Serial Correlation

Words I found today

2011-08-24T09:27:00.002-04:00

hectored - Talk to (someone) in a bullying way
churlish - Rude in a mean-spirited and surly way

SP500 Price, Value, ahhhh! The CNBC Talking Heads are going to make my brain explode

2011-08-23T09:43:00.003-04:00

A Wall Street strategist once said that when he walks into a financial services firm and they have a television programmed to CNBC, it's the same as walking into a hospital and they have their TV programmed to General Hospital. That is, it's laughable that doctors would learn anything from General Hospital and thus, it's laughable that any one worth their salt in finance can learn anything from the talking heads on business television.

The past few weeks have seen large gyrations in the stock market. I have seen friends and colleagues, the same who haven't looked at their 401Ks since the last crisis, frantically trying to log in to their plans website. The heads on CNBC are running about with their hair on fire, trying to claim the crown of most-over-the-top. The more the heads screamed the more my friends tried logging into their account. The friends told me the websites to change their allocations were down for days. ( An ancillary point, is that besides doing the minimum to garner the company match and then only plugging those funds into the cheapest bond fund offered, is insane.)

My only investment besides cash since 2006 has been Gold. In December 2008 I invested a huge amount of my portfolio 15% to that class and have just let it run to almost 30% now. The thing is I should re-balance it but I don't want to just put the money in cash, so the market gyrations might provide a buying opportunity. So I opened up the spreadsheet and did some crunching of the numbers.

The first thing I do is go to S&P's website and download the earnings data. Then I try and estimate how good the analysts estimates are for reported earnings. So the analysts proclaim that reported earnings will be 95.67 for 2012, if you divide that by the BAA bond yield of 5.67% you get that the SP500 should be worth 1,660.94. At today's current price it 1,140 it would be a screaming buy. [This is a hybrid of the "Fed Model" and a Dividend Discount Model, basically the price of the index will equal the earnings divided by the discount rate. (I use earnings because companies do stock buybacks now instead of dividends because they are economically the same and there is a tax advantage buying back stock)]

However, what if the estimates are too rosy, corporate earnings look pretty high relative to GDP. With macroeconomic gyrations, we might go into a recession and earnings could plummet precipitously. In S&P's own spreadsheet earnings in 2008 were 14.88 after being 66.18 in 2007. If we take the average annual earnings over the past 10 years earnings have been about $52 per year. If we divide that by the BAA yield we get a fair value of 917.81, thus we are overvalued at current levels.

So which is it are we overvalued by 24.2% or are we undervalued by 45%. This is why economist will always be employed, that is, there is a lot of tea leave reading in the economic circles. So I include a different method altogether to gain some insight into momentum.

Basically, by looking at the 200 day exponential moving average (EMA) I can gain a look at how people feel about the current valuations. When the index drops below the EMA the standard deviation of each day's return elevates and not in a good way because of economic uncertainty. When you are above the EMA the standard deviation lowers and the returns are more positive. Basically, the method tries to see the confidence of the market makers. Unfortunately, we are about 11% below the EMA currently. So it is not a good time to buy based on momentum.

Now, if the market were to plunge even further down to levels closer to a 9 handle, I would definitely pare my gold holdings back to 15%, and bring up my equity exposure to 20%. So I wait for the fire sale.

Imagine if CNBC had a sane talking head who did a quick analysis like above and said "Meh, prices looked elevated. I took this opportunity to sell some of my holdings and will wait for the prices to drop. The further prices drop the more earnings I get. This is akin to waiting to buy a 60" LCD televisions set after the Super Bowl (when prices drop) versus buying a 50" set before." The important thing to remember is that you are buying earnings; you are not buying a lottery ticket when you purchase stock.

PS~ Alternatively, if the news picks up and the index pierces the EMA I would take a short time frame position in SPX, but not rotate out of my over-weighted gold allocation

The green arrows are when you would want to buy and the red arrows are the sells. Specifically, I would buy when I am in the range for what the index should be bought for and you pierce the 200 day EMA, and I would sell when the index seems too high in price to earnings and it blows through the EMA.

Why you should run surpluses in good times, so the budget doesn't look like crap when bad times invariably arrive

2010-06-27T08:11:00.002-04:00

Greece viewed thru an American lens

2010-05-14T14:15:00.000-04:00

Over the course of the past two months Greece has dominated the headlines. Even the comedians piled it on this weekend with "Really Greece - you're in crippling debt and you don't want to make spending cuts? Really? Where do you think your money is going to come from? Royalties for inventing civilization? Really? Your only exports are olive oil, takeout coffee cups, and Zach Galifinakis."

I could not really grasp how the country was such a hot mess. When asked by co-workers what the whole debacle was about I had a faint idea and feinted more than I knew. I knew Paul Krugman said they had a primary deficit. I merely nodded my head in agreement. Then headed off to the inter-tubes for some research.

Wikipedia states that a primary deficit is the pure deficit which is derived after deducting the interest payments component from the total deficit of any budget. Now I understand what the words mean but to a get a true understanding of I needed to dig into the data, play with it and return it back in my own words. However, there are two things at play with what comes next, a) I don't have as much access as I did in my graduate studies to robust data that would give me the information that Paul used to make his assertion and b) it would be far easier to look at the US data and it would be more meaningful to what I deem a US-centric audience.

I do not want to stray to far from the topic but this ancillary topic is important and probably deserves a post of its own. The deficit is the debt incurred in a single year and the national debt is all the debt accumulated over the past years that has not been paid off. When the debt comes due the Treasury, if there is not a surplus, will pay off the previous holders of the Treasury securities with new bond offerings. The cash received from the new offerings will pay the interest and principal on the old debt that is retiring. The structure of this debt is very important. As a country becomes increasingly risky it will find that it has to issue debt in shorter durations to achieve an acceptable funding rate because investors, here and abroad, will not want to take on a longer dated debt obligation due to the increasing risk of non-payment, i.e. default.

www.cbo.gov/budget/data/historical.pdf

Here is a historical chart. If you have eagle eyes you can see that we have been in a surplus in 5 of the 40 years that the chart covers. This chart does come with a caveat that you are looking at nominal holdings and thus inflation would erode some of the levity that this chart imbues.

Above is the average maturity of the United States debt as it has evolved over time and how it projects in the future. The Treasury is taking advantage of the need for US Securities by bringing back the 30 year bond and extending the maturity so that there will be less likely of a situation where there is need for short term issuance to pay interest payments. This is where the US and Greece diverge. Greece has its two year debt pre-bailout trading anywhere from 12-20% payments based upon the principal you would pay to get the coupons. The US is faced with the opposite, our rates are so low that we are extending out the maturity schedule to take advantage of the historically low rates.

Is the difference only a temporal one? No, Greece also has a structural deficit besides the primary deficit highlighted above. So think back to the total deficit above and ignore the primary deficit. The structural deficit is the portion of the debt that always exists because of expenses undertaken that it must pay either voluntarily or at its discretion, think social security versus military spending. Another way to view the structural deficit is via the business cycle. For simplicity, we hypothesize that there are only two states boom or bust. In boom there is low unemployment and tax revenues are growing. In the bust it is the opposite there is a high unemployment and tax revenues are declining. In the second status the deficit will grow because the government will be paying out the same amount of services but revenues will be down, hopefully though, the government planned for the rainy day and used it surplus in the boom to not only keep up the same amount of services but also to extend services that will need expansion during a recession. The biggest expenditure that needs expansion is unemployment insurance.

