Macroeconomic Updates

The Obama Administration has come under a great deal of heat over the poor performance of the economy and the lack of financial market reform. The Massachusetts election outcome may have been a political wake-up call for the administration: they need to do something to reform financial markets and get the economy going. The economic advice that the President has been getting from Treasury Secretary Tim Geithner and Larry Summers head of the National Economic Council, simply is not working in the view of many Americans. Obama clearly needs help.

So, to whom did the President turn? Watch the video and see…

Post your comments on the Macroeconomics Updates page…do you think the old hero can save the day once more? Or, is he simply out of touch with the current problems?

All the best,
MBrandl

I was having a lunchtime chat the other day when the conversation turned to one my favorite topics:  economic history.   Eugene Sepulveda and I were discussing the size and impact of the current government budget deficit over a nice lunch at the Blanton Museum’s Cafe.   Eugene asked me:  how did we deal with all of the government borrowing in during World War II?

Well…that generation - which Tom Brokaw correctly described as The Greatest Generation - actually thought about how to finance what is was going to spend before they did it.  Think before you spend - what a concept!

Basically, the leaders of the time realized that in order to finance a large increase in government spending, you can basically do three things:

1)      Raise Taxes

2)      Government borrow money from the public by issuing bonds

3)      Print money for the government to spend

During the Civil War we did number 3 - and it was a disaster.  The issuing of Green Backs to fund the Civil War led to a financial collapse as the money supply skyrocketed.

So, learning from that mistake in financing World War I we did a combination of 1) and 2).  Taxes were raised and the government issued Liberty Bonds.  The Liberty Bonds were basically 30 year tax free bonds that appealed to people’s patriotism.

But, since a large amount of the bonds were financed by an expansionary monetary policy the result was rapid inflation.  The annual inflation rates were around 17% during World War I and then around 15% until a severe recession hit in 1921.

Financing World War II

So when the Greatest Generation set out to finance World War II they took a cue from history - knew they had to do number 1 (raise taxes) and number 2 (sell bonds) BUT without trigger inflation.  How on earth would they do that?

The answer came from John Maynard Keynes.  Writing in 1940, in a pamphlet aptly titled “How to Finance the War” Keynes argued that keep inflation under control, rationing should be used for essential products.  He also argued for Wage & Price controls to be applied to key industries to keep prices (and especially wages) from going up.  The idea, classic Keynes, was to keep aggregate demand from increasing - or in English, to keep spending down so prices didn’t go shooting upward.

Keynes also argued for high progressive income tax rates.  His argument was that the rich could benefit from war production so thus they should help to pay for the cost of the war.  He also argued that these high tax rates would keep the rich from spending thus also help to control inflation.

Finally, Keynes argued for the government to sell bonds to public and banking system.  In buying bonds households would have less disposable income and thus less spending power.  This too would help to control inflation.

Keynes’ suggestions were adopted and worked fairly well - although wage and price controls had to be expanded to almost everything.  We had seven successful War Bond drives during World War II, goods were rationed, consumer spending was held down, unemployment all but disappeared and we military kicked the fascist asses.  All of this was accomplished with almost no inflation.  A job well done.

What the Past tells us about the Future

So…what does this tell us about our own future?  Well…we again have massive increases in government spending.  Although, not as large as during World War II - then government budget deficits as a percentage of GDP were about 25%, today’s deficit is about 12%.  This is still higher than the 3% that economist view as the upper limit for deficit, but still not World War II levels.

So, don’t look for a return of ration coupons anytime soon…but, in order to get these deficits down we will probably see a reduction in the level of consumer spending in the future.  This very well might come about simply because American consumers will not have access to the credit they have had in the past.  It might also come about because a falling dollar will mean more expensive imports, including that imported oil we all like so much.

It will probably will also mean high taxes on those in the higher end of the income distribution.  You already see the push to tax the bonuses of those on Wall Street….if history is our guide this might be only the start.

I know…I can hear the mashing of teeth of those on the right saying “this will kill the incentive to innovate…”  Well, if so, then that might be the price we are going to have to pay to get these budget deficits down.  We are now on the wrong end of a negative intergenerational transfer….sorry.

