Perhaps the most profound bit of information appearing in the news this morning concerning the budget proposal of the Obama administration is the citation of Stein’s law by the economist James Galbraith in the New York Times article “Huge Deficits May Alter U. S. Politics and Global Power.” (See David Sanger, http://www.nytimes.com/2010/02/02/us/politics/02deficit.html?hp.)
Stein’s law (as familiarly presented) states that “If a trend cannot continue, it will stop.”
Galbraith also provides us with his own wisdom: “Forecasts 10 years out have no credibility.”
Now to the budget of the United States government!
What is the primary trend connected with the federal budget? Government expenditures will go up, and up, and up. Congress does not have the discipline to stop expenditures from increasing. Neither do presidential administrations.
But, what about the deficit?
There is only one way the deficit can or will be reduced: revenues coming into the government must increase. And, of course, they must increase at a faster pace than expenditures are growing.
This was the pattern in the Clinton administration years, 1993-2001. For this 8-year period, total receipts coming into the federal government rose 7.1% per year. (Note that for the 7-year period of 1993 -2000, the annual rate of increase was 8.4%.)
This contrasted with the compound growth rate of total federal government outlays which rose by 3.6% per year. Thus, the Clinton administration began in fiscal 1993 with a total deficit of $255 billion and recorded a surplus in fiscal year of 1998 of $69 billion, followed by surpluses of $126 billion, $236 billion, and $128 billion.
The major contributors to the growth rate in total receipts was Individual income taxes and Social insurance and retirement receipts. The compound growth rates of these items was 8.7% and 6.2%, respectively. Note that the compound growth rate for real GDP during this time period was 3.5%.
The figures for Bush 43 show a substantially different configuration. Total receipts of the federal government grew by only 3.6% per year during this administration. (Note that the compound growth rate for real GDP was 2.3% at this time.) The greatest growth in revenue came from corporate income taxes which grew every year by 10.5%
There was a surge during the Bush 43 years of total outlays which rose by 8.3% year-after-year. The biggest contributor to this was the outlay for national defense, and these expenditures rose, on average, by 10.2% every year. (Note that in the Clinton administration these outlays rose by less than 1% per year.)
It seems to me that the trend in outlays over the next few years will remain rather high. America is a nation at war! Defense outlays will continue to rise. The question is, how much? This is a unknown known. My guess here is that present estimates are low!
The big question relates to how much other expenditures will rise, expenditures related to health care, energy, global warming and others. The exact cost of this spending are anyone’s guess right now. These expenditures we can put in the category of known unknowns. Given the history of government it is impossible for me to believe that health care reform will not “cost us one dime” as stated by the President. We don’t really know when these other programs will be pushed and expanded, but they still remain on the “to-do” list of the President.
There are always “other” things, the unknown unknowns. You guess.
The trend in outlays is up, but the question is by how much? The mean of the Clinton and Bush 43 years is just about 6% per year!
Is there any way that revenues can come anywhere close to a 6% per year annual increase?
It was done in the Clinton years, but that was with an economy that was increasing, in real terms, at 3.5% compound rate. I just don’t see it over the next 5 to 10 years.
Raising taxes? Are you crazy!
Yes, the Bush 43 tax cuts will not be renewed, but, there will not be any other tax increases that will raise revenues substantially. Not with the unemployment figures captured in the current budget document.
So, what are we faced with?
Given the scenario I have just painted my guess for the sum of government deficits over the next 10 years is from $15-$18 trillion. This is substantially above the $8.5 trillion total presented in the current Obama budget documents.
If this scenario for the federal budget is anywhere close to reality then one could argue that it is the blue-print for an excessive credit inflation in the upcoming years that will be unlike anything we have seen in the past in the United States!
And, what is the good news?
To quote Galbraith, “Forecasts 10 years out have no credibility.”
Whew! You had me scared two paragraphs ago.
Any more good news?
Sure, to quote Herb Stein, “If a trend cannot continue, it will stop.”
The trend commented on above is the growth of total federal government outlays. It must stop! But, it will not stop if the United States is fighting at least two wars, fighting unemployment, fighting for health care reform, fighting for other “musts” on the Presidential “to-do” list, and taking care of those unknown, unknowns that always seem to pop-up.
“If a trend cannot continue, it will stop!”
What is going to make the trend in total federal government outlays stop?
I’ve got my ideas. You go ahead and write your own script!
Tuesday, February 2, 2010
Monday, February 1, 2010
It's the Mood of the Workers, Stupid!
Robert Shiller of “Irrational Exuberance” has given us the answer to our problems in the Sunday New York Times. See “Stuck in Neutral? Reset the Mood!” http://www.nytimes.com/2010/01/31/business/economy/31view.html?scp=1&sq=robert%20shiller&st=cse. Shiller argues that, “In reality, business recessions are caused by a curious mix of rational and irrational behavior. Negative feedback cycles, in which pessimism inhibits economic activity, are hard to stop and can stretch the financial system past its breaking point.”
“Solutions for the economy must address not only the structural instability of our financial institutions, but also these problems in the hearts and minds of workers and investors—problems that may otherwise persist for many years.”
The solution: people must believe in the cause! “Reset the Mood!” “In most civilian fields, job satisfaction may not be a life-or-death matter, but a relatively uninterested, insecure work force is unlikely to bring about a vigorous recovery.”
But, the problem goes beyond the current malaise. Shiller advises us to look at the whole post-World War II period. He cites data from the Bureau of Labor Statistics and states that the annual growth of business output per labor hour averaged 3.2% from 1948 to 1973. From 1973 to 2008 the growth rate was 1.9%. He quotes Samuel Bowles of the Santa Fe Institute who has argued that the causes of this slowdown “are to be found as much in the loss of ‘hearts and minds’ of workers and investors as in the technology.”
A cause of this “loss of ‘hearts and minds’ of workers and investors” is not presented. Let me provide a possible cause: inflation!
Since January 1961 through 2009, the purchasing power of $1.00 has declined by about 85%, depending upon the price index used. That is, a $1.00 that could purchase $1.00 when John Kennedy became president could only purchase around $0.15 in 2009.
The “guns and butter” expenditure pattern of the federal government in the 1960s resulted in the wage and price freeze that came about in August 1971 along with the separation of the United States dollar from gold. The excessive inflation of the latter part of the 1970s resulted in the Federal Reserve tightening of monetary policy which finally broke the back of inflation in the early 1980s. Yet, even though the United States went through a period of moderate price inflation during the next twenty years or so (the Great Moderation) credit inflation continued. (For a review of what I mean by credit inflation see http://seekingalpha.com/article/184475-financial-regulation-in-the-information-age-part-c.)
This period of inflation had two major impacts on the United States economy. First, American manufacturers worried less about productivity than they did about getting products to market. Inflation does this to producers. Why? Because the pressure is on manufacturers to quickly get in new equipment so that they can meet the rising demand for goods and this means that executives focus less on the longer-lived, more productive plant and equipment and give their attention to more short-lived investments. As a consequence, productivity suffers!
The impact of this change in the composition of the capital stock of the United States is reflected in two other measures. First, capital utilization in manufacturing industry has continued to decline from the 1960s to the present time. (See chart: http://research.stlouisfed.org/fred2/series/TCU?cid=3.) For example, capacity utilization was above 90% in the middle of the 1960s. Through all the cycles in capacity utilization over the next 45 years, the peak rate constantly declined. In February 1973 the rate was slightly below 89%. The next peak was in December 1978 and was below 87%; then about 85% in January 1989; and again in January 1995 and in November 1997. The next peak came in August 2006 at about 81%. The most recent trough in capacity utilization came in June 2009 and has rebounded to 72% in December 2009. Expectations: it will not reach 81% again.
In addition, labor force participation has changed dramatically during this time period. Labor force participation increased substantially from the latter part of the 1960s until the latter part of the 1980s, primarily due to more women taking part in the measured labor force. Since the late 1980s the growth of total labor force participation began to slow down and in the 200s total labor force participation began to decline as more and more people became discouraged in looking for a job or only could find temporary employment. In 2009 the number of under-employed individuals of working age amounted to between 17%-18% of the labor force. Thus, we have unused capacity in the labor force as well.
