Darwin vs. Smith

From Economist's View:

"Trumped by Darwin?"

Robert Frank returns to the point he made in Alpha Markets, i.e. that Charles Darwin provides the "true intellectual foundation" for economics. Though the example this time is male elk rather than bull elephant seals, the central point - and it's one worth giving more thought to - is that "Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance." In these situations, which occur frequently in economic and social relationships, the assumption in neoclassical economic models that the maximization of self-interest is consistent with the maximization of social interest does not hold, and failure to recognize this has " undermined regulatory efforts ... causing considerable harm to us all":

The Invisible Hand, Trumped by Darwin?, by Robert Frank, Commentary, NY Times: If asked to identify the intellectual founder of their discipline, most economists today would probably cite Adam Smith. But that will change. ... Charles Darwin ... tracks economic reality much more closely. ...

Smith’s basic idea was that business owners ... have powerful incentives to introduce improved product designs and cost-saving innovations. These moves bolster innovators’ profits in the short term. But rivals respond by adopting the same innovations, and the resulting competition gradually drives down prices and profits. In the end, Smith argued, consumers reap all the gains.

The central theme of Darwin’s narrative was that competition favors traits and behavior according to how they affect the success of individuals, not species or other groups. As in Smith’s account, traits that enhance individual fitness sometimes promote group interests. For example, a mutation for keener eyesight in hawks benefits not only any individual hawk that bears it, but also makes hawks more likely to prosper as a species.

In other cases, however, traits that help individuals are harmful to larger groups. For instance, a mutation for larger antlers served the reproductive interests of an individual male elk, because it helped him prevail in battles ... for access to mates. But as this mutation spread, it started an arms race that made life more hazardous for male elk over all. The antlers of male elk can now span five feet or more. And despite their utility in battle, they often become a fatal handicap when predators pursue males into dense woods.

In Darwin’s framework, then,... [c]ompetition, to be sure, sometimes guides individual behavior in ways that benefit society as a whole. But not always.

Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance, as in the antlers arms race. In the marketplace, such reward structures are the rule, not the exception. The income of investment managers, for example, depends mainly on the amount of money they manage, which in turn depends largely on their funds’ relative performance. Relative performance affects many other rewards in contemporary life. ...

In cases like these, relative incentive structures undermine the invisible hand. To make their funds more attractive to investors, money managers create complex securities that impose serious, if often well-camouflaged, risks on society. But when all managers take such steps, they are mutually offsetting. No one benefits, yet the risk of financial crises rises sharply. ...

It’s the same with athletes who take anabolic steroids. ...

If male elk could vote to scale back their antlers by half, they would have compelling reasons for doing so, because only relative antler size matters. Of course, they have no means to enact such regulations.

But humans can and do. ... Darwin has identified the rationale for much of the regulation we observe in modern societies — including steroid bans in sports, safety and hours regulation in the workplace, product safety standards and the myriad restrictions typically imposed on the financial sector.

Ideas have consequences. The uncritical celebration of the invisible hand by Smith’s disciples has undermined regulatory efforts to reconcile conflicts between individual and collective interests in recent decades, causing considerable harm to us all. ...

[And, again, for those who might be interested, see also Paul Krugman's: What Economists Can Learn from Evolutionary Theorists Synopsis.]

The first thing that comes to mind when reading this is the game theory behind the mutual scaling back of antler size by the elk. If they could all decide together to scale back the size of their antlers, they would choose to do so. However, there would also be incentive for some to cheat because then you still have small enough antlers to avoid predators but you also have bigger antlers which benefits finding a mate. This compares directly the discussion of cartels where firms decide to scale back production together in order to raise the price, but there is incentive to cheat and produce more to increase the benefits of the higher price.

The second thing is how this may or may not refute the invisible hand. It seems to me that following the theory of evolution, the size of the elk's antlers probably has reached a happy medium or at least is along the path towards that, two of the elk's primary evolutionary goals being survival and to mate. If the size of the elk's antlers became to large to be able to run away from predators, the ones with the smaller antlers would be those that survive and go on to mate, thus "regulating" antler size.

Thus it should happen in the economic world. There is a balance that needs to be made between maximizing profits and survival. As we've seen, the incentive structure in the financial world was severely misaligned, and so now we're seeing the correction. Those that are able to properly evolve in this environment will be better and stronger companies as we come out of the recession. Along the same metaphor of evolution, when recently reading White Fang the allusion of a recession to a famine stuck out to me. In the wild, during a famine, those animals that are strongest and best equipped to survive difficult times are the one's that live on to reproduce and continue on the species. Sometimes there's luck involved and sometimes animals that maybe shouldn't have died, die. But overall, it is the strongest of the species that live on. The problem that we're seeing now is that the government is keeping alive even the very weakest of the companies, making the god-like decision of who is deserving to carry on the species (whether it be bank, car, small business, etc...).

And if it was a faulty incentive structure that was the downfall of the banking industry, what incentive structure can the government be expected to be held by?

Bailouts and the Free Market

Mark Thoma responds to Edward L. Glaeser of the Boston Globe:
http://economistsview.typepad.com/economistsview/2009/06/the-problem-with-bailouts.html

"The Problem with Bailouts"

Ed Glaeser doesn't like the auto bailout:

The problem with bailouts, by Edward L. Glaeser, Commentary, Boston Globe: Recessions can ... reveal weakness in seemingly invulnerable businesses, like Citibank and Toyota. But diagnosing the nature of corporate ill health may be difficult. Some firms suffer from a fatal disease; others have a temporary virus. ...

The distinction between permanent and transitory troubles appears across industries, companies, and cities. The metropolitan areas of San Jose and Detroit are both suffering from double-digit unemployment rates... Despite California's political mismanagement, San Jose has a superb base of tech-savvy entrepreneurs and a terrific climate. Silicon Valley will rise again, but the prognosis for Detroit is less rosy. Overdependence on one not very competitive industry, a shortage of college graduates, and a cold climate have led the city of Detroit to lose more than 50 percent of its population since 1950. ...

When investment is private, professional investors determine which companies are doomed and which are salvageable. In the current situation, however, the government has decided that a large number of firms are too big to fail and so our elected leaders are deciding which firms to save and which to let go.

The right answer is not "save everybody." Human and physical capital should move out of declining industries and into more productive areas, unless America wants to be a permanent, industrial underperformer. But public-sector intervention usually errs on the side of the status quo. Politicians respond to the workers in an existing firm who are ... rallying to keep their jobs. The customers and employees of the new firms that will rise from a collapse have no seat at the table.

Since the collapse of Lehman Brothers, the public sector has spent billions saving the banks. While these decisions are certainly debatable, they are understandable. The US financial industry misbehaved badly,... but it is still a sector with a future. ... After all, every other sector in the economy depends on banks for their financing.

But what about cars? ... Does anyone, other than GM's management, believe that this company can come back? The current treatment, cash infusion and a reduction in corporate liabilities, provides a solution for a company that is broke, not for one that is broken.

The great cost of saving GM as a single company is that ... America's car industry ... might be better served with a number of smaller, nimbler firms. Across metropolitan areas and across sectors within areas, there is a strong link between small firms and economic success. Detroit was, a century ago, among the most entrepreneurial places on the planet, and it achieved automotive miracles, the scale of which ultimately turned the city into a model of big-firm stagnation.

If General Motors becomes a permanent employee-owned, state-sanctioned enterprise, the firm will lose its chance to split up and become entrepreneurial once more. This could be the great price, even greater than the tax costs, of treating a permanently plagued company like one with a temporary cash shortfall. As flawed as the free market may be, it is hard to be enthusiastic when politicians start playing financier with our tax dollars.

