Smart Government™

It Takes More Than Good Intentions To Make Government Work

"There are some who question the scale of our ambitions -- who suggest that our system cannot tolerate too many big plans. Their memories are short.  For they have forgotten what this country has already done; what free men and women can achieve when imagination is joined to common purpose, and necessity to courage. What the cynics fail to understand is that the ground has shifted beneath them -- that the stale political arguments that have consumed us for so long no longer apply. The question we ask today is not whether our government is too big or too small, but whether it works."
President Barack Obama, Inaugural Address, January 20, 2009

I like Barack Obama, but I question the scale of his ambitions. I listened to his inaugural speech today and, while eloquent, it offered as policy every catchphrase he had ever learned in his career as a community organizer and politician.  As a cynic I question his view of the world--not his motives.

 His basic world view is that government is best at organizing our national resources in a way that serves (his) political goals. He clearly wants to go to the Center in these difficult times, but what he sees as the Center is skewed leftward. I don't think he'll be able to shed his intellectual foundations so easily. .

President Obama is very direct and open about his philosophy. His rhetoric recalls the era of the New Deal when FDR tried to expand government to control society and the economy on a grand scale. He used his eloquence to rally voters behind the ideal of government as the solution to our problems.

President Obama believes in the "free market" and private endeavor, but not in the way most advocates of the free market do. His view is that free market capitalism has failed over and over and that government needs to direct and regulate it. This is the view that is taught and believed by most educators, economists, and politicians. And, unfortunately, by most voters.

Here is the crux of Obama's premise: "The question we ask today is not whether our government is too big or too small, but whether it works." He accepts as a fact that Big Government is the way it is and all we have to do is make government work smarter.

This reminds me of what Hillary Clinton said the other day in her confirmation hearings at Congress. She said that the U.S. will employ SmartPower™ in the exercise of foreign policy. Now this is a dig a George W. Bush who apparently used DumbPower™.  But, this catchy phrase could just as well be the Obama Administration's motto: SmartGovernment™. Government will be made "smart" because they say so.

Obama's goal is to usurp many economic freedoms and substitute his judgment for those of yours and mine to "better" meet the goals of his political constituencies. I don't think he or most on the Left would deny this. They believe that this is the proper function of government.

Here is what really bothers me: "For they have forgotten what this country has already done; what free men and women can achieve when imagination is joined to common purpose, and necessity to courage." A nice sounding eloquent phrase but what does he mean?

I don't think it means that entrepreneurs acting upon rational self-interest in a free and risky marketplace  have created wealth and jobs that have made America great.

I think what he is really saying here has a lot to do with his activist background. The path of a community activist is a political one, not a market one. His M.O. was to lobby and politic his way to getting government to assist his constituents. I think what he means by that statement is that with the support of a majority of voters the really smart economic czars in his administration will create a lot of "common sense" laws that will make things better. This is SmartGovernment™.

Let me raise a "stale political argument" as he puts it. There are many government programs that "work," but they don't work very well or they are harmful.  I don't think "what works" is the right question to ask. The better question is: In light of the inherent wastefulness and lack of efficacy of government solutions to problems, would a free market alternative work better?

I'm not sure a former community organizer would ask that question. Brace yourself for lots of SmartGovernment™.

BofA Bailout: Let's All Start a Bank

Here is a comment from Credit Writedowns, a blog that I follow. Normally I make a point of writing all commentary on this blog in order to provide my readers information they won't find elsewhere. But this article by Marshall Auerback is too good to not repost here.

Posted January 16th, 2009 By Marshall Auerback:

Marshall Auerback here.  I wanted to add a few thoughts to the discussion about recent events in US banking.  Below is the Federal Reserve press release on the Bank of America bailout. [The Fed just announced that BofA would receive an additional $30 billion of TARP money.] Here are the most important words from the release:

where the debt is supported by collateral and the issuance supports new consumer lending.

The carrot and stick in the paragraph in red above ...  is something brand new and out of the box.  It is surprising that it came on Bush’s watch but it has Obama’s fingers all over it. This is a big new push by the government and it has Barney Frank and Sheila Bair's names all over it.

