i'll just talk to myself here a bit...

Thomas Lord

Fri Oct 03 19:03:09 -0700 2008

manage

We already have consumer choices between federally insured, completely uninsured, direct t-bills, etc. The new elements here are mainly the "taxpayer-preferred" treasury bonds with their steep at-the-treasury reserve requirement and surplus-income-to-general-fund rule; the end of FDIC as we know it but replacement with arbitrary-size deposits backed by taxpayer-preferred bonds; and the goal (hopefully the outcome) of very simple to understand yet profoundly meaningful consumer accounts where the customer gets to literally pick the X in his X% of risk.

When we don't have those new elements, the "X" of that X% risk is decided by a centralized process. It's kind of set by the executive, in operating the regulatory regime, the legislature, in defining the parameters of regulation, the fed and the treasury. We have a cabal, more or less by accident, choosing the value of "X riskiness" for most USians (i.e., for all "small depositors"). The regulation slacks for some random reason or other and cash flows inappropriately into the finance market -- which when lost leaves banks in crisis and meanwhile creates stuff like the housing bubble or other inflationary bubbles. It's that centralization of determining X it'd be good to get rid of. Democratize it not by overhauling our monetary system in some radical way but simply by creating the option of very-high-reserve-requirement deposits and withdrawing federal insurance from any other kind of deposit.

-t

i'll just talk to myself here a bit...

Thomas Lord

Fri Oct 03 19:27:09 -0700 2008

manage

Another way to say it: what should the reserve requirements on the acceptor of a particular deposit be? Well, engineer it so that (a) there is a state-based maximum requirement that is quite high; (b) it's easy and customary for each depositor to pick.

What can't be guaranteed in this system is the availability of a level of risk deposit X. It's highly probable deposits at risk level X% will be available for most X up to the reserve rate for taxpayer-preferred bonds, just not guaranteed that X will be available.

Which kinda makes sense as a natural fit to real life, if you think about it.

-t

containing taxpayer exposure

John Dalton

Fri Oct 03 19:11:55 -0700 2008

manage

You might be interested in the model Australian Superannuation funds use.

HESTA, one of the bigger "industry" (ie. non-profit) funds can be used as a typical example. Within your single superannuation account you can select a mix of risk options. These options are summarised on their investment returns page. They range from "Fixed Interest" options (essentially bonds) to various property and share options. You have a choice of international exposure or no international exposure.

The mix can be varied on-line, at will, by logging into their website. Essentially you are presented with a page on which all the investment classes are listed. You enter a percentage next to each and the sum of the percentages must be 100%.

They also offer a set of predefined mixes, classified from high risk to low risk. Alternatively you can go completely hands off and say just let them do everything, all summarised here.

containing taxpayer exposure

disco

Fri Oct 03 20:30:56 -0700 2008

manage

My understanding is that the FDIC insurance is, under normal circumstances, paid for by the banks, not taxpayers. Taxpayers only come into play if the pooled funds run out, which they're at risk of now, but they haven't yet.

> The new constraint (regulation) on banks would require that the bank not leverage insured deposits in any way except by investing it in federally insured instruments (such as treasury bonds).

a) Treasury bonds are only sold by the government to fund their deficit. No deficit (which is what we should aim for) = no need to sell treasuries. What do you propose the banks do with the money the budget is balanced? Even if we have a deficit there'll be significantly more deposits than there'll be deficit, and why would the government be fiscally responsible if they were now awash in all this income?

b) Where is anybody going to get a mortgage, or any other loan for that matter?

c) This is the antithesis of capitalism: "with these funds you'll do business with the government and no-one else". An enforced monpoly. It won't exactly be an efficient market, will be ripe for corruption, I don't see consumers getting much out of it, and who'd want to run a retail bank anymore? What's in it for them? 2% return on treasuries?

containing taxpayer exposure

Thomas Lord

Fri Oct 03 21:32:20 -0700 2008

manage

Yes, that's the kind of thing I'm looking for. I think I have pretty good rebuttals to those but (just so it' known) I'm soon off to bed and the weekend routine means it'll be a day, give or take, or so before I reply to this (or similar that comes in).

Thanks,
-t

containing taxpayer exposure

Thomas Lord

Sat Oct 04 08:38:54 -0700 2008

manage

My understanding is that the FDIC insurance is, under normal circumstances, paid for by the banks, not taxpayers. Taxpayers only come into play if the pooled funds run out, which they're at risk of now, but they haven't yet.

The problem is that FDIC's reserve level is basically under Congressional control with any shortfall from excessive claims coming out of the general budget of the US. So, the taxpayers are on the hook. Were enough banks holding insured deposits to fail over the next year or so, FDIC would run out of money until the taxpayers went deeper into debt to cover them.

a) Treasury bonds are only sold by the government to fund their deficit. No deficit (which is what we should aim for) = no need to sell treasuries. What do you propose the banks do with the money the budget is balanced? Even if we have a deficit there'll be significantly more deposits than there'll be deficit, and why would the government be fiscally responsible if they were now awash in all this income?

The new kind of treasury proposed, a "taxpayer-preferred bond", could generate a little bit of deficit funding for the federal government but, by design, not a lot. The bulk of the money due at maturity of the bond isn't available for government spending: it literally just has to "sit there" (the horrors!). The purpose of such bonds is not deficit funding but to encourage savings and investment by creating an instrument that serves as the basis for extremely robust forms of insurance with market-demand-driven reserve requirements. And these would be "hard" reserve requirements: no regulatory misjudgements possible.

The government would not be awash in income. The reserve behind taxpayer-preferred bonds and the amount of bonds outstanding is known to everyone, at all times. The only way congress could forcibly touch that money is by passing new legislation that lowers the reserve requirements: an event people are likely to notice and object to. Of course, congress could also get some of that money by imploring people to reduce their insured deposits and offering to redeem some bonds, at a discount, early.

c) This is the antithesis of capitalism: "with these funds you'll do business with the government and no-one else". An enforced monpoly.

I think that's twisting it a bit in an unfair way.