If you don’t like that - then you need to find other sources of revenue (e.g.  get rid of distortionary tax subsidies and tax breaks for the middle class) and/or find places to cut government spending (e.g.  cut corporate welfare programs and wasteful military spending).

All this still does not end the question of the future inflation.  Remember the civil war and World War I.  When government spending increases rapidly you have to keep an eye on inflation…today that is the responsibility of the Federal Reserve.  Or, at least it is suppose to be the responsibility of the Federal Reserve.

It all comes down to the question:  will Bernanke (as well as Congress and the Administration) learn the correct lessons from history…not the need to bailout financial markets during a lack of confidence, but the inflationary impacts of massive government budget deficits.  I hope so.

Post you thoughts on the Macroeconomics Updates blog.

All the best,

MBrandl

This past week Velocity Credit Union, one of the largest credit unions in central Texas, announced that it is going to ask its members if it should switch its deposit insurance from the government guaranteed NCUA to a private deposit insurance program offered by American Share Insurance Corporation in Dublin, Ohio.  Velocity is upset that NCUA is hitting Velocity with at $675,000 insurance premium payment, in addition to placing 1% of member deposits on reserve with NCUA.  The insurance premium payment is needed to recapitalize NCUA which has taken a hit due to the rise in the number of credit union failures recently.

What to make of this?

There are two ways to look at this - it is a sign of the changing structure of our financial markets or it is another short sighted attempt to cut costs.  Which is it?  I will let you decide (because I am not sure!).

The Failures of Government Sponsored Deposit Insurance

Clearly, the structure of our financial markets needs to change.  The entire system is wrought with misaligned incentives and perverse government regulations.  Government sponsored deposit insurance is a classical example of a poorly thought out program.  Deposit insurance is suppose to bring “calm” to financial markets in that it resolves the asymmetric information problem facing depositors.

In English that means depositors generally can’t tell a “safe” bank or credit union from an “unsafe” one.  Thus,  if depositors become worried that their bank/credit union might fail, they will pull their deposits out of both safe and unsafe banks/credit unions causing both to fail.  Thus, deposit insurance is designed to calm the fears of depositors - their funds are safe, even if their institution is not.

The downside to this system is that it encourages banks/credit unions to act recklessly.  If a bank/credit union makes risky loans with corresponding high interest rates, if these loans pay off, the bank/credit union can share the resulting high interest payments with depositors!  If on the other hand, the risky loans don’t pay off and the bank/credit union fails…oh, well…with government sponsored deposit insurance the depositor simply turns to the government to be made whole again.  It is the old game of “heads I win…tails the government looses.”

What is suppose to happen is that the government is suppose to oversee the banks/credit unions to ensure that the banks/credit unions don’t take on too much risk.  I know…stop laughing….that’s the way the system is supposed to work.

Of course, the banks/credit unions lobby the government to go easy on them…and the elected officials who want the campaign contributions from the banks/credit unions usually write laws that favor the industry (i.e. the entire home mortgage market).  Thus the banks/credit unions will often have an incentive to write risky loans (especially during good economic times) and as long as things are going well they will demand deposit insurance premiums be held low.

So everything is wonderful right - the banks/credit unions are lending money easily, profits are high, elected officials get campaign contributions, banks/credit unions pay little for deposit insurance since there are so few failures…everything is good,

Then a crisis hits.  The crisis comes about in great part to the excess risk taking of the banks/credit unions.  When the crisis hits, the government sponsored deposit insurance fund is underfunded and it must raise more money.  If first raises premiums on the banks/credit unions and then turns to the government for assistance.  Or, as is the case now, it does both at the same time.  Those banks/credit unions who did not take on excessive amounts of risk are mad - they are forced to pay for those risky institutions that caused the problem!

What a mess.  So, is private deposit insurance the answer?

Maybe.  In order for private deposit insurance to work it has to do a better job of standing up to pressure brought by banks/credit unions during the good times than has the government.  Will it be able to?  I’m not sure.  You can imagine a world where the banks/credit unions might play deposit insurers off against each other.  Might each deposit insurer go easy on banks/credit unions to attract their business?  If so, will the insurer be financial stable enough to make good on deposits when a financial crisis hits?

The key to this is:  how safe/reliable are the private deposit insurers?  Can they withstand a large number of claims all at once?

