Reasons for Economic Optimism

I was inspired by Justin Fox's recent post in Time, 5 Reasons for Economic Optimism (he gives 4). Although I differ with him rather sharply on what exactly are the reasons to be optimistic, I agree with his premise: it's vital to look for the ways in which the current economic situation is or will be, for the greatest good. Before I give you my list of reasons, let's take a look at Mr. Fox's list.

1. The Stock Market Is No Longer Overpriced

My response: stocks are still heavily overvalued. The current bear market has taken stocks more than 50% below their peak, to a low of 6548. As of 4/21/09, the dividend yield for the Dow was 3.51%, while that of the S&P 500 was 2.61%. A bear market historically reaches its bottom when the dividend yield is 6 to 8%. The stock market is coming off a 27-year bull market, which took the Dow from 800 to over 14,000. (check out my earlier piece on this) A bull market of this magnitude is not corrected in a few months. As a matter of mass psychology, we'll be near a bottom when the overall consensus is that putting money into stocks is as wise a thing to do as setting fire to your money.

2. The Government Is On The Case

My response: Unfortunately, much of what the government is doing is interfering with the process of adjustment which is necessary to restructure the economy, clear out losses, bring an end to corporate strategies that were essentially unsound, and move the economy toward productive economic activity. Expect the government to engineer massive amounts of inflation, as Greg Mankiw and others believe would be helpful.

3. Consumers Are Adjusting to the New Economic Reality - And Fast

My response: Mr. Fox argues that the speed at which consumers are cutting spending is a good sign, for it will lead to a rebound in consumer spending that will help the economy. Interesting point, but I don't find it persuasive. What we need is more investment, not more consumption. To that end, saving is needed, for ultimately, there is a macroeconomic equality between savings and investment. Though we have been able to avoid that equality for some time because of financial out-flows (i.e. the financing of US current account deficits and budget deficits through foreign buying of financial assets), savings ultimately equals investment. So more saving is good in itself, not only as a sign that the carnage of lower consumption is almost over.

4. Reinvention and Change Are What the US Is All About

My response: It's hard to argue with this one. And Mr. Fox also correctly identifies that many economic activities of the boom years were unproductive: he singles out finance and real estate as two of the big culprits. Unfortunately, he believes this means that the US dollar will continue to be the world's reserve currency forever. Does he fail to see the many signs that the reign of the dollar is nearly over? The strength of the dollar since Fall 08 is only a temporary response to fears of financial armageddon.

* * * * *

OK, so here's my list.

1. Moving from an economy dominated by unproductive activity to one dominated by productive activity will be good for America. For too long, American innovation and entrepreneurship went into venues that were basically deceitful, put others at risk in order to generate profits, or were unsustainable. We've gotten to be masters of finance, real estate sales, and retail sales. It will good for our innovation to be re-channelled into activities based on sustainable growth.

2. As I mentioned above, consumer saving is a good sign. Living with a zero or negative savings rate is unstable and tends to lead to volatile investment. A high savings rate should ultimately lead to a high level of investment. The fact that consumers are spending less means they are facing reality. That's a good thing in itself.

3. The End of Bling focuses our attention less on conspicuous consumption and more on the things that really matter. That will differ for each one of us, but it seems likely that the recession will lead to a decreased level of materialism in society, and an increased understanding that consumption should be in the service of the purpose of our life, not the other way around. Once one's basic survival needs are met, the kinds of things that tend to make people happy in a lasting way are having deep relationships, being able to meet one's responsibilities, and making a meaningful contribution to the world. This crisis offers us the opportunity to re-evaluate our lives.

4. The environment will be a beneficiary of decreased consumption among the rich nations. America cannot continue to consume 25% of the world's resources.

5. The financial crisis will end the international hegemony of the US dollar, and encourage nations to consider sound, honest money, based on an item of real value. The natural choices are money based on gold, silver, copper, or other metals. There are other possibilities for backing money, including a basket of commodities. (These are less desirable to me, for reasons I'll describe in a future post) Moving away from a world monetary order based on fiat currencies will be good for the US and good for the world, because fiat currencies are essentially dishonest.

