Saturday, February 28, 2009

Irrational Exuberance Revisited

We're back to the level of irrational exuberance. On Friday, Feb. 27, 2009, the S&P 500 closed at 735.09. That was the 9 points lower than the S&P 500's close of 744.38 on Dec. 5, 1995, when then Federal Reserve Chairman Alan Greenspan suggested that the stock market was affected by irrational exuberance. In the two weeks following Greenspan's remark, the stock market dipped lower, partly due to fear that the Fed might take action to discourage irrationality. But Chairman Greenspan decided that the world had changed, that a higher level of economic growth could be sustained, and that the Fed's policies should be accommodating. The S&P 500 index rose to double the irrational exuberance level, not once but twice (first in 2000 and, after the tech stock crash and the stock market resurgence that came with the real estate boom, again in 2007). Then, things got complicated and the market came back down to the level of irrationality.

Another pop by the S&P 500 above 1500 will be a ways off. The index's price-earnings ratio in Dec. 1995 was in the very high 20s, close to 30, and well above the historical average of 15. It might be logical to think that a high p/e ratio would signal a fall in the market. Maybe so in the days of yore, but not when the world has changed. In modern times, a high p/e ratio indicates confidence, indeed exuberance. Investors were willing to pay high prices because they expected even higher prices in the future. That's why the market kept rising in the late 1990s.

Today's S&P 500 has a p/e ratio of approximately 13.6. For the first time in close to two decades, the ratio has dipped below its historical average, which shows that investors have become discouraged. They're no longer willing to pay high prices because they don't expect prices to do a lot of rising in the foreseeable future. This lack of confidence is one reason why the market keeps falling (although the major reasons are the continued banking crisis and the slowing worldwide economy).

Irrationality is going out of style as an investment strategy. Economically speaking, we are in autumn rolling into winter. Rational strategies would include saving more cash, paying down debt, investing conservatively in a diversified portfolio, and ensuring good health insurance coverage. If you can't do all of the foregoing, do as many as possible. Thrifty squirrels have the best chance of surviving winter. And the forecast is for a very cold winter.

Friday, February 27, 2009

Ryanair's Fee to Pee: Now We Know a Depression is Coming

Today, Ryanair, the Dublin-based international airline, announced that it was considering charging customers a fee to use the toilets on its flights. Now we know a Depression is coming. When an airline considers the truly extortionate idea of charging passengers who are, say, 1500 miles from either Dublin or New York, to use the in-flight facilities, it must be desperate for revenues. Okay, so the travel business is slowing, like most industries. But this is the 21st Century. Pay toilets existed decades ago, but they were essentially gone by the disco era and haven't returned even though leisure suits have made a comeback.

What's next from Ryanair? Should passengers be charged for a boarding pass? How about a per minute charge for conversations with airline agents? Perhaps passengers should have to pay for a flight attendant to smile and be pleasant. Surely, they should pay for the preflight tutorial on safety and evacuation--that's mandatory, so extortionate charges could easily be imposed. How about a charge for having a pilot and a co-pilot? After all, the plane is manufactured and delivered with a computerized autopilot, so isn't it fair to require passengers to pay for additional pilots in human form?

If you've been wondering whether or not the world economy is sliding into Depression, you don't need to wonder any more. With Ryanair even thinking about a fee to pee, you know that international commerce and trade must be sliding fast. It can't be long before you'll consider rice and beans a luxury. Be sure to stock up on toilet paper, and learn to carry some with you. If Ryanair imposes a fee to pee, it would logically follow that they would impose an extra charge for tp.

Tuesday, February 24, 2009

Can We Have Economic Recovery Without Securitization?

Today, Fed Chairman Ben Bernanke said in Congressional testimony that the recession could end some time in 2009 if the financial system were stabilized. Although Bernanke cautioned that a full recovery could take two or three years, this statement helped to spark a stock market rally, with the Dow Jones Industrial Average rising 236 points, or 3.32%.

This is nice to know, but there's a rather big "if" in the statement. Chairman Bernanke prefaced his prediction of recovery on stabilization of the financial system. By now, we all understand that the financial system won't be easily stabilized. The front end of the problem involves trillions of dollars of bad debt from the real estate mess and American economic downturn, along with a growing crisis in Europe and Asia--Russia and the nations on its perimeter are, in particular, becoming increasingly problematic. Just stabilizing the formal banking system (i.e., those institutions legally chartered as banks) by removing toxic assets and recapitalizing will take trillions from the government.