Let us next look at the latest information.

What we are looking at here is the entire budget (revenues and expenses) encompassed in the large circle. By accounting convention the three pie pieces must equal. We have in order the Revenues in yellow, the expenses in blue and the deficit in red. The deficit must be balanced by borrowing in the capital market. The funding for the deficit is received form both US investors and those from abroad.

We break out the revenues by source to glean insight into how our federal government funds itself. The key categories are in order: income taxes (45%), social security and payroll tax (40%), corporation income tax (9%) and other (3%.) It becomes quite obvious that the taxpayer is the major supplier of all the revenues of the Federal government. What is quite amusing is that when viewed through a political lens one always hears about the gift tax or the estate tax. Now, both of those when added together equal 84 basis points of the Federal government's income or 0.84% for the lay person. Thus, anyone pontificating about that should explain why that particular issue is more pressing than payroll taxes or income taxes.

This chart is slightly different in that revenues and expenses are reversed. So it goes expenses in blue, revenues in yellow and deficit in red. There is continued color coding in the breakout. With the bright red being the mandatory spending in a particular year, the black being the interest paid out (mandatory,) and then the bright yellow being the discretionary spending. I'll just list the categories and spending percentages:

Social Security	$695	19.57%
Medicare	$453	12.75%
Medicaid	$290	8.16%
Potential Disaster	$11	0.31%
Other Mandatory Prog's	$571	16.08%
Interest on Debt	$164	4.62%
Defense	$663.70	18.69%
Govt Svc Programs	$704.10	19.82%

So the key for the US will be the mandatory programs (SS, Mc, Ma, PD, Other and Interest on Debt) versus the income received. Bluntly stated $2,380 income versus $2,184 mandatory expenditures.

Is there one easy cut in this list? Obviously, the interest on debt is above all others. SS, and the Medicare/Medicaid funds are a no-no. You cannot cut defense in a recession unless you wish the unemployment rate to increase further. However, there must be some fat in the Government Services programs; waste, fraud, incompetence, etc. Below is the department, the spending and the percentage of the total ($704.10.)

Health & Human Svcs	$78.70	11.18%
Transportation	$72.50	10.30%
Veterans Affairs	$52.50	7.46%
State	$51.70	7.34%
Housing	$47.50	6.75%
Education	$46.70	6.63%
Homeland	$42.70	6.06%
Energy	$26.30	3.74%
Agriculture	$26.00	3.69%
Justice	$23.90	3.39%
NASA	$18.70	2.66%
Commerce	$13.80	1.96%
Labor	$13.30	1.89%
Treasury	$13.30	1.89%
Interior	$12.00	1.70%
EPA	$10.50	1.49%
SSA	$9.70	1.38%
NSF	$7.00	0.99%
Corps of Eng	$5.10	0.72%
NIB	$5.00	0.71%
Ntl & Comm Svcs	$1.10	0.16%
SBA	$0.70	0.10%
GSA	$0.60	0.09%
Other Agencies	$19.80	2.81%
Other	$105.00	14.91%

Here are some poll results from a YouGov/Economist poll of what and where to cut.

26. If government spending is reduced in order to balance the budget, which of the following government programs should receive lower federal funding than they currently do? (Please check all that apply.)

Social Security ..............................................................7%

National Defense ........................................................ 22%

Medicare ....................................................................... 7%

Aid to the Poor .............................................................17%

Medicaid ..................................................................... 11%

Veterans’ Benefits ........................................................6%

Health research ...........................................................13%

Education ................................................................... 12%

Highways ....................................................................12%

MassTransit ................................................................27%

Foreign Aid .................................................................71%

Unemployment benefits ............................................19%

Science and Technology ............................................22%

Agriculture ..................................................................27%

Housing ......................................................................27%

The Environment ........................................................29%

None of the above ......................................................12%

Maybe it's just a notion that Americans would like to keep all the government programs in place just not pay for them. A phrase Krugman called using Alabama's taxation policy to fund Connecticut's services. The problem is that the expenditures for Social Security, and Medicare and Medicaid are only projected to continue rising. Thus, the structural deficit will only continue to rise. Currently, we are just below the cut off point where the structural deficit is larger than the annual tax income. However, if maintained it plays out like a nationwide game of chicken. It seems that there is an inertia present to maintain the status quo until a disaster occurs and then, and only then, will the entrenched interests' lobbying power be set aside toward popular opinion. One only need look at Katrina, the financial reform act, the oil spill in the Gulf for recent, vivid examples of this terrible game being played out.

It is also the game that Greece must now play as they must make fiscal cuts as a percentage of GDP instead of just a percentage of government receipts just to balance the books.

The above graphs show that the United States is on a path towards what Greece is currently experiencing, however, Greece has arrived at its day of reckoning while the US only faces the prospects if those elected to power or rather those electing politicians to power do not begin to make the tough choices needed.

Education Serial Malinvestment

2009-11-01T13:35:00.013-05:00

I was reading a post from Mish the other day about education malinvestment and wondered if I could model it. But first let me re-post the letter that started Mish off.

When I attended law school at George Washington U in 1969, the tuition was $1,900 a semester. I worked my way through and had no debts when I began to practice law. Later, student loans became the norm. The loans were subsidized, encouraging students to become indebted rather than build sweat equity in themselves. Student loans also took parents off the hook for saving to pay for their childrens’ education. The result was still more government dependency.

Screwing up the marketplace with subsidies, drove up the price of education, encouraged institutions to grow based on government support, and placed undue emphasis (economically) on higher and frequently useless education. We should expect the higher education market to suffer a similar fate to the real estate market, where subsidies, encouraging people to buy what they could not afford (and did not need) led them to a result that, when compared to their investment in time and treasure, was uneconomical.
Eugene Holloway

It seems like a very logical argument, but then I wanted to check what the real price was by inflating via CPI, and also comparing median household income for college graduates in 1969 to today.

He said that it cost 1,900 per semester and the price level has risen 487.52% since them, so in terms today that is $9,262.88. This is 617 dollars per credit hour assuming a full time course load of 15 credits. In my last year in my MBA at a private university the tuition was 1,040 a credit hour so even controlling for inflation the price for a graduate education has risen faster than other prices. [The premium is 68.56%] However, this is only one side of the puzzle, we also need to see what the income level has risen to as well.

With an advance degree the Census shows that in 2000 earned 55,242. The historical data set is not great for tracking down incomes by levels of education. However, in 2000 the median household earned 41,990, so there is a 31.56% premium for the advanced degree. The data set only goes back to 1975 but keeping the same premium when the 1975 median income was 11,800 is $15,524 for an advanced degree. When we inflate the salary so as to make an apples to apples comparison we then find out that the 1975 graduate salary would be $51,705. So there has been an increase in return to attaining a higher degree, but the premium here is 6.84%.