• We, the US government want to make consumer loans, you the bank want a nice interest spread, say 12% plus.
• The US will guarantee your loans that are presently going for only 200 bp over governments 94.5% for 10 years) and you can go and make credit card loans at 16% and make a 1200 bp profit margin.
• Then JPM just puts up the credit card loans as collateral as per the new government request.

Bottom line: The government is now making credit card loans and letting JPM make a 1200 bp profit margin, if not more.

Talk about restoring the banks’ balance sheets through a positive yield curve. They will backstop bond issuance from every firm that qualifies as a bank from GS to BAC, etc. for ten years if they agree to make consumer loans.

Do you realize that money is fungible and thus JPM for instance could go and get 10 year loans at FDIC rates, probably at several hundred basis points below prevailing market rates.

And all JPM has to do is to show the government that it made new consumer loans for the amount of the new government guarantees. That shouldn't be too hard as the money is fungible so JPM says that every new consumer loan that it makes in the normal course of its business will be from those new loans.

GS sold 3 year bonds at 2% over US govt 5 year for 3.25% in December.

Can you imagine, here was a firm that was collapsing in market confidence just 3 months ago that is now able to sell 10 year paper at 200 bp over 2.5% treasuries?

Here is an idea:

Let’s start a bank, borrow for ten years at 4.5%, use part of the money to buy gold, use part of the funds to buy government guaranteed mortgage bonds of equal or lesser maturities and use the positive yield spread between the cost of funds and the yield on the mortgage bonds to pay the interest on the portion of the funds used to buy the gold.

So at the end of the day you have gold that is funded by government guaranteed debt, the carrying cost of which is paid for by buying US government guaranteed debt (mortgage backed bonds) and use the positive carry to fund your gold purchases.

All you need to do is start a bank, fund it with 8% tier 1 capital and you are off to the races.

And you want to know why gold will trade at 5-10X in 5-10 years, you are looking at the reason in the paragraphs below.

What are we waiting for?

Tags: Bailout, Bank of America, fiscal policy

Flash News: Econophile Not Hired By Obama Administration

Dear President-elect Obama:

Since I haven't heard about my online application for a job in your administration, I thought I would inquire directly with you. I thought I had good qualifications to be appointed to some economics advisory position, but, apparently not. I was hoping for the Council of Economic Advisors, National Economic Council, or Assistant Secretary of the Treasury for Economic Policy.

I can understand why you thought Larry Summers, Christina Romer, or Tim Geithner would be better at it than me. MIT and Harvard and all that; I didn't attend those institutions. These are fine people  and are safe choices.  I'm guessing they were selected because they support massive deficit spending as fiscal stimulus. I don't.

 I remember that your call for change emphasized your support only for policies that work and you weren't going to do the 'same old, same old.' That's why you need my counsel on economic policy because you won't hear the same things everyone else is saying. Just in case the Keynesian remedies don't work, maybe you need a Plan B.

Your advisers are the ones who didn't see the crisis coming, and were supportive of the many things the government did to cause this crisis. So why would you want them to tell you how to get out of the crisis?

Mr. Summers is a fine economist but he believes strongly in Keynesian fiscal stimulus. Mrs. Romer wrote your economic plan, so she's supportive of fiscal stimulus (though she thinks tax cuts are better than spending). Geithner is a protege of Summers, so that kind of rounds it out.

If you hired me, the first thing I would do is ask your advisers when Keynesian spending ever worked. I would ask them to consider the experience of Japan from 1990 to 2005 as proof that it doesn't. Your advisers will tell you that Keynesian theory was fine, but it wasn't implemented soon enough, they didn't spend enough, or that there were intervening circumstances that caused it to fail. Defenders of failed theories always say thing like that.

I would tell you what I think will happen as a result of spending $800+ billion:

1. Money will pour into things that are politically desirable, not things people actually want. Thus no wealth will be created to support continued employment.
   
2. You will first try to pay for it by borrowing money. Since Americans don't save, the money will have to come from China or Japan.
   
