Sunday, June 29, 2008

Economics and the Regulation of the Housing Market

One of the more difficult aspects of understanding economics is the fact that in many cases it takes a long time for the full affects of economic policies to work themselves through the economy. As a consequence of this it can be difficult for people to identify cause and effect.

This allows those responsible for the economic policies to avoid blame because what they started…and continued…began a long time ago and it is difficult for people to specifically identify these policy makers as the culprits for what is currently taking place. In my estimation, one has to go back six or seven years to find the beginnings of the monetary and fiscal policies that have resulted in the present dilemma. One has to go back even further than that to find the beginnings of the United States energy policy that we are finally having to pay the price for.

And, since it is much easier to place the blame on something that people are doing now rather than on what people did a while ago, our leaders can point their finger at speculators, at dishonest real estate brokers and lenders, and at foreigners as the perpetrators of our current problems. Furthermore, if our leaders can shift the blame to these villains then they can escape from dealing with the hard problem of correcting the economic policies that really did create the situation. (See the piece by Paul Krugman in the June 27 New York Times, “Fuels on the Hill”,

The ultimate problem that results from a situation like this is that policy makers usually end up facing a real dilemma. Let’s pretend we are the Chairman of the Board of Governors of the Federal Reserve System. What is the dilemma we are in, if we are the Chairman of the Board? The value of the dollar has been declining for over six years. People are saying that the fall in value has helped to fuel the increases in the price of commodities worldwide, especially that of oil. They are also saying that this decline in value has resulted in a flood of United States wealth flowing into other countries…to the Middle East, to China, to Russia, to India, to Brazil…and this is going to come back to bite us. And, now, other central banks around the world are considering raising their interest rates which will only exacerbate the situation. We should raise our target interest rate to help strengthen the value of the dollar…or at least protect it from declining more.

But, if we raise interest rates that will only cause further economic distress and dislocation here in the United States and our financial institutions are not that strong…some forecasters are saying that some banks are going to have to write off another $65.0 billion in assets. Unemployment is increasing…home foreclosures continue to rise and housing prices continue to fall…the auto industry is in the tank…and so on and so on…

This is the problem of mismanagement…of getting away from fundamentals…of letting ideology dominate reality. Bad management results in situations in which there are no good or easy choices available. Something is going to have to be done about the value of the dollar…but what price are we going to have to pay to strengthen the value of the dollar? We can continue to postpone the day of reckoning…but the longer we postpone that day…the larger the cost will be!

Another rule in economics is that the day of reckoning does ultimately arrive!

One of the short run responses to the current situation is to change regulations…to create programs that alleviate the problems created by the economic distress being experienced. An example of this is the effort to produce a housing bill that will help people who face the possibility of losing their home…and most or all of their wealth. People want to help those in dire straits. There is no question that this is a worthy cause. However, are legislators want “results”!

Short run solutions always focus on “results”. One can understand that politicians want programs that create “results” so that can justify the expenditure of large amounts of money. Individual personal problems are a great help to politicians in generating a rationale for the legislation they want to enact. And, individual personal success stories are a great help to politicians who are explaining to voters why they should be re-elected. But, programs that are based upon the achievement of “results” hardly even come close to achieving what is needed or what is hoped for. “Results” are based on idealistic goals and objectives and seldom have any relationship to the reality of the situation.

Furthermore, “results” based legislation sets up rules and procedures that people can take advantage of. The writers of the Housing Bill seem to be aware of this and are concerned about how the bill will be administrated. Still, “results” orientated programs are taken advantage of because there always seems to be many individuals that find ways to circumvent the rules and procedures to their own benefit.

One final point on this issue relates to the organization that is going to administer the new Housing Bill. The designated institution in this case…the Federal Housing Administration. This is an institution that already has many problems and has rightly been criticized for its weaknesses. The others to be involved? Fanny Mae…and Freddie Mac. Oh, boy…where is FEMA when you need it?

There is another issue to consider in the creation of legislation and additional regulatory oversight. This is the issue of time. One of the big problems that regulators have in today’s environment is that things change so rapidly. Let’s just look at the housing market that the congressional leadership is attempting to help. Earlier this year it was estimated that the number of homeowners having financial troubles with respect to paying their mortgages was around 2.6 million. The figure is currently said to be around 3.0 million. Within the next year or so analysts are forecasting that another one to two million will be added to this total. And the Housing Bill…it is aimed to help around 400,000. The response to this shortfall? Legislators say that more housing bills will have to be enacted.

The other side to this is that legislation and regulation always tends to fight the last war. That is, legislators are responding to the behavior of individuals and the market instruments they believe got us into the current situation. My experience leads me to believe that while the legislators are responding to these historical issues there are already some people, somewhere in the markets thinking about what can be done in the future. Legislation and regulation will not be created to deal with these “new things” until sometime after they have been introduced and seem to need some kind of oversight.

Leaders in the United States have some hard decisions to face. The question is whether or not they will deal with them in the near term, or, will they, in whatever way that they can, postpone the hard decisions to some undefined time period in the future. What is sad to me is that the leaders seem to be postponing the hard decisions once again. This is why I believe that there is a growing discussion around the world about the credibility of those guiding the country at this time. Can you imagine China questioning the credibility of our economic policy makers?

Friday, June 27, 2008


Donald Kohn, Vice-Chairman of the Board of Governors of the Federal Reserve System gave a speech yesterday at the International Research Forum on Monetary Policy in Frankfurt, Germany. (See In that speech, Mr. Kohn spoke about “Global Economic Integration and Decoupling.” Decoupling, according to Kohn, “refers to apparent divergences in economic performance among different regions of the world economy.”

Kohn references three different aspects of this. First, “the business cycles of the United States and other industrial economies are becoming less synchronized…” Second, “economic growth in the emerging market economies is holding up, even as growth slows substantially in the United States and, to a lesser extent, elsewhere in the industrial world.” Third, “even as the financial markets of many industrial countries have been roiled by turmoil that emerged last August, conditions in the traditionally volatile financial markets of emerging market economies have proved surprisingly resilient.”