I don't think anyone is planning on "a permanent employee-owned, state-sanctioned enterprise." I don't disagree that the auto industry needs to change. However, there is a maximum rate at which the economy can transform itself, a maximum rate at which the economy can create new industry and absorb displaced and unemployed labor, and presently there's not much more the economy can do. Putting people out of work only to have to spend money in other ways to support those very same people through social insurance programs, losing tax revenues because of their lost income, and so on, is not wise. The transition needs to happen, and a break-up into smaller firms might very well be part of it, but it needs to happen at an acceptable rate.

When the bathtub is already draining as fast as it possibly can, dumping more water into it does not make the tub empty any faster, it only raises the water level. Similarly, right now the pool of unemployed is draining as fast as it can, and dumping more people into it will simply make the problem worse, the transformation of the economy won't happen any faster. Yes the car companies need to change, and yes, the government support needs to end as fast as possible. But the change can only happen so fast, and trying to push it faster doesn't do any good.

There will come a time once recovery is under way to make changes such as those discussed above. I know I don't want a permanent state-run or state-backed enterprise, and there will come a time when the companies must stand or fall on their own. But I also don't want to put people out of work during a recession based upon the notion that the industry must transform itself through private sector initiative when there's very little chance of that happening until things improve.


It seems to me that the two of them agree. Glaeser doesn't really focus on whether it is necessary or not for the bailout but seems more to be warning against any permanent state and employee run institutions as detrimental to productivity and growth. He says "If General Motors becomes a permanent employee-owned, state-sanctioned enterprise," the most important word being "if." I think his fear is that it's hard once the habit is started to break government dependence. As Glaeser points out: "But public-sector intervention usually errs on the side of the status quo. Politicians respond to the workers in an existing firm who are ... rallying to keep their jobs. The customers and employees of the new firms that will rise from a collapse have no seat at the table." So once recovery is underway and a proper restructering becomes timely, it will be hard to break the status quo. That is the difficulty of government intervention, easy to implement, difficult to reverse.

It's ok to make money!

From Bronte Capital:

Rortybomb is a blog where I find myself entirely agreeing with the mathematics and totally disagreeing with the conclusion. I have added it to the blog roll – and intend on taking a few shots at it. I consider Rortybomb as providing an illustration of all the things you can do to abuse mathematics in economics.

Mike (the blogger) posts empirical research suggesting the obvious – that big banks selling loans that can’t be securitised tend to have fatter margins. When they sell loans that can be securitised they tend to have thinner margins.

He then concludes that we should have smaller banks and more access to securitisation. Felix Salmon agrees with him and wants smaller banks and more securitisation.

No objection to the empirical fact that oligopolistic banks without securitisation competition are profitable. I see it in many places. And I see it today. Securitisation is being removed and bank margins are going up. Pre-provision, pre-trading loss profit of banks is rising.

My objection to Rortybomb is to the conclusion. Fat margins for banks are a good thing. They lead to the absence of financial crises. Thin margins lead banks to take more risk – and when they fail they have huge collateral damage.

Having a few fat rich banks is a small price to pay if you don’t trigger great depressions.

In the olden days banks used to give out toasters to anyone who would open an account. Why? Because new customers were frightfully profitable. Why didn't the banks compete with lower prices? Because they were not allowed to. Bank regulators actually regulated the value of the gifts (then known as "premiums") that banks could give their customers. They wanted to ensure that the toasters did not cost too much. Essentially they wanted to guarantee bank profitability. Krugman wants to go back to the toaster days. I just want to go back to days when banks were consistently very profitable over a cycle.

Big banks with no securitisation will be sufficiently profitable.

Rortybomb makes precisely my argument for big banks. That they rip us off. And that is a good thing.

The Temptation of Protectionism

I think that the really scary thing is that even though we've been through this before (although the article makes the point that it was in a different form) we seem to be making the same mistakes, in this case most specifically the Buy America provisions in the stimulus. There doesn't really seem to be a point if we can't learn from our mistakes. It seems coordination is the real problem here, as it is difficult to consolidate the different political pressures of various countries, which is the problem that the EU is facing in finding a solution for this crisis.

The protectionist temptation: Lessons from the Great Depression for today, by Barry Eichengreen and Douglas Irwin, Vox EU

TARP alternative. Why continue spending trillions?

I've found myself interested in hearing the alternative solutions that are put forward, particularly since defenders of programs such as TARP and more frequently the Stimulus argue that the other side simply hasn't put forward any solutions so these are our best options by default. This is an interesting proposal by Larry Kudlow, a bit technical but a clear description, that uses an upward sloping treasury yield curve and a mark-to-market reform. I particularly like this one point that Kudlow makes:

You could even have a two-tiered disclosure process: Accounting purists could be satisfied with a full mark-to-market disclosure, while regulators could forbear capital-standard rules that shouldn’t apply during this period of severe distress. As a result, banks would be in better shape to pass the Treasury’s new stress test and wouldn’t need new TARP capital-injections that further extend taxpayer liabilities.

This is nice because, as he points out, it satisfies both parties as there is still, if not more, transparency. So if the mark-to-market evaluation makes a company look less attractive than another, investors can choose to stay out.

A Shotgun-Marriage Proposal by Larry Kudlow

In depth analysis of Fiscal Stimulus

This is an interesting (a bit long) and thorough analysis by John H. Cochrane of the University of Chicago Booth School of Business discussing fiscal stimulus both in general but more specifically relating to the current situation and how the argument for a general fiscal stimulus (without much of a commentary on the specifics of the Obama team's plan) applies to the credit crisis. Although I would be interested to see a Keynesian's rebuttal to some of Cochrane's points, specifically on the points of the merit of the multiplier argument for fiscal stimulus, he provides some good insight and also a very interesting solution of his own. I specifically liked the points he made at the end of the paper where he points out, "Others say that we should have a fiscal stimulus to “give people confidence,” even if we have neither theory nor evidence that it will work. This impressively paternalistic argument was tried once with the TARP. Nobody could say how it would work in any way that made sense, but it was supposed to be important do to something grand to give people “confidence.” You see how that worked out. Public prayer would work better and cost a lot less." This rang true with something that bothered me with Obama's strategy of rushing a 1000 page long bill through congress. Basically, there may not be anything wrong with what he his proposing, but with so much money at stake, it is worth a closer look to make sure it will do what he says it will do.

Fiscal Stimulus, Fiscal Inflation, or Fiscal Fallacies?
By John H. Cochrane.

A Republican Road to Economic Recovery (WSJ Op-Ed)

Another WSJ Op-Ed piece:

Inheriting countless challenges, Congress and the Obama administration have moved quickly on many fronts to implement their economic agenda. After two months of drastic interventions, has hope replaced fear, and confidence pushed aside uncertainty? Hardly.

David Gothard

The budget the president released last week, however, does provide some certainty about where we are headed: higher taxes on small businesses, work and capital investment.

Add to this the costly burdens of a cap-and-trade carbon emissions scheme and an effective nationalization of health care, and it is clear that the government is going to grow while the economy will shrink. In a nutshell, the president's budget seemingly seeks to replace the American political idea of equalizing opportunity with the European notion of equalizing results.

A constructive opposition party should be willing to call out the majority when it falls short. More important, Republicans must offer alternatives. In this spirit, here is what I would do differently:

- A pro-growth tax policy. Rather than raise the top marginal income tax rate to 39.6%, it should be dropped to 25%. The lower tax brackets should be collapsed to one 10% rate on the first $100,000 for couples. And the top corporate tax rate should be lowered to 25%. This modest reform would put American companies' tax liability more in line with the prevailing rates of our competitors.