Then there's the back end of the problem of stabilizing the financial system: securitization. In the last 30 years, a shadow banking system evolved through the securitization market. A wide variety of loans, ranging from mortgages to consumer loans to corporate debt. were bundled into investment vehicles that were financed by investors who, for the most part, took the risk of loss on the bundled loans. This was a wonderful financial innovation for banks, since they could earn fees making, selling and administering loans, while not bearing the risk of losses from those loans. Securitization seemingly came to be viewed by bankers as one good thing there couldn't be too much of.

Well, just as there is no such thing as a free lunch, there's no good thing that you can't have too much of. Since securitization appeared to generate vast earnings for banks with minimal risks, they securitized early, often, over lunch breaks, after office hours, on weekends and even while in the shower. They defied contemporary social trends by setting aside multitasking in order to concentrate on securitizing. Generating the profits that would allow CEOs and other executives to earn tens of millions in bonuses required that the banks make more and more loans. There are, however, only a finite number of borrowers with good credit ratings. After that, in order to get more loans to securitize, you have to make loans to increasingly poor credit risks. Thinking that they could continue foisting the risk of loss onto investors, bankers kept the profit making party going by exercising increasingly poor credit judgment.

Today, we know how the story ended: today's economic mess. A rather under-publicized aspect of today's mess is that the securitization market is dead. Good riddance, one might say. It was a monster that Wall Street created but couldn't control. But the cash used to make trillions of dollars of loans came from the securitization process. Without it, banks have to use their capital and deposit base to make loans, and they are now stuck holding the loans they make. From one perspective, this is a good thing. If banks have to eat what they kill, they will be careful about what they aim at. However, today's bankers aren't like the bankers of yore. There's nary a J.P. Morgan among them. They don't really want to be responsible for the loans they make. We can analyze this as a Baby Boomer, Gen X, Gen Y, Millenial, all of the foregoing, or whatever problem. It remains a problem and, as a result, banks have cut back on lending.

The conventional discussion about fixing securitization revolves around requiring the banks that make the loans to "keep some skin in the game" by retaining some of the risk of loss on the loans they sell. This is the way securitization is sometimes down in Europe. But such a concept assumes two things: (a) banks are willing to retain risk; and (b) investors remain willing to invest in securitized assets. Both assumptions are questionable. Retaining risk takes away much of the advantage to banks of securitizing. Sure, the banks get to spread some of the risks around. But increased loan loss reserves, expanded risk management systems and other drags on earnings will get in the way of $50 million executive bonuses. Moreover, investors now profoundly mistrust the banks that underwrote the securitizations. Lawyers could draft elegant Indentures of Trust for securitization transactions that would make abundantly clear that underwriting banks bear some risk of loan losses. Yet, investors wouldn't fork over their money. A cat that walks on a hot stove top doesn't care who's legally liable for its veterinary care. It simply won't walk on that stove top again.

Thus, to get the banks lending again, they and the government need to deal with the loss of the securitization market. More precisely, the securitization market was the very large, unregulated segment of the banking system that collapsed last year. This loss must be replaced somehow, and eliminating toxic assets, recapitalizing banks, and tweaking the securitization concept probably won't take us the whole distance.

At the moment, the federal government has substituted itself for the securitization market. Mortgage loans are still being securitized by Fannie Mae, Freddie Mac and Ginnie Mae. All of these investments are guaranteed by the U.S. government, so investors will buy them. The Federal Reserve is buying or will buy bundles of consumer loans and corporate loans, in order to free up bank capital for more loans. In essence, the Fed is providing the funds for more consumer and corporate loans. The Fed guaranteed money market funds and bailed out auction rate securities (a money market fund equivalent). If you deposit your cash the right way into a bank, you can have unlimited federal deposit insurance, at least until the end of 2009 (hint: amounts over $250,000 should be placed in a non-interest bearing acccount). Our financial system has been de facto nationalized, although no senior federal civil servant will admit to it.

But we can't have financial markets that are all government, all the time. No one wants that, not the President, nor Congress, nor Democrats, nor Republicans. The federal government has only blunt instruments to combat the economic crisis. The Fed, in a variety of different and innovative ways, has flooded the banking system with printed money, which has kept the hounds at bay but with serious potential for inflation. The Obama administration has secured the passage of a $787 billion stimulus package, an impressive accomplishment for a rookie President, but it doesn't replace the loan funding formerly provided by the securitization market.

As we know from the mortgage crisis and credit crunch, a lot of the financial system's problems involve the fine details of the plumbing system. Just as the substance pipes are made of (copper, not polybutylene), and the washers and gaskets used, can be important to a home's plumbing, the structures of mortgage backed securities, CDOs, special purpose entities, credit default swaps and myriad other financial esoterica can make a great deal of the difference in the viability of the financial system. The federal government can't solve this problem. Federal civil servants can be far more creative and effective than popular culture would hold. But they can't develop new funding mechanisms for Wall Street, not if Wall Street wants to be privately owned. This is one for the private sector. Wall Street is fortunate to exist in a nation that believes in free enterprise and which will provide the funding to recapitalize banks after they have effectively collapsed through many faults of their own. If the major banks do not want to remain wards of the state, they must develop new funding mechanisms. Most likely, this will require sharing with investors some of the profits from securitization banks used to keep for themselves. That wouldn't be a bad thing. Investor confidence isn't going to come back by itself, or because the President tonight made one of his typically eloquent speeches. It's going to come back when investors get a better deal.

