Sunday, August 30, 2009

The Obama Administration's Best Bet: Take the Common Sense Approach

The unifying theme in President George W. Bush's two terms was his wealth of self-assurance. He was certain he knew the answers. He stuck hard to the principles in which he believed. He had too much faith in the amen chorus with which he surrounded himself, and gave them too much free rein.

The cost was enormous. Year after year, casualties in Iraq grew while the war continued with no end in sight. Even as military expenditures rose sharply, taxes were dramatically cut with little thought seemingly given to the long term consequences. The federal deficit ballooned, but we were told to take comfort from the beneficial effects that would come from making the wealthy wealthier. The financial markets were provided with vast amounts of cheap credit, and given a deregulatory atmosphere in which to mainline it. Real estate was favored because, in defiance of economic reality, it supposedly would be the golden goose of legend, the asset that would never fall in value. Derivatives were given the Mother of all legal loopholes, which led to the stealth creation of a vast, multi-trillion dollar unregulated banking system that went unnoticed by regulators until it collapsed.

Absent from the picture was a decent measure of proportion, moderation, and common sense. Adherence to the administration's received truths took precedence over contact with reality. Apostates were banished and true believers drew closer together in the firmness of their beliefs.

The Bush Adminstration's rigidity was one of the main advantages Barack Obama had going into last fall's general election. The electorate had had its fill of closed-minded, inflexible wackiness that threw away lives and money. The voters wanted change.

They've gotten less than they might have hoped for. The Obama administration has generally followed the same approach in dealing with the financial and economic crises as their predecessors. There is momentary calm, but really big deficits loom and the real estate market's problems have been swept under the carpet instead of being resolved. Its health insurance reform proposal is being shouted down, with volume substituting for reason. The American war in Iraq is winding down (although the Iraqi war isn't). However, the American war in Afghanistan is ramping up, as is the American proxy war in Pakistan.

It's important for the Obama administration to take some big steps back from the extremes of the Bush administration's policies. That's what Barack Obama was elected to do. At the same time, it's important for him not to become caught up in new extremes. We need some common sense.

For health insurance reform, let's institute the Great American Compromise. Like all industrialized nations, America spent much of the 20th Century coming to grips with the harshness of capitalism. While the free enterprise system is wonderful for innovation and economic growth, it spawns great inequality of wealth that triggers social unrest. Not all of the 20th Century solutions for this problem worked well (see history of Nazi Germany and the Soviet Union for illustrative examples). However, the American solution was to establish safety nets: unemployment compensation for wage earners innocently caught in economic downdrafts, Social Security to alleviate the poverty of the elderly and those unable to work, Medicare and Medicaid, and various welfare programs. The free enterprise system was largely left unchanged. People kept their private property, pursued their personally chosen careers, and in many cases vigorously exercised their Constitutional right to cuss out the government.

It's clear that those with good health insurance coverage don't want to give it up for the sake of health insurance reform. Nor should they have to. The biggest need is for a safety net--basic health insurance for those who can't find a private insurer. We already have such a system--it's called Medicare in some manifestations and Medicaid in others. These programs were created to provide health insurance for the elderly and poor, who would generally be uninsured anyway. Allowing other uninsured people to participate wouldn't be a terribly difficult modification. Their premiums could be adjusted for their ability to pay--a laid-off Wall Street millionaire would pay fair market rates while a laid-off furniture worker in North Carolina would get a break. Sidestep all the mouth-frothing about a National Health Service or single payer system. Just extend the safety net.

In Afghanistan and Pakistan, the U.S. and its allies are largely fighting members of just one ethic group, the Pashtun. The membership of the Taliban consists primarily of Pashtuns. They have successfully partitioned off part of Pakistan for their own country within a country, and give sanctuary to Al Queda in keeping with longstanding Pashtun traditions of hospitality and refuge for visitors in need. The United States has no strong interest in fighting the Taliban or other Pashtuns. They did not attack the World Trade Center or the Pentagon (the mostly Arab Al Queda did that). The U.S. should open channels of communication with the Taliban and other Pashtun groups, making it clear that harboring Al Queda will result in robust U.S. military action, but that peace is attainable if the house guests take a hike. It may seem implausible that the Taliban would make a deal with America. But the Shiites in Iraq did just that during the recent surge, and gave Al Queda the boot from their country. We should focus on destroying Al Queda, not fighting people who have not sought to fight with us.

The really big looming deficits stem from both the Bush administration's unwavering belief that they could get a free lunch--finance a tremendously expensive war in Iraq while sharply cutting taxes while increasing Medicare benefits (with Medicare D, the prescription drug program)--and the Obama administration's stimulus package. Since some 80% of government spending consists of entitlements like Social Security and Medicare, the government can't cut its way out of the fiscal mess. It will have to increase tax collections. That's just common sense. Letting the Bush tax cuts lapse would be a simple way of doing that--they're built into the Bush legislation anyway so nothing needs to be pushed through an increasingly rancorous Congress. But not fixing the alternative minimum tax would be a mistake. The alternative minimum tax is the stupidest tax in the Internal Revenue Code, taking back what the regular tax structure allows and hitting the middle class whom Barack Obama promised to protect against tax increases. The AMT has long ceased to serve its intended purpose and should be repealed or permanently adjusted way upward to hit only the wealthy (and kept upward with an automatic annual inflation adjustment, like the regular tax structure). Maybe more taxes will ultimately be needed. But let's start with the simple thing and let the Bush tax laws take their prescribed course.

In terms of financial and economic policy, the government has thus far dodged the difficult problems (like toxic bank assets, the festering illness that remains in the housing market and the spreading illness in commercial real estate) and softened their impact with the Federal Reserve's printing presses and stimulus legislation. But those problems haven't gone away, and with the real estate market likely to stagnate for years, they won't go away by themselves. These losses--cleverly pushed by Bush administration policies into President Obama's stewardship--will have to be booked eventually. That process is happening already, with each Friday afternoon's announcements of the past week's tally of failed banks. We're up to 84 failed banks for this year already, and many more collapses are expected. Real estate losses and losses from toxic assets will be booked one way or another. The only question is how and when. The banking system won't resume large scale lending while these zombie assets remain on its books. And the Federal Reserve can't keep printing money; indeed, it's trying to figure out how to get all those printed dollars back. Resolving these problems won't be simple. But common sense tells us that we can't avoid them indefinitely, and allowing them to fester may well make things worse in the long run. Green shoots can be overcome by noxious weeds.

One final common sense point. It's time for the administration to ignore the stock market. There is a fin de siecle quality to the market. Upwards of 40% of last week's trading on the New York Stock Exchange was in 4 financial stocks: Citigroup, Bank of America, Fannie Mae and Freddie Mac. There's nothing publicly known about these four companies that justifies this much attention. AIG stock is up some 250% for the month of August to date. That's even weirder, considering that there's no news about AIG, except that the new CEO has reportedly had some conversations with a former CEO, Hank Greenberg. Some rumors have it that Greenberg might be thinking of buying AIG back. But let's recall that the U.S. government, through the SEC, just settled an enforcement lawsuit against Greenberg, charging him with responsibility for improper accounting. He agreed (without admitting or denying wrongdoing) to pay $15 million. Do we really think that the U.S. government, which effectively owns AIG, would sell the company back to a guy it just punished? And then there's GM stock, which has traded all summer at a positive price. That's looney. The publicly traded GM stock is for ownership in the residual company that's going to be liquidated. The U.S. government bailed out, Fiat affiliated company that is making the Chevy Volt isn't traded publicly at all right now. The common stock of the residual company is worthless. But apparently not to numerous buyers in the stock market.