We've seen 10 years of growth in our equity markets wiped out in recent months, while 401(k)s, IRAs and college savings plans are down by an average of 40%. The administration and congressional Democrats want to raise capital gains tax rates by a third. Instead, we should eliminate the capital gains tax. It supplies about 4% of federal revenues, yet it places a substantial drag on economic growth. Individuals already pay taxes on income when they earn it. They should not be socked again when they are saving and investing for their retirement and their children's education.

Capital gains taxes are a needless burden on investment, savings and risk-taking, activities in short supply these days. Getting rid of this tax could help establish a floor on stock prices and stem the decline in the value of retirement plans by increasing the after-tax rate of return on capital.

Democrats oppose this, playing on emotions of fear and envy. But while class warfare may make good short-term politics, it produces terrible economics.

- Guarantee sound money. For the last decade, the Federal Reserve's easy-money policy has helped fuel the housing bubble that precipitated our current crisis. We need to return to a sound money policy. That would end uncertainty, help keep interest rates down, and increase the confidence entrepreneurs and investors need to take the risks required for future growth.

I believe the best way to guarantee sound money is to use an explicit, market-based price guide, such as a basket of commodities, in setting monetary policy. A more politically realistic path to price stability would be for the Fed to explicitly embrace inflation targeting.

Transcripts from recent meetings of the Federal Open Market Committee meetings suggest that the Fed may already be moving in this direction. This would be an improvement over the status quo: It could help combat near-term deflation concerns while also calming the market's longer-term inflation fears.

- Fix the financial sector. A durable economic recovery requires a solution to the banking crisis. There are no easy or painless solutions, but the most damaging solution over the long term would be to nationalize our financial system. Once we put politicians in charge of allocating credit and resources in our economy, it is hard to imagine them letting go.

The underlying structural problem at our financial institutions is the toxic assets infecting their balance sheets and impairing their operations. In order to help purge these assets from the system, we need a government-sponsored, comprehensive solution, but one that is transparent and temporary, and which leverages -- rather than chases away -- private-sector capital.

The general idea is to establish an entity or fund to purchase troubled assets from financial institutions and then hold them until they could be sold once the market has recovered. The Treasury has announced its intention to use capital from the Troubled Asset Relief Program, along with financing from the Fed's soon-to-be operational Term Asset-Backed Securities Loan Facility, to set up such an entity. It will be a tall task to get all the details and incentives right, but the administration's general strategy appears to be sound.

A good model for this government-sponsored entity is the Resolution Trust Corporation (RTC), which helped clean up bank failures in the wake of the savings-and-loan crisis in the late 1980s and early 1990s by absorbing and selling off bad bank assets. The circumstances of today's financial sector are different, but the goals of our current efforts should mirror the general merits of an RTC-like entity. We should aim to recoup a portion of our initial expenditures, and we should leave only a fleeting government footprint on the financial sector and the economy.

- Get a grip on entitlements. With $56 trillion in unfunded liabilities and our social insurance programs set to implode, we must tackle the entitlement crisis. President Barack Obama deserves credit for his recent efforts to build a bipartisan consensus on entitlement reform. But we can't solve the entitlement problem unless we acknowledge why the costs are exploding, and then take action.

I have proposed legislation, called "A Roadmap for America's Future," that would bring permanent solvency to Medicare, Medicaid and Social Security. By transforming these open-ended entitlements into a system with a defined benefit safety net for the low-income and chronically ill, in conjunction with an individually owned, defined contribution system for health and retirement, we can reach the goal of these programs without bankrupting the next generation. It would also show the world and the credit markets that we are serious about our debt and unfunded liabilities.

Republicans can help Washington become part of the solution, not part of the problem. We can do this by pushing to enact tax policies that boost incentives for economic growth and job creation, focus the Fed on price stability, fix our banking system to get credit flowing again, stop reckless spending, and reform our entitlement programs.

Our economy is begging for clear leadership that inspires confidence and hope that the entrepreneurial spirit will flourish again. Our goal must be to offer Americans that leadership.

Mr. Ryan, from Wisconsin, is ranking Republican on the House Budget Committee and also serves on Ways and Means.

Bernanke's Feb. 18th Speech on the balance sheet and credit easing

I found this transcript through Economist's View. I thought it gave some nice insight into what the Fed has been doing as well as another perspective on the Financial Crisis. He covers the steps that the Fed has been taking to resolve the crisis as well as what those implications are for both the Federal Reserve and the taxpayer.

Speech Transcript.

Putting the Recession into Perspective

From CNBC.com:

By: Albert Bozzo, Senior Features Editor | 13 Feb 2009 | 10:59 AM ET

If you think this recession is the worst since World War II, chances are you weren't born or working during the downturns of the 1970s and '80s, you're listening to President Obama too much or you're a white-collar worker in financial services.

If all three are true, you may even think we’re on the verge of another Great Depression.

At this point, the only thing that may be true is your age and employment status.

“The current situation has nothing in common with the Great Depression,” says economist Steve Hanke of the Cato Institute and Johns Hopkins University. “The sooner they [in Washington] stop spinning the bad news story and say nothing, the sooner we’ll be more confident.”

Hanke is not alone in dismissing what appears to be a potent cocktail of misinformation and doom and gloom, wherein the current recession—now in its 13th month—is already considered worse than the 16-month ones of 1973-1975 and 1980-1982.

“We were pretty scared in ’82; things looked horrible for awhile," says Bob Stovall of Wood Asset management and a 55-year veteran of the securities business. “I don’t think you can say it’s worse than then; its different. You have changed the landscape but you did that in the Midwest when you forced a lot of rust-belt companies to the wall."

“This time it's financial firms going out of business, instead of manufacturing ones, and the jobs are going with them," explains Stovall.

“I do think that's part of it,” says Robert Brusca, chief economist at Fact & Opinion Economics, saying that. “They’re the ones making the pronouncements. People in the financial sector are getting crushed.”

They’re not the only ones selling doom and gloom, though.

“I don’t remember a president talking down the economy as much as President Obama,” says economist Chris Rupkey of Bank of Tokyo-Mitsubishi. “The economy is very psychological. There’s a herd instinct.”

That herd instinct kicked into overdrive after the sudden collapse of Lehman Brothers, when many say the economy fell off a cliff and a classical cyclical downturn merged with a nasty one-of-kind credit crunch. So yes, economists agree things are bad, but they need to be put into perspective.

Employment

At this point, the current recession is worse than those of the '70s and '80s by only one statistical yardstick, and that’s the unusually quick ascent in the jobless rate—from 4.4 percent in March 2007 to 7.6 percent in January 2008.

“People are reacting so adversely to this is because the job market has become so weak,” explains Brusca.

But even though the sharp decline in payrolls over the past three months has been stunning, it is not as bad on a percentage basis as one period in 1974-1975, according to David Resler, chief economist at Nomura International. Resler says the economy would have to lose some 767,000 jobs a month over a three-month period from the current employment level to match that miserable performance.

During the 1973-1975 and 1980-1982 periods the unemployment rate almost doubled (4.6-9.0 percent, 5.6-10.8 percent, respectively), which means a peak of about 8.6-8.8 percent this time around. In further contrast, during a ten-month stretch in 1983-1983, the jobless rate was above 10-percent.

Nevertheless, that’s nothing compared to the Great Depression when the unemployment rate went from 3 percent to almost 25 percent in four years and national income was halved, notes Hanke in a recent column.

Growth

Thought it may be little consolation for the millions of unemployed, GDP is considered by economists to be the best and broadest gauge of a recession.

