Posts tagged ‘debt’

Bubble Prices are not Wealth

Conservative sites are running with this story:

OBAMANOMICS IN ACTION: Typical US Household Worth One-Third Less Than Under Bush

Seriously?  The bursting of the housing bubble, which actually began under Bush, is Obama's fault?  Because that is what likely drove middle class household worth down (while the Fed-sponsored asset boom in financial instruments drove up wealth of the top 1%).  I suppose one could say that the Republicans sponsored a bubble that helped the middle class while Obama is sponsoring a bubble that helps the wealthy.

I won't say this stuff is meaningless to the economy, because clearly they affect people's perception of wealth and thus spending and optimism.  But sound long-term economic growth has got to come from stable and rational monetary policy that allows interest rates and financial assets to find their correct level.  Getting political mileage out of bubble pricing of assets only creates incentives for politicians such that they will never stop fiddling with interest rates and credit.

When Regulation Makes Things Worse -- Banking Edition

One of the factors in the financial crisis of 2007-2009 that is mentioned too infrequently is the role of banking capital sufficiency standards and exactly how they were written.   Folks have said that capital requirements were somehow deregulated or reduced.  But in fact the intention had been to tighten them with the Basil II standards and US equivalents.  The problem was not some notional deregulation, but in exactly how the regulation was written.

In effect, capital sufficiency standards declared that mortgage-backed securities and government bonds were "risk-free" in the sense that they were counted 100% of their book value in assessing capital sufficiency.  Most other sorts of financial instruments and assets had to be discounted in making these calculations.  This created a land rush by banks for mortgage-backed securities, since they tended to have better returns than government bonds and still counted as 100% safe.

Without the regulation, one might imagine  banks to have a risk-reward tradeoff in a portfolio of more and less risky assets.  But the capital standards created a new decision rule:  find the highest returning assets that could still count for 100%.  They also helped create what in biology we might call a mono-culture.  One might expect banks to have varied investment choices and favorites, such that a problem in one class of asset would affect some but not all banks.  Regulations helped create a mono-culture where all banks had essentially the same portfolio stuffed with the same one or two types of assets.  When just one class of asset sank, the whole industry went into the tank,

Well, we found out that mortgage-backed securities were not in fact risk-free, and many banks and other financial institutions found they had a huge hole blown in their capital.  So, not surprisingly, banks then rushed into government bonds as the last "risk-free" investment that counted 100% towards their capital sufficiency.  But again the standard was flawed, since every government bond, whether from Crete or the US, were considered risk-free.  So banks rushed into bonds of some of the more marginal countries, again since these paid a higher return than the bigger country bonds.  And yet again we got a disaster, as Greek bonds imploded and the value of many other countries' bonds (Spain, Portugal, Italy) were questioned.

So now banking regulators may finally be coming to the conclusion that a) there is no such thing as a risk free asset and b) it is impossible to give a blanket risk grade to an entire class of assets.  Regulators are pushing to discount at least some government securities in capital calculations.

This will be a most interesting discussion, and I doubt that these rules will ever pass.  Why?  Because the governments involved have a conflict of interest here.  No government is going to quietly accept a designation that its bonds are risky while its neighbor's are healthy.  In addition, many governments (Spain is a good example) absolutely rely on their country's banks as the main buyer of their bonds.  Without Spanish bank buying, the Spanish government would be in a world of hurt placing its debt.  There is no way it can countenance rules that might in any way shift bank asset purchases away from its government bonds.

Root Cause

Arnold Kling argues that the root cause of mortgage and student debt problems is not the structure of mortgage and student debt contracts

What these forms of bad debt have in common, in my view, is that they reflect clumsy social engineering. Public policy was based on the idea that getting as many people into home “ownership” with as little money down as possible was a great idea. It was based on the idea of getting as many people into college with student loans as possible.

The problem, therefore, is not that debt contracts are too rigid. The problem is that the social engineers are trying to make too many people into home “owners” and to send too many people to college. Home ownership is meaningful only when people put equity into the homes that they purchase. College is meaningful only if students graduate and do so having learned something (or a least enjoyed the party, but not with taxpayers footing the bill).

Everything Looks Like a Nail When You Have A Hammer

Kevin Drum quotes Hugo Dixon on the Greek recovery:

Greece is undergoing an astonishing financial rebound. Two years ago, the country looked like it was set for a messy default and exit from the euro. Now it is on the verge of returning to the bond market with the issue of 2 billion euros of five-year paper.

There are still political risks, and the real economy is only now starting to turn. But the financial recovery is impressive. The 10-year bond yield, which hit 30 percent after the debt restructuring of two years ago, is now 6.2 percent....The changed mood in the markets is mainly down to external factors: the European Central Bank’s promise to “do whatever it takes” to save the euro two years ago; and the more recent end of investors’ love affair with emerging markets, meaning the liquidity sloshing around the global economy has been hunting for bargains in other places such as Greece.

That said, the centre-right government of Antonis Samaras has surprised observers at home and abroad by its ability to continue with the fiscal and structural reforms started by his predecessors. The most important successes have been reform of the labour market, which has restored Greece’s competiveness, and the achievement last year of a “primary” budgetary surplus before interest payments.

Color me suspicious.  Both the media and investors fall for this kind of thing all the time -- the dead cat bounce masquerading as a structural improvement.  I hope like hell Greece has gotten its act together, but I would not bet my own money on it.

Anyway, that is a bit beside the point.  I found Drum's conclusion from all this odd:

If this keeps up—and that's still a big if—it also might be a lesson in the virtue of kicking the can down the road. Back in 2012, lots of commenters, including me, believed that the eurozone had deep structural problems that couldn't be solved by running fire drills every six months or so and then hoping against hope that things would get better. But maybe they will! This probably still wasn't the best way of forging a recovery of the eurozone, but so far, it seems to have worked at least a little better than the pessimists imagined. Maybe sometimes kicking the can is a good idea after all.

For those that are not frequent readers of his, I need to tell you that one of the themes he has been pounding on of late is that the US should not be worried about either its debt levels or inflation -- attempting to rebut the most obvious critiques of his strong support for more deficit spending and monetary stimulus.

I would have thought the obvious moral of this story was that austerity and dismantling all sorts of progressive labor market claptrap led to a recovery far faster than expected**.  But since Drum opposes all those steps, his  conclusion seems to be simply a return to his frequent theme that debt is A-OK and we shouldn't be worried about addressing it any time soon.

** I don't believe for a moment that Greece has really changed the worst of its structural labor market, regulatory,  and taxation issues.  This story gets written all the time about countries like, say, Argentina.  Sustained incompetence is not really newsworthy, which is likely one reason we get so few African stories.  They would all be like "Nigeria still a mess."  A false recovery story gives the media two story cycles, one for the false recovery and one for the inevitable sinking back into the pit.

Media Accountability -- When The Arizona Republic Tried to Get Scottsdale To Bankrupt Itself

Three cheers for Greg Patterson holding the media accountable for their past support of costly corporate welfare.

You may have seen the recent Wall Street Journal Story about the financial fiasco that is Glendale Arizona.

Here's the Republic's take on it. 

Glendale ranked second in the U.S., according to the story, thanks to a $26.6 million negative fund balance at the close of fiscal 2012, due largely to sports-related debt.

