Tuesday, November 25, 2008

Whatever the Fed is doing - it isn't working

Or, what if the Fed gave out all this money to the banks and none of them are lending it out?

Econbrowser Plan A didn't work. Plan B didn't work. I suggest the Fed get going on Plan C. ... So here's my suggested Plan C. The goal of monetary policy should be to achieve a core inflation rate of 3.0% (at an annual rate) over the next 6 months. That's something that can be accomplished without rate cuts or lending facilities, and here's how.

Step 1 is for the FOMC to form a clear determination that a 3% core inflation rate is indeed their immediate goal. If you hope to get somewhere, it's a good idea to start with a plan of where you're trying to go.

Step 2 is to communicate the goal to the public. Bernanke and Kohn should state clearly that they're worried by the October fall in the CPI, that they see a danger of too much slack in the economy developing, and that they will now be adopting quantitative easing with the goal of preventing further declines in the overall price level.

Step 3 is to start creating money and use it to buy up assets until the goal set out in Step 1 is achieved. What sort of assets? My answer here would be the exact opposite in philosophy of the kind of purchases and loans that the Fed has been implementing over the last year. The Fed has been trying to sop up the illiquid assets that nobody else wants. But I think what the Fed should be doing is instead acquiring assets of a type that would allow it to quickly reverse its position if a sudden shift in perceptions causes inflation to come in above the intended 3% target. The Fed can't afford to dump the illiquid securities it's been taking on recently, and that leaves it with substantially less flexibility to ease out of an expansionary policy once it starts to be successful.

My goal would therefore be to buy assets for the Fed that won't lose their value with a reversal of expectations and whose sell-off by the Fed wouldn't be itself an additional destabilizing force.
What specifically would such assets be? I'd start with those clearly undervalued TIPS. Next I'd buy short-term securities in the currencies relative to which the dollar has been appreciating. Here again if the Fed has to sell these off in a sudden change in perceptions, the Fed will have both made a profit and, by selling, be a stabilizing force. If we're still seeing no improvement, the Fed can start to buy longer-term Treasuries.

What if the policy is unsuccessful, and we still get severe deflation despite the 3% inflation target? In some ways, that's the best outcome of all, since, as I
explained previously, in that scenario the Fed has solved the nasty problem of all that debt owed by the Treasury.

Over at Economist's View Mark Thoma says:
John Hempton disagrees with me and others that the problem in financial markets is fundamentally one of solvency, i.e. lack of adequate bank capital. He says it is a matter of trust, trust that was destroyed by lies and deceptive practices among other things. If he is right, bank recapitalization alone will not bring back the trust that is needed - well capitalized banks can still lie - and because of that he believes some sort of "full guarantee of all sorts of bank debt" is needed to get bank credit flowing again from financial wholesalers to financial intermediaries. His preferred solution to provide the necessary trust is bank nationalization - the government won't default on its obligations to provide payment - and this allows taxpayers to fully participate in the upside in return for assuming the risk inherent in guaranteeing debt payments ... We agree that fear is the problem, people will not be willing to provide financing if they are worried about getting their money back, the question is what is driving that fear, insolvency, something else, or both. If it is insolvency alone, then recapitalization ought to work, but if it is a lack of trust that a solvent bank balance sheet means what it says it means, then the problem is harder to fix unless you are willing to inject massive amounts of capital - enough to remove all doubt - or remove uncertainties from the books through a massive toxic asset purchase program (a public relations nightmare).

My thoughts are nationalization. It removes all uncertainty and gives taxpayers the upside. Perhaps what is needed is a financial version of the Powell Doctrine:
Overwhelming financial resources should be brought to bear on a crisis. The objective is to minimize uncertainty and bring stability and calm to the financial markets in the shortest time possible. The following list has to be answered in affirmitive:
1. Is a vital economic interest at stake?
2. Do we have a clear obtainable measureable objective i.e. volatility in stock market, etc.?
3. Have risks and costs been analyzed with best available information?
4. Will risks and uncertainty increase if we try all other possible smaller options?
5. Is there an exit strategy to recoup costs of bailout?
6. Have consequences of all actions been considered?
7. Will the action be supported?
8. Do we have international support?

I believe the answer to all of the above is Yes for nationalization of the financial industry/sector as far back as early October.

Update: Fama explains the reasoning behind nationalization (note: he does not support nationalization) as a debt overhang problem.

Update: Nationalisation Linkfest

The bailouts continue

In a previous post I asked if Citigroup could be next and thought they were safe (at the time). Well, it looks like not. Mark Thoma summarizes some thoughts on the Citi bailout - no one likes it.

Fortune ran an article on whether GE Capital and hence GE was safe:

Says Tom Priore, who runs the credit hedge fund ICP Structured Investments: "If you thought AIG was important, GE is many times a multiple of AIG." And now GE's future, like the economy's, looks as if it could tip either way.

... GE is known for seeing changes ahead of time - recognizing early, for example, that it had to go "green" - and responding to them faster and more creatively than the competition. Last year, however, signs began turning up that this admirable pattern wasn't holding at GE Capital. For example, the company had left the home mortgage business in 2000 but reentered it in 2004 when it was flying high, buying a subprime lender called WMC Mortgage from a private equity firm (the price was never announced). Home prices peaked in June 2006, yet it wasn't until a year later, with the subprime crisis on the front page of every newspaper, that GE Capital finally decided to bail out. WMC lost almost $1 billion in 2007 before GE dumped it in December. A Japanese consumer-lending company called Lake was another lousy business, but GE Capital again didn't face the music until it was too late. GE took a $1.2 billion loss on it last year after deciding in September to sell it - but by then consumer credit was deteriorating so fast that unloading it (to Shinsei Bank) took another year.

... Managers thought they were being bold in stress-testing their model against a percentage-point jump in rates, but didn't conceive of a sudden and nearly complete stop to interbank lending, a total absence of buyers for some securitized debt, and investors so panicked they're willing to accept negative interest rates to gain the safety of T-bills.

Last year it bought about $14 billion of them and this year over $1 billion, all at prices in the 30s. Now, just six days after suspending the repurchase program, it was selling $12 billion of shares to the public at about $22. That is, it was buying high and selling low.

Why was it so desperate for cash? The company offers only the blandest reasons for its move, but investors were clearly worried that commercial paper was an important factor. Commercial paper is how corporations borrow for short periods, typically just a few days, for immediate purposes; it's attractive because companies borrow only what they need, and interest rates are low. Lots of firms use commercial paper, frequently just for paying day-to-day bills, but no company uses it anything like GE. GE Capital alone has about $74 billion of commercial paper outstanding; the next largest player, J.P. Morgan, has about $47 billion. GE understood there was risk in relying so heavily on this source of funding but believed it was well prepared for any disruption through access to other sources, such as bank lines of credit.

On the morning of Oct. 1, the markets swirled with rumors that GE couldn't roll over its commercial paper coming due. Like so much else that has happened in recent weeks, this possibility would have seemed outlandish just a month before; a spokesman insists the company has experienced no such problems. But in light of GE's huge commercial paper obligations and the disruption of global credit markets, the rumors became just barely plausible. That's when the stock suddenly dropped 10%, and the price of GE credit default swaps jumped. Regardless of how realistic the market's fears were, the episode puts the Fed's decision five days later to backstop the commercial paper market in a new light, as a signal of support for the commercial paper market's biggest player.

... the company holds some $53 billion of off-balance-sheet assets that are pieces of securitized debt, some of which are hooked to interest rate swaps with counterparties that are now troubled, such as ABN Amro, owned by Fortis and RBS Group. Individually, none of those is enough to cause a major problem. But investors are justifiably spooked by the poorly understood web of connections interlocking global financial firms, which have caused such havoc over the past month, and they're unsure how GE might ultimately be affected.

Another example: GE Capital says that some of the debt it holds is extra-safe because it's covered by credit insurance. But in today's environment, how reliable are the credit insurers?
Investors worry also because GE Capital oversees one of the world's largest commercial real estate portfolios. Tom Shapiro of GoldenTree InSite Partners, a real estate investment firm, says commercial property values have declined 10% to 20% in some regions and are still falling. In addition, GE's portfolio includes residential-mortgage-backed securities, some with subprime exposure, for which there's virtually no market now. More uncertainty for investors.

Another concern is that the leverage in GE could be much higher than stated. Egan-Jones, an independent rating agency, calculates that GE is levered ten-to-one, a more conservative and higher number than the company's eight-to-one figure. Cofounder Sean Egan believes that, depending on the off-balance-sheet holdings, actual leverage could be still higher. His firm rates the company single-A.