That may seem also peculiar since the economy actually grew in the first two quarters of this recession, but some of that had to do with the Federal Reserve's early and aggressive interest rate cutting and the federal government’s first stimulus plan which quickly put money into people’s pockets.

Given that backdrop, GDP contraction thus far has been modest. It’s down 1.1 percent vs. 3.1 percent in the 1970s period, says Chris Rupkey.

And though the economy shrunk at a 3.8 percent annualized rate in the fourth quarter of 2008 and is expected to decline another 4.0-6.0 percent in the first quarter of 2009, imagine the reaction today to the 7.8 percent plunge in the second quarter of 1980 or consecutive swoons of 4.9 percent and 6.4 percent in 1981-1982.

"Half of the workforce until now hadn't seen more than 16 months of recession—total," quips Resler. The past two short (eight months) and relatively shallow.

During the 1990-1991 recession, the deepest quarterly GDP decline was 3.0 percent; in the 2000-2001 one it was 1.4 percent.

“GDP hasn’t been that weak because the productivity increase is one of the best,” says Brusca. “You get a quarter or two that really knocks the level down,” he adds, and it looks like we’re at that stage now.

This time other fundamental factors are playing a bigger role than the past.

“Consumer spending will be bad,” says Resler. “We haven’t three consecutive quarterly declines in consumer spending since the 1950s.” He’s definitely expecting a repeat of that.

It’s Still Bad

Comparisons aside, no one is saying the current recession isn’t a painful one, and some see very little reason for optimism.

“I can't identify anything than looks good,” says Dean Baker, co-director of the Center for Economic Policy And Research, adding that business investment—which appeared to be holding up—posted its sharpest decline in 50 years in the final quarter of 2008.

“I'd be shocked if we have growth this year,” says Baker, even though he expects the Obama administration’s stimulus plan to have a sizable economic positive impact.

So may the words of the President and his advisors, say economists.

“It’s not surprising that politicians exaggerate this,” says Resler, who predicts “The tone of the message is going to start changing immediately; now that we have the stimulus in hand, you enhance it by saying positive things.”

Tunnel Thinking

For all the comparisons with other recessions, exaggerated or not, the most meaningful one may be its duration. It is also the toughest.

• Economy: Full Coverage

The consensus is this recession will end sometime between the second half of 2009 and the beginning of 2010. The pessimists say wait till next year—period.

David Jones, CEO of DMJ Advisors, is among those who see “hints of stability.” By that he means, the rate of decline in areas like retail appear to be slowing.

“We'll see the same thing happening on the housing side in the next couple months,” says Jones.

“I'm just waiting for the shift in people’s expectations,” adds Rupkey.

© 2009 CNBC.com

Do your part for the economy: stay home, do not spend

Families in debt must face up to financial reality: they are in a debt danger zone and should ignore politicians and businesses urging them to go and spend in order to boost the faltering economy. They should spend a bit less, save a bit more, and pay down some old debt.

This message comes from a Canadian economist, Roger Sauvé. He recently released a report entitled "The Current State of Canadian Family Finances," an annual review he has written for the Ottawa-based Vanier Institute of the Family for the past 10 years.

Among its key findings:

Average Canadian household debt rose to $90,700 in 2008. Total household debt now amounts to 140 per cent of disposable income. That ratio is at a record high. In 1990, before the last recession, the figure was 91 per cent.

Consumer and mortgage debt last year equalled 127 per cent of disposable income in the average family. This is about the same as the U.S. rate in 2006 "just before the bubble burst," the report notes. "The recession will likely push many more Canadians over the edge."

Spending and debt have risen much faster than incomes. Between 1990 and 2008, average household income rose 11.6 per cent, while spending increased 24 per cent and debt grew sixfold. At the same time, annual savings shrank to 3 per cent of disposable income, down sharply from 13 per cent in 1990.

Average net worth (wealth), which had been on the rise, fell in 2008 as a result of plunging stock markets and housing prices and the accompanying rise in debt.

Year-over-year consumer insolvencies (including bankruptcies and proposals) jumped almost 25 percent in October. Of particular concern, he adds, is the gradual climb for those age 55 and older, who are traditionally among the least debt-laden.

Laurie Campbell, executive director of Toronto credit counselling agency Credit Canada, said families should heed Sauvé's warnings and ignore pleas to help the economy by buying.
In theory, encouraging people to spend during a recession makes sense if they have the means to do it, she said. But not this time. "When we have savings at all-time lows and debt levels at record highs, there is absolutely no wiggle room."

Financial Crisis from the inside

This is a great article that lays out in a very detailed way the present financial crisis from its origins: The End by Michael Lewis.

The Keynes Debate

From Economist's View

Someone from the Cato Institute sent me this with the message "I’ve been reading your blog posts on the Obama stimulus plan, and I wanted to bring this to your attention, something I think you’ll find interesting." I interpret "interesting" to mean "you are mistaken to think fiscal policy can benefit the economy":

Making Work, Destroying Wealth, by David Boaz: Journalists are telling us that John Maynard Keynes, the intellectual inspiration of the New Deal and its tax-and-spend philosophy, is all the rage again. The Wall Street Journal offers an interesting vignette on Keynes’s view of how to create jobs:

Drama was a Keynes tool. During a 1934 dinner in the U.S., after one economist carefully removed a towel from a stack to dry his hands, Mr. Keynes swept the whole pile of towels on the floor and crumpled them up, explaining that his way of using towels did more to stimulate employment among restaurant workers.

Now I should say that various people report this story, including Ludwig von Mises, but no one cites an original source. Assuming it’s true, though, it just seems to underline the absurdity of the whole “make-work” theory that is back in vogue. Keynes’s vandalism is just a variant of the broken-window fallacy that was exposed by Frederic Bastiat, Henry Hazlitt, and many other economists: A boy breaks a shop window. Villagers gather around and deplore the boy’s vandalism. But then one of the more sophisticated townspeople, perhaps one who has been to college and read Keynes, says, “Maybe the boy isn’t so destructive after all. Now the shopkeeper will have to buy a new window. The glassmaker will then have money to buy a table. The furniture maker will be able to hire an assistant or buy a new suit. And so on. The boy has actually benefited our town!”

But as Bastiat noted, “Your theory stops at what is seen. It does not take account of what is not seen.” If the shopkeeper has to buy a new window, then he can’t hire a delivery boy or buy a new suit. Money is shuffled around, but it isn’t created. And indeed, wealth has been destroyed. The village now has one less window than it did, and it must spend resources to get back to the position it was in before the window broke. As Bastiat said, “Society loses the value of objects unnecessarily destroyed.”

And the story of Keynes at the sink is the story of an educated, professional man intentionally acting like the village vandal. By adding to the costs of running a restaurant, he may well create additional jobs for janitors. But the restaurant owner will then have less money with which to hire another waiter, expand his business, or invest in other businesses. Before Keynes showed up in town, let us say, the town had three restaurants among its businesses, each with neatly stacked towels for guests. After Keynes’s triumphant speaking tour to all the Rotary Clubs in town, the town is exactly as it was, except the three restaurants are left to clean up the disarray. The town is very slightly less wealthy, and some people in town must spend scarce resources to restore the previous conditions. ...

Now we are told that “Keynes is back,” and we need a new New Deal, and the Obama administration is going to create millions of jobs by shuffling money through the federal government. And the theoretical underpinning of this plan comes from a man who thought you could stimulate employment by breaking things. ...