Glendale has made a lot of mistakes, but I think that there is near universal agreement that the critical error was their decision to build the hockey arena.

Yep.  I have written about the egregious hockey deals that have bankrupted Glendale on several occasions.  George Will even quoted me on the topic.

Greg Patterson went back and looked at what the Arizona Republic was writing before the Glendale deals went so noticeably bad.  I have written before about how the media goes into full cheerleader mode on those crony stadium deals.

Before Glendale bankrupted itself to subsidize the hockey team, Scottsdale was offered the "opportunity" to do so and turned it down.  The local paper Arizona Republic excoriated Scottsdale for passing on the chance to subsidize rich sports team owners, saying that "Once-in-a-lifetime projects are just that".  Here is the best quote from the 2004 Republic editorial:

Our view is that Scottsdale's mishandling of the arena idea was a leadership blunder of biblical proportions. Enough with the blame game. We hope that Scottsdale at least has learned some tough lessons from the disaster.

And this is classic:

Some city officials seemed content to nitpick, complain, second-guess and haggle over details. They're right to be diligent. Certainly nobody endorses a Pollyanna-ish panel of rubber-stampers. But at the same time, people who are forever looking for stuff to complain about always seem to find it.

I bet Glendale wishes it had more second-guessers on its city council.  The whole thing is worth reading.

Postscript:  This is one recommendation from the Republic I can agree with:

Think twice about ever launching a redevelopment effort like this again. Sensing that the Los Arcos Mall area was hurting economically, the council formed the Los Arcos Redevelopment District in December 1995. The council adopted a redevelopment plan the following July, and the Ellman Cos. subsequently acquired the 42-acre site. Not too surprisingly, Ellman was the only one to answer the city's request for proposals.

Ellman owns the Los Arcos property. That gives him a lot of advantages, including a position of negotiating authority. It allows him to stoke political outrage by wearing down the patience of neighbors who would like to see something built on this key corner. Got a great idea about what should be done at Los Arcos? Too bad. Ellman still owns it. Condemnation is not a viable political or financial course for the city, and Ellman knows it.

Redevelopment almost always means "crony giveaway" nowadays.

KlearGear Sucks

I don't have a lot to add about this story.  A company called KlearGear trying to fine customers for writing a bad review about it (based on some BS prior restraint on criticism buried in their terms and conditions) and then hounding the customers' credit rating through debt collection agencies.  But I am all for the Streisand effect bringing karmic retribution to such folks, so here is my contribution to Google.

By the way, I found their current header warning to be odd:

notice-tues

Anyone ever heard of a "business hour" before?  Since most customers would not really freak at a 48 hour or 2-day order processing time, anyone want to bet that this means 6 business days (6x8 hours) or over a week, but is meant to fool folks into thinking only two days?  I would ask them directly but there is no way to send them an email without registering first as a customer.  Since by registering, I apparently cede my ability to ever criticize them, I won't be able to write them for clarification.

Our business gets mostly positive reviews, but we get bad ones from time to time.  Every bad review is both a pain in the butt (as they hang around forever on the Internet) but also an opportunity for me to learn and identify problems in the business.  On a couple of occasions I have identified personnel problems through online reviews that let me fix a real problem before something much worse happened.

Update:  The bottom of their home page says "As seen on ABC's Good Morning America".  Yup.  LOL

 

My Corporate Tax Plan

Some folks on the Left are starting to question the corporate income tax, recognizing what economists have known for years, that a lot of the tax is paid by consumers, making it more regressive than just (say) punishing Exxon for being large and productive.

There are many other reasons to hate the corporate income tax

  • It does not raise very much money
  • Its administrative costs (think corporate tax attorneys) is very high
  • It is hugely distortive.  The tax preference for debt over equity helped drive the LBO boom, for example
  • It is the font of much corporate welfare and cronyism.  A LOT of political paybacks get made within the corporate tax system

So here is my simply two-point plan

  1. Eliminate the corporate income tax.  Entirely
  2. Tax dividends and capital gains as regular income on individual tax returns

Done.  All corporate profits get taxed but only when they pass through to individuals as capital gains or dividends.  I think this would actually raise more money but rates could be adjusted (or better yet deductions eliminated) if needs to keep it neutral.

I believe the economic benefits of this would be immediate and substantial.

Of course, corporate tax attorneys are rich and powerful and would cut their throats to stop this.  It would be enormously entertaining to see them try, and in turn see what the reaction of their clients was to this.

 

Nearly Two Centuries of Borrowing in One Day

It took into the mid-1960's for the Federal government to accumulate $328 billion in debt (yeah, I know, nominal dollars).  It rose that much in one day last week.

Trading $1 in Debt for 85 cents of Economic Activity

UPDATE:  Mea culpa.  One point in the original post was dead wrong.  It is possible, contrary to what I wrote below, to get something like a 0.7%  difference in annual growth rates with the assumptions he has in the chart below (Drum still exaggerated when he called it 1%).  I don't know if the model is valid (I have little faith in any macro models) but I was wrong on this claim.  Using the 0.7% and working more carefully by quarter we get a cumulative GDP addition a bit lower than the cumulative debt addition.  There is still obviously a reasonable question even at a multiplier near 1 whether $1 of economic activity today is worth $1 of debt repayment plus interest in the future.  

I am not a believer, obviously, in cyclical tweaking of the economy by the Feds.  To my thinking, the last recession was caused by a massive government-driven mis-allocation of capital so further heavy-handed government allocation of capital seems like a poor solution.  But what really drives me crazy is that most folks on the Left will seductively argue that now is not the time to reduce debt levels, implying sometime in the future when the economy is better will be the appropriate time.  But when, in any expansion, have you heard anyone on the Left say, "hey, its time to reduce spending and cut debt because we need the fiscal flexibility next time the economy goes wrong."

I will leave the stuff in error below in the post because I don't think it is right to disappear mistakes.  For transparency, my spreadsheet reconstruction both confirming the 0.7% and with the updated numbers below is here:   reconstruction.xls.

 

Kevin Drum is flogging the austerity horse again

I see that Macroecomic Advisors has produced a comprehensive estimate of the total effect of bad fiscal policies. Their conclusion: austerity policies since the start of 2011 have cut GDP growth by about 1 percentage point per year.

Something seemed odd to me -- when I opened up the linked study, it said the "lost" government discretionary spending is about 2% of GDP.  Is Drum really arguing that we should be spending 2% of GDP to increase GDP by 1%?

Of course, the math does not work quite this way given compounding and such, but it did cause me to check things out.  The first thing I learned is that Drum partook of some creative rounding.  The study actually said reductions in discretionary spending as a percent of GDP reduced GDP growth rates since the beginning of 2011 by 0.7% a year, not 1% (the study does mention a 1% number but this includes other effects as well).

But it is weirder than that, because here is the chart in the study that is supposed to support the 0.7% number:

click to enlarge

Note that in the quarterly data, only 2 quarters appear to show a 0.7% difference and all the others are less.  I understand that compounding can do weird things, but how can the string of numbers represented by the green bars net to 0.7%?  What it looks like they did is just read off the last bar, which would be appropriate if they were doing some sort of cumulative model, but that is not how the chart is built.  If we interpolate actual values and are relatively careful about getting the compounding right, the difference is actually about 0.45%.  So now we are down to less than half the number Drum quoted see update above (I sent an email to the study author for clarification but have not heard back.  Update:  he was nice enough to send me a quick email).