The veil of prices is very tricky. It is easy to allow yourself to look at an old bill and then compare it to one today, but you have fooled yourself since prices of goods and services including most importantly the wage portion of services have increased over time. On this basis, people who have an advanced degree today are better off than those that gained one back in the early 1970s.

Master’s Degree Cost: 64 credits

	1975	2000
Tuition	40,488	66,560
Salary	51,705	55,242
After tax Monthly Income	1,702.05	1,841.4
Student Loan Cost	352.69	579.81
% of Monthly Income	20.72%	31.49%

As you can see it becomes a little gray as to whether it is a good choice or not. It is a high amount of your disposable income but I also assume that it is paid back in 15 years, whereas these loans can be strecthed to 30 and even 40 years in some cases. It also depends on your cynicism to decide if getting a good job is more like winning a lottery than merit and skills based.

However, this recession might not be the same as previous versions. Salaries might plummet due to the supply of willing labor that hunts for employment. It will be interesting to watch this unfold over the next few years to see if this cohort of graduate students did make a bad economic bargain by going into debt to gain further education.

One of the key teachings that I received during my MBA was from my grouchy advanced finance teacher, by advanced I mean he taught the investment course and the futures & options course. Basically, he called us all idiots. He said and I quote, you make a bargain and you go into debt. You have a certain amount of payments to make at certain times. That's fine. However, you have no idea what your income is going to be. You could have a high-flying job and then get laid off. You may never attain the MBA salary, but it does not matter you still have that debt. The debt does not care and you have to pay it each month. The key is to keep your debt as low as possible so that when fate invariably intervenes with your income statement you can still make those payments until better economic times come back.

On to the model.

Here is the basic supply and demand curve shown along the price and quantity axis.

The government hopes by subsidizing the student loan market, which is a noble cause because having a better educated workforce not only makes for a better electorate but also is one of the only way that advanced economies can continue growth, will increase the supply of schools offering education.

However,

What we are seeing is an inducement for people to take on more education and the price rising. (This is not scaled at all, just showing the move.) So more students are getting degrees but Harvard can only hand out so many a year, thus, the cost must rise.

In truth what is happening is a little of both. Anectdotal evidence when I was obtaining my undergraduate degree at the University of Florida, the only "real" choices in the state was there or Florida State (that is if you did not get into Florida). Now, however, there are comparable educations offered at Central Florida, South Florida, there is a new university in Southwest Florida. So the state system has expanded to accept more students but prices have still risen. So the way I see it, I would model it like this...

How do I know this is correct? Here is the student population for each year of undergraduates and graduates.

You can see that even though prices have gone up by about roughly 60% the undergraduate population has grown by 238.36% and the population of the graduate students has risen 322.46%. Except for the total US population has grown over time as well, so we would need to control for that as well.

So the number belie Mr Holloway's argument and augment mine. Yes, prices have risen but the median salary for college educated workers has risen as well. The population is better off than it was before. The aggregate numbers of students has grown almost 3x as much the price difference meaning that higher learning schools are responding to the inducement to take on more students via financial aid, but it also shows that the demand is rising as well because of the government's program.

As I stated above and in other posts there are only a few "things" in an economy that can improve GDP and the standard of living for a country. For advanced countries there are even less because they will have already exhausted some of their natural resources and fully employed their labor. The last main way to better itself is through technology inlcuding the advancement of knowledge to have a better trained work force that is more productive.

While any program can invariably be run better; the Federal Student loan program has been a success on the whole for students have made use of it.

I hope this is not affirmation bias...

2009-10-29T15:52:00.002-04:00

This discussion follows up nicely with Rosenberg's piece from earlier.

Employment: Some slides

2009-10-29T14:39:00.004-04:00

Brad DeLong with no commentary provides these slides on his website.

This is what happens when you find a stranger in the Alps

2009-10-29T14:28:00.001-04:00

Google announces a GPS system and down goes Garmin and Tom Tom.

A Gold Idea

2009-10-29T10:38:00.005-04:00

Source Tudor Management

This is a chart that shows the market cap of gold in relation to the global money supply [blue](proxied by M2 of the G-20) and the US money supply [orange.] So relatively the metal is still cheap, even despite it's recent run up.

I took a long position in it in mid-December 2008 and feel it will be a good hedge until we (the market) can determine the austerity of the monetary/fiscal/political regimes in place around the globe. For a quick example of my dire view of the regimes here is David Rosenberg commenting on the US,

CASH FOR CLUNKERS CLUNKED
The government thought it could buy some time with this gimmick but of the 690,000 units that got sold, only 125,000 or less than 20% were truly incremental buying (according to Edmunds.com). In other word, the payback on future sales performance is going to be significant. Instead of wasting time and money trying to prevent households from kicking the spending and borrowing habit, shouldn’t the government be concentrating on helping the population save for retirement; helping the youth solve this 20%+ unemployment rate; finding ways in the fiscal system to promote growth in the capital stock, and improve skills and productivity enhancement?

That fact that equity markets are anal over whether an $8,000 tax credit for first-time buyers is extended or not should not be the focus of policymakers because this subsidy does not address the real fundamental problems in the economy, which is a defunct credit system, a jobs crisis, an massive overhang of vacant homes, apartments, shopping malls and office buildings — not to mention an economy that is becoming dangerously addicted to government
stimulus. As an example of what the government can do without adding further to what is already a burdensome debt load is to reverse the dramatic downtrend in skilled-worker immigration flows (have a look at the front page of the WSJ — slump Sinks Visa Program). Part of the problem — “the anti-immigrant tide in Washington.”

We see on page 2 of the FT, that the Obama team is now contemplating tax credits for new jobs created by companies — a gimmick that Jimmy Carter tried in the late 1970s (if we recall, two recessions followed quickly thereafter). But are companies really lacking in cash right now? Is that why they are not hiring, or is it a subdued and generally uncertain economic outlook? Or the fact that bank credit is contracting at a 15% annual rate and impairing the small business
sector’s ability to secure working capital. Or maybe domestic demand is just plain soft, notwithstanding a brief Q3 bump. A company may well use a tax credit from Uncle Sam to hire a worker, but if business is slow, what is the new worker going to do? File papers? Clip booklets? How does that add to productivity growth? The country needs a job and skills strategy for the future and here we have politicians still pulling out tired gimmicks from failed
presidencies. No wonder confidence is as low as it is.

We may seem overly critical, but if all this fiscal short-termism is what we can expect out of the Washington economic brain trust, then the prospect for a durable economic recovery and the transition to the next sustainable expansion will prove even more elusive than we currently think. The deficit is already 10% of GDP and government debt as a share of GDP is quickly approaching the 100% milestone. The budget plan for the future, at this point, has to be
carefully thought out because we are running out of fiscal bullets.

A Good idea

2009-10-29T09:48:00.003-04:00

The House has released its proposal for financial regulatory reform. While some of it is dicey, including the Resolution Fund (it charges fees to the surviving firms to pay for the failed firm) and also the wind down provision specifically excludes secured bond holders. All in all it is rather vague, which given the history means the regulators will have the tools but not the will to enforce the law.

