Streetwise Professor

September 11, 2012

You Read It Here First

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 6:01 pm

Bloomberg’s Brad Keoun has out a long piece today highlighting the risks of collateral transformation, a development driven by Frankendodd’s clearing and collateral mandates:

Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.

Keoun quotes Darrell Duffie and Anat Admati raising concerns about the systemic risk that collateral transformation creates.  And bully for them, because they’re right.  As I pointed out in this post from July, 2011, and in several others in the months since (as well as in a paper in the J. Applied Corporate Finance.)  Anat argues that clearing and collateral mandates are resulting in the shifting of risk, rather than its reduction as promised by Frank ‘N Dodd and Gigi and Timmy!:

The banks’ new lending business “smells like trouble,” said Anat Admati, a finance and economics professor at Stanford who studies markets and trading and advises bank regulators on systemically important firms.

“The point of the initiatives on derivatives was that derivatives can hide a lot of risk,” Admati said. “Now they’re going to just shuffle the risk around.”

I wrote that mandates would result in a substitution of new forms of credit exposure and leverage for the credit exposures and leverage eliminated from derivatives via collateral in this July, 2010 Cato Policy Analysis (see especially p. 25).

So although these consequences were unintended, they were foreseeable and foreseen.

But even though these developments have been in train for months, and although they are pregnant with systemic significance, regulators are ignorant of the potential risks.  In the most shocking but not really part of his piece, Keoun writes:

U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment. [Emphasis added.]

But Congress and the regulators pinky swore that Frankendodd would make the system safer!  Trust us on this, they said.  We know what we’re doing!

Uhm, I don’t even think they slept in a Holiday Inn Express before taking on the wholesale reshaping of the vast derivatives markets.

Gensler and Geithner are particularly culpable here, because both pronounced repeatedly that Frankendodd, and specifically its collateral and clearing mandates, would reduce the interconnectivity of major financial institutions.

Not exactly.  Out with the old, in with the new: new interconnections, and arguably more fragile ones, are being forged to replace the old ones.  Again, predictable and predicted.

And they continue to assure the world that Frankendodd has made the world safer-even though the analysis necessary to support that claim has not even been done.

Think about it.  It is widely recognized that shadow banking, including quite specifically repo, was a major source of systemic risk that contributed to the severity of the financial crisis.  Collateral and clearing mandates have essentially resulted in the development of a new form of shadow banking.

This is an improvement?  Maybe it is.  But inasmuch as key regulators haven’t even acknowledged the development, and haven’t analyzed its systemic consequences, their pronouncements are not credible.

And make no mistake: this will not be the last big unintended consequence of Frankendodd that will tend to undermine the intent of the act.  And take fair warning: regulators are likely to be well behind the curve in understanding and reacting to these consequences.  Meaning that, to paraphrase Anat Admati, the systemic risk hasn’t gone away, it’s just been shuffled around.  That includes, mind you, the systemic risk resulting from the regulations and the regulators.

September 10, 2012

Leave This One to the Market(s)

I’ve written about there being good HFT and bad HFT; HFT that enhances liquidity, and HFT that is predatory and attempts to exploit liquidity demanders (especially large traders).  Moreover, algorithmic trading (which may or may not be HFT, properly speaking) can potentially disrupt markets (e.g., the Knight Capital fiasco some weeks ago).

The question is: whatcha gonna do about the bad?  The knee-jerk response of many is to demand greater government regulation.  I have pointed out repeatedly, however, that this is an area where self-regulation is highly likely to be more efficient.  In particular, exchanges and other trading platforms have an incentive to design pricing structures and rules so as to reduce predatory trading, by HFT shops and others.  Predatory trading increases other market users’ trading costs, which reduces the derived demand for exchange services, thereby reducing the price the exchange can charge and the quantity of trading done on it.  Similarly, exchanges are hurt by disruptions caused by bad algos.

I’ve written a few posts on exchanges that have introduced pricing policies (e.g., charging high prices for “excessive” cancellations) with the specific purpose of reducing opportunistic trading.

Here is another example, this time from Forex:

Foreign exchange brokers are backing a series of changes unveiled by EBS, the world’s largest currency platform, designed to discourage predatory practices by high-frequency traders.