Depression economics

Not only do we know what caused the Great Depression, it seems like we don't really what ended the Great Depression:

MR: The traditional story is that President Franklin D. Roosevelt rescued capitalism by resorting to extensive government intervention; the truth is that Roosevelt changed course from year to year, trying a mix of policies, some good and some bad. ... In short, expansionary monetary policy and wartime orders from Europe, not the well-known policies of the New Deal, did the most to make the American economy climb out of the Depression.

Again MR: Bernanke notes that there were "remarkably strong" productivity gains throughout much of the 1930s, even though there was no capital deepening. This is a central puzzle which any account of the New Deal, or New Deal recovery, must incorporate. ... Rick Szostak's work suggests that the New Deal saw lots of labor-saving, process innovations, which meant both high productivity gains and pressure on labor markets at the same time. In my view most of these gains were simply the result of working through the implications of the earlier fundamental breakthroughs of the preceding twenty years. ... Whatever is the case (and we genuinely don't know), these productivity gains are central to the story of New Deal recovery. Roosevelt may deserve credit for some of them, or for allowing them to proceed, but don't assume that the New Deal caused such gains just because you see them in the gross data.

Arnold Kling via MR: The New Deal is a mythical event in history. Just as we revere the constitution as the basis for our government and we revere Abraham Lincoln for ending slavery and preserving the union, we are supposed to revere the New Deal as somehow providing the basis for our modern prosperity. Yet the policies of the New Deal are quite a mixed bag, to say the least. Most were discarded by 1950. The survivors include agricultural policies that were almost certainly wrong then and are almost certainly wrong now. Most of the financial regulations, such as interest rate ceilings on bank deposits, proved unworkable by the 1970s. Social Security, and its offspring Medicare, are going to be the next great financial crisis in this country.

Again, MR: Christina Romer writes:
This paper examines the role of aggregate demand stimulus in ending the Great Depression. A simple calculation indicates that nearly all of the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion. Huge gold inflows in the mid- and late-1930s swelled the U.S. money stock and appear to have stimulated the economy by lowering real interest rates and encouraging investment spending and purchases of durable goods. The finding that monetary developments were crucial to the recovery implies that self-correction played little role in the growth of real output between 1933 and 1942.

Did the World War Help End the Great Depression? Joseph Cullen and Price Fishback write:
We examine whether local economies that were the centers of federal spending on military mobilization experienced more rapid growth in consumer economic activity than other areas. We have combined information from a wide variety of sources into a data set that allows us to estimate a reduced-form relationship between retail sales per capita growth (1939-1948, 1939-1954, 1939-1958) and federal war spending per capita from 1940 through 1945. The results show that the World War II spending had virtually no effect on the growth rates in consumption that we examined. This contrasts with Fishback, Horrace, and Kantor's (2005) findings of about half a dollar increase in retail sales associated with a dollar of New Deal public works and relief spending. Several factors contributed to this relative lack of impact. World War II spending often required a conversion of plants designed for civilian good production into military factories and back again over the 9 year period. Substantially higher federal tax rates that were paid by the majority of households imposed much stronger fiscal drags on the benefits of the spending. Finally, less of the military spending was earmarked for wages and use of locally produced inputs, which reduced the direct stimulus to the local economy. ... My [Tyler Cowen] understanding has long been that wartime orders from Europe, by 1940, provided the decisive turning point for the American economy. So if WWII did end America's Great Depression, it was not through the traditional mechanism of massive domestic fiscal stimulus.

Some notes by Jim Hamilton on how the New Deal may have prolonged the Depression:
Cole and Ohanian noted that many in the Roosevelt Administration believed that the severity of the Depression was due to excessive business competition that led to wages and prices that were too low. I actually agree, in a perverse sense, with part of that diagnosis-- I see the rapid deflation of 1929-33 as quite destabilizing. But I'm inclined to believe that the way to fix that would have been through a monetary and fiscal expansion rather than trying to lift nominal wages and prices back up by sheer government fiat. ... The purpose of the NIRA and NLRA was to promote labor and trade practice provisions so as to limit the extent of competition between firms and competition between workers. Among the NIRA codes that Cole and Ohanian highlight include minimum prices below which firms were not allowed to sell their products, restrictions on productive capacity and the amount that could be produced, and limitations on the workweek. Cole and Ohanian concluded on the basis of model simulations that these kinds of New Deal policies might have accounted for 60% of the persistence in the output gap. ... I openly confess to believing that government policies that were explicitly designed to limit manufacturing, agricultural, and mining output may indeed have had the effect of limiting manufacturing, agricultural, and mining output.

Finally, via Mark Thoma, the views on fiscal policy and Christina Romer:
Citing Free Exchange: Mr Cowen is seeking to use Ms Romer's findings as evidence that little expansionary action should be taken beyond easy money, but I'm not sure the paper reflects that conclusion. For one thing, it is the extraordinary monetary actions that made the difference during the 1930s—the abandonment of the gold standard coupled with massive capital inflow from Europe. But as importantly, Ms Romer doesn't say that fiscal policy couldn't have worked, just that it didn't. The reason it didn't, as many commentators have pointed out in recent weeks, is that president Roosevelt didn't do a particularly good job of employing it. He was stubbornly resistant to deficit spending, and he threatened to undo the progress made to 1937 with a misguided attempt to balance the budget, throwing the country back into recession.

And quoting, Edge of the West:
She’s very clear throughout that deliberate policy choices were key, and she thinks the deliberate policy choice of FDR to devalue in 1933/34 was most key.
But there’s nothing particularly prejudicial there against fiscal policy. Nor an argument about the superiority of monetary policy. But an empirical case that owing to planning and luck, monetary policy worked in the 1930s. And just now we haven’t stabilized the banks quite as the New Deal did in 1933.

Real returns to S&P 500

I was surprised about two things from this graph that was posted on Worthwhile Canadian Initiative.
1. Real returns between 1960 and 1990 were so low ~ 1 percent.
2. Real returns doubled only only recently.
Stephen Gordon was wondering if his paper which used pre-1993 data could be extended to include the latest data and concluded not. The obvious question is: What caused the increase in real return? Fundamentals or bubble?
P.S. Why is it so hard to get publicly (i.e. free) data on total return of the paper S&P 500? Neither S&P nor Bloomberg have these as downloads.

Monday, November 24, 2008

Repent all ye free market believers!

The end of the world must be near. Condemnations have begun to appear. (HT: EV )
... Our belief in the market – the midwife of technological invention – was the result. We have embraced globalisation, the widest possible extension of the market economy.

For the sake of globalisation, communities are denatured, jobs offshored, and skills continually reconfigured. We are told by its apostles that the wholesale impairment of most of what gave meaning to life is necessary to achieve an "efficient allocation of capital" and a "reduction in transaction costs". Moralities that resist this logic are branded "obstacles to progress". Protection – the duty the strong owe to the weak – becomes protectionism, an evil thing that breeds war and corruption.

That today's global financial meltdown is the direct consequence of the west's worship of false gods is a proposition that cannot be discussed, much less acknowledged. One of its leading deities is the
efficient market hypothesis – the belief that the market accurately prices all trades at each moment in time, ruling out booms and slumps, manias and panics. Theological language that might have decried the credit crunch as the "wages of sin", a comeuppance for prodigious profligacy, has become unusable.

This monstrous conceit of contemporary economics has brought the world to the edge of disaster.

The above is from Robert Skidelsky.

Experiments in economics

I read very quickly though Field Experiments by Harrison and List as well as Toward an Understanding of the Economics of Charity: Evidence from a Field Experiment by Landry et. al. I used to have an aversion to experimental economics but am getting around to the idea that for some interesting questions such as risk aversion, experiments may be necessary. While the survey article by Harrison and List (also in JEL 12/2004) left me confused in some parts, it convinced me that economists have learned a lot over the years.

One thing that puzzled me is that there isn't more of an intersection between survey sampling ideas (as well as randomization) with experiments. One of the things I zeroed on was the use of students in experiments (or convenience samples such as church goers). It seems that the ideas of stratification and sampling used in surveys and randomization should be introduced into experiments. (The survey article only touched on this -- they point out that even randomization has large recruiting costs but the reason these costs are borne is because randomization is in some way more acceptable than experimentation.) The biggest hurdle is cost and large scale experiementation probably hasn't made in-roads because experimental economics has not yet firmly become part of the toolkit of mainstream economists.