Banks/Credit Unions More like Restaurants

Perhaps what might also be needed is outside, objective evaluators of private deposit insurers.  Think of it like restaurant critics - we need someone to tell us how good the service and food is at a restaurant before we will try it.  Maybe the same thing needs to happen with private deposit insurers and banks/credit unions - they need to be “rated.”  Maybe not all of them need to be the same - not all restaurants are the same, but there is a basic level of cleanliness and food safety.   Maybe some banks/credit unions will take on more risk (and pay higher interest rates on deposits) while others will be safer (but pay lower interest rates).  It will be up to do depositors to pick and choose where they want to put their money - just like we pick which restaurants at which to eat.

But, do NOT trust the current bond rating system to do this correctly.  As we have seen during this current financial crisis:  S&P, Moodys and Fitch are full of misaligned incentives and their ability to be “objective” is at best questionable.

But, then maybe this is a new market opportunity for financial market entrepreneurs - the need for someone to tell bank depositors which banks/credit unions are safe and which are not.  Depositors will have to pay for that information/analysis, but better to do that then to rely on the failed system we have today.

So…maybe these private deposit insurance systems are the wave of the future.  Depositors are going to have do their own “homework” and figure out what bank/credit union offers them the best deal at the best price.  In order to do that, new entities need to come along that will help depositors solve that old asymmetric information problem.  So, maybe, private deposit insurance is an important step in the evolution of our financial markets.  Maybe.  Or maybe they are just another way for banks/credit unions to find a way to cut costs, get around government oversight and get back to the old way of doing business…and create the next major financial crisis.

Your thoughts?

-MBrandl

Here are the Powerpoint slides I used during my lunchtime speech at the Northeast Business and Economics Association meeting in Worcester, MA on Nov 7, 2009. We had a great discussion following the presentation on a wide variety of topics including the importance of getting our students to see the connections between finance and macroeconomic concepts. It was a wonderful time!

All the best,
M Brandl

Last week the leaders of the Group of Twenty met in Pittsburgh with the goal reforming the global economy to “meet the needs of the 21st century…”  So how did they do?  Here are my thoughts.  Please feel free to add your own.

Point of clarification: Geithner’s four pillars are: IMF, World Bank, WTO and now the FSB

View the video on YouTube at: http://www.youtube.com/watch?v=ihnUKAHjD34

Tell me your thoughts…

All the best,
M Brandl

Late on Friday, President Obama signed an order to impose a tariff on Chinese tires of 35% on top of the existing 4% tariff.  The order raises tariffs for three years on tires coming from China - 35% the first year, 30% the second year and 25% the third year.

The Chinese Minister of Commerce blasted the move as “a grave act of trade protectionism.”  Beijing was so upset that they filed a complaint with the WTO and said they will launch an investigation into US “dumping”of auto parts and chickens in China.

Critics in the US called it “capitulation to trade unions.”

Watch the video on YouTube: http://www.youtube.com/watch?v=b0bxZ_PFypM

All the best,

M Brandl

I just finished reading Paul Krugman’s 6800 word rant in the New York Times on the fields of finance and macroeconomics.  Thanks Tom, Prabhudev and the 40 or so other people who sent it to me!  (See “How Did Economists Get It So Wrong?” The New York Times, Sept. 6, 2009)

In usual Krugman form, he twists the history of economic thought to suit his politically motivated  arguments.  Before pointing out where he goes wrong, let me point out where I agree with Krugman.

First, I think Krugman is correct in lambasting modern day macroeconomists for their obsessive love affair with formal economic modeling.  So much intellectual capital has been wasted over the last 50 years in developing mathematically sophisticated economic models that have added absolutely nothing to our understanding of how the economy functions.  Economic departments, both freshwater and saltwater, are stuffed to the gills with mathematical geniuses claiming to be economists, who impress each other with things like their newest stochastic dynamic processes.

I cannot tell you the endless hours I have spent pouring over working papers and published academic articles, solving a multitude of equations only at the end to arrive having gained absolutely no insight into how and why economic outcomes are they way they are.

But such is the life of an academic economist these days:  you must learn to pray at the quantitative alter if you are to be “accepted” by the tenured high priests of our profession.  Never mind that these mathematically gifted soothsayers have no idea how to get us out of the current mess in which we find ourselves.

