Tuesday, July 19, 2011

A Clearer View Of The Fireworks

And The Reader Said, "Say what?"

My comments in the last posting raised the need for some clarifications. By interspersing my comments in a more conversational mood, it may be clearer.

Parts of what you have written seem way over my head, only partly because of not reading some of your citations. I am jealous of your well-roundedness.
It probably isn’t over your head. It’s more my limitation -- English as a first language and all that. As you know, I do much better talking.

The citations have a simple explanation. Often you ask good questions that force one to think about the basis of an opinion. The citations are an explanation of where an opinion is coming from. Besides, one could say: “In the 1950s the Fed was trying to end the wartime practice of buying bonds across the spectrum. The Fed wanted to let the market determine the yield curve. It took a few unsuccessful tries and was very controversial.” However, that hardly conveys the complexity of the decision, the roles of players, or the ideological / theoretical arguments involved. The citation is one way to say,” I’m not projecting today backward; it did happen,” and “there’s more than I am covering.”

The reference to earlier Fed history is just a reminder that the notion that monetary policy can be effective just by influencing the price of credit (interest rates) is historically recent. Before 1930 the thinking was it should channel flows (volumes) as well as costs (interest rates). The “round-up-some-banks” reference just illustrates that just targeting prices has failed repeatedly. So, the “bailouts” aren’t unprecedented. What was new was how it was done: through direct Fed loans to non-banks. Traditionally, that was a Treasury role, for better or worse. That’s the subtler issue.

The entire issue of the Fed’s role probably could have been skipped except that it is going to explain why the Fed is going to lose any semblance of independence. Since I favor a relatively independent Fed, I consider that important.

If the Gov’t steps up in a bailout situation, why worry about whether they are pricing the risk appropriately?
Short answer is that’s what economists do. We worry about allocating resources properly. I confess; I’m addicted. Also, remember the issue was raised in connection with the accounting, not the economics; but as explained below, it’s relevant to the economics in a different form.

To me, it sounds like the old cliché of…arranging the deck chairs on the Titanic. I view the recent Gov’t action since 2008 (and during the 1930s) as a powerful entity attempting to steer the economy back toward equilibrium. The price need not be planned with sharpened pencils. The intended “ends” will be justified by most “means,” except by those who believe they were snookered by the “big boy” who stole his opportunity to capitalize on a bad situation.
Agreed! The consequences of a financial panic are always to be avoided. Like you say, the social accounting makes that clear. Bankruptcies, etc. aren’t pretty.

There is a limit on the “arranging the deck chairs on the Titanic” analogy that is particularly relevant to economists; it’s those pesky opportunity costs. That was my criticism of the Blinder / Zandi analysis of the “stimulus,” the topic of all my postings in September 2009 starting with “Stimulus more or less? A failure not being acknowledged. PART 1.”

[It is] kind of like John Paulson and Goldman’s “Fabulous Fab” (in some respects only).
We all have our part in creating bubbles. Think of all of the factors that contributed. Even the innocuous refi contributed, regardless of whether it was “cash out.” Many people refinanced to get a lower the rate and shorten the maturity. Also, the mortgage players, CITI, BofA, etc. are consistently in the most active list, and CITI and BofA were widely held by individuals, mutual funds and pensions as were Fannie and Freddie and their bonds. A lot of people participated by defaulting the management of their assets to others.

It also seems many people were later on the same side of the trade as Paulson et al without thinking about it. Those who paid off their mortgage in anticipation of retiring, or for any reason, eliminated the long side of the mortgage trade (at a personal level). Amortizing a mortgage is the same process in slow motion. For many conservative investors eliminating a long position is as close as they will come to shorting. More direct examples will surface with time, but the most obvious example is the number of people who cut bank stock exposure. The volume and price behavior of the stocks certainly indicates it wasn’t an isolated few who made that trade.

The Paulson trade was discussed in previous postings on The Hedged Economist in April and May of 2010 starting with, “Sometimes Wall Street provides more entertainment than Hollywood: PART 1 the winners.” The focus throughout was on what an individual investor could learn, and then use. That seems more productive than trying to assess how much blame should be apportioned to each player. To illustrate from personal experience, one of the analysts hired by Paulson had been retired from Fannie and a mortgage insurer (as in encouraged to leave, forced out, or just so discouraged he left). At one, his mistake was pointing out that the organization was taking on too much risk, and at the other, pointing out that reserve provisions were inadequate. How much blame should he get?

