the deficit.
The Tea Party actions, instead of helping, would lead to a long term worsening of the debt problem. There is an old saying: "Be careful of what you wish for. You may get it"
Thursday, July 28, 2011
Wednesday, July 20, 2011
They're At It Again
Einstein is credited with the statement:"...Insanity is doing the same thing over and over again expecting different outcomes...". I guess this is an apt description of the IMF. Let me explain: Yesterday, July 19th, an IMF representative said that any arrangement for a EURO bailout of Greece needs to be structured so that credit insurance will not kick-in.
It appears that European banks have continued to issue Credit Default Swaps, a form of insurance against financial instrument defaults,despite the experience of AIG in the last financial crisis. The IMF is worried that exercise of the provisions of the swaps will sink Europe's banking system.However, nobody has instituted regulations to prevent the issuance of these swaps.If the consequences of people collecting on these pseudo insurance policies are so dire then they should be banned.
The problem with banning Credit Default Swaps is that too many people are making money on them; in the event that they have to be paid on, everyone is sure that governments will bail out the issuers to prevent a financial collapse. Adding to the problem is the fact that the Swaps are in fact financial instrument and not insurance policies. They are securities which can be bought and sold on the open market. The current owners of these securities probably do not own the bonds (Greek Debt) that are being insured. Therefore,they do not have an insurable interest in debt which may default. However,if there is a default,they would get paid anyway.
Now to get back to who is making money:
1. The issuing institution is paid to write the securities.
2. The debt issuer gets a lower interest rate because the buyers of the debt can buy the Swaps.
3. The buyers of the Swaps can then sell them at a premium if it looks as if they will ever have to be paid off.
4. The original issuer gets paid off by various governments in order to avoid collapse.
5. Brokerages make commission money buying and selling the swaps to 3rd parties
6. The losers are the tax payer and the unsophisticated buyers who are holding swaps which will never be paid on because of government bailouts to the debt issuers.
So, our governments keep allowing these transactions because the Swap issuers are the same people who make large donations to their campaigns. On top of this, the government officials in charge of regulating these activities usually came from the offending financial institutions and will probably return to them when they leave government service.
"WE HAVE THE BEST GOVERNMENT MONEY CAN BUY"
It appears that European banks have continued to issue Credit Default Swaps, a form of insurance against financial instrument defaults,despite the experience of AIG in the last financial crisis. The IMF is worried that exercise of the provisions of the swaps will sink Europe's banking system.However, nobody has instituted regulations to prevent the issuance of these swaps.If the consequences of people collecting on these pseudo insurance policies are so dire then they should be banned.
The problem with banning Credit Default Swaps is that too many people are making money on them; in the event that they have to be paid on, everyone is sure that governments will bail out the issuers to prevent a financial collapse. Adding to the problem is the fact that the Swaps are in fact financial instrument and not insurance policies. They are securities which can be bought and sold on the open market. The current owners of these securities probably do not own the bonds (Greek Debt) that are being insured. Therefore,they do not have an insurable interest in debt which may default. However,if there is a default,they would get paid anyway.
Now to get back to who is making money:
1. The issuing institution is paid to write the securities.
2. The debt issuer gets a lower interest rate because the buyers of the debt can buy the Swaps.
3. The buyers of the Swaps can then sell them at a premium if it looks as if they will ever have to be paid off.
4. The original issuer gets paid off by various governments in order to avoid collapse.
5. Brokerages make commission money buying and selling the swaps to 3rd parties
6. The losers are the tax payer and the unsophisticated buyers who are holding swaps which will never be paid on because of government bailouts to the debt issuers.
So, our governments keep allowing these transactions because the Swap issuers are the same people who make large donations to their campaigns. On top of this, the government officials in charge of regulating these activities usually came from the offending financial institutions and will probably return to them when they leave government service.
"WE HAVE THE BEST GOVERNMENT MONEY CAN BUY"
Wednesday, July 13, 2011
THE FALLACY OF REFUSING TO RAISE TAXES FOR THE RICH
In February of 2005 I wrote a blog in support of the progressive income tax. Given the current Republican refusal to consider any tax increase for the rich and the proposals to substitute a Value Added Tax for a large portion of the Income Tax, I believe that my blog comments retain their relevancy. As a result I am reprinting the original blog below with some added comments at the end:
PROGRESSIVE INCOME TAXES EQUALIZE THE PAIN
Tax policy usually relies on either of two principles: The “Ability to Pay Principle” or the “Benefit Principle”. Both of these forget the fact that paying taxes is painful. If possible we would all like to pay as little as possible to the various levels of government. However, as long as we have to support our government we should make sure that when we pay taxes we are “equalizing the pain” to each of us. The problem with “Flat Taxes”, “Value Added Taxes”, and the various consumption taxes is that they tend to distribute the pain to the lowest economic levels in society. To see how this applies we need to look at the satisfaction people get from having income and/or wealth.
It is well known that as people obtain more and more of a good or service the satisfaction they get from the last unit of the good is lower than the satisfaction received from the immediately prior unit. In economics this is known as the Law of Diminishing Marginal Utility. This “law” applies to income and wealth as well as the consumption of goods and services. The more income or wealth you have, the less each additional dollar of income or wealth means to you in terms of your over all satisfaction.
Applying this to tax policy we can see that a 20% flat tax would cost $4,000 to a person with a taxable income of $20,000 per year and $20,000 to a person with a taxable income of $100,000 per year. In terms of the ability to enjoy the fruits of the economic system, the $4,000 to the low income individual is a much greater sacrifice than the $20,000 is to the high income individual. Equalizing the pain of paying taxes would require that the low income person pays a lower tax rate or the higher income person faces a higher tax rate or some combination of lower and higher rates.