The second major impact this period of inflation had on the United States economy was on the use and creation of debt. Inflation is good for debt creation! But, the foundation for the increase in debt during this time was the Federal Government, as the gross federal debt increased at an annual rate of 7.85% per year for the period of time from fiscal 1961 through fiscal 2009. The federal debt held by the public rose by 7.31% over the same time period.
Private debt, of course, increased very, very rapidly during this time period as did the financial innovation that spread debt further and further through the economy. Inflation is good for debt and it is also good for employment in the area of finance and financial services. As is well known there was a tremendous shift in the work force during this time from non-financial firms to financial firms. Furthermore, labor productivity does not increase as much annually in the finance industry as it does in non-finance.
Why should the labor force put its “hearts and minds” behind the future of the United States economic machine?
One sees no end to the environment of “credit inflation” created by the federal government. Estimates of federal government budget deficits still range in the $15-$18 trillion range for the next ten years which would more than double the gross federal debt that now exists. Then there are questions relating to the Federal Reserve’s inflation of the monetary base and the possibility that the central bank can pull off a magical “exit” strategy where the Fed removes roughly $1.1 trillion “excess” reserves from the banking system without causing any disruptions. The eminent scholar of the Federal Reserve System, Allan Meltzer, seems to have serious doubts about the Fed being able to pull this off. (See http://online.wsj.com/article/SB20001424052748704375604575023632319560448.html#mod=todays_us_opinion.) The failure to succeed here, along with the rise in the federal debt, would just further underwrite credit inflation in the whole economy.
The international investment community continues to have concerns over the ability of the United States to do anything different from what it has done over the last 50 years or so. There is nothing to indicate anything more than “business as usual” in Washington, D. C. If this is true, then we will see continuing credit inflation, sluggish performance in labor productivity, continued declines in labor force participation, and further softness in capacity utilization. And, if the environment of credit inflation continues, finance and financial innovation will continue to thrive.
We don’t need a change in the “hearts and minds” of the labor force. The change in “hearts and minds” that is needed is in the politicians in the federal government.
“Solutions for the economy must address not only the structural instability of our financial institutions, but also these problems in the hearts and minds of workers and investors—problems that may otherwise persist for many years.”
The solution: people must believe in the cause! “Reset the Mood!” “In most civilian fields, job satisfaction may not be a life-or-death matter, but a relatively uninterested, insecure work force is unlikely to bring about a vigorous recovery.”
But, the problem goes beyond the current malaise. Shiller advises us to look at the whole post-World War II period. He cites data from the Bureau of Labor Statistics and states that the annual growth of business output per labor hour averaged 3.2% from 1948 to 1973. From 1973 to 2008 the growth rate was 1.9%. He quotes Samuel Bowles of the Santa Fe Institute who has argued that the causes of this slowdown “are to be found as much in the loss of ‘hearts and minds’ of workers and investors as in the technology.”
A cause of this “loss of ‘hearts and minds’ of workers and investors” is not presented. Let me provide a possible cause: inflation!
Since January 1961 through 2009, the purchasing power of $1.00 has declined by about 85%, depending upon the price index used. That is, a $1.00 that could purchase $1.00 when John Kennedy became president could only purchase around $0.15 in 2009.
The “guns and butter” expenditure pattern of the federal government in the 1960s resulted in the wage and price freeze that came about in August 1971 along with the separation of the United States dollar from gold. The excessive inflation of the latter part of the 1970s resulted in the Federal Reserve tightening of monetary policy which finally broke the back of inflation in the early 1980s. Yet, even though the United States went through a period of moderate price inflation during the next twenty years or so (the Great Moderation) credit inflation continued. (For a review of what I mean by credit inflation see http://seekingalpha.com/article/184475-financial-regulation-in-the-information-age-part-c.)
This period of inflation had two major impacts on the United States economy. First, American manufacturers worried less about productivity than they did about getting products to market. Inflation does this to producers. Why? Because the pressure is on manufacturers to quickly get in new equipment so that they can meet the rising demand for goods and this means that executives focus less on the longer-lived, more productive plant and equipment and give their attention to more short-lived investments. As a consequence, productivity suffers!
The impact of this change in the composition of the capital stock of the United States is reflected in two other measures. First, capital utilization in manufacturing industry has continued to decline from the 1960s to the present time. (See chart: http://research.stlouisfed.org/fred2/series/TCU?cid=3.) For example, capacity utilization was above 90% in the middle of the 1960s. Through all the cycles in capacity utilization over the next 45 years, the peak rate constantly declined. In February 1973 the rate was slightly below 89%. The next peak was in December 1978 and was below 87%; then about 85% in January 1989; and again in January 1995 and in November 1997. The next peak came in August 2006 at about 81%. The most recent trough in capacity utilization came in June 2009 and has rebounded to 72% in December 2009. Expectations: it will not reach 81% again.
In addition, labor force participation has changed dramatically during this time period. Labor force participation increased substantially from the latter part of the 1960s until the latter part of the 1980s, primarily due to more women taking part in the measured labor force. Since the late 1980s the growth of total labor force participation began to slow down and in the 200s total labor force participation began to decline as more and more people became discouraged in looking for a job or only could find temporary employment. In 2009 the number of under-employed individuals of working age amounted to between 17%-18% of the labor force. Thus, we have unused capacity in the labor force as well.
The second major impact this period of inflation had on the United States economy was on the use and creation of debt. Inflation is good for debt creation! But, the foundation for the increase in debt during this time was the Federal Government, as the gross federal debt increased at an annual rate of 7.85% per year for the period of time from fiscal 1961 through fiscal 2009. The federal debt held by the public rose by 7.31% over the same time period.
Private debt, of course, increased very, very rapidly during this time period as did the financial innovation that spread debt further and further through the economy. Inflation is good for debt and it is also good for employment in the area of finance and financial services. As is well known there was a tremendous shift in the work force during this time from non-financial firms to financial firms. Furthermore, labor productivity does not increase as much annually in the finance industry as it does in non-finance.
Why should the labor force put its “hearts and minds” behind the future of the United States economic machine?
One sees no end to the environment of “credit inflation” created by the federal government. Estimates of federal government budget deficits still range in the $15-$18 trillion range for the next ten years which would more than double the gross federal debt that now exists. Then there are questions relating to the Federal Reserve’s inflation of the monetary base and the possibility that the central bank can pull off a magical “exit” strategy where the Fed removes roughly $1.1 trillion “excess” reserves from the banking system without causing any disruptions. The eminent scholar of the Federal Reserve System, Allan Meltzer, seems to have serious doubts about the Fed being able to pull this off. (See http://online.wsj.com/article/SB20001424052748704375604575023632319560448.html#mod=todays_us_opinion.) The failure to succeed here, along with the rise in the federal debt, would just further underwrite credit inflation in the whole economy.
The international investment community continues to have concerns over the ability of the United States to do anything different from what it has done over the last 50 years or so. There is nothing to indicate anything more than “business as usual” in Washington, D. C. If this is true, then we will see continuing credit inflation, sluggish performance in labor productivity, continued declines in labor force participation, and further softness in capacity utilization. And, if the environment of credit inflation continues, finance and financial innovation will continue to thrive.
We don’t need a change in the “hearts and minds” of the labor force. The change in “hearts and minds” that is needed is in the politicians in the federal government.
Thursday, January 28, 2010
Obama and Leadership
Where do I stand on the Obama Presidency?
I stand at about the same place I did last year at this time.
President Obama has put too many projects into his “top priority” list. After a year in office with not a whole lot to point to, he still insists that he will stay the course and continue to pursue the things he has been pursuing.
My experience in leadership cautions me that a leader cannot have too many top priorities. This is true if things are running pretty smoothly and it is especially true if one is in a turnaround situation.