So let's accept this 0.45% 0.7% number for a moment.  If GDP started somewhere around 16 trillion in 2010, if we apply a 0.45% the quarterly growth numbers from his chart, we get an incremental economic activity from 2011 through 2013:Q2 of about $333 billion.

So now look at the spending side.  The source says that discretionary spending fell by about 2% of GDP over this period.  From the graph above, it seems to bite pretty early, but we will assume it fell 1/12 of this 2% figure each quarter, so that by the end of 2013 or beginning of 2014 we get a fall in spending by 2% of GDP.  Cumulatively, this would be a reduction in spending over the 2.5 years vs. some "non-austere" benchmark of $388 billion.

Thus, in exchange for running up $677 billion $388 billion in additional debt, we would have had $445 billion $333 billion in incremental economic activity.  A couple of reactions:

  1. Having the government borrow money and spend it definitely increases near-term GDP.  No one disputes that.  It is not even in question.  Those of us who favor reigning in government spending acknowledge this.  The question is, at what cost in terms of future obligations.  In fact, this very study Drum is quoting says

    Economists agree that failure to shrink prospective deficits and debt will bestow significant economic consequences and risks on future generations. Federal deficits drive up interest rates, “crowding out” private investment. If government borrowing supports consumption (e.g., through Social Security and major health programs) rather than public investment, the nation’s overall capital stock declines, undermining our standard of living. The process is slow but the eventual impact is large.2 In addition, accumulating debt raises the risk of a fiscal crisis. No one can say when this might occur but, unlike crowding out, a debt crisis could develop unexpectedly once debt reached high levels.

    High deficits and debt also undermine the efficacy of macroeconomic policies and reduce policymakers’ flexibility to respond to unexpected events. For example, in a recession, it would be harder to provide fiscal stimulus if deficits and debt already were high. Furthermore, fiscal stimulus might be less effective then. Additional deficit spending could be seen as pushing the nation closer to crisis, thereby forcing up interest rates and undercutting the effects of the stimulus. With fiscal policy hamstrung, the burden of counter-cyclical policy is thrust on the Federal Open Market Committee (FOMC) but, particularly in a low interest-rate environment, the FOMC may be unable (or unwilling) to provide additional monetary
    stimulus.

  2. I guess we have pretty much given up on the >1 multiplier, huh?  Beggaring our children for incremental economic growth today is a risky enough strategy, but particularly so with the implied .66 .85 multiplier here.

This is not the first time Drum has taken, uh, creative data approaches to cry "austerity" during a mad spending spree. 

OK, This Is The Most Absurd Defense I Have Seen of Obama, At Least This Week

Via Kevin Drum

Dave Weigel notes a conundrum today: according to a new poll, 54 percent of the public disapproves of Barack Obama's handling of the deficit. And yet, as the chart on the right shows, the deficit is shrinking dramatically. Last year it dropped by $200 billion, and this year, thanks to a recovering economy, lower spending from the sequester, and the increased taxes in the fiscal cliff deal, it's projected to fall another $450 billion.

Weigel notes that this has deprived conservative yakkers of one of their favorite applause lines: "You don't hear Republicans lulz-ing at Obama for failing to 'cut the deficit in half in my first four years,' because he basically did this, albeit in four and a half." That's true. It's also true that contrary to Republican orthodoxy, it turns out that raising taxes on the rich does bring in higher revenues and therefore reduces the deficit.

The logic here is that Obama has been diligent about cutting the deficit, so therefore Republicans are wrong to try to use the debt ceiling and continuing resolution as a vehicle for forcing more cuts.

It is just possible that a person from another planet landing today might buy this story, but how can anyone who has lived through the last 5 years read this without laughing their butts off?  Every one of Obama's budgets have been dead on arrival, even within his own party, because they have raised spending to such stupid levels.  There has not been even a hint of fiscal responsibility in them.  And the Democratic Senate has passed one budget in something like five years**.

The only fiscal discipline at all has come from the Republican House, and they have only had success in keeping these deficit down by ... using continuing resolutions and debt ceilings as bargaining chips.  This is the President that treated the almost insignificant sequester as if it were the end of the world, and now these sycophants from team Donkey are giving Obama the credit for the deficit reduction?

PS-  This is not an advocacy for Republicans as much as for divided government.  The Republicans when they had years of controlling the Presidency and both houses of Congress under Bush II did zero to get our fiscal house in order and in fact with the Iraq war and Medicare part D, among other things, showed a profligacy that belies their current pious words.

PPS- Kevin Drum needs to have the balls not to play both sides of the street.  He has made it clear in other articles that he thinks it is an economic disaster that the government is spending so little right now.  When he shows a deficit reduction chart, if he were consistent, he should be saying that Republicans suck for forcing this kind of deficit reduction against Obama's better judgement and we need the deficit to go back up.  Have the courage of your convictions.  Instead, he plays team loyalty rather than intellectual consistency, crediting Obama for deficit reduction while at the same time hammering Republicans for austerity.  Dude, its one or the other.

PPPS-  For the first time during this Presidency, both the President and both house of Congress offered a budget:

[The] House passed a budget calling for spending $3.5 trillion in 2014, the Senate passed one calling for $3.7 trillion, and Obama submitted one calling for $3.77 trillion

So the actor that submitted the highest budget gets the credit for deficit reduction?

Single-Minded Obsession on Home Ownership

This article from the LA Times confused me greatly:

Advocates for borrowers took such comments to mean that the banks would prioritize debt write-downs on first mortgages, which banks resisted before the [$25 billion] settlement. Now, with nearly all the promised relief handed out, it is clear that the banks had other ideas.

The vast majority of the aid to borrowers, it turns out, came in the form of short sales and forgiveness of second mortgages. Just 20% of the aid doled out under the national settlement went to forgiveness of first-mortgage principal, the kind of help most likely to keep troubled borrowers in their homes. In terms of borrowers helped, just 15% of the total received first-mortgage forgiveness.

The five banks collectively delivered twice as much aid using short sales, in which owners sell their homes for less than the amount owed and move out, with the shortfall forgiven.

In all, the lenders sought credit for nearly $21 billion related to short sales and $15 billion related to second mortgages. That compares with $10.4 billion in write-downs on first mortgages.

Critics on the Left (example) are calling this a failure of the program, that most of the relief went to short-sales and 2nd mortgage forgiveness rather than first mortgage forgiveness.  The original article has this quote:

"It just shows you that the banks are running the government," Marks said. "There's virtually no benefit to borrowers, and yet you give the banks credit for short sales and getting second liens wiped out — something they were going to have to do anyway."

Hmm, well I am not the biggest fan of bankers in the world, but short sales and second lien forgiveness are principle forgiveness as well, just of a different form.  If they wanted a settlement that was first-lien forgiveness only, they should have specified that.

In fact, both short sales and second lien forgiveness have tremendous value to individuals if one considers individual well-being one's goal rather than just this obsessive fixation on home ownership.  