I guess I’m just a believer in “racing back to equilibrium…and then re-regulating” rather than letting things run their course. If smart boys took advantage of bad policy, I don’t hold harmless the smart boys. They really aren’t different than smart thieves.
When one says “to equilibrium,” remember Keynes’ point: There are multiple points where the economy is in equilibrium, some of which aren’t very pretty. But, I know what you mean, and it would be hard to disagree.

As to regulation, it seems a stretch to argue regulators are free from some guilt for the mess we are in. They are as likely to make errors as anyone less. In fact, again from personal experience, they were making exactly the same mistakes in many cases. There isn’t a more obvious and currently relevant example than bank capital requirements. Regulators have a long history of lowering them during expansion and bubbles, and raising them during contractions and crashes. So, regulations are hardly a total solution.

Crimes should be punished, but being right and profiting from it shouldn’t be a crime. If it is, we all need to get stupid. That’s certainly not what you’re advocating.

Your last thought… “if more people focused on their own self-interest as in “how to make oneself robust against the inevitable fact of uncertainty,” the asymmetric risk associated with consumer loans would not loom so large” …was a little hard for me to understand what you meant.

I thought about whether to say, "The borrower is betting his or her future. The lender is just betting someone else’s money," again. Or, closing with:

Any loan can involve agent issues. All consumer loans involve one agent (the lender) and one principal (the borrower). In that environment, it seems to me the quickest solution is through the principal -- as in educate the public.

Sorry for the awkward wording.

At the risk of mis-understanding, I would like to give you another thought…
Did you ever see the TV commercial for (I believe) Charles Schwab where the guy, someone who looks like he is successful/smart/wealthy/etc., complains that his broker “can’t figure out how much money he needs to retire.”… “…a vineyard? Give me a break!” I look at that commercial and wonder, if that guy hasn’t a clue, who the hell is supposed to? I know, I know. It was the point of the marketing effort….EVERYBODY NEEDS SCHWAB!

I get a kick out of that commercial too, especially since it describes my situation. (It is a Schwab commercial by the way). It may be that the guy is looking for certainty where there isn’t any. If one plays with the retirement planners (actually simulators) at Schwab, Fidelity, T Rowe Price, and the various free unaffiliated websites on financial education, it’s still a crap shoot. A close look at Monte Carlo methods shows lots of assumptions to question.

But my point is, massive numbers of people just don’t do what they are supposed to do. The reasons are many…lack of education, brain power, desire, time, some are too trusting, and some just don’t care.
There are lots of reasons for sure. What seems curious is the number who ignore the implication of the only universal truth in finance: If you always spend all the money you get on consumption, you will always be broke. A corollary of the axiom is that if you spend everything you have, you will achieve broke. Close behind that is the number who aspire to broke as in: “I want to spend as much as I can,” or “I want to get as many things and experiences as I can.” (See “The Only Truth About Finance,” for more on my take on the issue).

The point of this and the previous comments is that given the magnitude of the challenge we each face, it seems more productive to focus on what we can do, rather than what others did wrong. That’s not to imply a pass for those who commit crimes. We pay people to take care of that. It seems like better resource allocation given those pesky opportunity costs -- especially given that, as you say, massive numbers of people just don’t do what they are supposed to do.

There will always be Bernie Madoff types. Do we blame the successful, wealthy he stole from? Do we blame the system that enabled him to pull it off? Do we even think we will ever put in place solutions that can even stop it from happening again? Shouldn’t a country that claims it is the best in the world stand up to “dis-equilibrium-izers”? (Is that term patented yet? )

Churchill’s comment that “Democracy is the worst form of Government unless you compare it to all others,” seems relevant. We can be good, maybe the best, without being prefect. That’s just an observation, not an excuse for not striving to be better.

The questions about who to blame are one of the reasons I try not to play the blame game. As I said in a recent posting entitled, “It’s My Party, And I’ll Cry If I Want To,” bubble and crashes are mass phenomena. It’s probably impossible to find the blameless.

The overarching point of the discussion of blame is that the time can be better spent focusing on those things one controls. With that, the next posting will return to that theme.

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