To me, this speech misses the point and represents one of the major reasons why the Federal Reserve and the leaders of the Federal Reserve are facing a real crisis of credibility. (See my post on “Credibility” of June 23, 2007, The Federal Reserve is ignoring any role it has played in the decline in the value of the dollar over the past six years and the dislocations in world markets that this has caused. By continuing to ignore the role it has played in the decline in the value of the dollar it is undermining any remaining trust that might exist in its leadership.

And, the Fed is ignoring the role it is playing in the current financial turmoil. Concern over the behavior of the Federal Reserve is being expressed around the world. See for example the editorial comment in the Wall Street Journal, “The Fed at Ease”, Also see the editorial comment in the Financial Times, “Fed cannot ignore global inflation”, Yet, policymakers in the United States seem to turn their eyes elsewhere.

The Federal Reserve Open Market Committee met on Tuesday. It presented the results of that meeting Tuesday afternoon and the statement made was, if anything bland and tepid. The statement basically said…we really aren’t in the mood to do anything at this time.

That was sure a confidence builder!

This Federal Reserve leadership has introduced more innovation into the world monetary system than any before it. It has broadened the scope of financial oversight tremendously, even assisting in the Bear Stearns takeover, and is seeking more and more responsibilities. It is now looking at opening up the banking sector to private equity investment.

We are walking in new territory…never before explored. For example, we don’t know what all the new innovations mean for the future. We have been told that many of the actions taken will be removed in the future when the need for them recedes. Yet we see that there exists $150 billion in Term Auction Credit outstanding, $64 billion in “Other Credit Extensions” which includes swaps to central banks in Europe, $8.5 billion credit extension on the “Primary dealer credit facility” and $111 billion in securities lent to dealers in through the “term facility” window. What do all these billions mean for the financial institutions and financial markets? How will they be removed?

We don’t know what these innovations mean. We have nothing to compare them with!
And, then we seem to have leaders that are doing little or nothing to help their credibility in world financial circles! Where should the confidence come from?

Let me just say that if this attention on the credibility of Fed leadership is getting into the newspapers then we need to be concerned. In my experience, newspapers tend to be a lagging indicator of how participants in the market feel. If the newspapers are expressing concern over the credibility of the leadership of the Federal Reserve, then the rest of the world must be really concerned!

Wednesday, June 25, 2008

A Time of Transitions

Let’s start with the bad news first. I believe that we are in for an extended period of economic adjustment. This will take time for we are at a point where the foundation for the world economy has to be restructured so as to bring us to the start of a new era.

The good news is that the adjustment is taking place in a relatively orderly fashion. Yes, there still remains a lot of work to be done on repositioning portfolios and on the structure of industries. Yes, there will still be some surprises along the way. But, people are systematically working things out. People have, by-and-large, stopped hiding things and are finding out that within the current environment it is best to identify problems, disclose them, and then get to work on them. It just seems that the issues are deep and broad and will take an extended period of time to fully accommodate them.

In the United States, and some other developed countries, a lot of wealth has been lost. Layoffs are taking place or will take place in many major industries…I’m thinking of financial services and motor vehicles as starters. The housing industry is depressed and some experts think that house sales and the decline in housing prices may continue in and through 2009. Prices for oil and other commodities continue to rise. Consumer confidence has reached a 16-year low. This is a time of transition.

Perhaps the greatest transition underway is that in the field of energy. Transitions always hurt a lot of people. Major transitions are just that much worse. Yet, many agree…this transition has to take place…sooner or later. The United States, and much of the world, has done almost everything it can to postpone the day of reckoning, have band-aided the existing system here and there, and have protected the current economic structure as much as it could. Maybe that day is here.

Transitions hurt. Did I say that before? It is going to hurt many, many people to move on to the new way to power the world but maybe it is time for the United States, and others, to deal with the energy problem seriously and encourage the transition. Humans are problem solvers. Humans are great innovators. Look what has happened in terms of Information Technology over the past 50 years! Look what has happened in terms of the biological and physical sciences over the past 50 years! We can only be optimistic about what humans can do to solve problems.

Yet, over the last 50 years, politicians have provided incentives to the energy industry to maintain existing energy platforms. In doing so, they raised the “switching costs” of moving on to other energy platforms because the incentives have been structured away from innovation and change. Sure, the day would come when new sources of energy would be forthcoming, but the politicians creed is to keep getting re-elected in the current environment…the transition to these new sources and the disruption accompanying the transition will come on someone else’s watch.

Maybe we should celebrate oil selling for $135 per barrel. Maybe we should celebrate gas at the pump selling in excess of $4.00 per gallon. Maybe we should hope that prices go even higher! The transition is here! Let it happen!

My concern is that efforts will be made to alleviate the short run pain of the energy problem and drug the world once again so as to maintain the status quo for a little longer. It seems that the United States, and the world, only move on issues like this when there is a crisis. It seems as if times like this are the only times when pain is sufficiently wide-spread to gain the attention of politicians and others in positions of leadership. Do we really want to provide another narcotic release from the pain and postpone attacking the real problem? Drugs are addictive but if health is to be achieved the addiction must somehow, sometime be broken.

The new energy platform…whatever that platform will be…will result in a substantial change in the way people live their lives. I can’t predict what the new platform will look like. I don’t believe that anyone can predict what the new energy platform will look like. As an economist all I can say is that relative prices will change, incentives will be altered, and innovation will take place. What exactly this will mean for life on this planet is currently a mystery.

Individuals, as early as the 18th century talked about computing machines. But, who predicted the changes in life that the mainframe computer brought about in the 1950s and 1960s? Who predicted the creation of the personal computer and how it would alter how people worked in the 1980s? Who predicted the development of the Internet and how it would change how people lived and worked in the 1990s and beyond? And so on, and so on…

This adjustment will take time and the transition will be painful for individuals, for businesses, for industries, and for governments. I talked about a 50-year periods in terms of other transition cycles. Maybe…just maybe…we need to bite-the-bullet and move on into the future.

There is another transition that needs to take place and this is as good a time as any to accept the need for it and move forward with it. This is the transition the United States must make to become a full economic partner of other nations in the world of the 21st century. Other nations have gone through the transition the United States must go through and it is painful. But, why should the people of the United States postpone this adjustment if it can be accomplished from where we are now? Why can’t the United States move from where it is and change its way of conducting economic policy?