Saturday, February 21, 2009

Health Insurance Help in the Stimulus Bill for the Unemployed

For many of those who have been laid off, there's help from the Obama administration's economic stimulus bill paying for COBRA health insurance coverage. COBRA is a law that gives you the right to continue employer-sponsored health insurance coverage for up to 18 months after being laid off or otherwise involuntarily terminated. It's a crucial benefit for those with pre-existing medical conditions, who otherwise could have a very difficult time getting insurance coverage.

The problem with COBRA is that you have to pay the full cost of the premiums; there's no employer subsidy and there is a 2% administrative fee. Full freight for a family policy can easily run over $1,000 a month--a steep bill for someone who's just been laid off.

The stimulus package provides a 65% subsidy for those who were laid off between Sept. 1, 2008 and Dec. 31, 2009. The subsidy lasts nine months and phases out for individuals making over $125,000 a year and married couples making over $250,000. Eligible laid off employees who didn't initially opt into COBRA should receive a notice about the subsidy from the their former employers giving them 60 days to enroll for subsidized coverage. Dec. 22, 2009: here's a little holiday cheer. The 65% federal subsidy has been extended through June 30, 2010, and workers laid off between Jan.1, 2010 and Feb. 28, 2010 are entitled to the subsidy, as well as those laid off between Sept. 1, 2008 and Dec. 31, 2009, who are covered by the original stimulus package.

Health insurance coverage is one of the most important things to maintain even while you're unemployed. Life without a job is hard, but it can become a disaster if you have major medical expenses and no insurance. Stinting on health insurance coverage can easily prove to be pennywise and pound foolish. If you're uninsured and can take advantage of subsidized COBRA coverage, buy it. No one likes paying for insurance--until they need it. Then, it seems like a wise purchase. Health problems are inevitable. The only question when you will have them. Since that's unpredictable, health insurance coverage is essential.

If you or someone you know needs more information about health insurance resources, see and

If you or someone you know is facing the loss of a job, there are a number of financial considerations to keep in mind. See

Thursday, February 19, 2009

The Economic Crisis: Is the Government Bubble Bursting?

Since taking office, the Obama administration has expanded the scope of the bank bailout plan, secured passage of a $787 billion stimulus package, and announced a mortgage modification program designed to assist struggling homeowners keep their homes. The Dow Jones Industrial Average has dropped from a closing level of 7949 on Jan. 20, 2009, the day President Obama was inaugurated, to 7465 today, approximately 6%, in one month. That the market should drop after so much governmental action indicates that the government bubble in the stock market may be bursting.

From the fall of 2007, the stock market has been propped up by news of governmental interventions aimed at stemming the mortgage crisis, the credit crunch and the recession. Almost every announcement of a new program or measure precipitated a short term rally. Most recently, on Nov. 21, 2008, with the Dow languishing around 7500 in the middle of the afternoon, the Obama camp leaked its intention to nominate Timothy Geithner as Treasury Secretary. The market liked this news and rallied over 500 points in one hour to close at 8046 that day.

However, the problems in the financial system and the economy have overwhelmed every governmental measure, and the stock market has buckled under the pressure of the truth--that the U.S. and world economies are in deep trouble. Most recently, we've learned that Eastern Europe and former Soviet Union satellite republics are struggling to pay their sovereign debt. The possibility of another international debt crisis a la the 1997 Asian financial crisis looms. European banks, in particular, are exposed to these nations, and significant sovereign debt losses, piled on top of their current problems, may render them insolvent. The U.S. banking system, by all appearances, is insolvent. This is not to say that every U.S. bank is individually insolvent. But the system as a whole appears to be underwater. And it's taking the economy down with it.

The recent drop in the stock market indicates that even as the federal government is spending more than ever to combat the recession and the financial crisis, the efficacy of its spending is diminishing. This may, in part, be due to the way it's financing its spending. Hundreds of billions are being borrowed. The Federal Reserve's programs involve the printing of perhaps over $1 trillion. Printing money in our current circumstances amounts to a roll of the dice. If enough people have enough confidence in the dollar that they'll accept the printed money as valuable, and proceed to spend, invest and rebuild the real economy, the Fed's program may work. However, an objective economist from, say, Mars could easily conclude that the U.S. is debasing its currency and that each incremental dollar of government spending would have diminishing impact. Even though the stock market is subject to almost innumerable whimsies, fantasies, irrationalities and emotions, it ultimately must face up to hard, cold reality. The hard, cold reality is that the financial system is in extremis and the economy is sinking. All the government's horses and all the government's men can't put things back together again, at least not with an increasingly debased currency. The stock market has been propped up by a stream of government interventions. But the government is using increasingly questionable means to finance its programs, and the stock market could be starting to smell a rat.

