Convergences

Who Said It?

Excessive intervention in economic activity and blind faith in the state's omnipotence is another possible mistake.

True, the state's increased role in times of crisis is a natural reaction to market setbacks. Instead of streamlining market mechanisms, some are tempted to expand state economic intervention to the greatest possible extent.

The concentration of surplus assets in the hands of the state is a negative aspect of anti-crisis measures in virtually every nation.

In the 20th century, the Soviet Union made the state's role absolute. In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly. I am sure nobody wants to see it repeated.

Nor should we turn a blind eye to the fact that the spirit of free enterprise, including the principle of personal responsibility of businesspeople, investors and shareholders for their decisions, is being eroded in the last few months. There is no reason to believe that we can achieve better results by shifting responsibility onto the state.

And one more point: anti-crisis measures should not escalate into financial populism and a refusal to implement responsible macroeconomic policies. The unjustified swelling of the budgetary deficit and the accumulation of public debts are just as destructive as adventurous stock-jobbing.

Sounds like Rush Limbaugh, or perhaps someone from AEI? Maybe even Cato?

Actually it was Russian Prime Minister Vladimir Putin, speaking at Davos. It seems a bit odd to look to Moscow for a counter to the dirigiste spirit of Washington these days.

Putin also noted:

In the last few months, virtually every speech on this subject started with criticism of the United States. But I will do nothing of the kind.

I just want to remind you that, just a year ago, American delegates speaking from this rostrum emphasised the US economy's fundamental stability and its cloudless prospects. Today, investment banks, the pride of Wall Street, have virtually ceased to exist. In just 12 months, they have posted losses exceeding the profits they made in the last 25 years. This example alone reflects the real situation better than any criticism.

Whew! It's certainly good that he wasn't feeling critical.

Don't Just Do Something . . .

The Group of Thirty (est. 1978) is:

a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia. . . . It aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers.

It just issued Financial Reform: A Framework for Financial Stability, which "addresses flaws in the global financial system and provides 18 specific recommendations" for additional regulation.

AEI's indispensable Peter Wallison raises an emperor's clothes type question in Regulation without Reason: The Group of Thirty Report:

A good summary is that bank-like regulation would be spread beyond the banking industry. But there’s a problem: banks have been tightly regulated for years, both in the United States and Europe, and of all the institutions hurt by the financial crisis, they are in the most trouble. How do the bankers, academics, and financial policymakers who make up the G30 deal with this? They don’t. In the wake of this report, the principal question that Congress, the Obama administration, and the American people should ask is why regulation should be extended to most of the major players in the financial system when it has been a consistent failure for banks.

One should also ask what existing regulatory authorities went unused. For example, Warren Buffet issued his classic characterization of derivatives in 2003:

other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with  derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly
multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our
owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

So why didn't any of the regulatory agencies pick up this hint and try to introduce some transparency? Come to think of it, where was the Group of 30? Perhaps a little Maoist self-criticism is in order.

The Rich Get Richer

Or at least they get poorer more slowly. During 2008, "hedge funds were down, on average, 19% in 2008 (vs. 42% for the MSCI World Index)."  The full study is Credit Suisse/Tremont Hedge Fund Index, One for the History Books: Hedge Fund Performance in 2008 (Jan. 2009).

The hedge funds sort of promised to make money in all kinds of climates, so some of the clients are unhappy, but losing half as much as the basic market in the worst financial gale since 1930 is not bad.

Of course, it is possible that some illiquid positions have not been marked down far enough, so perhaps revisions will be made. But that could cut in either direction. The panicky flight to liquidity may have caused excessive markdowns in some assets.

Amazing!

The papers this morning express surprise over an increase in home sales in Dec. of 6.5%, triggered by a decline in home prices. Gee, what an amazing idea! Prices decline and people buy more! A new concept -- shall we call it supply and demand?

Also interesting -- the National Association of Realtors says:

National median existing-home price: (for all housing types) was $175,400 in December, which is 15.3 percent below December 2007 when the median was $207,000. There remains a significant downward distortion in the current median from a large number of distress sales at discounted prices, currently 45 percent of transactions; the median is where half of the homes sold for more and half sold for less. For all of 2008, the median price was $198,600, down 9.3 percent from $219,000 in 2007.

A 15%  decline does not seem too serious. As I recall, that is about the decline necessary to restore real estate prices to their long term trendline. What happened to all the predictions about prices being in free fall, yada, yada?

Hidden in the Fiscal Stimulus, Slow Poison for Health Care

Scott Gottlieb reports in the WSJ online on provisions in the fiscal stimulus package now before the House that would restrict the drugs doctors could prescribe based on cost effectiveness. This entails top-down assessments not only of how good the drugs are, but what an additional year of a person's life is worth. What this means is that a doctor would not be allowed to prescribe a remedy that did not pass bureaucratic muster... experimental remedies and such, now available only in the United States, would be available nowhere. Rather ironic, in an environment where some argue in favor of a government controlled health care system because health care is a "right." His article also points the way to a better solution--let private companies that study the effectiveness of treatments publicize the results.