The period of the liquidity crises has been passed in this policy cycle. It appears that further adjustment of portfolios and expectations are proceeding in an orderly fashion. However, the full adjustment back to robust economic health is expected to be slow and painful. The United States government must not disrupt this transition back to health. But, it must act in a way that allows this adjustment to take place while bringing discipline back into its operations. The value of the dollar must be protected and supported, especially during this time when other central banks throughout the world will probably be raising their short term interest rates. Thus, the Federal Reserve must walk a fine line between not further disrupting the economic re-alignment going on and fully supporting the value of the United States dollar. Trust must be re-established in international financial markets that the Federal Reserve is fully cognizant of its responsibilities with respect to its currency and will fight the good fight against inflationary pressures. The relatively weak economy should help in this fight although the battle against worldwide commodity inflation will make the adjustment just that much more difficult.

The new President and his administration must also bring fiscal discipline back to the government. Again, this will be difficult and cannot be fully achieved in the near term. It is hard to see how the Bush tax cuts can be rescinded within the current environment. It is hard to see how other tax cuts can be implemented anytime soon. New programs? Well, prudence must rule the day. Any new president is going to be limited in what can be accomplished in the near term if this fiscal discipline is going to be achieved. If the transition is going to be made, however, it should be done now and not postponed indefinitely.

The reality of the situation is one in which the United States is going to have to work with others in the world. It cannot act independently of other nations in either energy policy or in terms of economic policy. Our period of transition is here…in many areas. The past is no guide at this time and we must not try to hold onto it. We must be open to the future while helping people through the pain of change.

Monday, June 23, 2008


This is what it all boils down to…

Saturday, the Wall Street Journal put it on the line. In an editorial titled “Bernanke’s Market Week”, the Journal states that “The most precious commodity a Fed Chairman has is credibility.” The article goes on to say, “the Fed has a growing credibility problem” related to the weakness in the value of the dollar. You can find the editorial at

Unfortunately, this is only one piece of the picture. This whole administration has a credibility problem. And, it starts right at the top. (You might note Thomas Friedman's column for Sunday June 22: "Mr. Bush: Lead or Leave."

The culture of an administration…whether it be a business…a family…a non-profit organization…or the national government…is determined by the leader. Everything that a leader says…or does…should reflect the culture that he or she wants to see permeate his or her administration. It is reflected in the people that the leader chooses to join the administration. It is reflected in what happens to people once they join the administration. That is, everything that is done by the leader “hangs together”.

The consequences of the culture created are ultimately there for all to see.

The leader cannot control events…the leader can only control how his or her administration anticipates or respond to events. And, the actions of an administration reflect the thing that it can directly influence…the culture established by its leader. And this culture engulfs all who are a member…the talented as well as the less talented.

This administration only has a few more months left. Lost credibility cannot be regained in that period of time. The world has begun to focus on the credibility of the people now seeking to become the leader of the United States. What kind of culture will these people create once they achieve the goal they are chasing?

Within this kind of environment, it is hard to imagine that the financial markets will settle down. There will be rallies here and there. There will be sell-offs here and there. Given that there is little or no credibility to be found these days in Washington, D. C. who can place a bet on what anyone says.

In the waning days of this administration…

this is what it all boils down to!

Thursday, June 19, 2008

The Basics of Financial Regulation

Another cycle of suggestions for financial regulation is upon us. Treasury Secretary Hank Paulson is giving a major speech today, June 19, 2008, calling for increased oversight of financial institutions on the part of the Federal Reserve System and for an understanding of the need for regulators to intervene in the banking system to avoid unnecessary systematic risk. Recently, Tim Geithner, the President of the Federal Reserve Bank of New York, in a speech given in New York, argued that investment banks should operate under the same uniform regulatory framework as other financial institutions so as to encourage appropriate liquidity, capital, and risk management practices.

I believe that it is a certainty, coming out of the financial dislocations of the past 12-18 months, that a new, modified regulatory structure will be forthcoming out of Washington. It is highly unlikely, however, that any action will be taken before a new President and administration is seated. Treasury Secretary Paulson is trying to impact the future by laying out ideas that will serve as the basis for an agenda of the discussions that will follow. How much impact he will have on these future discussions remains to be seen. It is the only hope someone going out of office has of influencing the course of forthcoming decisions.

Control of regulatory restructuring is in the hands of the Democrat-controlled Congress. The Democrats have no reason to hurry any discussion along for they are looking at the highly likely scenario of having a Democratic President take office in January 2009 along with larger majorities in both the Senate and the House of Representatives. They are looking at being able to control the debate and dominate the decisions about how the new financial structure is to be designed. The Democrats in Congress have absolutely no reason to show their cards before these changes take place and the elections this fall will not include debates on regulatory issues because of the esoteric nature of the issues and a lack of insight and interest on the part of the electorate.

Yet, changing the regulatory structure of the United States financial system can have very important implications for the future of the country…and for the world. Without knowing what is “in play” in terms of proposed regulatory changes it is impossible to define what these implications might be. The downside is that the new regulatory system could put the United States financial system at a disadvantage relative to the rest of the world so as to harm the ability of American-based financial institutions to compete in world markets. This would be exactly the wrong time for such restrictions to be imposed because of the growth of other financial capitals throughout the global economy, especially with all the wealth accumulating in the Middle East, China, and India.

The fundamental issue of oversight of financial institutions (actually all business institutions) is openness and transparency. In fact, to me, the essence of good management is openness and transparency. Winners are teams that execute better than other teams. Losers are teams that have to rely on secrecy and tricks. Secrecy and tricks are relied upon when you do not have the resources to perform at a high level. Secrecy and tricks can get you by in the short run, but over time the inability to operate efficiently and effectively will catch up with you. Teams that rely on secrecy and tricks, in my book, seldom, if ever, win championships.

The best teams…and organizations…are the ones who do not disguise what they do best, but execute their plans better than anyone else does. In essence, they say, “this is what we are going to do…try and stop us!” These teams…and organizations…play by the rules and are not afraid of full disclosure.

There are two reasons why strong organizations support this kind of approach to management. First, it causes them to focus on what they do well and staff their organizations so as to refine and perfect the execution of their plans as much as possible. This builds strength and confidence in the organization and provides an environment that people who are talented and highly capable want to join. Strength builds on strength as the culture of success grows and prospers. Nothing can substitute for a culture that supports excellence rather than craftiness.