This particular section though, was pretty spot on in regards to securitization.
Credit Risk Retention

Directs the federal banking regulators and the Securities and Exchange Commission to jointly write rules to require creditors to retain 10 percent or more, of the credit risk associated with any loans that are transferred or sold including for the purpose of securitization. Regulators can adjust the level of risk retention above or below 10 percent, but not lower than 5 percent. In the case of the securitization of assets that are not originated by creditors, the regulators will require the securitizer to retain the credit risk.

I have thought all along that the originate-to-distribute model was flawed because it favored applying teaser rates to allow the borrower to make the minimum amount of payments necessary to then sell their loan asset into the securitized pool. It will be interesting to see, again the wording is vague, how this portion gets hammered out. It's one thing if the pools, is just that a pool which pays out regular cash flows. However, if the pool is tranched so that i-bank can create super senior tranches all the way down to the equity tranche, then what portion will the originator have to keep. Would it be just the equity portion which suffers first loss or will it be a portion of each tranche? (If you have no idea what I am talking about with tranching please click here for a primer.)

Source

Correlation, correlation but where art thou causation

2009-10-28T19:35:00.006-04:00

This chart is produced from a data set kept by Yale and Robert Shiller. It shows the 10 year price earning ratio in a scatter chart plotted against the actual 10 year return.

It looks like it could be follow a logarithmic or power law function, and is definitely not linear.

However, we can see that as the PE level is lower the returns are higher. So I made another chart just showing the different levels of PE <5,>25. Here it is.

So while each section has a considerable range between its high and low points, you see lower highs and lower lows as you move from left to right. So this Shiller might be on to something.

Currently Mr. Shiller's has us at 19.48, at the market low in March we briefly nuzzled 13.32 so in the 6 month expansion we have seen the multiple increase by 6x!!!

Last chart

So you can see the bubbles like in 1929 and 2000 were all caused by multiple expansion, as they correlate tightly in those periods. However, in more recent times (2003 - 2007) you can see that earnings kept growing while the price of the index rose in accordance [the P/E line is flat while the red index line moves upward] Finally, as I stated above this last move seems to be all about the multiple expansion as opposed to real growth prospects.

I'd be happy to keep up momentum trading for awhile, even after this week's set back but I think we will test the 750 level again before the Great Recession is over.

Life as a Consumer

2009-10-28T14:16:00.004-04:00

Yuppie 911 is a darkly amusing side effect of our lives as a consumer.

The Grand Canyon's Royal Arch loop, the National Park Service warns, "has a million ways to get into serious trouble" for those lacking skill and good judgment. One evening the fathers-and-sons team activated their beacon when they ran out of water.

Rescuers, who did not know the nature of the call, could not launch the helicopter until morning. When the rescuers arrived, the group had found a stream and declined help.

That night, they activated the emergency beacon again. This time the Arizona Department of Public Safety helicopter, which has night vision capabilities, launched into emergency mode.

When rescuers found them, the hikers were worried they might become dehydrated because the water they found tasted salty. They declined an evacuation, and the crew left water.

The following morning the group called for help again. This time, according to a park service report, rescuers took them out and cited the leader for "creating a hazardous condition" for the rescue teams.

Just goes to show, that as emergency services become accessible it needs to have consequences just like 911. Prank calls to 911 can result in arrest and fines, therefore it would make sense to apply those same rules and punishments to calls to rescue services. As a benevolent dictator, I would first outlaw the beacons. The emergency service provider cannot speak with the signaler, so there is no way of knowing what the emergency is or how critical the situation is, thus they are inherently dangerous and expensive tools. Then once the service is set up via sat-phones or regular cellular phones let calls for rescues because of "salty water" be faced with fines and repayments of the cost of rescue personnel and equipment.

Basically, these signaling devices have removed the fear that you can get into trouble in the wilderness, so that people take risks that they might not take if they did not have the safety device. It is what an economist might call a moral hazard. Another interesting take is called the Tullock effect.

Strategic Non-Foreclosure

2009-10-28T13:19:00.000-04:00

Just saw this! Pretty strong affirmation of my post "Lifecycle of Bad Mortgages Surprisingly Uncorrelated"

Strategic Non-Foreclosure: "

This morning, we discussed Strategic Mortgage Default. This afternoon, let’s look at Strategic Non-Foreclosure.

Data via LPS‘ Monthly Mortgage Monitor shows a growing disparity between delinquencies and foreclosure starts. In other words, as more people fall behind on their mortgages, banks are becoming increasingly leery of putting them into foreclosure.

LPS calls this “Shadow Foreclosure Inventory” – The number of loans deteriorating further into delinquent status is more than twice the volume of foreclosure starts.

Why would they wait? Some of it is voluntary foreclosure abatement, some mortgage mod delays. Yet the chart below implies something beyond that. Perhaps its strategic.

Consider: The bank may have other (more expensive?) local properties that would be effected by a foreclosure. They may be waiting for a more advantageous time of year to put the homes up for sale. But I suspect the biggest reason are costs: Until foreclosure, the nominal owner remains liable for all state, real estate and local school taxes. Plus, some localities require regular maintenance (mow yard, clean street, shovel sidewalk, etc.)

Hence, not foreclosing not only gives the owner time to get current, but may also prevent the bank from accruing expenses . . .

Here is LPS chart:

>

click for larger graph

Data as of September 30, 2009 Month-end

As Annaly Salvos notes:

“As the graph illustrates, delinquencies are rising, but foreclosure starts are not. As of September 2009, 90+deterioration more than doubled actual foreclosure starts. LPS has dubbed this “shadow foreclosure inventory.” Higher unemployment begets delinquencies and defaults, but foreclosures aren’t flowing through due to modification efforts and various moratoria. Depending on the success of programs like HAMP, more than a few of these loans are still destined for foreclosure.”

Good stuff.

Hat tip Scott F!

Sources:

September 2009 Mortgage Performance Observations

LPS Mortgage Monitor, October 15, 2009

http://www.lpsvcs.com/NewsRoom/IndustryData/Documents/10-2009%20Mortgage%20Monitor/LPS%20Mortgage%20Monitor%20Sep09.pdf

Who Knows What Evil Lurks In The Hearts of Men?

Annaly Salvos

October 27th, 2009

http://www.annaly.com/blog/?p=659

Serial Inventory Growth (Home Edition)

2009-10-27T18:52:00.004-04:00

I live to read David Rosenberg's daily missives, so you can imagine my disappointment on Thursday when he said he was not going to be posting one on Friday morning. Well, he made up for it in spades on Monday.

I just wanted to highlight one section though he sent a 16 pager and it is about a topic that I have been fascinated by, housing inventory.

