Sunday, October 30, 2011

Solyndra Could Teach Us Something

But will we learn?

It seems unlikely we will learn anything from Solyndra, and that’s not a reference to the Company’s use of the 5th amendment. When there is a potentially juicy scandal or blame is in play, no one, least of all the media or politicians, is going to resist posturing. However, any scandal and who is to blame are irrelevant to the important issue.

There are two important lessons. First, the government should severely limit its use of loan guarantees. Second, development of technology firms is based more on the availability of equity than credit. They need more owners investing, not loans.

Solyndra provides plenty of material for entertainment, FOR SURE. Just for starters, Congressman Henry Waxman defending businessmen’s use of the 5th amendment to stiff Congress is a true laugh-out-loud moment. If hypocrisy were an impeachable offense, he’d be out in a moment; but then we do expect California to generate entrainment. On a serious note, we definitely need to repeal whatever law creates a punishment for Contempt of Congress. Otherwise, public polling data indicates, we’re going to have to punish the entire nation.

Unfortunately, those media that aren’t dominated by Democrats are focused on who knew what and who did what. The Treasury Department warned that the loan to solar-panel maker Solyndra LLC might be illegal. So what? We all know the Obama administration may have brushed aside warnings, prudence, and conflict of interest. Others question the administration’s quasi-religious belief in solar. However, those aren’t the important issues. The mistake isn’t that the government didn’t do its due diligence or may be tilting at windmills. Set those issues aside; just file your opinion as yours. The real issue is not what people in government did; it’s whether government should have been doing anything special at all.

The government should stop doing things it is bad at doing. It’s wise to remember that the entire Solyndra mess began with a loan guarantee. Someone needs to recognize the parallel between Solyndra, Freddie Mac, Fannie Mae, failed banks and thrifts (e.g., Indy Mac, WAMU), government-backed student loans, and the legion of government guarantee borrowers.

On July 18th, in a discussion of the tendency of the blame game to distract from productive activities (see: “More Fireworks”), this blog noted that:

“With few exceptions, The Hedged Economist doesn't like government loan guarantees as a policy. They move a liability of unknown size to the treasury. The preferred approach is the cut and dry of either making the loan or not. But, loan guarantees can make sense in a panic.”

Why? It’s very hard to determine the subsidy the guarantee implies. Basically, the government is providing a benefit of an undetermined size with a cost that is uncertain. Further, the government is lousy at assessing credit risk and default risk. Interesting thing is that the government employees at the regulatory agencies that do credit assessment for a living (e.g., bank examiners) realize how difficult credit assessment is.

There is one important exception: That’s during a legitimate panic that is creating a liquidity crisis. During a panic it gets a bit easier to determine who is insolvent as opposed to who is illiquid. The panic and its impact on liquidity are the problem, not the solvency of most firms. It’s still hard to determine solvency. In fact, it is hard enough to expect some errors, but that’s life. The object is to be right most of the time, not every time.

The unfortunate thing is that the public has a mistaken belief that a loan is a bailout rather than an investment. Thus, we may end up dependent on loan guarantees as the only option during liquidity crises. That, however, only reinforces the need to avoid using them for other reasons.

Even government loans, as opposed to guarantees, should be avoided. The reason is simple. As noted back on September 15, 2010 in “Stimulus more or less? A failure not being acknowledged. PART 3:”

“… some observers object to loans that made a profit, but applaud those that will be written off and vies-a-versa, often with no justification based on differences in benefits.”

Not only do a lot of people think loans are a bailout, many think that they should be. You’d think the mortgage bubble would have taught us that making loans that can’t be paid back isn’t sustainable.

But, you say, the government can identify good things to do: why shouldn’t it direct resources toward those good things? That’s totally irrelevant to the issue. Governments have budgets. Let them tax and spend. The issue is the false efficiency of loan guarantees and loans that aren’t paid back.

