Sunday, August 28, 2011

Murray Rothbard was wrong

Other people who have known the man personally or read more of his stuff than I ever will have pointed out that much of his historical commentary is flawed or contains serious errors.  But one that I found in his Mystery of Banking is this line (emphasis mine):
"And, indeed, under the Monetary Control Act of 1980, the Fed now has unlimited power to buy any asset it wishes and up to any amount--whether it be corporate stocks, bonds, or foreign currency."  

I see no evidence supporting this.  Here is an outline of how the MCA altered the Fed's powers. Section 13, Subsection 3 of the Federal Reserve Act gives the Fed the power "in unusual and exigent circumstances" to expand credit various ways. The Fed used this in 2008 when it bought commercial paper, MBS, student loans, etc. but this has never been interpreted as giving the Fed the power to buy corporate stocks. A recent conversation with a Wall Street journalist confirmed this, she had recently interviewed someone on the Board of Governors (or a former Governor, not sure) who explicitly said the Fed did not have power to buy stock.  An error like this, spread through the internet as much of Rothbard's writings are widely read, gives people a different perception from reality as to what the role of the Fed is.

Rothbard wrote that in 1983, much closer to the time period than today.  But apparently he misremembered the details a bit and never let the record stand corrected.  Let the reader beware and reach his own conclusions as to his motives.

Wednesday, August 24, 2011

Real men use Pinterest (aka The Economics of Pinterest)

Follow Me on Pinterest
I first heard of Pinterest through a co-worker who got my wife hooked on it. It's a social network that is for sharing ideas and "likes" via the power of visual image (here's a good example). The way it works is you surf the web and see something you like on a site-- could be a recipe or a photograph, any image.  You click "Pin This" on the button you've installed on your browser, and it gets added to your Pinterest feed, under a category that you choose.  Others who follow you or are searching for things in the same category can see it, and then re-pin it... like RT'ing a tweet on Twitter.  A visual idea spreads like wildfire.   Visiting the site you'll find it's 99% used by women.

But here is my Pinterest profile, you'll find I found another perfect use for it.  It's like social bookmarking through Delicious, except for images. Since I collect an awful lot of graphs and charts for class every day, I now have a way to store them and see them all on one screen.  No need to sort through a textual description of it via Delicious.  Every economist should use Pinterest.

Note, this post isn't really about the economics of pinterest, I just titled it that to shamelessly get search hits.

Tuesday, August 23, 2011

Book Review (#29 of 2011) The Mystery of Banking

The Mystery of Banking by Murray N. Rothbard. Austrians have made pretty much all of their books free, which is part of why their ideas are far-reaching.

This book reads like a well-written textbook and has basically three parts:
1) A primer on supply and demand for money.  (Those are parts I quoted from in my previous post).
2) An explanation of how fractional reserve banking works.
3) A history of banking in the U.K. and U.S., with some prescriptions to how an ideal Rothbardian system would work.

While Von Mises and Rothbard build and develop from much earlier monetarists, they reach radically different conclusions from them: Any increase in the overall price level is evil. Fractional reserve banking is immoral because it creates something out of nothing. Our modern banking system is built to create inflation to enrich some at the expense of others.  Only by returning to a gold standard and eliminating our central bank and all fractional reserve banking can we achieve a completely stable business cycle (utopia with no involuntary unemployment).

Except for these ideas, parts 1 & 2 are similar to any textbook on Money and Banking, or a Principles of Macro text.  Part 3 is very jaded, there is a lot of history that Rothbard omits or reinterprets. For example, there was a lot more going into the Panic of 1873 for the U.S. than Jay Cooke's bubble bursting-- the crisis started in Europe, which doesn't get mentioned.  That said, there are a lot of interesting facts I was unaware of.  I also liked having a Money & Banking text that didn't deal with interest rates at all, everything was in terms of supply and demand for money.  That monetarist bent is badly needed in today's world focusing on a mythical "zero bound."

The book really illustrated for me the quixotic nature of the Austrian cause.  Since coinage was invented, the makers of those coins have been debasing them in order to profit or inflate away debt.  Since people have gotten used to calling their currency the "pound," "dollar," etc. instead of it just being "gold," people don't notice the debasement.  But it would take a radical departure from thousands of years of human nature to move people away from this problem, even if currency was "denationalized."

Rothbard compares the fixing of a price of gold as the same as a government determining uniform weights and measures -- a centimeter is the same everywhere.  But the value of a centimeter never changes whereas gold-- being a commodity-- sees its value change with supply and demand, which then changes the value of any currency whose price is fixed to it.  The Austrians seemingly ignore this.  For example, the late 1800s period in the U.S. the population was growing, output was increasing, but gold supplies were not growing so much so the value of gold rose and prices fell.  Rothbard would say this is a naturally good thing, lower prices mean people can afford to buy more.  But if you're a farmer who has fixed obligations -- contracted workers, a loan from a bank, etc. lower prices means it's much harder to stay in business and not default. (Hence we had a bimetallic inflationist political movement as a result.) Rothbard completely ignores this.

These fluctuations in the value of gold can happen suddenly and unexpectedly.  Given so much of the (correct) emphasis that I see Von Mises placing on expectations of entrepreneurs, I find Rothbard's position pretty problematic. 

As mentioned in my previous post, Rothbard and Mises acknowledge that prices are often sticky, but have a one-size-fits-all explanation for this that doesn't actually fit everywhere. All weight is put on the evil of prices inflation, no weight is put on the harmful effects of deflation.

I now see the Austrians as on par with the hard-core left-wing Communists who want to issue in a utopia that is impossible due to human nature.  The idea that simply by moving to a 100% reserve gold system and moving to anarcho-capitalism will solve all of our ills and make everyone purely rational yet benevolent is pure nonsense. It's odd to me that as such an astute student of history, Rothbard doesn't see the continual "Road to Serfdom"-like cycle that all civilizations have ridden since the Fall of Man.