Second, by creating an environment of openness and transparency, the organization identifies weakness, problems, and mistakes as quickly as possible so that appropriate actions can be taken in a timely manner. Effective organizations do not “win” all of the time, but they minimize weak performance and losses so as to sustain an overall record of high achievement. All too often we see organizations that want to shelter poor performance because they kid themselves into believing that it is just a matter of time before “things will turnaround” and “everything will be alright.” As losses mount, they rely on trickery and ‘innovative” accounting to gloss over the real problems and as the hole they are digging becomes deeper and deeper…they fail to stop digging.

There are three specific issues that I am particularly concerned about in terms of openness and transparency. First, I am against “off balance sheet” items. We have seen how major institutions have used this mechanism to bury what they are doing as well as to avoid concerns over capital adequacy. I could never understand why this practice was allowed and, as far as I am concerned, it should be forbidden in the future. If the asset cannot stand the light of being on the balance sheet there are serious questions in my mind about why the organization should be engaged in such activity.

Second, I believe in marking assets to market on a regular basis. Opponents of this disclosure argue that the markets are so volatile that investors would be confused with the constant marking portfolios up and then marking them down on a regular basis. My question to these people is that if an organization has invested in assets that are so volatile…should they be invested in them at all? Have these organizations “stretched” for yield by investing in longer term assets or “high-yield” assets that are not consistent with their charters? If this is the case, then this decision should be revealed to investors in an obvious way and not covered up because, in the short run, the income streams of the institution are relatively constant. Furthermore, for assets that are not traded on markets or are infrequently traded, efforts should be made on a regular basis to determine their value and openly report them. This, not only is good discipline for the management, but it is also important for the investment and regulatory community to know.

Third, some institutions have argued that they cannot reveal what transactions they are involved in because if they did the spreads that they were operating at would go away. I have two comments to make on this concern. If the spreads are so narrow, the organization will probably be very highly leveraged in order to achieve the gains they believe they need to earn and the risk associated with this extreme use of leverage is probably unrecognized by investors. Also, research has shown that everyone seems to know what the transactions are anyway and that is why the spreads are so narrow in the first place. The question that needs to be ask, therefore, is whether or not the risk associated with the transaction is really commensurate with the return that the organization is promising on its operations. Disclosing the nature of these transactions would be helpful to investors in understanding the risks that they are investing in.

Openness and transparency not only can assist regulators and investors, it can also help managements. But, there is one more important point that continually needs to be made to those considering a change in the regulatory structure. “Inflation everywhere and at every time is a monetary phenomenon.” This statement, of course, came from Milton Friedman. Regulation of the financial system is needed, but we must not muddy the waters when it comes to the responsibility of the central bank, the Federal Reserve System. The more oversight and regulation it is responsible for the more its focus becomes blurred. The Fed is already hampered by the responsibility to maintain economic growth as well as to control inflation. As is apparent in the current climate, this is an impossible thing to do. Adding, more and more functions to the Fed can only make its task of keeping inflation at low levels more and more difficult.

Monday, June 16, 2008


The concept of “Rubinomics” seems to generate some rather emotional responses…for and against the basic ideas…for and against Robert Rubin. Therefore, I felt the need to follow up my earlier post (June 13, 2008) on “Rubinomics” with this post, ““Rubinomics”—two’.

First, it is perhaps destructive of a idea to tie it so closely to an individual. “Rubinomics” and Robert Rubin seem to draw a visceral response much as did “Keynesian” and John Maynard Keynes. Milton Friedman was lucky enough not to get his name tied to the prominent idea which he promoted, “Monetarism”…which did allow for the creation of an opposition title…proponents were not called “Keynesians” but “Fiscalists”.

Calling something by a person’s name can be used to draw together those opposed to the person and his/her ideas and as a term of derision. It can also be used to rally those that pursue similar ends. Oftentimes the use of such titles direct attention away from the real issues at hand and the policies being proposed. Name-calling can be helpful…and it can be destructive. In order for any productive discussion to take place, however, focus must be returned to the real issues at hand.

Second, ideas must be placed within their historical context. In the case of “Rubinomics”, we have to go back to the Paris Peace Talks following World War I. To create the economic situation at that time is very simple terms I will argue that there were two major conditions at hand. The allies were very divided in terms of what they wanted to achieve…there were as many programs for the “new world order” as there were major nations involved in the discussions. In addition, the Russian Revolution had just taken place and there was great fear among the discussant nations that the threat to the future was labor unrest and the Bolsheviks, the proposed new order for the revolutionary world.

This was the world that John Maynard Keynes was involved in and his goal was to create a model of the world in which labor unrest could be avoided as much as possible so that the wave of revolution did not overcome the Western world as he knew it. The fundamentals of his model were fixed exchange rates between countries so that each nation could pursue its own independent economic policy and a government program to stimulate a national economy so as to avoid severe economic collapse and maintain high rates of employment.

As is well known, Keynes worked over the next twenty years or so to develop a theoretical model to support his perception of the world and to bring politicians and institutions to incorporate his ideas for low employment and peace. He then continued to work throughout World War II to create the international financial system that would actually implement his ideas.

So, for roughly fifty-five years efforts were made to try and create a world of fixed foreign exchange rates and the institutions and rules that could maintain such a system so that countries could operate their fiscal and monetary policies in a relatively independent manner. As history has shown, this system proved to be unworkable in the long run…because even in such a regime, nations cannot operate fully independently of one another. The post-World War II period was dotted with inflations and devaluations that periodically disrupted the system. In the early 1970s the system broke down. (I am in the process of writing a book on this period and the theoretical and practical issues that were a part of this history.)

The next twenty years or so the nations learned to operate in a world that was becoming more global and integrated in nature. Nation after nation learned that in such a world that they could not operate independently of one another and that a firm discipline needed to be maintained in order to exert some control over their destiny. A lack of governmental discipline and the slight smell of inflation could set into play forces in international financial markets that would completely disrupt the internal policies that these nations were attempting to follow. Nation after nation had to bring their budgets under control and follow a strictly disciplined approach to their debt creation. Also, these nations made their central banks independent of the national government and charged them with keeping inflation under control. This has become the foundation of the model for international cooperation on international trade and globalization.