EBS, owned by interdealer broker ICAP, plans to widen the price spreads on its platform, raise targets on quote-to-buy ratios and set new quoting guidelines for Asian markets to discourage investors who exploit delays in technology to make money.

. . . .

Mr Mandelzis said that, while the changes were technical, they were aimed at encouraging genuine liquidity and discouraging disruptive behaviour, such as arbitraging prices.

With respect to dealing with the risk of runaway algos, CME and NYSE LIFFE are installing a kill switch functionality that permits FCMs to halt or limit trading activity by a malfunctioning algo:

Futures commissions merchants will be able to halt or limit trading activity at high speed on CME, operator of the world’s biggest futures exchange, and NYSE Liffe, one of the Europe’s dominant futures and options markets, if a computer begins to malfunction or a customer breaches risk limits.

Exchanges have an incentive to get these decisions right: they lose business if they basically provide hunting grounds for predatory HFTs or are unduly vulnerable to runaway algos.  Exchanges also have the information: they can observe what goes on on their systems, see who does what, and get feedback from customers.  Exchanges have a broad array of tools-outright bans on certain practices, and discriminating pricing policies. Exchanges are also able to move unilaterally and quickly.  In contrast, regulators have low powered incentives; poorer information; typically have blunt tools; and are less able to respond quickly and flexibly.  This is a clear case where self-regulation has advantages over government regulation.

This is particularly true in derivatives markets, where single platforms dominate a particular instrument.  Things may be more complex in equities, due to the potential spillovers across fragmented trading platforms.  But even there, the spillovers may be salutary.  A trading platform that clamps down (through pricing, for instance) on predatory arbs may push them to other platforms, but that just increases the incentive of those platforms to take action.  Moreover, different platforms have an incentive to compete to attract legitimate liquidity suppliers and liquidity demanders (especially the latter, since they are the ones that pay the freight), which means they have an incentive to compete to devise pricing schemes that penalize the predatory.

In brief, the task of reducing predatory computerized trading strategies should be left primarily to exchanges.  Predation will not disappear: it is almost never efficient to eliminate opportunistic/predatory conduct completely (because this would be too costly, primarily due to the fact that eliminating predatory conduct would almost certainly reduce some beneficial conduct), but exchanges have the strongest incentive, the best information, the most discriminating tools, and the greatest flexibility.  There will be an arms race between exchanges and predatory traders, but there would also be an arms race between government regulators and such traders.  Exchanges can run the race more efficiently and effectively.  Leave it up to them.

September 9, 2012

Did Krugman Commit a Keynesian Heresy? Is He a Closet Austrian? Or Just a Political Hack?

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 3:01 pm

This Krugman oped is the usual blah, blah, blah, but this line jumped out at me:

This return to financial normalcy did not, however, produce a robust recovery. Fast recoveries are almost always led by a housing boom — and given the excess home construction that took place during the bubble, that just wasn’t going to happen.

“Fast recoveries are almost always led by a housing boom.”  I’m not sure that’s true.  But that’s not relevant.   What stood out is this: “given the excess home construction that took place during the bubble, that just wasn’t going to happen.” In a Keynesian, aggregate-demand-is-dominant viewpoint, why should an overhang of housing stock matter?  OK.  People don’t want to direct “aggregate demand” (WTF that is, but bear with me) to purchasing housing.  So they buy big screen TVs or cars or vacation travel or whatever.  They buy more of what is not surfeit (as Krugman claims housing is).  And the economy chugs along at a pace consistent with the level of aggregate demand, regardless of whether previous (Keynesian) policies have led to over-investment in one asset class.

Krugman could reply that fiscal and monetary policy have created insufficient aggregate demand.  But even if that’s true, the housing overhang is irrelevant.  That’s why that argument is such a clanger; why it stood out.

For once you bring up an excess supply of a particular asset as being material in determining the course of economic growth, you come perilously close to Austria.  Or at least Austrian economics, which emphasizes “malinvestment.”  The Austrian narrative of the Crisis emphasizes malinvestment in housing, driven by monetary policy assisted by pro-housing policy on other dimensions.  You also come dangerously close to acknowledging that structural imbalances, and mismatches between skills (driving a nail, running wire, plumbing a bathroom) and demand (changing bed pans, writing an app, lobbying a Congressman), are relevant in determining economic performance.  That is also an Austrian point.