The market rally has become increasingly concentrated in a few large cap stocks. This brings to mind the halcyon days of late 1999 and early 2000, just before the big tech stock collapse. The market rally of those days also became increasingly concentrated in a few big stocks. If that handful of stocks stumbled, then the house would be revealed to be made of collapsing cards. They did, and it was.

Day trading is becoming fashionable again. That's always a bad sign, because the least knowledgeable and most inexperienced traders tend to jump in just before indexes nose dive. The fact that corporate insiders are now selling about 30 times as much of their own companies' stock as they buy (as opposed to an average of 7 times sales to buys) is another hint that the salad days will be short-lived. If the smartest money is selling heavily, what's the logic to buying?

Of course, all presidential administrations deny that their policies are affected by the stock market. But there hasn't been one yet that doesn't scrutinize market indexes. If the Obama administration fixates on stock market movements, it will find itself straitened into dysfunction or adopting policies that exacerbate problems instead of cure them. At some point, common sense dictates that governments can't stop lunacy snd shouldn't try.

Wednesday, August 26, 2009

How About a Few Fireside Chats from President Obama?

The temperature's rising in the Oval Office, with health insurance reform, increasing federal deficits and the war in Afghanistan swirling in controversy. Critics on the right and left are emerging from the woodwork to get their 17 seconds of coverage on the evening news. The President's approval levels are dropping, although they remain strong overall.

To a large degree, these problems are not of President Obama's making. He didn't mismanage the war in Afghanistan for 7 and 1/2 years. He didn't blow up the financial system and throw the economy into a severe recession through weak regulation poisonously accompanied by a recklessly accommodative Federal Reserve monetary policy. He didn't create the tortuous labyrinth that is our health insurance "system," where Minotaurs lurk at every turn.

But he has allowed himself to be pushed into playing defense. His health insurance reform proposal consists of general ideas that shift with the tides; in particular, the public insurance option does the hokey pokey in and out every other day. The amorphousness of his health insurance proposal allows his critics to claim he's taking something away from the public while imposing undue taxes to cover other people. As for the government's projected deficits, his detractors make Godzillas of their size. Missing from the picture is what we get from health insurance reform and from spending all this money.

As for Afghanistan, it's clear the President is concerned about appearing soft on terrorism. He's been pushed hard by Dick Cheney, the right wing's Prince of Darkness, and has drifted noticeably closer to the Bush II administration's antiterrorism policies. The Democratic Party's liberals are starting to shuffle their feet nervously. The President hasn't articulated an end game or an exit strategy. When it came to combating terrorism, the Bush II administration ultimately had nothing to offer except fear itself, a fear that apparently was used to justify a costly war in Iraq, official torture, overlooking CIA transgressions of the administration's torture policy, overly broad domestic electronic surveillance, nondisclosure to Congress of the proposed use of mercenaries to assassinate Al Queda leaders, and the legal cancer that grew at Guantanamo Bay. The problem with fear is that it is a raw emotion, not a reasoned principle, and therefore cannot serve as a foundation for democracy.

The great Presidents--the ones historians write about and people remember--are the ones who got things done. Smart, talented, but unproductive ones like Bill Clinton and Jimmy Carter barely get footnote treatment. Barack Obama's proposed programs will die the death of a thousand cuts if he plays defense against the barrage of political trash talking that has come his way. He can't please all the people all the time, and his promises of bipartisanship are being twisted around behind his back to shackle his agenda.

Franklin Delano Roosevelt was famous for his fireside chats--radio addresses aimed directly at the electorate--to explain how he intended to make things better for America. Barack Obama--not his spokesperson, not his aides, but he himself--should take the lead. He needs to more specifically define his health insurance reform and then explain why it will improve things. He cannot deny that the costs of universal coverage won't be large. He needs to describe the benefits of universal coverage and explain why they justify the costs. The American people didn't support Social Security because it would increase their taxes. They supported it because it would alleviate poverty in old age and they considered that goal worth the extra taxes.

President Obama must explain why the federal deficit is so large and why the extra expenditures will make America better off. We had comparable deficits during World War II, but the people understood why and were willing to pay the price.

He must develop an end game and exit strategy for the war in Afghanistan. In this regard, he should not exclude a non-victorious conclusion. President Reagan's withdrawal from Lebanon and President Clinton's withdrawal from Somalia arguably took some pressure off terrorists. President George W. Bush's wind-down of the war in Iraq acknowledged a humiliating failure of American policy that can only encourage terrorists. But the American people were willing to live with these consequences because continuing to fight in those locations became too costly. The United States has the naval and aerial resources to hit Al Queda training camps without needing American infantry on the ground. American diplomacy can exploit potential differences between Al Queda and the Taliban to undermine support for the terrorists. Maybe that sounds far fetched right now, but so did the notion of Richard Nixon attaining a pragmatic alliance with the Communist Chinese (against whom America fought a bitter war in Korea) in order to weaken the Soviet Union.

Taking the lead publicly would place Barack Obama at considerable political risk. But he's there already. He has charisma, and could do well. It's not enough to do a couple of town hall meetings and then take a vacation on Martha's Vineyard. President Obama should become his own principal spokesperson. Franklin Roosevelt personally gave his fireside chats. He also became the greatest President of the 20th Century.

Monday, August 24, 2009

Bernie Madoff's Prison Blues

News services reported today that Bernie Madoff is claiming he has cancer, although federal officials deny that there has been any cancer diagnosis. News services also report that Bernie’s participating in Native American purification ceremonies, taking about 20 pills a day, and getting other prisoners to cook sandwich wraps for him. Supposedly, various gangs in the prison—the federal medium security facility in Butner, NC—are trying to recruit Bernie. He reportedly was assigned to the engraving section at the prison when he first arrived, but is now painting fences. The following is a work of fiction.

“Here’s your chicken fajita, Bernie.”

“Oh, hi, Doug. Did you use less vinegar like I told you?”

“Yeah. Less vinegar and a dash of paprika, like you said.”


“You how hard it is to get paprika in this place, Bernie?”

“Come on, Doug. All you had to do was talk to that reporter, and tell him that I was taking 20 pills a day and not feeling so good.”

“I think he thought it was funny, giving me some spice for information.”

“It was probably the cheapest tip the guy ever got.”

“Okay, well, Bernie, you got my ten bucks?”

“Oh, yeah. Ten bucks. Here it is.”

“This a good bill?”

“It’s as good as anything out there.”

“Bernie, I know you were assigned to the engraving section first. Then, they moved you to fence painting real fast. What were you doing in engraving?”

“Nothing that the Federal Reserve isn’t doing.”

“What the hell does that mean, Bernie?”

“It means take the ten and have a good time spending it. Now, look it, here comes Ray Ray. I gotta talk to him. “

“Okay, Bernie. Let me know when you want another sandwich.”