In the end, there is an Appendix where Rothbard absolutely rips Lawrence White, also an Austrian, for what Rothbard sees as an incorrect interpretation of the history of free banking.  Austrians, like Keynesians, have a good reputation for trying to destroy and humiliate those they don't like.

George Selgin, whose Theory of Free Banking will be my next read, is a former Rothbardian disciple who sums it up thus:

Rothbard, on the other hand, was only too determined to identify himself with the Austrian School and, more than that, to both take part in a personality cult, built around von Mises, and attract such a cult himself. One sign of the presence of such a cult is precisely the scorn its members heap on potential rivals to the cult figure.
As a monetary economist (I don't pretend to judge Rothbard's other economic contributions) Rothbard was mediocre to bad. His version of the Austrian business cycle theory was naive--in essence it equated behavior of M consistent with keeping interest rates at their "natural" levels with the elimination of fractional-reserve banking, an equation that holds only with the help of about a dozen auxilliary assumptions, all of which are patently false. He then went on to conjure up an equally false history of banking and of bank contracts designed to square his theory of the cycle, with its implied condemnation of fractional reserve banking, with his libertarian ethics.

As such, I give this book 3 stars out of 5.  It's very readable, and you can learn a good deal of history, monetary economics, and how banking works from it.  However, if you don't take it with a large grain of salt you may not see the many errors and omissions that cause it to be quite slanted.

Sunday, August 21, 2011

Did Murray Rothbard believe in aggregate demand? (Yes, he did)

I'm currently reading Rothbard's Mystery of Banking. In the first few chapters I found some things in Austrian thought I wasn't expecting.  It appears to me that the Austrian model has a basic framework that it is very much possible to increase output and decrease unemployment by increasing aggregate demand through monetary policy. While heavy on monetary policy, there's hardly any mention in this book of interest rates (which Scott Sumner would appreciate) and nothing about interest rates being artificially below some Wicksellian natural rate.   There are also the basic ideas of sticky prices and wages (but explained using only one hypothesis put forth by Von Mises) and an elucidation of the time-consistency problem (this book was written in 1983, same year as Barro and Gordon's paper and two years before Rogoff's time-consistency paper was published).  In the models developed in book, I don't see much difference between Sumnerian quasi-monetarist and Austrian thought, except for what Rothbard leaves out--namely the effects of an increase in the money supply on output and employment.

Page 60:
"The only way in which consumers, especially over a sustained period of time, can increase their demand for all products is if consumer incomes are increasing overall, that is, if consumers have more money in their pockets to spend on all products.  But this can only happen if the stock or supply of money available increases; only in that case....can most or all demand curves rise...and prices can rise overall."  
Is this not NGDP or aggregate demand?  Sure sounds like it, though Rothbard never calls it that. Rothbard focuses on the increase in price level as being immoral.  But what Rothbard leaves out is what happens to supply.  If demand shifts to the right, quantity supplied also increases (if more stuff is being bought, more stuff has to be produced and more resources utilized to produce it).  It appears that supply curves are perfectly inelastic in the Austrian short-run, but elastic:
"If...that increase (in demand) is perceived by the producers as lasting for a long period of time, future supply will increase" (Pg. 58). 
So, wouldn't an expected permanent increase in price level cause a permanent increase in quantity supplied (Pg. 59)? So, in that sense the Austrians could agree that FDR's devaluation of gold, a clear price-level target, could cause the increase in demand, output, and employment.  Am I wrong?  To the freshwater economists who contend there is no such thing as aggregate demand, or to those who believe that business cycle fluctuations can't be caused by aggregate demand, it would appear Rothbard disagrees:

"Despite the currently fashionable supply-side economists, inflation is a demand side (more specifically monetary or money supply) rather than a supply-side problem. Prices are continually being pulled up by increases in the quantity of money and hence the monetary demand for products."

This is important because it doesn't say "an increase in the money supply just causes prices to increase," Rothbard is saying prices rise because demand for products increases.  Rothbard's model would appear to have to accept that a central bank (or whoever is in charge of the money supply if centrally controlled) has the ability to determine the growth rate of NGDP over a long haul.

It seems pretty clear that if we're not experiencing a high rate of inflation right now then Rothbard would say it's because demand for money is high relative to the supply of money.  If people aren't spending it, and firms aren't producing, it's because they don't expect price levels to rise.

More interesting is the contention of sticky wages.  Why doesn't a 20% increase in M cause prices to rise by 20%?  A 20% increase in M would lead to an increase in aggregate demand and an increase in quantity supplied.  Von Mises apparently explained this in Post WWI Germany by saying the Germans simply expected prices to eventually fall again, therefore they held on to their money (demand for money increased, causing a deflationary offsetting of the increase in money supply, Pg. 119-120). **Update. Alex Tabarrok graciously pointed out that it appears Mises was making Krugman's argument on why Japan's monetary stimulus has been ineffective in increasing inflation-- the Japanese simply don't believe the central bank would allow inflation, and hence have expected lower or stagnant prices and kept up their money demand (and they've been correct at calling the central bank's bluff). **

(Rothbard's words):
"(Expectations are sluggish in revising themselves to adapt to new conditions. Expectations...tend to be conservative and dependent on the record of the recent past...Unfortunately, the relatively small price rise often acts as heady wine to government...They can increase the money supply...and prices will rise only by a little bit!"  
This is clearly an explanation of a non-vertical Phillips curve (without mentioning such a thing).  So long as expectations are anchored, an increase in the money supply can cause an increase in aggregate demand without a 1-for-1 increase in prices.  This works until "the public's deflationary expectations have been superceded by inflationary ones," and prices begin to rise faster than output increases (Pg. 122).

So, even Austrians agree that a central bank can fool people in the short-run and get growth at the expense of testing credibility.  We all agree that in the long run the effect will be higher inflation as expectations adjust (the long-run Phillips curve is vertical).

Do any Austrians disagree with these contentions?

Wednesday, August 17, 2011

How to stop a European bank run

This piece from Joseph Cotterill on the FT Alphaville blog this morning reminded me of what I learned about bank runs from Gary Gorton's book.  It relates directly to what the Eurozone countries are trying to do to stave off a run on their banks.