To me, Obama’s job was to execute the turnaround of a pretty sick patient!
Leadership is to bring focus to a situation, identifying what is immediately important and what can be put off for awhile. Leadership is about communicating this focus to others so that they know what they are to concentrate on and they can get on board with the leader. Then the leader needs to bring sufficient resources to bear on the problem so that the goals and objectives of the organization can be met.
There will be diversions along the way. That is just the way the world is. Because the leader knows that she or he will face these other, unknown bumps along the road, having a disciplined agenda will allow the leader to take care of these “diversions” while still pursuing the major goals and objectives.
President Obama put too many projects on his “top priority” list. He did not focus. He had the “Audacity of Hope” driving him on. And, while that may be very appealing and good speech material, everything would have had to go “just right” for the president to achieve all the goals he set for himself.
Someone once was elected to office by focusing on the claim, “It’s the economy, stupid!”
But, this tunnel vision never seemed to be a part of the Obama persona.
Looking back one year, however, it is easy for us to now say, “It was the economy, stupid!”
Last year at this time we were tottering on the brink of another “Great Depression.” There was a lot of fear in the country. America’s biggest banks were on the edge, the economy was in the tank, and unemployment was growing. Foreclosures were rising as were bankruptcies. And, most of the rest of the world was in at least as bad shape as was the United States.
The Obama administration, along with Congress, produced a stimulus plan. There was the interjection of the government into the auto industry and one or two other efforts to head off problems. The Federal Reserve pursued “quantitative easing” keeping its target interest rate around zero.
Things did get better. Analysts are claiming that the “Great Recession” ended somewhere in the second half of 2009. But, unemployment still remains high. Foreclosures and bankruptcies are still taking place at near record rates. There remain over 550 banks on the problem bank list of the FDIC. And, the economy seems lethargic. Our consumer advocate, Elizabeth Warren, is raising concerns over the demise of the middle class. There is the criticism that the focus of the recovery was on Wall Street and not Main Street. Some prominent economists, Stiglitz, Krugman, and Roubini, are worried about a double-dip in the economy.
News about the President’s efforts on the economy were quickly displaced by trips around the world, about health care reform, about global warming, about energy policy and a myriad of other initiatives.
Of particular concern here was the Obama health care effort. I will just make three points here. First, President Obama turned the development of the legislation over to the Reid/Pelosi leadership in the Congress to craft the bill. Obama disappeared. Questions about where the president stood or what he was for received vague, disconnected answers because he was not leading the charge.
The story I heard for this tactic was that the health care bill presented by President Clinton failed because it was crafted in the White House and did not include sufficient Congressional participation in the process. Obama was not going to make this mistake. President Clinton, of course, denies this reason for the failure of the 1993 effort at health care reform.
Second, the emphasis that was placed on obtaining 60 votes in the Senate to pass the legislation put several self-seeking Senators in the driver’s seat. (Who says ‘moral bankruptcy’ is just centered in the Wall Street banks?) Rather than focusing on the health care bill itself, the nation was appalled by the behavior of a few of America’s elite holding everyone else hostage in order to get their special interests taken care of.
Third, the size of the effort was overwhelming. All people heard was universal coverage, coverage of pre-existing conditions, public option, and so forth and so on. The picture that came through to ordinary people was “huge plan” must be connected with “huge cost.” This was the way the government worked. All the efforts and machinations of the politicians to build a plan that would not cost the American people “one dime” just did not resonate with the public. Universal efforts were expensive and always cost more than expected. And, this would just add to the huge deficits predicted for the next ten years or so.
And, this was going on while the president spoke, always eloquently, about his other concerns.
Then, there was Iran, and Iraq, and Afghanistan, and the Christmas terrorist bomber, and Massachusetts (and Virginia and New Jersey) and other detours.
The consequence? Confusion, uncertainty, frustration, anger, you name it, on the part of the people. What are the priorities? Where does the president stand? What does the president want us to do? What are the rules? Who is in charge, Congress or the President? What is important?
And, the economy? I don’t know when I have seen a situation in which such uncertainty exists. First, the big banks are helped. (Yesterday we heard that the crucial thing was that the economy did not collapse, not how much money Goldman or the French or whoever got.) Then the big banks became the big bad guys. Now we need to re-regulate them. But, how are they going to be regulated? What about foreclosures? Can anything be done about them? And, then the small- and medium-sized banks aren’t lending. How can we get credit flowing again? And, so on and so on.
People and businesses can’t follow if they don’t know where their leaders are heading, what their main priorities are. People and businesses can’t plan if they don’t know what the rules and regulations are going to be. People and businesses can’t commit if they are plagued with uncertainty.
The State of the Union address last evening did not resolve any of these issues for me or lessen my concerns. To me the issue is leadership and the respect for a leader is earned. This is a question of the rubber hitting the road and no speech, no matter how eloquent it might be is going to change this fact. I am still waiting for the focus of intention and the focus of effort.
I stand at about the same place I did last year at this time.
President Obama has put too many projects into his “top priority” list. After a year in office with not a whole lot to point to, he still insists that he will stay the course and continue to pursue the things he has been pursuing.
My experience in leadership cautions me that a leader cannot have too many top priorities. This is true if things are running pretty smoothly and it is especially true if one is in a turnaround situation.
To me, Obama’s job was to execute the turnaround of a pretty sick patient!
Leadership is to bring focus to a situation, identifying what is immediately important and what can be put off for awhile. Leadership is about communicating this focus to others so that they know what they are to concentrate on and they can get on board with the leader. Then the leader needs to bring sufficient resources to bear on the problem so that the goals and objectives of the organization can be met.
There will be diversions along the way. That is just the way the world is. Because the leader knows that she or he will face these other, unknown bumps along the road, having a disciplined agenda will allow the leader to take care of these “diversions” while still pursuing the major goals and objectives.
President Obama put too many projects on his “top priority” list. He did not focus. He had the “Audacity of Hope” driving him on. And, while that may be very appealing and good speech material, everything would have had to go “just right” for the president to achieve all the goals he set for himself.
Someone once was elected to office by focusing on the claim, “It’s the economy, stupid!”
But, this tunnel vision never seemed to be a part of the Obama persona.
Looking back one year, however, it is easy for us to now say, “It was the economy, stupid!”
Last year at this time we were tottering on the brink of another “Great Depression.” There was a lot of fear in the country. America’s biggest banks were on the edge, the economy was in the tank, and unemployment was growing. Foreclosures were rising as were bankruptcies. And, most of the rest of the world was in at least as bad shape as was the United States.
The Obama administration, along with Congress, produced a stimulus plan. There was the interjection of the government into the auto industry and one or two other efforts to head off problems. The Federal Reserve pursued “quantitative easing” keeping its target interest rate around zero.
Things did get better. Analysts are claiming that the “Great Recession” ended somewhere in the second half of 2009. But, unemployment still remains high. Foreclosures and bankruptcies are still taking place at near record rates. There remain over 550 banks on the problem bank list of the FDIC. And, the economy seems lethargic. Our consumer advocate, Elizabeth Warren, is raising concerns over the demise of the middle class. There is the criticism that the focus of the recovery was on Wall Street and not Main Street. Some prominent economists, Stiglitz, Krugman, and Roubini, are worried about a double-dip in the economy.
News about the President’s efforts on the economy were quickly displaced by trips around the world, about health care reform, about global warming, about energy policy and a myriad of other initiatives.
Of particular concern here was the Obama health care effort. I will just make three points here. First, President Obama turned the development of the legislation over to the Reid/Pelosi leadership in the Congress to craft the bill. Obama disappeared. Questions about where the president stood or what he was for received vague, disconnected answers because he was not leading the charge.
The story I heard for this tactic was that the health care bill presented by President Clinton failed because it was crafted in the White House and did not include sufficient Congressional participation in the process. Obama was not going to make this mistake. President Clinton, of course, denies this reason for the failure of the 1993 effort at health care reform.