"All right, Doug. See you around."

“Bernie, my man.”

“Hello, Ray Ray.”

“I got the thing you wanted.”

“You mean the bagel with cream cheese and lox?”

“That’s right, Bernie. Here it is.”

“Ray Ray, you’re a genius.”

“It was easy. It was like you said. That reporter, he gave it to me ‘cuz I told him we was trying to recruit you.”

“Good. Even in this place, life is sometimes a bowl of cherries.”

“Say what?”

“I was just making an observation.”

“So, Bernie, you gonna join up with us?”

“I don’t know, Ray Ray. Why do you want an old guy like me in your gang?”

“Bernie, my man. You the biggest hustler of all time. I seen a lot of hustle and jive. But I ain’t never seen no one take $65 billion. All the blow that goes through LA, it ain’t worth nothing like $65 billion. You the man. You the main man. We can learn from you. You gotta tell us how you did it. You gotta teach us.”

“It’s nice of you to say that, Ray Ray. I’ll think about it.”

“There’s a lot more bagel, lox and cream cheese if you join up with us.”

“I'll keep that in mind. Look, the Chief is coming. If you’ll excuse me, I need to speak with him.”

“Okay, Bernie. Keep on talking to me.”

“Okay, Ray Ray.”

“Hello, Bernie.”

“Hello, Chief Running Bear. Everything ready?”

“The lodge is ready and the stones are hot.”

“Good. I’ll just take my shirt off and we can get started.”

“This is your third purification ceremony this month, Bernie. I think we’re getting you in pretty good shape.”

“I do enjoy the ceremonies, Chief. I feel better afterwards.”

“That’s good, Bernie. Maybe, before we get started this time, you could tell what you’ve been seeing.”

“You sure you want to know, Chief?”

“Bernie, I’m full-blooded Native American. I can’t stay cooped up here. It’s bad enough being on the reservation. This place will kill me.”

“Okay, Chief. I’ll tell you what I saw while I was painting. The fence in the northeast corner of the perimeter looks kind of loose at the bottom. Maybe, if you scraped away enough of the dirt, you might be able to slip underneath. And you know the manhole cover near the fence along the south side of the perimeter, for the storm water drainage?”

“I know what you mean.”

“When I was painting there, I overheard a couple of maintenance guys talking while they were inspecting the drainage pipe. They said the bars in the pipe are getting rusty, and that it might not be that hard to push through them. You’re a big, strong guy, Chief. Maybe you could lift up the manhole cover, get into the drainage pipe--it's big--and push through the bars.”

“Thanks, Bernie. That’s good to know. Let’s get the ceremony going. We’ll have you in great shape soon.”

“I’m glad to hear that.”

“By the way, Bernie. Do you mind if I ask a personal question?”

“No, not at all. Fire away, Chief.”

“You look pretty healthy to me. Do you really have cancer?”

“Chief, what you don’t know won’t hurt you.”

“Bernie, no disrespect intended, but a lot of your investors would argue with that.”

“Chief, like you, I don’t want to stay here forever. The cancer story worked out well for that Libyan guy in Scotland. I might as well give it a try.”

Saturday, August 22, 2009

You Were Worried Obama Would Redistribute Income? Life is Just an Asset Bubble.

The moneyed classes need not have worried. During Barack Obama's Presidency, their wealth, if anything, has grown. The stock market is up from the end of the Bush, Part Deux years. This favors the well-to-do, who own most of the stock. Oil prices have risen sharply; OPEC and other oil producers worldwide are celebrating. The Federal Reserve's interventions have financed, not new loans, but stability for banks, big bonuses for bankers and nice gains for bank shareholders. Ordinary folks have benefited from the federal stimulus package. But the well-to-do have benefited more, since they had more to lose and their larger holdings of assets have enjoyed greater gains. Yes, the high end of the real estate market is slow. But most wealthy people--i.e., those with net worths over $5 million--have well under half their net worth invested in their homes. These are today's equivalent of coupon clippers and their wealth is mostly invested in financial assets.

The last point is important. It's not that the President is trying to make the wealthy wealthier while leaving the poor behind. He isn't. It's just that when the Federal Reserve and federal fiscal policy do things to help fix the economy, those things tend to favor the already prosperous. In recent years, Federal Reserve monetary policies have involved dumping large quantities of cheap credit and printed money into the economy. When the government prints money, as it is doing now, that money is like a flood. It has to go somewhere. Inflation hasn't been a problem. With rising unemployment, falling real estate values and thoroughly cowed consumers, retailers can't raise prices. They'd only scare off more customers. Instead, the money's been going into asset markets. Wealthy people own most of the assets, so when assets bubble up, wealthy people pocket most of the gains. This is an important reason why some investment banks are suddenly doing very well and paying large bonuses. They are dealers in asset markets--and participate in the gains from the asset bubbles.

An irony of all this is that the Fed was created to smooth out the economy's ups and downs. It was supposed to be a lender of last resort to banks in bad times, and a prudent regulator that would restrain banks' reckless tendencies in good times. Now, the Fed has become pro-cyclical as a regulator--seeing, hearing and speaking no evil while much evil was done in boom times, but cracking down when the economy slumped--and a printer of money too much of the time. The result has been an exacerbation of economic cycles. Realistically speaking, there's no going back on the idea of central banking. But the question arises whether the Fed is abusing its privilege to issue fiat money and should be subject to statutory constraints. It's no longer enough to require the Fed to control consumer price inflation. It also has to control the impact of government handouts of liquidity on asset markets.

Asset bubbles feel good at first. Owners of assets receive speculative profits, and spend the stuff like found money. Remember the way so many people burned up their home equity on good times? But the good times have passed while the debts remain. The bubbles created transitory prosperity, and lasting economic damage.

The Fed has announced that it will begin to withdraw the myriad accommodations it's provided to the financial system, although it has barely managed to inch forward thus far. What could easily happen when it really begins to retrieve some of the trillions of dollars of handouts would be increased mortgage rates, which would heighten the distress in the real estate markets, a falling stock market (and political repercussions from the concomitant drops in 401(k) accounts), and a further tightening of bank credit. Maybe credit cards would altogether disappear except for the wealthy, while home equity loans would be mentioned in the same breath as Triceratops. There would be political howling of the first and to the nth degrees. The Fed would probably back down and take the easy way out, printing money three shifts a day to shoot up the liquidity junkies again. Only once in its history has the Fed chosen integrity over expediency, when Chairman Volcker raised interest rates and held them up in order to quell the inflationary surge of the 1970s. To this day, he remains marginalized by Wall Street and official Washington for his uprightness.

So life has become a series of asset bubbles. If you're feeling blue because of portfolio losses, don't lose heart. The Fed will pump up asset values again sooner rather than later.

And if you're not a member of the moneyed classes and need a paycheck to put food on the table, you might see some wealth redistribution come your way when health insurance reform is enacted--whenever that is.

Thursday, August 20, 2009

Resources for the Down and Out

If you're running out of money, and think you're out of options, remember that, as harsh as economic conditions may get, there still is a compassionate side to America. Taking help from others isn't easy. But hard times sometimes require hard choices. Many who might go hungry themselves for the sake of maintaining appearances have a different outlook when their families are hungry. In this most nasty of recessions, many middle class people who were living paycheck to paycheck experience hunger if they're laid off. It's no longer unusual for visitors to food pantries to drive good cars and live in middle class neighborhoods; they've simply lost their jobs and have no cash for food.