6. The crisis will end US military adventurism in the Middle East and elsewhere. The reason for this is that as the dollar loses its status as a reserve currency, we will not be able to afford to continue to occupy Iraq, Afghanistan, or any other country. We will have to dramatically cut all government spending, for deficit spending will no longer be an option. When we have to balance the budget, these foreign military adventures will simply become untenable. They were only possible based on the unrealistic idea that we wouldn't have to pay for them. Americans are not motivated enough to go to war in distant lands when they realize it will mean fewer schools, hospitals, roads, and smaller pensions.

So take heart America! This crisis will return us to our core values.

New Forecast for the Dow, New Feature for the Blog

In a previous post, I gave a prediction for the Dow to rise to 8300. Given what has now happened, I'd like to revise that. The Dow has just broken through its most recent high mark (of Apr 17th), and I now see the rally taking the Dow back above 10,000.

Which brings me to the new feature of the blog. I give my calls, and we'll see how a hypothetical $10,000 invested as I say will do over time, assuming a trading fee of $9.99.

Since I see the market rally continuing, I'm taking a position in DDM, which is a leveraged ETF (exchange-traded fund) that returns twice the daily performance of the Dow. I'm going to start the clock now, even though I bought DDM a few days ago. I'm going to say you can pick up DDM at its current price of $26.93, you can get 370 shares. (More if you're on margin, but let's keep it straight.)

I don't believe the bear market is over. I think the Dow will still fall to the 1000 range or below. (In a previous post, I called for 400). The reality is that the stock market has been on an outrageous tear for 27 years. That kind of growth is not corrected by an 18-month bear market, even one of this severity.

Once this rally has tapped out, I'll call for taking the opposite side, with an ETF called DXD, which moves double the inverse of the Dow.

PermaRenter: "Full Commanding Denial"

I liked this comment that I found on patrick.net, written by PermaRenter:

Full Commanding Denial

If central casting called for a poised, straight-talking, and capable-seeming president, it would be hard to come up with someone better than the Barack Obama who walked and talked around the White House grounds with Steve Croft on “60-Minutes” Sunday night. He may perfectly represent the majority who elected him, though, because he also appears to be in full commanding denial of the realities overtaking our American experience.

Those realities include the fact that we can’t possibly return to the easy credit and no money down “consumer” economy no matter how many nominal dollars get shoveled into the fiery furnaces of banks too-big-to-fail. As Treasury Secretary Geithner’s underling, Stephanie Cutter, said last week, “Our singular focus is on increasing lending to support economic recovery. Everything we do to stabilize the financial system is done with that goal in mind.”

Lending on the scale that became normal over the last decade is for sure the one thing that we will not recover. We turn around in 2009 to find ourselves a much poorer nation than we thought we were a year ago, especially among that broad range of formerly middle-class wage-earners who lived so luxuriously until yesterday. The public can’t process this reality and the president, for all his relaxed charm, is either not ready to articulate it, or can’t process it himself.

Everything that we’re doing right now is engineered to avoid reality, to sustain the unsustainable, to recover the unrecoverable, when the mandate of reality compels us to face our losses in order to move on to the next chapter of a collective American life. The next chapter would be a society that runs on a much more local and modest scale, centered on essential activities like growing food, requiring harder physical work, and focused attention — in other words, the opposite of a society lost in abstractions, long-range daisy chains of off-loaded responsibility, and incessant pleasure-seeking.

In retreat from this reality, we’ve set in motion two forces that are pretty certain to bring us to grief. The first proceeds from the fateful FMOC [sic.] decision last week at the Federal Reserve Bank to begin buying massive amounts of our own treasury bonds and bills. This is predicated on the idea that the mechanisms of wealth production — even of illusory wealth, such as the fortunes created by trading securitized unpayable debt — can keep chugging along, spinning off limitless additional suburban villas, chain stores, car trips, and deep-fried snacks. It would be sententious to explain how this destroys currencies, but wherever “monetizing debt” has been tried before in history, that is the outcome. The result would be ruinous at every level and would lead straight to the second terrible force: social upheaval brought on by the conversion of economic problems into political turbulence.

Those two forces are underway right now, in fact, since the overt monetizing of last week was preceded by the shoveling of bail-outs, which tacitly guaranteed a collapse of credibility in US debt instruments. I’m not in favor of violence and anarchy, but after the AIG bonus affair, it’s hard to imagine that we are not one more corporate misdeed away from a rocket-propelled-grenade, or something like that, being fired into a glass office tower somewhere — and then the “first-broken-window” rule of social disintegration comes into play. Meanwhile, I stick to my time-table of six-to-eighteen months before the reckless creation of new money-for-nothing filters through the system, overcomes even compressive mass bankruptcy, and starts expressing itself in the sinking value of dollars and the revved up velocity of their circulation in pursuit of tangible commodities.