The Federal Reserve has suggested that it might buy Treasury securities in the open market as a way to lower interest rates (or keep them from rising, as they have been recently). While this concept is presented as a means to assist the real estate market and corporate borrowers, it would further debase the dollar because the Fed would have to print more money to pay for these purchases. The Treasury Department is embarking on its biggest borrowing program since World War II. If the Fed buys up existing Treasury securities while the Treasury Department issues new ones, the effect would be for the Fed to print money and hand it over to the Treasury. Thankfully, the Fed hasn't embarked on its program of buying up Treasuries yet. But if it does, watch out. Stocks might prove to be even more of a losing investment, and the dollar could devalue through inflation (look at today's PPI numbers; inflation isn't dead yet). While gold and silver are, in truth, false financial deities, their disciples might gain credibility in ways detrimental to the dollar.

It's understandable why the government seeks to alleviate our economic problems; that's what the government is expected to do. But the worst case scenario would be for the government to go bankrupt while futilely combating economic problems with ineffectual weapons.

Lending without restraint bankrupted the banking system. Borrowing without restraint bankrupted the real estate markets. Printing money without restraint will bankrupt the government. With the economy spiralling downward, our resource base is getting awfully thin. Bankrupting the government would leave no line of defense. Perhaps the government bubble in the stock market is now bursting and stock prices will fall in the near term. The Obama administration and Federal Reserve should resist the impulse to artificially prop up stock prices with more spending financed with printed money. Stock prices ultimately derive from the value of underlying economic activity. That's where the hurt is the worst and the need for government assistance is the greatest. Focus on reviving the real economy and financial assets will join in the revival. But asset bubbles can't be maintained forever, and the government bubble is no exception.

P.S. To make things worse, another apparent massive investment fraud, the Stanford Financial Group case, has surfaced. As with the Madoff case, the Stanford Financial Group case raises questions whether the financial regulators missed the ball. With perhaps $8 or $9 billion at risk in the Stanford Financial case, investor confidence may now be further shaken, especially because the regulators were on the scene in the past two years without finding the big problems. As we noted when the Madoff scheme was exposed (see, a falling stock market reveals a multitude of sins. It is no surprise that the problems with Stanford Financial surfaced, and it wouldn't be a surprise if more such large cases emerge. If you have money in an opaque investment (i.e., for which you don't know the details of how your money is invested), strongly consider withdrawing it asap and putting it in something simple and transparent. A low-yielding bank account or money market fund is vastly better than being defrauded. There are reasons why some money managers keep their investments opaque and those reasons all too often aren't good ones.

Tuesday, February 17, 2009

We have an Expanded Bank Bailout and a Stimulus Package. So What Have You Done For Us Lately?

President Obama has done remarkably well in his first four weeks. His administration revamped the financial sector bailout, significantly expanding its focus, and pushed a $787 billion stimulus package through Congress. This is more than his predecessor accomplished in two years. Nevertheless, the Dow Jones Industrial Average fell 297 points today. Percentage-wise, the Nasdaq and S&P 500 averages fell even more. There's gratitude for you.

Many commentators, foreign and domestic, believe that the current measures are inadequate. They point to accelerating economic decline in America and around the globe, and less than exuberant stimulus measures proposed by other nations. Perhaps the only country that is going farther than the U.S. in stimulating its economy is China, and China's economy is too small to serve as a locomotive for the rest of the world.

So the U.S. government probably will have to do more. Given the accelerating global downturn, it may have to act sooner rather than later. But we're now getting to the point where things get complicated (more so than they are already).

First, let's look at the bank bailout problem. Mortgage relief is a priority on the administration's agenda. There is talk about subsidizing mortgage modifications with federal assistance that induces banks to give borrowers breaks before they default. And bankruptcy judges may get the authority to rewrite mortgages. These measures could force banks to take more writedowns, as mortgages they've been carrying at optimistic values are modified. The more writedowns the banks take, the more federal capital they will need for recapitalization. So, federal measures to alleviate mortgage problems may well increase the cost of the bank bailout, above and beyond the $50 billion already allocated for mortgage relief.