If you think you're just about out of options, here are some resources to keep in mind.

Unemployment Compensation. If you think you qualify for unemployment comp, apply. It's a public benefit for those that have been laid off. Go to your state's website for information.

Food Stamps. This is a federal program that in the past you paid for with your tax dollars. It's there for you if you're in need. The states administer the food stamp program, so go to your state's website for information.

Food Banks. Many communities have food banks, food pantries and soup kitchens. Remember that donations to food banks are wasted if hungry people don't accept the donated food. Your acceptance completes the circle of virtue that comprises charity. When you get back on your feet, you can repay with dividends.

Welfare. The controversial federal Aid to Families with Dependent Children program ended in 1997, but welfare still exists as a federally funded program administered by the states. Go to your state's website for information. Many people who go on welfare stay there for a while and then get their middle class lives back together. Welfare can serve as a temporary safety net until the storm clouds roll away.

SCHIP. If you have children who are 19 or younger and don't have health insurance, there is a program called State Childrens Health Insurance Program that provides subsidized coverage for children in families with moderate or low incomes. It's a federal program administered by the states, so go to your state's website for information.

Medicaid. This is the federal health insurance program for those with low incomes. If you've gotten to the point where your income is low and you have pretty much burned up your net worth, you may qualify for Medicaid. It's a lot better than nothing. Of course, if you're old enough (65), there's also Medicare.

If you need more information about how to survive a layoff or unemployment, see our Survival Kit for the Laidoff and Unemployed:

Tuesday, August 18, 2009

Health Insurance Reform: Barack Obama's Leadership Test

All the posturing, yelling, screaming and even firearms displaying in the Democrats' health insurance reform road show highlight a crucial weakness in President Obama's tactical approach to the reform process. He's playing politics. By that, we mean he's trying in a politician's way to work with all the important constituencies to formulate a compromise that has bi-partisan support. Earlier this year, he enunciated broad principles for reform, but let Congress put together a detailed package. Since then, he's let the most vocal of his critics shape the contours of changes to the package. Only belatedly has he seemed to realize that he could be at risk of losing the entire initiative, at least for 2009, and has taken to the road himself.

Barack Obama is the most skilled politician of our times. He is cool, subtle, clever and smart. During the 2007-08 primaries and the 2008 general election, he danced like a butterfly and stung like a bee. His opponents, weighed down by outdated conventional wisdom, fought earlier elections and lost this one.

But like so many Presidents in the last 30 years, he has bogged down since his inauguration. Candidates from outside the Beltway have almost always been the winners of Presidential elections in recent decades. That's understandable, but it means we get rookies in the White House. Washington is a tough town on outsider Presidents. Jimmy Carter, Ronald Reagan, Bill (and Hillary) Clinton and George W. Bush all found that out the hard way.

Barack Obama may have Chicago grittiness when it comes to dealing with snow. But nowhere in his political experience has he been in a mosh pit like Washington. Chicago and Springfield, Illinois have their political rivalries and battles. But party discipline still means something in those towns. In Washington, members of Congress quickly learn that the squeaky wheel gets the most attention--to get re-elected, you have to negotiate with your own party's leadership for goodies to take back to your home district or state, so there isn't a big payoff from being quietly loyal. The Democratic Party, in particular, remains a collection of not-Republicans that resembles the coalition governments in countries with Parliamentary systems, where fringe members of the coalition have the greatest voice over policy.

Moreover, the Republicans now get to play their stronger role, that of the opposition party. They're lousy at governing--foreign policy failures in Iraq and Afghanistan, domestic disaster in the financial markets and the economy. But they're really good at the obstructive defeatism that can undermine major policy initiatives like health insurance reform. It's easy to criticize, and the Republicans always take the easy way out when they're the opposition party.

President Obama surely understands that the Voting Rights Act of 1965 was one of the principal reasons why he was elected President. Without this landmark legislation to secure for minorities the right to vote, he wouldn't be sitting in the White House. He should reflect on the President who pushed--no, bulldozed--that law through Congress.

Lyndon Johnson was dramatic, melodramatic, overbearing, ingratiating, idealistic, principled, and hyper-determined to get his way. When crucially important legislation was on the line, he'd sermonize, badger, harangue, and arm-twist. To bring around the last few reluctant legislators whose votes were needed, he'd pigeon-hole them and in his uniquely domineering way, subject them to character-building experiences that made them see the wisdom of guaranteeing fundamental rights for all Americans. He was the greatest domestic President of the 20th Century after Franklin Roosevelt, and he got there by exercising leadership. With a black President in the White House and a much larger role in society for nonwhites, today's America is in many ways Johnson's Great Society. But for the tragedy of the Vietnam War, Lyndon Johnson would be lionized by Presidential historians.

Even though the decibel level has been high, and histrionics have received almost all the press coverage, the contours of an acceptable health insurance reform have emerged. Americans want choice, and do not want to lose what they already have. But they'd also like a safety net. A national health service that forces all medical personnel onto the government's payroll and eliminates all private insurers wouldn't be acceptable. But neither is the status quo, and Republicans, wittingly or unwittingly, will end up protecting the status quo, warts and all, if they succeed. That would be a Pyrrhic victory for them, because Americans don't want the status quo any more. Just about everyone, including the well insured, has a sibling, parent, child, good friend, or neighbor who is uninsured. There isn't one of us who doesn't realize that we or someone dear to us could be uninsured sooner or later. The federal government has for decades provided health insurance to the vulnerable through Medicare, Medicaid and SCHIP. A safety net program, perhaps like enrolling the uninsured in Medicare, or a newly formed sister program, would follow in the same tradition.

Health insurance reform is today's greatest domestic challenge. It's understandable why Barack Obama started the reform process by playing politics. He's a tremendously skilled politician and we naturally fall back on our strengths in difficult situations. But politics won't get the job done this time. This isn't an election. This is a legislative process, with a difficult problem that the legislative process normally would be incapable of addressing effectively. President Obama doesn't have the compliant Congress President Franklin Roosevelt had in his first year. He should take a page from Lyndon Johnson's playbook and lead legislators to places that they may not until later realize they wanted to go. Perhaps he'll need to be more forceful than would come naturally. Perhaps he'll feel like he's at greater political risk if he steps out front and center. But Washington's natural inertia will overwhelm him unless he fights it with all his strength and all his willpower.

Sunday, August 16, 2009

Have the Federal Reserve's Monetary Policies Failed?

Now that bank profits and bonuses abound, green shoots are alleged, and stock market investors are opening their 401(k) statements again, it would be worth asking whether the Federal Reserve's monetary policies have failed. At first glance, considering that the economy seems to have taken a step back from the abyss, that might seem absurd. But let's consider where things are.

Unemployment continues to rise. Wages stagnate and shrink. Consumers are pulling back on spending. Consumer confidence is falling. Home prices are mostly falling, except in the most moribund of markets where they've already dropped more than 50%. Housing starts and home sales have more or less stabilized, but at extremely tepid levels. Consumer debt is shrinking as Americans struggle with the unfamiliar experience of saving.