From the 1860s to 1913, there was no U.S. central bank to be lender of last resort.  Banks formed "coalitions or clubs of banks" to coordinate in processing checks and to monitor one another's behavior.  During a bank run or panic (Gorton):
"banks would jointly suspend convertibility of deposits into currency...clearinghouse member banks joined together to form a new entity overseen by the Clearinghouse Committee...The clearinghouse would also cease the publicatoin of individual bank accounting information...and would instead only publish aggregate information of all the members...the clearinghouse issued new money, called clearinghouse loan certificates, directly to the public." 
So, the good banks and bad banks were all lumped behind a firewall, and no one knew who was bad or good; no depositor could redeem his deposit until the banks behind the firewall dealt with the problem, the panic subsided, and the firewall was taken down.  This created incentives for banks to behave well and not get risky in the first place or risk being kicked out of the coalition.  (Ironically, when the Fed was created in 1913 this practice became illegal and actually made the system less stable.)

Europe is now trying to do the same thing by eliminating individual country debt and only issuing joint Eurobonds.  Greece is experiencing the run, and rumors abound that maybe all the countries are doomed-- so Spain and France see their interest rates rise and CDS on their bonds also get more expensive as investors fear default.  This is just like a bank run, and a run is a self-fulfilling prophecy.

Like the banking coalition, the Eurobond proposal requires greater uniformity in the behavior of the individual members, lest they be kicked from the club.  So, European countries will have to adopt a much stronger fiscal union than before. (Think of the 50 U.S. states that all uniformly have balanced-budget requirements in their constitutions.) Fiscal unity is a prerequisite for a common currency, so this step should have been taken long ago if the euro experiment was to succeed.

It remains to be seen if all the countries will jump on board.  Just like the banking coalition, the fiscally sound countries hate the implicit subsidy to the weak countries, but it's necessary if their coalition is going to survive. If they don't adopt the measure, the Eurozone as we now see it is doomed.

Monday, August 15, 2011

Book Review (#28 of 2011) Slapped by the Invisible Hand

Slapped by the Invisible Hand: The Panic of 2007 (Financial Management Association Survey and Synthesis) by Gary Gorton.


Gorton is a Yale Professor of Management and Finance and an expert in the history of banking and financial markets. Perhaps no one has done as much work on the makeup of the "shadow banking" system as he has.  This book is a compilation of a few of his papers, one of which was famously presented at the Fed's Jackson Hole conference in 2008. Gorton's work is at the top of Ben Bernanke's financial crisis reading list.

What is a bank--can you define it?  If banks are regulated, but certain non-banks engage in similar activities as a bank, what types of issues arise?  I step away from all the books I've read on the issue and come away with two definitions of a bank:
1. An entity that creates a riskless, information insensitive, liquid asset for a customer and funding that asset by creating a relatively risky, information sensitive, illiquid liability for itself. 
2. An entity that borrows short and lends long. 

Gordon gives some insight into earlier U.S. banking panics that I was unaware of. In 1907, bank consortiums facing a run basically united behind the castle walls of a clearinghouse. Deposits at any individual bank could not be redeemed and customers were instead given a makeshift loan from the clearinghouse.  In a panic no one knows which bank is safe, therefore even the healthiest ones are at risk of failure, so the clearinghouse protected all the banks until the panic subsided. Creation of the Federal Reserve eliminated this local clearinghouse concept as the Fed became the clearinghouse, and later allowed banks to fail en masse. 

Today, the repo market acts as the banking system for large firms. This activity is performed largely by non-banks and allows firms to earn interest on their large amounts of cash in exchange for collateral-- usually Treasury or other AAA assets.  This collateral is generally information insensitive, liquid, and riskless. 

"Repo trading has been likened—by repo traders—to speed chess; that is, there is no time to do due diligence on the collateral offered and indeed almost none is done."

As the repo market grows, so does demand for AAA collateral. As subprime lending increased, the collateral more and more became claims on CDOs backed by mortgages.  Once doubts began to arise about the worth of that collateral, the repo market began to seize up.  There became a general panic about which assets were safe, everyone started to demand larger haircuts and Treasuries.  As lending seized up, firms like Lehman Brothers went under and the dominoes fell. 


If you have to read one book explaining the Panic of 2007, this is the one. Gorton isn't providing much narrative here, he is an academic looking at the data. As such, much of it is fairly technical. He delves into the prospectuses of various ABS and details how CDOs operate. He looks at econometric analyses to try and develop a theory about why banks and non-bank entities make the decisions they do under regulatory regimes.

If you piece together a narrative, it looks like this:
1. Deregulation of the financial sector led to increased competition and lower profits for banks who were now competing with non-banks. 
2. "(I)n attempts to maintain profitability, banks enter new activities which are not necessarily a source of public policy concern per se, but become entwined with traditional banking activities and, hence, a source of concern." Capital requirements were navigated by doing off-balance-sheet activities and increasing securitization. 
3. As this continued, the activities of banks and non-banks were increasingly "off the radar" of bank regulators. The repo market was one example of this, the Fed stopped trying to measure the activity altogether.
4. Eventually, ABS and CDOs were created from loans that required housing prices to keep going up in order to be profitable. A sub-prime loan was made with an initial 2-3 year fixed rate that then adjusted upward, with the expectation that in 2-3 years the borrower would refinance the loan having earned equity as the value of his house increased; this could be repeated indefinitely.  The loan was sold and securitized as part of a bundle, which was then sliced and diced again into CDOs, CDO-squareds, etc.
5. In 2006, the ABX was introduced, for the first time introducing a price index for subprime securities. People could then bet/trade on what they thought they were worth, and the ABX started to decline as the market started to short subprime.
5. When housing prices stopped going up and the ABX started going down, the CDOs started to take major losses.
6. This triggered even more losses on CDS issued on the CDOs. 
7. Adherence to mark-to-market accounting rules forced major write-downs of firm assets, instantly causing many firms to become insolvent. 
7. Panic ensues. 