Progressive income taxation is not a “soak the rich” scheme. It is the only system which has the capability of equalizing the pain of supporting government.
The problem with a VAT (Value Added Tax) is that it has lower income households paying a large portion of their income in taxes than higher income households. This is because all spending is taxes under a VAT. Assume that the VAT is 14% (this is low compared to most VAT countries). A family of 4 with an income of $40,000 per year will probably have no Saving. This means that the whole $40,000 would be subject to VAT and the Tax paid of $5,600 would be 14% of their income. A household with an income of $400,000 per year would have a saving rate approximately 20%. They would be spending $320,000 with a VAT of $44,800. This is 11.2% of the higher income family's gross income. In other words the low income family has a higher effective rate of taxation than the high income family.
ADDITIONAL COMMENTS REGARDING THE VAT
Please remember that the VAT results in a lower quality of life at the lower income level because the low income VAT payment means that true spending on goods and services is $34,400 which is the $40,000 less the $5,600 VAT. The higher income families can opt lower net spending of reduce their saving to maintain the quality of life. Even if this decision is made, the high income effective tax rate would still be lower than the effective rate paid by the lower income family. The numbers are slightly off for the low income family because the VAT would be applied to only their spending.The math works out to Spending of $35.087.72 and VAT Taxes of $4,912.28 or 12.2% of gross income.The high income family still has a lower effective tax rate of 11.2% if they pay the tax by reducing their saving. If they reduce their spending the would spend $280,701.75, have a VAT of $39,298.25, and have a effective tax rate of 9.82%.
All in all the lower income people pay a higher percentage of their income than the higher income people. This is the definition of a regressive tax system.
PROGRESSIVE INCOME TAXES EQUALIZE THE PAIN
Tax policy usually relies on either of two principles: The “Ability to Pay Principle” or the “Benefit Principle”. Both of these forget the fact that paying taxes is painful. If possible we would all like to pay as little as possible to the various levels of government. However, as long as we have to support our government we should make sure that when we pay taxes we are “equalizing the pain” to each of us. The problem with “Flat Taxes”, “Value Added Taxes”, and the various consumption taxes is that they tend to distribute the pain to the lowest economic levels in society. To see how this applies we need to look at the satisfaction people get from having income and/or wealth.
It is well known that as people obtain more and more of a good or service the satisfaction they get from the last unit of the good is lower than the satisfaction received from the immediately prior unit. In economics this is known as the Law of Diminishing Marginal Utility. This “law” applies to income and wealth as well as the consumption of goods and services. The more income or wealth you have, the less each additional dollar of income or wealth means to you in terms of your over all satisfaction.
Applying this to tax policy we can see that a 20% flat tax would cost $4,000 to a person with a taxable income of $20,000 per year and $20,000 to a person with a taxable income of $100,000 per year. In terms of the ability to enjoy the fruits of the economic system, the $4,000 to the low income individual is a much greater sacrifice than the $20,000 is to the high income individual. Equalizing the pain of paying taxes would require that the low income person pays a lower tax rate or the higher income person faces a higher tax rate or some combination of lower and higher rates.
Progressive income taxation is not a “soak the rich” scheme. It is the only system which has the capability of equalizing the pain of supporting government.
The problem with a VAT (Value Added Tax) is that it has lower income households paying a large portion of their income in taxes than higher income households. This is because all spending is taxes under a VAT. Assume that the VAT is 14% (this is low compared to most VAT countries). A family of 4 with an income of $40,000 per year will probably have no Saving. This means that the whole $40,000 would be subject to VAT and the Tax paid of $5,600 would be 14% of their income. A household with an income of $400,000 per year would have a saving rate approximately 20%. They would be spending $320,000 with a VAT of $44,800. This is 11.2% of the higher income family's gross income. In other words the low income family has a higher effective rate of taxation than the high income family.
ADDITIONAL COMMENTS REGARDING THE VAT
Please remember that the VAT results in a lower quality of life at the lower income level because the low income VAT payment means that true spending on goods and services is $34,400 which is the $40,000 less the $5,600 VAT. The higher income families can opt lower net spending of reduce their saving to maintain the quality of life. Even if this decision is made, the high income effective tax rate would still be lower than the effective rate paid by the lower income family. The numbers are slightly off for the low income family because the VAT would be applied to only their spending.The math works out to Spending of $35.087.72 and VAT Taxes of $4,912.28 or 12.2% of gross income.The high income family still has a lower effective tax rate of 11.2% if they pay the tax by reducing their saving. If they reduce their spending the would spend $280,701.75, have a VAT of $39,298.25, and have a effective tax rate of 9.82%.
All in all the lower income people pay a higher percentage of their income than the higher income people. This is the definition of a regressive tax system.
Sunday, July 05, 2009
Profit vs. Value
To those few of you who read my blog on a regular basis, I want to apologize in advance for what will be a fairly technical blog.
As I read about the various arguments regarding how to revise the financial regulatory system, I am amazed at the fact that the discussions never seem to get to the basis of modern financial decision making. In the modern world we use the term “Value Creation” to describe the goal of maximizing shareholder value. This means keeping the price of a stock as high as possible. Almost all of the executive compensation packages are based upon the principle that maximizing the current price of a share of stock is the goal of all companies. This is based upon the assumption that we have perfect markets with perfect information. However, as we have found out, al la ENRON, the market often does not have the information necessary to properly value a company’s shares. In fact, the management has huge incentives to engage in long run value destroying activities because they appear to add value in the short run.