Perhaps with more experiments done over the Web, e.g. playing games of chance/answering questions on-line the line between surveys and experimentation will merge. I see recruiting as an ever growing problem with constant Polls, marketing surveys etc. the response rates have been declining for the past 20 years.

One last jab at JEL survey articles is that they tend to cover too much with too little depth and too much jargon. I think this article could have been made a lot simpler and narrower and hence more interesting.

Sunday, November 23, 2008

Sandra Tsing Loh reviews Jonathan Kozol

I've heard Sandra Tsing Loh on NPR and liked her humor. Here she reviews Kozol's Letters to A Young Teacher. Not so much of a review as a criticism and a way to push her story out, but funny nevertheless. Her criticism is that Kozol is ignoring parent participation. Some excerpts:

Through his somber, exquisitely detailed accounts, I’ve watched countless poor black children begin as charmingly inquisitive and hopeful 5-year-olds, and then, as years pass, as concentric circles of chain-link fence close in, to the beat of that grim government drum, I’ve seen their once-bright spirits dim, heard their once-mellifluous questions ebb to dull monosyllables. I have ridden this roller coaster so often that at one point I took my tower of Kozols to my therapist’s office and despairingly set them on her glass coffee table, like a basket of orphaned kittens. Pfizer should develop a special antidepressant—“Zokol: for when you’ve read too much Kozol.”

... I wept over Kozol’s books for years, but I myself am no freedom fighter. If I could have afforded either a $1.3 million house in La Cañada or $40,000 a year to send my two girls to a private school (that is, if we’d gotten into said school; I confess that, even though I described my older daughter as “marvelously inquisitive” when we applied, we were wait-listed) I wouldn’t waste two minutes on social justice. Let them spell cake! (Which is to say, let them spell it “kake.”) We tried to flee to the white suburbs, but we failed, and in failing, we seem to have fallen out of the middle class, because today my daughters attend public school with the urban poor.

... But whither the “white” people? If you’d asked me five years ago what ethnic mix in a school would feel “comfortable” for our family (my husband being white, me being a Southern California native of German-Chinese extraction), I would have guessed, if not two-thirds white, or if not half, certainly at least a third—a third whitish English-speaking children, like mine. A third with freckles, striped shirts, and lunch boxes of tuna-fish sandwiches, the totems I myself grew up with in this region in the ’60s. But, as I’ve since learned, in 21st-century Los Angeles, expecting such a relatively high percentage of pale children is statistically unrealistic. Today, the Los Angeles Unified School District is overwhelmingly Hispanic (73 percent), the remaining quarter a roiling mishmash of black, yellow, perhaps a dab of red, and white. In fact, it is less than 9 percent white, and since the technical LAUSD definition is “non-Hispanic white,” that includes children of Middle Eastern and Armenian descent. In L.A. Unified, white may actually refer to a brown-skinned Syrian Muslim English-learner.

... The anxious solution typically involves private-school diversity committees that produce “diversity retreats” (retreats from diversity?), as in one case I heard about where a school’s seniors went on a weekend trip to Santa Barbara to watch and discuss the movie Crash.

... After a fair amount of heartache, I have to admit I have given up on trying to charm white people, at least a certain NPR-listening, Bobo, chattering class of white people, back into public school. ... Asians, on the other hand, tend to overlook the occasional snarl of graffiti (in our city, a way of life). What they see at Van Nuys High, for instance, with penetrating laser vision, are the math and medical magnets embedded within. Indeed, I’ve gradually become aware—via frequent newsletters—that behind those high brown walls flourishes a buzzing hive of Korean Magnet Parents. They are busily committee-meeting, Teacher Appreciation–lunching, and catapulting their children from Van Nuys High School directly into Harvard, Stanford, Yale, Caltech, Berkeley! Why should they spend $25,000 for each year of high school to make the Ivy League? These immigrants know how to find value!

... Parents never seem to play a dynamic role in Kozol’s solutions—although, to be fair, parents are missing from almost every public-school policy analysis. This was a group also worth addressing, wasn’t it? Particularly affluent educated parents, of a liberal social bent. Kozol himself has said that private schools “starve the public school system of the presence of well-educated, politically effective parents to fight for equity for all kids.” If anyone had a bully pulpit from which to address these folks, it was Jonathan Kozol. In such desperate times, why not go from third person to second? Why not be more aggressive, putting blame where it belonged? So I asked him: “Speaking of moral leaders, since your work is so admired by such magazines as Harper’s and The Nation, why don’t you simply exhort those readers to SEND THEIR KIDS TO PUBLIC SCHOOL? How many of those staffers’ kids are in elite privates? Talk about Shame of The Nation!”

He observed again, doggedly, that if the government RAISED EDUCATIONAL FUNDING, schools would improve and the middle class would naturally return. Ha! I’ve lost enough cocktail-party arguments to know that social change doesn’t happen until economic self-interest is at play. He then admitted—softly and tellingly—that as he himself was not a parent, parents’ personal decisions, he would not judge—What? Kozol? Not judge?

Of course Kozol underestimates the potential of parents as a tool for improving public schools. Or perhaps, after decades of his own lost cocktail-party arguments, he has simply given up on them. Instead of exploring the chaotic and the new, Kozol seems more comfortable retilling the familiar territory of his ’60s civil-rights jeremiads inhabited by only two cartoonish, archetypical kinds of parents: 1) poor, black, eternally noble, Langston Hughes–quoting parents too beaten down by the system to escape horrible schools; and 2) “savvy,” white, affluent parents who successfully connive to get their children into fabulous suburban schools, with nary a look behind them. If he were a parent and had to navigate our hardscrabble world, both the problems and the solutions might appear different to him.

What happens to poor public schools when, God forbid, pushy middle-class, Type A, do-it-yourself PTA mothers become involved and agitate to lift up the boats, not just of their own children but, perforce, of their children’s disadvantaged classmates as well?

Upon dropping off my daughter one morning, I heard a virtuosic tuba player warming up in the amphitheater; a brass quintet sent by the L.A. Music Center was giving a 90-minute morning assembly. I snuck in, and it was extraordinary—they played Copland and Mozart and Rossini. Excitedly smelling if not blood in the water, then chardonnay, I soon accumulated more information about all the free stuff the Los Angeles Unified School District has—the music teacher who comes with 65 free instruments, the arts money, and so on. In time I would learn to see the LAUSD as a giant Costco—overcrowded parking, gray lighting, mini-skyscrapers of cat litter—but replete with buried treasure. Free upright pianos in every school, for instance, serviced by LAUSD tuners. No one in my circle knew anything about this, because no one had actually had a child in a public school in years.

(read the rest of the article to find out how Sandra Tsing Loh becomes one the pushy middle-class Type A parents)

Saturday, November 22, 2008

Data I wished were in the public domain

For free:
1. Car repo rates
2. Home foreclosure rates
3. Spending on luxury goods
4. Spending on Spa

Might be interesting to look at trends and/or possible leading/lagging indicator.

Nigeria's Christians and Muslims

Eliza Griswold's impressive article in The Atlantic Monthly:

... Nigeria is Africa’s most populous country, with 140 million people (one-seventh of all Africans), and it’s one of the few nations divided almost evenly between Christians and Muslims. Blessed with the world’s 10th-largest oil reserves, it is also one of the continent’s richest and most influential powers—as well as one of its most corrupt democracies. Last year’s presidential election in particular—in which President Olusegun Obasanjo, an evangelical Christian, handed power to a northern Muslim, President Umaru Yar’Adua—was a farce. Ballot boxes were stuffed by thugs or carted off empty by armed heavies in the pay of political candidates. Across the country, political power is a passport to wealth: according to Human Rights Watch, anywhere from $4 billion to $8 billion in government money has been embezzled annually for the last eight years. The state has all but abdicated its responsibility for the welfare of its people, roughly half of whom live on less than $1 a day. ...

“These conflicts are a result of secular processes,” said Sanusi Lamido Sanusi, one of Nigeria’s leading intellectuals and a top executive of one of the country’s oldest banks, FirstBank. “It’s about bad government, economic inequality, and poverty—a struggle for resources.” When a government fails its people, they turn elsewhere to safeguard themselves and their futures, and in Nigeria at the beginning of the 21st century, they have turned first to religion. ...

The Pentecostal movement is so vast and varied, it’s a mistake to generalize about its unifying principles. But Pentecostals do tend to share an experience of the Holy Spirit, or the numinous, that offers the gift of salvation and success in everyday life—particularly in the realms of personal health and finance. Archbishop Akinola, whose own Anglican Church is more threatened in some ways by the rise of Pentecostalism than by the rise of Islam, finds these teachings suspect: “When you preach prosperity and not suffering, any Christianity devoid of the cross is a pseudo-religion.” ...