The Fed has partially succeeded--its policies helped the regulated banking system to survive, for the most part (Bear Stearns, Lehman, R.I.P.). But the unregulated multi-trillion dollar shadow banking system--mortgage and other asset backed securities, and credit default swaps--has largely collapsed. The collapse of a sizeable portion of the banking system leads to economic stagnation. It happened when a number of trust companies failed in the Panic of 1907, and again when thousands of banks failed in the late 1920s and early 1930s. What we're starting to see now--a jobless recovery where growth will probably be slower than molasses--is reminiscent of the stagnation that followed earlier banking collapses.

Monetary policy is heavily entwined in how we got here. We've experienced a series of asset bubbles facilitated by the central bank. There was the tech stock bubble of 1999, the real estate and credit bubble of the mid-2000s, and the oil bubble of 2008. Each bubble caused a lot of damage. Adjusted for inflation, the stock market reached its all time high in March and April of 2000, and has never regained those levels. Thus, some losses from the tech stock debacle remain. After that, stocks lost their luster and many investors headed for the real estate markets, while others sought refuge in "conservative" mortgage-backed securities backed by the hasn't ever fallen real estate market. The ensuing morass bogs us down even today, as losses continue to mount. The oil bubble, spurred by the lowest fed funds rate ever, wrecked every business plan the auto companies might have had, forcing GM and Chrysler to seek federal help while permanently laying off tens of thousands of workers. No wonder consumers have hit the mattresses. In the last 10 years, the Fed has administered one smack down after another to the economy.

Bug-eyed, audibly breathing advocates of the gold standard cite these cycles as evidence of the failure of fiat currency, and demand a return to the gold standard. Although a lot of mouth-foaming accompanies criticisms of fiat currency, the more the Fed provokes asset bubbles, the more we need to wonder if something has gone astray with the Fed's monetary policies.

Fiat currency is paper currency not backed by gold, silver or any other physical asset. It derives its legal value from laws making it legal tender. These laws require creditors (including sellers) to accept fiat currency from debtors (and buyers). In effect, because a law says fiat currency has value, it has value. It's also possible for fiat currencies to have value as a matter of custom. The U.S. dollar is often considered more valuable in many parts of the world than the local currency, not because it is legal tender but because people simply consider it more reliable than the ruble or whatever.

The basic reason for fiat currency is that people need something as a means of exchange, and physical commodities like gold and silver aren't available in adequate supply. Currency (fiat or otherwise) is as an intermediate asset, held in between ownership of property that has use value (like food, clothing, heat, housing, etc.). Without currency, only barter exists as a means of trade. A producer of clothes needs only so much food, and a producer of food can't barter for clothes if the clothes producer already has enough food. But if a medium of exchange exists, the producer of clothes will accept currency from the producer of food because the currency can be used to buy heat, housing or other things the clothes producer does need. Both parties profit from the exchange.

When accepted currencies are not available in sufficient supply, substitute means of exchange come into use. Tobacco became a form of currency in Colonial Virginia because English currency was in short supply. Many private banks in 19th Century America issued paper currency because there was no national currency and bank customers needed a means of exchange. Currencies spur economic activity. The velocity of economic transactions increases when there exists a medium through which to transact. An abundance of currency should facilitate economic growth (which happened when tobacco came into use as currency in Colonial Virginia).

Central bank monetary policy, although implemented at an exponentially more complex level than tobacco-as-currency, is aimed at the same fundamental dynamic. By lowering short and long term interest rates, lending to banks and other financial institutions, and purchasing government and asset-backed securities, the Fed is increasing the supply of the medium of exchange in the hope of increasing the velocity of economic activity. The policy worked, spurring a tech boom, a real estate boom and a petroleum boom. Only it worked too well, and each boom ended in a bust.

Now, in 2009, we may be seeing the comeuppance of it all. The Fed has flooded the financial system with currency but economic activity remains moribund. Newly printed fiat money isn't increasing the velocity of economic activity. Banks aren't making new loans; indeed many credit card customers are having their cards cancelled without prior notice. (Sometimes, they find out when a merchant rejects the charge; we always thought the credit card companies were mean-spirited but this is a new low.) Trillions of dollars of toxic real estate-backed assets--the product of a Fed funded asset boom and bust--remain on the books of the major banks, crippling their ability to extend new credit. Nothing meaningful is being done to remove this tumor from the banking system. Official policy appears to consist of hoping that the real estate sector revives and boosts the value of these assets. But official policies to modify mortgages and otherwise revive real estate are, on good days, ineffectual. We don't have zombie companies, like Japan in the 1990s. We have zombie real estate assets, that reside more or less permanently on the books of the banking system, impairing lending and holding back the economy.

Although fiat currencies have true economic utility, central bank monetary policies can too easily take advantage of that utility and produce bipolar, destabilizing swings in asset values. Inflation, too, is a threat when the central bank floods the financial system with money. It hasn't materialized yet only because the consumer has been so thoroughly flogged by the recession that spending is almost painful and retailers dare not raise prices.

The ridge-dwelling, rifle-cleaning fringe of the gold standard crowd call for an end to central banking and fiat currencies. Neither will happen. But it's time to consider whether we've reached the limits of monetary policy. There seems to be a belief in an economic Holy Grail, that somehow the "science" of economics can simultaneously achieve stability in growth and prices, and full employment. Economists will be the last to suggest that this quest is impossible, because then none of them could achieve the purity of Galahad. But we should remember central banking's greatest hour, in 1980, when Paul Volcker, newly appointed as Fed Chairman, raised interest rates and threw the United States into a severe recession in order to break the inflationary spiral of the 1970s. A painful confrontation with economic reality, accompanied by struggle and sacrifice, produced the long prosperity of the 1980s and 1990s. There is no free lunch, no new paradigm, no magical printing of fiat money that will transport us to Avalon.

This past week, the Fed announced that, even as it continues to hold short term rates at zero, it will soon wind down its program of buying longer term U.S. Treasury securities. This may provide a tiny glimmer of hope, that perhaps the central bank is beginning to recognize the limits of its power. Let's hope so. The path out of today's stagnation won't be paved with further abuse of the fiat currency. It will be built on hard work and investment directed at boosting the capacity of the U.S. economy to produce tangible goods that Americans and others want to buy. The U.S. economy needs to produce more intrinsic value; it doesn't need more paper value.

Thursday, August 13, 2009

Understated Economizing

It's become chique to be cheap. But conspicuous penny pinching can have the same declasse overtones as buying expensive things. If you're doing it to impress people, you've only proven yourself a nouveau-pauvre. Understated economizing, just like understated elegance, connotes good taste. How, then, to maintain grace under financial pressure and not appear like a parvenu?

1. Buy brand names on sale. Just about all brand name goods go on sale eventually, especially now that the economy is slow. Or else, they are sold by high end retailers to discount outlets that sell them for a fraction of the full retail price. Think of yourself as a bargain hunter, not a penny pincher. Every time you get a good deal, consider it a success, not parsimony.