The whole value maximization approach is aimed at a trading rather than an investing mentality. This is an outgrowth of the work of Nobel Laureates Miller, Modigliani, and Sharpe. Miller and Modigliani establish that the value of a company is independent of the debt/equity ratio of the firm. They even establish that the optimal financial structure in the presence of taxes is 100% debt. Sharpe, through the Capital Asset Pricing Model establishes that a firm’s expected return is related to the variability of the returns a firm earns as compared to market returns and returns on risk free assets. For both of these systems to be applicable firms need to be traded in efficient markets and risk associated with specific firms can be diversified away. It appears that the people implementing value maximization forgot these underlying assumptions.
When we look at a firm’s capital structure, i.e. debt/equity ratio, we need to remember that higher debt leads to a wider variation in the returns available to the shareholder. Higher debt equals higher risk. As more and more firms follow the approach of increasing debt the less likely it becomes that risk can be successfully diversified. As a result, we demand higher and higher returns to off-set the higher risk. In an attempt to meet these higher expectations, managements increase the risk of the projects they undertake because higher risk usually results in higher returns. The whole system becomes subject to the types of risks that, in the past, had only been associated with specific firms (Specific Risk). The Financial System starts to rise on a spiral staircase that has a drop-off at the top. The financial meltdown of 2008 was the result of the system going over the top of the staircase just described.
Going back to Miller, Modigliani, and Sharpe we find that they appear to work under the assumption that managements look toward valuing a firm as the present value of the future stream of income. In the absence of Wall Street Analysts this might be true. However, analysts seem to have a trading mentality. As a result, the concept of investing in solid profit earning firms on a long term basis is lost. Even many of our institutions, such as pension plans, which should be long-term investment oriented have turn-over ratios nearing or over 100%. The resultant trading mentality combined with higher levels of specific risk leads to very high levels of risk for the entire system. We have turned into speculators and gamblers rather than investors.
Please do not misinterpret what I am saying:
1. I do not have the hubris to place my ideas on the level of Nobel Laureates. I am, however, criticizing those who have misused their works.
2. Speculators serve an excellent purpose in an economic system. Through arbitrage, they act to effectively stabilize the markets. However, this only works if we have markets dominated by investors. When speculation dominates the system we find that we are operating a casino instead of a financial market.
Our regulation writers have to take into consideration how we got where we are. I believe that they are spending too much time looking at specifics rather than the general approach which got us into trouble to begin with. “…We can’t see the forest for the trees…”
As I read about the various arguments regarding how to revise the financial regulatory system, I am amazed at the fact that the discussions never seem to get to the basis of modern financial decision making. In the modern world we use the term “Value Creation” to describe the goal of maximizing shareholder value. This means keeping the price of a stock as high as possible. Almost all of the executive compensation packages are based upon the principle that maximizing the current price of a share of stock is the goal of all companies. This is based upon the assumption that we have perfect markets with perfect information. However, as we have found out, al la ENRON, the market often does not have the information necessary to properly value a company’s shares. In fact, the management has huge incentives to engage in long run value destroying activities because they appear to add value in the short run.
The whole value maximization approach is aimed at a trading rather than an investing mentality. This is an outgrowth of the work of Nobel Laureates Miller, Modigliani, and Sharpe. Miller and Modigliani establish that the value of a company is independent of the debt/equity ratio of the firm. They even establish that the optimal financial structure in the presence of taxes is 100% debt. Sharpe, through the Capital Asset Pricing Model establishes that a firm’s expected return is related to the variability of the returns a firm earns as compared to market returns and returns on risk free assets. For both of these systems to be applicable firms need to be traded in efficient markets and risk associated with specific firms can be diversified away. It appears that the people implementing value maximization forgot these underlying assumptions.
When we look at a firm’s capital structure, i.e. debt/equity ratio, we need to remember that higher debt leads to a wider variation in the returns available to the shareholder. Higher debt equals higher risk. As more and more firms follow the approach of increasing debt the less likely it becomes that risk can be successfully diversified. As a result, we demand higher and higher returns to off-set the higher risk. In an attempt to meet these higher expectations, managements increase the risk of the projects they undertake because higher risk usually results in higher returns. The whole system becomes subject to the types of risks that, in the past, had only been associated with specific firms (Specific Risk). The Financial System starts to rise on a spiral staircase that has a drop-off at the top. The financial meltdown of 2008 was the result of the system going over the top of the staircase just described.
Going back to Miller, Modigliani, and Sharpe we find that they appear to work under the assumption that managements look toward valuing a firm as the present value of the future stream of income. In the absence of Wall Street Analysts this might be true. However, analysts seem to have a trading mentality. As a result, the concept of investing in solid profit earning firms on a long term basis is lost. Even many of our institutions, such as pension plans, which should be long-term investment oriented have turn-over ratios nearing or over 100%. The resultant trading mentality combined with higher levels of specific risk leads to very high levels of risk for the entire system. We have turned into speculators and gamblers rather than investors.
Please do not misinterpret what I am saying:
1. I do not have the hubris to place my ideas on the level of Nobel Laureates. I am, however, criticizing those who have misused their works.
2. Speculators serve an excellent purpose in an economic system. Through arbitrage, they act to effectively stabilize the markets. However, this only works if we have markets dominated by investors. When speculation dominates the system we find that we are operating a casino instead of a financial market.
Our regulation writers have to take into consideration how we got where we are. I believe that they are spending too much time looking at specifics rather than the general approach which got us into trouble to begin with. “…We can’t see the forest for the trees…”
Friday, June 19, 2009
NOT ALL MARKETS BENEFIT FROM COMPETITION
Having been trained in Economics and Finance, I am a strong believer in the benefits of market based competition. However, I also recognize that there are many markets where for some reason the free market does not lead to economic efficiency which economists often define as producing at the lowest possible cost. The medical industry may fall into this category of non-market based efficiency.