“God isn’t against wealth,” Professor Famous said. “Revelations talks about streets paved with gold.” He added, “Look at how Jesus dressed.” When I appeared baffled, he patiently explained that since the soldiers cast lots for Christ’s clothes, they were clearly expensive. In Canaanland, clothes matter: the pastors wear flashy ones and they drive fast cars as a sign of God’s favor. They draw their salaries from sizable weekly contributions. On Sundays at some Nigerian Pentecostal churches, armored bank trucks reportedly idle in church parking lots, while during the service, believers hand over cash, cell phones, cars—all with the belief that if they give to God, God will make them rich. It’s said that if the Christian Prosperity churches disappeared, the banks of Nigeria would collapse. ...

Pastor James Movel Wuye was born in Kaduna into an ethnic minority called Gbagyi. ... James incited violence by relying on the literal, inspired word of scripture. “I used to say, ‘We’ve been beaten on both cheeks, there’s no other cheek to turn,’” he said. “I used Luke 22:36: as Jesus said to the disciples the night before his crucifixion, ‘And if you don’t have a sword, sell your cloak and buy one.’” ... Imam Muhammad Nurayn Ashafa is also a former militia leader, from the other side of the river, where he still lives. “We were fighting on either side of town, James and I,” he told me when I first visited his home in August 2006. ... When the religious crisis hit Kaduna in 1987, Ashafa, like James, became a militia leader. The two were enemies. “We planted the seed of genocide, and we used the scripture to do that,” Ashafa said. “In Islam, you must fight in defense of any women, children, or old people—Muslim or not—so as a leader, you create a scenario where this is the only interpretation,” he explained. But Ashafa’s mentor, a Sufi hermit, tried to warn the young man away from violence. “You will not cross the ocean with hate in your heart,” he told Ashafa.

In 1992, Christian militiamen stabbed the hermit to death and threw his body down a well. Ashafa’s only mission became revenge: he was going to kill James. Then, one Friday during a sermon, Ashafa’s imam told the story of when the Prophet Muhammad had gone to preach at Ta’if, a town about 70 miles southeast of Mecca. Bleeding after being stoned and cast out of town, Muhammad was visited by an angel who asked if he’d like those who mistreated him to be destroyed. Muhammad said no. “The imam was talking directly to me,” Ashafa said. During the sermon, he began to cry. Next time he met James, he’d forgiven him entirely. To prove it, he went to visit James’s sick mother in the hospital.

Slowly, the pastor and the imam began to work together, but James was leery. “Ashafa carries the psychological mark. I carry the physical and psychological mark,” he said. “He talks so much. I’m a little miserly with words. So when he uses his energy like that, he sleeps very deeply. There were instances where we shared a room. He’s a very heavy sleeper. You can actually take the pillow off his head and he will just struggle and go back to sleep. More than once, several times, I was tempted to use the pillow to suffocate him. But this restraining force of the deepness of my faith comes ringing through my ears.”

At a Christian conference in Nigeria sponsored by Pat Robertson—one of the most anti-Muslim preachers in the world—a fellow pastor pulled James aside and said, in almost the same words as the Sufi hermit, “You can’t preach Jesus with hate in your heart.” James said, “That was my real turning point. I came back totally de­programmed. I know Pat Robertson might have had another agenda, but I was truly changed.”

For more than a decade now, James and Ashafa have traveled to Nigerian cities and to other countries where Christians and Muslims are fighting. They tell their stories of how they manipulated religious texts to get young people into the streets to shed blood. Both still adhere strictly to the scripture; they just read it more deeply and emphasize different verses.

Speculation on the next slum

Some interesting thoughts on what the future of suburbs will be:
... the story of vacant suburban homes and declining suburban neighborhoods did not begin with the [subprime] crisis, and will not end with it. ... For 60 years, Americans have pushed steadily into the suburbs, transforming the landscape and (until recently) leaving cities behind. But today the pendulum is swinging back toward urban living, and there are many reasons to believe this swing will continue. As it does, many low-density suburbs and McMansion subdivisions, including some that are lovely and affluent today, may become what inner cities became in the 1960s and ’70s—slums characterized by poverty, crime, and decay. ...
The experience of cities during the 1950s through the ’80s suggests that the fate of many single-family homes on the metropolitan fringes will be resale, at rock-bottom prices, to lower-income families—and in all likelihood, eventual conversion to apartments.

Reminded me a little of Paris, where the "suburbs" (banlieue) are the "slums"

More about credit default swaps

This is a follow-up to the previous post on CDS. This Fortune magazine article on credit default swaps was entertaining but not too illuminating. The charts are from the article.

... by ostensibly providing "insurance" on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble.

"If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books,'" says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. "If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'"

THERE'S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."

... Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million - or a $100 million - contract.

... You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw!

... ONE REASON THE MARKET TOOK OFF is that you don't have to own a bond to buy a CDS on it - anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people's debt. That's why it's possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt.

"It's sort of like I think you're a bad driver and you're going to crash your car," says Greenberger, formerly of the CFTC. "So I go to an insurance company and get collision insurance on your car because I think it'll crash and I'll collect on it." That's precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors' subprime mortgage bonds would default.

So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world's largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, "To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract."

There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation.

Wednesday, November 19, 2008

Popping bubbles

WSJ had an interesting discussion on whether the bubble was unexpected:

A Factiva search of the top 50 newspapers in the U.S. returns 268 stories referring to a housing or real-estate bubble in 2003. In 2004 that number increases to 369 and in 2005 it swells to 1,608. Going month by month in 2005, there’s a steady increase in “bubble” stories in the first part of the year, coming to a peak in June. ... For policymakers, how widespread knowledge of the housing bubble was matters. It is one thing to say that hardly anybody saw the bubble. It is quite another to say it was generally recognized, yet nobody did anything to stop it and nobody recognized just how bad the fallout from the eventual bust would be.

Note: Google Trends places the peak somewhat later (at around August if I can read the axis correctly) - I used the phrase "housing bubble" rather than "bubble".

It made me wonder: What if the Fed began raising interest rates when the bubble stories peaked?

Oh, well.
More interestingly is whether the end of the bubble was foreseen? Using Google Trends I was not able to come up with anything.

Tuesday, November 18, 2008

Credit crunch update

In a previous post on credit crunch, I was ready to believe there was some evidence of a credit crunch. An update on some other blog posts - this time on credit cards:

1. MR:
But even so:
Despite the decline in offers for new cards, US consumers still have access to an increasing amount of credit. Household credit lines across all cards edged up to an average of $27,626 per household (YTD 3Q 2008) from $26,902 in 2007 despite evidence that issuers are cutting credit lines on certain customers.
..."Much has been reported about issuers reducing credit lines for certain customers but this is not the case for the majority of people. Across the industry as a whole, we continue to see credit access and usage at record high levels" said Davidson.

2. Megan Mcardle conducts some self-experimentation:
Result: Instant new credit of about 10% of my annual income from the two that approved me within two minutes. American Express very sensibly makes you wait a few ways for your exclusive Costco membership card/Amex, and when they notice that I seem to have a sudden interest in acquiring large amounts of new credit, I imagine they might just turn me down. The terms on both cards were attractive, with a 0% one year introductory APR, collision liability waiver for car rentals, and other perks that might tempt someone who already has way too many airline miles.

Talking to someone reminded me that perhaps my feelings are based on the fact that we are in Washington DC which tends to be less recession prone than other regions of the country.

3. Finally, some more general observations:
... lending has decelerated; but if anything it is reverting back to a historical average rather than contracting outright. In fact, on November 5, real estate lending grew at a 6% annual rate, commercial & industrial lending at a 15% annual rate, and consumer lending at a 10% annual rate.
Quoting WSJ:
Banks actually are lending at record levels. Their commercial and industrial loans, at $1.6 trillion in early November, were up 15% from a year earlier and grew at a 25% annual rate during the past three months, according to weekly Federal Reserve data. Home-equity loans, at $578 billion, were up 21% from a year ago and grew at a 48% annual rate in three months.

The numbers point to one of the great challenges of the crisis. The credit crunch is surely real, but it is complex and not easily managed. Banks are lending, but they're also under serious strain as they act as backstops to a larger problem -- the breakdown of securities markets."

