Streetwise Professor

March 20, 2009


Filed under: Economics,Politics — The Professor @ 8:30 pm

Some follow up on yesterday’s post, which was written in haste at the airport (with me pushing the “Publish” button while walking down the jetway).  

The Fed’s plan to increase its balance sheet by a third through the purchase of $300 billion in long term Treasuries and $700 billion in other assets is highly significant, not the least because it betrays a lack of confidence in the political branches’ ability to craft a reasonable policy to address the banking crisis, and associated economic woes.  Go figure.  Where could they possibly get that idea?  

Whatever remained of hopes that Treasury and Congress could craft and implement something workable died with the AIG fiasco.  Not the bonuses themselves, mind you, but the demagogic response to what should be at most a symbolic issue.  Congress’s willingness to take extraordinary measures to punish the parties to contracts it dislikes will make virtually impossible the passage and successful implementation of any restructuring plan, or any plan to deal with toxic assets.  Banks will fight any legislation.  If and when legislation passes, or Treasury implements some plan under existing authority, financial institutions will be extremely reluctant to participate.  (Note that banks are already looking for ways to escape TARP.)  Absent credible commitments to honor contracts, the legal risks facing any participant in a program to buy toxic assets, for example, would be extreme.  Take a risk, make a big profit–expect to be excoriated for greed and taking advantage of the taxpayers, and to face substantial risk of expropriation of these gains.  

Theoretically ironclad legal language would provide little protection, for Congress has shown that it is more than willing to use the power to tax as a policy neutron bomb that leaves the formal contract standing, but which kills the contract’s economic benefits. (Indeed, this neutron bomb can destroy the effects of already enacted legislation while leaving the bill intact, pace the Dodd provision in the “Stimulus” bill.)  And that is only one weapon at their disposal.  With Nancy “nobody can hide behind a contract” Pelosi and her legion of Congressional Orks in control, credible commitments to honor the terms and conditions of any rescue plans, or toxic asset purchase plans, are impossible.  Without credible commitments, few will invest capital in anything involving parallel government contributions.  

This fiasco contributes mightily to the already oppressive atmosphere of fear, uncertainty, and doubt that hangs over the economy.  Consumers are not spending (note savings rates have reached levels not seen in recent years); businesses are not investing; banks and individuals are hoarding cash (money supply is way up, but velocity is way down–meaning that money demand is way up.)  All of these are reasonable behaviors in the face of massive uncertainty.  What military pilots call “the pucker factor” is clearly evident, and quite rational.  

Real options theory shows quite clearly that as uncertainty increases, it is economically rational to delay making irreversible investments and spending decisions.  The current policy chaos and hyper-ambitious plans are creating intense uncertainty.  Unprecedented spending plans with unprecedented deficits unimaginable even months ago.  The prospect for such deficits also raises the possibility of massive tax hikes: income taxes; new “environmental” taxes (e.g., cap & trade plus auctioning of credits); inflation taxes; taxes that haven’t even been thought of yet.  Thus, there is incredible uncertainty about how any income arising from current investments (in physical, financial, or human capital) will be taxed; so why not wait to invest until that uncertainty is resolved?  Radical proposals to revamp the largest single sector of the economy.  Untested environmental policies (cap & trade again) with substantial implementation risks (a subject of a future post) and highly uncertain costs.  The list is unending.  

And the failure to deal in a credible way with the uncertainty in the financial sector only contributes to the problem.  

What’s more, banana republic governance that undermines the security and reliability of contracts adds another entirely unnecessary, self-inflicted source of uncertainty.  To add insult to injury, it undermines the very means by which economic actors attempt to manage uncertainty.  (As would the various proposals to limit sharply the trading of risks through the imposition of more onerous financial market regulations.  Great combination.  Create risk, and simultaneously compromise the effectiveness of the economic tools and markets needed to manage it and share it efficiently.)  

What we need is a more sober, stable, Zen approach to the current situation.  A calm and orderly approach, not a pressured, frenetic one.  (I note too that the pressure to act Now! Now! Now! has been the hallmark of hucksters from time immemorial.)  One lacking in demagoguery, not marinated in it.  One that takes first things first–namely, addressing the financial sector–and leaves other things for later.  

But, suffice it to say, we ain’t gonna get it.  

Hence my pessimism, and my predictions for stagflation.  Uncertainty, plus a massive increase in government spending (almost certainly largely unproductive), necessarily entailing a substantial increase in the tax burden, plus far greater government control over far more extensive reaches of the economy is a recipe for stagnation.  Massive injections of liquidity cannot overcome the severe drag resulting from a crippled and likely insolvent banking sector; government spending on unproductive, unvalued things; rising taxes; and inefficient regulation.  All such injections will achieve is to spark inflation, resulting in a stagflation that is likely to make the 70s an idyll by comparison.  

Have a great weekend!

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  1. I say either a) cut off all bailouts to banks and let the invisible hand prune tthe financial sector down to its appropriate size (advantage – optimal outcomes, disadvantage – huge short-term fall in output and social unrest) or b) fully nationalize the banks, use them to redirect resources to more promising sectors of the economy and make examples of complaining bankers in a bout of populist authoritarianism (advantage – will enjoy popular support, can improve longterm competitiveness by incubating technologies, education, developing infrastructure, etc, disadvantage – can be hijacked by special interests resulting in sub-optimal longterm outcomes, undermines “rule of law” which I think is generally overrated but is quite important in the US because it is one of the things underpinning the $’s status as global currency reserve, risks debt-and-currency crisis).

    What I dislike about current policies is their muddle and indecisiveness. It seems that for now the Obama administration is doing its best to aggregate disadvantages, being both populist AND supportive of Wall Street. Although, could it be part of a big plan to shower the banks with money, make them fail anyway, and thus lay the framework for a decisive shift towards socialism / Huey Longism in a few years (although this also risks discrediting the government too)? Or are they just clueless?

    Comment by Sublime Oblivion — March 20, 2009 @ 9:14 pm

  2. R–LOL. That starry eyed optimism is what I get for writing on too little sleep and too much travel!

    DR–I’d go for a) over b) any day. “Redirecting resources to promising sectors.” Right. Wanna buy a bridge? I have a promising sector you can invest in! I wouldn’t say “can be hijacked by special interests.” I’d say “will be hijacked by special interests as sure as nite follows day.” And I think rule of law is a big thing. Absent credible commitments, transactions over time are very problematic, leading to underinvestment and misinvestment (i.e., the direction of investments to things that are harder to expropriate, even though they offer lower returns.)

    I agree completely with your dislike of “muddle and indecisiveness.” That contributes to the FUD. As my father would say, fish or cut bait. (Well, he actually used a more vulgar expression, but I try to keep the blog somewhat family-friendly.) Nobody is gonna do nuthin’ until there is some structure in place.

    And, in my (many?) cynical moments, I think that your Huey Long scenario is not far fetched. But never, never, never, discount the possibility of cluelessness.

    The ProfessorComment by The Professor — March 20, 2009 @ 9:41 pm

  3. I’m preparing for the worst.

    Comment by Matt — March 21, 2009 @ 1:42 am

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