Now to the second point, loans are NOT always the right solution, although one can understand why governments that can’t balance a budget might not see that. Talk to entrepreneurs, and more than likely equity will come up. That’s especially true of entrepreneurs in new types of businesses (e.g., new business models or new technologies). It’s invariably the case with entrepreneurs who are focused on having a significant impact.

In that environment a loan is a totally inappropriate approach. From the lender’s perspective, it bares the same risk without the potential return. From the borrower’s perspective, it drains cash flow on debt service that the entrepreneur needs to grow.

The problem in start-ups isn’t credit availability as much as equity capital. The government seems incapable of recognizing the damage it does by directing excessive credit to pet fascinations (be they housing, solar, small business, etc.). These activities need equity capital not credit. Combine that with its focus on protecting equity investors from the risks inherent in start-ups, and the government has forced many entrepreneurs into relying on the wrong forms and wrong sources for cash.

If government wants more new solar technology it should focus on the obstacles it places in the way of entrepreneurs seeking equity. One obstacle was discussed from the investor’s perspective in “Investing PART 12: Angel Investing.” Specifically it noted:

“Angel investing is just one of many potentially beneficial financial behaviors the government makes difficult.”

For a broader discussion, “The discussion Congress should be having: PART 1 Angels, entrepreneurs, and diversification” addresses a number of obstacles. It is not a policy prescription. Rather, it discusses obstacles.

The key mistake and the one that is essential to understanding how Solyndra relates to the failures of our current economic policy was summarized in this blog’s first posting on entrepreneurs on April 9, 2010, “Angels, entrepreneurs, and diversification: PART 1.” After relating how the issue explained the anemic recovery and would result in continued slow growth, three points were noted:

"First, equity capital is particularly hard for entrepreneurs to access.”
“Second, equity capital and borrowed capital, like bank loans or SBA-backed funds, have differential economic implications.”
“Finally, access to angel investors and early stage equity capital has different impacts on different industries.”

The last point is particularly relevant to Solyndra. The market supports solar applications that pay for themselves. In 1978, the first solar-powered calculator appeared. Since the 1950s, solar has dominated the powering of satellites in earth orbit. In almost every state, homes that aren’t on to the grid have found it cost-effective to combine solar with diesel generation. Many decades ago The Hedged Economist invested in a solar firm with quite acceptable results. It generated hot water. That was before photovoltaic was the rage.

Solar is a big industry, with a long history and lots of expertise. The expertise and experience to figure out where solar opportunities lie is there. There is no reason to believe government can successfully outsmart an entire industry of solar experts. But, worse yet, one has to wonder at the hubris that also led them to believe government could better structure the financing than the entrepreneurs and investors involved. Clearly, they got it wrong. Solar deserves more equity, and government loan guarantees or loans are a silly substitute. They may even retard the development of viable solar applications.

Note that other than the disclosure about a previous investment, nothing said above represents anything positive or a negative about solar. Further, if Solyndra had turned out to be a roaring success, everything said above would still be equally true.

Monday, October 17, 2011

Stimulus Can Backfire: Monetary Policy

If Bernanke needs a break today, he should go to McDonalds like the rest of us.

The previous posting addressed how fiscal stimulus can backfire. This posting addresses monetary policy. Alan Blinder’s opinion piece, “Ben Bernanke Deserves a Break” from the WALL STREET JOURNAL September 28, 2011 is the point of departure.

The fiscal stimulus discussion, “Stimulus Can Backfire: Fiscal Policy,” and previous discussions of fiscal stimulus focused exclusively on how stimulus can fall short of, or fail to achieve, expected results. That was facilitated by the focus on the economic impact of the analysis being discussed. By contrast Blinder’s opinion piece spends a lot of time on the politics and optics surrounding monetary policy. It eventually does mention the economic aspect of operation twist. This posting will follow the same outline.

If one examines each of the pressures Blinder mentions, it is hard to see how one can seriously exempt Bernanke from some responsibility for creating the sources of most of the pressures. That is especially true of Blinder’s forays into politics and the optics. So, let’s deal with that first.