... the WSJ implies that Scharfstein and Ivashina do not actually solve the paradox, bank lending is flowing in spite of a credit crisis in the financial system. Scharfstein and Ivashina (via the WSJ article) simply suggest that banks are crowding out new lending, i.e., the drawing on already existing lines of credit are reducing the availability of new business lending. The implication is the following: had the existing lines of credit not been in place, there would be new lending. The paradox has not been solved.

4. From John Quiggin's Blog though not John Quiggin himself a chart of the money multiplier as evidence of a credit crunch:

I was curious what it would look like with a longer time frame. (Too bad it only goes to 1984.)

Encouraging consumption

With more signs that the economy is now in a recession, there have been suggestions for a fiscal stimulus (Krugman), or even possibly to encourage more consumption. It has been pointed out that the drop in auto sales is extremely worrying since households are now cutting back on auto spending. Instead of changing cars every 3 years (or whatever the number is supposed to be), they are now holding on longer to their vehicle. So should we encourage consumption to get out of a recession?

Before the crisis, economists were pointing to the large global economic imbalance and how this might be addressed by a depreciation in the dollar which would in turn lower the current account deficit and possibly consumption or investment. (For current research on current account sustainability, see here.)

Those who support increasing consumption point to the Paradox of Thrift. Quoting Interfluidity:
It is true that one person's spending is another person's income. But it does not follow that an increase in saving translates to a decrease in aggregate income. There are two kinds of spending, consumption and investment. Laying a subway line adds to somebody's income as surely as buying a Ferrari does. Ordinarily, nearly all savings are actually spent on investment goods, and there is no "paradox of thrift". What is "saved" is really spent on current production of future capacity, and there are plenty of paychecks to go around. There is no "fallacy of composition": individually and in aggregate, today's thrift lays the groundwork for tomorrow's abundant consumption. ... However, for this to work out, two things must be true: Today's savings must be invested in projects that will actually generate future wealth, and savers must believe they will retain a stake in the increased wealth commensurate with the size and wisdom of their investments. ... Encouraging people to go shopping in order to help the economy is not "second best" policy. It's a desperate last resort. We're not at a point where there's so little economic activity that we can't foresee future wants. We're at a point where people are beginning to shift from investment to storage because of a well-deserved loss of confidence in the financial system. Encouraging consumption now is nihilistic.

So perhaps we shouldn't encourage consumption.

Unfortunately, since we are not spending on cars, carmakers need someone to spend something on them, and that someone is going to be Uncle Sam. From the WSJ on bailing out Detroit:
In 1993, the legendary economist Michael Jensen gave his presidential address to the American Finance Association. Mr. Jensen's presentation included a ranking of which U.S. companies had made the most money-losing investments during the decade of the 1980s. The top two companies on his list were General Motors and Ford, which between them had destroyed $110 billion in capital between 1980 and 1990, according to Mr. Jensen's calculations. ...

Over the past decade, the capital destruction by GM has been breathtaking, on a greater scale than documented by Mr. Jensen for the 1980s. GM has invested $310 billion in its business between 1998 and 2007. The total depreciation of GM's physical plant during this period was $128 billion, meaning that a net $182 billion of society's capital has been pumped into GM over the past decade -- a waste of about $1.5 billion per month of national savings. The story at Ford has not been as adverse but is still disheartening, as Ford has invested $155 billion and consumed $8 billion net of depreciation since 1998.

As a society, we have very little to show for this $465 billion. At the end of 1998, GM's market capitalization was $46 billion and Ford's was $71 billion. Today both firms have negligible value, with share prices in the low single digits. Both are facing imminent bankruptcy and delisting from the major stock exchanges. Along with management, the companies' unions and even their regulators in Washington may have their own culpability, a topic that merits its own separate discussion. Yet one can only imagine how the $465 billion could have been used better -- for instance, GM and Ford could have closed their own facilities and acquired all of the shares of Honda, Toyota, Nissan and Volkswagen.

So it turns out that while we car makers cannot encourage consumers to buy their cars, they can just as well persuade the government to spend on them. While the latter does not increase their sales, the carmakers hope that it will increase their future productivity. But as the WSJ article points out, they do not have a good track record in investment. Is the deadweight loss of a government bailout larger than the deadweight loss of giving each U.S. consumer a $5,000 check to spend on a new car? Note: Population of the U.S. is approximately 305,700,000.

Monday, November 17, 2008

Gains from Globallization roundup

I've been sitting on some bookmarked blog entries on globalization that I wanted to pull together to summarize and I came across this (which I wish I had thought of) pretty much says it all:
.. globalization is not the main cause of developing countries' problems, contrary to the claim of critics of globalization -- just as globalization is often not the main solution to these problems, contrary to the claim of overenthusiastic free traders.

That was from Pranab Bardhan's Does Globalization Help or Hurt the World's Poor in SciAm (April 2006).

Dani Rodrik in Is Export Led Growth Passe echoes the sentiment that increased protectionism need not necessarily spell disaster for developing economies:
Nothing works as potently to inflame protectionist sentiment as large trade deficits. According to a December 2007 NBC/Wall Street Journal poll, almost 60% of Americans think globalization is bad because it has subjected US firms and workers to unfair competition. ... If globalization has acquired a lousy reputation in the US, the external deficit deserves much of the blame. ... None of this implies a disaster for developing countries. Long-term success still depends on what happens at home rather than abroad. What is moderately bad news at the moment will become terrible news only if economic distress in the advanced countries – especially the US – is allowed to morph into xenophobia and all-out protectionism; if large emerging markets such as China, India, and Brazil fail to realize that they have become too important to free ride on global economic governance; and if, as a consequence, others overreact by turning their back on the world economy and pursue autarkic policies. Absent these missteps, expect a tougher ride on the global economy, but not a calamity.

Moreover, the computed gains from trade are really not that large. From Dani Rodrik's The Globalization numbers game:
The Bradford et al. study argues that removing all remaining barriers to trade would raise U.S. incomes anywhere from $4,000 to $12,000 per household (or 3.4-10.1% of GDP). ... I do have a big quarrel with the kind of numbers presented by Hufbauer and company. They seem to me to be grossly inflated. ... So how come Bradford et al. get wildly different numbers? Some of the difference is due to Bradford et al.'s attempt to take into account liberalization in services as well as in merchandise trade. But that is only a small part of the story. The real action is in the non-standard methodological choices made by Bradford et al.--choices which are designed to generate large numbers.

What puzzles me is not that papers of this kind exist, but that there are so many professional economists who are willing to buy into them without the critical scrutiny we readily deploy when we confront globalization's critics. It should have taken Ben Bernanke no longer than a few minutes to see through Bradford et al. and to understand that it is a crude piece of advocacy rather than serious analysis. I bet he would not have assigned it to his students at Princeton. Why are we so ready to lower our standards when we think it is in the service of a good cause?

Josh Bivens (via Economists View) concurs and adds:
I also disagree that empirical research shows no (or a trivial) role for trade flows in influencing income distribution. The more immediate point, however, is that we have time to get this debate and our response to globalization right ...

The gains from globalisation that Rodrik and Bivens refers to are summarized in this VoxEu piece:
The Peterson Institute calculates that the US economy was approximately $1 trillion richer in 2003 due to past globalisation – the payoff both from technological innovation and from policy liberalisation – and could gain another $500 billion annually from future policy liberalisation (Bradford, Grieco, and Hufbauer 2005). Past gains amounted to about 9% of GDP in 2003, and potential future gains constitute another 4%.

They rebut Rodrik and Bivens:
So why do our estimates differ so much from Rodrik and the World Bank? First, both Rodrik and the World Bank authors disregard services, which account for a substantial share of total US trade and therefore a large part of the globalisation story. ... If forces like monopolistic competition, economies of scale, and productivity gains are left out of the mix, the Peterson Institute calculations would approach the Rodrik and World Bank estimates, but that would be less than half of the globalisation story. ... A key point worth emphasising is that, in the Peterson Institute estimates, policy liberalisation was not the only or even primary driver of the estimated gains. Rapidly falling transportation and communication costs are perhaps more important features of the globalisation story.

A nice roundup of various CGE models (which does not include the Bradford et. al. model) is in How Much Will Trade Liberalization Help the Poor? Comparing Global Trade Models:
The traditional argument in favor of a positive relationship between liberalization and poverty reduction focuses on the first two linkages. A large proportion of poor people work in the agricultural sector, where trade distortions are particularly high. Liberalization could lead to higher world agricultural prices and raise activity and remuneration in this sector in developing countries. The same beneficial outcome could occur in the textile and apparel sectors, where protection remains high and developing countries have a comparative advantage.