Another dilemma is the toxic asset problem. Everyone agrees that these assets must be removed from the major banks' balance sheets if the banks are to be restored to health. But these assets are becoming ever more toxic as the economy continues to decline, so the cost of removing them increases by the day. The major banks could be carrying as much as a trillion dollars in toxic assets on their balance sheets. Moreover, the largest portion of toxic assets isn't even shown on bank balance sheets, but rather is held in off-balance sheet vehicles for which the banks have some liability. These off-balance sheet assets may amount to perhaps another two, three or four trillion dollars. All told, the toxic asset problem could absorb trillions of federal dollars. Treasury Secretary Geithner has proposed raising private capital to join with federal capital to buy up the toxic financial waste. But it remains to be seen whether the federal contribution ($50 billion) can bring in enough private capital to put a meaningful dent in the problem. Secretary Geithner has talked about raising $500 billion (or more) in private capital. The investors that would buy toxic assets are Wall Street pros who would make Las Vegas card counters look angelic. They may not see a 9% federal buffer as much of an inducement in a declining economy to buy some of the most volatile of financial assets, especially at prices the federal government would like to pay. The government would probably not want to bargain hard for the toxic assets because low prices would increase the federal costs of recapitalizing the banks. But private investors would want to low ball the banks, because on Wall Street money talks and bull chips walk. With this inherent conflict, how will Secretary Geithner's public-private partnership work?

For better or for worse, and very reluctantly, the government will probably nationalize most of the major banks, at a cost that will run into trillions. Perhaps a few very healthy banks will remain independent. But those bedeviled by toxic assets will likely end up in federal receivership. Then the toxic assets will belong to the taxpayers. Let's hope that federal stewardship seeks to maximize taxpayer profits on them.

With the true cost of the bank bailout likely to be trillions, how much will be left for additional economic stimulus? Nothing is forever, which in this context means that there is a limit to how much money the federal government can borrow or print. No one today knows exactly where that limit is. But just as the real estate market couldn't continue to rise forever, America's solvency can't be taken for granted. If history is any guide, consider the Spanish Empire. In the 1500s, gold and silver from the conquered Aztec and Inca empires made Spain the wealthiest and most powerful nation in Europe. But all this precious metal led Spain to invest heavily in New World mines, and not so much in manufacturing. Meanwhile, the poorer but more industrial-minded nations in northern Europe concentrated on manufacturing, rising to power in the 1600s as Spain unhappily learned that financial assets alone don't produce lasting wealth. The rest is history, as northern Europe to this day remains an important manufacturing center while Spain has lagged.

It's said that there can't be an economic recovery without a sound banking system. That's true, but it doesn't present the complete picture. A sound banking system alone doesn't produce a healthy underlying economy. Look at the Great Depression. Thousands of banks failed in the early 1930s, until FDR's administration created the Federal Deposit Insurance Corporation in 1933. Once the safety of deposits was guaranteed, bank failures diminished significantly. But the U.S. remained mired in depression for the remainder of the 1930s. Not until America began rearming in 1939 and 1940 in anticipation of its likely entry into World War II did the nation achieve a lasting recovery. Simply stabilizing banks didn't bring prosperity.

If we spend trillions for bank bailouts and mortgage relief, where will we get the money to rebuild the real economy? The Federal Reserve has been printing bucketsful of money in order to assist banks and other financial institutions. The Treasury is embarking on the biggest borrowing spree since World War II. We need to make some careful decisions about how to allocate the trillions that the federal government will be spending in the next few years. Giving the financial sector a blank check while placing the real economy on short rations isn't the best answer. At some point, the financial system's creditors (other than insured depositors) should take losses if that's what is necessary to get the unemployed back to work. Most of the creditors are financial professionals or wealthy people who, in lending to banks, did understand or should have understood they were taking risks. Most of the unemployed are innocent victims of a financial drive-by shooting. FDR brought compassion back to the government's policies, and that more than anything else spawned hope.

Tuesday, February 10, 2009

The Financial Bailout Plan: First, Mr. President, k . . . ban all . . . uh, most of the economists.

Dear Mr. President:

As you know, the stock market today bungee jumped without a rope after Secretary of the Treasury Geithner announced the financial bailout "plan." All told, the Dow Industrials fell about 381 points, closing at their lowest level since last November. The salient reason for the market drop was the lack of details in the "plan." Another concern was the adequacy of funding for the plan.

The first and foremost thing business people want from the government is clarity. Skilled business people can find a way to make money if they know how things are going to work (and you want them to make money if we are to have a functioning economy). Without clarity, commerce is hindered. To take you back to your law school days, that's why all 50 states adopted the Uniform Commercial Code.