President-elect Obama proposes that the federal government “create or save” jobs by spending upwards of $600 billion. Where would this money come from? If it comes from taxes, it will be taken out of the more efficient private sector to be spent in the less efficient government sector, and the higher tax rates will discourage work and investment. If it is borrowed, it will again simply be transferred from market allocation to political allocation, and our debt burden will grow even greater. And if the money is simply created out of thin air on the balance sheets of the Federal Reserve, then it will surely lead to inflation. ...

You ... can’t get economic growth back by breaking windows, throwing towels on the floor, or spending money you don’t have.

It's easy enough to dispense with this by simply mentioning public goods, i.e. goods with high social value that, because of market failure, will not be produced without government intervention. Producing these goods is just the opposite of "throwing towels on the floor," and the net benefits from these projects are particularly high now since input costs have fallen so much as the economy has weakened. There are other easy counterarguments as well, but rather than rehashing those, I want to play the window game.

Suppose there is an economy that is humming along at full employment. Then, all of a sudden, out of nowhere, a giant, extremely rare windstorm - it's like nothing anyone can remember - comes along and blows out many of the windows in town's homes and businesses. The windows are broken.

This is unfortunate. The town specializes in delicate goods that cannot be exposed to the weather, and when the windows were broken and the weather rushed in all of the inventory, or much of it anyway, was destroyed. In addition, since all of the town's wealth was invested in the inventory, and then some (i.e. they had borrowed to finance some of the inventory), the people of the town lost both their wealth and their ability to borrow from residents of other towns.

So they are wiped out. With all of their wealth gone and no way to borrow, there is no way to rebuild the town and go on as before. Most people are struggling just to get by each day, they don't have time to repair the windows, let alone the resources to finance the repairs and then restock the shelves.

Or maybe there is a way. Suppose the government steps in and hires people to replace the broken windows, and then makes loans as needed (or makes loan guarantees, with an appropriate allowance for risk, or even outright grants in some cases) to recapitalize the businesses and cover the cost of the repairs. That way, the business owners can purchase new inventory and go on as before (well, not exactly as before, one condition of the government loan is that windows of a certain strength are installed, by regulation if necessary, so that the government financed inventory is safe from another disaster).

Thus, instead of destroying wealth, the government is essential in creating it. After the economy-wide window disaster, the government ignores the advice to turn its back in a time of need, and instead steps in and provides the help that is needed to get the economy up and running again. Because of the government action, the economy is revived, and they all live happily ever after.


So in the end we have to hope for two things: One, that the government is able to efficiently distribute resources to those areas that suffer from market failure (the most popular example is roads and now Obama is looking at renewable energy) and second, that those companies that "get their windows replaced" by the government have actually learned their lesson rather than suffer from what is called moral hazard, meaning that the store owners in the town appreciate the help of the government but are not reliant on future government help (bailout) in the case of any future disaster. Otherwise, the government guaranteeing resources now in an unforeseen disaster to ensure short to medium run growth will only result in further, future waste of resources that could have been avoided through the allocation of resources in the private sector by the better run, more efficient businesses.

"Bailouts and Stimulus Plans"

By Eugene Fama from his blog:


There is an identity in macroeconomics. It says that in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit),

PI = PS + CS + GS ⁽¹⁾

In a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole. For example, in recent years private investment in the US has been greater than the sum of private, corporate, and government savings in the US. This means the US has been importing savings from the rest of the world (by selling US securities to the rest of the world). But the equation always holds for the world as whole.

The quantities in the equation are not predetermined from year to year, and government actions affect them. The goal of government policy is to expand current and future incomes. When I analyze the auto bailout and the stimulus plan below, I judge them on whether they are likely to achieve this goal.

Government bailouts and stimulus plans seem attractive when there are idle resources - unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another. And bailouts and stimulus plans only enhance future incomes when the activities they favor are more productive than the activities they displace. I come back to these fundamental points several times below.

A Bailout of the Auto Industry

The bailout of the auto industry is a good place to cut one's teeth on the effects of government action.

Most politicians favor the auto bailout. They fear that if the big three automakers fail, millions of jobs will be lost. Many people have pointed out that U.S. bankruptcy law makes this outcome unlikely. When a big company goes into (Chapter 11) bankruptcy, it is not liquidated. Instead, the company continues to operate, while reorganizing under court supervision.

There is, however, an important point, never mentioned by those in favor or those against a bailout. I phrase it in terms of the equation above. Bailouts of auto firms will be financed with government debt. The government deficit gets larger; that is, government savings, GS, become more negative. If private and other corporate savers do not save more in response to additional government debt, the auto bailout displaces productive investments elsewhere. If private and other corporate savers do save more in response to additional government debt, private consumption must go down by the same amount. This lost consumption and investment, and the incomes they would create, are the big costs of a bailout.

The real question posed by the auto bailout is then clear. Will the benefits, in terms of higher current and future incomes in the auto industry, fully offset the incomes lost as a result of the lost consumption and investment that the bailouts displace?

We are all moved by the visible prospect of lost jobs in the auto industry. We tend to forget the unnamed people who lose jobs or don't get jobs, the businesses that close or the new businesses that don't start, because the bailout displaces productive activities elsewhere.

The Sad Logic of a Fiscal Stimulus

In a "fiscal stimulus," the government borrows and spends the money on investment projects or gives it away as transfer payments to people or states. The hope is that government spending will put people to work, either directly on government investment projects or indirectly through the consumption and savings decisions of the recipients of government spending. The current stimulus plan adds up to about $750 billion. Will it work?

Unfortunately, there is a fly in the ointment. Like the auto bailout, government infrastructure investments must be financed -- more government debt. The new government debt absorbs private and corporate savings, which means private investment goes down by the same amount.

Government infrastructure investments benefit the economy if they are more productive than the private projects they displace. Some government investments are in principle productive. The government is the natural candidate to undertake investments that have widespread positive spillovers (what economists call externalities). For example, a good national road system increases the efficiency of almost all business and consumption activities. Because all the benefits of a good road system are difficult for a private entity to capture without creating inefficiencies (toll or EZ Pay booths on every corner), the government is the natural entity to make decisions about road building and other investments that have widespread spillovers.

Like all government actions, however, government investments are prone to inefficiency. To survive, private entities must invest in projects that generate more wealth than they cost. Public investments face no such survival threat. Even good government investment projects can become wealth burners because their implementation is captured by interest groups (for example, minority or gender set asides, or insisting on unionized labor). Moreover, a $750 billion stimulus package will draw a feeding frenzy by public (state and local) and private interest groups, to pressure for their favored projects, which might not otherwise meet the market test. If the interest groups win, the country will be poorer, and future incomes will be lower.

But we're talking about future benefits. "Stimulus" spending must be financed, which means it displaces other current uses of the same funds, and so does not help the economy today. If you want to build roads or do other investment projects, defend them by standard cost/benefit calculations. And don't use the misleading "s" word.

Suppose the stimulus plan takes the form of lower taxes, another proposal of the incoming administration. Alas, we can't get something for nothing this way either. If the government doesn't also spend less, lower tax receipts must be financed dollar for dollar by more government borrowing. The government gives with one hand but takes them back with the other, with no net effect on current incomes.

The details of the effects of lower taxes depend on how the public uses the proceeds. If taxpayers understand that lower taxes now are exactly offset by the current market value of the future tax liabilities implied by the current increase in government debt, they may simply save the proceeds from the tax windfall. Private savings then substitute for the fall in public savings due to the government debt issue, and there is no effect on private investment or economic activity more generally. (This is what Robert Barro dubbed Ricardian Equivalence.)