Krugman has declaimed heatedly and repeatedly against both views many times.  He is clearly of the AD is What Matters school.  But if AD is what matters most, and by far, why should the supply of a particular asset matter a whit?

The current debate over why the recovery has been so pitiful, as compared to say 1983-84, revolves around whether insufficient aggregate demand, or some structural imbalance (driven by previous policy-induced malinvestment) is the underlying cause.  Ed Lazear (for whom I TA’d donkey years ago) has created a buzz with a paper claiming that AD deficiency, rather than structural/skill imbalance is the problem.  Color me unconvinced.  I suggest you look at Sober Look’s recent post for some interesting evidence relating to structural imbalance.  His recent post on the Beveridge Curve is particularly compelling.

This debate is on the fringes of my professional competence.  But I know a logical problem when I see one.  Krugman’s invocation of the overhang of housing as a source of drag on the recovery is clearly a logical problem.  Any explanation based on a structural factor, a structural imbalance, is clearly problematic to any Keynesian.  This is why they get so shrill in responding to evidence and arguments relating to skill imbalances or other structural problems in the economy.  So it is passing strange that Krugman should make it the first-yes, the first-argument in his defense of Obama against charges that the recovery has been pitifully weak.

So is Krugman a heretic? Or just an intellectual hack willing to seize on any argument, no matter how inconsistent with his alleged world view, when he takes to the NYT oped page to defend his political heroes?

I know where my money is.

September 7, 2012

Another Great Shorting Opportunity

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 9:58 am

EUphoria has broken out again with the ECB announcement that it would engage in “unlimited” buying of short term (maturities<3 years) Spanish, Italian, etc., debt . . . under certain conditions.

The crucial condition is that the beneficiaries of Mario’s largesse formally apply for and receive assistance from the EU’s bailout mechanism, the European Stability Mechanism (ESM).  Since this assistance comes with conditions, all of the political and credibility issues are still in play.  The game of chicken between the mendicant countries and Germany will continue.

My read on this announcement is as follows.  Over the past year plus there has been concern that the ESM and its predecessor the ESF did not have sufficient funds to save a big country like Spain.  So there were all sorts of plans mooted to lever ESF/ESM resources.  The most recent included a proposal to give the ESM a banking license, allowing it to borrow from the ECB, thereby permitting it to lever its capital.  This proposal foundered on German opposition.

The ECB announcement seems crafted to achieve the same objective.  Instead of the ESM providing higher levels of funding to Spain, etc., by borrowing through the ECB after negotiating bailout conditions, the ESM and the ECB will work in parallel.   The ECB will effectively lend directly to the bailed out instead of lending indirectly through the ESM.  So both alternatives involve conditionality and the use of ECB resources to supplement ESM resources.

The allocation of credit risk may well be different under the two alternatives, but I haven’t had time to sort through that.  That issue is likely to be crucial, though, and impact negotiations between the ESM and the countries requesting assistance.  The ESM and the countries that fund it (I’m looking at you, Angela!) know that an ESM bailout will get the ECB involved, and that involvement will create credit risk and the potential for monetization.  These countries will take that into account when deciding whether to provide support and the conditions under which it is provided.

Meaning that fundamentally things haven’t changed all that much.  The crucial issue is still the political dynamic between the countries with the money and the countries that need it.  Draghi hasn’t changed that problem one bit.  Indeed, he has just raised the stakes in the negotiations, making them all the more fraught and complicated and less likely to succeed.  Levering up the ESM (whether directly or indirectly) also levers up the risks, stakes, and complexity in any negotiation.

Which means that in my opinion, as with most “solutions” proffered up by the Euros, this is a great shorting opportunity.  It hasn’t changed the fundamentals in Spain, which are getting worse by the day.  It hasn’t reduced the fundamental difficulties (moral hazard, credibility and crucially distributive effects) associated with any bailout.  Which means that when Spain is in extremis, which seems inevitable, a deal will be very hard to accomplish, especially in light of bailout fatigue in Germany.  In other words, the ECB action affects the outcome conditional on achieving a bailout agreement, but crucially it also affects the likelihood and terms of such an agreement.  The market has focused on the first issue, and is ignoring the second.  But I think that the second is fundamentally far more important.