For many people, the worst part of their negative equity is that it created a barrier to their moving.  Perhaps they could find a job in another part of the state or country, or they wanted to move into a home or apartment with less expensive payments but were stuck in their current home because they could not afford to bring tens of thousands of dollars to closing.  In such cases, a short sale is exactly what the homeowner needs and facilitating and expediting this likely helped a ton of people  (It is also an example of just how unique our mortgage rules are in the US -- in almost any other country in the world, the amount of the negative equity in a short sale would get hung on the seller as a lien that must be paid off over time.  Only in the US do buyers routinely walk away clean from such situations).  Given that first mortgage loan forgiveness more often than not does not save the loan (ie it eventually ends in foreclosure anyway), short sales are the one approach that lets lenders get away clean for a fresh start.

As for second mortgages, I can tell you from personal experience that it is virtually impossible in the current environment to restructure or refinance a first mortgage with a second lien on the house -- even in my case where everything is performing and the underlying home value is well above the total of the two liens.  Seriously, what is the point in reducing principle in the first mortgage if there is a second mortgage there, particularly when the second mortgage is likely far more expensive?  For people with a second mortgage, forgiveness of that is probably the first and best gift they could get.  They may end up still losing their home, but they can't even begin to discuss a restructure or refinance without that other mortgage going away.

The Government, Nudging, and Delay Discounting

The theory behind the idea that government should nudge (or coerce, as the case may be) us into "better" behavior is based on the idea that many people are bad at delay discounting.  In other words, we tend to apply huge discount rates to pain in the future, such that we will sometimes make decisions to avoid small costs today even if that causes us to incur huge costs in the future (e.g. we refuse to walk away from the McDonalds french fries today which may cause us to die of obesity later).

There are many problems with this theory, not the least of which is that many decisions that may appear to be based on bad delay discounting are actually based on logical and rational premises that outsiders are unaware of.

But the most obvious problem is that people in government, who will supposedly save us from this poor decision-making, are human beings as well and should therefore have the exact same cognitive weaknesses.  No one has ever managed to suggest a plausible theory as to how our methods of choosing politicians or staffing government jobs somehow selects for people who have better decision-making abilities.

Here is a great example.  These are the people who think YOU have a problem with delay discounting:

When all the numbers are crunched, one fact is crystal clear: Yes, a disaster was looming for Detroit. But there were ample opportunities when decisive action by city leaders might have fended off bankruptcy.

If Mayors Jerome Cavanagh and Roman Gribbs had cut the workforce in the 1960s and early 1970s as the population and property values dropped. If Mayor Dennis Archer hadn’t added more than 1,100 employees in the 1990s when the city was flush but still losing population. If Kilpatrick had shown more fiscal discipline and not launched a borrowing spree to cover operating expenses that continued into Mayor Dave Bing’s tenure. Over five decades, there were many ‘if only’ moments.

“Detroit got into a trap of doing a lot of borrowing for cash flow purposes and then trying to figure out how to push costs (out) as much as possible,” said Bettie Buss, a former city budget staffer who spent years analyzing city finances for the nonpartisan Citizens Research Council of Michigan. “That was the whole culture — how do we get what we want and not pay for it until tomorrow and tomorrow and tomorrow?”

Ultimately, Detroit ended up with $18 billion to $20 billion in debt and unfunded pension and health care liabilities. Gov. Rick Snyder appointed bankruptcy attorney Kevyn Orr as the city’s emergency manager, and Orr filed for Chapter 9 on July 18.

Raise Medicare Taxes

I have made this argument before -- your lifetime Medicare taxes cover only about a third of the benefits you will receive.   Social Security taxes are set about right -- to the extent we come up short on Social Security, it is only because a feckless Congress spent all the excess money in the good years and has none left for the lean years.

But Medicare is seriously mis-priced.  I have always argued that this is dangerous, because there is nothing that screws up the economy more than messed up price signals.  In particular, I have argued that a lot of the glowy hazy love of Medicare by Americans is likely due to the fact that it is seriously mis-priced.  Let's price the thing right, and then we can have a real debate about whether it needs reform or is worth it.

A recent study confirms my fear that the mispricing of Medicare is distorting perceptions of its utility.

As debate over the national debt and the federal budget deficit begins to heat up again, an analysis of national polls conducted in 2013 shows that, compared with recent government reports prepared by experts, the public has different views about the need to reduce future Medicare spending to deal with the federal budget deficit. Many experts believe that future Medicare spending will have to be reduced in order to lower the federal budget deficit [1] but polls show little support (10% to 36%) for major reductions in Medicare spending for this purpose. In fact, many Americans feel so strongly that they say they would vote against candidates who favor such reductions. Many experts see Medicare as a major contributor to the federal budget deficit today, but only about one-third (31%) of the public agrees.

This analysis appears as a Special Report in the September 12, 2013, issue of New England Journal of Medicine.

One reason that many Americans believe Medicare does not contribute to the deficit is that the majority thinks Medicare recipients pay or have prepaid the cost of their health care. Medicare beneficiaries on average pay about $1 for every $3 in benefits they receive. [2] However, about two-thirds of the public believe that most Medicare recipients get benefits worth about the same (27%) or less (41%) than what they have paid in payroll taxes during their working lives and in premiums for their current coverage.

Update:  Kevin Drum writes on the same study.  Oddly, he seems to blame the fact that Americans have been trained to expect something for nothing from the government on Conservatives.  I am happy to throw Conservatives under the bus for a lot of things but I think the Left gets a lot of the blame if Americans have been fooled into thinking expensive government freebies aren't really costing them anything.

Keynesian Multiplier of 0.05

So much for that Keynesian stimulus notion (emphasis in the original)

With everyone focused on the 5th anniversary of the Lehman failure, we are taking a quick look at how the world's developed (G7) nations have fared since 2008, and just what the cost to restore "stability" has been. In a nutshell: the G7 have added around $18tn of consolidated debt to a record $140 trillion, relative to only $1tn of nominal GDP activity and nearly $5tn of G7 central bank balance sheet expansion (Fed+BoJ+BoE+ECB). In other words, over the past five years in the developed world, it took $18 dollars of debt (of which 28% was provided by central banks) to generate $1 of growth. For all talk of "deleveraging" G7 consolidated debt has been at a record high 440% for the past four years.

The theory of stimulus -- taking money out of the productive economy, where it is spent based on the information of hundreds of millions of people as to the relative value of millions of potential investments, and handing it to the government to spend based on political calculus -- never made a lick of sense to me.  I guess I would have assumed the multiplier in the short term was fractional but at least close to one, indicating in the short run that if we borrow and dump the money into the economy we would get some short-term growth, only to have to pay the piper later.  But we are not even seeing this.

Meet the Person Who Wants to Run Your Life -- And Obama Wants to Help Her

I am a bit late on this, but like most libertarians I was horrified by this article in the Mail Online about Obama Administration efforts to nudge us all into "good" behavior.  This is the person, Maya Shankar, who wants to substitute her decision-making priorities for your own

article-2381478-1B11DB61000005DC-332_308x425

 

If the notion -- that a 20-something person who has apparently never held a job in the productive economy is  telling you she knows better what is good for you -- is not absurd on its face, here are a few other reasons to distrust this plan.