This can be illustrated by the following: About 25 to 30 years ago the Blue Cross/Blue Shield system dominated the health insurance industry. There was sharp criticism because the hospital portion of medical care was paid on a cost plus basis. Those who did not understand the system assumed that this led to uncontrolled growth in hospital costs. Governments forced the Blues into a different payment system and hospital costs skyrocketed. What the critics failed to understand is that the Blues audited hospital costs and refused to include many costs in the payment base. In fact, hospitals were required to get advance approval for major capital purchases. This means that if one hospital had an underutilized MRI the blues would not reimburse another hospital in the area that acquired an additional MRI. The Blues encouraged the second hospital to contract for MRI services with the first hospital. This led to lower overall costs in the system. The elimination of the Blue Cross single payer cost-plus system led to duplication of services and higher per unit costs due to under utilization at some institutions and higher over-all costs due to scheduling of unnecessary tests designed to justify the acquisition of the equipment at others. In this case competition led to higher costs instead of economic efficiency.
Now we are hearing health insurers and their congressional apologists screaming that a single payer system would not be economically efficient because we would eliminate competition. In addition, they claim that a single payer system would lead to rationing. What they fail to consider is that we already have rationing. In a world of scarce resources the market based system allocates, i.e. rations, resources on the basis of prices. In the realm of health care, those who can afford to pay the price get the care. Medical care is rationed to those with either high wealth or good insurance. Those without either get poor or no care. In addition, as was explained earlier, market based health care leads to higher costs.
The time has come for Americans to join the rest of the developed world and treat health care as a non-market service. Those who claim that the government cannot operate efficiently just need to look at Medicare as a model. I have many friends, over 65, who rail against government involvement in health care. When I ask them if they’re going to give up their Medicare coverage their universal response is that Medicare is great. Why would they give it up? When I point out their contradictory attitudes they just ignore me. They fall into the category of those people who dislike economists because economics often disproves their preconceived notions and people are reluctant to change cherished beliefs when evidence contradicts them.
This can be illustrated by the following: About 25 to 30 years ago the Blue Cross/Blue Shield system dominated the health insurance industry. There was sharp criticism because the hospital portion of medical care was paid on a cost plus basis. Those who did not understand the system assumed that this led to uncontrolled growth in hospital costs. Governments forced the Blues into a different payment system and hospital costs skyrocketed. What the critics failed to understand is that the Blues audited hospital costs and refused to include many costs in the payment base. In fact, hospitals were required to get advance approval for major capital purchases. This means that if one hospital had an underutilized MRI the blues would not reimburse another hospital in the area that acquired an additional MRI. The Blues encouraged the second hospital to contract for MRI services with the first hospital. This led to lower overall costs in the system. The elimination of the Blue Cross single payer cost-plus system led to duplication of services and higher per unit costs due to under utilization at some institutions and higher over-all costs due to scheduling of unnecessary tests designed to justify the acquisition of the equipment at others. In this case competition led to higher costs instead of economic efficiency.
Now we are hearing health insurers and their congressional apologists screaming that a single payer system would not be economically efficient because we would eliminate competition. In addition, they claim that a single payer system would lead to rationing. What they fail to consider is that we already have rationing. In a world of scarce resources the market based system allocates, i.e. rations, resources on the basis of prices. In the realm of health care, those who can afford to pay the price get the care. Medical care is rationed to those with either high wealth or good insurance. Those without either get poor or no care. In addition, as was explained earlier, market based health care leads to higher costs.
The time has come for Americans to join the rest of the developed world and treat health care as a non-market service. Those who claim that the government cannot operate efficiently just need to look at Medicare as a model. I have many friends, over 65, who rail against government involvement in health care. When I ask them if they’re going to give up their Medicare coverage their universal response is that Medicare is great. Why would they give it up? When I point out their contradictory attitudes they just ignore me. They fall into the category of those people who dislike economists because economics often disproves their preconceived notions and people are reluctant to change cherished beliefs when evidence contradicts them.
Tuesday, April 14, 2009
IS ECONOMICS REALLY DEAD?
More and more, today, we are reading the current economic crisis proves that Market Economics is dead. Looking at the behaviors exhibited in the last twenty years, the detractors tell us, proves that people do not follow the rational economic choices that are espoused by classical economists. They claim that the new wave of economics is behaviorist and behaviorism destroys all classical analysis. In other words: “Adam Smith is no longer relevant.”
Although there are strong arguments for this approach, I believe that the classical Supply/Demand Model still works. It only needs a minor modification to remain relevant and reliable predictor of human behavior. Most of us, who only had a cursory course or two in economics, remember that the Supply/Demand approach looks at prices and quantities. There is an assumption that all of our decisions are based upon changes in prices. What we forget is that the price quantity relationships are stipulated as operating ceteris paribus. This means that everything else remains constant. Economists are not stupid. They know that people spend based upon their tastes and preferences, their income, their wealth, their expectations and many other factors. The model, however, holds these items constant and says that people will act rationally in a supply demand situation.
Where our model appears to fall apart is that people seem to be acting irrationally. If this is the case, then maybe economics is irrelevant. Looking at the same behaviors, I have come to a different conclusion. I concentrate on peoples’ expectations. I believe that people act with economic rationality based upon their expectations. However, there is nothing in the model that says peoples’ expectations have to be rational. So, if you believe that the basics of the economy have changed and there will never be a down real estate market again, you will be willing to take on an in ordinate amount of debt because the rising asset value will give you a growing net worth. Expecting a market with no down side risk is irrational. But, if you are faced with experience that has never seen a down side in real estate you will act as if the lack of a downside is reality. Your actions are rational within the context of your belief and follow standard economic models regarding supply and demand.