We’re already seeing the first twinges of that in the up-creep of oil prices, busting through the $50-a-barrel barrier last week. Since scarcity tends to express itself in gross volatility, it’s easy to imagine oil prices rising swiftly beyond the $147-per-barrel record level of last year. As that occurs, the most basic premises of everyday life in the USA will be called into question. If you think car sales have been bad lately, with oil in the $35-a-barrel range most of the winter, just wait. The newly-minted unemployed will be marooned in their subdivisions. They will not be buying GMC Yukons on 48-month installment contracts, let alone X-boxes on their Visa cards. They might be very very hungry, though. All bets are off as to how these social classes may organize themselves to alleviate their hunger (and express their anger about it).

Given all this, it’s kind of hard to believe that the savvy, thoughtful Mr. Obama is going along with such a disastrous program as the one his “team” is rolling out. Perhaps his ease and confidence masks a tragically conventional world-view, an incapacity to imagine “change” outside a very narrow range of possibility. I must say I doubt this is the case. I think, he is going along, for the moment, with a consensus of wishes to prop up life as we know it at all costs. This consensus emanates from the top down and the bottom up. The millions of “Joe-the-Plumber(s)” out there don’t want to rethink the terms of existence anymore than the lords of Goldman Sachs. I also think that circumstances will force Mr. Obama’s hand before long — specifically that a moment will arrive when he goes on TV and tells the American public that things have changed way beyond the scope of what they even imagined when they pulled the levers last fall and voted for an uncharted future.

Capable observers are calling, meanwhile, for a robust bear market rally moving through Spring, on technical grounds that have little to do with the greater forces roistering in the background. Reality is a cruel mistress. If the stock market rally rolls out as predicted, it will surely fake-out the mainstream media. They’ll conclude wishfully and foolishly that something like “recovery” is underway. They may even interpret rising oil prices as a “positive sign” that the great groaning enterprise of the something-for-nothing economy is back “on track.”

They’ll be shocked sometime after Memorial Day when it all comes off the rails again. We have a lot to sort out and very little time to get on with job. Notice, I haven’t even mentioned the potential for mischief and instability coming out of the rest of the world — enough black swans to blot out the sun. Want some concrete advice? For those of you sitting on US Treasury bonds and bills, now would be a good time to get out.

Wow. After that summary of our woes, check out my Reasons for Economic Optimism - coming tomorrow!

Real Estate: The New "Don't Ask, Don't Tell"

According to an article in the New York Times, New Yorkers are dealing with falling real estate values the old fashioned way: denial.

Let's not forget that falling real estate prices are good. Yeah, let me say that again: falling real estate prices are good.

Falling real estate prices remind us that homes are not investment goods, they are consumption goods. That will help us make smart investments in actual businesses that produce actual stuff. Homes don't produce anything, you see, so there's no good economic reason why the price of homes ought to go up faster than the rate of inflation. Does your car go up in value each year?

Falling home prices make real estate affordable again, for those who want to own. Owning vs renting is always multi-dimensional question, having as much to do with your preferences for responsibility and maintenance as it does with your propensity to move and the tax advantages of the mortgage interest deduction. The point is, not everyone is or should be a homeowner, and that's a good thing. When home prices reach a reasonable and affordable level (the median home price should be about 3 times the median income, maybe as high as 4 or 5 for a big city) then those who want to own don't have to use the mortgage equivalent of financial derivatives to afford housing.

Did the Oil Boom Cause the Recession?

There are several recent papers which make the argument that without the oil price boom of 2007-08, there wouldn't have been a recession. James Hamilton says "I don't quite believe the conclusion myself."

These papers make some interesting points, and there certainly is a connection between rising expenditures on gas and falling consumer spending. That said, I don't find it persuasive that rising oil prices "caused" the recession. The primary cause of the recession is the bursting of the artificially induced credit bubble. What caused that bubble was the rapid expansion of the money supply, which is always the ultimate cause of bubbles. There is only one way that stocks can outpace overall productivity growth over a long period, there's only one way that any asset can become outrageously overvalued without coming under pressure from short sellers and that is money creation.