Who You Gonna Believe? Herbert Obama or Your Lyin’ Eyes?

Filed under: Economics,Politics — The Professor @ 9:36 am

We now understand exactly why Obama gave such a listless performance last night.  He knew the jobs report would be abysmal.

And abysmal it is. Anemic payroll growth of 96,000, along with downward revisions of the July numbers.  The unemployment rate declined-but only because labor force participation fell to its lowest level in 31 years.

And like clockwork, the administration trotted out its Chief of Economic Advisors, Alan Krueger, to say  it was “important not to read too much into any one monthly report.”

That is truly comical.  Krueger has been saying that every month.  I figured he would say it again, so I Googled “Krueger one monthly jobs report” and bingo, up came that link.

Not too predictable.  But too pathetic.  This pointillism-trying to discredit each single jobs report as not particularly informative-rings quite hollow when each successive jobs report is anemic.  Individually-yes, probably not important.  Collectively: damning. I wonder how Krueger maintains his self-respect.  But I guess you have to check that at the door when you take that job in troubled times.

So I guess Recovery Summer will have to wait until 2013, having failed to appear in 2010, 2011, and 2012.

Given this report, Obama’s speech looks even more Hooveresque (“Prosperity is around the corner”) than it did when I made the comparison yesterday afternoon:

President Barack Obama portrayed himself as a stout defender of the middle class and a leader with a plan to create jobs across the U.S. economy in a speech Thursday accepting the Democratic nomination for re-election.

. . . .

“I’m asking you to rally around a set of goals for your country,” Mr. Obama said. He cited ambitions to create manufacturing jobs, slow the growth of college tuition and bolster trade. He called them “real, achievable plans that will lead to new jobs, more opportunity, and rebuild this economy on a stronger foundation.”

“That’s what we can do in the next four years,” he said.

Mañana, mañana.  Always mañana.  Just renew his contract, and voila!, jobs will magically appear.  Yeah, hasn’t worked out so well the last four.  But just wait!  He has ambitions!  Real, achievable plans!  Promises trump performance!

Slow Joe did Hoover one better.  He claimed that the corner has actually been turned:

“America has turned the corner,” Vice President Joe Biden said, taking the stage before Mr. Obama. He added: “The work of recovery is not yet complete, but we are on our way.”

Thanks, Joe, for helping build the meme!  I will gladly acknowledge you did build that!

The disconnect between rhetoric and reality, promise and performance, is plainly obvious.  Hoover, contrary to decades of political propaganda, was no free marketer: he was an interventionist who contributed to impeding recovery in the 1930s, although the Fed was the main culprit in turning a deep recession into an enduring Depression.  Obama is another interventionist, and although the Fed arguably staved off a depression, this interventionism has impeded a recovery similar to those following earlier deep recessions, including those caused by financial crises.

Hopefully Obama’s political fate will mirror Hoover’s as well.  And also hopefully, Romney will not be the hyper-interventionist that Roosevelt was, for the New Deal also extended and deepened the Depression.  Not that I have high hopes, either on the outcome of the election or for economic policy even in the event of a Romney victory.  An Obama defeat is a necessary but not sufficient condition for economic health in both the short and the longer term.  This jobs report makes that defeat more likely, especially in light of the yawning gap between glittering promises and lackluster (I am feeling generous) performance.  More likely, but not inevitable.

September 6, 2012

Same Old Bill Clinton BS

Filed under: Economics,Financial crisis,Financial Crisis II,Politics — The Professor @ 3:54 pm

Bill Clinton’s DNC speech was vintage Clinton mendacity.  It was long-too long for a point-by-point response, so I’ll limit my comments to some of the standout lowlights.

Starting with the beyond cartoonish version of the Republican philosophy:

“This Republican narrative, this alternative universe says that…
… every one of us in this room who amounts to anything, we’re all completely self-made. One of the greatest chairmen the Democratic Party ever had, Bob Strauss, used to say that every politician wants every voter to believe he was born in a log cabin he built himself.”

Always beware when anyone says “every one of us” and “completely.”  Sure tip-off to a straw man argument, a grotesque exaggeration.