Gorton empirically examines two common hypotheses of the crisis and finds them wanting:
1. Lender's increasingly lower lending standards created the problem.  This isn't backed up by the empirical evidence.
2. Originate-and-distribute (securitization) created misaligned incentives that created the problem. Gorton points out that all the originators suffered major losses, many going bankrupt. All originators kept a great deal of risk on their books. 

The problem was, basically, the creation of assets that were a one-way bet on housing prices.  Once assets created from those started to rated well by rating agencies and considered riskless collateral, the system quickly spread soon-to-be-toxic risk all over the world. (I take issue with people who in hindsight say "everyone knew housing prices would fall," because if everyone knew that they wouldn't have made the loans and willfully taken billions in losses and gone bankrupt, would they?)

Gorton takes issue with a few recommendations in regards to regulation.  He sees higher capital requirements as only effective in shrinking the banking sector, which may not be what a society really wants or needs.  He also notes that until "banking" is better defined, we're always going to have a hard time policing banking activity.  Better to create a system that aligns incentives and eliminates information assymetry problems.  Mark-to-market accounting adherence during a crisis is ill-advised as well. 

There aren't any grand political statements in this book, or vilification of demons. Mostly facts and analysis and some stylized examples. 

I only give it 4 stars out of 5 because a lot of the information is jumpy and overlapping. Some of it, like his letter at the end to someone in 2107 was also a little...odd.  I also read it on the Kindle and some of the equations and charts were hard to read in Kindle format. But I highly recommend the book.  

Thursday, August 11, 2011

Should your tithe go to a lobbyist? (Part 3)

Part 1, Part 2

Here's a different take on the issue. If you subscribe to the Dominion theology school, then you will probably say "Yes" to my question. The wiki definition:
"Dominion Theology is a grouping of theological systems with the common belief that society should be governed exclusively by the law of God as codified in the Bible, to the exclusion of secular law (and) in which the Kingdom of God will be established on Earth through political and (in some cases) even military means."

Ryan Lizza has followed Michelle Bachmann for years and wrote this recent piece in The New Yorker. Lizza explores the spiritual roots of Bachmann's political beliefs, including Dominionism. Bachmann, like many on the Religious Right, was influenced by Francis Schaeffer. Schaeffer's ideas have become repopularized lately by people like Charles Colson and Nancy Pearcey, who together wrote the Schaeffer-inspired How Now Shall We Live (which I read and led a group study on in college. I should say I'm not sure Pearcey should be lumped in with some of the others in the article).

You can read the article for yourself, research the various names, and draw your own conclusions.

I find an odd symmetry on the far religious Left and Right.  Dominionists on the Right and Liberation Theology or Christian Anarchist types on the left seem bent on using political means to dictate what they believe to be biblical outcomes (both sides also approve of violent change in some cases).  For Schaeffer, John Rushdooney, and the Right, it's an Old Testament-style theocracy with Austrian (Von Mises school) economics at the core.  For Jim Wallis and those on the Left, it's essentially communism, and the focus is more socio-economic. Both sides openly hate each other. Both sides have co-opted philosophies of non-Christians for their own use (even though Nancy Pearcey is quoted as saying that all systems created by nonbelievers "must be false"). And churches in both camps currently spend a large amount of resources lobbying and working to change laws and government, and not so much the Church.   (Both extremes scare me.)

Wednesday, August 10, 2011

Meanwhile, in China...

Little noticed in all the news is that China is letting its currency appreciate at a little faster pace this month.  Back in May, Laura D'Andrea Tyson penned this piece in Economix, pointing out that the renminbi was appreciating in real terms:

"With inflation hitting 5 percent annually in China last month, the renminbi has appreciated in real terms by 8 to 9 percent relative to the dollar during the last year. According to calculations by The Economist, since 2005, when China  adopted its managed-band system, the renminbi has appreciated about 24 percent in nominal terms and about 50 percent in real terms relative to the dollar."

Today, the renminbi hit a new high against the dollar.  Jennifer Hughes at the Financial Times tells us:

"The renminbi this month has been allowed to rise against the dollar at an annualised rate of about 11 per cent, compared with an average 4 per cent this year." 
Hughes makes the accurate point that they're probably not shifting into euros, they're just shifting away from their currency peg.  This is what Geithner, the IMF, and loud economists like Paul Krugman have been pushing China to do.  They still hit a new record trade surplus this month, so they have a long way to go.  BUT, it's a sign that China really is moving to stimulate domestic demand instead of subsidizing exports. 
 
The reason many economists in the U.S. have been clamoring for this is because the "Bretton Woods II" arrangement where the world lends money to us while we buy their stuff hasn't been real helpful for U.S. manufacturing or our current account balance. (This is outlined in this book here). China rotating away from U.S. Treasuries eventually means higher interest rates.In an ideal world, we would coordinate all this with China. For us, it means a depreciating dollar and potentially more competitive exports and fewer imports from China. But unless the U.S. starts saving more our trade deficit will simply shift from China to some other countries (current account balance is a function of national savings and investment, I explain that here).    

This was brought to my attention today by someone who told me a factory in China they do business with is now requiring payments in RMB instead of USD. That's a good signal that the factory expects more real appreciation.

Book Review (#27 of 2011) Lombard Street

Lombard Street: A Description of the Money Market by Walter Bagehot (1873, reprinted by Project Gutenberg).
This is the original book about bank runs, financial crises, and the role of a central bank. This is on Ben Bernanke's short-list of recommended books, and he quotes Bagehot often. Bagehot influenced those who would later create the Federal Reserve.

Bagehot is examining the British financial system, then the biggest and most well-capitalized in the world. (Known deposits in London in 1873 were 120,000,000 pounds, while New York was next with the equivalent of 40,000,000 pounds).  The capital had done wonders for British industrial development, as a properly functioning financial market is necessary for any advanced country.  But risk is inherent:
"The peculiar essence of our banking system is an unprecedented trust between man and man: and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it."