Blinder does not seem to realize that purchasing across the yield curve has always embroiled the Fed in politics. The Hedged Economist noted this cost of quantitative easing and TARP on July 19, 2011 in “A Clearer View Of The Fireworks.” As stated, “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.”

A number of examples of the political pressure on the Fed that are the inevitable result of trying to manage the yield curve are discussed below. They are from the period around the Fed / Treasury accommodation of the 1950’s. That period is used to confuse the partisans since many partisan roles were the opposite of today’s, although the methodological issues are often the similar.

Wall Street expectations of a twist are a curious issue. During the 1950’s they were viewed by some as a potential reason why the Fed should not buy long-dated bonds. Two concerns were 1) that bond buyers would game the Fed, and/or 2) it would reduce private sector markets for long-dated bonds. Often both arguments, although to some extent contradictory, were used by the same person. Now, Blinder views them as a pressure to implement a twist: just the opposite conclusion.

Wall Street expectations are an issue that seems totally irrelevant. What economic impact does whether Wall Street expected operation twist have? Little to none seems a reasonable answer. The most that Fed research staffs can come up with is that expectations may have a slight impact on timing. The pressure that Blinder thinks Bernanke felt due to Wall Street expectations would be totally of Bernanke’s creation.

Here’ a quote from an article: “Stocks jumped, then sank and then rose again, as investors tried to bet on whether the Federal Reserve is going to intervene again to support financial markets.” Without a reference, it could be any article (it also could have been about bond prices rather than stocks), but here’s the telling question. In what decade was it written and did the Fed act? Do a little research, and you will find it has been written in many different decades. You will also find that whether market participants’ expectations were accurate had NO relationship to future economic performance.

The real issue concerns more extensive price controls (which is what manipulating the yield curve is). The question is: Do price controls implemented through Fed purchases produce efficiency? Given the dislocations of wartime wage and price controls, this was a major issue during the 1950’s. Interestingly, in the 1950’s, justifying price controls was a major challenge for advocates because of potential adverse effects on investment. Currently that issue has been largely ignored. By contrast, some contemporary critics of purchasing longer-dated bonds point to negative impact on savers (e.g., pensions, retirees, and life insurers), an issue that could safely be acknowledged and then ignored back in the 1950’s due to the huge forced savings built up during wartime.

The divided vote among the Fed committee members is an issue where Blinder’s comments make him appear far less knowledgeable than he is (or should be). He almost certainly knows they are typical, and he has often been a party to such divisions. Let’s take one of many examples from the 1950’s where Blinder’s personal behavior isn’t at issue. Fed Chairman Martin, and the New York Fed Sproul are the best example. They are only one example, but one that was common, almost the norm.

The Martin-Sproul differences are informative currently. Two characteristics are very timely. First, the differences often originated from differences in what each individual thought should be the focus/objective of policy at the time. Yet, unlike the fictitious employment vs inflation tradeoff economists cling to despite lengthy periods of stagflation, their differences didn’t facilitate positions that were dogmatic. Blinder’s consistent advocacy of easier monetary policy wouldn’t fit into the Martin and Sproul discussions. Their differences weren’t one sided with each one always advocating the same policy.

As also exists currently, behind some of their policy differences there were significant differences in perceptions of how markets would react. Although the issues were different, the market-reactions issue is akin to the adaptive expectation-rational expectations issue. The current differences between those who rely on comparative statics verses those who believe market reactions are path dependent are also similar to the Martin-Sproul differences. There were fundamental differences in how the two parties thought markets behave.

Blinder just brushes aside the potential methodological/theoretical bases of policy differences. In an academic environment he may be more open minded. His reporting, however, leaves an impression of dogmatic refusal to question the current economic conventional wisdom. That’s unfortunate because it raises questions about whether he can actually view the policy issues objectively.

The partisan political pressure is also not new. One suspects that Blinder’s reporting it as unprecedented reflects his partisan leaning more than anything else. Democratic Senator Douglas was the highest profile congressional critic of the Fed during the 1950’s. While Douglas and the recent efforts Blinder notes represent a single chamber of Congress, surely Blinder knows that at times both chambers and the executive branch have historically pressured the Fed from time to time.