2. Don't buy services you don't need. Maintain cars in accordance with the manufacturer's recommendations. But don't buy the additional services recommended by dealers. They can double the cost of routine maintenance while adding little value. For example, many car dealers will recommend changing the oil every 3,000 miles or 3 months, whichever comes sooner. If you're an ordinary suburban driver, that kind of maintenance hasn't been necessary since leisure suits were the rage. In addition, don't buy service contracts or extended warranties for quality equipment (computers, household appliances, etc.), unless you're going to use them a lot. A small business may wisely buy an extended warranty for a computer, but the ordinary home Internet surfer is probably wasting money. Consider whether the $120 haircut is essential to your image; maybe a less expensive hair stylist would offer new, refreshing ideas.

3. Save where spending more wouldn't matter. Buy the cheapest gas you can find. There's no real difference between gasoline brands. Use the cheapest vino in a box for cooking wine. The cooking process ruins a wine's bouquet, so there's no point putting Chateau Arriviste in a frying pan. Re-use bags from grocery stores. Kitty litter doesn't mind if it's disposed of in a grocery bag used a second time.

4. Spend more when it gets you more. Buy nonperishable goods in bulk when the bulk sizes go on sale. For example, toilet paper is inevitably on our shopping lists, so buy it when the family-size packages go on sale.

5. Spend less when it gets you more. Invest in low cost mutual funds. Index funds, and other low cost investments like exchange traded funds, are often a better bet than managed funds. Many and perhaps most managed funds don't meet, let alone beat, the performance of index funds or ETFs. Spending less on management fees and the like means more investment gains for you in the long run. In this case, less really is more.

6. Eat where the Chinese eat. If you want to find the best Chinese food, ask the local Chinese people where they eat. You'll probably end up at a cubbyhole of a restaurant in a strip mall with an aura of vinyl and formica. But the food will be great and modestly priced. The Chinese are genetically wired to be gourmands and they'll sniff out a good meal wherever it can be had. Since it's no longer fashionable to be seen in the restaurants where people go to be seen, you might as well go the ones with the best food.

Tuesday, August 11, 2009

What Will Frank DiPascali Say About the Bernie Madoff Scandal?

Frank DiPascali, depicted by the government as Bernie Madoff's right hand man, pled guilty today in the federal court in Manhattan. The charges against him include ten felony counts, enough for a maximum 125-year sentence. If imposed, that would be close to Bernie's 150 year sentence. But DiPascali will probably get something much less than 125 years.

Unlike Bernie, DiPascali entered into a cooperation agreement with the government. Although the plea agreement isn't public, it likely requires DiPascali to reveal everything he knows about the Madoff scandal. At age 52, DiPascali has a chance, by singing loudly and at length about every crime he's aware of, to avoid a lifetime sentence. It's clear that's his goal.

Bernie, on the other hand, has refused to cooperate. As we discussed previously (see, there are pressures on Bernie to talk. Things have only gotten worse for him today, with DiPascali getting friendly with the government.

In the "information" (the government's document setting forth the criminal charges) and in the "complaint" (a document containing civil charges) filed simultaneously by the SEC against DiPascali, one gets the picture that contrary to Bernie's claims, he had a number of people helping him out. DiPascali and other "co-conspirators" allegedly fabricated documents and misled investors, the government, and auditors. They evidently enjoyed lying to the SEC, because they supposedly did it early (beginning in 1992) and often (again in 2004, 2005 and 2006).

Rather intriguing are the allegations that the fraud went back to at least the 1980s, and that in 1992, things almost fell apart when Bernie had to prove that he actually held some $300 million in assets for clients he got through a firm called Avelleno & Bienes. The SEC sued Avelleno & Bienes, and a receiver appointed by the court in that case asked for redemption of all accounts of A&B customers and records of those accounts. Bernie had to scramble to come up with $300 million actual dollars while DiPascali helped to fabricate phony documentation. They were successful in deceiving the receiver and the SEC, and many A&B clients returned to Madoff to be defrauded further. (This shows you the allure of Ponzi schemes--when the culprits successfully meet withdrawal requests, many victims think everything is legit and come back to be fleeced again.)

This may have been a critical moment in Bernie's Ponzi scheme. If it had been exposed in 1992, the total loss might have been in the hundreds of millions or low billions--a very large fraud, but nothing on the scale of the ultimate scam. But Bernie thwarted any possibility of that by coming up with the $300 million needed for the redemptions.

Bernie's ability to come up with this much cash in 1992 raises interesting questions. Since the scam was probably much smaller in those days, with fewer feeder funds and what not, how did Bernie come up with such a big pile of dinero so quickly? There are allegations in the court papers that in recent years the Madoff firm kept well-funded bank accounts at J.P. Morgan Chase as a reserve against customer redemption requests (in other words, the crooks were prudent about taking steps to keep the fraud going). But did they have a reserve fund in 1992? If so, was it funded with $300 million (probably not, since the SEC complaint says that Bernie "scrambled" to raise the money).

Since Bernie didn't hold real assets, but ran a fraud, he couldn't have simply gone to his neighborhood bank, pledged some collateral, and got a $300 million loan. He was running a criminal enterprise, not a legitimate business. In the world of crime, there are ways to get loans. But they tend to be expensive, and repayment is very important unless you want to be fitted with really heavy shoes. Is this why Bernie has been mum? Are there investors in, lenders to, or owners of his scheme whose identities he can't afford to reveal no matter where he is?

Today's court papers also reveal that DiPascali made off with more than $5 million of investor funds by siphoning them into accounts he personally controlled. That, it appears, was boat money and other such pocket change. It's unclear whether Bernie knew about DiPascali's sticky fingers--when you're stealing tens of billions, the disappearance of a few million might go unnoticed. But perhaps DiPascali wasn't alone in pinching off a few pennies here and there. Perhaps Bernie quietly stashed a few nickels in places he doesn't want to reveal.

You can expect that DiPascali will name everyone in the Madoff organization or elsewhere who was involved in the nastiness. It would improve his prospects at the sentencing hearing (conveniently set for ten months from now to give him plenty of time to sing) if he can truthfully finger high profile people (like members of Bernie's family). His "co-conspirators" are now under the gun to come in out of the cold and cut deals with the government to sing themselves. Otherwise, they might be sitting ducks once the prosecutors have DiPascali's evidence. The tabloid quality of this story could improve.

As for Bernie, the enigma of his silence only increases. He could have fingered DiPascali and other "co-conspirators" to get a chance at a lesser sentence. That he didn't suggests he wants to be in prison (a possibility we discussed in Now, with DiPascali doing his best Pavarotti imitation, Bernie's lost some leverage. We may never learn why Bernie's taken a vow of silence. But, then again, with the number of indicted songbirds likely to increase, perhaps we will. Stay tuned.

Sunday, August 9, 2009

Federal Economic Policy: Winning the Statistical Battle, Losing the War?

The financial headlines are filled with proclamations of the stabilization of the financial system and the end of the recession. Prominent figures ranging from the President to the Chairman of the Federal Reserve to high profile analysts and economists working for investment banks that sell stocks all declare the recession in its last months. While most are cautious in predicting the strength of the economic rebound, they display growing certitude that the the economy is on the mend.