This approach also helps us understand why people buy high and sell low in the stock market: If the market has been growing for a long time but you are afraid of market cycles there is a high probability that you stayed out of the market during its early growth phase. As the market keeps growing you begin to experience cognitive dissonance. That is, your behavior is at odds with everything you now appear to know about the market. You finally give in and go into a buy mode. However, you waited too long and the market drops shortly after your purchases. You are now in the “…I knew I never should have done this…” mode. Your real expectations have been reinforced and you decide to “…cut your losses…” Your observed behavior is irrational. But, based upon your expectations you behaved rationally.
We do need to spend more time addressing how expectations are created. We also need to do more in the realm of education that allows expectations to be created based on rationality. The problem we have had is that the experts, who should have known better, were making so much money that they were reluctant to burst the balloon and eventually began to have irrational expectations of their own. They began to believe their own hype.
Although there are strong arguments for this approach, I believe that the classical Supply/Demand Model still works. It only needs a minor modification to remain relevant and reliable predictor of human behavior. Most of us, who only had a cursory course or two in economics, remember that the Supply/Demand approach looks at prices and quantities. There is an assumption that all of our decisions are based upon changes in prices. What we forget is that the price quantity relationships are stipulated as operating ceteris paribus. This means that everything else remains constant. Economists are not stupid. They know that people spend based upon their tastes and preferences, their income, their wealth, their expectations and many other factors. The model, however, holds these items constant and says that people will act rationally in a supply demand situation.
Where our model appears to fall apart is that people seem to be acting irrationally. If this is the case, then maybe economics is irrelevant. Looking at the same behaviors, I have come to a different conclusion. I concentrate on peoples’ expectations. I believe that people act with economic rationality based upon their expectations. However, there is nothing in the model that says peoples’ expectations have to be rational. So, if you believe that the basics of the economy have changed and there will never be a down real estate market again, you will be willing to take on an in ordinate amount of debt because the rising asset value will give you a growing net worth. Expecting a market with no down side risk is irrational. But, if you are faced with experience that has never seen a down side in real estate you will act as if the lack of a downside is reality. Your actions are rational within the context of your belief and follow standard economic models regarding supply and demand.
This approach also helps us understand why people buy high and sell low in the stock market: If the market has been growing for a long time but you are afraid of market cycles there is a high probability that you stayed out of the market during its early growth phase. As the market keeps growing you begin to experience cognitive dissonance. That is, your behavior is at odds with everything you now appear to know about the market. You finally give in and go into a buy mode. However, you waited too long and the market drops shortly after your purchases. You are now in the “…I knew I never should have done this…” mode. Your real expectations have been reinforced and you decide to “…cut your losses…” Your observed behavior is irrational. But, based upon your expectations you behaved rationally.
We do need to spend more time addressing how expectations are created. We also need to do more in the realm of education that allows expectations to be created based on rationality. The problem we have had is that the experts, who should have known better, were making so much money that they were reluctant to burst the balloon and eventually began to have irrational expectations of their own. They began to believe their own hype.
Tuesday, March 24, 2009
GEITHNER IS TOO CLOSE TO THE STREET
Up until now I had the attitude that Secretary Geithner needed all the support we could give him. The country needed to have a solid voice that could implement plans without creating a sense of uncertainty. However, I now believe the time has come for him to go. His recent plan to deal with the “toxic assets’ is fatally flawed. It is based upon the assumption that the markets have undervalued the assets and government guarantees will get the private sector to buy them. The problem with this approach is that it relies upon the banks being willing to sell the assets at the price the market is willing to pay. The private sector which has already priced the assets at extremely low levels and the Geithner plan expects it to miraculously start buying at inflated prices due to government guarantees. There is not even an assurance that the banks holding the assets will sell them at anything less than face value.
In addition, if the assets prove to have little worth, the US government, read you and me, will have to pay off the guarantees. It would be a lot cheaper to the taxpayer if we nationalized the illiquid, read that as insolvent, banks, let the assets mature, and pay back the taxpayer to the extent that the maturing assets will allow. We, in aggregate (government), have a much greater capacity to wait out the market than do profit making institutions. In the long run a single “Bad Bank” will have a greater capacity to renegotiate loans, the disruption to the market from bank bankruptcy will be mitigated, and the costs to the tax payer will be lower.
Mr. Geithner appears to be too obsessed with preserving the current insolvent banks rather than solving the problems facing the financial system. I believe that in his role as President of the Federal Reserve Bank of New York he may have gotten too close to the “Movers and Shakers” who caused the problem to begin with. This makes him overly amenable to their approaches that are design to preserve their own positions. Once again the economics of greed is winning out over Adam Smith’s “Enlightened Self Interest”
In addition, if the assets prove to have little worth, the US government, read you and me, will have to pay off the guarantees. It would be a lot cheaper to the taxpayer if we nationalized the illiquid, read that as insolvent, banks, let the assets mature, and pay back the taxpayer to the extent that the maturing assets will allow. We, in aggregate (government), have a much greater capacity to wait out the market than do profit making institutions. In the long run a single “Bad Bank” will have a greater capacity to renegotiate loans, the disruption to the market from bank bankruptcy will be mitigated, and the costs to the tax payer will be lower.
Mr. Geithner appears to be too obsessed with preserving the current insolvent banks rather than solving the problems facing the financial system. I believe that in his role as President of the Federal Reserve Bank of New York he may have gotten too close to the “Movers and Shakers” who caused the problem to begin with. This makes him overly amenable to their approaches that are design to preserve their own positions. Once again the economics of greed is winning out over Adam Smith’s “Enlightened Self Interest”
Saturday, March 21, 2009
MATERIALITY AND THE AIG BONUS PROBLEM
When I was reading about the AIG bonuses I was as outraged as anyone else. The first thing that came to my mind was “How could Geithner let them get away with this?” Then I stopped and thought about the days when I managed a half-billion dollar portfolio. Number in the thousands didn’t seem very significant. The problem arises from the fact that large numbers contain a lot of digits. Most people working with large numbers drop several digits due to what accountants call immateriality. For example: Most company financial statements have (000) written under the title of the individual financial statement and all of the numbers are in thousands of dollars. So, $1,985 is really $1,985,000. We’re talking millions of dollars, not thousands and hundreds of dollars get lost in the shuffle.