David presents this as his ultimate rebuff of the NAR's exciting existing home sales report on Monday. Along with this musing "which dragged the months’ supply to 7.8 from 9.3 in July and August and the 11.3 months’ peak in April 2008. This may seem like a great level, but keep in
mind that during more normal market conditions, the average months’ supply is between 4.5 and 5.0 months. However, this could be the calm before the storm as first-time homebuyers rush into the housing market to take advantage of the $8,000 tax credit that is about to expire that the end of November. According to the National Association of Realtors, this is indeed what is happening – “first- time home buyers accounted for more than 45% of home sales during the past year…”

David points out that Census bureau keeps track of year round vacant housing units, which is currently at 3.5 million homes. Additionally, 300,000 homes are being foreclosed on each month. So instead of looking at the drop of month's supply of housing from 9.3 to 7.8, what we really have is 15 months, and growing, supply of homes. Ouch!

Looks like I will be a serial renter for awhile longer.

AD & AS in concert and in dischord

2009-10-27T10:11:00.013-04:00

Shifts in Aggregate Demand
First, we begin with a chart.

This chart shows the Aggregate Demand (AD) curve, the Aggregate Supply (AS) curve and the Long Run Aggregate Supply (LRAS) curve. Currently, it is in equilibrium with the price level at the natural rate of output of the economy. From our previous posts, we know that the AS and AD curves can shift, which will cause short term fluctuations in the economy. Now we can use this model to explore why things happen, like they did in 2007 and 2008.

So let's examine the recent crisis, more closely. In a nutshell, loans were given to bad credit risks with little to no documentation because in the originate to distribute model, the borrower would only need to meet a minimum amount of payments before the loans could be sold to investors. Investors, relying on the advice of credit rating agencies, believed that the securitized pools offered superior returns for the high credit ratings and bought these investments. After, it was revealed that most of these investments were, when the tide rolled out swimming naked. This caused people to stop consuming and start saving as their financial asset portfolio and housing investments were no longer worth as much as was believed. Thus, the chart.

Here you can see that AD curve shifts downward [to the left] to a new equilibrium in the short run but that there is an output gap between what the economy can normally produce. We saw this when looking at the CBO's GDP projections, shown here.

You can picture that the gap between the actual GDP in black and the thinner natural output line is the same in the chart above where it is shown the gap between short run equilibrium and its gap from the darker red line which indicates the natural output of the economy. Eventually, [shown below] the gap will close again just like in the CBO's projections.

Here the output gap is closed by the short term AS curve adjusting to the new pricing paradigm as the veil of prices is lifted. Stated another way, as the costs of goods/services decline workers will not need as great a wage to maintain their standard of living. The workers will then return to work at the new lower wage and capacity in the economy will return to normal.

All of the above assumes that policymakers do nothing. That is, if they followed an Austrian School of Thought, that any policy will invariably make matters worse and instead the free market should be allowed to work to clear prices. Instead, what usually happens, is that policymakers tend to use fiscal and monetary stimulus to stop the process at price equilibrium 2 and return it to price equilibrium 1.

Again, usually, the Federal Reserve will act first to loosen the money supply, which through the financial system will drop interest rates making it more attractive to buy capital goods via financing and will make business opportunities more attractive. If this does not work, then in concert, the fiscal authorities can undertake stimulus by borrowing when the private sector will not, to invest in capital goods. This should have a multiplier effect in that companies hired by the government will then give money to their employees who then spend it on consumption ... until economic growth ensues.

Shifts in Aggregate Supply
This usually comes about in changes in the cost of production to firms. There is some interesting work done by Professor Jim Hamilton in this area with regards to oil and the global economy, a post is here, so we will run with it. In his post, he uses econometrics to describe the global economy and its growth from 2004 to 2008. He shows that the price of oil could have risen to 142 dollars per barrel on fundamentals alone. This cost shock affects many areas of the economy because oil is not only used to transport so many goods around the globe but it literally makes up goods as well.

Some examples, products that contain petroleum that could be affected by oil prices: Antiseptics, Baby strollers, Balloons, Bandages, Cameras, Candles, Clothing, CDs and DVDs, Computers, Crayons, Dentures, Deodorant, Diapers, Food preservatives, Garbage bags, Glue, Hair dryers, Ink, Insecticides, Medical equipment, Nylon rope, Pacemakers, Photographs, Roofing, Shampoo, Shaving cream, Soft contact lenses, Telephones, Toothpaste, Toys, Vitamin capsules. Source: Ohio Petroleum Council

So the tripling of oil prices would shift the AS curve to the left, which is to state that the cost of production is higher at any price level. This causes an output gap and perhaps even more perversely, prices rise. As shown in the chart below.

We can see this in actual practice by looking at a chart from Dr. Hamilton.

Here the natural rate of output is the green dotted line and the back line is the actual. You can see that the professor's model does an accurate job of describing the oil shock and its affect on GDP.

So now what happens. Well a couple of things can happen:

The natural rate of output of the economy could fall permanently, this would shift the dark red LR AS curve to the left to meet the new price point.

Alternatively, the government can stoke AD curve [via the same mechanisms described above] so that the equilibrium rises to the natural rate of output again but at the cost of permanently higher cost of goods/services.

Finally, the sticky wage theory would propose a scenario like this: because the economy is stagnating but at the same time shows inflation, herein called stagflation, the workers will see their cost of living declining and demand higher wages to compensate them. Firms will lose more money as the cost of goods/services (inputs) continue to rise, called the wage-price spiral. Eventually, the under-utilization (output gap) though will cause more workers to be unemployed. Unemployed workers will work for less thus dropping the costs to firms and make it more profitable to produce more goods. Eventually you return to the original price equilibrium 1.

Economic Odds and Ends

2009-10-27T09:19:00.005-04:00

Great chart from Calculated Risk

I had looked at this earlier with total borrowing but this chart focuses solely on the mortgage market. Here you can see how securitization really takes hold at the end of 2004 through 2006, somewhere in the order of 40% of the market. Since then there was a switch into bank portfolio loans as the securitizations came onto the bank's balance sheets, and finally the current state where the GSEs (Frannie and Ginnie) now make up 90+% of the market.

Good annotated chart from Mish Shedlock

Here you can clearly see the dichotomy of the recessions pre-1982 and post and it is a tale of two eras. Job recoveries have always been a "lagging indicator," but I wonder now if NBER calls the end of the recession too soon [queue conspiracy theorists "Nothing to see here. Move along."] So the recession of the 90's and the twin killings in the 2000's have both had job losses continue into the recovery. We should expect that job losses will continue into 2010 and possible 2011, most likely with an upper limit of over 10.5%, that is on the U-3 number. If you look at the broader unemployment situation ( underemployed, discouraged, part time, etc) we are already nearing the 20% mark.

Serial Solipsism

2009-10-27T09:10:00.002-04:00

Not too long after watching The Century of the Self along comes a new take, in a different field, presenting the same symptoms that the documentary does. In the first paragraph the author has you imagine other people and their pain; how it does not bother you. However, if you were one of the people in pain then it would become significant. Thus, your own pleasure and pain are more significant to you than anyone else. You are egocentric, you are a consumer, who votes and buys what is best for yourself; which leaves the task of squaring our recurring self-interest with the common good, day after day.

Caspar Hare would like you to try a thought experiment. Consider that 100,000 people around the world tomorrow will suffer epileptic seizures. "That probably doesn't trouble you tremendously," says Hare, an associate professor in MIT's Department of Linguistics and Philosophy.