Running the "taxpayer-preferred bond" show is hardly a business. It's the role of borrowing money, doing nearly nothing with it, then returning it with very little interest.

It's nice to have around an entity engaged in that kind of "loser's business" if you are absolutely certain that that entity really just keeps the money in a vault and then gives it back -- if a deposit slip from the loser really is "good as gold". It's nice because then we can use those instruments to take a bit of the poker game out of everyone else's reserves.

I don't see consumers getting much out of it, and who'd want to run a retail bank anymore? What's in it for them? 2% return on treasuries?

I think in this system retail banking would look a bit different: it would be more common to have small depositor accounts which (by the choice of the consumer) are not 100% insured. If a customer wants 100% insurance, fine, then the bank is a fee-based service-provider to that customer. If the customer wants 50% insurance, now maybe the bank is paying interest on the checking account instead of collecting fees. The point is, it's mostly up to each consumer to pick a level of risk they like. Note that in a panic a lot of 50%-insured customers might want to rapidly shift to, say, 90% insured but they may not be able to if the bidding on taxpayer preferred bonds becomes too low to satisfy the reserve requirements on those.

Still, we wind up with a situation where if the bank does fail the customer gets his 50% back at no cost or risk to the taxpayers.

-t

containing taxpayer exposure

rubycodez

Fri Oct 03 22:10:50 -0700 2008

manage

the big problem isn't the deposit/withdrawal side, but keeping quality of loans high, and perhaps lack of transparency of loan status since those are the big assets. Have a plan for money supply side?

 

On a related note, normally the big assets (someone else's debt) of the fed itself are the most secure thing of all, treasury notes.  But now instead of 90% of the assets being those, now only 40% are and the rest are outside securities, much more risky.   hmmm, could the fed  be shaky like a so many troubled banks with too many of those securities being bad loans?  Could it even be this is the 800 lbs. gorilla riding the pink elephant in the corner of the room our treasury doesn't want to talk about, but has the senior members of our government ready to foul their britches?

containing taxpayer exposure

Thomas Lord

Sat Oct 04 08:59:23 -0700 2008

manage

the big problem isn't the deposit/withdrawal side, but keeping quality of loans high, and perhaps lack of transparency of loan status since those are the big assets. Have a plan for money supply side?

I'm thinking about the role of bond insurance in determining credit ratings. Insurance on crappy mortgage debt artificially inflated the bond ratings of the aggregated mortgages -- only then it turns out that the insurance is no good either. And then people lose confidence in the rating system and credit dries up.

This is part of why I want insured deposits (backed by taxpayer-preferred bonds) of basically unlimited amounts: these aren't just for retail:

Instead of someone saying "My shiny new CDO is insured at 90% par value by some big-name experts who looked it over say 'it's all good'" you would hear "My shiny new CDO is insured at 90% by those big names who back that up with 40% in insured reserves."

There would have been fewer but not 0 sub-prime mortgages, of higher quality.

On the related note part: I dunno. I see the rumors of the Fed's insolvency as well although I don't want to feed that bear.

-t

containing taxpayer exposure

Alcibiades

Fri Oct 03 23:28:23 -0700 2008

manage

You're only seeing part of the problem.  There is a problem with the security of customer deposits.    But that is a fairly small part of the general problem, and its very easy to fix.  Government guarantees of deposits is one way.  It obviously needs to be coupled to proper bank regulation and auditing.

The present problem with the financial system however is not do do with that.  Its to do with credit and the creation of credit.  In this respect, its similar to the twenties.  With the creation of the Fed, reserve requirements were lowered, and in consequence banks had the ability to lend far more.  The process is documented in Murray Rothbard's book.  Fannie and Freddie did something similar with mortgages.  When mortgages could be originated and sold, and then financed from F&F bonds rather than from savings deposits, we started to make housing credit into a form of government bond, and so increase the supply.  When we started to use commercial bonds for the same purpose, the supply of housing credit rose further.  This in turn produced a boom in prices.  This in turn produced a rise in the value of assets that could be used as security for raising more debt.

This is one form of government sponsored credit boom.  As it goes on, consumer deposits are probably the least important source of credit. 

At the peak, in the economy as a whole, debt rises to the point where the servicing of it requires the issuance of ever more debt.  Before that point is reached however, the effectiveness of incremental amounts of debt starts to diminish.  The extra debt incurred raises prices lower and lower percentages.  It produces smaller and smaller increases in consumer spend.

In the later stages of a credit bubble, the first large default is a key marker.  The difficulty is that X has failed.  Before they failed, it was inconceivable that such a thing should happen.  X had been in business 100 or 200 years, an old established firm, marble and mahogany.  Now its happened, and people start to worry about who else might fail.  Cautionary tales start to spread about Y, who had some float on deposit overnight with X.  After a little while, loans of all kinds to anyone start to seem too risky in relation to the gain.  I have cash now, why should I put it into 30 day commercial paper even from blue chip companies?  Anything can happen in 30 days.  At this point, the process goes into reverse, and banks no longer have money to lend.  They cannot sell on any mortgages if they grant them.  Bonds are not being bought or rolled over.  The supply of credit shrinks, and lots of economic activities now become simply impossible.  As this goes on, tax receipts fall, state and local governments find they cannot meet payroll, from taxes, and cannot borrow to meet it either.  The laid off employees cannot buy stuff, cannot pay their mortgages.....so there are more defaults.

Any solution to this problem has to address the credit cycle, the ability and willingness of governments to create credit bubbles.  Solving the problem of how to insure deposits in one way or another is quite important, and the detail of how to do it best is quite interesting and difficult, but its not the core of the problem with the economic system.  Read the Austrian economists - Mises and von Hayek.  Google 'Minsky Moment'.  The Austrians had lived through a disastrous credit bubble and spent all their subsequent intellectual lives trying to understand it.  They fell out of fashion as the memory of those times faded enough that we could repeat that history without realizing it.  But they are back now with a vengeance, as we find we have done just that.