Suppose the recipients of the tax reduction from the stimulus don't know about Ricardian Equivalence, and they use the windfall to buy consumption goods. Does this increase economic activity? The answer is again no. The composition of economic activity changes, but the total is unchanged. Private consumption goes up by the amount of the new government debt issues, but private investment goes down by the same amount.

I must shade my arguments a bit (but just a bit). Remember that the (investment equals savings) equation above holds for the global economy but not necessarily for an individual country. If we can get foreigners to buy the additional debt to finance bailouts and a stimulus, we can have additional government spending without reducing private spending. This is how we have financed government deficits for at least the last eight years, so perhaps we can do it for another year or so, and on a grand scale. At the moment, however, most countries are deep into their own bailout-stimulus games. More important, this "cure," if available, is temporary. When foreigners transfer savings to us now in exchange for our government bonds, they take back the resources plus interest later. If the government expenditures generate less wealth than they cost, the wealth loss is borne by future taxpayers, when the government debt is repaid.

A common counter to my arguments about why stimulus plans don't work is to claim that the current situation is different. Specifically, the investment equal savings equation doesn't work because savers currently prefer to invest in low risk assets like government bonds rather than in potentially productive but more risky private investment projects. In other words, there is a "flight to quality." Sorry, but this is a fallacy. A flight to quality does raise the prices of less risky assets and lower the prices of more risky assets. But when new savings are used to buy government bonds, the people who sold the bonds must do something with the proceeds. In the end, the new savings have to work their way through to new private investment, and equation (1) always holds.

The Bottom Line

The general message bears repeating. Even when there are lots of idle workers, government bailouts and stimulus plans are not likely to add to employment. The reason is that bailouts and stimulus plans must be financed. The additional government debt means that existing current resources just move from one use to another, from private investment to government investment or from investment to consumption, with no effect on total current resources in the system or on total employment. And stimulus plans only enhance future incomes when they move current resources from less productive private uses to more productive government uses - a daunting challenge, to say the least. —EFF

Joseph Stiglitz on Longer Term solutions

I came upon this on Economist's View:

Drink-driving on the US's road to recovery, by Joseph Stiglitz, Project Syndicate: A consensus now exists that America's recession – already a year old – is likely to be long and deep, and that almost all countries will be affected. ...
The United States Federal Reserve, which helped create the problems through a combination of excessive liquidity and lax regulation, is trying to make amends – by flooding the economy with liquidity... In some ways, the Fed resembles a drunk driver who, suddenly realising that he is heading off the road starts careening from side to side. When the economy starts recovering,... will ...America face a bout of inflation? Or, more likely, in another moment of excess, will the Fed over-react, nipping the recovery in the bud? ...
I am not sure that there is sufficient appreciation of some of the underlying problems facing the global economy... For a long time,... without American profligacy, there would have been insufficient global aggregate demand. In the past, developing countries filled this role, running trade and fiscal deficits. But they paid a high price, and fiscal responsibility and conservative monetary policies are now the fashion.
Indeed, many developing countries, fearful of losing their economic sovereignty to the IMF – as occurred during the 1997 Asian financial crisis – accumulated hundreds of billions of dollars in reserves. Money put into reserves is income not spent.
Moreover, growing inequality in most countries of the world has meant that money has gone from those who would spend it to those who are so well off that, try as they might, they can't spend it all. ...
America's government will, for a time, partly make up for the increasing savings of US consumers. But if America's consumers go from their near-zero savings to a modest 4% or 5% of GDP, then the depressing effect on demand ... will not be fully offset by even the largest government expenditure programmes. In two years, governments, mindful of the huge increases in the debt burden..., will be under pressure to run primary surpluses...
We need not just temporary stimuli, but longer-term solutions. ...
First, we need to reverse the worrying trends of growing inequality. More progressive income taxation will also help stabilise the economy, through what economists call "automatic stabilisers". It would also help if the advanced developed countries fulfilled their commitments to helping the world's poorest by increasing their foreign-aid budgets to 0.7% of GDP.
Second, the world needs enormous investments if it is to respond to the challenges of global warming. Transportation systems and living patterns must be changed dramatically.
Third, a global reserve system is needed. It makes little sense for the world's poorest countries to lend money to the richest at low interest rates. The system is unstable. The dollar reserve system is fraying, but is likely to be replaced with a dollar/euro or dollar/euro/yen system that is even more unstable. Annual emissions of a global reserve currency (what Keynes called Bancor, the IMF calls SDRs) could help fuel global aggregate demand and be used to promote development and address the problems of global warming.
This year will be bleak. The question we need to be asking now is, how can we enhance the likelihood that we will eventually emerge into a robust recovery?


I liked what Stiglitz had to say about the Fed and how we're not quite looking at long term solutions but just pumping money into the economy as well as his analysis of the current situation. However, I don't know quite how I feel about his proposed solutions, particularly about the progressive tax system. Progressive taxing would imply taxing more at the top and less at the bottom, the goal being at stabalyzation. But for sustained stable growth it seems to me that we need to provide incentives for the savings, that excess money that the rich can't spend, to go into investments: whether that goes into building more factories, training employees, etc... If those upper classes are taxed more, there will be less incentive for companies like Toyota to keep idle workers and train them. So if there are more lay offs, more people at the bottom won't have an income to tax less at all. I'm not saying that taxes should increase at the bottom or have tax cuts across the board at the top, but why not have targeted tax cuts on investment spending? Helping people keep their jobs is as good if not better than a tax cut and sets a foundation for sustained growth; encourage those on the top to employ that idle money. This seemed to me like more rhetoric of saying, "Well the Republican's way didn't work so let's forget about all that and try our way, because if we're in this mess after they were in power, our way must be right," exploiting the current situation to push an agenda.

Does the U.S. need Stimulus spending?

Here's a Wall Street Journal opinion piece that tracks Japan's lost decade and how it might apply to possible solutions for the U.S.:

As January 20 nears, Barack Obama's ambitions for spending on the likes of roads, bridges and jobless benefits keep growing. The latest leak puts the "stimulus" at $1 trillion over a couple of years, and the political class is embracing it as a miracle cure.

Not to spoil the party, but this is not a new idea. Keynesian "pump-priming" in a recession has often been tried, and as an economic stimulus it is overrated. The money that the government spends has to come from somewhere, which means from the private economy in higher taxes or borrowing. The public works are usually less productive than the foregone private investment.

In the Age of Obama, we seem fated to re-explain these eternal lessons. So for today we thought we'd recount the history of the last major country that tried to spend its way to "stimulus" -- Japan during its "lost decade" of the 1990s. In 1992, Japanese Prime Minister Kiichi Miyazawa faced falling property prices and a stock market that had sunk 60% in three years. Mr. Miyazawa's Liberal Democratic Party won re-election promising that Japan would spend its way to becoming a "lifestyle superpower." The country embarked on a great Keynesian experiment.

WSJ Asia editorial page editor Mary Kissel says massive "stimulus" plans didn't help Japan. (Dec. 18)

August 1992: 10.7 trillion yen ($85 billion). Japan passed its largest-ever stimulus package to that time, with 8.6 trillion yen earmarked for public works, 1.2 trillion to expand loan quotas for small- and medium-sized businesses and 900 billion for the Japan Development Bank. The package passed in December, but investment kept falling and unemployment rose. By the end of the year, Japan's debt-to-GDP ratio was 68.6%.

April 1993: 13.2 trillion yen. At exchange rates of the day, this was a whopping $117 billion giveaway, again mostly for public works and small businesses. Tokyo erupted into domestic politicking over election practices, the economy went sideways, and the government fell. New Prime Minister Morihiro Hosokawa floated tax cuts, deregulation and decentralization to spur growth. But as the economy worsened -- inflation-adjusted GNP shrank 0.5% in the April to June quarter -- the political drumbeat for handouts increased.