So, how did Mr. Geithner miss $250 million? It is easy to do when the bailout is in the billions. Simply, most of the numbers crossing Mr. Geithner’s desk were probably written in billions. The bailout package to AIG was probably written as $185 instead of $185,000,000,000. This means that the bonuses would have been written as $0.165. This is a number that looks insignificant in the overall scheme of things and could easily be missed. Especially by a person who is dealing with a national debt number in the trillions. Let’s face it, if all day long you’re seeing number like $9,654.4 which is the national debt, $0.165 looks like peanuts. That fact that the true numbers are $9,654,400,000,000 and $165,000,000 gets become obscured.
What is needed is to have people working with the Treasury Secretary and the Fed Chairman who understand that apparent small percentage numbers have a high impact when read as whole numbers. People in the rarefied air of Washington and New York do not realize that the AIG bonuses could eliminate the debt of many smaller cities and pay for the complete budgets of many school districts. I do not blame Mr. Geithner for missing the impact news of the Bonuses would have on the public. I do blame the loud mouthed critics who would have claimed that the Obama administration was destroying the capitalist system if the bonuses had been blocked. Once the bonus contracts were written, it became a lose-lose situation for the Obama team.
So, how did Mr. Geithner miss $250 million? It is easy to do when the bailout is in the billions. Simply, most of the numbers crossing Mr. Geithner’s desk were probably written in billions. The bailout package to AIG was probably written as $185 instead of $185,000,000,000. This means that the bonuses would have been written as $0.165. This is a number that looks insignificant in the overall scheme of things and could easily be missed. Especially by a person who is dealing with a national debt number in the trillions. Let’s face it, if all day long you’re seeing number like $9,654.4 which is the national debt, $0.165 looks like peanuts. That fact that the true numbers are $9,654,400,000,000 and $165,000,000 gets become obscured.
What is needed is to have people working with the Treasury Secretary and the Fed Chairman who understand that apparent small percentage numbers have a high impact when read as whole numbers. People in the rarefied air of Washington and New York do not realize that the AIG bonuses could eliminate the debt of many smaller cities and pay for the complete budgets of many school districts. I do not blame Mr. Geithner for missing the impact news of the Bonuses would have on the public. I do blame the loud mouthed critics who would have claimed that the Obama administration was destroying the capitalist system if the bonuses had been blocked. Once the bonus contracts were written, it became a lose-lose situation for the Obama team.
Sunday, March 15, 2009
THE ARROGANCE OF AIG
About 15 years ago, when I was working in corporate treasury, my company’s insurance broker asked me to write a letter to him expressing my experience in dealing with AIG as the carrier of our Liability and Workers Compensation coverage. My response was that the AIG representatives behave in such an arrogant manner that one would think that you were dealing with the Department of Motor Vehicles. The recent announcement that AIG would be paying in excess of $165 million in bonuses convinces me that nothing has changed.
Remember, AIG is a company that has required tens of billions of dollars in bailouts from the government in order to avoid cascading failures to the world economic system. In addition, AIG’s losses have been larger than the GDP’s of many medium countries. Yet, the executives of AIG have the arrogance to believe that they are entitled to huge bonuses. Yes, I said entitled. Executives at AIG believe that they entitled to receive a form government transfer payments similar to the welfare system. However, these payments go to those who are well off: Welfare for the rich. The executives will claim that government money isn’t paying the bonuses. If that is the case then AIG doesn’t need the $165 million and the government payments should be reduced by value of the bonuses.
I fear for the future of the United States. We have gone from a country where Adam Smith’s enlightened self interest has changed into the arrogance of greed. I cannot think of any behavior which could do more to convince Americans that there is something wrong with the capitalist system. The executives’ actions could not do more for advancing socialism than they could if they were on the payroll of the Socialist or Communist parties.
Remember, AIG is a company that has required tens of billions of dollars in bailouts from the government in order to avoid cascading failures to the world economic system. In addition, AIG’s losses have been larger than the GDP’s of many medium countries. Yet, the executives of AIG have the arrogance to believe that they are entitled to huge bonuses. Yes, I said entitled. Executives at AIG believe that they entitled to receive a form government transfer payments similar to the welfare system. However, these payments go to those who are well off: Welfare for the rich. The executives will claim that government money isn’t paying the bonuses. If that is the case then AIG doesn’t need the $165 million and the government payments should be reduced by value of the bonuses.
I fear for the future of the United States. We have gone from a country where Adam Smith’s enlightened self interest has changed into the arrogance of greed. I cannot think of any behavior which could do more to convince Americans that there is something wrong with the capitalist system. The executives’ actions could not do more for advancing socialism than they could if they were on the payroll of the Socialist or Communist parties.
Friday, March 13, 2009
REPUBLICAN GOVERNORS ATTEMPT TO TURN US INTO EUROPE
The Republicans tell us that President Obama is attempting to adopt European socialism in the USA. However they are actually trying to establish European separatism as an alternative. Let’s face it; Europe is an amalgam of over 20 separate countries with few mechanisms for coordinated Fiscal Policy. Monetary Policy is centralized through the European Central Bank in the same manner that our Monetary Policy is centralized through the Federal Reserve System. However, Europe does not have a strong central government to design and implement fiscal policy. As a result, even the Europeans have doubts about their ability to recover. Each country is pretty much on its own regarding stimulus issues. That means if Italy tries to increase spending and create jobs the result could be that the new spending ends up creating jobs outside of Italy. This would happen if France decided not to stimulate its economy. As a result wages, and therefore, prices would be lower in France and the Italians who were hired under the stimulus would buy French goods. This would result in sporadic growth in Europe and a prolonged recession.