I have not looked at the details of this plan, but it seems to me that especially if it does not leave patients the option of paying out of pocket for alternative treatments, it is ripe for consitutional challenges, under Griswold that protects rights to use contraceptives, for example. It will be interesting if restrictions on speech, prohibiting doctors from telling patients that alternative treatments are available that they are not permitted to prescribe, eventually accompany the the attempt to restrict prescriptions. I understand that this is the case in Germany, to cite one example: Imagine, your child is dying of cancer, an experimental remedy is available that might be effective, but no one is permitted to tell you of it.

And the Winners Are . . .

The House Appropriations Committee released a summary of the American Recovery and Reinvestment Bill of 2009, "$275 billion in economic recovery tax cuts and $550 billion in thoughtful and carefully targeted priority investments with unprecedented accountability measures built in" (aka the biggest pork barrel in the history of the world).

Of interest for the tech/telecom community:

$6 billion for broadband "so businesses in rural and other underserved areas can link up to the global economy." [N.B: the focus on businesses is interesting -- this means trunk lines to towns rather than an effort to subsidize household use. This makes sense; the high value of broadband is in business and medical applications, not in video on demand -- cable and telephone companies, plus Netflix, already distribute high volume broadband for video quite effectively, and pass by more than 90% of all households].

$10 billion for science facilities, research, and instrumentation.

$20 billion for health information technology.

$11 billion "for research and development, pilot projects, and federal matching funds for the Smart Grid Investment Program to modernize the electricity grid making it more efficient, secure, and reliable and build new power lines to transmit clean, renewable energy from sources throughout the nation." [N.B. Smart Grid is information technology, but it is not clear how much of the money will go there rather than to conventional power lines -- and good luck with those, considering that it is impossible to build anything energy-related without affronting a thicket of laws protecting species, viewsheds, and general obstreperousness].

Drew Clark has more detail on the broadband issues.

The Financial Crisis: Liquidity vs Transparency

Everyone knows the joke about looking for a lost item under the lamp post instead of where it was actually lost “because the light is better there.”

So, in the financial crisis, it looks like the government, urged on by the bankers, seems bent on treating the problem as a lack of liquidity when the real issue is transparency. This matters, because Washington these days, with the scent of hundreds of billions of dollars of free money in the air, resembles the pig farm in Hannibal.

Stanford economist John Taylor argues compellingly in The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong (Nov. 2008) that the great credit freeze was not because institutions were unwilling to lend but because they lost the ability to assess counter-party risk.In such an environment, simply adding cash does not resolve the crisis because it does not improve the ability of the participants to assess risk.

Model Behavior

When I read that the debate over climate change is over because the computer models tell us so, a question immediately occurs: are these the same model makers and techniques used to develop the risk models that broke the financial industry?

To paraphrase the immortal words of Fagin in Oliver, I think they better think it out again.

Bail Outs

"Bail out" is a term of many meanings -- bail out of jail; bail out a boat; bail out of an airplane. 

Congress is now adding a new definition -- jumping into a doomed automobile [company]. A $15 billion bail out of Detroit has been agreed to "in principle." But the principles do not include any haircut for the  dealers, the bondholders, the UAW, state and local governments, or any of the other dug-in vested interests that have put the companies into stasis for 30 years, nor any restructuring or serious planning. The best the government will get is an agreement from the companies to consider possibly doing something. Sometime.

At least not all the money will be wasted. GM can continue to be the world's largest private buyer of VIagra. Maybe this is the secret -- drop enough of it into the soup in the Senate cafeteria and the Congressional urge to waste money, a drive stronger than sex, becomes irresistible.

One can make a case for a bail out that takes the form of a bankruptcy with the government then providing Debtor in Possession financing. But this deal gives political corruption a bad name.

Finance: Regulation as a Cause of the Crisis?

Julian Morris (International Policy Network) and Bill Stacey (Lion Rock Institute) have published How Not To Solve a Crisis (Nov. 2008). Given the current level of screaming that the crisis was caused by insufficient regulation, their thesis is worth attention. They think that four types of mis-regulation were crucial:

First, sharply divergent capital rules for banks, security companies and special purpose vehicles (SPV) led to ‘regulatory arbitrage.’ Specifically, by purchasing asset-backed securities through an SPV, banks were able to minimize capital requirements on their balance sheets and thereby increase their return on equity, performing better within capital adequacy rules. . . .

Second, US government sponsored entities, Freddie Mac and Fannie Mae, were required to buy up, securitise, and resell hundreds of billions of dollars of mortgages, with an increasing proportion coming from people on low incomes. . . .

Third, the existence of Federal Deposit insurance and other explicit and implicit government guarantees led to the mispricing of counterparty risk. Under the presumption that certain companies (such as major insurers) would not be allowed to fail, banks and other financial companies bought credit default swaps (CDSs), thereby insuring themselves against the failure of less privileged companies. Moreover, these CDSs, created opportunities to create synthetic credit structures, again purchased through SPVs, that added substantially to leverage in the financial system.

Fourth, governments granted privileged roles to certain ratings agencies, leading to over-reliance on those agencies in determining the risk of ABS, CDOs and other SIVs. [W]e now know that . . . serious errors were made in some ratings models and that liquidity and counterparty risks embedded within these structures were under estimated.

The piece is a useful counter to the assumption that a hysterical competition to create yet more regulatory structures to be gamed by the politically privileged is the road to salvation.