There is no solution to the present problem that does not involve the large scale writing off of bad debt.  This basically means that shareholders in institutions which have made those bad loans get wiped out.  Their bonds default to some degree.  The money is lost.  The loans were bad, the assets have lost value, those half built condos on the Florida coast are toast.  Just as all those routers and fiber will never be used, those semi factories will lie idle.  It all has to be closed down, and the assets redeployed as best can be done.  Maybe they are worth something as landfill.

We are one third or less of the way into this.  What is coming next is hedge fund crashes, a blowup in the credit default swaps market, lots of state and local government bankruptcies, commercial real estate bust, bankruptcies in consumer goods manufacturing. At some point the government is going to realize it cannot raise enough money to save everyone.  The classic mistake made in the thirties was the desperate and futile effort to keep everyone working in the same job, making the same things, and selling them for the same prices.  In fact, the bailout is a modern version of this, it will make matters worse, because it will soak up the limited amount of credit still left in the economy, and direct it to unproductive purposes and the acquisition of worthless assets at inflated prices.

The issue is not really reducing taxpayer exposure from deposit loss.  The issue is restructuring the finance system around these huge writeoffs and losses, and getting the country through the resulting convulsions in employment that result.  It is going to be painful, real painful, but we had the boom and now have no way to avoid the bust.

containing taxpayer exposure

Thomas Lord

Sat Oct 04 09:05:39 -0700 2008

manage

The credit cycle this recent time when boom then bust because of bogus insurance on CDOs, right? Bond ratings basically came out of thin air and were completely unjustified. For something uncertain and unclear like a CDO, buyers could demand that the insurance be itself backed by a substantial insured reserve.

Remember, a key element of my plan here is no limit on insured deposits. These aren't just for retail. They are also for "put your money where your mouth is" when people talk up the value of more complex instruments.

Taxpayer exposure is a big deal as we're now discovering that, like it or not, the taxpayers insured a lot of crap "de facto". Never again, to that. This form of insured deposits helps by making ratings claims less plausible in the first place unless they are backed by substantial insured deposits.

It might be interesting to figure out what it would be like if we got to a state where, most of the time, half of all money were in insured deposits. It would make unwinding of bogus positions in the other half a lot less painful.

-t

containing taxpayer exposure

Alcibiades

Sat Oct 04 23:22:14 -0700 2008

manage

The credit cycle this recent time when boom then bust because of bogus insurance on CDOs, right?

No, not really.  That was a symptom not a driver.  The driver is the rising supply of credit, which is directed to less and less credit worthy borrowers and projects, until finally one of them defaults.  The ratings issues, subprime and other madnesses are all symptoms.  The underlying driver is the quantity of credit.  This is driven by the government.   Its easy to get confused about what is driving it, versus the signs that it is going on. 

Yes, we should clean up ratings.  Yes, we should better insure deposits.  But this will make no difference unless we stop creating mountains of credit that the lending institutions then feel obliged to move.  Read Rothbard and Mises to understand this.

containing taxpayer exposure

Thomas Lord

Sun Oct 05 10:35:30 -0700 2008

manage

The driver is the rising supply of credit, which is directed to less and less credit worthy borrowers and projects, until finally one of them defaults. The ratings issues, subprime and other madnesses are all symptoms.

I sort of agree but not quite. Yes, too much credit was bogusly extended so we have to ask why: what processes drove that.

Insurance, including bond insurance, is a form of credit. The insurer, in effect, loans the insured the value of the policy but records it as a deposit in the insurer's liability column. The insured pays for the policy, effectively paying interest on the loan. We know now that the reserves backing those deposits were inadequate to keep the market confident.

The bogus credit offered to CDO sellers in turn drove extension of bogus credit to unqualified borrowers, thus forcing the eventual unwinding. The bogus credit offered to CDO sellers also raised the price of CDOs, making it temporarily very profitable to crank out bad mortgages and sell CDOs.

You say "the underlying driver is the quantity of credit", ok, but, that is pretty much tautological. Why did the quantity rise so high? The Fed should be lowering the price of cash at times when demand for cash by sound lenders is high. The problem here was that the set of instruments in play fooled the models customarily used to recognize "sound lenders". Gee, insurance on these bonds, AAA ratings on some of them ... historically these are usually good indicators of safe bets and fueling that fire with cash would be expected to lead to non-inflationary or at least low-inflation growth.

So, it was the bogus quality of insurance and ratings that "tricked" the fed into lending out. To be sure, when the fed observed the inflation of housing prices that should have sent up a red flag and led to some regulatory changes but, well, that didn't happen.

The quality of insurance and the quality of ratings as it stands is basically a bunch of BS. The quality is supposed to be maintained by a mix of regulation and by reputation and past performance. Which is a fancy way of saying that a few thousand guys and gals in expensive suits sit around various tables and make stuff up.

You can't fix that by printing up some new rules for those few thousand folks to follow. They'll get fooled again. And you know the old saying: "Fool me once, shame on ...uh... you... you fool me ... uh ... you can't get fooled again."

The heart of the issue was credit extended by financial elite institutions on the basis of their opinions rather than on the basis of proved reserves. They underwrote much more than they ought to have without the goods to back it up. Instead of trying to fix this with new regulation, why not create a new class of instruments - proven reserves - and let markets demand the proven reserve levels they are comfortable with? That's what a "taxpayer preferred bond" would be: a proven reserve. For example, if someone tells you that they are insured up to $K you ask to see the insurer's proven reserves before you decide that $K (or some part of it) is sound.

If the market in fact demanded to see proven reserves behind CDOs (rather than just the speculative current price of the collateral on the loan) then insuring CDOs would have been much more expensive and less of it would have happened. With less of that happening, credit to consumers and homeowners would not have been so liberal and there wouldn't have been a mad rush to hand out mortgages on the street.

Another nice thing about adding a new instrument like proven reserves rather than trying to radically reform regulation is that nobody has to suddenly rewrite their books. "Mark to market" becomes a less important question. On the other hand, financial reports from financial firms need to expand with two new numbers: proven reserves and insured liabilities. Under no circumstance should the latter (insured liabilities) rise beyond the former (proven reserves). If markets adopt and begin to use a new proven reserve instrument, there can be an orderly transition while the market itself works out the right reserve level.