Repo Fee

The Treasury reports that as of Friday, a new fee will be levied on participants in the Repo market of 3%. This is an interesting development; it's pretty unusual for the government to place any kind of punitive fee on any financial market. Why are they doing it?

A "repo" or "sale and repurchase agreement" is a kind of fixed rate short-term lending that uses debt or equity as collateral. A common form of debt to use is US Treasury debt.

An example of a repo transaction would go like this. Say I'm a bank with $10 mil in Treasury debt, and say I'd like to make an investment, but I also want to keep the Treasuries on my balance sheet. I can use a repo to sell the Treasuries to another bank, agreeing to repurchase the Treasuries some time later, for a set amount. Let's say I agree to repurchase the debt 100 days later for $10,0136,986.30. (This would imply that the yearly rate is 5%) I pay $136,986.30 to the lender for giving up my illiquid Treasury debt but knowing I could buy it back later at a fixed price. Why would I do it? Perhaps I have an idea in mind for an investment which would have a higher yield, but I need money to do it, not Treasury debt. Why not simply sell the Treasuries in the bond market and buy them back later? If I did that, there would be no entry in my balance sheet, and say I need to keep the Treasuries on my balance sheet because they are my reserves, and I must keep a certain ratio of reserves to deposits.

Repos are in fact commonly used by banks to have their cake and eat it, too. Banks can lend their reserves at a proft (thereby reducing their reserve ratio, which banks always want to do) and they can keep the Treasuries on their books as if they own the Treasuries, when in fact the bank no longer owns the Treasuries (at least for the term of the repo). The implied interest rate on repos (called the "repo rate") is usually a bit below the federal funds rate, currently at zero.

The unusual thing that began to happen on a large scale during the credit crunch of the fall of 2008 is that many of the buyers of repos (the lenders) did not return the Treasury debt on time. In fact, the total of all the late repos added up to $5 tril (there's a good discussion on the Naked Capitalism blog). There's no real penalty for this, but one question we might ask is: why?

Are the lenders unable to come up with the Treasuries? What did they do with them? Could they have done a repo on the Treasuries they just bought?

The Treasury will place a fee of 3% on the late repos. Because rates are so low, this will probably push the repo rate into negative territory. (Hey, just what Greg Mankiw wanted!) So if the repo rate is negative 3%, the math on my $10 mil repo changes. I now buy back my $10 mil in Treasury debt for only$ 9,917,808.72. Wow, free money! I get to make my investment (hope that works out) and I get to make an easy profit of over $82 grand!

Will the negative repo rate spur banks to make more repos, and hence to make more loans? Perhaps that's the goal of this policy change. My guess is that there will be unforeseen consequences. Who will rush to take the money-losing side of the repo? If there is no counterparty, then the repo market could be diminished, which may have the effect of raising reserve ratios, further contracting the money supply. Most economists these days are against a contraction in the money supply during a recession, especially "The Great Recession".

The End of Bling

Time Magazine calls it the new frugality on its cover for this week. I call it the end of bling. Bling is shiny stuff, conspicuous consumption; it symbolizes the fast times and easy living of the boom years, but also the artificiality and denial.

Time reports that

Among people earning less than $50,000 a year — roughly half of U.S. households — 34% have not gone to the doctor because of the cost, 31% have been out of work at some point, and 13% have been hungry. At the same time, 4 in 10 people earning more than $100,000 say they are buying more store brands, 36% are using coupons more, and 39% have postponed or canceled a vacation to save money.

These kind of facts are often reported as though they are bad news. The real question is, does increased consumption make people happier? It's good news that we're slowing down our consumption, because it'll help us focus on the things that truly matter. And our bling years were pretty hard on the environment. When I think of bling, I think of a big Escalade or Hummer with massive chrome rims. That image hardly makes me think we have much of a future. But now that the recession has dulled our appetite for bling, I think we have a much better chance of facing the challenges we must face.

Great New Proposal by Kotlikoff and Leamer

Professors Kotlikoff and Leamer offer a bold yet simple way to reform the banking sector in their article in Forbes entitled A Banking System We Can Trust.