Second, the emphasis that was placed on obtaining 60 votes in the Senate to pass the legislation put several self-seeking Senators in the driver’s seat. (Who says ‘moral bankruptcy’ is just centered in the Wall Street banks?) Rather than focusing on the health care bill itself, the nation was appalled by the behavior of a few of America’s elite holding everyone else hostage in order to get their special interests taken care of.
Third, the size of the effort was overwhelming. All people heard was universal coverage, coverage of pre-existing conditions, public option, and so forth and so on. The picture that came through to ordinary people was “huge plan” must be connected with “huge cost.” This was the way the government worked. All the efforts and machinations of the politicians to build a plan that would not cost the American people “one dime” just did not resonate with the public. Universal efforts were expensive and always cost more than expected. And, this would just add to the huge deficits predicted for the next ten years or so.
And, this was going on while the president spoke, always eloquently, about his other concerns.
Then, there was Iran, and Iraq, and Afghanistan, and the Christmas terrorist bomber, and Massachusetts (and Virginia and New Jersey) and other detours.
The consequence? Confusion, uncertainty, frustration, anger, you name it, on the part of the people. What are the priorities? Where does the president stand? What does the president want us to do? What are the rules? Who is in charge, Congress or the President? What is important?
And, the economy? I don’t know when I have seen a situation in which such uncertainty exists. First, the big banks are helped. (Yesterday we heard that the crucial thing was that the economy did not collapse, not how much money Goldman or the French or whoever got.) Then the big banks became the big bad guys. Now we need to re-regulate them. But, how are they going to be regulated? What about foreclosures? Can anything be done about them? And, then the small- and medium-sized banks aren’t lending. How can we get credit flowing again? And, so on and so on.
People and businesses can’t follow if they don’t know where their leaders are heading, what their main priorities are. People and businesses can’t plan if they don’t know what the rules and regulations are going to be. People and businesses can’t commit if they are plagued with uncertainty.
The State of the Union address last evening did not resolve any of these issues for me or lessen my concerns. To me the issue is leadership and the respect for a leader is earned. This is a question of the rubber hitting the road and no speech, no matter how eloquent it might be is going to change this fact. I am still waiting for the focus of intention and the focus of effort.
Tuesday, January 26, 2010
Regulation and Information--Part C
The final point I would like to make in this series is that you cannot build and maintain a rigid financial regulatory system based on the achievement of specific outcomes if you insist on inflating the economy that includes this regulatory system and expect the regulated institutions to remain idle. This is the story of the last 50 years when the dollar lost 85% of its purchasing power. If the government creates an inflationary environment, financial institutions will not stand still, especially in this Age of Information.
Also, in my view, the United States government has injected large amounts of moral hazard into the economy and the financial markets over the past fifty years or so. And, the presence of this moral hazard has had a lot to do with the recent collapse of the financial markets and the economy.
Before going into this let me just say that I believe that almost everyone is greedy. I use the word greedy with all the bad things it conveys, because that is the word being tossed around so loosely these days. I do not believe, as the economist Joseph Stiglitz seems to, that the bankers of Wall Street are any more “morally bankrupt” than he is or any of the rest of us. We all are greedy and respond to the incentives that are placed before us. With that said, let’s now move on.
I want to concentrate on two specific areas in which the government has created moral hazard and helped to form the incentives that led to the bust of 2008. The first has to do with monetary policy and the second has to do with housing finance. Both have contributed to what I have called the credit inflation of the last 50 years.
A credit inflation occurs when the credit in an economy grows more rapidly than the economy itself or more rapidly than specific sectors in the economy. In the early part of the period under review, focus was primarily on consumer and wholesale price inflation. At this time, analysts were mainly concerned with money stock growth and the consumer price index or the GDP Deflator. Asset bubbles were not on the radar yet.
However, inflation creates the incentive to increase debt and as the amount of debt in the economy increases there is pressure on both financial and non-financial institutions to increase their financial leverage, to create a greater mismatch between the maturities of their assets and liabilities, and to take on riskier assets, to goose up returns. Credit creation thrives in an inflationary environment!
Inflation is good for credit and so the cumulative effect of a period of inflation is the creation of more debt! In the Age of Information, the incentive to create more debt is a license for financial innovation.
The dance began in the 1960s and, as former Citigroup CEO “Chuck” Prince so eloquently expressed it in the 2000s, if the music continues to play, you must continue to dance!
And, the enormous creation of credit spilled over into sectors other than consumer purchases creating a bubble here and a bubble there. The beauty about financial innovation in the Age of Information is that specific assets and specific asset markets don’t really matter because all that is being traded is information. The result: as “Chuck” Prince implied, the dance continued in the areas where the music was still playing. Credit flowed into the markets that had the most action so that you got one market “popping” at this time and another market “popping” at another time. And, innovations in new financial instruments and markets were created to help the music flow to all markets.
How does this scenario relate to monetary policy? Well, the monetary authorities acted in a very asymmetrical way. If markets seemed to be dropping, the Federal Reserve would come in and stop the fall. This was especially important if unemployment seemed to be impacted by the drop. The behavior became so predictable that it was given a name: the “Greenspan put.”
On the upside, the central bank attempted to maintain control of consumer price inflation, especially after the pain of the late 1970s and early 1980s, but believed that it could do nothing with respect to asset bubbles that inflated prices in various sub-markets, like housing.
The moral hazard that was created allowed prices to constantly rise for the Fed would always reflate the economy before there was any chance for prices to fall. And, consumers could only buy about 15 cents worth of goods and services in 2010 with what $1.00 could buy in January 1961. Also in asset markets like housing, prices rose and rose and rose during this period to the point where people were absolutely confident that housing prices could never fall. So, where are you going to place your bets after all this time which created the fundamental assumption that policymakers would continue the credit inflation indefinitely.
The other area where the government created moral hazard was in the housing market. To own your home is a big part of the “American Dream.” Owning your own home creates self-respect and stability. It is a great place to raise kids and it generates community. It produces good citizens.
So, anything that can be done to support home ownership in America is good!
The savings and loan industry was dedicated to financing homes. The Federal Housing Administration (FHA) was there to help people get mortgages for homes and played a huge role in home ownership for GIs returning home from World War II. But, Fannie Mae and Freddie Mac were created to help mortgage finance and to make sure money flowed into the industry. Then the Department of Housing and Urban Development was created and help flowed through a myriad of programs to assist low-income families to own their own homes. And, then the mortgage-backed security was created and so on and so forth.
Ultimately, we got a great information age idea, the sub-prime loan. This program combines the drive to get home ownership to more and more individuals and families, often without the needed financial wherewithal, and credit inflation, because if housing prices never go down they must be going up. And, this allows people who cannot afford the down-payment on a house to earn that down-payment through the inflation of the price of their home. Oh, by-the-way, you can originate the loans and then get them packaged and securitized to sell to financial institutions in China or Sweden.
Isn’t the Age of Information great! If the government has anything to say about it, “No downside risk!”
Well, Fannie Mae and Freddie Mac own most of the American mortgage market now and both are ‘bankrupt.’ The FHA is in deep, deep financial trouble. And, so are many banks and other financial institutions in the United States. And, the Treasury is going crazy trying to develop a program or programs that will help individuals and families stay out of foreclosure and lose their homes.
Bottom line: in the Age of Information, information spreads and spreads rapidly. Financial innovation will accelerate as we go forward for financial innovation will be applied to any area, regulated or not, that promises financial gain. Unfortunately, my guess is that the federal government and Congress will not have the discipline it needs to stop creating credit inflations and to keep from creating more and more moral hazard in the future. Consequently, the financial regulation that will be forthcoming will be backwards looking and, hence, will not prevent the next crisis.
Also, in my view, the United States government has injected large amounts of moral hazard into the economy and the financial markets over the past fifty years or so. And, the presence of this moral hazard has had a lot to do with the recent collapse of the financial markets and the economy.