The lack of clarity is greatest with respect to toxic assets. The "plan" proposes to take $50 billion of government money, raise up to $500 billion or more of private money, and use the total to buy toxic assets. First, there are hundreds of billions of dollars worth of toxic assets remaining on the books of major banks. Then, there are trillions more in off-balance sheet vehicles for which the banks probably bear some liability (if you don't understand this point, Mr. President, get briefed on it because it's really important). All told, there might be three, four, five or more trillions worth of toxic assets out there. Today's proposed plan doesn't explain what prices will be paid for toxic assets. But it's clear that the total funding available (say, $550 billion) wouldn't begin to buy up all the financial waste. So, when some toxic assets are priced and purchased by the government program, those prices would logically apply to unpurchased assets (most likely those lurking in off-balance sheet vehicles), something that could force the banks to take major writedowns. The amount of money designated for recapitalizing banks, $120 billion, is highly unlikely to be enough to keep the banks on life support. The result could be that the toxic asset purchase plan, if it has any traction at all, could put the major banks under.

We also wonder whether the government could raise $5oo billion or more of private capital to participate in this venture. If the government puts in $50 billion and private investors put in $500 billion, that implies that the government will absorb not more than 9% of the losses. Given the toxicity of the assets and the still declining state of the economy, a 9% share for the government isn't necessarily going to bring in vast amounts of private capital.

The plan also includes $50 billion for foreclosure relief and $100 billion to help stimulate consumer lending. This plan has all the hallmarks of a multitude of chefs. Like many political programs, it appears to represent a mixed bag of viewpoints, with the nondecision on how to handle toxic assets being the most mixed up. Clarity is lacking. Investors can't see what the heck is really going on. That's why the market fell so sharply today. That's part of the reason why the market fell so sharply last year while the Bush economic team thrashed around.

A vague and underfunded plan will, unintentionally, lead to the nationalization of the banking system. If the government doesn't decisively do something else, there's no other option. Nationalization wouldn't necessarily be a bad thing, if it's temporary (see But it would be more effective if done sooner rather than later. The current "plan" for all we can tell means more delay and dithering, while the financial system's losses mount.

Recall, Mr. President, the joke about asking 3 lawyers the same question and getting 4 opinions. The same applies to economists, only more so. Lawyers learn to compromise, if for no other reason than they don't want to deal with frowning judges. Economists, being academics, tend to view compromise as undermining their intellectual (and therefore professional) integrity. You won't get a decisive or, ultimately, an effective financial bailout plan from a large group of economists. At last count, they've got you surrounded and seriously outnumbered, with one group headed by Summers, another by Romer and a third by Volcker. This is econ-overload. You're probably getting a plethora of opinions that you find impossible to parse and reconcile. That's what happens when you assemble enough economists in one place. Don't lock them in a room and tell them to work it out among themselves. That's a classic bureaucratic maneuver that turns what should be a thoughtful process into a power struggle; and is likely to produce, well, what we got today.

Pare down the number of economists you talk and listen to. Most likely, you'll have to choose one of the economic stars on your team and follow that person's point of view, even over the protests of the others. How you'll choose among them is impossible for a blogger looking into the White House from outside to figure out. But choose you must. Then, ask that person to put together a plan that is decisive and clear. Understand that the essence of the problem you face is nothing more or less than the allocation of the financial system's losses emanating from the mortgage crisis, the credit crunch, and the declining economy--trillions of dollars worth. Someone has to take these losses. There's no way to make them magically disappear. Creditors, shareholders, executives, employees, investors, depositors, and taxpayers are all likely to bear some of the losses. The bailout "plan" is simply a way to decide who bears how much. There is no perfect allocation. Whatever plan you choose will induce howls of outrage by hordes of people, because the enormity of the losses will inflict a lot of pain regardless of where the losses fall. The Bush administration's failure was, in many ways, a failure to do anything definitive enough. The best thing now is to put together a clear and decisive plan that allocates losses in a reasonable and well-defined way, and then get on with it. In the end, the most important thing is to get some sort of recovery process going, or the economy and financial system will continue their downward spiral.

Sunday, February 8, 2009

Benefits of a Strong Dollar

Over the past year, the dollar has risen sharply against Europe's currencies and the Canadian dollar. Although it has weakened against the Japanese yen, that has had less impact because the U.S., comparatively speaking, doesn't import as much from Japan than it did, say, 30 years ago. Many and perhaps most countries sliding into recession would like to weaken their currencies, because then they can try to export their way out of their problems. The U.S. cannot, for practical purposes, weaken the dollar. The Fed has already lowered short term interest rates to an effective rate of zero. And it's been printing truckloads of money as part of the financial system bailout, without any obvious impact on the value of the dollar.

The dollar is strong because of market forces. Other nations' economies are fading faster than the U.S. economy (if you would believe it). Capital is fleeing to the dollar, because it remains the safest haven available. Even though we can't export our way out of our problems, we receive countervailing benefits from a strong dollar.