Now imagine that one those 100,000 people will be you. "In that case you probably would be troubled," observes Hare, speaking in his office. If this is your reaction, he says, "You regard you own pleasures and pains as being especially significant." Which seems natural, Hare adds. "We have a tendency to think that what we care about is important in and of itself."

Yet this tendency creates an apparent inconsistency. You cannot claim your own well-being is uniquely meaningful, more important than the well-being of others, and expect anyone else to regard that notion as an objective fact, something that could be part of a universally acceptable morality.

How should we reconcile these differing perspectives? In recent decades, many philosophers have dismissed our self-interest as a kind of illusion. Indeed, a major current of contemporary thinking has questioned whether a stable "self" exists at all. "We are not what we believe," the British philosopher Derek Parfit has written. Rather, this view holds, we are nothing more than ever-shifting collections of mental and physiological states, lacking a definite, lasting identity.

The joy of solipsism

Hare has leaped into this philosophical fray with a distinctly different view, which he outlines in his new book, "On Myself, and Other, Less Important Subjects," published this fall by Princeton University Press. The fact that we care so much about ourselves, Hare thinks, tells us something deep about the world: It is correct after all, he believes, to regard our pleasures and pains as uniquely important among all pleasures and pains in the universe.

So if we think our self-interest is singularly significant, we are not being fooled. Instead, the fact that we know ourselves best reinforces our sense of individuality over time; we do have stable identities, and our minds are more than a shifting kaleidoscope of impressions. Our ability to make moral judgments flows from this fact.

On the other hand, Hare asserts, our minds are independent enough from the rest of the world that, when other people state their pleasures and pains are present, we should not regard their statements as true. Instead, Hare writes, we should regard those claims as "false, but rightly so."

In so arguing, Hare is reviving the philosophical concept of solipsism — the notion that one's own self has a special status in the world. More specifically, Hare claims in his book that we exist in a mildly solipsistic state he calls "egocentric presentism." To make sound moral judgments despite this condition, Hare asserts, just takes an act of imagination.

Thus Hare states that of course he would rather that he suffer a hangnail than that someone else's leg be crushed, even knowing the other person's pain would not be present. "For an egocentric presentist," writes Hare, "empathizing with an unfortunate [person] involves imagining that the unfortunate has present experiences."

Other philosophers note that Hare's ideas appear counterintuitive. "The argument seems controversial on the surface because it goes against common sense," says Berit Brogaard, an associate professor of philosophy at the Australian National University and the University of Missouri, St. Louis. "There is something eyebrow-raising about it," says Benj Hellie, an associate professor of philosophy at the University of Toronto.

Hare, however, does not think his own theory is radical. "One way to be a solipsist is to insist that other people don't have inner lives," explains Hare. "Another is that there are no other people. But I'm not saying either of these things. I'm not denying that other people exist, are fully conscious, and have brains and minds like my own."

Is universal morality possible?

For this reason, asserts Hare, solipsism need not lead us down a slippery slope into a world where, say, violence toward others could be tolerated. "Even if we give special significance to our own pleasures and pains," says Hare, "we don't go about ruthlessly trying to maximize our own pleasure and others' pain." He calls that "a crude caricature of human psychology," popularized by the 17th-century English philosopher Thomas Hobbes.

We may be self-centered, Hare argues, but not solely moved by self-interest: "It's certainly possible to think your self-interest is important without thinking it's the most important thing in the world." Still, Brogaard, for one, thinks Hare's ideas "are even more extreme" than Hare believes they are. By accepting that we are solipsistic, she believes, we may sacrifice the idea that there is an objective universal morality.

If so, the modestly solipsistic state Hare describes — in which we are still social and moral creatures — represents a trade-off. We may lose our ability to define an objective moral system. But we do have stable selves that can craft moral judgments. "My book is putting perspectival questions back into the ontology, into our picture of the way the world is," says Hare.

That still leaves the task of squaring our recurring self-interest with the common good, day after day. But that is at least a task for which we can each take responsibility, as distinct selves. "Caspar is pointing to a problem we have to come to terms with," says Hellie.

Aggreagte Supply

2009-10-26T17:08:00.007-04:00

Back on the 14th I began working on short run models of the economy. The first post focused on Aggregate Demand, now I will continue on to aggregate supply and finally I will work with them to create an equilibrium.

Like the AD line, the AS line tells you how much good/services an economy will provide across the pricing continuum. Most economist believe that in the long run the AS curve is vertical in the long run. This is because it is based upon the natural resources of a country, its capital, its labor and its technology. It relies on these inputs to create output goods & services. Thus, pricing will not really have an effect "in the long run" on what an economy produces. This is because prices are a nominal feature of the economy, if you took two countries with identical economies except A had 3x as much money in circulation as B, then the prices of goods in country A would be three times more expensive but both economies would produce the same amount of output.
However, in the short run the veil of prices may allow for economic fluctuations, which is what this post focuses on.

Here is the chart of the economy in the long run. If the pricing level rises or falls it should not effect the long run output of the economy. However, we might ask what can shift the AS left or right?

Above we mentioned natural resources of a country, its capital, its labor and its technology as factors that can affect the LR AS curve, so we should look at these variables in turn.

Natural Resources -not as big an effect on the US at this point, but it is very important for say Mongolia. Basically, as new mineral deposits are found this will shift the curve outward; dwindling reserves, if that happened in Saudi Arabia, would have the opposite effect of shifting AS down.
Capital - factories, machines, houses, worker knowledge. Any effect on these variables will affect the LR AS, and it is a perfect correlation. A storm that permanently disables a factory would shift the LR AS curve down, left.
Labor - Again a perfect correlation, additions add to the AS curve and subtractions remove from it. If a plague attacks the citizens of France, the loss of workers would shift the AS curve downward [left] as France would no longer be able to produce as much as it had in the past.
Technology - additions to technological knowledge will make processes more efficient. This is what has enabled crop yields to double from 1950 to 1980 and triple by 2008. The addition of technology adds to the LR AS curve.

Next, we can see how an economy shifts around in the long run.

As the economy adds technology, workers and capital its LR supply curve shifts outward. Holding everything else equal (ceteris paribus) this will cause prices to decline. [Right chart] However, the Federal Reserve mandate is to maintain price stability, so it will be increasing the monetary supply so that aggregate demand increases in accord with shifts in the AS curve. So in the second graph, we show the secondary effect in red arrows as the Fed adds money to keep prices stable at P1* and P3*.

We can also more importantly view the AS curve in the short term, which is why we have undertaken this post. Economists believe that the supply curve slopes upward (from bottom right to upper left) so that the quantity of goods/services supplied increases with increases in the price level. The theory underpinning this idea, at least the one I subscribe to, is called sticky-wage theory. The idea, is that wages do not adjust to changing economic environments as quickly as the price of other goods/services. One aspect may be contracts, like union contracts, and another might be that firms rarely drop wages and instead tend to lay off workers.

So you can imagine a company that pays it's worker 20 cents for each good it makes, which costs 1 dollar total including the wage. In the upcoming year the price level falls so that the firm receives on average 95 cents. It cannot asks its workers to take the 5% cut in their wages, so it must suffer. Now the company is less profitable, so it may lay off workers and cut capacity. Over time wages will match the new price level but in the meanwhile employment and production remain below its optimal level. Sound familiar workforce 2008?