One pressure that belongs squarely with Bernanke (and those like Blinder who report and comment on the Fed) is reflected in every discussion of “bailouts.” Bernanke and maybe even Blinder understand that Fed policy represents two different issues depending upon whether the policy is designed to address a liquidity crisis, or a slow, tentative recovery. Bernanke hints at it with his “the Fed can’t do it alone” rhetoric, but he hardly helps by trying to defend current actions by referencing parallels between two very different policy imperatives.

During a liquidity crisis a central bank’s role is to add liquidity: Lend freely at usurious rates against good collateral. That will end the liquidity crisis. That was the origin of the October 2, 2010 posting, “TARP: A success not being acknowledged.” However, as the recent Republican presidential debates and the Occupy Wall Street campouts demonstrate, the Fed failed to go back and explain what they did and why.

Most of the economic pressures Blinder also notes seem like nonsense. The Fed’s role (i.e., monetary policy) is economic. Economic “pressure” is the only reason for having a Fed.

What is strange about Blinder’s argument that Bernanke deserves a break is that once he turns to economics, Blinder undermines the argument fairly effectively. He notes that all Bernanke has to offer is a “relatively weak weapon.” He goes on to say: “Any … influence of monetary policy on the economy was bound to be modest.” If any positive impact is expected to be modest, it would seem advisable to question whether the policy action should be taken. That is only reinforced by the widespread acknowledgement that the action has risks. Even Bernanke has often mentioned the risks.

That risk was mentioned even before the posting on TARP on September 15, 2010 in “Stimulus more or less? A failure not being acknowledged. PART 3.” The quote is: “One doesn't have to be terribly familiar with what is called a "barbell" portfolio strategy to understand that there is a rational way around this potential impact of having more equity on the balance sheet. Forcing banks to hold more of a conservative asset or a conservative liability can be offset by increasing the holding of an offsetting high risk item. The overall risk doesn’t change. In fact, it’s a rational response if one wants to maintain a given overall portfolio return. One just takes on a high risk, high return positions to offset the low risk, low return position; risk and return stay the same. If the reader doesn’t understand why, consult anything on portfolio theory. Or, …”

An interesting aspect of the quote was that it came up in 2010 in connection with efforts to force banks to reduce leverage and the associated risk. However, now it explains why Bernanke can’t force people into taking more risks. One can always adjust the weights across the barbell in order to maintain any given overall risk-return profile.

Between the postings “Speak Softly But Carry a Big Stick, Dr. Bernanke,” “Operation Twist, Or Is It the Logic That’s Twisted?” and “The Fed Cannot Force Investors to Shift to a Different Risk-Return Profile,” the potential that operation twist will backfire has been covered fairly thoroughly. This is not the dogma of some political figures nor a belief that the Fed or Bernanke are evil failures. Rather, it reflects the fact that TARP and the associated liquidity injections of the earlier period would succeed while operation twist will do little under current conditions. Furthermore, what it does accomplish may do more harm than good. What is worse whatever the result of operation twist, it wasn’t worth the price.

The point where Blinder’s comments get particularly telling is when he compares quantitative easing efforts. He states: “… I was a huge and enthusiastic supporter of QE1, which concentrated on MBS, but only a lukewarm supporter of QE2's Treasury purchases. (It was better than nothing.) Since then, a few scholarly studies have estimated that QE1 was indeed more powerful than QE2. So any move back toward dealing in MBS, or in other private-sector securities for that matter, is welcome."
This statement could easily be the subject of a separate posting. Just to summarize. First, the scholarly studies he cites lend no support to his conclusion about the current program. This blog has defended QE1 (and TARP) as highly effective. It defended QE2 as consistent with a reasonable interpretation of how monetary policy could contribute to economic recovery. In both cases the impact was in NO way dependent on what assets the Fed acquired. The results the studies identify are totally dependent on the economic environment at the time. (That realization has a lot to do with the dissention on current policy).