England had recently (1866) gone through a panic very similar to our recent financial crisis, the Overend Gurney crisis, where some very large players dealing with risky schemes and assets went bust and triggered a panic, handled controversially by the Bank, which suspended payments as the system collapsed.
Bagehot on Overend, Gurney, and Co.:
"(T)hese losses were made in a manner so reckless and foolish, that one would think a child who had lent money in the City of London would have lent it better."

The Bank hasn't always done a bad job of being the lender of last resort, and Bagehot gives a good bit of interesting history. 

The Bank of England was privately owned and operated by a large board of executives from various types of industry.  It had a rotating presidency and governorship (which Bagehot actually recommends eliminating for a permanent governor and vice-governor) who seemed to run the bank well and rather conservatively.  The Bank of England held deposits from all the other banks on Lombard Street as well as the British Exchequer, and foreign governments. 


In 1844, Parliament gave the Bank of England exclusive authority to issue notes (ie: currency), so long as they were 100% backed by gold (a rule the Bank could suspend during a crisis).  The Act also created a fractional reserve banking system in the U.K., with no required reserve ratio.  The Bank of England was the bedrock of the system, and it typically kept a very large reserve as a result.  Bagehot gives a lot of insight and praise into its conservative governorship, but suggests it be even more conservative. 

Bagehot much prefers the British system to the American, which had just nationalized the currency after the Civil War. He deplores the 2-charter U.S. system with its different regulators required to keep tabs on what banks are doing.  There are some interesting comments seemingly in favor of free banking, which I found interesting. Bagehot

Bagehot's role for a central bank during a panic is to:
1. Before the panic, build up a large reserve.
2. During the panic, lend freely, at high rates of interest, and on good collateral. 

"A panic...is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready...to advance it most freely for the liabilities of others."


The high rate of interest is to penalize the bad banks who can't afford the loan. Here, he is unaware of the concept of adverse selection--those who will borrow at high interest rates are more likely to be the bad banks, not the sound ones. He makes the point earlier in the book that a bank or creditor in trouble will pay any price for money rather than go broke, but seemingly misses the connection here. 

The collateral is important, it needs to be what Gorton would call "information insensitive," something everyone recognizes is most likely a good asset--bank loans, for example.  If everyone sees the bank lending freely on decent collateral, then they will stop panicking.  These are the days before deposit insurance.

All banks during a bank run need to lend more, not less.  Otherwise, people will think they don't have enough money to meet their obligations and the run will intensify-- wiping out good banks as well as bad.  The best modern day illustration of this from the Great Depression was in Episode 3 of Milton Friedman's Free to Choose series, I show it to Money and Banking every year.

Another aspect that Bagehot deals with is joint stock companies and the principal-agent problem. He totally identifies that managers and owners may have conflicting incentives. His suggestion is that the members of the board of directors with the most "spare time" basically micromanage the manager's decisions to make sure he's not engaging in overly risky behavior.

Bagehot describes the speculation that happens just before a panic, reminiscent of our housing boom/bust:
"The good times too of a high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made...when most people think they are making it, there is a happy opportunity for ingenious mendacity." 
Another good quote:
"I am by no means an alarmist. I believe that our system, though curious and peculiar, may be worked safely; but if we wish so to work it, we must study it...Money will not manage itself, and Lombard Street has a great deal of money to manage."
I enjoyed this book and consider it a must-read for students of money, banking, and financial crises.  I have one more book on my crisis reading list to finish before the semester starts.

Tuesday, August 09, 2011

Liquidity and Inflation

Well, according to the grand Expectations Theory of the Term Structure of Interest Rates, longer-term interest rates should have fallen on news of the Fed's decision today-- and they did. However, if the market expected economic growth and inflation to outweigh the liquidity effect, we'd have seen long-term yields rise instead of fall. Basically, the market has acknowledged that rates will be lower for longer than it thought before, but it doesn't see the possibility of increased growth. This isn't a good thing.

That Bernanke doesn't have more support on the Board of Governors for Really Useful Policy is an unforced error by Obama. Republicans haven't helped by filibustering candidates and such, but Obama could always recess appoint someone to the Board of Governors who knows you don't fight a house fire with a garden hose. Judging from the last couple weeks, I think Ken Rogoff probably wishes he could be on the FOMC; he'd have no problem getting bipartisan support.  What's the point of having a central bank if it's not going to do its job adequately?  That's an argument of free bankers that I think has real merit. The data don't say the Fed (or the ECB) has done a good job. If it's batting .100, maybe it's time to find another batter.


Monday, August 08, 2011

Today in a historical perspective

 S&P 500 P/E ratio adjusted for inflation in a 10-year moving average:

Today we returned to the 50-year average (and are still above the average since 1890). So, maybe stocks were overpriced. 

I think the BEA's recent GDP revisions really killed us because it told us that we weren't as wealthy as we thought we were, and not growing as fast as we thought either, hence earnings forecasts were probably overvalued and stocks overpriced. Europe's near implosion last week also hurt, where is growth going to come from?  S&P downgrades our long-term Treasuries, and the market gobbles them up:


Historically: 6 month, 5 year, 10 year, and 30 year yields:



So, the market has never before shown both such confidence in U.S. Treasury's ability to repay and ever had such pessimistic views about inflation (economic growth).

But the market also gobbled up gold:



That suggests to me that people are worried about "uncertainty" and probably European defaults more than anything.

If the Fed comes out tomorrow with an explicit NGDP level target, price level target, or just says "we'll hold the fed funds at 0.25% until 2014, no matter what," we'll see a strong rally and the economy will get moving again. If they had done that in 2007 we wouldn't be here right now. But, alas. 

If Boehner locks the Tea Party in a closet and holds another slurpee summit with POTUS to get a "Grand Bargain" that includes serious tax reform and revenue increases ironed out clearly beyond 2013 we would also see a strong rally and S&P would probably throw itself on its sword. If they had done that a month ago, what a wonderful world it would be. But, alas.