But openness can also have negative effects. First, government transfers can shrink as liberalization cuts the government's receipts of trade-related taxes. Second, terms of trade can deteriorate as liberalization affects world prices. Third, liberalization can impose adjustment costs and raise short-run risk owing to competition from imports and reallocation of productive factors.

The paper shows that estimates of gains from trade have been declining over the years - more recent studies tend to show smaller benefits. The reason?

Trade pessimism comes first from data on market access. The research community now acknowledges that simulations of full trade liberalization need to completely account for preferential schemes and regional agreements. These agreements have changed the global picture of trade protection, making average world protection lower than previously thought.

When preferences and regional agreements are not accounted for, agriculture has an average
world protection rate of 26.8 percent. When these trade regimes are taken into account, it is only 19.1 percent. Second, trade policies from industrial countries appear less anti-development than
previously believed. In fact, they are not regressive, as once thought, but slightly progressive, in the sense that the poorest countries are facing lower average duties on their exports than richer countries. On average, world protection is 5.6 percent. It is 5.7 percent for developed countries’
exports and only 4.9 percent for least developed countries’ exports.

Despite all these differences, Brad DeLong is Making the case for Globalization:
In the neoclassical Heckscher-Ohlin-Vanek framework, freeing up trade is good for owners of "abundant" factors of production in the trading country and bad for owners of "scarce" factors. The efficiency gains from trade--the increase in the size of the pie--goes roughly with the square of the differences in factor proportions between countries, but the redistributive gains and losses go roughly linearly with the differences in factor productions. Thus for freeing up trade to be bad for the greater part of the citizens in the country, two things must all be true:

(1) The bulk of the people must have little "ownership" of the abundant factors which reap the gains from freeing up trade--their income must depend overwhelmingly on the returns to the "scarce" factors of production.
(2) The differences in factor proportions that generate the possibility of gains from trade must be small in order to make efficiency gains small relative to redistributional shifts.

The argument as applied to the United States cannot be that differences in factor proportions are small: differences in capital-labor ratios across the U.S. in China are on the order of 20-to-1. So the argument must be that the abundant factors of production are things like capital, organization, and technology, which have concentrated ownership. The scarce factor of production is labor. Hence free trade will be bad for the majority of voters because their incomes depend only on returns to the "scarce" factor--and those returns will drop with free trade. ...

But in actual fact to argue that the incomes and living standards of the bulk of Americans depend on the real wages of raw labor and of raw labor alone seems to me to be equally implausible. A very large number of factors give Americans a substantial stake in the returns to--a degree of "ownership" of--the "scarce" factors. First there is the government, which is the property of all but which raises its money by disproportionately taxing the incomes of the "scarce" factors (for that is, after all, where the money is). Second, there are all the degree of formal and informal cross-ownership institutions like labor rent sharing, efficiency wages, local monopolies, and other deviations from perfect competition that give all stakeholders rather than formal equity owners alone a share in the value of the capital, the technology, and the organization: we are all stakeholders in Wal-Mart, if only through the pressure its competition exerts on other businesses' prices.

Bhagwati rails against the so-called traitors of free trade:
Episode 1. The Rise of Japan: Krugman and Tyson
The protectionists who had celebrated Krugman [and his writings on monopolistic competition] as their icon were disappointed, even furious: Kuttner would write fierce critiques of Krugman, for instance, for years. But the truth of the matter is that, even as these economists came back to the fold on free trade, Japan ceased to be a threat and the hysteria over Japan, thick as a dense fog, subsided. Free trade as our choice policy option was back in business.
Episode 2. The Rise of India and China: Paul Samuelson
Although Samuelson had been careful that this did not mean that the United States should respond with protection, the protectionists thought that they had another icon, this time the arguably greatest economist with Keynes of the 20th century and a longtime proponent of free trade in their camp! ... only an unsophisticated economist (and Samuelson is right that there are some, though not necessarily the ones he cited) would rule out the logical possibility that the rise of China and India could harm the United States.
Episode 3. India and China and Fear of Outsourcing: Alan Blinder
I described the basic distinction between service transactions that required physical proximity and those that did not, whereas Sampson and Snape brilliantly sub-divided the former into those where the provider went to the user and the other way around. Blinder, who does not appear to have known all this when he wrote his celebrated Foreign Affairs article any more than I know about the relevant intricacies of macroeconomics where he holds the comparative advantage, has been wrong therefore to think only of Mode 1.

And on Baumol and Gomory, Bhagwati continues:
... these authors make one important but familiar point, with little policy relevance as I argue now. ... sufficiently increasing returns would imply multiple equilibria and that this in turn implied (among other things) that there could exist a better free trade equilibrium than the one we may be in. But when translated into policy prescription, all it could mean was that industrial policy, buttressed Tyson-style by appropriately tailored trade policy, could nudge us towards the “better” equilibrium. But neither author managed to do this, as far as we know. So, paraphrasing Robert Solow on externalities, one might say: yes, if scale economies are important, there could be multiple equilibria and we could use trade and industrial policies to choose a “better” equilibrium; but, alas, who can plausibly compute this better equilibrium? Besides, it is hard to imagine today that, with world markets so large due to the death of distance and extensive postwar trade liberalization, there are any industries or products left where the scale economies do not pale into modest proportions. Baumol and Gomory, a brilliant pair indeed, therefore do not carry any policy salience, in my view.

And what now for globalization? According to Rogue Economist (Part 2 here):
...once growth comes back in the world, and consumers in the developing world reverse the demand destruction happening right now, many of them will again want to buy goods manufactured in the developed countries. Whether because of better research, design, or innovation, products from the US for example, remain coveted status symbols in much of Asia.Once the financial markets get through with their current panic, product innovation rather than financial innovation will be the focus of investments in the developed world. The growth in the financial markets will likely swing back to venture capitalists and private equity, while hedge funds will probably scale back.

Wireless electricity

I ran across an old SciAm article on Nikola Tesla and was surprised to learn that he had experimented with transmitting electricity without wires. Wireless energy transfer sounds great and has in fact already found its way to the market (without my realizing it):

From How Stuff Works:
Nicola Tesla proposed theories of wireless power transmission in the late 1800s and early 1900s. One of his more spectacular displays involved remotely powering lights in the ground at his Colorado Springs experiment station.

Tesla's work was impressive, but it didn't immediately lead to widespread, practical methods for wireless power transmission. Since then, researchers have developed several techniques for moving electricity over long distances without wires. Some exist only as theories or prototypes, but others are already in use. If you have an
electric toothbrush, for example, you probably take advantage of one method every day.

A toothbrush's daily exposure to water makes a traditional plug-in charger potentially dangerous. Ordinary electrical connections could also allow water to seep into the toothbrush, damaging its components. Because of this, most toothbrushes recharge through inductive coupling.

But like all dreamers:
'Drilling Up' Into Space for Energy
The Defense Department this October quietly issued a 75-page study conducted for its National Security Space Office concluding that space power -- collection of energy by vast arrays of solar panels aboard mammoth satellites -- offers a potential energy source for global U.S. military operations.

It could be done with today's technology, experts say. But the prohibitive cost of lifting thousands of tons of equipment into space makes it uneconomical.

That's where Palau, a scattering of islands and 20,000 islanders, comes in.

In September, American entrepreneur Kevin Reed proposed at the 58th International Astronautical Congress in Hyderabad, India, that Palau's uninhabited Helen Island would be an ideal spot for a small demonstration project, a 260-foot-diameter "rectifying antenna," or rectenna, to take in 1 megawatt of power transmitted earthward by a satellite orbiting 300 miles above Earth.

That's enough electricity to power 1,000 homes, but on that empty island the project would "be intended to show its safety for everywhere else," Reed said in a telephone interview from California.

Bailing out AIG's Bailout

Naked Capitalism came out against the recent plan to further stabilize AIG. The plan from WSJ:

The U.S. government was near a deal Sunday night to scrap its original $123 billion bailout of American International Group Inc. and replace it with a new $150 billion package, according to people familiar with the matter.
While the proposed arrangement would considerably ease terms on the faltering insurer, it would give the government an unprecedented role as an actor in financial markets. It could also spark a political backlash, especially from congressional Democrats, because the Treasury, while adding to its AIG obligations, has thus far refused to extend a hand to the struggling Big Three auto makers.