Yet, at the same time, all concede that unemployment is a serious problem, and that the unemployment rate might well rise above 10% next year. This past week, it fell to 9.4% in July from 9.5% in June. That sounds like an improvement, but less so when one considers that people dropping out of the labor force had a lot to do with the improvement. In other words, it was a product of the statistician's definition of being the labor force. You have to have made at least one attempt in the last 4 weeks to find a job in order to be considered unemployed. If your last attempt was 5 or 6 weeks ago, you're out of the labor force and not counted as unemployed even if you want a job. Thus, an increase in hopelessness apparently had much to do with last month's "improved" unemployment rate.

The housing market has shown a few glimmers of green shoots, with new home starts and existing home sales rising slightly in recent months, after falling by roughly 50% over the past year. But prices continue their downward trend in most markets. Last week Deutsche Bank analysts predicted that by 2011, about half of all mortgage borrowers would be underwater on their loans (meaning the mortgages would exceed the value of the home). If true, a vast number of homeowners (about one-third of all homeowners) would struggle with the question whether to abandon their homes rather than pay an above-market price. In many cases, neither discretion nor valor but expediency would probably be chosen. That wouldn't bode well for a rebound in housing prices.

Consumer credit is falling and the savings rate is up, which means that personal consumption is down. With the federally subsidized, bailed out, survival guaranteed big banks cutting back on consumer lending so that they can preserve their profitability and bonuses, and with rising unemployment coupled with falling real estate values, there is no hope for a major revival of consumer spending for years. This time, the little engine won't be able to, perhaps for a long time.

It appears that in Washington and New York, statistics are triumphing over reality. Government policy is producing an end to the recession, as technically defined. Federal bailouts, stimuli, Cash for Clunkers and other handouts appear in statistical compilations as economic activity adding to GDP. There is the minor irritation of Brobdingnagian deficits (which aren't subtracted from the GDP, even though for ordinary people borrowing detracts from wealth). But we shouldn't be tiresome. Instead, consider that government statisticians can measure the end of a recession from routinely gathered data. Further, the mainstream media gives a lot of coverage to a collection of pundits, analysts, officials and executives who compete with each other to make predictions. The ones who spot trends are deemed to be perspicacious; there doesn't seem to be much recognition that a lot of the time they're just dumb but lucky. It having become trendy to see light at the end of the tunnel, myriad favorable predictions are blossoming.

The stock market has celebrated. But when you get past easy commuting distance from Manhattan and the District of Columbia, the fact that a bad economy will soon stop getting worse isn't sparking a lot of champagne sales. Pay cuts, layoffs, falling home values, and credit line reductions all combine to put the chill on consumption. In an economy that is 70% consumer spending, that's toxic. What will provide the impetus for growth remains a very big question with no clear answer. We won't have much of a recovery if things simply stop getting worse.

We seem to be splitting into two economies--the statistically good economy, and the bad ground level economy. Recall the adage about lies, damned lies and statistics. The U.S. government, by spending trillions on big banks, billions on auto companies, and billions more on diverse and sundry stimuli, is producing a statistical end to the recession. But what comfort is that to the numerous Americans still trapped in the bad ground level economy?

Friday, August 7, 2009

Was There Insider Trading Based on AIG's Profit?

Surprisingly, AIG announced this morning a profit for the most recent quarter. This is the company that was on the verge of blowing itself up last fall, and the U.S. financial system with it, when the government stepped in and bailed it out to the tune of over $100 billion. AIG hasn't reported a quarterly profit since 2007, so this unexpected news is good. Maybe fiscally stressed U.S. taxpayers will get back a few pennies on the dollar of their largess.

What's troubling is that AIG's stock more or less doubled in price in the last two days, before the profit announcement. That's a pretty good indication someone may have had advance knowledge of the profits and used it to make some fast money in the stock markets. There's already been lots of profiteering from the government bailouts of Wall Street. AIG wouldn't exist but for the generosity of the taxpayers. Insider trading based on nonpublic corporate financial information often involves company executives or employees, who might trade and/or tip family and friends who then trade. AIG's executives and employees wouldn't have jobs today if the government hadn't saved the company. Thus, such insider trading, if it occurred, wouldn't have been possible but for the government bailout. We don't need insider traders stepping up to the trough to illegally slop up their fill while millions of unemployed try to make a go of it on unemployment. Let's hope the SEC and maybe TARP Inspector General Neal Barofsky have already started investigating.

Thursday, August 6, 2009

Don't Invest in Just the Sunny Side of the Street

People pay attention to financial products that seem to be generating current returns. Maybe that's a modern manifestation of the predator's instinct to focus on motion. In the savanna, something moving might make a good meal. Financial products that are currently paying off appear to be a more certain bet than something that's taken a tumble.

Thus it is that many investors (or at least money managers) have lately been jumping into the stock market. It's moving and appears to be providing good eating. Money managers, in particular, are measured against market indexes and don't want to appear behind the curve when quarterly results are announced.

Another product that has become more popular is the variable annuity with a guaranteed return. These annuities, for a rather large fee, promise the investor a minimum return no matter how badly the stock markets do. When the stock markets do badly, this variable annuity has its moment in the sunshine. But pay close attention to the fine print if you consider investing in one. There are significant limits on the upside potential, so you won't feel so brilliant when the stock market is rising. Insurance companies may be less generous with the terms of new annuities, because they didn't anticipate a bear market as ferocious as the recent one and some of their earlier products are turning out to be costly for them.

There are "principal-protected" mutual funds. which also look good when the Dow looks bad. But they have high fees, charges for early withdrawal and sometimes limits on your upside potential. They may be basking in the sun right now. But they won't always look so rosy.

By and large, human beings make lousy investors. It's instinctive to seek out places where there is sunlight and lots of other people have congregated. But the investment du jour, which will be sought by clamoring crowds throwing money, will probably have less upside potential than the downtrodden and disfavored. Sooner or later, today's frenetic running of the bulls shall pass, and some investors may be gored in the process.

What to invest in, then? Let us posit the one thought that Wall Street and its swarms of well-credentialed analysts would never admit: maybe there aren't any really great investments at the moment. (Since virtually all analysts on Wall Street failed to call the Big Bear of 2007-08, we'd been well-justified to think that they basically have no idea what they're talking about.) Stocks have dropped precipitously and then risen deliriously. Bipolar behavior isn't what most people want from their investments. Commodities are, on a percentage basis, even more volatile. Real estate is a tough call. In a few Sunbelt markets, it's fallen so much that it's probably a decent investment if you have a lot of cash and years to wait. But in most of America, real estate is something you should view as a place to live, not as a way to save for retirement. Frankly, plain old cash isn't a bad idea in a time when we have deflation, not inflation. Even with banks paying a couple pieces of bubble gum per month in lieu of interest, you get a positive return just by holding the stuff. While cash isn't a great long term investment, it's not a bad idea for now, until the smoke clears a bit. Otherwise, keep the portfolio well-diversified.

Tuesday, August 4, 2009

Cash For Clunkers: Policy or Marketing?

The Cash for Clunkers Program has burst out of the blocks. It was meant to run from July 1, 2009 to November 1, 2009, but ran out of money in less than a week. This may be too successful.