This is the most important proposal I have yet seen in the mainstream press to reform the financial system. Unlike the other plans I've seen, it would actually work, for it would end the fractional reserve banking system, while preserving the function of banks, which is to serve as a conduit for savings to flow to investment. Kotlikoff and Leamer call it "Limited Purpose Banking".

Everyone who is concerned about the financial crisis should read this article. I hope that policymakers and my fellow economists take heed.

There is one further step I'd suggest to protect the financial stability of the banking sector: tie the value of the dollar to a commodity. In an earlier post, I outlined a plan to do this. A commodity basis is necessary for the dollar to serve its function in the long term, which is to provide a stable store of value to facilitate trade and investment. Because the Federal government seems to run on deficit spending, it has tended to escape the discipline that commodity money imposes. But an escape from that discipline is only found in inflating the money supply, which cannot work in the long term.

The Cash System

The way banks have over-leveraged themselves, it is wise to consider minimizing your exposure to the banking system. Just as you would be unwise to put all your assets in one investment, consider diversifying outside of banks. Hold some cash for transactions, instead of relying on credit or debit cards for everything. Hold some savings in gold. (A good way to do that is to use an "online gold" bank, of which I think the best is Goldmoney.com.)

Instead of taking out cash when needed, consider the reverse. Keep a minimum amount in the bank, hold basically all your money for transactions in cash, and put money into the bank to pay bills.

There is some evidence that using the cash system will help in the budgeting process. It gives you a good idea of how much money you have at any given time, and it imposes a psychological discipline on spending, called the denomination effect. Basically, you're more reluctant to break a $100 bill than you are to break a twenty.

Obama: China Is Not Manipulating the Yuan

The Obama Administration has backed off from labeling China a currency manipulator.

All this back-and-forth on whether or not China's currency, the Renminbi, or Yuan (RMB) is being manipulated or not really starts to beg the question of what currency manipulation actually means. In a world of fiat currencies, it doesn't mean very much.

China is well aware that in order to defend the value of the RMB against the dollar and other major currencies, it must maintain a foreign exchange reserve, mostly composed of dollars, since the dollar is the reserve currency of the world. However, with China's foreign exchange reserve at around $2 tril, it is impossible for currency speculators to attack the RMB, as George Soros did with the British Pound back in 1992, when he broke the bank of England.

So China can credibly defend the RMB. But what is the intrinsic value of the RMB? Well, there is none. Fiat currencies do not have an intrinsic value, which is what makes their movements so unpredictable relative to each other. The charge that China is a currency manipulator is not only vacuous, but it serves no real purpose other than stirring up anti-China sentiment. Perhaps that is a useful tool for politicians who trade in fear and want to create a new enemy. It's good that the Obama Administration has not taken further steps down that path.

Footnote: Paul Krugman has written an interesting piece recently arguing that China's steps to move away from the US dollar are signs of weakness rather than strength.

Interesting Article on Piracy

Johann Hari has written a very interesting article on the recent piracy in Somalia. Writing for The Independent, the articles is titled You Are Being Lied To About Pirates. I don't know enough about the issues to comment, but I do recognize a persuasive, provocative argument when I see one. That makes it worth considering.

The Wall Street Journal tends to take the other side of this issue, arguing for harsh international penalties on piracy. Here's a piece arguing for convoys to protect ships, for example. Another piece refers to this as a struggle of civilization vs. barbarism.

It certainly seems like some kind of desperate situation has arisen to make people take the kind of risks involved in piracy. While we deplore violence and lawlessness, we'd be wise to consider why it arises.

Karl Case on Real Estate (and Banking)

On 3/31/09, me and a few dozen of my economics professor colleagues tuned in to a webcast by Karl Case, co-creator of the Case-Shiller Home Price Index. He told an interesting story of how the housing market came to be constructed, how home prices became collateral for all kinds of other assets, and how the smartest statisticians on earth could have been wrong about default rates on subprime mortgages, since they were deceived by a 30-year long real estate boom. I liked his story of the real estate bubble, though I think he missed the primary cause, the only logical reason why housing could become hideously overvalued: money creation.

I questioned him on the connection between fractional reserve banking and the housing bubble. His response showed how little he had thought about banking. "There's no need to destroy the entire credit system and bring lending to a halt," he replied.