The next fifteen years or so the world had to deal with a United States that was at first receptive to this new world financial order and then at odds with the system and even rebellious. It was within this context that “Rubinomics” was born. Again, putting things in relatively simple terms, the fundamentals of “Rubinomics”, to me, is the essence of the “new world order”. First, a country needs to get its fiscal affairs in order and minimize its creation of new debt. Second, the nation needs an independent central bank whose primary focus is on controlling inflation…and little else. Third, this country needs to operate as a partner within the world…even though it may be the world’s only super power…and help to facilitate the growth and interaction of nations into as fully an integrated world as possible.

It seems to me that this approach was attempted in the 1990s and was relatively successful. It seems to me that this approach was snubbed in the first decade of the twenty-first century and, as a consequence, we have substantial financial dislocation in the world and a fractured world community. It seems to me that “Humpty-Dumpty” needs to be put back together again.

Where do we start?

Paul Volcker (whoops another name), I believe, was right in writing “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), p. 232.) This is where the United States must start!

United States fiscal and monetary policy must be responsive to what the rest of the world is trying to tell us. If the value of the U. S. dollar has been falling for seven years or so, maybe the market is trying to tell it something. This is what happened in the 1972-1992 period to many other countries. (Last post I mentioned a book by Steven Solomon that reviews this period: “The Confidence Game: How Unelected Central Bankers are Governing the Changed World Economy”, 1995.) In the Clinton years, policymakers seemed to understand this message. In the years that followed, the policymakers seemed to go out-of-their-way to avoid hearing this message.

The United States needs to start listening again. The Federal budget must be brought under control and the nation must move ahead in a disciplined manner with respect to debt creation. The Federal Reserve System must not be charged with multiple responsibilities that distract it from what should be its main focus…inflation. Note that this is more complex than just concentrating on the “flow” prices that are captured in the major price indices. There will be more on this in future posts.

There is no question that the United States government needs to review its fiscal programs and policies, its needed public investment. A lively debate must take place with respect to things like the war in Iraq and elsewhere, universal health care, the infrastructure, education, and so on. But, this discussion must take place within the constraint of what it takes to be a partner within the world community and operate according to the rules of membership. We may not like this…we Americans do not take well to the discipline of others. But, we are a member of the world community and we must be a GOOD member. Citizens of the United States must remember this.

We must also get away from the “Fundamentalism” that permeates both ends of the political spectrum. We cannot promote a left wing “Tax and Spend” fundamentalism any more than we can promote a right wind “Tax Cut and Spend” fundamentalism. We cannot be locked into past doctrine…we must be more pragmatic in practice. We cannot hold up politically correct tests of membership…from the right or from the left. We must shake off these remnants of the past!

Thursday, June 12, 2008


Financial markets are built upon trust. Financial securities are just information, in effect just 0’s and 1’s. The only way that markets in these financial assets can function is if there is sufficient trust in the markets to warrant individuals and institutions buying and selling these assets.

“Rubinomics” is based upon the building up of market trust. The figure behind “Rubinomics”, Robert Rubin, spent twenty-six years at Goldman Sachs, beginning in the arbitrage department and rising to the position of co-senior partner, before he got involved with the Federal Government. His training and experience is working in these markets and observing the role that trust plays in their operation.

Rubin also was a market participant during the age, the 1980s, in which international financial markets effectively became the controlling factor on the undisciplined fiscal management of sovereign nations. Time and again during this period the financial markets would react against the debt of a nation that was felt to be conducting economic policies that were inflationary. Participants in financial markets had gotten burned in the 1970s as inflation became a worldwide problem with inflationary expectations dominating the movement in interest rates. As the interest rates rose, bond holders took some substantial capital losses due to the falling market prices of the debt issues. With this experience firmly in mind, these market players were not going to get burned again in the 1980s. (For a good history of this period see the book by Steven Solomon titled “The Confidence Game: How Unelected Central Bankers are Governing the Changed World Economy, 1995.)

This experience was brought to Washington, D. C. as Rubin moved to become Director of the White House National Economic Council and then to assume the position of Treasury Secretary. In my mind, the basis of everything that he did in these positions was to restore trust in the economic policy making of the United States government and to restore trust in the financial management of that government. This is why the government’s fiscal deficit had to be brought under control. But, it was also why Rubin felt that the United States had to be a partner in the world community and not the ‘big bully’ of the world’s only super power who could go-it-alone whenever it felt like it was in the country’s best interest.

In the recent article in the New York Times ( it is reported that several leaders of labor unions have been critical of the Rubin program arguing that it is too slanted toward corporations and too open to free trade. Rubin has apparently countered this reaction with the response that “We need today a multiyear path to a sound fiscal position, but in that context you need to make room for critical public investment.” His argument I think can be put another way: if the United States does not work to achieve a sound fiscal position and re-establish trust within the international market place, it will not be able to produce the critical public investment that is needed. In other words, the markets must be listened to.

Here are the facts, as I see them. The United States, although it is the lone super power in the world, is still a partner in a very intertrelated world. In the last seven years or so, the United States has thumbed its nose at the rest of the world and acted unilaterally. As a consequence, the world has split into several different configurations of “them” versus “us” and things have fallen apart. The worst scenario is for the dollar to continue to fall against the Euro and other major currencies which will force the United States government to respond with a real austerity program. This we don’t want and such a program would be especially hard on the union leaders and their troops.

The markets must be listened to! ! !

What Rubin is advocating and what, I think, is vitally important for the construction of an economic program for the new President is a realistic effort designed to get ourselves out of the hole that the present administration has dug for the American people and create an environment where the new Administration can then focus on the “critical public investment” that is being advocated.

Certainly, the present administration has made it very difficult for any new President to enact a program that provides a “new direction” for the country. I have written before about the political effort an administration can make to “tie-up” a succeeding administration. This theory has been applied to the Regan-Bush(41) administrations and their “leavings” which caused the Clinton team to postpone the social programs it wanted to introduce until it straightened out the mess it was left with. Here we could accuse the Bush(43) team for doing exactly the same thing…if one could give them credit for doing anything in a competent way. Whatever, the mess that Bush(43) is leaving for the new administration is going to take some time to unwind before any “change” can be forthcoming.