In the Clintonian (and Obamaian) telling, Republicans are more Randian than Ayn.  Not even close.

The same caution about absolutes goes for “always” (emphasis added):

Unfortunately, the faction that now dominates the Republican Party doesn’t see it that way. They think government is always the enemy, they’re always right, and compromise is weakness.

And just who said “you’re on your own?” Gotta name?  A quote?:

You see, we believe that “We’re all in this together” is a far better philosophy than “You’re on your own.”

In brief, Clinton flogged a theme you are likely to hear ad nauseum in the next 60 odd days (and they will be odd!): the Social Darwinist Republicans vs. the Kind, Compassionate, Communitarian Democrats.

Then there’s this whopper:

One of the main reasons we ought to re-elect President Obama is that he is still committed to constructive cooperation.

Constructive as in “I won”? I guess in the Obamathaurus “constructive cooperation” means “do what I want.”

Clinton was at his con man/Music Man best when trying to explain why Obama deserves re-election, despite the stuttering recovery.  You see, Prosperity is Just Around the Corner! But you have to “renew the president’s contract” in order to achieve it:

Now — but he has — he has laid the foundations for a new, modern, successful economy of shared prosperity. And if you will renew the president’s contract, you will feel it. You will feel it.

Uhm, channeling Herbert Hoover isn’t exactly that persuasive.  But that presumes, I guess, that people with a bigger megaphone than I will point out the Hooveresque parallel.

The con man vibe was only reinforced by the cheap TV evangelist “I believe” trope:

Folks, whether the American people believe what I just said or not may be the whole election. I just want you to know that I believe it. With all my heart, I believe it.


Now, why do I believe it? I’m fixing to tell you why.

“I’m fixing”? Spare me the faux corn pone populism. (When was the last time Clinton was in Arkansas, anyways?)

The other analogy that comes to mind is Tinker Bell.  If you only believe, children, Tinker Bell will live and the economy will thrive!

Some of the most laughable parts of the speech were when Bill ventured into the realm of economics.  As when he discussed the administration’s (insane) fuel economy standards proposal:

Now, the agreement the administration made with the management, labor, and environmental groups [note the corporatist, not to say fascist undertones here] to double car mileage, that was a good deal, too. It will cut your gas prices in half, your gas bill. No matter what the price is, if you double the mileage of your car, your bill will be half what it would have been. It will make us more energy independent. It will cut greenhouse gas emission. And according to several analyses, over the next 20 years, it will bring us another 500,000 good, new jobs into the American economy.

So, first of all, we are apparently too stupid to make choices to cut our gas bill in half.  After all, we have the choice now to buy high MPG autos instead of Escalades, but us idiots apparently don’t understand that will cut our gasoline bills in half.  So we have to be forced to buy such vehicles. Could it be, perhaps, that fuel economy is not the only attribute that we value in automobiles?

A perfect illustration of the we-know-better-than-you-idiots, anti-choice mindset that infests the Dems.  Except where abortion is concerned, of course.   (Sort of on topic: Is Sandra Fluke as stupid as she seems? Does Georgetown Law School really want her as their poster child?)

Second of all, despite all the self-confidence of the delivery, the economics are cracked.  Both theory and empirical evidence prove otherwise.  If you reduce the marginal cost of driving a mile by forcing people to drive more fuel efficient vehicles, they will drive more miles, whereas Bill’s calculation assumes that the number of miles driven will be the same. Thus, CAFE advocates always-always-overstate the fuel consumption effects of their coercive policies.

Not to mention the body count of forcing people into smaller, lighter vehicles.  (Bill certainly didn’t mention it.)

And the last line reeks of the seen-unseen problem. Costs are not benefits.

His disquisition on energy was risible:

The president’s energy strategy, which he calls all-of-the-above, is helping, too. The boom in oil and gas production, combined with greater energy efficiency, has driven oil imports to a near 20-year low and natural gas production to an all-time high. And renewable energy production has doubled.

A good part of the import decline is due to the fact that a weak economy results in weak demand for fuel.  And Obama didn’t have a damned thing to do with natural gas production increases.  His administration (notably the FDA)  is fighting the technology that has made it possible.  It is worse than the rooster claiming credit for the sunrise.