If Europe would just protect Greece's creditors and Europe's banks and let Greece exit the euro, I think we'd also see a strong rally.  They should have done that in 2008. But, alas.

Unfortunately, I think all the above scenarios are equally highly unlikely, and everyone above is hosed.

Sunday, August 07, 2011

Should your tithe go to a lobbyist? (Part 2)

Part 1 here.

The Southern Baptist Convention, of which I am a member, funds a parachurch organization called the Ethics and Religious Liberty Committee (ERLC) which is:
"(D)edicated to addressing social and moral concerns and their implications on public policy issues from City Hall to Congress. With offices in Nashville, Tennessee, and Washington, D.C...the ERLC provides millions of Americans with information vital to preserving the soul and spirit that makes the United States the greatest nation in history."

The ERLC's mission: "To awaken, inform, energize, equip, and mobilize Christians to be the catalysts for the Biblically-based transformation of their families, churches, communities, and the nation."

The ERLC promotes fundraising for causes ranging from world hunger to sonographs for pregnancy counselors. ERLC contains a thinktank of Christian scholars to discuss issues of religion and ethics. It also issues statements urging voters to call congressmen about specific legislation. Prominent in ERLC actions (and on the website) is its long-time president, Dr. Richard Land. Land preaches, writes articles, meets with various legislators, and debates more liberal Christian activists like Jim Wallis.

A few weeks ago, I came across this piece written by Brian Kaylor, a professor at James Madision (who is an SBU alum and son-in-law of a co-worker). He takes Land to task for calling Obama a "playboy" and for spreading verifiable falsehoods. Land also has publicly called a Jewish senator a "schmuck" (which is Yiddish for "dick," which apparently Land didn't know),and used a lot of other derogatory terms for public figures (including comparing the Obama administration to Nazis. I encourage you to read through the various articles). To my knowledge, no Southern Baptist leader or member of the ERLC's board have criticized Land's comments, or called for him to step down or even apologize, even though the SBC recently passed a resolution to "denounce the speech or activities of any individual or group that brings shame upon the name of Christ and His gospel."

Land has become a rather offensive character, not for God's Word, which is offensive (Jer. 6:10), but for his own opinions and falsehoods.  That he represents Southern Baptists so prominently in the public eye is of great concern for me.

The ERLC is funded out of the Cooperative Program of the SBC, meaning that a portion of every donation that every SBC church collects goes to fund its work-- including Land. Am I the only Southern Baptist that finds this highly problematic or a gross misuse of resources?

Also problematic for me is the overreach of pastors into the realm of specific sciences, law, and economics. Land overreaches in discussing climate science and advocating voters to lobby for particular legislation, like Cut, Cap, and Balance.  It's not the role of pastors to be experts on all matters in the world. There are laypeople in the church that God has gifted for that.  I repeat C.S. Lewis' advice here: "“I am not an economist and I simply do not know whether the investment system is responsible for the state we are in or not. This is where we want the Christian economist.”

Does this also mean that the SBC implicitly endorses the view that "the United States is the greatest nation in history," as the ERLC statement says? (Even greater than Israel, wow).  Do other Christians around the world unite in this belief?  Am I supposed to support such nationalist rhetoric through my tithes?  Since Land represents the SBC and states that the earth is getting colder and not hotter, does that mean the SBC endorses his view?

Further, why is the SBC's convention filled with making resolutions and statements about legislation?  (Even more eerie from the article: why are some Southern Baptist pastors literally praying for Obama's death??)

The only answer I've so far gotten is from someone close to the ERLC who implies people are waiting for Land to retire so that others can move the ERLC "in a different direction."  Why not now?

Part 1 gave my understanding on what the role of the Church in society should be, which is rooted in Anabaptist thought. The SBC views and activities outlined above make it seem quite far from my views.  Can someone tell me where I'm wrong?

Downgrade reading

This is the best piece I've seen on what institutional investors expect from the market tonight and Monday morning.  Binyamin Appelbaum's piece is a decent one with a bigger picture.

We don't so much have to worry about U.S. banks or money market funds. Most rules were written assuming that Treasuries would always be AAA, or rely on the fact that 2/3 major rating agencies still have it at AAA. And money market funds hold Treasury bills, which were not part of the downgrade.

Treasury loudly objects to the downgrade, harping on the $2 trillion math error S&P acknowledged. But it's ridiculous to say that if S&P had gotten it right it would have seen that the U.S. debt/GDP ratio was "much more stable" in 2021 (S&P was only off by 8%... do you think 8% makes a huge difference?)

What matters is not 2021, but 2041.  We issue 30-year bonds.  Debt is projected to be 87% of GDP in 2041, according to the CBO's baseline.  And that assumes higher income, payroll, dividends, and capital gains taxes from 2012 to 2041 than would be politically palatable.  It also assumes no changes to the Affordable Care Act, and that it bends the cost curve as CBO projects.

Congress has shown itself unwilling to take the measures necessary to address the entitlement problem, and hence, long-run deficits. S&P is highly skeptical that the U.S. will raise taxes as is currently on U.S. books.  Why not?

CBO's alternative fiscal scenario, which assumes that Congress does what it always does projects debt-to-GDP over 200% in 2041.  Knowing that, why shouldn't the U.S. be downgraded?

Friday, August 05, 2011

Should your tithe go to a lobbyist? (Part 1)

During the recent heated political discourse, I discovered something that is making me think hard about church membership. What if your denomination uses part of your offering to lobby legislatures and organize political action? Is that the most effective use of resources? Is there any biblical justification for it? Would that fit Francis Chan's challenge of Crazy Love? What standards should be held up for someone lobbying on behalf of a church or parachurch organization?