But, there is a wider issue that must be discussed within the context of the debate between “Rubinomics” and the position taken by the union leaders. Both sides of the discussion need to be listened to. An Obama Administration cannot just rush off with a program of new “critical public investment” without considering the implications such a policy would have on international financial markets. And, those in favor of “Rubinomics” cannot enforce fiscal discipline without policy goals and objectives related to the social issues that need to be dealt with. The Democratic Party is a community and needs to hear from its different constituencies and sub groups, their positions and arguments. The diversity of the party is one of its strengths. This diversity allows for many, many voices to be heard and incorporated into the change that needs to take place.

That is what a democracy is all about. And, the Democratic Party needs idealists just as it needs realists. In this sense, the idealists need the realists in order to achieve something that will be not only feasible, but also sustainable. What good is implementing something if it cannot last?

So, “Rubinomics” is back. It is good to have some advice being given to one of the candidates that bears some relationship to how the world works. The world needs to come to trust the United States again. The world needs to see that the United States as its partner and not as its adversary. Then the world can see how the United States acts as a democracy to respond to the will of the people!

Tuesday, June 10, 2008

Earning the Trust of the World

It is difficult for an individual or an organization to earn the trust of the market. Although market participants may want to give an individual or an organization the ‘benefit of the doubt’, especially when a person or the leadership of an organization is new on the job, trust has to be earned and trust is not gained overnight. But, trust can be quickly lost and once it is lost it becomes even harder to earn it back..

There seems to be very little trust in the Bush administration these days and to hear members of “the team”, including President Bush, out in public talking up a strong dollar seems a little bit absurd and surreal. From time-to-time, the Bush administration has spoken about a strong dollar, but has never seemed to do anything about it. And, this charade has gone on for seven years or so.

Now, when this administration is in its waning days, when it can do little or nothing in the way of implementing appropriate policies, when it is subject to internal questioning of what it has done, “talking the good talk” just highlights how incompetent and how out-of-touch the Bush administration really is. The President has never really had much of an interest in economic policy making and has failed to appoint or listen to quality advisors. The results that have been achieved only point up these failures.

The internal questioning is another issue. Individuals that have been members of the Bush administration have given us their impressions about economic policymaking after they have left the administration, but now we have people within the monetary wing of the team expressing doubts and concerns in the public square. (See my post of June 6, 2008, The Bermuda Triangle?” which was posted on Speaking Alpha on June 10 with the title “Fed Policy and U. S. Economic Turmoil”.) Fed Chairman Ben Bernanke has spoken out three times in the past week to argue for a strong dollar and to waylay worries about the jump in the unemployment rate. (see: Yet, one worries about the leadership within the Federal Reserve System with so many governors and district bank presidents speaking out. This is coupled with the fact that the Board of Governors only has three confirmed governors plus one who resigned a week ago. Where is the source of any confidence here?

But, let’s look to the future, to the presidential candidates. Polls inform us that the state of the economy is, by far, the most important issue on the menu of voters concerns. The two candidates are contending that economics is the big issue that they will fight over in the upcoming election and that they stand miles apart in terms of what they would do.

Yet, what do the participants in international markets hear? They hear discussions about tax cuts…tax cuts for middle-income families and retirees…tax cuts for corporations and upper-income families…and expanded unemployment aid…and subsidies for state relief programs…and enlarged coverage of health care…and help for families facing foreclosure on their homes…and so on, and so on.

How will these be paid for? By letting the Bush tax cuts expire…by cutting back on other programs…by the reduction of support for the military through redirecting the use of resources…by taxing corporations like those in the oil industry…by better management of programs…by efficiencies…and so on, and so on.

The markets are interpreting this debate as promising more and more government debt. They have heard these arguments before. More benefits for the electorate…paid for through reductions in government or better management of programs. International markets are just hearing “more of the same”. And, when they look at the advisors to these candidates they see one candidate who admits that he doesn’t know much about economics and has two old friends, Phil Gramm and Jack Kemp, as his primary advisors. (“Back to the Future” Part VII or VIII.) The other candidate…well, that remains to be seen…we are told that the overall plans will be forthcoming this fall. Not much of a confidence builder here.

What about monetary policy? The bet is still on that United States monetary policy will help to underwrite the government debt. The first concern is with the leadership of the Federal Reserve System. Disarray within the body is not a good sign. The absence of so many principals it also not a good sign. And, the monetary authority is still strapped with the assignment to pursue both economic growth and low inflation...something that is very, very difficult to do. Furthermore, with a credit crisis still at hand…the Lehman earnings report did not help nerves at all…and the possibility of a recession…unemployment up, car sales and retail sales down and the housing market still in the tank and so forth…along with high oil and food prices…the best bet is that the Fed will support policy actions to lower unemployment and spur on economic
growth. It is currently the American way to inflate oneself out of problems.

Not only is this the way of the government, it is also the way of the people. A timely article on this point is the David Brooks piece in the New York Times of June 10, 2008: I have also presented some points on this: see my blog of June 4, 2008, “Economic and Financial Power and Leverage”. Discipline does not seem to be a word to be found in the American vocabulary these days.

One of the problems is that we have to get rid of the Keynesian idea that monetary policy has a responsibility for high levels of economic employment. For one, statistical research has shown that monetary policy has very little, if any, influence over the unemployment rate over time. So, empirically, the relationship between monetary policy and employment is a weak one. Secondly, the Keynesian model was developed to provide a foundation for government spending policies at a time when greater national autonomy in economic policymaking was desired to achieve higher levels of employment so as to avoid social revolution. (See Donald Markwell, “John Maynard Keynes and International Relations, Oxford University Press, 2006.) These times have passed, yet, as Keynes himself argued, the ideas of economist long dead still influence the making of economic policy. The monetary authority needs to focus on inflation as its primary responsibility and not some dream about achieving high employment.