And all of the above? Don’t make me laugh.

This was also rich:

Today, interest rates are low, lower than the rate of inflation.

Uhm, true-but that’s nothing to brag about: it is unquestionably the symptom of a weak economy.  Negative real interest rates last occurred in the late-70s.  That was such a great time.  I remember it fondly.

Again, the economics genius.

I could go on.  But you get the idea.

September 4, 2012

In What Sense of the Word “Belong”?

Filed under: Uncategorized — The Professor @ 5:44 pm

Ein Volk, Ein Reich, Ein Furher. Yes, that is over the top, but the attached video from the Democratic National Committee that says that government is the “one thing we all belong to” pegged the Creep-o-Meter and brought that phrase to mind because of the video’s collectivist overtones, especially given its release at the time of the personality cult extravaganza also known as the Democratic National Convention.

“Belong to.” Not an unambiguous phrase. It can mean “a member of”-which connotes a voluntary association. It can also mean “owned by”-which is anything but voluntary. Government is much nearer to the latter than the former, and is becoming more so every day. Deal with the IRS and you’ll get a very clear understanding of which meaning is operative where government is involved.

Note the folksy “I’m from the government and I’m here to help you” voice. As Reagan said: those are the nine most terrifying words in the English language.

The claim that government is somehow the collective embodiment of the people is also the stock trope of authoritarians and collectivists of all stripes. Contemporary example: Putin. Standing on the battlefield of Borodino, where 200 years ago the conscripts of one autocracy battled the conscripts of another, Putin called for unity-which in Russia means unity under the control of the wise state:

For the second time in five days he called for unity, underlining his concern that the insurgency could spread and threaten the integrity of Russia, home to many nationalities and religions.

“Only when Russia’s nations were united, were together, they achieved the best results in the development of their fatherland,” Putin told Russian and foreign dignitaries, including former French president Valery Giscard d’Estaing.

“By and large patriotism, which was the basis of all our major victories, comes down to the unity of the Russian nation.”

If you needed confirmation that the Democrats are the Party of Government then (a) you are a slow learner, and (b) you now have it.

Not that Romney and the Republican Party can be confused for even lukewarm libertarians. But at least they pay some deference to individuals acting outside the government. The Dems, on the other hand, raise up government above all other things-meaning that it subordinates us to it, and rejoices.

So if you want a sense of belonging, go right ahead and vote for the Party of Government. You may think you are voting for the warm, cuddly meaning of the word, but you will find out soon enough that you are getting the other.

September 2, 2012

Better Fed Than Dead?

Filed under: Economics,Politics,Regulation — The Professor @ 7:06 pm

Reuters has a story in which several prominent economists lament the alleged Republican threat to Fed independence:

Increasing political encroachment on the Federal Reserve, particularly from the Republican Party, could threaten the central bank’s hard-won independence and undermine confidence in the nearly 100-year old institution.

That was the pervasive sentiment among economists gathered at the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming. Against the dramatic backdrop of the Grand Teton mountain, many said a closely-contested presidential race has turned the monetary authority into a political football.

“I do fear for it a bit if the election comes out that way, especially if some of the more radical voices, that happen to be Republican voices nowadays, get reelected,” said Alan Blinder, Princeton economics professor and a former Fed vice chairman, adding that historically opposition to the U.S. central bank had come predominately from the left.

“Independence” is something of a red herring.  The key issue is the scope of the Fed’s discretion in which it can exert its independence.  And as John Cochrane notes in the WSJ, the Fed has greatly expanded its activities:

Momentous changes are under way in what central banks are and what they do. We are used to thinking that central banks’ main task is to guide the economy by setting interest rates. Central banks’ main tools used to be “open-market” operations, i.e. purchasing short-term Treasury debt, and short-term lending to banks.

Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.

These “nontraditional” interventions are not going away anytime soon. Many Fed officials, including Fed Chairman Ben Bernanke, see “credit constraints” and “segmented markets” throughout the economy, which the Fed’s standard tools don’t address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that “we should not rule out the further use of such [nontraditional] policies if economic conditions warrant.”

But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed’s independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.