We agree that creating mountains of credit is the problem. I'm saying that if we want credit at all (and of course we do) then we'll always have trouble tuning the right amount of credit to have so long as that's centrally decided. Taxpayer-preferred bonds create an instrument that let's the market decide.

-t

austrian hoohaw

Thomas Lord

Sun Oct 05 15:47:10 -0700 2008

manage

Read the Austrian economists - Mises and von Hayek.

With prompting from commentators on this blog I've started looking into them a bit. So far I'm impressed mainly by the curious similar to another Austrian school of thought: Freudianism.

As with Freud they seem to consider an eclectic and biased selection of qualitative observations using the tools of a qualitative, intuitive application of fluid dynamics.

A neat thing about fluid dynamics is that, like approximations to a fourier transform, you can encode just about any signal you like, often compactly. Freud was able to (approximately) "sum up" a lot of observed psychological phenomenon by offering a fluidic circuit with similar behavior; the Austrian economists seem to do something similar. Problem is, there's no (true) demonstration of mechanism there; no predictive power that's useful; etc. It's like Freud invented a system of mnemonics to sum up his note-books compactly -- the economists are doing something similar.

It doesn't look like particularly good work.

-t

austrian hoohaw

Alcibiades

Sun Oct 05 22:50:23 -0700 2008

manage

Rothbard's history of the Depression is the thing to start with.  No, it is not like Freud at all.  Its a quantified economic history, with the evidence laid out in tabular form on lots of pages.

Actually, your own position on savings and lending is in some ways not far from the Austrian one (proving Keynes' acid remark that people riding an economic or political hobby horse will usually be found to be reverting to an obsolete economic theory). 

The Ausrian view would be that governments should not intervene to cause credit to grow over the population's propensity to save.  Or put it another way, banks should lend based on prudent use of deposits with appropriate reserve ratios.  Its not too far from what you say, except you locate the core of the problem and its solution in measures to safeguard deposits, but you arrive at a very similar solution.  It would have a lot more important and larger implications than deposit safety, but yes, it is actually the issue at the heart of the credit boom.   The problem was Fannie and Freddie and the Fed, who together mulitplied the amount of credit available to Americans way over what would have been available had it been determined by their propensity to save.

Hence we got net dissaving accompanied by ever rising borrowing.

austrian hoohaw

Thomas Lord

Mon Oct 06 08:48:49 -0700 2008

manage

your own position on savings and lending is in some ways not far from the Austrian one

I don't think that too liberal credit led to over-investment in capital equipment and raw materials that then outstripped demand leading to a bust.

Domestically, if anything we are woefully under-invested in real productive capacity.

Robert Reich in yesterday's S.F. Chronicle offers a pretty simple explanation for demand collapse: US labor prices (middle class wages) in real terms are all but flat from 30 years ago but meanwhile the top 1% has more than doubled its take-home share of business revenues from only 8 years ago. That top 1% isn't consuming a proportionally larger amount nor are they investing it in real productivity (that is, in useful enterprises that would tend to increase the price of labor by coming up with more for labor to do).

I would add to his observation that neither monetary policy change or increased government spending can fix that, alone or both combined. It fundamentally requires a serious attitude (and hence behavior) change by our fiscal elite. Perhaps they will be thrashed badly enough by the current crisis that such change may begin to come about.

Guy in "Credit where credit is due" offered that open source technocrat types ought to just act as if they are in charge, without a care in the world for their own immediate needs, and engage in a program of "management by walking around" in their own regional back-yards. That is, go and find the regional opportunities that languish under absent or over-leveraged investment in real productive capacity, identify which of those opportunities can be done "faster, cheaper, better" especially using all-things-"open", and give freely of that knowledge. If successful, such a program would begin to stimulate demand for real productive capacity.

The combination of Guy's idea and similar ideas with direct stimulus to consumers and monetary policy tweaks to ease the current logjam could work to damp down the so-called business cycle while at the same time creating economic progress.

The Ausrian view would be that governments should not intervene to cause credit to grow over the population's propensity to save.

And that is not my view. Real production is not a 0-sum game. An inflationary monetary policy is the best model we've got. We get into problems only when central lenders misjudge the borrowers, as in the case at hand. There is no simple fix to that. You can't just write down some new regulations and expect that to change much. You can't simply throw good money after bad. You can't stimulate your way out of it. What you can do is create alternative, more conservative instruments to help the market balance out monetary policy: what the fed overly-giveth, a nervous market can quietly stick back on the shelf for a rainy day (by putting it in proven reserves). And what we ultimately have to bring about is that attitude/behavior change back towards investment in real productive capacity.

The problem was Fannie and Freddie and the Fed, who together mulitplied the amount of credit available to Americans way over what would have been available had it been determined by their propensity to save.

Hence we got net dissaving accompanied by ever rising borrowing.

Back to Robert Reich's piece:

The average productivity of an American worker has gone up over the past 30 years with wages staying flat and with inflation. To compensate, the US labor force upped the number of working adults per household, upped the number of hours worked, and then finally started dipping into credit in a big way. Meanwhile, real productive capacity has fled (which helps to explain wage stagnation).

The way back is to increase wages by stimulating domestic demand for labor which is done by investing in real productive capacity. To do so will require that the top few % begin accepting smaller shares of revenues and start looking for better, more meaningful investments for what they've got.

It shouldn't be a hard sell, really. Which would you rather grow old as: a gazillionair in a decrepit, hostile, barren land or an average joe in a wealthy land of plenty?

-t

austrian hoohaw

Alcibiades

Mon Oct 06 23:42:10 -0700 2008

manage

The first place I saw the claim that the problem of the depression was income disparities was in Galbraith.  Galbraith has an unerring ability to focus on symptoms and think they were causes. Its not surprising that it is repeated now. 