Cash for Clunkers is really just a government funded version of the old standby for spurring auto sales: incentives. Instead of coming from the auto makers, it comes from, well, you, me and all other U.S. taxpayers. Its popularity stems from the fact that car buyers are addicted to incentives offers, and tend to hold off buying until someone waves a big rebate at them. Cash for Clunkers was the waving cape that made this bull charge.

Cash for Clunkers is a bit strange when viewed as government policy. It benefits those who can afford to buy new cars. Granted, the government subsidy is either $3,500 or $4,500. But the average new car costs somewhere around $28,000. So a subsidized purchase is probably going to be in the low to mid-20s, on average. Most of the people who can afford to pay this much for a car will be making $60,000, $70,000 or more per year. They're the folks who have borrowing power or the savings to spend this much on a car. In other words, Cash for Clunkers is likely to be mostly a subsidy for people close to or in the upper middle class. Since they generally would be able to afford a new car anyway, Cash for Clunkers may simply give them some cash, or a nicer (read, probably larger) car than they would have bought without the government largess.

The stated purpose of Cash for Clunkers is to get car sales moving and improve the mileage of cars on the road. By all indications, it is doing that. But it is just a variation, and a highly successful one, of the traditional auto sales incentives programs that have become essential to car sales. Now that the auto makers are struggling financially, will they and their employees henceforth turn regularly to the federal government for more incentive programs? The problem with really successful government handouts is that they are incredibly difficult to eliminate (see agricultural subsidies, which also tend to go to the relatively well off, for further information). And car buyers have learned that it pays to patiently drive the old heap until someone--the car makers, or now perhaps the government--sticks some moola in their hands to make them buy.

The government is boxed into a corner on this issue. With a handful of large financial institutions slobbering at the federal trough for trillions of dollars of subsidies and bailouts, it's hard to deny the auto companies a couple more billions for Cash for Clunkers. And, if late this year or early next year, the economy is still stagnating and the car companies want an additional two or three billion, could they fairly be turned away? After all, federal subsidies have made it possible for banks to pay multiple billions in employee bonuses. Can the government say no to a car incentive program that costs less than Goldman Sachs' bonus pool this year? One thing is for sure: the buyers will be waiting.

Sunday, August 2, 2009

Financial Regulatory Reform: Ask Basic Questions About Computerized Trading

One of the principal reasons for the financial crisis of 2007-08 was the failure--of Wall Street executives, lenders, investors and regulators--to ask basic questions about the computer modeling that was used to construct the now infamous derivatives contracts whose flaws triggered our lengthy, ongoing recession. While these models covered, more or less, 99% of the potential market scenarios that could arise, they didn't cover the possibility that the real estate market might, on a national level, fall. Such a phenomenon had not occurred in a very long time. And because of that, the big players in the derivatives markets presumed it wouldn't occur. That was a mistake. We are still paying the price.

High speed computerized trading has recently been in the news. Outsized profits at Goldman Sachs, followed by outsized bonuses, were partly the result of electronic trading at speeds measured in the millionths of seconds. The alleged theft of some of Goldman's ultra-fast trading software by a former IT employee added tabloid sensationalism to the story. Complaints about flash trading, where some firms with superfast computers can see and trade ahead of other large orders, have led the SEC to consider banning the practice. "Naked access," which is about money, not sex (remember, this is Wall Street), involves a favored customer of a brokerage firm using the broker's identity to trade directly on an exchange. This would presumably heighten the speed of its trade executions. The high speed firm would, to the rest of the market, appear to be an exchange member. But it wouldn't necessarily behave like an exchange member and might destabilize the market. A third kind of high speed trading involves the arbitrage of prices in more than one market, an established trading strategy now conducted at exponentially faster speeds.

Computerized trading is now reported to be more than half the total trading volume in the stock markets. This represents a fundamental change. Back in the days when landing a human being on the Moon was still a dream, the stock markets consisted of the interactions of human judgments. Human interactions can be strange and even destructive. The history of financial booms, bubbles and busts demonstrates that. But at least people more or less understand each other most of the time. Family bonds, society and commerce wouldn't be possible if that weren't true.

But computer models are another thing. They don't always work as intended, because of imperfections in design by their human financial engineers. Yet, the image of computers as more reliable and thorough than humans leads to the notion that they are less prone to errors. That, as we know from the recent mortgage-backed mess, is demonstrably untrue. We need to know if computerized trading could have unintended consequences at a time when we really don't need more unintended consequences.

It's important to consider basic questions. Flash trading could create a two-tiered market, with better prices for well-computerized big players and crumbs for everyone else. This ultra-short term profiteering isn't in keeping with the baseline purpose of the stock markets--to provide capital for long term investment. Flash trading doesn't offer much in the way of societal benefits. Yes, there are arguments that it increases liquidity. But let's remember that not all liquidity is the same. There is the liquidity provided by exchange specialists and market makers, which is "counter-cyclical." This means that they sell when investors want to buy and buy when investors want to sell. Counter-cyclical liquidity is good for markets because it keeps things flowing. But wouldn't flash trading liquidity more likely be "pro-cyclical," meaning it would be used to buy ahead of a market surge and sell ahead of a market drop? This would destabilize markets.

It's also important to look at the collective interaction of these high speed trading strategies. When more than half the trading volume in the markets is computerized, it's fair to conclude that machines are observing and interacting with other machines a lot of the time. Perhaps flash trading or naked access could create price anomalies that a multi-market arbitrage system would believe to be the beginning of a profit opportunity. But, without the human element that made historic trading patterns what they were, the markets might move in unexpected directions. The hyper vigilance that a computer can provide might result in large wolfpacks of high speed traders pouncing on pricing anomalies with ultrafast trades, pushing prices far into the opposite direction and producing asymmetries never before seen. That might be bad.

And there's also the problem of inputs. Remember what they say about computers: garbage in, garbage out. Interest rates, for example, have historic relationships with the values of other assets. The Federal Reserve has pushed interest rates down to extraordinarily low levels. It's possible that the computers are misinterpreting what the human action by the Fed means. Perhaps these extremely low interest rates make the computers think that stocks are more valuable than they really are. The humans pretty much know that the Fed can't keep interest rates down with the flounders forever. But who knows when the humans at the Fed will begin the process of draining the vast oceans of liquidity they have dumped into the economy, how fast they will do it, and what mechanisms they will use. The computers may have contributed heavily to the upside delirium we have recently seen in the markets, where there is no such thing as bad news and all news makes the market rise. Interest rates--especially short term rates--are the product of government policy, and today we have government policies and intervention never before seen. Might the computers, programmed to react to historical patterns, misinterpret what's going on? If the computers exaggerate the upward momentum, might they draw in humans who--thinking they're seeing, not computers, but other humans buying--invest when they would otherwise be worried about jumping in at the top of an asset bubble?

There are surely many other questions that could be asked, especially if one can get a detailed understanding of how these computerized trading strategies work. The regulators can get that information, and should. It won't be easy to evaluate this stuff. A lot of it involves technical complexity and serious math, things that the liberal arts majors who heavily populate the legal staffs of regulatory agencies don't hanker for. But you can't regulate an industry if you don't understand it, and it's time to get a thorough understanding of what high-speed trading is all about, before unintended consequences once again wreak havoc in the markets.