The difficulty that the United States is facing is exacerbated by other institutions within the world that are earning the trust of international financial markets. The European Central Bank (ECB) is one such institution and the Bank of England is another. The ECB has, as its main function, the goal of low inflation. It is determined to crush inflation. (See The Bank of England is also taking a strong stance against the rising tide of inflation. Nations within the world community cannot ignore what is going on in the rest of the world and conduct economic policy independently of everyone else. History seems to side with the nations and institutions that establish and maintain the trust of others within the world community. To this end, participants in international financial markets are leery about placing any trust in the current leadership of the United States and are not comfortable with what they are hearing from the potential future leadership.

The future of the value of the dollar? Right now, it is hard to be bullish. There will be recoveries and rebounds…there always are. But, aside from these short-term swings, what is there to be confident about in terms of the future of the economic policies of the United States. Candidates have to get elected…and the candidates have to tell the electorate where they stand in terms of what they would do if elected. The policies and programs that are being proposed almost assuredly will not be enacted within the next two or three years. America must get its act together. That is the only way that the rest of the world will come to trust this country again. What needs to be done, however, will take time and patience. And, with time, trust can be re-earned. Until then, I believe the value of the dollar will remain soft.

Friday, June 6, 2008

The Bermuda Triangle?

Is the United States flying into a period of economic turmoil that one can only describe as a Bermuda Triangle? Financial institutions are not out-of-the-woods yet in terms of cleaning up their balance sheets. The economy has surprisingly remained stronger than expected, yet there are layoffs in the airline industry, the car industry, the housing industry, and other industries that are bound to contribute to future weakness. And, there is talk within central banking circles that interest rates may need to be raised in upcoming months.

Furthermore, there seems to be some uncertainty among the pilots flying the monetary ship in the United States. After leading the Federal Reserve through a period of historically massive reductions in the Fed’s target Federal Funds rate, the introduction of major innovations in the way the Fed conducts its monetary policy, and after intervening into areas of the financial sector in ways that are reminiscent of the Great Depression (of which he is a major academic scholar), Chairman Bernanke has stated that maybe the Federal Reserve better look out after the decline in the value of the United States dollar.

But, now several other members of the Federal Reserve leadership have expressed doubts about how the Federal Reserve has acted in recent months. On June 5, Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond has come out and expressed concerns about the Federal Reserve lending to major securities firms. Charles Plosser, the president of the Federal Reserve Bank of Philadelphia has also spoken out defining more clearly the boundaries of what the Federal Reserve System can and should do. Both raised concerns about whether or not the Fed should actually be doing these things.

But, these are not the only voices that have expressed concern. Two other presidents of Federal Reserve banks have expressed similar thoughts. Gary Stern, president of the Federal Reserve bank of Minneapolis, discussed, in April, the expansion of the Fed’s authority, while Thomas Hoenig, president of the Kansas City Federal Reserve bank discussed the threat of moral hazard in the financial system due to the Fed’s actions.

On the other side, Ben Bernanke, vice chairman of the Board of Governors of the Federal Reserve System, Donald Kohn, and Timothy Geithner, president of the Federal Reserve Bank of New York, have defended the recent actions taken by the Fed.

I cannot remember a time when there has been so much discussion, in public, about what the Federal Reserve is doing or has done by the individuals within the Federal Reserve System that have responsibility for making the policy decisions that the Fed executes. The Federal Reserve does no usually “wash its dirty linen” for the whole world to see. Just what is going on here?

One final point: the timing of the departure of Governor Frederic Mishkin to return to his teaching position at this time raises a question mark. This is a very delicate time for the Federal Reserve System because the departure of Mishkin will reduce the number of openings in the ranks of the Governors to four…out of seven. This, of course, is not Mishkin’s fault because the administration has made appointments for the other three positions. It is just that the Democratically controlled confirmation process has held up the confirmation on these other three appointments for over a year. But, Mishkin’s resignation is tremendously awkward at this time. I don’t want to make too big a point out of this, but the timing, given the internal debate within the Fed and with the shortage of Governors on the Board, the timing of the departure is curious.

But, let’s return to the other points mentioned above. First, the condition of the financial system. Foreclosures remain high and will probably continue to rise. Bankruptcies have increased and probably will increase. Charge offs of credit card debt are high and rising. There remains the question about further charge offs at major financial institutions. And, if the economy is going to get softer, delinquencies and other financial dislocations are going to increase. The question still remains…how stable are the financial institutions of the United States, particularly if short term interest rates need to rise?

Second, the state of the economy, although it has been stronger than expected, shows signs of growing weakness. It is kind of like watching this whole thing evolve in slow motion. The bad news piles up, yet the economy seems to be hanging in there. However, the unemployment figures are up and the impacts of the higher oil and gas prices seem to be spreading to more and more major industries. The unexpected strength in the economy has allowed Chairman Bernanke to express concern about the weakness in the value of the United States dollar, but one really wonders about how much can be done in this election year to actually combat its falling value if the economy gets softer and financial institutions remain in a tenuous state.

Finally, there is the reality that the United States is “out-of-step” with the rest of the world in terms of where it is policy wise. On June 5, the European Central Bank and the Bank of England, both left their target interest rates at their current levels, but, especially Jean-Claude Trichet, the president of the European Central Bank, they both stated that there was a strong possibility that these target interest rates would need to be raised in the future. The focus of these central banks on inflation remains firm in spite of weakening economies. These central banks are earning their reputation for trying to keep inflation in their areas under control.

The direct effect of this effort has been to cause renewed weakness in the value of the United States dollar and a rebound in the price of oil. And, this points up the main dilemma facing the United States government and the Federal Reserve. Policy wise, the United States is in a different place than is much of the rest of the world. The “go-it-alone” attitude of the Bush administration which thumbed its nose to the international community in foreign relations as well as in its economic and financial policies has now left it at odds with much of the rest of the world and isolated it in terms of what it needs to do. Whereas the United States seemingly cannot act to protect the value of the dollar because of the fragility of its economic and financial system, other major players in the world now are indicating that they, in all likelihood, will raise interest rates in the future. If others do raise interest rates this can only put the United States in a more difficult position because if the Fed does need to act to further protect the economy or even if it does not move from the targets it now has, the weakness in the value of the dollar will only continue. The actions of others will place the dollar in a relatively worse position than it is now

Once again, we see the problem of a major nation going off on its own path. Now, when the United States is reaping the consequences of its past actions, the only way others can contribute to helping it resolve its difficulties is to weaken their own discipline and act in a way that is not consistent with the long term welfare of their own people. The future direction of the United States economy and the health of its financial system is heavily dependent upon what others might have to do to maintain the health and welfare of their countries. We have already seen the United States president “beg” for relief on the oil front. Will he also need to “beg” for other relief?