It is getting things exactly reversed.  Credit bubbles cause and accentuate income disparities, not the other way around.  They distort the economy, so that those activities to do with manipulation of money and credit and funnelling of investment become hugely profitable and very large, and also, they produce asset price inflation, particularly financial asset price inflation, and this generally favors the rich.

The other great difficulty with credit bubbles is that the flow of credit is unpredictable.  We know there will be malinvestment, we just can't tell in advance where it will be.  In the recent bubble, the malinvestment was in real estate.  There are more houses of the wrong sort than America needs, in the wrong places, and more real estate agents probably than the whole world needs, with all the associated investment.  You say that " I don't think that too liberal credit led to over-investment in capital equipment and raw materials that then outstripped demand leading to a bust".  But this is exactly what has happened twice in the last 10 years:  once with the dot com bubble, and now with the Florida (and elsewhere) condo bubble. 

We also do have over investment in some kinds of manufacturing, it is just that it has not happened in America for America.  Its happened in Asia for America, by American companies, but there are still way too many plants making far too many goods that people cannot buy. A big motor for this malinvestment has been the opacity of the Chinese loan and banking system.  The big one coming down the pipe is the wholesale bankruptcy of Chinese banking as their wildly generous loans go bust.  Whether we will see it through the veil of Chines accounting is a different matter.  A huge amount of this malinvestment has been financed by the US trade deficit, and that in turn by the US Government spending deficit.

The Austrian account is not so much that there is over investment, its not the quantity they emphasize, though there is too much.  It is not said to be general however, the problem is that some areas may be starved, and others have an enormous glut.  This is why its called malinvestment not over investment.  Look at all those Florida condos, or greater LA for examples, or indeed China.

The place you are fairly close to Austrian prescriptions is what the effect of your proposals would be on the relation between savings and lending by banks.

I agree with your account of what has happened to American working households, who could not?  But the cause is due to heavy deficit spending and a credit bubble.  Over-spending on defence, wars, combined with a desire (rather determination) to finance it out of somethng other than taxation.  Its like a desire to have huge investments and enormous volumes of loans, combined with a desire to finance it out of something other than savings.  There is no such crittur.  And so we get a global credit boom, which eventually busts.

It is very natural to look at the fact that wages have not risen, and think this is the problem, and in a way it is.  But you have to look deeper.  What is the reason for the collapse of labor bargaining power?  Just as the explanation of the bubble is not (pace Galbraith) greed.  Greed we have always with us:  ask rather, what made it work this way this time?

austrian hoohaw

Thomas Lord

Tue Oct 07 11:01:26 -0700 2008

manage

Credit bubbles cause and accentuate income disparities, not the other way around. They distort the economy, so that those activities to do with manipulation of money and credit and funnelling of investment become hugely profitable and very large, and also, they produce asset price inflation, particularly financial asset price inflation, and this generally favors the rich.

This does come down to competing claims about cause and effect. If you ask me, the growth of financial industries during a credit bubble is the main malinvestment. Big investors unwisely try to lay claim to as many gains as possible and to "put those to work" in financial markets with relatively few investors rolling up their shirt-sleeves and investing directly in real productive capacity. Then you wind up with very little growth in real production coupled to huge growth in leverage until things are forced to unwind.

The problem here wasn't that investors were given too much cash. The problem wasn't a shortage of demand for cash for investment in real production. The problem is simply poor spending decisions on the part of the economic elite.

It isn't a problem that can be fixed by making money more expensive. When the big investors are flush they argue they can't make long term investments in real production because they need their money to "work harder than that" and when they are nearly bust they can't put their money in real production because they need to protect their remaining assets. The credit knob doesn't much help.

This is part of why I think the problem is more a culture problem: the root cause lies in the world view and value systems of the average economic elite. And I don't only think this on the basis of macro-economic results but also based on direct observation and interaction with some of these folks. They live in an echo chamber. They are, indeed, snobs (as a general rule, with exceptions). They listen to one another using a different set of rules and a different frame of mind from the way they listen to everyone else. They are impervious to criticism of their investment choices. They are constitutionally unable to consider good ideas from outside of their immediate society (where "good" means something other than "strokes their egos and fantasies"). They're nuts. They're bonkers. The fed loosens up credit and Greenspan tut-tuts about how the aim is to work on real productive capacity and those fucks just pocket it as fast as they can and head to the race track. In recent years they've taken to expressing their denial over their lameness by investing in simulacrums of real productive capacity like space tourism, electric sports cars, the New Eugenics, and the Wacky World of the Web 2.0 Corporate Police State and Slave Plantation. And then they act all surprised when their house of cards financial plays go bust.

It ain't the availability of credit that does that. That's all *them*.

The other great difficulty with credit bubbles is that the flow of credit is unpredictable. We know there will be malinvestment, we just can't tell in advance where it will be. In the recent bubble, the malinvestment was in real estate. There are more houses of the wrong sort than America needs, in the wrong places, and more real estate agents probably than the whole world needs, with all the associated investment. You say that " I don't think that too liberal credit led to over-investment in capital equipment and raw materials that then outstripped demand leading to a bust". But this is exactly what has happened twice in the last 10 years: once with the dot com bubble, and now with the Florida (and elsewhere) condo bubble.

So, there's one topic there we might want to draw out into other threads and over time because it is complicated and interesting. I think I would be prepared to debate that, no, on the contrary, our housing stock post-bubble is a net improvement not an over-investment. The numbers on paper are all screwed up - too many properties are way too over-leveraged - but with apologies to Jim Kunstler I don't think we have a fundamentally irrational stock, on the whole.

The demand-collapse for housing does not, I think, make the Austrian case that credit bubbles create over-investment in productive capacity and the evidence for this is the sharp rises in employment and housing insecurity. The pricing bubble for housing is a symptom of over-leveraging investment in housing production. It became a bubble (with attendant bust) because of under-investment in the real production that would raise demand for labor.

You could say "there was too much credit in the sense that the bozos at the top had no good clue what to do with it" and I wouldn't disagree but I would say it's the bozos that need fixing, not the credit supply.