Before going into this let me just say that I believe that almost everyone is greedy. I use the word greedy with all the bad things it conveys, because that is the word being tossed around so loosely these days. I do not believe, as the economist Joseph Stiglitz seems to, that the bankers of Wall Street are any more “morally bankrupt” than he is or any of the rest of us. We all are greedy and respond to the incentives that are placed before us. With that said, let’s now move on.
I want to concentrate on two specific areas in which the government has created moral hazard and helped to form the incentives that led to the bust of 2008. The first has to do with monetary policy and the second has to do with housing finance. Both have contributed to what I have called the credit inflation of the last 50 years.
A credit inflation occurs when the credit in an economy grows more rapidly than the economy itself or more rapidly than specific sectors in the economy. In the early part of the period under review, focus was primarily on consumer and wholesale price inflation. At this time, analysts were mainly concerned with money stock growth and the consumer price index or the GDP Deflator. Asset bubbles were not on the radar yet.
However, inflation creates the incentive to increase debt and as the amount of debt in the economy increases there is pressure on both financial and non-financial institutions to increase their financial leverage, to create a greater mismatch between the maturities of their assets and liabilities, and to take on riskier assets, to goose up returns. Credit creation thrives in an inflationary environment!
Inflation is good for credit and so the cumulative effect of a period of inflation is the creation of more debt! In the Age of Information, the incentive to create more debt is a license for financial innovation.
The dance began in the 1960s and, as former Citigroup CEO “Chuck” Prince so eloquently expressed it in the 2000s, if the music continues to play, you must continue to dance!
And, the enormous creation of credit spilled over into sectors other than consumer purchases creating a bubble here and a bubble there. The beauty about financial innovation in the Age of Information is that specific assets and specific asset markets don’t really matter because all that is being traded is information. The result: as “Chuck” Prince implied, the dance continued in the areas where the music was still playing. Credit flowed into the markets that had the most action so that you got one market “popping” at this time and another market “popping” at another time. And, innovations in new financial instruments and markets were created to help the music flow to all markets.
How does this scenario relate to monetary policy? Well, the monetary authorities acted in a very asymmetrical way. If markets seemed to be dropping, the Federal Reserve would come in and stop the fall. This was especially important if unemployment seemed to be impacted by the drop. The behavior became so predictable that it was given a name: the “Greenspan put.”
On the upside, the central bank attempted to maintain control of consumer price inflation, especially after the pain of the late 1970s and early 1980s, but believed that it could do nothing with respect to asset bubbles that inflated prices in various sub-markets, like housing.
The moral hazard that was created allowed prices to constantly rise for the Fed would always reflate the economy before there was any chance for prices to fall. And, consumers could only buy about 15 cents worth of goods and services in 2010 with what $1.00 could buy in January 1961. Also in asset markets like housing, prices rose and rose and rose during this period to the point where people were absolutely confident that housing prices could never fall. So, where are you going to place your bets after all this time which created the fundamental assumption that policymakers would continue the credit inflation indefinitely.
The other area where the government created moral hazard was in the housing market. To own your home is a big part of the “American Dream.” Owning your own home creates self-respect and stability. It is a great place to raise kids and it generates community. It produces good citizens.
So, anything that can be done to support home ownership in America is good!
The savings and loan industry was dedicated to financing homes. The Federal Housing Administration (FHA) was there to help people get mortgages for homes and played a huge role in home ownership for GIs returning home from World War II. But, Fannie Mae and Freddie Mac were created to help mortgage finance and to make sure money flowed into the industry. Then the Department of Housing and Urban Development was created and help flowed through a myriad of programs to assist low-income families to own their own homes. And, then the mortgage-backed security was created and so on and so forth.
Ultimately, we got a great information age idea, the sub-prime loan. This program combines the drive to get home ownership to more and more individuals and families, often without the needed financial wherewithal, and credit inflation, because if housing prices never go down they must be going up. And, this allows people who cannot afford the down-payment on a house to earn that down-payment through the inflation of the price of their home. Oh, by-the-way, you can originate the loans and then get them packaged and securitized to sell to financial institutions in China or Sweden.
Isn’t the Age of Information great! If the government has anything to say about it, “No downside risk!”
Well, Fannie Mae and Freddie Mac own most of the American mortgage market now and both are ‘bankrupt.’ The FHA is in deep, deep financial trouble. And, so are many banks and other financial institutions in the United States. And, the Treasury is going crazy trying to develop a program or programs that will help individuals and families stay out of foreclosure and lose their homes.
Bottom line: in the Age of Information, information spreads and spreads rapidly. Financial innovation will accelerate as we go forward for financial innovation will be applied to any area, regulated or not, that promises financial gain. Unfortunately, my guess is that the federal government and Congress will not have the discipline it needs to stop creating credit inflations and to keep from creating more and more moral hazard in the future. Consequently, the financial regulation that will be forthcoming will be backwards looking and, hence, will not prevent the next crisis.
Monday, January 25, 2010
Regulation and Information--Part B
In my previous post, “Regulation and Information—Part A” I argued that banking and finance has become nothing more than information, and in this Age of Information, money and finance have just become the movement of 0s and 1s. As a consequence, finance has gotten away from people and physical assets and paper money and other forms of wealth, like gold, and just become bits of information that can be “diced and sliced” every which way and that can be bought and sold worldwide.
This post, as promised, has to do with my ideas about the possibilities for the regulation of banking and financial institutions. I will post a Part C tomorrow.
First, I need to explain a little bit about where I am coming from. I call myself an “Information Libertarian”. I believe that history shows that information spreads and cannot be contained. Its spread can be slowed down for a while, by governments or religious bodies for example, but eventually the spread of information wins out. As an Information Libertarian, I believe that it is my responsibility to help speed along the spread of information and, where this spread is being contested or resisted, help to unlock the doors that is keeping information bottled up.
To me, information must see the light of day so that it can be tested, used, and lead to the discovery of more information. In this way false information, information not allowed to change, and other constraints on the problem solving and decision making capabilities of humans can be seen for what they are and transcended.
Rules and regulations in the past have tended to rely too much on what I would call “the achievement of outcomes” and not enough on the “process of how things are being done.”
Reliance on “outcomes” focuses upon the wrong things and is very expensive for those being regulated as well as for those that are doing the regulating. The reason: if there is sufficient incentive for the regulated to do the thing being regulated, it will get done in one way or another, in spite of the regulation. This was the essence of the quote by John Bogle, the founder and former chief executive officer of the Vanguard Group, in my post of January 19 (see http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations). Bogle stated that “There are few regulations that smart, motivated, targets cannot evade.” This was a part of what I was attempting to say in Part A of my discussion of regulation and information: the means of evading regulations has become sophisticated and easier in this Age of Information.
Also the cost of regulating in such an environment has increased substantially. The talent and skill required, along with the necessary patience and persistence of the regulator has gone up exponentially. In my experience, the regulator is ALWAYS behind the industry in knowing and understanding what is going on. How far behind they are varies from situation to situation and is a constant concern. But, you can rest assured that the regulators are behind the regulated.
As I have written in previous posts, the big banks have once more jumped ahead of the regulators in the past year as these banking giants have gained strength. Nothing has helped them more than the subsidy the Federal Reserve has given them by maintaining short term interest rates at such low levels: the Fed has given them “the gift that keeps on giving.” Not only have these banks regained health, they have moved way ahead of the regulators who have been dealing with all the problem small- and medium-sized banks and the squabbles takikng place in Washington, D. C. over how the banks and other financial institutions should be regulated.
This is the problem of focusing on “outcomes.”
I have argued over and over in earlier posts that banks and other financial institutions need to be subject to greater openness and transparency. This is consistent with my views on the need for information to spread and is consistent with my views on what kind of regulation can achieve some degree of success. It is also consistent with the idea that laws and regulations should focus on “process” and not “outcomes.”
Making banks and other financial institutions open up their books and causing their operations to be more transparent is the only way that I can see, in this Age of Information, to effectively have some impact on the behavior of these organizations. Having to report accurately and often to not only the regulators but also to shareholders as well as the public in general is the only way to be able to have some impact on them over time. The idea is that if they can’t hide what they are doing they will be a little more careful about what actions they take.