  • Proponents first, second, and third argument for doing this kind of thing is that it is all based on "science".  But a lot of the so-called science is total crap.  Medical literature is filled with false panics that are eventually retracted.  And most social science findings are frankly garbage.  If you have some behavior you want to nudge, and you give a university a nice grant, I can guarantee you that you can get a study supporting whatever behavior you want to foster or curtail.  Just look at the number of public universities in corn-growing states that manage to find justifications for ethanol subsidies.  Recycling is a great example, mentioned several times in the article.  Research supports the sensibility of recycling aluminum and steel, but says that recycling glass and plastic and paper are either worthless or cost more in resources than they save.  But nudgers never-the-less push for recycling of all this stuff.  Nudging quickly starts looking more like religion than science.
  • The 300 million people in this country have 300 million different sets of priorities and personal circumstances.  It is the worst hubris to think that one can make one decision that is correct for everyone.  Name any supposedly short-sighted behavior -- say, not getting health insurance when one is young -- and I can name numerous circumstances where this is a perfectly valid choice and risk to take.
  • The justification for this effort is social science research about how people manage decisions that involve short-term and long-term consequences

Some behavioral scientists believe they can improve people's self-control by understanding the relationship between short term memory, intelligence and delay discounting.

This has mostly been used to counter compulsive gambling and substance abuse, but Shankar's entry into government science circles may indicate that health insurance objectors and lapsed recyclers could soon fall into a similar category

I am sure there is a grain of truth in this -- all of us likely have examples of where we made a decision to avoid short term pain that we regretted.  But it is hilarious to think that government officials will somehow do better.  As I have written before, the discount rate on pain applied by most legislators is infinite.  They will do any crazy ridiculous thing that has horrible implications five or ten years from now if they can just get through today.  Why else do government bodies run massive sustained deficits and give away unsustainable pension and retirement packages except that they take no consideration of future consequences.  And it is these people Maya wants to put in charge of teaching me about delay discounting?

  • It probably goes without saying, but nudging quickly becomes politicized.  Is nudging 20-something health men to buy health insurance really in their best interests, or does it help keep an important Obama program from failing?

Postscript:  Here is a great example of just how poorly the government manages delay discounting.  In these cases, municipalities are saddling taxpayers with almost certainly bankrupting future debt to avoid paying any short-term costs.

Texas school districts have made use of another controversial financing technique: capital appreciation bonds. Used to finance construction, these bonds defer interest payments, often for decades. The extension saves the borrower from spending on repayment right now, but it burdens a future generation with significantly higher costs. Some capital appreciation bonds wind up costing a municipality ten times what it originally borrowed. From 2007 through 2011 alone, research by the Texas legislature shows, the state’s municipalities and school districts issued 700 of these bonds, raising $2.3 billion—but with a price tag of $23 billion in future interest payments. To build new schools, one fast-growing school district, Leander, has accumulated $773 million in outstanding debt through capital appreciation bonds.

Capital appreciation bonds have also ignited controversy in California, where school districts facing stagnant tax revenues and higher costs have used them to borrow money without any immediate budget impact. One school district in San Diego County, Poway Unified, won voter approval to borrow $100 million by promising that the move wouldn’t raise local taxes. To live up to that promise, Poway used bonds that postponed interest payments for 20 years. But future Poway residents will be paying off the debt—nearly $1 billion, all told—until 2051. After revelations that a handful of other districts were also using capital appreciation bonds, the California legislature outlawed them earlier this year. Other states, including Texas, are considering similar bans.

Or here is another example, of New York (the state that is home to the mayor who tries to nudge his residents on everything from soft drinks to salt)  using trickery to consume 25 years of revenue in one year.

Other New York deals engineered without voter say-so include a $2.7 billion bond offering in 2003, backed by 25 years’ worth of revenues from the state’s gigantic settlement with tobacco companies. To circumvent borrowing limits, the state created an independent corporation to issue the bonds and then used the money from the bond sale to close a budget deficit—instantly consuming most of the tobacco settlement, which now had to be used to pay off the debt.

By the way, I recommend the whole linked article.  It is a pretty broad survey of how state and local governments are building up so much debt, both on and off the books, and how politicians bend every law just to be able to spend a few more dollars today.

Previewing the President's College Rankings

Today, President Obama sort-of kind-of acknowledged a problem with Federal college student lending:  Federal loans are doing nothing to improve the affordability of colleges, as colleges are just raising tuition in lockstep with increased lending, thus leaving students massively in debt for the same old degree.

His proposed solution is to somehow tie the availability of Federal funds to some type of government scoring system for colleges.  The probability that this will do anything to reign in student debt is exactly zero.  But it will potentially give the Feds another vehicle for control (similar to what Title IX has given them) of even the most mundane university policies.  Why not, for example, give high scores to universities with the restrictive and politically correct speech codes this Administration favors, thus effectively denying money to students of universities that don't have Eric Holder-sanctioned speech policies?

If you think I am exaggerating, look at the recent Washington Monthly college rankings as a prototype for the Obama scoring system.  In their system, colleges are ranked higher if they have a higher percentage of Peace Corps*** graduates, if more of their Federal work-study grant money is used for jobs at non-profits rather than for-profits**, and if their school reports more community service hours.  This latter points to another issue -- a number of schools rank really low on community service hours, effectively all tied with zero.  This is obviously a reporting issue.  The Obama plan just about guarantees that universities will start to game all these metrics -- does no one pay attention to the fraud that has been found in the law school rankings?

They also have a ranking of the schools providing the best value.  The good news, I suppose, is the school my son attends is #1.  The bad news is that my alma mater Princeton is not even on the list.  I found this odd, because while the authors explicitly laud Amherst's generous program that helps fund students through grants rather than loans, Princeton actually was one of a few schools that did this first (update:  Princeton was the first school to eliminate loans from financial aid packages of low income students, and since has eliminated loans altogether from all financial aid packages.  If you can get in, you can graduate debt-free).

It says this of Amherst:

 It chose to tap its sizable $1.6 billion endowment to provide tuition discounts so generous that the annual net cost to students with family incomes below $75,000 is only $843, less than a third of the sticker price of a year at the average community college. Another elite liberal arts college, Williams, also makes our list. But instructively, none of the other prestigious, well-endowed private colleges and universities in America—not Harvard or Yale, Swarthmore or Smith, none of them—can make that claim.

Actually, we don't know if that last sentence is true because the authors left Harvard and Yale off the list entirely.   My impression is that Princeton makes is very inexpensive for families making less than $75,000 as well, so I could not understand the claim -- perhaps even without debt the tuition charges to low-income families are still unreasonably high.  But we will never know, because apparently Princeton is not even on the list -- not because it does not direct a lot of its endowment to need-based scholarships, but because it has only 10% students on Pell grants, and the authors decided that you could not be on the list unless that number was at least 20% "to make sure they aren’t just catering to the affluent."  This just points to how quickly such a system gets politicized.  What does "catering to the affluent" have anything to do with bang for the buck?  If they really trust their methodology, they would have included these schools and if they are really just over-priced rich kids' playgrounds, that should have come through in the ranking.  Instead, the author's have explicitly invented an unrelated criteria to weed Ivy League schools out, a criteria more related to admissions requirements than to financial aid requirements and affordability and value (the ostensible bases for the rankings).

By the way, if you want to get a really good laugh, this is supposed to be a value or "bang for the buck" ranking, but they only rank the costs.  There is absolutely no ranking of "bang".  Bizarre.  It is as if any degree of any type from any institution is equally valuable.  Which, by the way, is part of the problem in the student loan bubble -- just this assumption.