In that light, when you say:

The Austrian account is not so much that there is over investment, its not the quantity they emphasize, though there is too much. It is not said to be general however, the problem is that some areas may be starved, and others have an enormous glut. This is why its called malinvestment not over investment. Look at all those Florida condos, or greater LA for examples, or indeed China.

Well, yes, malinvestment is formed by a combination of inexpensive money plus bozos. The inexpensive money isn't the problem -- it's needed for good reasons all over the place. It's the bozos that are the problem. That's part of what I meant when elsewhere I talked about the boom bust cycle being the "ping" (or, I prefer the analogy "degaussing button") that creates opportunity for improvement: there's some chance here to displace or at least maybe change the thinking of the bozos.

It is very natural to look at the fact that wages have not risen, and think this is the problem, and in a way it is. But you have to look deeper. What is the reason for the collapse of labor bargaining power? Just as the explanation of the bubble is not (pace Galbraith) greed. Greed we have always with us: ask rather, what made it work this way this time?

I have a theory about that which amounts to: a generational shift in the economic elite. The reins have been passing to a generation that doesn't really get "how stuff works"; that has done very little physical work themselves; that mostly faked their way through science and engineering classes overestimating the profundity of the few accomplishments they achieved. It's (on average) a bunch of pampered brats.

Guy wrote some beautiful stuff on this blog, months or maybe a year ago about his experiences as a marine engineer and the differences between old money (the employer who gets down there in the bilge with you and helps bail because as much as he wants your labor to maintain the boat he also wants to keep a feel for how its going) vs. new money (the oblivious guy who thinks if he just orders everything to be done by noon loud enough and then shorts you on the money later while insulting your character in the process that this is good management and is how things "get done"). New money's attitudes attract and select for a swarm of sychophantic and useless attendants sheltering oneself from all hard reality and it is from that context that new money makes its "qualified investor" choices.

The other problem, as I've written elsewhere, is us software engineers. We sent the most mediocre, self-centered, vaguely sociopathic, pathological liars into the financial industry and the rest of us basically sighed with relief "Oh, good, at least that ass isn't someone I'll have to work with day to day". Once there, they BSed like mad and used that as cover to start playing "core wars" with trading systems on someone else's dime. They and "new money" were made for each other.

-t

austrian hoohaw

Alcibiades

Tue Oct 07 23:04:09 -0700 2008

manage

The most powerful observation that the Austrian account explains, but which yours has problems with, is that when the credit bubble occurs, the same people start to behave crazily who behaved quite reasonably only a couple years earlier.  We can assume that the bankers and brokers are equally greedy and incompetent all the time.  However, at one point in history, they are insisting on proof of income, and only lending 2-3 times gross income on mortgages.  Then all of a sudden they are throwing money at people.  Rothbard in his book on the Depression makes the same point about industrial investment.  Why is it that managers who previously were very able for many decades to make reasonable decisions about investment and capacity suddenly go crazy?  They are just as competent as they used to be.  His answer is, the cues in the environment have changed.  Who changed them?  His answer:  the government.

The problem with using greed and incompetence of the elite as the explanation, is that this did not change.  Its a bit like using lust as the explanation of a sudden wave of sexual promiscuity.  But people have been equally lustful through time and across the globe:  what we are trying to explain is why this lustfulness resulted in a sudden wave of promiscuity in country X in year Y.

What happened in the US was that real interest rates were lowered to the extent that in fact the lenders were paying you to borrow.  There was actually a negative carrying cost on your loans.  That in turn made riskier and lower return projects seem attractive and rational.  It is not that the Austrian account wants to see higher interest rates.  It wants to see interest rates and levels of investment that vary with propensity to save.  It is about balance between saving and investment.  At some times this will lead to higher rates, at others to lower ones.  Its should be a system with some feedback in it, and the feedback should not be some guy in Washington setting a price for money, any more than the feedback on (say) disk drives or dual core processors or cars, or chisels, should be some guy in Washington deciding how many to make of what size and selling at what price.

I think you are only half right about the malinvestment being in the finance sector.  It is of course.  But it is also in where the overgrown finance sector directs the flow of credit to. In previous times its been  the Mississipi, Darien, the South Sea, canals, railways,  radio, dot coms...   And  that's just Europe and the UK!

austrian hoohaw

Thomas Lord

Wed Oct 08 09:59:07 -0700 2008

manage

See, you've given a fine example of how the Austrian school seems (like Freud) to use a kind of hand-waving, qualitative, fluid-dynamics style of pseudo-model. Let's look at this:

The most powerful observation that the Austrian account explains, but which yours has problems with, is that when the credit bubble occurs, the same people start to behave crazily who behaved quite reasonably only a couple years earlier. We can assume that the bankers and brokers are equally greedy and incompetent all the time. However, at one point in history, they are insisting on proof of income, and only lending 2-3 times gross income on mortgages. Then all of a sudden they are throwing money at people. Rothbard in his book on the Depression makes the same point about industrial investment. Why is it that managers who previously were very able for many decades to make reasonable decisions about investment and capacity suddenly go crazy? They are just as competent as they used to be. His answer is, the cues in the environment have changed. Who changed them? His answer: the government.

That's kind of a "you push in here, it pops out there" explanation: too much pressure (cheap money) on the investors and they wind up being over-driven. Current (cash flow) through them does indeed rise but in this over-driven state the "rational" quality of their signal shaping falls away.

It's an intuitively pleasing explanation because it is simple to understand and appeals to a mechanical intuition. It's "just like" if the municipal water supplier doubled the pressure in the mains: suddenly a lot of household plumbing systems would exhibit "rationality failures" and develop leaks. The government should no more tinker with interest rates / money supply than the municipality should tinker with the water pressure in the mains.

Only... well... huh? The fluid flows in a plumbing system can be modeled with extreme quantitative precision. The mechanisms that give rise to the familiar properties of fluid flows are well and quantitatively understood down to the molecular level. The limits of our theories about, say, actual water flows are mainly limits in our ability to calculate fast enough. The quasi-fluidics in the Austrian explanation you gave share none of these properties. At best, they are a hand-waving, ex post facto analogy.