American governors who refuse the stimulus money would be placing our country in the same boat a Europe. The lack of spending in their own states would lead people to relocate to states where the stimulus money is working. The result would be a continued recession in their own states and a delayed recovery in the country as a whole as unemployed workers cross state lines. The only reason to seek this type of scenario is to be able to say: “See the stimulus didn’t work so vote Republican.” The Republicans are willing to see the country suffer so that they can regain power. It is this selfish approach which can threaten the state of the Union. The Republican Governors are traitors who have stronger loyalties to their party than to the country.
American governors who refuse the stimulus money would be placing our country in the same boat a Europe. The lack of spending in their own states would lead people to relocate to states where the stimulus money is working. The result would be a continued recession in their own states and a delayed recovery in the country as a whole as unemployed workers cross state lines. The only reason to seek this type of scenario is to be able to say: “See the stimulus didn’t work so vote Republican.” The Republicans are willing to see the country suffer so that they can regain power. It is this selfish approach which can threaten the state of the Union. The Republican Governors are traitors who have stronger loyalties to their party than to the country.
Monday, March 09, 2009
Warren Buffett Has It Right
The more I read Warren Buffett’s comments regarding business and economics the more I believe that he has more practical sense than all of congress combined. Today on CNBC Mr. Buffet stated that it is time to treat our economic problems as if we were at war. In doing so our congressional political parties have to put their partisan differences aside and treat our president the way we would in a full scale war situation. In an all out war, the people need to believe that we will win and the president must be commander in chief. Buffett (along with Krugman, Stieglitz and most economists) stated that confidence is necessary for an economic recovery to take place. As long as the congressional Republicans fight everything President Obama tries to accomplish and the Democrats try to add pet projects to every piece of stimulation legislation, the public will have serious doubts about the prospects for recovery.
It is time to end the fighting if we are to preserve the nation. Recovery is a matter of national security and we should all be a part of it. The problems that will arise from the tactics used to stimulate a recovery are far more manageable than the slide that will turn into a plunge if we do not act. Monetary Policy has done well at preventing a full scale plunge. However, monetary policy has reached its limit because we are now in what economists call a liquidity trap. It is time to let Fiscal Policy do its job.
It is time to end the fighting if we are to preserve the nation. Recovery is a matter of national security and we should all be a part of it. The problems that will arise from the tactics used to stimulate a recovery are far more manageable than the slide that will turn into a plunge if we do not act. Monetary Policy has done well at preventing a full scale plunge. However, monetary policy has reached its limit because we are now in what economists call a liquidity trap. It is time to let Fiscal Policy do its job.
Saturday, March 07, 2009
Treat Banks As You Would Treat a Heart Condition
People often ask me why we can’t let banks and organizations such as CITI and AIG just fail. The answer is simpler than most of us would expect. First it is important to think of the economic system as an organism comprised of a series of interrelated systems similar to the human body. The banking system is the circulatory system of the economy; Money is the blood of the economy. If an artery, such as a major bank, gets clogged some other major organ may fail or be severely impaired. We can equate the failure of major financial institutions to the clogging of arteries that lead to cascading organ failure. Clogging of the renal artery can lead to kidney failure. We can survive with one missing kidney but a loss of both will kill the organism. A bad kidney can lead to a bad liver which can affect other organs. CITI or AIG going under can lead to a cascading collapse of other banks and financial institutions to the extent that the whole organism we call an economy can die. Therefore it is necessary to prevent the total failure of these organizations.
However, this does not mean that we must preserve the plaque that got us into trouble to begin with. Just as arteries can be opened using stints and plaque can be reduced with Statins, financial institutions may need a complete change in the clogging agent known as outdated management. In addition, a pacemaker (regulatory agency) and regular check-ups (audits) may need to be added to keep the system healthy.
However, this does not mean that we must preserve the plaque that got us into trouble to begin with. Just as arteries can be opened using stints and plaque can be reduced with Statins, financial institutions may need a complete change in the clogging agent known as outdated management. In addition, a pacemaker (regulatory agency) and regular check-ups (audits) may need to be added to keep the system healthy.
Friday, March 06, 2009
REAGANOMICS AND FISCAL RESPONSIBILITY
Whenever I hear the minions of the Republican Party, and the right wing goofballs such as Rush Limbaugh, screaming about the Democratic Party’s lack of fiscal responsibility I am dumbfounded by their self deception. The fact is that history shows our worst years of fiscal responsibility have occurred under Republican Administrations. Data on the Federal Debt as a percentage of GDP, generated by the OMB, demonstrates this.
From 1960 through 1980 there was a general decline in Federal Debt as a percentage of GDP from 56% to 33.1%. However, with the beginning of Reaganomics in 1981 we can see a sharp increase in this percentage. It continues to grow sharply throughout the Reagan and Bush senior years. As stated earlier in 1980 the debt was 33.1% of GDP. Republican prolificacy led the percentage to top out at 67.3% in 1996. Throughout the balance of the Clinton years the value dropped. In 2002 it was down to 59.2%. With Bush junior’s ascendance to the presidency there was a sharp increase in debt until it is projected to reach 67.5% when the final figure for fiscal 2008 is in.
Somehow the Republicans have managed to deceive the press and the public into believing their myth of Fiscal Responsibility. I guess they have learned well from Joseph Goebbels: If you tell a big enough lie often enough people will begin to believe it. When will the press start doing its job and start challenging the deceptions of the right?