Thus, you can see since price level has decreased the factory will provide less goods. This of course works in the reverse, if the price level is higher the firm will higher more workers and create more goods.

There are some other theories as well including menu costs (this posits that it takes time for suppliers of goods/services to communicate changes of prices to their customers, like changing the menu board at a fast food restaurant) and mis-perceptions theory (this posits something like gasoline prices at the pump in 2008, when you see those numbers rolling like a slot machine once a week, you think that all prices are rising.) Thus, they conclude that they need to ask more for wages or increase the amount of goods they supply at their job. Both these theories explore why the curve slopes upward.

Now we can ask why the short run AS curve might shift. All three theories should give you some idea that the key in the short run is expectations. If the price level is different than what is expected than the supply curve can either shift outward (gasoline prices rising) or inward based upon what the consumers think that price level will be.

BusinessWeek, I love and despise you

2009-10-26T13:07:00.004-04:00

New economic article by BusinessWeek talks about how bottlenecks could cause inflation. Ostensibly a "economic bottleneck" follows the same logic as water through a pipe. It would be limited by the exit of each section of the pipe. If there are not enough factories, or steel or workers than firms will not be able to respond to increased demand. Thus, prices will rise in a short period to allow the market to clear.

Seems plausible, the author even cites James Bullard, President of the St. Louis Federal Reserve Bank in which he points to the stagflation period after the recession in 1974. He states that the Fed at the time overestimated the productive capacity of the economy and inflation resulted until Mr. Volcker killed it in the early 1980s.

Three charts in retort.

This is duration of median unemployment hitting all time highs. These are workers who have not had work in almost 6 months. You think their demands for pay will be higher or lower than that of the workers in the 1975 who had been out of work for 3 months?

Here is the employment-to-population graph. You can see we have a lot of room to fall to hit the level of jobs related to the entire population that we experienced in the 1975 recession.

Finally, you can see here that unemployment rate is also higher than that of the 1970s, also showing that inflationary fears are very dim.

Now the article does take a balanced view of the economic environment. The author still feels that deflation is the bigger threat at this point, but that inflation always needs to be watched. While I can agree with the sentiment, I find it very dull to be espousing this information in this manner to the non-economic audience reading Businessweek. It is a very nuanced argument that needs to be made, just like the one Bullard made that the article cites.

What the Fed is doing is telegraphing its actions for when it actually defeats deflation. There are methods in which it stops buying Treasury securities, where it stops repo'ing [very short term loans to i-banks] collateral, where it stops buying MBS, stops buying Frannie paper and removes reserves from banks by changing the amount of interest it credits to banks. This will remove the monetary stimulus from the economy very quickly, if needs to be, but can also be done at the margin, like a Father guiding the handlebars on his child's bicycle.

Given the last paragraph, I find it very disenginous to discuss inflation to an audience that does not understand what the Fed has done, and is going to do. BW should be cheering on the Federal Reserve and hoping for inflation because deflation is far, far worse.

Barry!

2009-10-25T20:32:00.005-04:00

I was going to do a post on Existing Home Sales and how they were not up except in a bizarro world. Barry not only got off a rant but then backed it up with another post explaining why his rant was correct. I recommend both of them.

So I'll just put up Calculated Risk's chart of the action.

These are non-seasonally adjusted. CR likes to use the previous 5 years of data for each of the month so you can make a comparison. The thinking is something along the line of month-on-month growth may not tell the whole story because there are underlying reasons why September sales are always lower than August. [It's because people have to move before school year starts to have their children start on time.] Here we can see sales were up year-on-year, which is a positive. However the headline Big Rebound in Existing-Home Sales Shows First-Time Buyer Momentum belies the fact sales actually dropped from August. Also as TBP reports the tax credit is also extending the sales season as buyers are motivated to close before the November deadline. NAR though has skin in the game in distorting the data in a manner which looks the most beneficial to them like Edward Bernays script tells them to do.

Finally, one last idea on existing home sales (EHS) effect on the economy; it is not that big. It is most certainly not as big as a new home sale. A new home sale has raw materials being turned into a sale. EHS are secondary market activity, akin to equities, it just shifts money from one party to another. If the previous owner made renovations and upgraded the home than their is an addition to the capital stock of housing but secondary markets of themselves add little to the economy. [commissions, etc]

Serial Drivel: Someone new to take over for James C Cooper

2009-10-22T12:51:00.009-04:00

I stumbled upon this post from Real Clear Markets via ZeroHedge. A quick aside: I have a love hate relationship with ZeroHedge. They produce some great research but they also engage in yellow journalism without real well thought out analysis as well. A la Hearst, this drives a lot of people to their website. For now the balance is well on the former but this link to RCM was clearly the latter.

The author of this piece is John Tamny. It took some extensive searching to find out who the author is. His signature says he is an economic adviser to two companies but not recognizing the companies, please forgive my ignorance, I continued looking about the intertubes. I found this:
Prior to his present work, Mr. Tamny worked at the Cato Institute, and before that in private wealth management for Credit Suisse and Goldman Sachs. Mr. Tamny received a BA in Government from the University of Texas at Austin, and an MBA from Vanderbilt University's Owen Graduate School of Management. He lives in Washington, D.C.

Now I have an MBA, so I definitely understand the value of the degree, but putting up an MBA grad with a Government undergrad versus a Nobel Prize winning economist, well... maybe he will be agreeing with Mr. Krugman.

1st the headline has Paul Krugman's name and the word myth. This immediately sends off warning bells in my head. I generally follow on economic matters, (not so much political)
Brad DeLong’s Krugman rule:

Rule #1. Paul Krugman is always right.
Rule #2. If you think Paul Krugman is wrong, see Rule #1

Here is an excerpt from the article.
As Krugman put it in the New York Times, "The truth is that the falling dollar is good news." Krugman's reasoning here is that a weak dollar makes it easier for U.S. companies to export. A nice thought at first glance, but what Krugman ignores is that we can't export unless we're importing, and a weak dollar makes imports more expensive. Trade always balances.

Supposedly, according to John's logic, trade always balances. He seems to posit that imports and exports form an identity, similarly to the idea that National Savings must equal Investment and Net Capital Outflow. I couldn't find any literature anywhere that states this is so, perhaps it is a black swan.

Let's examine this a little further. Let's imagine a steel conglomerate who mines its own ore, processes it and then sells it to the highest bidder. A falling dollar makes this conglomerate's goods cheaper. It sells the goods in the export market and then has euros, or yen in exchange. Now here is where John's logic may come into play. Since it has the yen, it then needs to decide whether to purchase something from Japan or sell the yen to gain dollars which it can pay its employees. The latter is where the fungible nature of money comes into play. However, it seems John believes that it can only be the former. I wonder if he has a model or a chart to back up his assertion.

Back to the article: So while a weak dollar might in the near-term make U.S. goods attractive, the globalization of production means that the costs of the myriad imported inputs that go into the creation of U.S. goods will eventually have to rise. Inflation steals the benefits of devaluation...