Indeed, while simple demand curves are a bit "fluid-like" in some coarse ways, overall it would be unlikely for trade overall to act like a fluid. There simply aren't enough trades for that to be plausible.

The specifics matter and I'm skeptical of any over-reaching claims that the causes of the Great Depression and current events are necessarily "the same" in any important way.

An example is the claim you attribute to the Austrian explanation that "what changed" -- the new "environmental signal" -- was the government lowering the price of money. On the one hand that raises the question of what precipitated that action by government (i.e., even if the explanation is correct are we looking at proximate cause or ultimate cause)? On the other hand, and much more importantly, a lot changed in the environment, not just interest rates.

At least my hypothesis (restated following) is falsifiable, at least given some transparency into the operations of the failing banks over the past few years. My hypothesis is that computerized trading and a big cloud of snake-oil BS around it is the ultimate cause. We know now, for example, that CDSs were over-valued. We know now, for example, that a lot of "you'll have to just trust us, it's all very complicated" surrounded the CDOs. Those problems were brought on by Moore's law, the Internet, and lot of greedy young hackers snowing people (possibly many snowing themselves). Recall that computerized arbitrage, for example, got started only around 30 years ago (giving rise to a precedentially important software patent, no less). The price of large data centers has absolutely crashed since then even while capacity skyrockets. A "complex derivative" in 1970 was something that a bunch of folks at desks with ledger books and printing calculators had to maintain. By 2000, it's something that "smart" programmers in cahoots with lawyers and a handful of economists huddle in a room to talk about, emerging with contract forms and a software artifact about which the knowledge claims made almost certainly exceed the knowledge possessed. The folks at desks with calculators are largely gone, replaced with executives staring at high-level-view "dash-boards" and trying to guess how what they see relates to all the "theory" going around about what the software is doing. There emerges by this time a vast labor shortage of brokers. With all of these new instruments floating around, financial firms took to literally pulling people in off the street: "Yesterday you were a bartender. Today, you sell CDOs."

Priming that pump: deploying the software, creating new instruments, creating a new climate of and approach to high-level financing -- none of that took much money. Cheap money didn't cause that. Cheap computers and snake-oil software engineers caused that.

Much of this (e.g., CDSs) were "off the regulatory map," my hypothesis continues by observing. The regulatory regime that formerly, for decades, was never completely off the rail managing the money supply was in effect bamboozled by an illusory appearance of real economic growth (growth in real productivity). That illusion was writ large on the books of the large banks. Indeed, if productivity had been growing as fast as it appeared by the old measuring techniques then loosening up the money supply would very much have been the right thing to do.

You can see support for my hypothesis in, for example, the number of financially unsophisticated home buyers who bought the explanation "home prices always go up; you'll be able to re-finance." And to a sophisticated investor (still someone naive about the math) that almost sounds plausible: the cheap mortgages will increase consumer confidence, create consumer demand, and drive the rest of the economy to catch up and support those rising home prices. Sure, why not? It all ultimately goes back to a cloud of BS kicked up by the CS types.

You can falsify my hypothesis with a forensic analysis of the development of these problematic instruments. Look at the history of the decision making and the rationales applied. Look at the timing relative to interest rate moves. Such forensics might give further evidence in support of the hypothesis and they could certainly falsify it.

My hypothesis has a second part that I think is less controversial and is also bad news for those looking for simple regulatory fixes. The second part is that IT has also made it certain that much or most trade in financial markets will be outside of regulatory regimes. The CDSs are a fine example. Famously the Clinton administration resisted regulating CDSs early on and this is regarded in hindsight as a fatal mistake. Not so, I would say, for if regulation had cracked down on CDSs then an extra-regulatory alternative would have been invented. The opportunity and motive to avoid the transaction costs of regulation were two palpable, too real to be ignored. The motive is simple economics. The opportunity was created by clounds of IT bullshit snake oil.

That's one reason why I like the idea of "proven reserves" and taxpayer preferred bonds: it creates a transparent instrument which sophisticated and unsophisticated investors alike can use, using market mechanisms, to test just how well their counter-parties really are secured. Current markets, instruments, and accounting practices offer no mechanism by which players can truly test the reserve levels of their counter-parties. Taxpayer preferred bonds would create such a mechanism and in a way that doesn't require radical reform to accounting practices or regulations.

The problem with using greed and incompetence of the elite as the explanation, is that this did not change. Its a bit like using lust as the explanation of a sudden wave of sexual promiscuity. But people have been equally lustful through time and across the globe: what we are trying to explain is why this lustfulness resulted in a sudden wave of promiscuity in country X in year Y.

Translating my hypothesis by analogy, it would be as if a bunch of guys in horned rimmed glasses with white lab coats and stacks of supposed medical research showed up in the night-clubs and convinced everyone that there was no STD risk at all for parties who take the vitamin pills they are selling -- so, it's free love time, baby. Vitamin pills aren't necessarily bad for you but relying on them to protect from AIDS or syphilis etc. is not exactly a well-founded theory. Yet if people believed it were well-founded, they would act accordingly and loosen the reigns on their former sexual conservatism.

What happened in the US was that real interest rates were lowered to the extent that in fact the lenders were paying you to borrow.

Wasn't that because of the IT inventions of CDOs (and similar) and CDSs? Perhaps I don't understand what you are referring to when you talk about the carrying costs being too high. If you don't have to carry the loan (thanks to securitization) then you're basically manufacturing CDOs and shoving them out the back door so of course the cost of carrying the loan long term is unimportant to you.

It is not that the Austrian account wants to see higher interest rates. It wants to see interest rates and levels of investment that vary with propensity to save. It is about balance between saving and investment.

The market itself can (I am arguing on the basis of my hypotheses) do that given a way to test the reserves of counter-parties without overburdening the system with new regulation. Thus, taxpayer preferred bonds. As I said, this makes playful adversaries out of the market and the central bank for once the market has "a lot" saved up in taxpayer preferred bonds then the market can decide, at each point in time, to counter any move by the central bank by raising or lowering its own free-market reserve requirements and thus taking money in or out of circulation itself.