Michael Gerson's latest column, "What Would Jesus Cut?" illustrates two religious groups who lobbied for opposite outcomes on the debt ceiling debate. An ecumenical group of primarily mainstream denominations (with Jim Wallis prominent) led the "Circle of Protection" movement to prevent cuts in poverty relief programs. Two conservative groups, CASE and FRC, argued directly against the Circle, arguing that freedom and economic growth would help the poor and not "poverty programs." One group asks "What Would Jesus Cut?" and the other asks "Who Would Jesus Indebt?" (Gerson makes some salient points in his column, but he misses on some things--just like his book.) I agree with many goals of both groups (but seeing too many Jim Wallis-isms in the Circle documents makes me leery. HT to Brian Kaylor for all of this). Both groups spent money on attack ads.

As I laid out at the end of this post, I'm skeptical of the idea of Christians trying to legislate morality or remake the world by law as there is no biblical precedent for this. I see us as called to be set apart, a community that loves one another and sets an example that invites the rest of the world to join. Our chief allegiance is to God and His Church (worldwide), not to a temporary country. I see Christians lobbying for government to better fund certain poverty programs as a sign of laziness, the Church does and should be doing many of these things and shouldn't ask someone else to do it. Further, government funds these programs through taxation, which is a forced, coerced activity and there is no love in coercion. Why would we ask the government to do more of it? Why not, as Francis Chan says, just give until it hurts? Why not work for reformation and revival inside churches instead of political band-aids?

Granted, there are certain activities that a government should engage in that the Church or private sector can't-- like funding AIDS and other basic research. Those activities have positive externalities that the private sector won't realize on its own. Catastrophic insurance is another good example. But providing meals for the poor, homeless shelters, job banks, those are all things that churches and other faith-based charities do effectively. But why should my church provide meals for hungry kids if a government kitchen down the street does it?

Libertarians tend to argue that America did a good job in the 19th century of handling poverty--given how poor we were as a nation--without government getting involved. We had active churches and charities that didn't spend much time lobbying the government and you don't read of people dying of starvation, even in our most severe economic downturns. I don't know if any hard data exists about this, but I'd be curious what the arguments are for private charity decline and government rise (or vice-versa).

In Part 2, I'll look at some problems I have with my tithe money going to support Christians who are active in politics and offending a wide range of people with things other than the Gospel.

More reading the yield curve as a tea leaf

**UPDATE. I wrote this top part just before 4pm today when it was unclear what S&P would say.**
Today's curve. I will call this "fiscal policy failure:"

Gold fell today, and stocks were mostly down all over the world, so my own guess here is that people dumped longer-term Treasuries for cash. That would actually be monetary policy failure. Very little risk of inflation combined with heightened doubt about the U.S.'s long-term creditworthiness could create a steepening of the curve like this.

Though I don't like his jumping to conclusions, I can agree with much of what Tyler Cowen writes here. My own hypothesis the last few years has been that Congress won't deal with entitlement spending/health care costs (ie: the long-run deficits) until they face rising real interest rates. Anyone touching Medicare/Medicaid is at a first-mover disadvantage because they immediately become demonized as a senior citizen hater.

But I do not buy the notion that ratings matter that much. A Treasury downgrade means that mutual funds will be dictated by their prospectuses to rebalance their portfolios by buying more Treasuries since their overall weighted average rating would fall. There are no available assets more safe than U.S. Treasuries-- other than straight cash. Cash is only a good store of value when inflation (and economic growth) is expected to be quite slow.

*UPDATE at 7:56 CST**
The U.S. is downgraded by S&P. The worry now, just like with the default hypothetical, is over things like the $500 billion repo market, where Treasuries are collateral. FT Alphaville wrote this during the debt ceiling debate. They were focusing on Treasuries as collateral for Fed discount loans and speculated a downgrade could cause trouble. The Fed typically requires AAA debt as collateral, but I've read that the AAA rating doesn't apply to the Treasuries, and if you read the Fed's guideline document you can see no eligibility requirement for them.

In short, we'll get a good sense on Sunday evening when our Asian trading partners, who own a large part of our debt, open their markets.

**UPDATE at 9:15 CST**
The Wall Street Journal posts this good summary with this closing (emphases mine):
"J.P. Morgan Chase & Co. analysts estimate some $4 trillion worth of Treasurys are pledged as collateral by borrowers such as banks and derivatives traders. If that collateral isn't considered as high quality by lenders, the borrowers could be required to cough up more cash or securities to put the minds of lenders at ease.

That could force investors to sell off other assets to come up with the money. In a worst case scenario, credit markets could seize up, as they did during the Lehman Crisis.

Money market funds held by millions of Americans hold some $1.3 trillion in securities directly or indirectly exposed to Treasury and government agency securities, as well as short-term loans to financial institutions, known as repos, which are backed by Treasurys. Experts say that the downgrade won't force money market funds to sell. But there are still risks.

If Treasurys tumble in value, funds will be forced to mark down their holdings, raising the potential for some to "break the buck" as the Reserve Primary fund did during the worst of the financial crisis."


Good luck, everyone.

Thursday, August 04, 2011

Book Review (#26 of 2011) A Prisoner in Turkey

A Prisoner in Turkey by John Still (1920). Reprinted by Project Gutenberg here.

This was a fascinating memoir of a World War I prisoner of war. Still was a British veteran who was one of the first British captured in Gallipoli, and spent over three years incarcerated in various places in Turkey. As far as POW memoirs go, I can only compare it with John McCain's Faith of Our Fathers (my review). There are many similarities of experience. Sometimes they had a decent prison commander, and sometimes a very cruel one. Still is not fond of Turks as a whole:
"There were good [T]urks; there are good wolves, for I have known one; but their rarity was above that of rubies."


A large number of Allied POWs died due to forced marches or labor or malnutrition and lack of medicine. Still was a commissioned officer who was spared some of the abuse of the enlisted men. It was fascinating to get a view of pre-Ataturk Turkey, the Ottoman Empire in its last throes and a society that, to Still, was unready to stand on its own economically.

At one point, Still is housed in Ankara (Angora) where his company was free to explore, and I enjoyed the descriptions of the old town:
"Even to the present day Angora is a great rendevous of caravans...we used to see long strings of laden camels approaching the town from far away...They looked as if they had walked straight out of the Old Testament, and many of the men with them looked much more like what the Patriarchs must have..."