3. Since no one will want to lend us money at 0%, interest rates will be driven up to attract lenders.
   
4. Your advisers fear this will put the brakes on any recovery, so you won't want to do this.
   
5. If we can't get the money from Asia, you can try to raise taxes. Since your advisers know that also squelches any recovery, you might not want to do that either.
   
6. Your last resort will be to pay for it by printing money. Inflation. It's really a hidden tax but harder for voters to see.
   
7. Eventually all prices will go up, interest rates will rise, and debtors will pay back loans with cheaper dollars, thus eroding savings and investment capital.
   
8. This may turn the economy around in the sense that you will reinflate the economy and start a new credit bubble the consequences of which may be worse than the one we are recovering from now. But it might get you through the next election.
   
9. The most likely result will be economic stagnation like the Japanese suffered for 15 years. They tried all the things that you and your advisers say they will do and got nowhere.
   

You might consider Plan B which would be to not spend any more money, cut federal spending, further reduce trade tariffs, support the dollar, reduce taxes on business and high income taxpayers, and not prop up failed businesses. I can actually point to history and show you when this worked. After all, you don't want to take a credit bubble and turn it into a 20 year depression like Hoover and FDR, do you?

I'm a busy man, but I'll be waiting for your phone call. 

Sincerely,

Econophile

Tags: Keynesian economics, fiscal stimulation, Obama economic plan

Keynesian Stimulus Examined in Video

Here is a short video from the Cato Institute critiquing Keynesian fiscal stimulus. It's everything you wanted to know about the failure of Keynesian theory.

Click here if you want to see a longer version of this video.

What's Wrong With Mark-to-Market?

There has been a huge controversy among economists, politicians, regulators, and bankers on how to deal with bank assets that have lost value. There is a FASB rule (Statement 157) that requires public companies (i. e., banks) to value some of their capital assets on their balance sheets at fair market value. This is the mark-to-market (MTM) rule. Banks want to change the rule to allow them to value these assets at what they think the values should be (Statement 115).

This is important to banks because it determines the amount of capital they have in relation to their ability to lend a multiple of that amount. Because of fractional reserve banking, a bank can lend up to 10X or 20X or even 50X the amount of their capital base, depending on who's looking.

Many banks bought subprime securities which became a part of their capital base. Their values have collapsed and banks are complaining that MTM unfairly requires them to value these assets at fire sale prices. If they don't have to carry them at cost their balance sheets would still look good, they wouldn't have to come up with additional capital, and their ability to lend wouldn't shrink.

The controversy has been that this rule has helped cause our financial crisis. When credit supposedly has dried up, the MTM rule compounds the problem the critics say. It is pro-cyclical because it magnifies financial problems by requiring them to value these assets at prices that are too low, thus impairing their ability to make loans. According to Brian Wesbury of First Trust Advisors in Chicago, it's as if a house is burning down in your neighborhood and your lender says because of that fire your house's value is now diminished and they require more equity to support your existing loan.

Not a very good analogy. Better: you started a slow fire in your brand new McMansion and finally it caught the drapes and your house in burned in the conflagration. Then you whine about it.

It's interesting that many on the right have rallied around this issue. Their argument is that the government has implemented another stupid regulation without understanding the consequences and now it has hurt the banks and turned the crash into a financial disaster. If only the SEC would suspend the rule everything would be OK.

Everyone knows that it's a good financial practice for lenders to properly value their assets. Otherwise how would you know if your deposits are safe at any bank? Now, I certainly don't question the government's role in causing this crisis (see, Law of Unintended Consequences). But let's examine the MTM rule. It was adopted by the SEC because it was adopted and recommended by the Financial Accounting Standards Board (FASB), a private association of financial accountants and industry people who self-regulate accounting standards. So, even if the SEC didn't adopt this rule, companies would have had to adhere to the MTM rule. If they didn't no one would lend them money.

In an article by Nicole Galinas of the Manhattan Institute, MTM isn't something new. And companies only have to MTM those securities that are held for short-term investment or derivatives like subprime based securities. If securities are going to be held to maturity, they don't have to MTM unless they believe that it is "permanently impaired." Even then, they must only mark down values of the bad mortgages.

I therefore don't see anything wrong with MTM.

Why should MTM be suspended in times of financial crisis? This is precisely the time when we should demand that banks should MTM.