Its should be a system with some feedback in it, and the feedback should not be some guy in Washington setting a price for money, any more than the feedback on (say) disk drives or dual core processors or cars, or chisels, should be some guy in Washington deciding how many to make of what size and selling at what price.

You can have both at once, each buffering the other, with taxpayer preferred bonds.

I think you are only half right about the malinvestment being in the finance sector. It is of course. But it is also in where the overgrown finance sector directs the flow of credit to. In previous times its been the Mississipi, Darien, the South Sea, canals, railways, radio, dot coms... And that's just Europe and the UK!

This gets to my call for a "cultural change" among the financial elite.

Now, I don't know how much you've read of Guy's posts but they're helpful here. Look at what he's doing with his own capital equipment purchases. He likes to "play" with Mother Machines (3-axis mills) and cost efficient automation and flexibility. He opportunistically shops the market and acquires when the getting is good. And, as a result, he is constantly honing a basis set of very flexible productive capacity with which to react to ever broader ranges of economic conditions.

Big investors needs a similar strategy -- a kind of "dollar cost averaging" strategy for investing in new, highly flexible, real productive capacity.

If real productive capacity was on a sounder basis, regionally, everywhere, then owners would have a far easier time reacting to the inevitable screw-ups in financial markets. Real wealth would be on a more secure footing and thus we'd enjoy more of the upside and less of the downside of chaos in financial markets.

-t

austrian hoohaw

Alcibiades

Fri Oct 10 00:42:51 -0700 2008

manage

My hypothesis is that computerized trading and a big cloud of snake-oil BS around it is the ultimate cause.

People thought, analogously, in the thirties, that what had caused the bubble was the rise in the number of special investment vehicles (holding companies), excessive margin trading and also mixed roles between commercial and investment banks.  It is always easy to point to things that happened at the time of the bubble, and think they were causes.

For the twenties, the rise in lending capacity of the banking system is well documented. We know how much it rose, we know what the reserve requirement changes were, we know finally when the changes occurred and what produced them. 

Similarly, we know that there was a long period during the last bubble when interest rates on loans were actually negative.  I have seen this quantified at 1% per year.  If people are in effect paying you to borrow, of course, you will.  This is none of it Austrian Hoohaw.  This is quantified economics and real world observations.

You only get negative interest rates when the supply of credit has been enormously increased.  It is not so much, in the Austrian view, that interest rates are lowered.  If that is all that happened, we would have queues for loans, and we would have non-price based credit rationing, but no increase in supply.  What actually happens, and happened in the latest bubble, is that the supply of credit is dramatically increased, and this lowers the price in risk adjusted terms.  So part of what happens is that riskier loans are priced very cheap.  Of course the Fed participated by lowering its own rates as supply increeased. 

So when the Austrians say that bankers and business managers behaved normally and responsibly for many years, but that we have to explain why their styles changed, and then point to something that had changed, it is nothing like Freud.  There is a real world phenomenon which is measurable and provable independently of the theory.  Freud of course the problem is, you appeal to the existence of repressed memories, whose existence you cannot prove independently of the theory.  This is quite different.  We say, there is a phenomenon, increased supply of credit.  It accompanies and predates a certain kind of behaviour in some sectors which are heavily credit sensitive.

I find it very odd that anyone could maintain that huge fluctuations in the supply of credit would not be expected to have any marked effect on behaviour of credit dependent sectors.

Is there any reason to think the twenties and today are similar?  Yes.  Both were characterized by enormous increases in the supply of credit, increases which can be quantified, and listed independently of any economic theory.

There is something to explain.  It is why bank guidelines changed.  In the UK, for instance, buying rental property on individual mortgage used to be impossible.  A mortgage of more than 2.5 times income was difficult or impossible to get.  A down payment of at least 10-15% was essential.  These were the rules by which loan officers were managed.  At some point they changed - either formally or informally.  We need to ask why.  It was not program trading, it happened when program trading was very small.  It was not derivatives - causation runs the other way, it was the abundance of credit that gave rise to the volume of derivatives.

Austrian economics is having a revival at the moment, and I would expect that in a few years it will be the mainstream Newsweek account of the economy.  Popular and textbook accounts will incorporate debt and credit cycles in a way they have not since Keynes.  Most of the arguments of the school have been accepted in academic accounts of the Depression.  After the current debacle, credit and credit movements will become mainstream elements.

This has been an interesting discussion, but I think probably I have little new to say now, so will drop out from further replies.  Thank you for the opportunity to argue the point, and for some spirited replies!

containing taxpayer exposure

President4242

Sat Oct 04 08:53:11 -0700 2008

manage

I hope it happens for the sake of the economy.  But my personal subscription will be going to the first 1:1 deposits to reserve bank that opens in the wake of this incredible stupidty. 

I'm sorry, but I'm willing to give up on the idea of interest entirely, at least for the majority of my money which is just cash flow anyway and will be until I can move myself out of the debtor class and into the investor class.  And I no longer believe, at all, that I can borrow money to invest my way out of debt.  So I'm better off searching for a bank that offers the 21st century version of a thrift:

1.  I want 100% reserve.  This is non-negotiable.

2.  I want direct deposit, might as well save some trees.

3.  I want a debit card, I'm fine with a hard limit money spent. 

4.  I want electronic checks.  No paper for me, and instantaneous.

That is all I've ever wanted from a bank, a service for processing my pay and paying my bills.  And I'm willing to pay as much as I'd pay an ISP for the service.

containing taxpayer exposure

Thomas Lord

Sat Oct 04 09:07:45 -0700 2008

manage

Shop around. You can probably find something just about like that or build yourself a pretty close approximation.

-t

containing taxpayer exposure

President4242

Mon Oct 06 07:18:58 -0700 2008

manage

I am, but I'm finding the tragedy of the commons has hit this:  Any bank like this will only be as profitable as it's subscriptions, so most bankers go for the "invent money to loan" model.