Second, I think Krugman is correct to point out the advancement made by behavioral economists.  The field of behavioral finance in particular has much to offer in giving us a better understanding of how markets actually function.  Behavioral economics, experimental economics, behavioral finance, etc. start with observations of what actually happens in markets and/or what people actually DO as opposed to how our elegant mathematical models suggest they should act.  More economists should be encouraged to observe how markets, societies and people actually do function and how they have functioned in the past.  Let us be more like the natural scientists that start with observations and then move to develop theory and models of behavior, not the other way around.

Next, Krugman is also correct in pointing out the disconnect between finance and macroeconomics.  I think The Economist did a much better job of describing this disconnect than does Krugman (I think that is where Krugman got the idea for his most recent op-ed, but that’s beside the point).  The Economist correctly described the “silos” macroeconomists and financial economists find themselves.  That is, the macroeconomists basically exclude financial interactions in their description of the overall economy, and financial economists basically ignore the total impact of financial market instability.

This siloization (if that is word) has come about because to uber-specialization of our fields.  Multi-disciplinary approaches to economic issues are shunned by both macro and financial economists.  In a recent meeting with colleagues when it was suggested that financial economists actually consider a multi-disciplinary approach to their subject, a leading “scholar” in the field snapped “none of the cross-discipline research that is being done is any good.”  What my esteemed colleague failed to recognize is that he and his ilk are the ones who decides what is “good” or not by determining what gets published in the leading academic journals.  Thus, since inter-disciplinary work is not “valued” by the quantitative high priests, very little of it actually gets done.

This leads to where I disagree with Krugman and/or where I find fault with his arguments.

First, Krugman misrepresents the Chicago School’s approach to business cycle fluctuations.   What he leaves out is that idea that government policies, while well intentioned, can actually prolong recessions by creating distortions in a variety of input markets.  Thus, it is not that markets work perfectly all of the time, as Krugman claims the Chicago models suggest, rather it is that excessive government rules and regulation keep markets from achieving equilibrium.

And so it is with the recent crisis.  Krugman completely leaves out how government policies were major contributors to this current economic crisis.  Nowhere does he mention how the defacto government guarantees of Fannie Mae and Freddie Mac lead to a misallocation of capital.  He also fails to mention how past government bailouts of our banking system created a massive moral hazard problem that contributed to this current crisis.  No, instead in Krugman’s view, government policies only seem to react perfectly in stimulating demand reversing the economy’s slide into recession that was brought about by “the casinos” that are financial markets.  And then he wonders why people snicker at the Keynesian simplistic explanations.

Next, Krugman’s argument of what went wrong in financial markets completely leaves out the role of incentives.  Because of past government bailouts, large financial institutions and the traders within them, realized that their institutions were “too big to fail.”  And yet, they also realized that if excessive risks they were taking paid off, they would be rewarded with huge financial bonuses.  Thus, the incentives within the financial markets were completely misaligned.  It was a replay of the savings & loan crisis of the 1980s:  heads I win, tails the government loses.

The massive Treasury/Fed bailout, supported by Larry Summers, Greg Mankiw and other leading Neo-Keynesians does little to address these misaligned incentives. At least the Europeans are looking at some type of restructuring of incentives within their financial markets to ensure a disaster like the current one does not occur again.  Where are the American Keynesians to suggest real world policies to correct the structural problems that exist?  Oh that’s right, they are too busy pointing the finger of blame at Chicago to be bothered with “reality.”

Which gets me to my final point:  yes, we need to rethink what economists do and how we do it.  Krugman is right that we need to learn from the past, but I think it is more John Hicks we should learn from as opposed to John Maynard Keynes.  About 20 years, Will Baumol wrote an excellent piece on Hicks entitled “Sir John Versus the Hicksians or Theorist Malgre Lui?” which appeared in the December 1990 issue of The Journal of Economic Literature.  In it Baumol described how Hicks, creator of the IS-LM model among other things, wanted to be known for his work on economic history.  In fact it was Hicks’ wish that he was awarded the Nobel Prize for that as opposed to his work on labor theory, money or value for which he is better know.  To quote Baumol:

“Hicks simply remained a product of the time of his training, when economic analysts were expected to derive understanding from explicit study of institutions and history, and when there was no doubt that real economic phenomena were the central preoccupation of economists.”