Banks for years have been making bad financial decisions and now they want to paper it over as if they shouldn't pay the penalty for their mistakes. Bruce Wasserstein of Lazard says says, “Accounting has now become an exercise in creative fiction,” he said. “Saying assets are worth a lot doesn't make them worth a lot.” The problem is not MTM but bad decisions. And they know this. If you had bought a subprime security with money borrowed from them, I can assure you that they would require you to MTM and pay down the loan.

Let's face it: they bought risky securities that aren't worth what they paid for them. They then used their inflated balance sheets to lend far more than the underlying economic reality of their asset base should have allowed. This only added to the instability of the economy. If we let them avoid MTM now, then more instability will result because now we know they have over-leveraged their capital base.

There is a reason that we need to allow this debt to fall to its true value. Until all the bad assets of the boom years are properly valued (i.e., reduced to fair market value) the crisis will continue because no one will trust bank balance sheets. By propping up banks with phony values, the government will only create continued instability in the financial system. Instead of "pro-cyclical" revaluation being bad, it is actually good for the economy. The sooner it happens, the sooner we will be out of this recession/depression. This is nothing but a bailout of banks for making bad decisions. The interference of the government in this revaluation of bank capital is one of the things Japan tried. They turned their crash into a 15 year nightmare.

Tags: mark to market, financial crisis, subprime

The Japanese Disease

President-elect Obama says that he will spend upwards of a trillion dollars the kick-start the economy. President Bush fully supports Hank Paulson and Ben Bernanke in their efforts to spend our way out of a serious recession-depression. Almost all economists, liberal and conservative, agree that the government will have to spend hugely to get things back to normal, though they disagree on the specific implementation of the cure.

If I tell you they are wrong you may think I'm either delusional or ignorant for rejecting the mainstream conventional wisdom. However, there is another economic theory which has been proven right in the past, namely Austrian theory economics. I am a student and advocate of Austrian School economics which is almost diametrically opposed to Keynesian theory which most economists follow.

I think the Keynesian cures for our shattered economy will make things worse. Much worse.

Who's right?

By looking at Japan in the 1990's and early 2000's we can see the results of a Keynesian solution to a set of facts almost identical to our present situation. The "solution" caused an almost 15-year (1990–2005) stagnation of the Japanese economy.

It's not as if mainstream economists are unaware of the parallels to Japan and its failures. But the universal response of Keynesians, instead of an admission of failure of their theory, is that the Bank of Japan didn't act soon enough and were not aggressive enough in their application of "corrective" Keynesian programs.

Here's the Japanese experience which is startlingly similar to our present situation.

They started with a huge credit expansion. Their discount rate was cut from 4.4% to 2.5% in 1986-1987.

1. Real estate and equity prices soared.
   


2. To counter the speculative boom, the discount rate was raised in 1989-1990 from 2.5% to 6% and their markets crashed.
   


3. The Nikkei went from 40,000 in 1989 to 11,000 in 2005. Real estate values plummeted 80%.
   


4. GDP grew at only 1.17% from 1992 to 2003.
   


5. Unemployment went from 2.1% in 1991 to 4.7% by 2004 (a very high rate in Japan).
   


6. Consumption and investment fell dramatically.
   


7. Banks were not lending.
   

What was the response of the government to this crisis?

1. In order to kick-start the economy, the government went on an infrastructure spending binge and cut taxes.
   


2. From 1992 to 1995 they spent ¥65.5 trillion on projects and cut taxes.
   


3. In 1998 they cut taxes ¥2 trillion.
   


4. In 1998 they spent another ¥40.6 trillion on spending stimulus.
   


5. In 1999 they spent another ¥18 trillion in fiscal stimulus.
   


6. In 2000 they tried another ¥11 trillion spending package.
   


7. They set up a ¥20 trillion fund to lend directly to businesses (the Financial Investment and Loan Program [FILP]).
   


8. To try and push money into the system the Bank of Japan and Ministry of Finance bought more than half of existing government bonds from the private market at a cost of ¥2.22 trillion.
   