I cannot buy the argument that financial institutions need to keep their information on customers or what they are doing proprietary for if they don’t their spreads will go away. We saw what a disaster this was in terms of Long Term Capital Management. To me, the running of a financial institution is like coaching a football team: everyone knows the plays; the winning team is usually the one that executes the best or is the luckiest. Everyone knew what Long Term Capital Management was doing and others mimicked them. When things went the wrong way everyone tried to exit at the same time. Sounds like the subprime mortgage market doesn’t it?
I have also been a constant proponent of “mark-to-market” accounting. Let me describe to you how I see this tool. Banks, and other financial institutions, take risks. In order to achieve a few more basis points return over competitors, executives have either taken on assets that are a little riskier than they did before, or, mismatch the maturities of assets and liabilities a little more than they did. Shouldn’t we the regulators, the investors, the depositors, the analysts know this?
They, the bankers, have taken the interest rate risk and the credit risk and should be held accountable. To me it is childish for the bankers to “cry foul” when the market goes against them saying that it is unfair to force them to recognize the mismatched position they have taken. They are the ones that took the risk, they should be held accountable for doing so. They get the credit when things go well. Shouldn’t they be called on the carpet when things go the other way? If you know you might get caught, should you go ahead and do something?
In this case, maybe the bankers need to present two sets of books. One set to show what the value of the assets are if they (the assets) are held to maturity. Another set of books to reflect actual market values. The crucial thing is that the current real position of the bank needs to be “owned” by those running the bank.
The point is that if a management doesn’t want the public and the regulators to know that they have taken excessive risks, then they shouldn’t take the excessive risks.
In the Age of Information, the probability that people will find out what you are doing, particularly if you have some prominence, is higher than before and is increasing every day. We have just seen what can happen when some prominent person lives a life all out of character with who people thought he was. And, the fall has been pretty substantial.
Again, if this person didn’t want us to find out about his extra-curricular activities, he shouldn’t have pursued them. Simple as that!
The objective in requiring openness and transparency in reporting financial data is to say to people “before the fact”: if you take on too much risk or run your business in a careless manner, we will call you out on it. The “we” stands for investors, depositors, or regulators. The financial position of a bank or a financial institution should be “out-in-the-open” in great detail and the analysis of investors and regulators should be shared. If the bankers know they may be exposed then maybe the banks will attack their problems sooner rather than later.
This post, as promised, has to do with my ideas about the possibilities for the regulation of banking and financial institutions. I will post a Part C tomorrow.
First, I need to explain a little bit about where I am coming from. I call myself an “Information Libertarian”. I believe that history shows that information spreads and cannot be contained. Its spread can be slowed down for a while, by governments or religious bodies for example, but eventually the spread of information wins out. As an Information Libertarian, I believe that it is my responsibility to help speed along the spread of information and, where this spread is being contested or resisted, help to unlock the doors that is keeping information bottled up.
To me, information must see the light of day so that it can be tested, used, and lead to the discovery of more information. In this way false information, information not allowed to change, and other constraints on the problem solving and decision making capabilities of humans can be seen for what they are and transcended.
Rules and regulations in the past have tended to rely too much on what I would call “the achievement of outcomes” and not enough on the “process of how things are being done.”
Reliance on “outcomes” focuses upon the wrong things and is very expensive for those being regulated as well as for those that are doing the regulating. The reason: if there is sufficient incentive for the regulated to do the thing being regulated, it will get done in one way or another, in spite of the regulation. This was the essence of the quote by John Bogle, the founder and former chief executive officer of the Vanguard Group, in my post of January 19 (see http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations). Bogle stated that “There are few regulations that smart, motivated, targets cannot evade.” This was a part of what I was attempting to say in Part A of my discussion of regulation and information: the means of evading regulations has become sophisticated and easier in this Age of Information.
Also the cost of regulating in such an environment has increased substantially. The talent and skill required, along with the necessary patience and persistence of the regulator has gone up exponentially. In my experience, the regulator is ALWAYS behind the industry in knowing and understanding what is going on. How far behind they are varies from situation to situation and is a constant concern. But, you can rest assured that the regulators are behind the regulated.
As I have written in previous posts, the big banks have once more jumped ahead of the regulators in the past year as these banking giants have gained strength. Nothing has helped them more than the subsidy the Federal Reserve has given them by maintaining short term interest rates at such low levels: the Fed has given them “the gift that keeps on giving.” Not only have these banks regained health, they have moved way ahead of the regulators who have been dealing with all the problem small- and medium-sized banks and the squabbles takikng place in Washington, D. C. over how the banks and other financial institutions should be regulated.
This is the problem of focusing on “outcomes.”
I have argued over and over in earlier posts that banks and other financial institutions need to be subject to greater openness and transparency. This is consistent with my views on the need for information to spread and is consistent with my views on what kind of regulation can achieve some degree of success. It is also consistent with the idea that laws and regulations should focus on “process” and not “outcomes.”
Making banks and other financial institutions open up their books and causing their operations to be more transparent is the only way that I can see, in this Age of Information, to effectively have some impact on the behavior of these organizations. Having to report accurately and often to not only the regulators but also to shareholders as well as the public in general is the only way to be able to have some impact on them over time. The idea is that if they can’t hide what they are doing they will be a little more careful about what actions they take.
I cannot buy the argument that financial institutions need to keep their information on customers or what they are doing proprietary for if they don’t their spreads will go away. We saw what a disaster this was in terms of Long Term Capital Management. To me, the running of a financial institution is like coaching a football team: everyone knows the plays; the winning team is usually the one that executes the best or is the luckiest. Everyone knew what Long Term Capital Management was doing and others mimicked them. When things went the wrong way everyone tried to exit at the same time. Sounds like the subprime mortgage market doesn’t it?
I have also been a constant proponent of “mark-to-market” accounting. Let me describe to you how I see this tool. Banks, and other financial institutions, take risks. In order to achieve a few more basis points return over competitors, executives have either taken on assets that are a little riskier than they did before, or, mismatch the maturities of assets and liabilities a little more than they did. Shouldn’t we the regulators, the investors, the depositors, the analysts know this?
They, the bankers, have taken the interest rate risk and the credit risk and should be held accountable. To me it is childish for the bankers to “cry foul” when the market goes against them saying that it is unfair to force them to recognize the mismatched position they have taken. They are the ones that took the risk, they should be held accountable for doing so. They get the credit when things go well. Shouldn’t they be called on the carpet when things go the other way? If you know you might get caught, should you go ahead and do something?
In this case, maybe the bankers need to present two sets of books. One set to show what the value of the assets are if they (the assets) are held to maturity. Another set of books to reflect actual market values. The crucial thing is that the current real position of the bank needs to be “owned” by those running the bank.
The point is that if a management doesn’t want the public and the regulators to know that they have taken excessive risks, then they shouldn’t take the excessive risks.
In the Age of Information, the probability that people will find out what you are doing, particularly if you have some prominence, is higher than before and is increasing every day. We have just seen what can happen when some prominent person lives a life all out of character with who people thought he was. And, the fall has been pretty substantial.
Again, if this person didn’t want us to find out about his extra-curricular activities, he shouldn’t have pursued them. Simple as that!
The objective in requiring openness and transparency in reporting financial data is to say to people “before the fact”: if you take on too much risk or run your business in a careless manner, we will call you out on it. The “we” stands for investors, depositors, or regulators. The financial position of a bank or a financial institution should be “out-in-the-open” in great detail and the analysis of investors and regulators should be shared. If the bankers know they may be exposed then maybe the banks will attack their problems sooner rather than later.
Sunday, January 24, 2010
Regulation and Information--Part A
One of the things that bothers me about all the talk concerning the re-regulation of banks and other financial institutions is that it is “framed” within the context of the Great Depression and the Glass-Steagall Act, the Banking Act of 1933.
Get real people, times have changed!