 

** This is EXACTLY the kind of incentive that will help pay off those future college loans -- lets make sure to encourage every student to work in non-profits rather than for-profits jobs.

*** Why the Peace Corps?  Why not a myriad of other useful and productive occupations?  If you want to have a service metric, why is Peace Corps there and, say, Teach for America not?

Government-Enforced Pre-Paid Medical Plans

What she said

The banning of catastrophic-only plans infuriates me the most. Those are the only plans that are actually financially sensible for a healthy individual to purchase. Everything else on the market is a perverse by-product of the employer-based insurance system.

Worst case scenario with a catastrophic-only plan is you end up with $10,000 in debt. That’s a debt load many times smaller than what the Federal government thinks students should take out to get a college degree. We’ll let you borrow $100,000 to get a sociology degree but, we think that $10,000 is an unconscionable amount to pay for medical expenses? So unconscionable that we have to FORCE YOU to buy a plan with more extensive coverage?

Of course, we all know the real reason for this. it’s meant to force healthy young people to subsidize healthcare for older sicker people. Just force them to pay more for insurance than they ought to, and force them to buy more extensive coverage than is rational.

Obama Didn't Need to Order IRS Crackdown on the Tea Party

There won't be any direct order found telling the IRS to go hassle Conservative groups.  That's not the way it works.  Obama's style is to "other" groups he does not like, to impugn their motives, and to cast them as pariahs beyond the bounds of civil society.  Such and such group, he will say, opposes me not because they have reasonable differences of opinion but because they have nefarious motives.  Once a group is labelled and accepted (at least by your political followers) as such, you don't have to order people to harass them. They just do it, because they see it as the right thing to do to harass evil people.  When Joe Nocera writes this in support of Obama in no less a platform as the NY Times, orders are superfluous

You know what they say: Never negotiate with terrorists. It only encourages them.

These last few months, much of the country has watched in horror as the Tea Party Republicans have waged jihad on the American people. Their intransigent demands for deep spending cuts, coupled with their almost gleeful willingness to destroy one of America’s most invaluable assets, its full faith and credit, were incredibly irresponsible. But they didn’t care. Their goal, they believed, was worth blowing up the country for, if that’s what it took...

He concludes by saying

For now, the Tea Party Republicans can put aside their suicide vests. But rest assured: They’ll have them on again soon enough. After all, they’ve gotten so much encouragement.

There are probably some deeply confused people in the IRS right now -- after all they were denying tax exempt status to terrorists, to enemies of America.  They should be treated like heroes, and now they are getting all this criticism.  So unfair.

Postscript:  And they are racists.  Racist terrorists.

But Obama, in his most candid moments, acknowledged that race was still a problem. In May 2010, he told guests at a private White House dinner that race was probably a key component in the rising opposition to his presidency from conservatives, especially right-wing activists in the anti-incumbent "Tea Party" movement that was then surging across the country.

This is totally the Obama way of fighting a political battle.  He is saying, "forget their stated reasons for opposing me, such as opposition to the health care law, to Wall Street bailouts, and to rising government debt.  They really oppose me because they are racists and I am black."  Obama's opposition are absolutely never, ever people of good will who simply disagree.

PS#2:  It's pretty hilarious the NY Times published Nocera's "Tea Partiers are Terrorists" editorial just 6 months after they editorialized against incivility in the context of the Giffords shooting, which by the way had as much to do with civility in public discourse as the Benghazi attacks had to do with a YouTube video.  In fact, it sure seems like this administration has a history of falsely blaming tragedies on their political opposition's speech.

The Plan For Universities to Raise Tuition to Infinity

Via the WSJ, President Obama is proposing debt forgiveness for student borrowers

The White House proposes that the government forgive billions of dollars in student debt over the next decade, a plan that cheers student advocates, but critics say it would expand a program that already encourages students to borrow too much and stick taxpayers with the bill.

The proposal, included in President Barack Obama's budget for next year, would increase the number of borrowers eligible for a program known casually as income-based repayment, which aims to help low-income workers stay current on federal student debt.

Borrowers in the program make monthly payments equivalent to 10% of their income after taxes and basic living expenses, regardless of how much they owe. After 20 years of on-time payments—10 years for those who work in public or nonprofit jobs—the balance is forgiven.

Already, it's pretty clear that many students pay little attention to size of the debt they run up.  Easy loans for students have essentially made them less price sensitive, however irrational this may seem (did you make good short - long term trade-offs at the age of 18?)  As a result, tuition has soared, much like home prices did as a result of easy mortgage credit a decade ago.  The irony is that easier student debt is not increasing access to college for the average kid (since tuition is essentially staying abreast of increases in debt availability), but is shifting student's future dollars to university endowments and bloated administrations.  Take any industry that has in the past been accused of preying on the financially unsophisticated by driving them into debt for profit, and universities are fifty times worse.

So of course, the Progressives in the White House and Congress (unsurprisingly Elizabeth Warren has a debt subsidy plan as well) are set to further enable this predatory behavior by universities.  By effectively capping most students' future financial obligations from student debt, this plan would remove the last vestiges of price sensitivity from the college tuition market.  Colleges can now raise tuition to infinity, knowing that the bulk of it will get paid by the taxpayer some time in the future.  Just as the college price bubble looks ready to burst, this is the one thing that could re-inflate it.

Postscript:  By the way, let's look at the numbers.  Let's suppose Mary went to a top college and ran up $225,000 in debt.  She went to work for the government, averaging $50,000 a year (much of her compensation in government is in various benefits that don't count in this calculation).  She has to live in DC, so that's expensive, and pay taxes.  Let's say that she has numbers to prove she only has $20,000 left after essential living expenses.  10% of that for 10 years is $20,000 (or about $13,500 present value at 8%).  So Mary pays less than $20,000 for her education, and the taxpayer pays $205,000.  The university makes a handsome profit - in fact they might have given her financial aid or a lower tuition, but why bother?  Mary doesn't care what her tuition is any more, because she is capped at around $20,000.  The taxpayer is paying the rest and is not involved in the least in choosing the university or setting prices, so why not charge the taxpayer as much as they can?

Postscript #2:  It is hard to figure out exactly what Elizabeth Warren is proposing, as most of her proposal is worded so as to take a potshot at banks rather than actually lay out a student loan plan.  But it appears that she wants to reduce student loan interest rates for one year.  If so, how is this different from teaser rates on credit cards, where folks -- like Elizabeth Warren -- accuse credit card companies of tricking borrowers into debt with low initial, temporary rates.  I  find it  a simply astounding sign of the bizarre times we live in that a leading anti-bank progressive is working on legislative strategies to get 18-year-olds further into debt.

A Couple of Thoughts About Reinhart & Rogoff

As quick background, R&R had a study that found that higher government debt levels correlated to lower, even negative, economic growth.  More recently, others have found computational errors that exaggerated this result, and have criticized their methodology, particularly their approach to weighting data from different countries and years.