Blinder goes on to say: “Indeed, if we indulge ourselves in a bit of blue-sky thinking, we can even imagine the Fed doing QEs in corporate bonds, syndicated loans, consumer receivables and so forth.” This is perfectly consistent with my statement above: “In both cases the impact was in NO way dependent on what assets the Fed acquired. The results the studies identify are totally dependent on the economic environment at the time.” The big issue is monetary policy.

However, the hollowness of Blinder’s very argument strongly supports the contention that the Fed shouldn’t be free of supervision in deciding which types of assets it purchases. As pointed out, even purchasing across the yield curve has always embroiled the Fed in politics. That’s of questionable justification, but once the assets aren’t Treasuries, it is legitimate to argue that it should be political. It’s also why the Fed should avoid it whenever possible, and why the current operation twist, which may have no beneficial impact, isn’t worth the political cost.

Monday, October 3, 2011

Stimulus Can Backfire: Fiscal Policy

Start with the consumption multiplier

A recent posting on The Hedged Economist commented: “The public has completely out thought the Keynesians. Increase the stimulus and the public saves more in order to pay the inevitable higher taxes. Furthermore, drive down interest rates and they’ll just hold cash.”

“Liquidity trap is what economists call it when people hoard their cash. In the discussion of stimulus back in September 2010, this blog argued the multiplier wouldn’t be linear. Well, it seems the wizards in charge may have succeeded in producing a negative aggregate multiplier, a result that should be darn near impossible.” (See: “Who Killed Stimulus as a Policy Option”)

Take a step back from the generalization and one’s view about rational expectations eliminates the need for a lot of other questionable assumptions (or substitute rational responses as an assumption). To illustrate, this blog will use two items. The first will be the topic of this posting. It is a recent (September 9, 2011) piece by Mark Zandi that Moody’s Analytics (a.k.a. makes available (“An Analysis of the Obama Jobs Plan”). It addresses fiscal policy.

The second is an opinion piece by Alan Blinder from the September, 28, 2011 WALL STREET JOURNAL (“Ben Bernanke Deserves a Break”). It will be the subject of the next posting. It addresses issues related to monetary policy.

Zandi and Blinder are two economists whose analyses and opinions are worth knowing. They also coauthored the only analysis of the initial stimulus efforts that this blog reviewed. That review was posted in September 2010 before the actual effectiveness of the stimulus was known. “PART 3, PART 4, and PART 5 of that review all dealt with their analysis.

The above links to the relevant parts of the review are live. They contained the first cautions about some of the methodological issues that led to a stimulus that accomplished much less than expected.

Obama’s first stimulus failed by any definition including his own, and it almost certainly fell well short of the result Blinder and Zandi anticipated. Yet, it might seem naive to advocate a rational expectations assumption given the considerable evidence on irrationality developed by behavioral economists. That, however, isn’t the right question. The more appropriate question for those who need point estimates of macro responses is: Is a rational response a better assumption than the greater fool assumption implied by responses that are assumed to be fixed? Neither is going to be correct.

Interestingly, in their analysis and forecast of the impact of the initial stimulus efforts, Zandi and Blinder acknowledge that multipliers vary based on economic circumstances. They focus on capacity utilization ignoring other factors that influence the multiplier.

More recently (September 9, 2011) Mark Zandi in “An Analysis of the Obama Jobs Plan” makes a very explicit reference to changes in behavioral responses:

“Confidence normally reflects economic conditions; it does not shape them. Consumer sentiment falls when unemployment, gasoline prices or inflation rises, but this has little impact on consumer spending. Yet at times, particularly during economic turning points, cause and effect can shift. Sentiment can be so harmed that businesses, consumers and investors freeze up, turning a gloomy outlook into a self-fulfilling prophecy. This is one of those times.”

“Consumers and businesses appear frozen in place. They are not yet pulling back—that would mean recession—but a loss of faith in the economy can quickly become self-fulfilling.”