As Cochrane notes, it is utterly impossible for any entity to undertake such breathtakingly broad responsibilities without engendering a political reaction.

And can you really think that it is a good idea to have an institution exercise such incredible power without accountability?  The Fed, like any human institution, is fallible.  Look at the Great Depression.  Look at the 1970s stagflation.  Big mistakes that led to huge adverse consequences.

Yes, perhaps the Fed has learned from its past mistakes-but the markets have become much more complex too, and the Fed is dealing with different problems.  It is now going where no central bank has gone before: can you be confident that it is not going to commit new mistakes when dealing with new problems?  And given that its role is more all encompassing than ever, the consequences of such mistakes will be even weightier than ever.

Hayek’s dictum applies with special force to the Fed: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

You also cannot overlook the political economy angle.  Even now, the putatively independent Fed is subject to political pressures, from the White House, from Congress.  Moreover, it is an odd creature.  The regional Fed banks participate in policymaking, and private banks that “own” the regional Federal reserve branches select some of their directors.  In addition to these formal roles in governing the Federal Reserve System, banks also influence its operation in the way that other regulated industries influence their regulators: through the provision of information that the Fed uses to make decisions.  Fed decision making is therefore not Spock-like and disinterested, but human, and subject to interested influence.  Some form of accountability is necessary.

The current controversy over control of the Fed is a natural consequence of understandable fears that the Fed is out of control, and exercising powers that could be misused. The currency doesn’t say “In Ben We Trust.”  Not yet, anyways.

Yes, some of the proposals to rein in the Fed are crackbrained.  But the concerns that motivate these proposals are not crackbrained.  A degree of independence makes sense if that independence is exercised within a relatively well-defined and circumscribed set of responsibilities.  Independence-that is, vast discretion with attenuated accountability-is much more dangerous, and much more ominous, when it is exercised in a much broader realm, and when the Fed has considerable power in asserting its authority in new, unprecedented areas.

The Bane of Corporate Existence: the Corporate Income Tax

Filed under: Economics,Politics — The Professor @ 1:56 pm

The NY attorney general has subpoenaed a dozen private equity firms-including Bain Capital-over their use of a certain tax strategy.  The political motivations here are pretty obvious, so I will leave that as an exercise for the class.  I want to focus on one statement in the article that speaks volumes about the US tax code:

The tax strategy — which is viewed as perfectly legal by some tax experts, aggressive by others and potentially illegal by some — came to light last month when hundreds of pages of Bain’s internal financial documents were made available online.

So different tax experts look at the same strategy and their conclusions run the gamut from “A-OK” (“not risky or even aggressive” in the words of one) to “pushing it” to “lock-’em-up.”

A perfect testament to the dysfunctional arbitrariness of the tax code.  An invitation to spend large amounts on tax advice and tax planning-which is a waste of real resources.  A source of uncertainty and risk that interferes with business planning and distorts resource allocation.  And crucially, a source of discretion for government authorities that they can use to reward favored companies and punish disfavored ones.

Note that the authorities can use the tax code to dragoon those it has targeted even if the likelihood of a successful prosecution is small.  The costs of tax litigation can be immense, and the risks greater.  And there is a profound asymmetry between the government and the targeted company.  If the government loses, no big deal.  Yeah,the prosecutor loses face,  but s/he usually has a way to minimize that.  If the company loses, however, the costs-in dollars and cents, and possible imprisonment-can be very large.  (Note that tax prosecution of political enemies is a favorite tactic in Putin’s Russia, cf. Khodorkovsky.  There’s a reason for that.  It is a very powerful cudgel-or knout, if you will.  It would be naive to think this a uniquely Russian phenomenon.)

The economic case for corporate taxation and capital taxation is dubious even when you abstract from the realities of the tax code. When those byzantine, Kafkaesque realities are considered, it is pretty clear that the deadweight costs of the system are large and that it should be scrapped, or thoroughly overhauled.  Unfortunately, that will never happen because (a) there is a widespread belief that “corporations” should pay taxes as a matter of fairness (a view ironically pushed by those who go ballistic at the notion that corporations are persons on certain legal dimensions), and (b) the tax code got the way it did for political economy reasons, i.e., there are those who benefit from this byzantine provision or that, or who have a competitive advantage in exploiting the complexity of the tax code.