I understand that response, for I thought much the same a few years ago, before I began to research the issue. Banks are a major conduit through which savings become investment. It is an economic necessity that such a conduit exists, but it is far from the only one. When corporations issue stocks or bonds, for example, savings become investment. (Assuming the corporation uses the money it raises for investment and not some other purpose.)

If we insist that banks are honest and do not permit them to engage in fraud, it does not mean that there will be no credit system and no lending. It simply means that lending will be done on a basis that is absolutely solid and does not involve the fraud and instability of the fractional reserve system.

The great American economist Irving Fisher showed this quite clearly in his 1935 book 100% Money. Murray Rothbard argues for the same thing in his article The Case for the 100% Gold Dollar. A full reserve system would not destroy banking, nor would it end credit. Banks would be restricted to lending only from bonds they would issue specifically for the purpose of investment. People who bought such bonds would know that they are taking a risk, sacrificing liquidity for a return. No lending from demand deposits (checking and savings accounts) would take place.

Full reserve banking would not end credit, it would simply make the credit system rational, functional, and morally sound.

Econ Quiz from the NY Times

This quiz is a sample of some Advanced Placement economics questions. Unfortunately, what the quiz purports to do, tell you whether you're a classical, Keynesian, or monetarist, it doesn't do. It just tells you how many questions you got right.

Inflation Coming Soon

Wow. Greg Mankiw has written an unusually provocative argument in favor of inflation, even outright monetary destruction. Addressing the problem that the Fed can only push rates to zero, (and if that doesn't stimulate lending, what will?) he writes:

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

I am shocked by how reckless his proposal is. Unbelievable. The way out of the financial collapse is to basically render useless one-tenth our money. (As Mankiw no doubt realizes, in practical terms this wouldn't work, since the overwhelming portion of the money supply is not attached to paper notes. Only about $800 bil of the money supply is paper currency, while M3, the broad measure of the money supply, is nearly $15 tril)

Imagine if stimulating the economy were as easy as Mankiw suggests. If destroying 10% of our money is this good, why not destroy 50%? Why not simply build immense fires and burn all our paper Federal Reserve notes that we call money? What a fantastic stimulus that would be.

Destroying money through inflation will not cause a stimulus of any kind, it will cause chaos. Inflation introduces distortions into the economy. Businesses cannot easily calculate future returns; inflation transfers money from worker to employer, from saver to borrower, from the poor who tend to be far away from the money-generating mechanism, to the wealthy and well-connected, who tend to be nearer to the source, and hence can spend their income before prices rise.

Because Greg Mankiw is a towering figure in the economics establishment (professor at Harvard, chair of the Council of Economic Advisors under Bush, influential blogger and textbook author), and because this interesting article appears in the NY Times, (where it is immediately heralded by Paul Krugman) I suggest that Mankiw is striking a chord that will resonate with the central banking and political establishment, which no doubt sees the logic of inflation.

Though the CPI indicates that deflation has been our recent history, that will not last under a determined attempt to produce inflation. Remember, the Fed can print money and drop it from Helicopters. The Fed can write the US government a check for a trillion dollars. (The Fed can even write me a check for a trillion dollars, but I'm afraid I will not stop blogging.) If the Fed wants inflation, the Fed will get inflation. Mankiw simply says what needs to be said to ease the way toward that inflation.

By the way, it is completely wrong to say that inflation will stimulate bank lending. Banks are extremely reluctant to lend under inflationary conditions, unless interest rates are fully flexible, indexed to inflation and all other relevant conditions. Does that sound familiar? That is what an adjustable rate mortgage is all about. But even if rates are fully adjustable, there are two additional problems:

1) what if raising the rate high enough to cover the bank and ensure that the loan is profitable destroys the borrower?

2) how many borrowers are willing to borrow with such uncertain costs of borrowing?

If inflation was such a reliable way to stimulate bank lending, Zimbabwe would've become the world's banker, instead of the world's most recent example of the failure of central banking.

Within a year, we'll see double-digit inflation rates.

Nice Graphic on Unemployment by County

Check out Slate for a nice animated graphic on unemployment by county in the US.

The graph shows something that apparently Paul Krugman has forgotten: the real estate bubble actually did cause important economic distortions, which are now manifesting in real job losses.

Krugman argues that the real estate bubble isn't what's behind job losses now; I agree insofar as the real estate bubble is an intermediate rather than primary cause. The primary cause is the explosion of money created by the fractional reserve banking system, overseen by the Federal Reserve and the Federal government.