We are not back in the age of the manufacturing, we are in the information age. We are not early in the 20th century, we are at the beginning of the 21st century. And, while no person commands my respect in the same way that Paul Volcker does, we do not need regulation that is in the mold of Glass-Steagall.
Finance is information. This dollar bill can be exchanged for that dollar bill. These dollars can be exchanged for so many Euros. Even more so, my set of 0s and 1s can be traded for your set of 0s and 1s: your checking account, my debit card, and her credit card.
Even individuals don’t trade in anything more than 0s and 1s these days. Finance, even at the most elemental level is just about information. And the more sophisticated that one gets, the more esoteric the information flow can become. And, that is the issue.
But, the post-World War II transformation in the financial industry began in earnest in the 1960s. The commercial banks were constrained by the Glass-Steagall Act and by geographic constraints. Yet, the world was growing. And, the banks, in order to be competitive in the world needed to become bigger and more geographically dispersed.
Three financial innovations were in place by the end of the 1960s that began to change of everything: the creation of the Bank Holding Company; the invention of the large denomination negotiable Certificate of Deposit; and the Eurodollar account.
The Bank Holding Company gave banks a freedom that they did not have when their charters limited their activity to just being a deposit taking bank. The large denomination negotiable Certificate of Deposit was an innovation that indicated that just about any financial instrument could become marketable. The development of the Eurodollar market showed that banks could raise funds worldwide and in different forms.
These three changes, when combined, turned large banks into liability managers and not asset managers. In essence, the invention of the large CD and the Eurodollar put an end to any constraints on the size of a financial institution. These instruments allowed banks to buy or sell all the funds they wanted at the going market interest rate. For all intents and purposes, by the start of the 1970s all interstate constraints on bank operations were history. And, except for capital requirements, all constraints on the size of financial institutions were history. The ability to manage liabilities ended these boundaries.
Other developments took place during this time. I will just discuss two of them. The first is the mortgage-backed security. In the 1960s politicians decided that if more housing got into the hands of the middle income classes that there would be a greater chance that they could get re-elected. They considered the mortgage, a long term asset. Then they looked at pension funds and insurance companies and saw that these institutions held long term assets. Mortgages were not quite what the pension funds or insurance companies wanted: mortgages came in sizes less than $100,000 in value when they wanted assets in the millions of dollars; also mortgages paid principal and interest whereas these funds and companies just wanted interest payments. So there were some hurdles to overcome.
As people worked with the idea, they saw that the mortgages generated and held by depository institutions could be bundled up into another form of security in order to get the size of asset needed. They also worked with the idea that the cash flow streams from the initial mortgages could be cut up in different ways so as to make individual streams of cash flows that were more desirable to the pension funds and insurance companies. Eventually they saw that securities could even be created that paid just interest (Interest Only securities or IOs) or that just made principal payments (Principal Only or P0s).
Bottom line, cash flows could be cut up (or in current terms ‘sliced and diced’) in any way that could sell! And, what is the abstract view of this? Cash flows are just 0s and 1s and 0s and 1s can be put in any form that anyone wants. These cash flow 0s and 1s could have assets behind them like houses, autos, or credit cards, or they could just be cash flows. What difference did it really make?
Of course, it could make a lot of difference. (I can’t be too ironic in what I write!)
If cash flows could just be created, why not asset values? Hence the idea of “notional” values.
Take an interest rate swap, for example. No money changes hands, the whole transaction is based on ‘notional’ values. Thus, a swap of a fixed interest payment arrangement for a variable interest payment arrangement could be achieved. Both parties are ‘better off’ and there is no real exchange of liabilities.
I could go on, but I don’t think I need to. By now you can see where I am going. Finance, today, is just 0s and 1s and people, individuals as well as institutions, don’t need real assets on which to base cash flows and cash flows can be ‘sliced and diced’ in any way imaginable so as to meet the needs and desires of those that want to acquire them. In essence, everything, all information, can be computerized and treated as interchangeable.
At least in the machines: at least ‘on paper’. But, this is the modern world of finance. That is why mathematicians, statisticians, physicists, and other “Quants” can play with this stuff. The modern world of finance is just information and information is just 0s and 1s. At the highest level, it is not people and assets and things. It is just 0s and 1s.
And, if you are concerned with this then you need to be aware of what is coming. This is the world of the future. There is a vibrant area of study that deals with information markets. The idea is that everything, and I mean everything, can be transformed into information and a market can be created for it. Robert Shiller, the behavioral economist of “Irrational Exuberance” is one of the leaders of this field.
Modern day finance is the model with the idea that this model can be extended to anything and everything. So get ready!
The fundamental point I want to make today is that the world of finance in the Age of Information is entirely different than the world of finance in the Age of Manufacturing. The 1930s are not directly transferrable into the 2010s! The rules and regulation of the modern world are not the same as the rules and regulations that needed to be applied to the world of the thirties. And the way to regulate the world of the 2010s is the subject of my next post.
Let me just close by saying that even Paul Volcker missed the point when he said that the only banking innovation of the last 50 years that was significant was the ATM machine, that all the other financial innovation contributed nothing to the age. The ATM is an ‘information age’ machine and is a part of the innovation that took place in the Age of Information. If one really understands this age then one cannot make the distinction between the ATM and all the other financial innovations that took place during this time period. Volcker has missed the point!
Get real people, times have changed!
We are not back in the age of the manufacturing, we are in the information age. We are not early in the 20th century, we are at the beginning of the 21st century. And, while no person commands my respect in the same way that Paul Volcker does, we do not need regulation that is in the mold of Glass-Steagall.
Finance is information. This dollar bill can be exchanged for that dollar bill. These dollars can be exchanged for so many Euros. Even more so, my set of 0s and 1s can be traded for your set of 0s and 1s: your checking account, my debit card, and her credit card.
Even individuals don’t trade in anything more than 0s and 1s these days. Finance, even at the most elemental level is just about information. And the more sophisticated that one gets, the more esoteric the information flow can become. And, that is the issue.
But, the post-World War II transformation in the financial industry began in earnest in the 1960s. The commercial banks were constrained by the Glass-Steagall Act and by geographic constraints. Yet, the world was growing. And, the banks, in order to be competitive in the world needed to become bigger and more geographically dispersed.
Three financial innovations were in place by the end of the 1960s that began to change of everything: the creation of the Bank Holding Company; the invention of the large denomination negotiable Certificate of Deposit; and the Eurodollar account.
The Bank Holding Company gave banks a freedom that they did not have when their charters limited their activity to just being a deposit taking bank. The large denomination negotiable Certificate of Deposit was an innovation that indicated that just about any financial instrument could become marketable. The development of the Eurodollar market showed that banks could raise funds worldwide and in different forms.
These three changes, when combined, turned large banks into liability managers and not asset managers. In essence, the invention of the large CD and the Eurodollar put an end to any constraints on the size of a financial institution. These instruments allowed banks to buy or sell all the funds they wanted at the going market interest rate. For all intents and purposes, by the start of the 1970s all interstate constraints on bank operations were history. And, except for capital requirements, all constraints on the size of financial institutions were history. The ability to manage liabilities ended these boundaries.
Other developments took place during this time. I will just discuss two of them. The first is the mortgage-backed security. In the 1960s politicians decided that if more housing got into the hands of the middle income classes that there would be a greater chance that they could get re-elected. They considered the mortgage, a long term asset. Then they looked at pension funds and insurance companies and saw that these institutions held long term assets. Mortgages were not quite what the pension funds or insurance companies wanted: mortgages came in sizes less than $100,000 in value when they wanted assets in the millions of dollars; also mortgages paid principal and interest whereas these funds and companies just wanted interest payments. So there were some hurdles to overcome.
As people worked with the idea, they saw that the mortgages generated and held by depository institutions could be bundled up into another form of security in order to get the size of asset needed. They also worked with the idea that the cash flow streams from the initial mortgages could be cut up in different ways so as to make individual streams of cash flows that were more desirable to the pension funds and insurance companies. Eventually they saw that securities could even be created that paid just interest (Interest Only securities or IOs) or that just made principal payments (Principal Only or P0s).