Oil prices, which are denominated in dollars, have fallen as the dollar has risen. This price drop directly boosts consumer incomes, at the expense, in some cases, of people who harbor ill-will toward the United States. Better that they should provide a stimulus now than the U.S. taxpayer.

Federal Reserve monetary policy is made much easier. Ordinarily, lowering interest rates weakens a nation's currency while exacerbating inflation, and encourages capital flight. But the strong dollar has done much to stop the acceleration of inflation that, as recently as six months ago, was a major potential complication to the Fed's strategy. Chairman Ben Bernanke is a very lucky central banker. If we are going to have a central bank, we want a lucky one.

The federal deficit is easier to finance with a strong dollar. Much, if not most, of the Obama administration stimulus and bank bailout packages will have to be financed with money from overseas. A strong dollar provides reassurance to foreign investors. The U.S. should be able borrow at lower interest rates.

International commerce operates more smoothly with a strong dollar. The dollar is the world's reserve currency and is used more than any other currency for international trade. Commerce benefits from a strong, stable currency. One need only look back at pre-Civil War America for times when there was no permanent national paper currency. There was tremendous demand for a medium of exchange, however, and a variety of things served as currency, including tobacco, deer and other animal skins (whence the term "buck"), pieces of Spanish coins (the origin of "quarter," which resulted when a Spanish doubloon was cut into four equal sized pieces), and promissory notes issued by state banks, private banks and even individuals. It's not an accident that the U.S. experienced its greatest industrial growth after the permanent adoption of federally issued paper currency. International commerce, which must remain vigorous in order to facilitate a recovery, would struggle if there were no readily accepted transnational currency.

However, before we congratulate ourselves on the might of the dollar, let's remember that our current good fortune results from market forces. The past two years have abundantly demonstrated the market is tempestuous even on good days, and what it giveth it can easily taketh away. With the government about to borrow a trillion or more, and the Fed printing another trillion or more, the market could turn tail and flee the dollar in a New York minute. The music you hear in the background isn't "Columbia, the Gem of the Ocean." It's Carly Simon's "You're So Vain."

Wednesday, February 4, 2009

Federal Limits on Executive Compensation Are Good for Capitalism

Today, President Obama announced that annual compensation for executives of banks and other companies receiving federal aid will be limited $500,000 (except for restricted stock). Equity compensation, such as restricted stock, would have to be held by the company until the government has been repaid. These limitations smack of government price controls. But they are in fact very good for the future of capitalism,

This limitation is aimed first and foremost at the banking industry. Banking, especially, investment banking, is a field you go into only for the money. The hours are long, the work can be difficult and the bosses can be very demanding. Forget about personal time; and warn your family (if you even have one) that they might see you on Thanksgiving and Christmas, but not otherwise. If you can't make a gazillion dollars, there's no reason to do this for a living.

The federal limits on executive compensation hit bank executives where it hurts the most, and prevents them from pulling a capital markets arbitrage. Under the Bush/Paulson regime, banks got taxpayer subsidies while bankers got rich. If banks had received no federal assistance and had to turn to private sector resources, the few investors that would have been willing to help them would have demanded strict accountability for results and carefully measured executive compensation. Executives that didn't write down bad assets, clean up their balance sheets, eliminate unduly risky lending and other undesirable activity, and turn their banks around would have been shown the door. Under the Bush/Paulson bailout, the same executives could have received bounteous bonuses with every prospect for more in the future, for all the government limitations that were placed on them. Only a public shaming process forced the boards of major banks to compensate senior executives in line with their nonperformance.

The new Obama administration limits will lead healthy banks to pay back federal assistance asap. Unhealthy banks will undertake to clean up their balance sheets, moderate risk and operate in profitable manner, so that they, too, can pay back federal assistance asap. They may even make some hard decisions about writing down and selling their toxic assets, all the while raising private capital to replace taxpayer money. That would lessen the need for a federal "bad" bank to buy those assets. In all cases, taxpayer subsidies will be lessened and banks will return to the freedom--and discipline--of the markets. We should be glad for these federal limits on executive compensation. They will push banks off the public dole and back toward a constructive role in the free enterprise system.

Sunday, February 1, 2009

The Economic Crisis: Square Pegs and Round Holes in Federal Policy

Some of the fundamental premises of federal economic policies are flawed, and the government's efforts to bail out the financial system and stimulate the economy may push futilely on a string instead of instigating a recovery. Let's look at the specifics.