September 1993: 6.2 trillion yen. Mr. Hosokawa announced a compromise "smaller" stimulus of $59 billion, along with minor deregulation. He dropped plans for an income-tax cut. The stimulus included 2.9 trillion yen in low-interest home financing, one trillion yen for "social infrastructure," and another trillion for business. The economy didn't respond. By the end of the year, Japan's debt-to-GDP reached 74.7%.

Is any of this beginning to sound familiar? There's more.

February 1994: 15.3 trillion yen. This stimulus included 5.8 trillion in income-tax cuts, 7.2 trillion in public investment, 1.5 trillion for small business and employment-support, 500 billion for land purchases and 230 billion for agricultural modernization. The income tax cut was temporary, effective only for 1994. The economy stagnated and Prime Minister Hosokawa resigned amid a corruption scandal. By the end of the year, debt-to-GDP was 80.2%.

September 1995: 14.2 trillion yen. The Socialist government of Tomiichi Murayama, with a wobbly coalition, rolled out a $137 billion whopper, with 4.6 trillion in public works, 3.2 trillion for government land purchases, 1.3 trillion in business loans, and more. Mr. Murayama resigned in early 1996, and in June Prime Minister Ryutaro Hashimoto agreed to raise consumption taxes to 5% from 3%, starting in April 1997, to reduce the fiscal deficit.

In 1994 and 1995, Japan spent 3.1% and 2.9% of its annual GDP, and (helped by central bank easing) the economy did respond with modest growth for about two years. Debt-to-GDP hit 87.6%.

April 1998: 16.7 trillion yen. When growth starting slowing again, the re-elected LDP turned to old medicine: 7.7 trillion yen for public works. The $128 billion grab-bag also included 2.3 trillion for the disposal of bad loans. The government announced four trillion yen in (again) temporary income-tax cuts, spread over two years. Mr. Hashimoto resigned in July after voters registered their discontent at the polls.

November 1998: 23.9 trillion yen. Desperate to get the economy moving, Prime Minister Keizo Obuchi rolled out the country's largest-ever stimulus, valued at $195 billion. The giveaway included 8.1 trillion yen in social public works, 5.9 trillion for business loans, one trillion for job-creation programs, 700 billion in cash handouts to 35 million households, and more. By the end of the year, debt-to-GDP hit 114.3%.

November 1999: 18 trillion yen. In a "last push," Mr. Obuchi's government spent 7.4 trillion yen to prop up businesses, 6.8 trillion yen for social infrastructure projects like telecommunications and environmental projects, and two trillion yen for housing loans, among other things. Debt-to-GDP reached 128.3%.

Japan's economy grow anemically over that decade, but as the nearby chart shows, its national debt exploded. Only in this decade, with a monetary reflation and Prime Minister Junichiro Koizumi's decision to privatize state assets and force banks to acknowledge their bad debts, did the economy recover. Yet recent governments have rolled back Mr. Koizumi's reforms and returned to their spending habits. But Japan does have better roads.

Now we're told that a similar spending program -- a new New Deal -- will revive the U.S. economy. How do you say "good luck" in Japanese?

My own opinion is that we need a mix of well targeted infrastructure spending as well as targeted tax cuts to encourage business growth and investment, because historically businesses, though not perfectly, implement and distribute capital more efficiently than the government. But since a large part of the problem is a lack of confidence and therefore an unwillingness to spend or invest by private companies, infrastructure spending by the government will help to instill the initial spurt of confidence needed both by opening up new, green markets as well as providing jobs. But in the end, it needs to be private businesses that pull us out of this in order for there to be any long term sustained growth, because in the end where is the money coming from that will be used for any further government spending plans?

Norway's Financial collapse

This is a follow up post by John Hempton on Bronte Capital that describes Norway's financial collapse.

The Norwegian bank collapse – a fixed currency model with a current account deficit

In my post about the Japanese bank collapse I showed how insolvent banks could remain liquid and hence operating for decades provided that they had (a) sufficient deposit funding and (b) low enough interest rates. [Please read the Japan post before you read this one.]

Given that the Japan situation required sufficient deposit funding I argued the Japanese deflation model was not a good model for how the US situation would wind up. I promised to talk about the Scandinavian bank collapse in a follow up post.

As I wrote this post I realised that I did not know enough about the Scandinavian collapse generally to write a useful post. But I know plenty about the Norwegian collapse.

This is helped by the Norwegian Central Bank (Norges Bank) who have published a long English language description of the Norwegian banking debacle and its aftermath. You will find it online here – and it is free. This is the single most useful document I have ever read on decoding that sort of banking disaster – and anyone that claims to speak knowledgeably about this sort of banking collapse who has not read it should probably be ignored for spouting theory rather than data. (Ideology abounds amongst the pundits – ignore it.)

The Norwegian case is held up by many pundits (including Krugman and myself) as the best model for how government and central banks should behave in a financial debacle. For reasons that will become clear in this post I am not sure that is always the case.

Anyway Norway had a few preconditions not all of which are necessary but which are often associated with bank failure:

• It had a recently deregulated financial system where new forms of lending and new processes of credit approval were rapidly introduced
• It had a current account deficit
• It had a fixed exchange rate and
• It had a fairly recent adverse terms-of-trade change (namely a big fall in the oil price).

Of these – in my view – and probably in Norges Bank’s view – the most important factors were the fixed exchange rate and current account deficit.

Financial institutions and current account deficits

Financial institutions intermediate current account deficits. Joe Sixpack is hardly borrowed a couple of hundred thousand for his mortgage by going to the global financial market. Instead he goes to a local bank and the local bank raises the money in global markets either by issuing debt in its own name or by securitisation, covered bonds or some other route. This is true everywhere that there are current account deficits. When there are sustained current account deficits banks on average lend more than they take in deposits.

If there is a run on a fixed currency – meaning people want to take money out of that currency – that in effect becomes a run on the wholesale funded banks.

Norway had a current account deficit and naïve wholesale financed banks. They were naïve because recent deregulation meant that they really knew relatively little about wholesale funding risks or the new types of lending they were doing. Worse it had a fixed exchange rate. This was a nasty set of preconditions.

Further, in the early 1990s there were several countries that had fixed exchange rates in anticipation of European monetary union. In some of those countries (especially the current account deficit countries) the exchange rates were too high – and were vulnerable to speculative attack. By far the most famous speculative attack was against the UK pound. George Soros famously made a billion pounds “breaking” the bank of England. To this date the UK has never never even looked like again fixing its currency to the Eurozone.

The Scandinavian countries were likewise subject to speculative attack. The Norwegian attack was the most severe because the current account was getting massively worse. [Norway – an oil rich economy – had a massive spending boom financed by bank lending as the oil price crashed towards $10.] The speculative attack quite literally ran the banks out of money. There was thus an economy wide crash.

It is worth making an aside here. When the banks actually run out of money they can’t lend. Asset prices depend critically on the ability to borrow against them (and that includes the price of current mortgages in the secondary market). When the banks can’t lend asset prices can fall to very low – indeed insanely low levels. At the height of the crisis some 2 bedroom apartments walking distance from the centre of Oslo (one of the richest cities in the world) and with full 180 degree fjord views traded hands for USD15000. You would have easily made 30 times your money buying those properties. Property prices can fall to very low levels without any bank lending. Indeed the ability to borrow to buy assets is often crucial in maintaining their prices…

Now at this point it is worth noting that the banks are illiquid and point-in-time insolvent. When property prices had fallen to such (absurdly) low levels the entire market was upside-down and if you were to liquidate the banks they would be grotesquely insolvent.