Naked Capitalism's bottom line:
...the worst is that not only was the initial AIG de facto bankruptcy a case of looting, the government has now decided to aid and abet AIG management in further looting. What pro-taxpayer purpose is there in the improvement of terms above? None. As we pointed out, there were only a couple of reasons for easing up on AIG, and they could have been provided for with minor changes that would not leave the taxpayer materially worse off. Instead, major concessions have been made to AIG, all to the detriment of the taxpayer. AIG management now has job security for five years (and AIG top brass is very well paid) and better odds of salvaging something for themselves when the five years are up thanks to the government giving them an unwarranted subsidy.

I say it really is high time to nationalize the entire industry.

On a different note, Fortune ran an almost fawning article about ex-CEO Hank Greenberg. True, he may not have been responsible for the CDO mess (he's sometimes considered an "unindicted co-conspirator" in an attempt (he says is legally pushing the envelope) to inflate loss reserves at AIG. Executives at AIG and General Re were indicted by jury on securities fraud. However, the problem with CDOs arose as follows:

The roots of the troubles lay in a series of insurance-like contracts that AIG had entered into almost as an afterthought from 1998 through 2005. Nearly half the deals were initiated under Greenberg's regime. Here's how it happened:

Starting in 1998, Wall Street's major mortgage-bond underwriters - Merrill Lynch, UBS, Citigroup, and others - approached AIG to insure certain classes of a then-arcane type of security called a collateralized debt obligation. AIG executives liked the fact that the company didn't have to own this illiquid paper. If the credit rating of the CDOs deteriorated, the swap owner could get AIG to pay them the face value of the CDOs no matter where they were valued in the market. There was a risk, of course, but it seemed almost impossibly remote.

Under Greenberg's supervision, AIG wrote credit default swaps on 200 or so CDO deals, charging an average of $750,000 per deal - but only a handful were exposed to subprime mortgages. After Greenberg left the company, Sullivan accelerated the use of those derivatives. Between Greenberg's departure in March 2005 and the end of that year, AIG insured another 200 or so CDO transactions - the majority of which were subprime. In all there were about 420 deals done that brought in between $315 million and $400 million, according to AIG executives and Wall Street brokerage officials. The risk managers started getting the jitters in late summer and decided to stop both the swap insurance business and all subprime mortgage issuance.

But by then, AIG had committed its once-pristine balance sheet to backing about $63 billion in increasingly illiquid CDOs. Sullivan had risen through the brokerage side of the business and wasn't familiar with complex financial instruments. He took office in a period of turmoil at the company, when it was under siege by the government. But he made missteps too. At a time when the company was trying to raise capital, he hiked the dividend, a move that even his supporters say was a horrible mistake.

Then again, shouldn't CEO's bear the price of their failures?

Investment advice (or what's so great about growth stocks)?

I was struck by Jim Hamilton's stock picks in his advice for a wild market. Mainly, I was curious about the relative importance he seems to have placed in the dividend rate. I've always wondered whether growth stocks really beat stocks/firms that are "slow and steady" in the long run or over the trough to trough of a business cycle. I haven't really looked into this but I probably should shelve this to be looked into as future research. My research question is the following: What if we're in for a "lost decade" as in Japan or Latin America. Is the performance of a "growth stock" during this time better than that of a stock that promises certain dividends but relatively slow growth? Now project 5,10,15,20 years after the "lost decade" - which portfolio performs better: growth stocks or the "slow and steady"?

On a more personal note I had to disagree with his pick of Home Depot (They should survive, and when growth resumes, they have a very successful strategy.) I'm in the middle of trying to reinsulate our attic and of course I head to Home Depot to get some insulation. We have 15 inch floor joists in the attic and all Home Depot had were 24 inch wide batts. I had to go to Lowe's to find 16 inch wide batts. I realize that being pissed at a company does not an investment strategy make but I wonder how I can be neutral in this case since Lowe's a little more out of the way than Home Depot. Uggh!

Relative status

I was reading Bruno Frey et. al.'s Relative Income Position And Performance: An Empirical Panel Analysis and this passage:

There are two countervailing theories about how income differences influence performance. One stream of literature stresses the negative consequences of envy (see, e.g., Schoeck 1966). An envious person may “prefer that others have less, and he might even sacrifice a little of his own wealth to achieve that end” (Zeckhauser 1991, p. 10), behavior that has been found in experiments (see, e.g., Kirchsteiger 1994). An envious person increases his utility by destroying some of the others’ assets, even if such an action carries its own costs (cutting off one’s nose to spite one’s face). Thus a negative sum interaction is started.

reminded me of another passage in Robert Rubin's An Uncertain World.
Bob Strauss once captured this dynamic when he said that a lawyer at his firm earning $90,000 a year -- this was some time ago -- and offered a $10,000 raise with the stipulation that a peer next door would get a $20,000 raise would prefer no raise at all to someone on his own level being paid even more. (p. 102)

The bottom line of the paper:
Using a unique data set for 1114 soccer players over a period of eight seasons (2833 observations), our analysis suggests that the larger the income differences within a team, the worse the performance of the soccer players is. The more the players are integrated n a particular social environment (their team), the more evident this negative effect is.

What I've been reading

I thought I might be able to come up with some witty comments as well as contrast the styles/voice/narration of the three books that I've read:
1. Arundhati Roy's God of Small Things
2. Richard Flanagan's Gould's Book of Fish
3. Rachel Cusk's The Lucky Ones

Unfortunately, I haven't been able to come up with anything except that of the 3 books, in terms of voice, Gould's Book of Fish is very distinctive (although the best I've read is Robert Bausch's The Gypsy Man). Roy's narration is almost melodic and the best word that I can come up with is that it has a "lilt" to it. Unfortunately, the narration jumps back and forth through time that (at my age) I was easily confused and kept having to go back to look at some chapters to verify the time line. Rachel Cusk's was interesting in that the collected stories in the book are all linked by characters that at first seem tangential to the original story. For me it didn't really have a beginning or and end although the narration was smooth enough to carry the book along.

I read these books mostly over lunch and I would not recommend (1) and (2) as "lunch" books. Some of the description of bodily processes almost made me lose my lunch.

Friday, November 7, 2008

Credit crunch revisited

After this post I decided to take a look at: A note on pitfalls of credit crunch regressions

The credit crunch regression:
Δy(t) = β0 + β1 × Δb(t) + ε(t),
where Δy(t) and Δb(t) denote growth rate of output and loans from banks. ε(t) is an i.i.d. error term. The regression should detect statistically significant effect of Δbt with a positive estimate
of β1.

Using simulations in a Kiyotaki-Moore (KM) economy, the author notes:
In KM model, the credit crunch regression only works fine if the technology shocks are expected to be long-lived.

I.e. Neither the model by the author nor the regressions are as general as they appear to be.

Water technologies

I thought that this was interesting:

The article talks about desalination using oil tankers based off-shore and then leads into:
Desalination, of course, is well and good for communities that are close to the ocean and that can afford relatively expensive water. In the villages of sub-Saharan Africa, that's not the case. Forty-two percent of the region's population lacks access to a safe water supply, and the impact of waterborne diseases on public health is staggering: Of the 396 million cases of malaria every year, the majority are in sub-Saharan Africa; 90 percent of those who die from the disease are children under 5. About 100 million Africans are infected with the parasitic disease schistosomiasis, which kills tens of thousands annually, also mostly children. The death toll from diarrheal diseases is probably much higher. What's more, a lack of reliable, clean water precludes meaningful economic development. By one estimate, some 40 billion hours a year are spent collecting water in sub-Saharan Africa -- or roughly a year's labor for the entire work force of France. The work usually falls to women and children, who are left with little time for things like growing food or going to school.

Moving Water Industries, an 82-year-old, family-owned manufacturer of water pumps based in Deerfield Beach, Florida, has been selling portable pumps for irrigation and flood protection in Nigeria for more than 30 years. But its mission in Africa has taken on a new focus: addressing the problem of safe drinking water in rural villages. The company's solution is the SolarPedalFlo, a solar- and pedal-powered pump that can provide filtered and chlorinated water for thousands of people a day -- three to four times the amount that can be produced from a borehole equipped with a hand pump. Each unit costs about $15,000.

The article continues with on-site treatment technologies that does not require storage of chlorine as well as other technologies on the horizon. This was another one that I found interesting:

As a kid, Mark Sanders hated brushing his teeth with cold water. But watching all that clean, drinkable water run down the drain as it warmed up bugged him. So at the age of 9, he began thinking about ways to capture it and save it for some other purpose -- say, flushing the toilet. Three decades later, during a visit with his wife's family in drought-stricken Oklahoma in 2000, he took up the problem again with a newfound sense of urgency.