There are some interesting observations on the Armenian "deportations." Still is often housed in quarters vacated by previous Armenian owners.

One thing I learned was that in those days, the government that captured you was supposed to be responsible for maintaining your pay at the rate it would pay officers of the same rank. But Turkish wages were so much lower than British wages that captured Turkish prisoners were compensated by the Crown at a lower wage than their British counterparts, even though it was higher than what the Turks could earn. Turkey reciprocated by paying their British captives the same wage in Turkish currency. But as the war progressed and Turkey inflated their currency, the pay of the prisoners decreased and they struggled to buy their necessities, as these were not provided by the Turkish government.

Upon his release at the end of the war, Still travels through Smyrna, a Greek part of western Turkey inhabited by many Americans. I found the American presence in Turkey interesting (the Ambassador provides for the prisoners in a few places) . Still concludes that Turkey will have a hard time after the war and might better be off being ruled and organized by a colonial power than standing on its own. He clearly did not forsee the rise of an Ataturk, nor the Turkish army's ability to reclaim portions given to Greece as part of the Armistice.

I'm struck by how British the memoir is. While much detail is given to the activities of prisoners-- writing books, plays, teaching each other languages and plenty of other subjects, making furniture, etc. -- not much is given to death and dying, and none to religion. Still avoids writing much detail about the really graphic subjects. He only mentions his wife and newborn daughter in passing, never mentions any emotions or longing for them. That really separates it from McCain's memoirs and other POW documentaries I've seen. Still and his international prisoners faced weeks below freezing, disease, starvation, and confusion but just muddle through and maintain their dignity.

I enjoyed the book, I'd say it's a must-read for a World War I buff.

Inflation expectations are falling. This is not good.

A picture of monetary policy failure today:

Wednesday, August 03, 2011

CBO Baseline Projections for June 2011

If anyone wants to see what assumptions go into CBO's model (as of June), I have uploaded their data into Google Spreadsheets here. You can see the projected RGDP, tax revenue, Medicare outlays, etc. Thanks to @BCAppelbaum for sending it. He's one of the best economics/finance journalists out there, very much worth following.

The last debt-related post (for a while, anyway) I promise.

Alex Tabarrok links to Russ Roberts' graph of the debt deal:



FT Alphaville linked to this chart from a private forecaster (click to enlarge).


Tuesday, August 02, 2011

A chart worth pondering


From David Cay Johnson:
"Both political parties contributed to our federal debt. Manufactured crises like the debt ceiling vote mask the real issue, which is our desperate need for prudent policies that create broad prosperity by taxing, spending and managing debt for the good of country, not party."

Counterfactuals

This handy NY Times graphic shows us what might have been.

The Grand Bargain would have kept us from having another debacle before December, and another next year over the Bush tax cuts. It would have made the tax code flatter, simpler, and lowered marginal tax rates while increasing tax revenue by phasing out tax expenditures and raising the income cap on the payroll tax (in 2013). It also would have raised the retirement age and phased out certain subsidies.

But the payroll tax increase on top incomes, elimination of certain tax expenditures, and no "balanced budget amendment" were anathema to the Right. Raising the retirement age and repealing certain aspects of "Obamacare" were anathema to the Progressives, and neither party really wants to cut Medicare/Medicaid expenditures. But I think the deal would have been pareto-efficient (everyone wins), and conservatives would have experienced the greatest of those gains.

Instead, we're basically left punting to December and asked to believe in a "super committee," and everyone loses. Hayek was right, the more your democratic government does the harder it is to reach a deal where everyone wins.

Monday, August 01, 2011

Is the debt ceiling deal really a deal?

It depends on what your definition of "is" is...

From the CBO:
"CBO estimates that the legislation, with the proposed amendment, would reduce budget deficits by about $915 billion between 2012 and 2021." (this is the scoring on the Boehner bill, but my understanding is the final deal agreed upon is set up the same).

The thing to keep in mind is that CBO's projections assume current law stays on the books. That means the projected $915 billion in deficit reduction assumes:
1. The Bush tax cuts expire next year (marginal tax rates and taxes on dividends/capital gains rise dramatically (see chart here).
2. The AMT is not "patched," so that millions of Americans who didn't pay it this year will end up paying it.
3. Medicare/Medicaid payments to doctors are reduced dramatically, ie: there is no "docfix" after this year.

How likely is it that those three assumptions happen? ( #2 and #3 are "patched" every year.)

So, if the majority of congress ensures that these assumptions don't hold, then the deficit reduction is dramatically less. According to the plan, the "super committee" has to come up with further spending cuts or find other ways to make up the difference. Otherwise, you have automatic massive cuts to the budget, primarily to defense. Theoretically, the "super committee" could push tax reform to increase tax revenue without raising the rates, but they have to be able to match or beat the revenue increase from the expiration of Bush tax cuts, otherwise they will have increased the deficit.

It's also worth remembering that this CBO graph from 2010
also assumed #1-3 above, and we still had a long-run problem. The negotiated deal shifts the curve down a little, but the slope is still the same. The driver is health care inflation and its effect on Medicare/Medicaid outlays. You fix that, you fix the debt problem. Otherwise, nothing effective has been accomplished.

*Update*- here's Will Wilkinson saying essentially the same thing, but everyone liked his piece better. What I left out of the above was also that CBO assumes some baseline rate of GDP growth, which I take from previous documents to be around 4% after 2012. If we don't get 4% growth tax revenue is less than projected and the long-term problem is much worse. Unless the Fed gets much more pro-active, 4% is not a realistic assumption for 2013.

**UPDATE 2** - via the magic of Twitter, Binyamin Appelbaum was kind of enough to send me the CBOs baseline numbers. They're assuming 3.33% growth in 2011, peaking at 3.64% from 2014-2015, and then declining to 2.05% by 2021, basically 2% average annual growth after 2020.

Wow, that's depressingly realistic. I'd forgotten that is often a criticism of the Left of the Medicare Trustees-- they (conservatively) assume fairly low rates of economic growth.