All this ended very rapidly. The government guaranteed bank liquidity – and wound up with ownership. The mechanism by which they nationalised the banks is beyond the scope of this post. Most importantly they floated the Kroner – and the currency driven run on the banks ended almost overnight. Certainly the crisis had seriously abated within three months.

When the run ended the banks were again liquid – so they could again lend. Property prices rapidly rose returning to something that looked more normal (if not expensive by global standards) and the banks were solvent. This was a strange crisis because if the underlying assets were priced rationally the banks were solvent always – they were just illiquid.

There is a proof of this assertion. Paul Krugman suggests in the NYT that the Scandinavian bank bail-out cost a lot of money. But the Norwegian government actually made a profit on the bank bail out. The loans wound up not-very bad and the Norwegian government wound up owning most of the banking sector which they again privatised. Norway is as close to the case of illiquid but solvent banks as I am aware of.

What does this mean in the US context?

It is regularly asserted that the Norwegian model is the superior model for dealing with banking crises. The economy bounced back very fast (and isn’t that the goal?). The government didn’t wind up insolvent. Indeed all was indeed well.

But this misses the point. Norway was the case example of illiquid but solvent banks. Bailing out illiquid but solvent banks is the right thing to do (if you can trust the government to identify illiquidity without insolvency). Bailing out insolvent banks tends to reward behaviour that makes you and insolvent. And it is costly. If you think that the Norway experience can be duplicated in any bank bail out – then unfortunately you are sadly mistaken. I doubt the average government can identify the difference between illiquidity and insolvency. Certainly the bulk of the investor population couldn’t (or the banks would not have been illiquid). The Norwegian government got really lucky because the banks it chose to bail turned out just fine.

What does this mean generally?

For investors there is a simple lesson: be careful of fixed exchange rates and current account deficits. I have already pointed to Spain. I have a post coming which points to what I believe is a huge forthcoming financial crisis with nasty geopolitical implications. Oh, and a great investment idea.

But dear readers, you will have to wait for that one…

John

Japan's lost decade

This is a great article from the Bronte Capital blog written by John Hempton. This describes Japan's lost decade, their bank failure and how the government dealt with it. This, along with another post from the same blog about Norway, really helps to put America's own financial collapse into perspective.

Deflation and bank bailouts in Japan

Given what is happening with Fannie Mae at the moment I should share a little of the history of non-US bank bail outs. I will start with Japan and later do Scandinavia.

Japan was an unusual bank collapse. It happened despite excess savings in the system. This is really strange. Most bank collapses happen when there is a lending binge that drives excess or investment or consumption and with a current account deficit. (See for instance Korea – where there was excess investment or Argentina where there was excess consumption.)

Japanese banks always had (at least collectively) sufficient deposits. [See my post on 77 Bank to see just how much excess deposits they now have.]

But the Japanese banks lent very badly indeed. Part of this lending was to the "Zombie companies" but most was on property. The formalised golf-club membership exchange in Japan at one stage was worth a good multiple of the entire Australian stock exchange (including giants such as BHP and Conzinc Rio Australia). Golf club memberships were of course a pure-play method of speculating on land.

But you need to notice that the Japanese bank collapse looked very different from what is going on in America now. The Japanese bank collapse was not a collapse of funding – it was a collapse of asset values and solvency. [Exceptions noted.]

American financial institutions are now having wholesale funding runs (or finding wholesale funding is unavailable which amounts to the same thing). Japanese financial institutions did not need wholesale funding (most had deposits) and hence by-and-large did not have runs. [There were some institutions such as the long-term-credit banks and similar institutions which had wholesale funding – they were effectively nationalised.]

Many Japanese regional banks (Nishi Nippon for example) were breathtakingly insolvent at the height of the crisis but they remained liquid because they had plenty of deposits. Because they remained liquid they never actually failed.

The zero interest rate policy

Insolvent but liquid banks are the key to understanding Japanese interest rate policy. There are several prominent macroeconomists in America (led notably by Krugman but joined by Bernanke) who argue that the zero interest rate policy was insufficiently expansionary – and that monetary policy should have been eased until it induced inflation. In theory this could be done by flying a helicopter over Tokyo throwing out freshly printed 5 thousand yen notes. Indeed it was in a speech about Japan that Bernanke uttered the famous helicopter line.

The BOJ always thought this policy was “risky”. Krugman’s response was that it was less risky that the endless government deficits Japan ran. Krugman missed the point – the question was who was inflation risky for? My answer: the banks.

A hypothetical insolvent bank

Imagine a hypothetical insolvent bank. Suppose the bank has 90 in funding, 10 in “stated equity” and “stated” 100 in assets. [I have left the currency blank because this could be 100s of billions of yen or billions of dollars.]

And suppose that the assets are not really 100 but 70 good and 30 bad - and everyone knows about the bad assets.

Then the bank “really” has 70 in assets, 90 in funding and minus 20 in equity. This is a realistic picture of insolvent Japan in 1994.

If the bank was in a current account deficit country like America, Australia, New Zealand or the UK there would be an immediate problem. In a wholesale funded market the 90 in funding would be say 60 of deposits and 30 of wholesale funds – and the wholesale funding would leave. The bank would go insolvent quite rapidly (see Northern Rock which was very reliant on wholesale funding).

But in Japan the 90 in funding was all deposits and was sticky. The funding never left and the bank continued quite nicely. Capital market discipline was not imposed – and the hypothetical bank could pretend there was no problem for many years. Banks fold when they go illiquid - not when they go insolvent. No liquidity problem means no crisis.

But the problem is still real. Over time insolvency may turn into illiquidity.

Now suppose that (and this is a gross simplification) that the spread between deposit rates was 2%. But rates could either be 10 and 12 percent or 0 and 2 percent.

If the rates were 10% and 12% the 90 of funding would cost 9 per year. The 70 of “real” assets would yield 8.4 per year. The bank would be cash flow negative. Anything that is cash flow negative for long enough goes illiquid eventually. The insolvency problem would turn into a liquidity problem.

Now suppose the rates were 0% and 2%. The 90 in funding is free. The 70 in assets yields 1.4%. The same banks is cash flow positive in a low interest rate environment. If they are cash flow positive for 15 years the bank will fully recapitalise.

• Summary: zero interest rates were critical to bank recapitalisation in Japan.

The reason why the BOJ rejected the Krugman/Bernanke line was that it was risky to the banks and the BOJ (and the MOF) are totally captured by their bank constituency. It was risky not to the economy but to banks. [Note the practice of amakudari translated as “descent from heaven” where former government officials get to be CEO of banks late in their career.]

Why this form of bailout won’t happen in America

In America it is the wholesale funded institutions that are in the most trouble. Think Bear Stearns, Lehman, Fannie, Freddie.

They are in diabolical trouble.

The funding is leaving them. It does not matter whether rates are 0 or 10 – the funding is still going.

America will look far more like Scandinavia than Japan. Scandinavia was a funding crisis. The posts by Naked Capitalism and others suggesting that Japan’s wasted decade will be the new normal are just plan wrong.

Implications

I still have not worked out what side of the inflation/deflation divide I am. But the people that point to Japan as a likely outcome miss a point. Japan chose deflation because the alternative was nationalising the banks.

America does not have that choice. The American institutions are wholesale funded and hence will nationalised or fail if the wholesale funding disappears.

Nationalisation can be inflationary if it involves printing. The date the Federal Reserve is not printing – but Helicopter Ben has made clear that in Japan the BOJ should have printed. And the institutional imperative to stop him printing will not be present in America.