A few thoughts:

  1. A major reasons the errors were found is that R&R actually made their data available for replication.  This is apparently rare - certainly it is rare in the climate world.  I am glad they are getting kudos for this and hope the academic world can find a way to incentivize / force more data sharing
  2. I would not have expected a direct relationship between country debt levels and economic growth.  What I would expect is that growth can still be good at higher debt levels, but the risk of hitting a tipping point starts to rise dangerously with debt levels.  Eventually levels get so high that an interest rate shock or liquidity shock is almost inevitable
  3. More than a relation between GDP growth and absolute debt levels, I would have expected a relationship between GDP growth and changes in debt level.  Absolute government debt levels may represent resources removed from the productive economy years and decades earlier.  Increases in government debt represent recent decreases in capital available for productive use.

Bitcoin, Short Sales, and Volatility

I am fascinated by Bitcoin and would love to see it be a success.  But Tyler Cowen has a quote that reflects some of my concerns about it:

…bitcoins are an uncomfortable combination of commodity and currency. The commodity value of bitcoins is rooted in their currency value, but the more of a commodity they become, the less useful they are as a currency.

Bitcoin is in the midst of an enormous price bubble, with increases in value of as much as 50% over just a few days.  This is astounding volatility for even a commodity, much less a currency.

Cowen said something at the end of the post, almost as a throw-away, that got my attention:  "There is, by the way, no current way to short Bitcoin."  The reason this caught my eye is that I have argued a long time that short selling is an important mechanism to reduce market volatility.

Every time we get to a market bubble or problem, insiders always start arguing against short selling saying it makes volatility worse and undermines markets.  But what they are really saying is that they like volatility so long as it is up. They had no problem with the bubble that propelled their securities up, they just don't want them to come back down to Earth.

In certain bubbles, when interest in a certain asset class gets really frothy, anyone who is skeptical of the asset and its new high values will sell and get out.  This means that as the bubble grows, all the skeptics are long gone from the market.  No longer owning the asset, these skeptics have no further "vote" or influence on the price.  Short selling is a way for skeptics to continue to influence the price and asset values.  To this extent, I think it tends to limit the peak of bubbles, just as bottom-fishers limit the debt of troughs.

Bitcoin would likely benefit from skeptics having some sort of influence on bitcoin values.  But without a way to short, Bitcoin values are driven solely by wacky anarcho-capitalists (e.g. people like me) and people fearful of Cyprus style depositor losses.  Essentially all the true believers are bidding against themselves.

Re-Inflating the Bubble

We all know from progressive and Democratic writers the the Community Reinvestment Act and other efforts to offer cheap home loans to people without good credit had nothing to do with the mortgage industry offering too many loans to people without good credit.

So we should not be in the least bit worried that the Obama Administration is calling for more mortgages to be given to people with weaker credit, while sub-prime auto loans are simply booming.  Because we have learned from Iceland and Greece and Cyprus that the best way to deal with a debt crisis is by encouraging consumers to take on more debt, and the best way to respond to an asset bubble is to try to re inflate the bubble.

All of this, of course, is simply crazy talk.  The people who are involved HAVE to know this won't end well, because the most recent example of this leading to disaster is only 4 years old.  Hell, the people doing this were in office when this same approach fell apart last time.  But politicians refuse to face some pain now to avoid huge pain in the future - for politicians, the discount rate on pain is infinite.

Krugman Dead Wrong on Capital Controls

I am a bit late to the game in addressing Krugman's comments several days ago when he said:

But the truth, hard as it may be for ideologues to accept, is that unrestricted movement of capital is looking more and more like a failed experiment.

This was in response to the implosion of Cyprus banks, which was exacerbated (but not necessarily caused) by the banks being a home for a lot of international hot money - deposits so large they actually dwarfed the country's GDP.

I generally rely on Bastiat's definition of the role of the economist, which I will quote from Wikipedia (being too lazy on this Friday morning to find a better source):

One of Bastiat's most important contributions to the field of economics was his admonition to the effect that good economic decisions can be made only by taking into account the "full picture." That is, economic truths should be arrived at by observing not only the immediate consequences – that is, benefits or liabilities – of an economic decision, but also by examining the long-term second and third consequences. Additionally, one must examine the decision's effect not only on a single group of people (say candlemakers) or a single industry (say candlemaking), but on all people and all industries in the society as a whole. As Bastiat famously put it, an economist must take into account both "What is Seen and What is Not Seen."

By this definition, Krugman has become the world's leading anti-economist.  Rather than reject the immediate and obvious (in favor of the larger picture and the unseen), he panders to it.  He increasingly spends his time giving intellectual justification to the political predilection for addressing symptoms rather than root causes.  He has become the patron saint of the candle-makers petition.

I am not naive to the fact that there are pools of international hot money that seem to be some of the dumbest money out there.  Over the last few years it has piled into one market or another, creating local asset bubbles as it goes.

But to suggest that international capital flows need to be greatly curtailed merely to slow down this dumb money, without even considering the costs, is tantamount to economic malpractice.

You want to know what much of the world outside of Western Europe and the US would look like without free capital flows?  It would look like Africa.  In fact, for the younger folks out there, when I grew up, countries like China and India and Taiwan and Vietnam and Thailand looked just like Africa.  They were poor and economically backwards.  Capital flows from developed nations seeking new markets and lower cost labor has changed all of that.  Over the last decade, more people have escaped grinding subsistence poverty in these nations than at any other time in history.

So we have the seen:  A million people in Cyprus face years of economic turmoil

And the unseen:  A billion people exiting poverty

By pandering to those who want to expand politicians' power based on a trivial understanding of the seen and a blindness to the unseen, Krugman has failed the most important role of an economist.