Let us return to that.

All the best,

MBrandl

In 1994 Paul Krugman wrote an article in Foreign Affairs that questioned the idea of the “Asian Economic Miracle.”  Krugman simplified that argument made by Alwyn Young and others that the economic growth in Southeast Asia was driven by capital investment and increased labor force participation and NOT by total factor productivity.  What this means is that the “numbers” of economic growth really weren’t telling the whole story.  Bascially, the “Asian Miracle” was not sustainable.  Alas…the analysis was correct.  The result:  The Asian Financial Crisis.

But, when these economist sounded this warning in the mid 1990’s they were ignored by the business press and non-economists.  The screams went out “how can these pencil-headed economists question what is happening in the Tiger economies?  We are making money so everything is fine.”

No it wasn’t.  U.S. banks poured money into Southeast Asia, feeding the asset bubble that ultimately imploded.

Fast forward 15 years to today.  A recent report from John Makin at the American Enterprise Institute is questioning China’s recent economic “rebound.”  For a nice quick summary see Jim Jubak’s 8/11/2009 Jubak’s Journal article on msn’s moneycentral.  Basically Makin argues that the Chinese government statistics about their economic growth do not really reflect what is going on in the economy.  Essentially, the Chinese government maybe destroying a great deal of resources/wealth in an attempt to make their GDP numbers look good.

If this is true (and it looks as though it is) remember what happened in Southeast Asia 15 years ago.

But…I can hear the pundits in business press and the non-economists already:  “China is different!  You economists don’t know what you are talking about - we are making money there, so don’t question what is going on.”

Hmmm…mispricing of risk…not understanding data…where have I heard that before???

All the best,

MBrandl

This week the University of Texas Longhorns baseball team is in the college world series against LSU. I have had some interesting conversations with fans of Texas A&M who refuse to pull for the Longhorns despite the fact Texas A&M and UT are in the same conference. These Aggies argue that they are always “against” anything that has to do with UT.

I started to think more about this mentality that we are developing of “them” versus “us.” We seem to have a growing intolerance of those we consider not to be “us.” And it seems who we define as “us” is getting more narrow and more extreme.

Here is what I mean: in policymaking it used to be that Republicans and Democrats would debate, argue and reach some type of compromise. In business, firms would compete in many markets but would also co-operate with each other in other settings.

But we see this less and less now it seems. Democrats refuse to consult Republicans in the drafting of legislation. Republican talk show hosts wish for the collapse of the economy simply because the Democrats are in power. Management sees it as their responsibility to destroy the competition at every turn.

And the behavior doesn’t seem to end with these broad definitions. Within the Republican Party we see Rush Limbaugh and Dick Cheney seeking to kick people like Colin Powell out of the party because they see Powell as not a “true” Republican. It seems only the true-believers; those who don’t question the elite are welcome in the Republican Party today.

So too it seems with the Democrats. Anyone who dares to question the rising level of government debt is shunned into the intellectual corner as “not understanding” the current economic situation. Even the President claims there was “no disagreement” among economists that his stimulus package was needed.

Really?

So disagreeing with those you support or agreeing with and working with those on the other side is no longer “allowed?” That seems to be the accepted behavior.

So what happens is Conservative Christian Republicans only talk to other Conservative Christian Republicans. Progressive Well Educated Democrats only hang out with other Progressive Well Educated Democrats. As a result the Conservatives become more conservative and the Progressives become more liberal.

This is dangerous.

We learn from people who are different from us and think differently than us. By talking to those who think differently than we do we broaden our insight and sometimes we even change our minds.

Think about this: Ronald Reagan started off as a Democrat in the 1940s. He didn’t talk only to Truman Democrats of the time, and as a result his views evolved. That did not mean, however, he simply repeated everything other conservative Republicans said. Reagan and the great conservative intellectual William F. Buckley, Jr. had a nationally covered debate on the issue of the Panama Canal Treaty in 1978. Could you imagine the leaders of the (so-called) conservative movement debating and disagreeing with each other in public today? No, they aren’t that deep. We need another William F. Buckley.