9. Trying monetary policy, they lowered the discount rate from 4.5% in 1991, 3.5% in 1992, 1.75% 1993-1994, to 0.5% 1995-2003.
   


10. They set up a $524 billion bailout fund in 1998 to buy stock in failing banks or nationalize them.
    

It is estimated that the Japanese spent about $1 trillion about (¥135 trillion) to cure their financial problems. But the problems lingered, banks remained weak, lending and investment was severely reduced, unemployment was high, government debt went to more than 150% of GDP, and the yen devalued. Nothing seemed to work.
In a January 2008 article in USA Today on the lessons learned from the Japanese "disease," several prominent economists were quoted as saying the lessons of Japan have been learned and if there is a problem we'll jump on it immediately.

Robert Rubin said, "If you look back at Japan, and you think to yourself what was their monetary policy like and why did that happen, I don't think this is an analogous situation." Ken Rogoff of Harvard said of the parallels, "If the U.S. escapes with just a mild recession, we'll be lucky," says Rogoff. "There's a chance we'll have no recession, but there's at least an equal chance of a deep and long recession with high direct and indirect costs." Rogoff predicted a $450 billion price tag.

It appears we are following the Japanese experience almost to the letter. To date we have done many of the same things that the Japanese tried yet these remedies have failed to rescue the economy. While there are substantial differences in our respective economies, the parallels to our banking crisis are more similar than not. The same Keynesian remedies being implemented in the US now were tried in Japan with disastrous results. Surely there's a better way.

Tags: financial crisis, Keynesian economics, fiscal stimulation, Japanese disease

$1,000,000,000,000

The commentary quoted below from the Wall Street Journal ("Feel Like a Trillion Bucks") caught my attention. How much is a trillion?

The human mind is not well equipped to fathom a number that large. A check for $1 trillion -- a million million dollars -- would have 12 zeros to the left of the decimal point. Homo sapiens hadn't evolved a trillion seconds ago: 31,546 years in the past, Neanderthals were still trying to make fire.

More immediately, $1 trillion is about one-third of annual U.S. government spending and 13% of the U.S. economy. It is more than the GDP of all but 12 countries in 2007 (America, Japan, Germany, China, the U.K., France, Italy, Spain, Canada, Brazil, Russia and India, in that order).

A thousand billion. A million million! We are tossing that number around in reference to the government bailout without grasping its meaning. It's as if you took $100,000 from 10,000,000 people, or $10,000 from 100,000,000 people. It's a lot.

Click on image to enlarge

How Long Will It Last?

Historical Data May Give Guidance

This economic recession is considered to be the worst financial hit to the US since the Great Depression. How can we plan ahead and make good business and investment decisions? One of the questions I am frequently asked is: how long will it last? My answer is that (a) I don't know and (b) that it would be irresponsible for me or anyone to say. I'm not as dumb as the-smartest-guys-in-the-room who thought they knew and got us into this mess. But I know anything I say would be a guess. It all depends what our government will do. And, I suspect that would have a negative effect on recovery.

That aside, a new paper published by Carmen Reinhart and Kenneth Rogoff examines reliable historic data and compares past cycles around the world. ("The Aftermath of Financial Crises," January, 2009). They examined the before and after of banking crises in rich countries and in emerging markets and found a number of similarities among them. The results for the average of major banking recessions are fascinating:

    Housing prices declined an average of 35% over six years;

    Equity prices declined an average of 55% over 3.5 years;

    Unemployment rises to an average of 7% over four years;

    GDP declines an average of 9% for over two years;

    Government debt increases an average of 86%.

The charts below show where the current crisis is in relation to the historical average. You can draw your own conclusions.

One of their interesting conclusions is that, compared to earlier downturns, this one has a global impact which will make it more difficult for countries to export their way out of it. Also, it may make it more difficult to continue foreign borrowing (i.e., the US).

Does this mean our recession will be "average?" I personally don't believe so: I think it will be worse. We've had the greatest credit bubble the world has ever seen. The proposed solutions offered by our government have been shown historically to lengthen the down cycle.

I find the charts, below to be fascinating. Notice the numbers for the US during the Great Depression and Japan in the '90s and early 2000s.

To make chart larger, click on chart.