How Long Will the Stock Market Rally Last?

Here's where I go out on a limb. My feeling is that the rally will take the Dow to 8300 or so, before the market returns to its downward course. How long will that take?

On the one hand, the rally that began after the March 9th low has only been around 5 weeks, but already it has wrought a powerful change in sentiment. There is big money on the sidelines hoping to recoup some losses. Some have no doubt been tempted to get back in.

On the other hand, it feels as though the rally has already begun to cool. Yes, the last few days have shown gains, but it feels like the winds are changing. Perhaps we'll see the market move sideways for a while, as it did today, ending flat (+5.90 or 0.07%).

The recession is just beginning. How will the market respond to further bad news? Has the market discounted all the bad news? Has the market already looked ahead?

I don't think so. The conventional wisdom is that the recession will last the year. My own view is that we are in for a 5 to 10 year recession.

An interesting possibility is how the market may respond to the inflation that is coming soon, once the deflationary pressures have abated. Will stocks leap ahead, encouraging investors that the bear market is over, a rally that is stimulated by inflation, not real underlying growth? That is a distinct possibility.

Did Mark-to-market Accounting Destroy the Economy?

Mark-to-market accounting basically means that assets will be valued according to what the market price of the asset at the time. This is a commonsense practice. What is your house worth, what is your car worth, what is your time worth? The answer is the same for all: it is worth what the market will bear.

Frank Holmes argues that this simple and commonsense practice (recently suspended by the Financial Accounting Standards Board, here is the original guideline) says yes, in a recent article on the Kitco website. Unlike most analysts on this issue, he provides some data. Holmes argues that the FASB accounting rule (implemented at the beginning of 2008) caused a vicious cycle: the rule caused banks to write down losses that were at that point unrealized, which then caused them to be under-capitalized, causing them to then restrict lending.

Here's his chart (in $bil):

What makes Holmes' argument spurious is that the very time when the graph begins its sharp descent corresponds with the end of the peak performance of the stock market (the Dow hit its record in Oct 2007, with a long downward slide since). (To be fair, Holmes notes this when he says credit market became 'impaired', meaning they were on the way down, but because of rigidity in some derivatives markets, supply and demand did not clear.)

It simply does not matter whether banks 'realize' their losses or not. As long as the market value of the asset is below what they paid for it, there is a loss. If a person buys a 1000 shares of a stock at $10 a share and that stock falls to $7, that person has lost $3,000. If he sells, the loss is realized. If he decides to keep the stock, he has a paper loss, or an unrealized loss. Perhaps he decides he doesn't want to take the loss, and hopes the market improves taking the stock back to $10, or even above. Fine, but that doesn't change the fact that the asset is worth $7,000 today. No amount of wishful thinking will change that, and this is why the suspension of mark-to-market accounting will do nothing to solve the financial crisis.

In fact, the FASB rule did not cause banks to restrict lending. It simply revealed how short banks are. That information was readily available well before FAS 157 (the mark-to-market rule) took effect. Federal reserve data shows that bank reserves had fallen to well below 1% of deposits. That only works during the boom years; when markets began to flag, and then seriously head downward, banks pulled back their lending because they saw banks failing, being taken over by the FDIC, and those that were still left standing panicked, beginning a mad rush for deposits that took bank reserves to about 12% (as of 4/8/09, reserves $861 bil, deposits of $7,361 bil). Eric deCarbonnel has a nice article on bank reserves steadily moving to basically zero.

It was the over-use of leverage that created the conditions for the financial collapse, and the main culprit is the fractional reserve banking system. Don't blame honest accounting for the collapse.

Did the Gold Standard Cause the Great Depression?

(I'll be out of town until 4/12, so I won't be blogging. Can you live without me?)

A fascinating 1997 paper by Barry Eichengreen and Peter Temin argues that the gold standard caused the Great Depression. (Well, at least that the gold standard 'mentalite' was part of a set of factors that caused the Depression.) Eichengreen (UC Berkeley) and Temin (MIT) are top-notch economists; each has published a slew of articles on economic history. They represent the mainstream orthodox neoclassical-Keynesian synthesis on this point.