From 1960 through 1980 there was a general decline in Federal Debt as a percentage of GDP from 56% to 33.1%. However, with the beginning of Reaganomics in 1981 we can see a sharp increase in this percentage. It continues to grow sharply throughout the Reagan and Bush senior years. As stated earlier in 1980 the debt was 33.1% of GDP. Republican prolificacy led the percentage to top out at 67.3% in 1996. Throughout the balance of the Clinton years the value dropped. In 2002 it was down to 59.2%. With Bush junior’s ascendance to the presidency there was a sharp increase in debt until it is projected to reach 67.5% when the final figure for fiscal 2008 is in.
Somehow the Republicans have managed to deceive the press and the public into believing their myth of Fiscal Responsibility. I guess they have learned well from Joseph Goebbels: If you tell a big enough lie often enough people will begin to believe it. When will the press start doing its job and start challenging the deceptions of the right?
Thursday, March 05, 2009
HAVE WE LOST CONFIDENCE IN OBAMA?
If you read the current press or watch television news you may have heard that Americans have lost confidence in President Obama's ability to engineer an economic recovery. This is despite the fact that he is very popular. The real problem is that the media in their stupidity has given credence to the latest scam of the obstructionists from the right.
The over-riding issue is that the right wing, who believe that government has no role to play, has spent so much time talking about how Obama's plans couldn't work that the economically ignorant press has begun to believe them. If Obama’s plans fail it is because the right has been obstructing so much of anything he tries to do that the people have lost confidence not in him but in the whole political process. When Rush Limbaugh says he wants Obama to fail and Rick Santorum, a light of the "Right" agrees, we find we are all in trouble. The right has learned that expectations have an awful lot to do with how an economy operates. If they can destroy positive expectations then the failure of the recovery can move the right into power in 2012.
Rush and his ilk are traitors. They are more interested in their regaining power than they are in the health of the country. Their governors’ refusal of stimulus funds borders on criminal behavior and implications that they can refuse to follow laws they believe to be unconstitutional is a step toward cession and a new civil war. They would rather see a failure of the republic than allow their opponents any semblance of success.
The over-riding issue is that the right wing, who believe that government has no role to play, has spent so much time talking about how Obama's plans couldn't work that the economically ignorant press has begun to believe them. If Obama’s plans fail it is because the right has been obstructing so much of anything he tries to do that the people have lost confidence not in him but in the whole political process. When Rush Limbaugh says he wants Obama to fail and Rick Santorum, a light of the "Right" agrees, we find we are all in trouble. The right has learned that expectations have an awful lot to do with how an economy operates. If they can destroy positive expectations then the failure of the recovery can move the right into power in 2012.
Rush and his ilk are traitors. They are more interested in their regaining power than they are in the health of the country. Their governors’ refusal of stimulus funds borders on criminal behavior and implications that they can refuse to follow laws they believe to be unconstitutional is a step toward cession and a new civil war. They would rather see a failure of the republic than allow their opponents any semblance of success.
Saturday, February 07, 2009
DO WE DESERVE THIS?
Someone once said that we get the government we deserve. My problem is that I cannot fathom what grievous harm we’ve done to the world to get the congress we have today. We have both Republicans and Democrats screaming that we have a spending program instead of a recovery program on the table. My guess is that all of them failed their Introductory Economics course or they decided that nothing in the field developed after 1899 has any relevance. Our illustrious elected leaders seem to forget that spending is economic stimulus. When Republicans complain that the New Deal took too long and we needed WWII to get out of the depression, they are ignoring the fact that it was the stimulus spending for WWII that finally ended the depression. Even FDR had a tough time spending enough to end the disaster. Now Republicans and some conservative democrats are complaining that President Obama is spending too much. These naysayers are going to end up extending the problem through under spending.
I can understand why the Republicans might want to do this. They believe that they can win the mid-term congressional elections if they make sure that a recovery doesn’t take place. They are willing to see the country go down the tubes in order to gain an electoral victory in 2011. They bring out the old saw of giving money to business to get the economy moving. They believe in something called “Say’s Law” which states that supply creates its own demand. The problem is that nobody in his/her right mind is going to produce goods in the absence of demand. Without an increase in demand, reducing the cost of labor merely increases business profits without increasing employment.
It is time to get tough and call the obstructionists to the carpet. I would use their old saw and state that they are threatening the security of the United States. I would not hesitate to call them traitors who are more interested in lining the pockets of the internationalist multi-national corporations than they are in the security of America. Progressives have, for too long, been too timid in their pursuit of their goals. They have tried to appeal to the mind. It is now time to use the tactics of the conservatives and start appealing to the gut. In 1932 the USA could have gone the way of Germany and Italy or the way of Russia. We found a third way through FDR and the new deal. If the conservative have their way, I’m afraid that our fate will be to resemble Mussolini’s Italy.
I can understand why the Republicans might want to do this. They believe that they can win the mid-term congressional elections if they make sure that a recovery doesn’t take place. They are willing to see the country go down the tubes in order to gain an electoral victory in 2011. They bring out the old saw of giving money to business to get the economy moving. They believe in something called “Say’s Law” which states that supply creates its own demand. The problem is that nobody in his/her right mind is going to produce goods in the absence of demand. Without an increase in demand, reducing the cost of labor merely increases business profits without increasing employment.
It is time to get tough and call the obstructionists to the carpet. I would use their old saw and state that they are threatening the security of the United States. I would not hesitate to call them traitors who are more interested in lining the pockets of the internationalist multi-national corporations than they are in the security of America. Progressives have, for too long, been too timid in their pursuit of their goals. They have tried to appeal to the mind. It is now time to use the tactics of the conservatives and start appealing to the gut. In 1932 the USA could have gone the way of Germany and Italy or the way of Russia. We found a third way through FDR and the new deal. If the conservative have their way, I’m afraid that our fate will be to resemble Mussolini’s Italy.
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