I think it was Milton Friedman that pointed out that tax reform occurs when politicians figure they’ve given out all of the tax breaks they can, they take them away in a tax simplification effort so they can sell the favors again in the future.

The AG’s action gets attention only because of the Romney connection: and arguably, the Romney connection is the only reason for the AG’s action.  But it should get attention for a completely different reason: it demonstrates how arbitrary and subject to abuse the tax system is.

September 1, 2012

Obama Diagnoses His Worst Mistake: He Hasn’t Campaigned Enough

Filed under: Economics,Politics — The Professor @ 11:33 am

Today’s Wall Street Journal has a looonnggg piece on Obama Agonistes, the struggler facing a tough reelection campaign.  Oh! The injustice!

In it, his confidants identify his problem: He hasn’t campaigned enough:

Over his first term, Mr. Obama, 51 years old, has fundamentally shifted his view of modern presidential power, say those who know him well. He is now convinced the most essential part of his job, given politically divided Washington, is rallying public opinion to his side.

As a result, if he wins a second term, Mr. Obama plans to remain in campaign mode.

Note: that was not from The Onion.  Follow the link, and you’ll find the above in the WSJ.

Umm, when has he ever been out of campaign mode?

This explanation for his failures is a variant on a theme that he personally and his minions have flogged for the past several years: his biggest mistake has been that he hasn’t taken the time to explain the brilliant wonderfulness of The One and his deeds to the boobs in the boonies and the burbs.  So he will dedicate himself to righting that mistake and instructing us slow learners.

This is a rather pathetic attempt to rationalize doing what he really likes to do, and for avoiding what he doesn’t.  He obviously has a distaste for governing, and performing executive functions.  He relishes the adulation of swooning crowds.  He doesn’t like face-to-face pushback from political opponents or those all too few journalists who aren’t flacking for him.  He loves to be able to speak unchallenged to faceless masses of smitten acolytes.

Campaigning is what he likes.  So he has succeeded in justifying in his own mind that it is what the nation needs.  It is all about the personality cult.  Governing, not so much.

And it gets better-or worse, depending on how you look at it.  For what, pray tell, will he campaign? For this:

The president views a second term in some ways as a second chance, an opportunity to approach the office differently, according to close aides. He would like to tackle issues such as climate change, immigration, education and filibuster reform.

Again: Not the Onion.

Filibuster reform?  I say again: Filibuster Reform?  Yeah.  That’ll sweep the nation like a firestorm. And yeah, that’s an obvious priority right now.

And the rest of the list is bizarre, given current circumstances.  The economy is growing slowly.  Unemployment remains chronically high, and the employment rate has declined to multi-decade lows.  The nation’s fiscal situation is fraught, and Europe is providing a real time example of what can happen when fiscal issues are allowed to fester.  Entitlements are clearly unsustainable.  These are the things that matter, in my mind objectively, and undoubtedly in the minds of most Americans.

But Obama intends to squander his second chance the way he squandered his first one, chasing progressive unicorns.

A common meme in many elections past was that Republican presidential candidates were “out of touch.”  What could possibly be more out of touch with pressing concerns than a focus on climate change, immigration, education and freakin’ filibuster reform?

Heretofore Obama’s campaign has been relentlessly negative, focusing on Romney’s business past and his alleged extremism.  (Romney extremist?  Who knew?)  This negativity is quite understandable, given the lack of positive accomplishments to run on: even his signature achievement-Obamacare-is a political albatross that he has to tippy-toe around.  Claims that he will adopt policies that will restore growth, increase employment, and improve our fiscal future would immediately raise the question: why should you be given a second chance on these issues, given you’ve flubbed the first?

Romney and Ryan need to try to force Obama to state a positive program for a second term, and hope that he indeed runs on climate change, or even better, filibuster reform (which would be especially rich given that Obama was not shy about the filibuster when he was in the Senate). They need to turn around the “out of touch” meme.

The WSJ piece is intended to present a sympathetic portrait of Obama, but it is anything but.  It portrays a self-pitying man who craves adulation who is overwhelmed by the real challenges and who detests the gritty reality of contending with the opposition in a closely divided country.

He is, in short, much more interested in being Messiah than Moses.

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