Other thoughts:  I would offer a few other random, related thoughts on Cyprus

  • Capital controls are like gun and narcotics controls:  They stop honest people and do little to deter the dishonest.  In the case of Cyprus, Krugman obviously would have wanted capital controls to avoid the enormous influx of Russian money the overwhelmed the government's effort to stabilize the banks.  But over the last several weeks, the Cyprus banks have had absolute capital controls in place - supposedly no withdrawals were allowed.  And yet when the banks reopened, it become increasingly clear that many of the Russians had gotten their money out.  Capital controls don't work as a deterrence to money that is already corrupt and being hidden.
  • No matter what anyone says, the huge capital inflows into Cyprus had nothing to do with the banking collapse.  The banks had the ability to invest the money in a range of international securities, and the money was tiny compared to the size of those security pools.  So this is not like, say, a housing market where in influx of money might cause a bubble.   The only harm caused by the size of the Russian investments is that once the bank went bad, the huge size of the problem meant that the Cyprus government did not have the resources to bail out the bank and protect depositors from losses.
  • Capital controls are as likely to make bubbles worse as they are to make them better.  Certainly a lot of international money piling into a small market can cause a bubble.  But do capital controls really create fewer bubbles?  One could easily argue that the Japanese asset bubble of the late 80's would have been worse if all the money were bottled up in the country. When the Japanese went around the world buying up American movie studios and landmark real estate, that was in some sense a safety valve reducing the inflationary pressure in Japan.
  • Capital controls are the worst sort of government expropriation.  You hear on the news that the "haircut" taken by depositors in Cyprus might be 20% or 80% or whatever.  But in my mind it does not matter.   Because once the government put strict capital controls in place, the haircut effectively became 100%, at least for honest people that don't have the criminal ability or crony connections to beat the system.  Cyprus basically produces nothing.  Since money is only useful to the extent that it can buy or invest in something, then bottling up one's money in Cyprus basically makes it worthless.
  • Capital controls are a prelude to protectionism.   First, international trade is impossible without free flow of capital.   No way Apple is going to sell ipods in Cyprus if they cannot at some point repatriate their profits.  Capital controls can also lead to export controls.  If I can't export money, I might instead buy jets, fly them out of the country, and then sell the jets.
  • Let's not forget that the core of this entire problem is a government, not a private, failure.  Banks and investors treated sovereign euro-denominated debt as a risk-free investment, and banking law (e.g. Basil II) and pension law in most countries built this assumption into law.  Cyprus banks went belly-up because the Greeks, in whom they had (unwisely) invested most of their funds, can't exercise any fiscal responsibility in their government.  If European countries could exercise fiscal responsibility in their government borrowing, 80% of the banking crisis would not exist (housing bubbles and bad mortgage securities have contributed in some countries like Spain).  There is a circle here:  Politicians like to deficit spend.  They write regulations to encourage banks to preferentially invest in this government paper.  When the government debt gets iffy, and the banks face collapse, the governments have to bail them out because otherwise there is no home for their future debt.  The bailouts get paid for with more debt, which gets crammed back into increasingly over-leveraged banks.    What a mess.
  • All of this creates an interesting business school problem for the future:  What happens when there are no longer risk-free investments?  Throughout finance one talks about risk free rates and all other risks and risk premiums and discussed in reference to this risk-free benchmark.  In regulation, much of banking capital regulation and pension regulation is based on there being a core of risk free, liquid investments.  But what if these do not exist any more?
  • I have thought a lot about a banking model where the bank accepts deposits and provides basic services but does no lending - a pure deposit bank with absolute transparency on its balance sheet and investments.  I think about a web site depositors can check every day to see exactly where depositors money is invested and its real time values.  Only listed, liquid securities with daily mark to market.   Open source investing, as it were.  In the past, deposit insurance has basically killed this business model, but I think public confidence in deposit insurance just took a big-ass hit this week.

Postscript:  I don't want to fall into a Godwin's law trap here, but I am currently reading Eichmann in Jerusalem and it is impossible for me to ignore the role strict capital controls played in Nazi Germany's trapping and liquidation of the Jews.

PS#2:  Oops, Hayek beat me by about 70 years to the postscript above

The extent of the control over all life that economic control confers is nowhere better illustrated than in the field of foreign exchanges. Nothing would at first seem to affect private life less than a state control of the dealings in foreign exchange, and most people will regard its introduction with complete indifference. Yet the experience of most Continental countries has taught thoughtful people to regard this step as the decisive advance on the path to totalitarianism and the suppression of individual liberty. It is, in fact, the complete delivery of the individual to the tyranny of the state, the final suppression of all means of escape—not merely for the rich but for everybody.

Why Europe Won't Let Banks Fail

Dan Mitchell describes three possible government responses to an impending bank failure:

  1. In a free market, it’s easy to understand what happens when a financial institution becomes insolvent. It goes into bankruptcy, wiping out shareholders. The institution is then liquidated and the recovered money is used to partially pay of depositors, bondholders, and other creditors based on the underlying contracts and laws.
  2. In a system with government-imposed deposit insurance, taxpayers are on the hook to compensate depositors when the liquidation occurs. This is what is called the “FDIC resolution” approach in the United States.
  3. And in a system of cronyism, the government gives taxpayer money directly to the banks, which protects depositors but also bails out the shareholders and bondholders and allows the institutions to continue operating.

I would argue that in fact Cyprus has gone off the board and chosen a fourth option:  In addition to bailing out shareholder and bondholders with taxpayer money, it will protect them  by giving depositors a haircut as well.

The Cyprus solution is so disturbing because, hearkening back to Obama's auto bailout, it completely upends seniority and distribution of risk on a company balance sheet.  Whereas depositors should be the most senior creditors and equity holders the least (so that equity holders take the first loss and depositors take the last), Cyprus has completely reversed this.

One reason that should never be discounted for such behavior is cronyism.  In the US auto industry, for example, Steven Rattner and President Obama engineered a screwing of secured creditors in favor of the UAW, which directly supported Obama's election. In Cyprus, I have no doubt that the large banks have deep tendrils into the ruling government.

But it is doubtful that the Cyprus banks have strong influence over, say, Germany, and that is where the bailout and its terms originate.  So why is Germany bailing out Cyprus bank owners?  Well, there are two reasons, at least.

First, they are worried about a chain reaction that might hurt Germany's banks, which most definitely do have influence over German and EU policy.  There is cronyism here, but perhaps once removed.

But even if you were to entirely remove cronyism, Germany and the EU have a second problem:  They absolutely rely on the banks to consume their new government debt and continue to finance their deficit spending.  Far more than in the US, the EU countries rely on their major banks continuing to leverage up their balance sheets to buy more government debt.  The implicit deal here is:  You banks expand your balance sheets and buy our debt, and we will shelter you and prevent external shocks from toppling you in your increasingly precarious, over-leveraged position.

Update:  Apparently, there is very little equity and bondholder debt on the balance sheets -- its depositor money or nothing.  My thoughts:  First, the equity and bondholders better be wiped out.  If not, this is a travesty.  Two, the bank management should be gone -- it is as bad or worse to bail out to protect salaried manager jobs as to protect equity holders.  And three, if depositor losses have to be taken, its insane to take insured depositor money ahead of or even in parallel with uninsured deposits.

Statists Write History

In today's history lesson, we have something called the "Addled Parliament."  Surely that cannot be a good name to have, and in fact the name was given as a term of derision, very like how the Left describes the current Congress as obstructionist and ineffectual.

So why did it gain the name "addled"?  It turns out, for about the same reasons the current Congress comes under derision from Obama:  It did not give the King all the money he wanted.  Via Wikipedia:

The Addled Parliament was the second Parliament of England of the reign of James I of England (following his 1604-11 Parliament), which sat between 5 April and 7 June 1614. Its name alludes to its ineffectiveness: it lasted no more than eight weeks and failed to resolve the conflict between the king, who wished to raise money in the form of a 'Benevolence', a grant of £65,000 and the House of Commons (who were resisting further taxation). It was dissolved by the king.

Parliament also saw no reason for a further grant. They had agreed to raise £200,000 per annum as part of the Great Contract and as the war with Spain had reached its resolution with the 1604 Treaty of London, they saw the King's continued financial deficit as a result of his extravagance (especially on Scottish favourites such as Robert Carr) and saw no justification for continued high spending.

Moreover there remained the continuing hostility as a result of the kings move of setting impositions without consulting Parliament.

Wow, none of that sounds familiar, huh?  In fact, James was an awful spendthrift.  Henry the VII was fiscally prudent.  Henry the VIII was a train wreck.  Elizabeth was a cheapskate but got into expensive wars, particularly in her declining years, and handed out too many government monopolies to court favorites.  But James came in and bested the whole lot, tripling Elizabeth's war time spending in peace time, mainly to lavish wealth on family and court favorites, and running up debt over 3x annual government receipts.   History, I think, pretty clearly tells us that Parliament was absolutely correct to challenge James on spending and taxes, and given that it took another century, a civil war, a Glorious Revolution, a regal head removal, and a lot of other light and noise to finally sort this issue out, it should not be surprising that this pioneering Parliament failed.  Yet we call it "addled".