In this view, which is really more Keynesian than classical, sound money tends to tie the hands of government during a recession. Sound money is 'inelastic', you see, and cannot be made to do what government officials want it to do. The government often wants the impossible: lots of spending, while at the same time cutting taxes.

Eichengreen and Temin's paper is good to read alongside Murray Rothbard's America's Great Depression. (Freely available in its entirety at the previous link). Rothbard essentially argues the opposite: it was the rapid expansion of bank credit during the 1920s which caused the inevitable contraction in the money supply as banks rushed to cover; the government's response in the form of stimulus made things far worse by lengthening the time of adjustment.

FASB Suspends Mark-to-market Accounting Rules

And the market loves it! The Dow is up 270 points as I write this. (Here's a link to a WSJ article on this development.)

Well, we should have known that with the steady drumbeat of analysis (examples here, here, and here) blaming the financial crisis on mark-to-market accounting that this would eventually happen.

Unbelievable. It is absolutely absurd to blame the financial crisis on mark-to-market accounting. What causes banks to suddenly realize that they have solvency problems is that they are insolvent every single day of every year; it's only that a dip in asset prices causes them to worry about it for the first time. Modern banks run on the fractional reserve system. During a credit boom, market competition pushes banks to decrease their reserve ratios, for this is key to higher profits. The Fed tends to look the other way as banks move assets around to avoid mandatory reserve requirements (either 10% or 3% depending on the size of the bank.) According to Fed data, aggregate bank reserves fell to 0.74% of bank deposits, showing that banks are adept at getting around mandated reserve ratios. (Reserves have exploded since the fall of 2008, showing the fear that has struck the banks.)

Allowing corporations more flexibility to value their assets (i.e. facilitating wishful thinking or outright deception) will not make this crisis go away, it will prolong it. The crisis will be over when markets clear. That requires accurate information, not opacity.

Krugman vs. Austrian View of Booms and Busts

Robert Murphy has an interesting blog post on the Austrian economic explanation for booms and busts. Austrian economics is based on the writings of Carl Menger, Ludwig von Mises, Friedrich Hayek, and Murray Rothbard.

This post is a critique of a recent post by Paul Krugman, who seems to intentionally misunderstand the views of other schools of thought in economics. Is it so difficult to understand each perspective and give it a fair hearing before attempting to refute it?

It seems this crisis may offer an opportunity to test which of the predictions from these schools of thought end up being more accurate: the Keynesian view, as seen in Paul Krugman's writings, or the Austrian view. For example, Krugman writes:

Just a quick note on the new, pessimistic CBO budget projections:
1. These projections have no bearing on the case for a large stimulus now — none. Adding, say, another $600 billion to stimulus spending would, on net, add around $400 billion to debt a decade from now (net is less than gross because the stimulus expands GDP, which leads to higher revenues that partly offset the initial outlay.)

This is a testable hypothesis. We shall see if it is the case that spending another $600 bil actually results in an addition of (only) $400 bil in debt in a decade.

Just to be fair, let me throw in my own prediction: this crisis will be a severe test of the Keynesian faith in monetary and fiscal stimulus, for neither one is capable of solving the problem. All indications point to an inflationary recession and stagnation, much like the Japanese experience of the 1990s. Of course, Japan did not have the world's reserve currency. We do, and we're tempted to use that power to inflate away our massive debts. I predict we will do so, like Roosevelt did in 1933 when he essentially defaulted on US debt by suspending the gold standard and devaluing the dollar by 41%.

Rather than saying, along with Krugman, that debt doesn't matter, we ought to be recognizing that expanding the Federal debt burden to finance an economic stimulus is exactly the wrong direction. We ought to trim spending and cut taxes, and get out of the way of the inevitable economic adjustment to equilibrium.

Amariglio vs. DeLong

Looking for an amusing diversion from the financial collapse?

Have a look at Brad DeLong's blog post from 2007 attempting to take David Ruccio and Jack Amariglio to task over the definition of postmodernism and its legacy. Did he even read their book Postmodern Moments in Modern Economics before attempting to teach them the meaning of the term 'postmodern'?

The amusing part is Amariglio's response. I have not seen such an erudite and proper public spanking in some time. It reminds me of Jim Cramer's recent treatment on the Daily Show. DeLong had nothing to say in response, because it is evident that he has only the most cursory exposure to the ideas he is attempting to discuss.