That comes very close to acknowledging a shift toward rational expectations in the following sense. If one expects bad times, the response may be to batten down the hatches in ways that ensure bad times. The difference is his assumption that there is an irrational fear motivating the loss of confidence. It could just be that the response isn’t to an irrational fear. It may be a totally rational response to previous and probable policies.

To illustrate, consider this quote from an article by another economist, Gene Epstein (BARRON’S October 1, 2011, “Big Stimulus, Little Effect):

“It [fiscal stimulus] used to be called the fiscal gas pedal. If a recession strikes, you stomp down on the accelerator to help get the economy out of the ditch, pushing the federal budget into deficit. Or more realistically, because balanced budgets have become a rarity, you make sure that this year's deficit is noticeably larger than last year's.”

It’s perfectly rational to expect continuous deficits to result in higher taxes, and to cut spending in order to prepare to accommodate the tax burden.

When discussing a new stimulus, it’s possible to argue that the failure was then: this is now. It is also extremely hard to estimate how short of expectations the initial stimulus was. However, there is an even more fundamental problem with the “that was then, this is now” argument. If unsupported, it can be used either to justify or question any stimulus.

If, however, the involuntary accumulation of debt that the first stimulus imposed on the public inhibited the effectiveness of the stimulus at all, one would expect that negative impact to be greater now. The debt, the rate at which the debt is expanding, and the focus on the debt’s implications are all greater now. Most importantly, no one, not even an ideologue, can pretend that the debt can just keep growing, although some politicians think they can convince the public someone else will have to do the paying down of the debt.

It’s important to remember the phrase “for those who need point estimates of macro responses” in the discussion above. There is a more practical approach. The reality is the “no change, stable multipliers assumption” and “the rational expectation, complete adjustment assumption” are both logical constructs that allow point estimates. However, they don’t even bound the possible. People could over-adjust to the debt and more than offset the stimulus. The practical approach is to view the potential responses as providing nothing more than a way to estimate the potential impact of stimulus.

What’s particularly dangerous about the current stimulus proposal is that it’s being proposed as being offset by taxes. If that were the case, the simulative impact is totally dependent upon a very questionable, small difference. It depends upon the positive impact on those being subsidized being greater than both the proposal’s direct negative impact on those providing the subsidy and any negative adjustment it induces among those negatively affected. While advocates of stimulus point to differences in timing as justification, it’s a weak defense in an environment where the timeframe just happens to coincide with the election cycle.

Further, it’s an election cycle that is focused on the issue central to the entire concept of government stimulus. As stated in PART 4 of the discussion of the initial stimulus efforts: “There are more basic questions about potential alternative policies. Basically, the underlying philosophy of the entire policy response should be questioned. It is not the need for a policy response, but the assumption inherent in parts of TARP and most of the fiscal stimulus that is questionable. Both are predicated on the assumption a trickle-down approach is best. In essence: give the money to a government, an investor, an automaker, etc., and just count on it to flow to the general benefit of the population.”

Current circumstances weaken Zandi’s confidence argument. If, as hypothesized above, there is a substantial portion of the population questioning the underlying philosophy of government stimulus, stimulus might actually undermine confidence. Further, the confidence issue is aggravated by differences in the resources (capital and incomes) of those who believe stimulus will help and those whose confidence would be undermined by another stimulus.

Some might consider it partisan to point out the high potential of failure of a new stimulus. The subtitle and focus of “Stimulus more or less? A failure not being acknowledged. PART 1,” was “The economic impact of fiscal stimulus isn’t a partisan issue. Nor should partisan leanings be the criteria for defining stimulus.” Beyond recommending that posting there isn’t much one can say.

Others may conclude it reflects an ideological predisposition. That’s nonsense. If people could over-adjust as individuals undermining stimulus, they are equally likely to over-adjust collectively through their democratic process. If they are the greater fool a constant multiplier implies (consumers that don’t respond to debt are foolish), then they would be equally likely to display their foolishness collectively through policy as individually as consumers. Ideological predisposition (and The Hedged Economist has his own) do not determine when stimulus is advisable or what impact it will have.