Wednesday, June 4, 2008

Economic and Financial Power and Leverage

In my post of Thursday, May 29, “Finance, Credit Cards, and the Fed: Three Comments” I made reference to “the loss of respect for the field of finance.” Given some of the comments I have received on this subject over the past week I want to follow up with what, I think, is crucial in understanding the role of finance in the world and how strong leadership in the field of finance is necessary if the goals and objectives of companies and governments are to be achieved. I am willing to accept the criticism that I am saying nothing new and that my comments are so fundamental that they can just be skimmed over before moving on to something more important. The problems that accompany an attitude like this are that they lead to ignoring these fundamentals and the “something more important” cannot really be attained if the fundamentals are ignored.

Finance is secondary to what companies and governments do, including financial companies. Strong financial leadership facilitates and allows companies and governments to focus on what they should be focusing on…the goals and objectives of the company or the government. Weak financial leadership ultimately can result in companies and governments losing their focus because they have to deal with financial dislocations…that is, they have to put out fires and engage in restructurings. Strong financial leadership should contribute to what it is that the company or government does best because a strong financial position enhances the power and leverage a company or government already has achieved. Weak financial leadership reduces and then often overcomes whatever position of strength a company or government has attained.

On a personal level, I have had the opportunity to lead several successful turnaround situations in the financial industry. In all cases I can say that weak financial leadership either caused the difficulty the company faced or exacerbated the results due to the other bad decisions that were being made in the organization. In order to turn these companies around it was necessary to get the financial affairs of the company “under control” so that the organization could “re-focus” on what it could do best. In terms of banking organizations, the re-focusing had to do with becoming a financial intermediary once again. That is, although the institutions were “financial” institutions, their major business was “intermediating” between borrowers and depositors. Re-establishing strong financial fundamentals allowed management to direct its focus to the things that made the banks competitive in their markets.

It is, of course, very easy for managements to lose focus when there seem to be incentives that can “add” to the performance of an organization by dabbling in extra-curricular financial adventures. But, should H & R Block really have been dealing in subprime mortgages? The argument had been given that H & R Block needed to offset the slowing down of it tax-preparation business, but what did it know of the subprime mortgage market? The incentives of making such a move seem so obvious to a management, however, and it is always hard to maintain one’s focus and discipline in the face of such incentives. One has to ask, in retrospect, why the management of H & R Block didn’t keep its focus and re-tool its business model. Where could H & R Block have built on what it did best rather than explore areas it had little or no knowledge of. Maybe, in the face of the competition coming from the Internet, an organization like H & R Block could not sustain the competitive advantage it once held. But, that is another problem. The difficulty that a firm faces is that once management moves away from its primary business it is very hard to reverse the momentum.

Another example pertains to the use of debt and the exorbitant reliance on leverage. For example, we are told over and over again that the only way to make any real money in many arbitrage opportunities where only small spreads exist is to massively leverage a position so as to magnify the returns on a deal. And, of course, the nature of the arbitrage cannot be revealed because if everyone knew about the deal, the spreads would go away. Well, massive arbitrage bets make the spreads go away and raise the question as to whether or not trading really produces, on average, positive returns over time. Also, one has to ask the question about whether or not situations of asymmetric information are really that plentiful in an environment where information is readily available and “super crunching” is becoming ubiquitous. To me, strong financial leadership can stand the glare of openness and transparency.

Governments can also exhibit weak financial leadership which can contribute to a nation’s loss of power within the world community and a lessening of its influence in international relationships. Financial markets can lose confidence in the administration of a country if that administration loses its fiscal discipline. This loss of confidence can result in a consequent decline in the value of a nation’s currency. A depreciating currency weakens the economic position of the country relative to the other countries it trades with. This position of weakness either reduces the other strengths a nation might possess in the world, or, it can exacerbate the problems being created in other areas due to poor government decisions. Strong financial leadership within the government of a country can contribute to the respect and influence a nation has in the world community. Strong financial leadership within a government enhances the other economic strengths that the nation possesses.

There are many other areas where financial leadership can have an influence on the power and leverage a company or government has relative to other companies or governments. Strong financial leadership does not allow financial issues to dominate those things that a company or government should be doing. Strong financial leadership can contribute to the position a company or government can achieve because it allows that company or government to relate to others from a position of strength, a position where the company or government can really do what it does best…and back it up. And, that is what a company or government should do…focus on what it can do best!

I believe that this sermon is especially necessary at this time because of the impending change in the leadership of the government of the United States. I believe that a new administration in Washington, D. C. must exhibit strong financial leadership based on sound fundamental financial practices. I believe in this for two reasons. First, it is important for the United States to re-establish itself as a world leader. Times have changed and although the United States never lost its position as the only superpower in the world, its relative position has changed in that several other nations have economically become much stronger. (See my post of Thursday, May 22, “The World Has Changed. When will America Realize It?”)

Secondly, other leaders within the United States tend to emulate the culture established by the President and his administration. If the government does not follow sound financial principals it sends signals out to the rest of the community that it is not necessary for those within the community to pursue sound financial principals either. In fact, if the government does not follow sound financial principals, it can be expected that incentives will change and it will become more beneficial, at least for a while, for the rest of the community to become less disciplined as well.

In the current campaign for the Presidency, both candidates are presenting programs that lack any appearance of fiscal or monetary discipline. The talk is about tax cuts, universal health coverage, and other programs that resonate with the electorate. This is not unexpected. As a historical example, Bill Clinton ran on such a platform in 1992. Fortunately, after became President, he had an advisor that argued that these programs would just have to wait until the government got its fiscal affairs under control and saw the value of the dollar strengthen. Fortunately, Bill Clinton listened to this advisor. The question is, does either of the candidates have such an advisor at the present time? And, if so, will that candidate listen to the advisor once he becomes the new President? In my view, financial discipline will have to be re-established at some time…the ultimate question is…when will it be done?