Great leaders don’t tell us what to think, they teach us how to think. This is true in policymaking, in leading businesses and in raising & educating our young.

Maybe college sports really are a window into the rest of our society. What a pity.

All the best,

M. Brandl

This week the Obama Administration will formally lay out its so-called “reform” of financial market regulation.  Early reports tell us the “reforms” will be little more than what is already being discussed in Congress:

• an attempt to hold loan originators to be more accountable by requiring them to hold 5% of the credit risk of the loans they secure
• give the Federal Reserve additional responsibility of being a “systemic risk” regulator
• create a new regulator over consumer financial products and minor reforms to bond rating agencies

Reports in the business press tell us that the Administration has caved into pressure from the banking lobby and thus abandoned any attempt to undertake far reaching financial market reforms.  Reports in the popular press tell us the Administration also gave into political pressure from those in Washington who would loose power if financial markets were truly reformed.

Instead of preparing our financial markets for the world of the 21^st century, Congress and the Administration will slap yet another patch on the system that has not been restructured in over 70 years. Thus, it seems, little will change. Yet another patchwork solution will be put forward, instead of an attempt to truly reform our financial markets.

What a shame.

What would true reform of the financial markets look like?  It would start with a realization that the world has changed since the 1930s.  While commercial banks are very important to the functioning of our system, these banks can (and should) come in a variety of forms.  In addition, there are now many important non-bank financial institutions that need to be considered.

One way to think about this new landscape is in terms of deposit insurance and the amount of federal oversight and regulation that is truly needed.  Imagine a world where financial entities would be classified into a five-star risk/return/regulation framework.  It might look something like this:

Five Star Institutions:  Extremely Safe - Low Returns.  These institutions would have 100% deposit insurance, be required to fully disclose their financial statements in real time every day, face bank examinations monthly and pay shareholder very low returns.  Many of them might opt for a non-profit status.

Four Star Institutions:  Relative Safe - Relative Low Returns. These institutions would have deposit insurance on the first $50,000 of deposits with the ability to purchase private deposit insurance if desired, fully disclose financial statements every six months, face bank examinations yearly and pay shareholders low returns.

Three Star Institutions:  Moderately Safe - Moderate Returns.  These institutions would have deposit insurance on the first $5,000 of deposits with the ability to purchase more private deposit insurance, fully disclose financial statements every year, face examinations every two years and pay shareholders moderate returns.  These institutions could invest deposits in equities as well as debt instruments, much like mutual funds.

Two Star Institutions: Risky - Potential Significant Returns.  .  These institutions would have deposit insurance on the first $5,000 of deposits only by paying a fee to the FDIC, fully disclose financial statements every year, face examinations every two years and pay shareholders higher returns.  These institutions could invest deposits in a wide range of financial instruments.  Many of the accounts the offer would be illiquid.

One Star Institutions: High Risk - Potential High Returns.  These institutions would offer no deposits insurance, would agree to standardization in the reporting of returns, face bi-annual audits, subject to systemic risk regulation.  These institutions would undertake private equity (especially venture capital) investments and some hedge funds investments along with other asset purchases.  Most of the accounts they offer would be illiquid.

This type of system would offer the banking public (both savers and borrowers) a variety of choices. Underlying the system would be a level of safety and security, notice even one star institutions are subject to regulation, but competition would determine which entities succeed and which fail.

Think of this system as analogous to our restaurants.  We have a variety of restaurants that do different things:  fast food restaurants with their quick cheap food served on plastic trays all the way to high end restaurants with gourmet food and fine linen table cloths.  Are they all the same?  No.  Are we told what restaurant we must eat?  No, we choose.  When we choose we know there is a basic level of safety/regulation-someone we trust has inspected the kitchen and made sure it is clean-but we choose.

Even if a restaurant is closed by the health inspector, does that cause us to stop eating out all together?  No.

If we collectively choose not to go to a certain restaurant that restaurant does goes out of business.

And so it should be with our financial market regulation and financial market structure:  allow people to choose, force them to pay for what they want, but the regulators should also offer a level of safety to the system and close down those that are unsafe.

This would be true financial market reform.

This would be “change we could believe in.”  This is what the Obama Administration should be doing.

All the best,
MBrandl