Bottom line, cash flows could be cut up (or in current terms ‘sliced and diced’) in any way that could sell! And, what is the abstract view of this? Cash flows are just 0s and 1s and 0s and 1s can be put in any form that anyone wants. These cash flow 0s and 1s could have assets behind them like houses, autos, or credit cards, or they could just be cash flows. What difference did it really make?
Of course, it could make a lot of difference. (I can’t be too ironic in what I write!)
If cash flows could just be created, why not asset values? Hence the idea of “notional” values.
Take an interest rate swap, for example. No money changes hands, the whole transaction is based on ‘notional’ values. Thus, a swap of a fixed interest payment arrangement for a variable interest payment arrangement could be achieved. Both parties are ‘better off’ and there is no real exchange of liabilities.
I could go on, but I don’t think I need to. By now you can see where I am going. Finance, today, is just 0s and 1s and people, individuals as well as institutions, don’t need real assets on which to base cash flows and cash flows can be ‘sliced and diced’ in any way imaginable so as to meet the needs and desires of those that want to acquire them. In essence, everything, all information, can be computerized and treated as interchangeable.
At least in the machines: at least ‘on paper’. But, this is the modern world of finance. That is why mathematicians, statisticians, physicists, and other “Quants” can play with this stuff. The modern world of finance is just information and information is just 0s and 1s. At the highest level, it is not people and assets and things. It is just 0s and 1s.
And, if you are concerned with this then you need to be aware of what is coming. This is the world of the future. There is a vibrant area of study that deals with information markets. The idea is that everything, and I mean everything, can be transformed into information and a market can be created for it. Robert Shiller, the behavioral economist of “Irrational Exuberance” is one of the leaders of this field.
Modern day finance is the model with the idea that this model can be extended to anything and everything. So get ready!
The fundamental point I want to make today is that the world of finance in the Age of Information is entirely different than the world of finance in the Age of Manufacturing. The 1930s are not directly transferrable into the 2010s! The rules and regulation of the modern world are not the same as the rules and regulations that needed to be applied to the world of the thirties. And the way to regulate the world of the 2010s is the subject of my next post.
Let me just close by saying that even Paul Volcker missed the point when he said that the only banking innovation of the last 50 years that was significant was the ATM machine, that all the other financial innovation contributed nothing to the age. The ATM is an ‘information age’ machine and is a part of the innovation that took place in the Age of Information. If one really understands this age then one cannot make the distinction between the ATM and all the other financial innovations that took place during this time period. Volcker has missed the point!
Saturday, January 23, 2010
Politics and Regulation
I would like to recommend two more articles on the growing move to greater regulation. Both appeared this Saturday morning. The first by John Authers, “Politicians look to enter another Faustian pact,” appeared in the Financial Times (http://www.ft.com/cms/s/0/b1379f2a-07bf-11df-915f-00144feabdc0.html). The second by Jason Zweig, “Will New Rules Tame the Wall Street Tiger?” appeared in the Wall Street Journal (http://online.wsj.com/article/SB20001424052748703822404575019423049886674.html#mod=todays_us_section_b).
Both articles discuss the unfolding drama in Washington, D. C. concerning the direction events are taking and both authors make some suggestion as to the direction regulation should take.
The important take-away from each article, however, is that politicians often enact laws, rules, and regulations that either miss the point or provide impediments to competition that banks and other financial institutions spend millions of dollars to get around, eventually succeeding.
Zweig argues in his piece that “the bad behavior on Wall Street in the 1920s wasn’t really caused by the blurring of commercial and investment banking”. The bad behavior he lists include “collusion among firms to jack up prices, sweetheart deals for favored clients, shoddy due diligence, too little disclosure of risk, too much trading on borrowed money, betting that securities would go down while telling the public they would go up.”
However, Zweig presents the argument that “there is a strain in the American psyche that has always worried about concentration of financial power.” Drawing upon this populist concern, Senator Carter Glass and Representative Henry Steagall were able to pass legislation fondly remembered as the Banking Act of 1933.
[Disclosure: I was born in the state of Missouri, formally a Unit Banking state, and my grandfather was a Missouri banker. My hand was photographed in the check copying machine in the latter part of the 1940s. Missouri bankers were paranoid about the “concentration of financial power!"]
Zweig’s conclusion is that “the Obama proposals are politically shrewd, because they tap into the same populist anger that motivated the Glass-Steagall legislation in 1933.”
Authers also compares the present time with that of the 1930s. He prefaces his discussion of the 1930s by stating that “Tighter regulation involves a Faustian bargain, of accepting greater stability in return for limiting ‘upside’, or potential growth.” The Glass-Steagall Act, the Faustian bargain, “worked” as “Bank runs, endemic for decades before the 1930s, disappeared in the US after this package of reforms. Growth in both markets and the economy was relatively stable.”
“Over the years, financial ingenuity and regulatory changes found a way around most of the repressive 1930s rules.” By 1998, there was basically nothing left and the rules were finally buried.
“The White House’s proposal on Thursday can loosely be called an attempt to apply the spirit of Glass-Steagall for the new era.”
The end result of the process will be up to Congress.
And what hope do we have?
Authers’ conclusion: “It is not clear that as a deliberative body it (the Congress) is capable of making a coherent decision.”
“It looks as though US and European political institutions are about to go through much the same test that they failed in the autumn of 2008. It is the risk that they fail again that worries the market.”
‘Nuff said!
See my position on this point: “Bracing for the New Banking Regulations” (http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations).
Both articles discuss the unfolding drama in Washington, D. C. concerning the direction events are taking and both authors make some suggestion as to the direction regulation should take.
The important take-away from each article, however, is that politicians often enact laws, rules, and regulations that either miss the point or provide impediments to competition that banks and other financial institutions spend millions of dollars to get around, eventually succeeding.
Zweig argues in his piece that “the bad behavior on Wall Street in the 1920s wasn’t really caused by the blurring of commercial and investment banking”. The bad behavior he lists include “collusion among firms to jack up prices, sweetheart deals for favored clients, shoddy due diligence, too little disclosure of risk, too much trading on borrowed money, betting that securities would go down while telling the public they would go up.”
However, Zweig presents the argument that “there is a strain in the American psyche that has always worried about concentration of financial power.” Drawing upon this populist concern, Senator Carter Glass and Representative Henry Steagall were able to pass legislation fondly remembered as the Banking Act of 1933.
[Disclosure: I was born in the state of Missouri, formally a Unit Banking state, and my grandfather was a Missouri banker. My hand was photographed in the check copying machine in the latter part of the 1940s. Missouri bankers were paranoid about the “concentration of financial power!"]
Zweig’s conclusion is that “the Obama proposals are politically shrewd, because they tap into the same populist anger that motivated the Glass-Steagall legislation in 1933.”
Authers also compares the present time with that of the 1930s. He prefaces his discussion of the 1930s by stating that “Tighter regulation involves a Faustian bargain, of accepting greater stability in return for limiting ‘upside’, or potential growth.” The Glass-Steagall Act, the Faustian bargain, “worked” as “Bank runs, endemic for decades before the 1930s, disappeared in the US after this package of reforms. Growth in both markets and the economy was relatively stable.”
“Over the years, financial ingenuity and regulatory changes found a way around most of the repressive 1930s rules.” By 1998, there was basically nothing left and the rules were finally buried.
“The White House’s proposal on Thursday can loosely be called an attempt to apply the spirit of Glass-Steagall for the new era.”
The end result of the process will be up to Congress.
And what hope do we have?
Authers’ conclusion: “It is not clear that as a deliberative body it (the Congress) is capable of making a coherent decision.”
“It looks as though US and European political institutions are about to go through much the same test that they failed in the autumn of 2008. It is the risk that they fail again that worries the market.”
‘Nuff said!
See my position on this point: “Bracing for the New Banking Regulations” (http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations).
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