On the plane ride home to Louisville, he made a sketch of a water recycling system that would take used water from the bathroom sink, disinfect it, and reroute it to the toilet tank for flushing. Back home, he took the drawing to a friend who did home remodeling, and two weeks later -- with a hot glue gun, some PVC pipe, and a Tupperware container -- the friend had a prototype working in his own home. Sanders, a CPA by trade and at the time the CEO of a large medical practice, patented the system, built a basic website, and began touting the system to anyone he thought might be interested. The result: thousands of hits for the site and affirmation that the interest was out there.

... The AQUS System -- named one of the 100 best innovations of 2007 by Popular Science magazine -- uses standard plumbing parts and can be installed by a professional plumber in about two hours. Priced at $395 (before rebates), it can save up to 6,000 gallons of water a year in a two-person household.

Blood donation

Gave blood last week and reached my four gallon donation the previous donation. The ARC seem to be more efficient these days although I wish they would stop using SSNs for identifying information.

Anyway, came across this (ht: Mark Thoma): Incentives for altruism? The case of blood donations:
Using a longitudinal dataset including the donation histories of all donors of an Italian town as well as demographic and employment information on the donors, we have studied (1) the impact of a legislative provision that guarantees Italian blood donors who are employees a paid day off work, and (2) the impact of an incentive scheme that offers symbolic rewards (“medals”) with social recognition value but no economic value to repeat donors. Our current results show that donors not only do not refuse the day-off incentive, but they respond to it by clustering their donation in those days (such as Fridays) which carry a high return in terms of consecutive days of leisure. This indicates that "material" considerations dominate over the potentially negative social-image effects of responding positively to economic incentives. We also show that the day-off privilege leads donors who are employees to make, on average, one extra donation per year.

I can certainly agree that a day off is warranted. I've noticed that over the years it's taking me ever increasingly longer to get over the effects (wooziness/light-headedness/weakness) of blood donation. Currently, I'm not really fully back to myself until about 5 hours later.

Tuesday, November 4, 2008

Auto sales

Jim Hamilton posted this chart on auto sales and I thought that maybe 2004-2007 might have been artificially high due to low interest rates and some kind of consumption boom so I thought I'd take a look at a longer series.

Credit crunch

In this post I had claimed that the effects of the financial crisis on the real side of the analysis was too anecdoctal. I am not the only skeptic judging by the following post (Part 3 of Where is the Credit Crunch at MR):
Back in February I pointed out that despite all the talk of a credit crunch commercial and industrial loans were at an all-time high and increasing. In September I once again pointed to data showing that bank credit continued to be high (even if growth was slowing.) At that time I also discussed how bank loans were not the only source of funds for business investment and that many substitute bridges exist which transform and transmit savings into investment. I suggested that despite the panic the problems which exist in the financial industry may be relatively confined to that industry.

Three economists at the Federal Reserve Bank of Minneapolis, Chari, Christiano and Kehoe, now further support my analysis pointing to Four Myths about the Financial Crisis of 2008.

Mark Thoma (pointing to The Economist) and Felix Salmon disagrees.
In a subsequent post, I commented:

The phrase "credit crunch" needs to be defined. I don't believe that looking at prices and quantities alone can determine if we're in a "credit crunch". Suppose that there are 4 states in the economy: high, low, normal and crisis. And suppose further that we are currently in a crisis state. A "credit crunch" is the gap between the current (crisis) quantities (or prices) and one of the 3 other states. I would be conservative and say that a credit crunch should be defined as the gap between "crisis" and "low-state" quantities and prices. If we are going to be in a recession, is the current quantities/prices lower/higher that they "should" be? Going into a recession, is a business owner that would have qualified for loans in a low-state not currently able to get a loan? This is the measure that I think is more interesting.

I may have been mistaken by looking solely at the business sector, however.
Naked Capitalism looks at international trade volumes:
One of our pet themes in recent weeks is that the fall in trade traffic, indicated and possibly overstated by a dramatic fall in the Baltic Dry Index, is due at least in part to difficulties in arranging and getting other banks to accept buyers' letters of credit. For those new to this topic, international trade depends to a large degree on letters of credit. While they can help finance shipments, an even more fundamental role is that they assure the shipper that he will be paid for the cargo sent. Without banks using letters of credit as the means to send payment to exporters, parties that are new to each other or conduct business with each other infrequently could never trade with each other (one type, a documentary letter of credit, requires that forms, often a very long and elaborate set of them, verifying that the goods have been inspected and certified, that customs, have been cleared and all relevant charges and duties paid, be presented and vetted before payment is released).

More on the Baltic Dry Index is here and here. Some background is here and here.
In any case I thought I'd toss in a few more anecdotes from the latest issue of Inc Magazine.
1. About Nau, an apparel store that went bankrupt (Too much too fast or credit crunch?):
In 2005, half a dozen outdoor-clothing guys got together at Portland's Urban Grinds coffee shop to sketch out their new retailing concept. Times were good, and they were feeling supremely confident. Their big idea was to combine the eco-friendly and mountain-climbing chic of Patagonia with the fashion-forward urban cool of, say, Prada. Not only would their clothes be practical on the trail, but they would look sleek and hip in the city as well. Nau would design its own fabrics with new sorts of eco-friendly materials. Even Nau's retail outlets -- the plan called for 150 of them -- would be constructed from recycled wood and plastic.

The team also decided to funnel 5 percent of sales from each item to dozens of worthy nonprofit organizations that buyers could choose from. The clothes would be pricey, but shoppers could feel good that by buying a $40 T-shirt or a $350 jacket, they would also be doing some good. ...

The company, with its five stores and four more under construction, assumed additional financing would always be around the corner. Then the credit crunch hit. With no recourse to bank financing, the team implored its biggest investors for additional funding. But the investors who had been so generous just a few months earlier clammed up. "Everyone on the board understood we had gotten in too far to turn around and pare this thing down," says Gomez, then board chairman of Nau. The money was gone. The board voted to close down Nau's stores and suspend all business.

2. Norm Brodsky seems to make a lot of sense to me:
... Not so long ago, you could still get what bankers affectionately referred to -- in private -- as an "air-ball loan." That was a loan based not so much on your assets but almost entirely on your relationship and history with the bank. Yes, the bank would glance at your company's earnings and cash flow, just to be sure you could make your payments and weren't about to go bankrupt, but the relationship mattered most.

We needed to borrow $4 million to cover the building costs, ... a week later, the bank president called and said that because we weren't giving a personal guarantee, the bank would lend us the money only if we made a "substantial" deposit, by which he meant an amount equal to 50 percent of the loan. I pointed out that a deposit of that size was hardly necessary from a security standpoint. Our development company had unencumbered assets of $7 million. Once the construction was finished, the value of these assets would rise to more than $16 million. The risk to the bank was minimal. But it turned out that risk wasn't the issue. "In order for us to make loans, we need deposits," he said. "Things are very tough right now."
"In that case," I said, "I think I'd rather give you a personal guarantee." I didn't like the idea of tying up my money in a bank account.
"OK," he said. "I'll run it by the board." Another week went by, and he called me back. "The board would really like to lend you the money," he said, "but we only want to deal with people who are customers."
"Fine; we'll open an account," I said.
"You would still have to make a substantial deposit," he said.
It was June by then, and every day brought news of another troubled bank. The big issue, I realized, was the Telluride bank's solvency, not mine. "Why don't you send me the bank's balance sheet," I said.

"Sure," he said. "But why?"
"The FDIC only insures $100,000 per account," I said. "If I'm going to make the kind of deposit you're asking for, I want to know where my money's going."
When the bank's financials arrived, I showed them to my partner Sam, who has served as the point person in our company's banking relationships. "What would you do?" I asked.
"I wouldn't put more than $100,000 in any bank right now," he said.
I knew he was right. I told the Telluride bank that we weren't going to need its money after all. If necessary, we would do the financing ourselves.

... So what does all this mean? I have no doubt that companies like mine will still be able to secure the bank financing we need -- mainly because we don't need it that badly. I worry about smaller companies that really do need bank financing and may have a hard time getting it. That will have ramifications throughout the economy. Yes, interest rates are still relatively low, but cheap debt does you no good if no one will lend to you.
Part of the problem, I sense, is that the bankers themselves are still trying to figure out the new rules and standards. If you are going for a bank loan, I would suggest you ask right away, "What does it take to qualify for a loan these days?" And make sure your finances are in order. Developing a relationship with a bank is still important, but you are going to need earnings and liquidity.