Consumers. There is much discussion of the need to get consumers spending again. But the foundations of personal finance have been shattered. Houses, stocks, bonds and other assets have plummeted in value. Credit lines and access to loans have evaporated. Most importantly, the pace of layoffs has been rising rapidly. You won't spend if you don't have a job; and you won't spend much if you're afraid of losing your job. No end is in sight for any of these trends. The American consumer has rationally become the American saver. When the chips are down, there's nothing as comforting as a nice pile of cash. People always seek whatever makes them feel good, and right now that's cash in the bank and less debt. The government can't persuade them to spend if they don't want to spend--you can't lead people where they don't want to go. Instead, the government may be better off helping individuals to save. Once personal balance sheets are stronger, people will feel better and spend more. How about a tax break for savers?

Bank Lending. The love of cash doesn't stop with consumers. Bankers love cash even more. Many hold toxic assets and almost all hold other assets that are sinking as the economy fades. They need the cash to offset investment and loan losses. That's why they haven't loaned out much of their federal bailout money. With the fervor of the recently converted, bankers now practice prudence as preached in Puritan New England. The sinking economy and rising tide of layoffs make almost every borrower suspect in their eyes. Bankers, as capitalists par excellence, elevate their self-interest above all, and right now making more loans looks to them like a quick march into quick sand. A number of banks are turning down federal bailout money because they don't want the pressure to make loans they don't want to make. Bailout money shouldn't simply be given to banks--especially healthy banks--in the hope of fostering lending. It should be given only to a limited number of major banks that are on the verge of collapse, for the purpose of preventing systemic financial collapse.

Fed Efforts to Lower Mortgage Rate. The Federal Reserve has been buying up mortgage-backed securities in an effort to lower mortgage rates. Does it make sense to lower mortgage rates at the same time that the Fed is trying to persuade banks to make more mortgage loans? The interest rate is where the banks' and other lenders' profits come from. If you lower their profits, why would they lend more? Since the government wants banks to lend more, it would more logically let interest rates rise to compensate lenders for the now increased risks of lending. (Remember that the real estate market continues to fall, so a mortgage loan made today could be in trouble in a few months.) When the government prescribes prices, as it now is trying to do with interest rates (including both short term and long term interest rates), it shouldn't be surprised if the market doesn't function well. Markets rarely function well when the government prescribes prices. Lower interest rates do bring more borrowers into the market, but many are not customers that banks want to lend to. That's why the recent drop in mortgage rates has yielded relatively few refis and even fewer home buyers.

China's Currency. Secretary of the Treasury Timothy Geithner has accused China of "manipulating" its currency to give itself trade advantages. This is a loaded term that could affect U.S. trade relations with China. Today, China is America's largest creditor. If you need a loan, would it make sense to poke your lender in the . . . well, let's say eye . . . with a sharp stick? America, even today, is a rich and powerful nation that doesn't have to do what China would like it to do. China is a rising power that doesn't need to do what America would like it to do. But going their separate ways would be very costly to both nations. Both are much better off working together. Let's hope that officials at the Cabinet level understand this.

Reviving Real Estate. It seems likely that the new Congress and the Obama administration will do much more than their predecessors to revive real estate. Authorizing bankruptcy courts to rewrite mortgages, slowing down or suspending foreclosures, federal buydowns of mortgage rates, and more favorable tax credits for buyers are all possible. Abstractly speaking, these proposals would help the real estate market. But they would have been far more effective if taken by Bush administration in the summer and fall of 2007. The real estate crisis then was far less severe then than it is today. Stated otherwise, it would have cost much less in late 2007 than it will now to stabilize the real estate market. Federal measures today would cost a mint, but could only slow the decline. They won't bring back rising real estate prices. So we can't count on real estate to finance a renewal of consumption. The mortgage refis and home equity loans that paid for so much of America's boom from 2002 to 2007 will be scarcer than hens teeth for years to come. Real estate won't pull America out of the recession.

So what should be done? First, keep people going. Extend unemployment benefits liberally. Make Medicaid available to those who are unemployed, running out of money and have no health insurance. If the dispossessed are cared for, everyone else will maintain a modicum of confidence. But if the unemployed end up living in their cars and dying uninsured in hospital emergency rooms, we'll have a consumer retrenchment comparable to the 1930s, when every nickel and penny was hoarded against hard times.

Second, focus on reviving the real economy. That especially means manufacturing. The true wealth of nations comes from using raw materials to produce valuable goods. That's why, despite having a raft of problems, Japan, Germany and China are economic powerhouses today. Wealth doesn't come from speculating in the value of real estate or stocks, or playing other financial games. We can't refi our way to prosperity, just as the cave dwellers of the Neolithic couldn't refi their caves and live in baronial splendor. They had to produce flint tools and learn to till the land. We, too, need to work and produce. Government policies aimed at promoting production have the best chance of leading to a lasting recovery.