So I took the change in dollar's nominal exchange rate and compared it to inflation (computed via CPI) in the United States to see if I could come up with a correlation.

There is a very weak correlation of +0.2, meaning that it can explain 20% of the variation. However, it is in the wrong direction. The plus sign indicates that as the dollar's value increases then inflation occurs, and when it devalues this becomes disinflationary. That cannot be correct, right?

Let's look at a common way to gauge commodity price inflation versus the dollar via oil prices.

Very interesting. Correlation= 0.3. This means that as oil induced inflation was striking the globe the dollar rose to counteract the effects of inflation. From 1973 to 1999 as the oil rose in price so did the dollar, the story at the time was that Europeans and Asians would have to bid up dollars to make their oil purchases. . Seems plausible.

From 2000 to 2008 the correlation rose in reverse -0.8. So as oil price has risen the dollar has fallen in value. Now it is in reverse from the previous period. Although, ostensibly the mechanism has not changed, these same areas of the world are not bidding up the dollar to make their oil purchases. So which is it? Not much can be ascertained.

So let us look somewhere else. Perhaps China, we import a lot from them, right?

In the Blue we have the US$/Yuan and the red line is the price level for imports from China. So we have a 21% rise appreciation of the yuan [restated a 21% devaluation of the dollar] from 2004 to 2007 to a 7% appreciation of the price level. Then the Yuan stopped appreciating, and yet even though apples-to-apples same yuan as the exchange rate hold steady due to their sterilization of dollar purchases, the price level fell making the total change in import price level from 2004 to 2009 3%. 21% devaluation equals 3% rise in prices.

If you accept this argument it seems to be a devaluation brings about a very, very slight increase in prices for Americans including American exporters.

As my friend Walter Sobchak said "Donny, you are out of your element."

John then transgresses into how this import induced inflation affects all manners of the US financial and capitalistic system. He makes a litany of errors confusing real and nominal prices, what capital is and is not, what investment is and is not and finally what saving is and is not. However, you can stop reading because as it has been made abundantly clearly in this essay the foundation John rests his argument upon is made up not only of sand, but quicksand at that.

If there is anything you should take away from today it is this:
Rule #1. Paul Krugman is always right.
Rule #2. If you think Paul Krugman is wrong, see Rule #1

Oh and if you are interested, while I was searching for John's credentials I found these nuggets of wisdom that may make you avoid his opinion. (All were found on the 1st page of Google's search results for his name.)

Lifecycle of bad mortgages, surprisingly uncorrelated

2009-10-22T10:12:00.007-04:00

I found this chart at Barry Ritholtz serially excellent website The Big Picture and of course it made me think, a lot.

At first I was just watching the categories swell up as people who took on debt they could not really afford just could not make the monthly payments any more. Then, I wondered about people who just stopped paying once they realized that the house was worth less than the mortgage contract they were paying for it.

Then I realized something else, that the categories are a function of time as well. First there are the thirty days late, which eventually leads to 60 days late, then 90+ days late [that plus sign will be key], then into foreclosure and finally real estate owned [bank owned.]

Now, of course, one category does not guarantee a transition to the following category. One could have a medical emergency, need the cash for a surgery and then hover in 30 day late category. However, there should still be an amount of correlation for the categories. As the 30 days late category rises, so too should the 60 day category and 90 day. In fact as the arrows show all categories do show a positive slope.

In fact, one should expect to see a pig-in-the-python effect. Look at the graph below, a demographic graph of the United States population, and imagine it on its side.
For some reason I cannot animate it. Please click here to see the chart move.

Imagine the 30 days late are the baby boomers. You can see the large effect [pig] they have as they move from the head to the rear of the distribution [python.] We should see the same for the mortgages. Not a perfect correlation because as I said above there are ways to save yourself from the foreclosure route. But...

Instead what I see is really a throughput problem. Let's look at the graph again with some new arrows.

As you can now see I simplified to just two arrows, 30 days late and 90+ days late. I discounted the seemingly aberrational June month for 30 days late. I then started the arrow for 90+ days late at a lag of 4 months because obviously these mortgages would pick up only after the initial delay in payment. What is happening is that the 30 and 60 day loans are making it to 90+ days and then sitting there. Slowly, the foreclosure and REO process is picking up but those two steps are slowing the assembly line down.

So the key issue for investors to consider is the plus. If you are going out an looking for a house right now, you must be cognizant that the banks own tons of houses that are in the 90+ day delinquent status and would be foreclosed upon except the banks do not have the manpower or willpower to further the process. Additionally the 30 day late loans are still rising meaning that even more houses have yet to find the pool of 90+ days late. If the house you are looking at has multiple bidders I would walk away, especially if they are bidding with cash.

Recovery

2009-10-21T17:03:00.003-04:00

David Rosenberg of Gluskin Sheff has been railing against the markets expecting a V-shaped recovery. So I went to the CBO to see what a V-shaped recovery would look like and it is below.

Basically from where we are at we would follow the red arrow and see growth rates of over 6.4% to return the economy back to its trend.

Here is where the document is a little suspect as it predicts the return to trend within 5 years which seems to be, um, a tad, convenient. I guess my argument would be more with the angle of the L.

Regardless, the CBO still sees an L-shaped recovery.

So what does the equity market know from reading the economic reports that the CBO does not know?

Personal Savings Rate

2009-10-21T16:26:00.004-04:00

I have found it an amusing example of not seeing the forest from the trees. I have heard pundits arguing about where the personal savings rate will move from here. Then I see a chart similar to this proposed.

So it is easy to see that savings rate has jumped but will probably be back to trend soon. However, what trend is probably the most relevant idea. Here is a second chart.

So which is it? A trend of savings around in the 4% range or is it in the high single digits?

Public Relations: the Conclusion

2009-10-21T15:23:00.004-04:00

I must say that I really enjoyed the documentary and you can watch it for free courtesy of Google. [The related videos will lead you through the four parts] The question though is how is this seemingly anthropological look at public relations relevant today? For this I will outsource to David Einhorn writing in his investment newsletter. [It is a PDF]

As I see it, there are two basic problems in how we have designed our government. The first is that officials favor policies with short-term impact over those in our long-term interest because they need to be popular while they are in office and they want to be re- elected. In recent times, opinion tracking polls, the immediate reactions of focus groups, the 24/7 news cycle, the constant campaign, and the moment-to-moment obsession with the Dow Jones Industrial Average have magnified the political pressures to favor short-term solutions. Earlier this year, the political topic du jour was to debate whether the stimulus was working, before it had even been spent.

Paul Volcker was an unusual public official because he was willing to make unpopular decisions in the early ’80s and was disliked at the time. History, though, judges him kindly for the era of prosperity that followed.

Presently, Ben Bernanke and Tim Geithner have become the quintessential short-term decision makers. They explicitly “do whatever it takes” to “solve one problem at a time” and deal with the unintended consequences later. It is too soon for history to evaluate their work, because there hasn’t been time for the unintended consequences of the “do whatever it takes” decision-making to materialize.

The second weakness in our government is “concentrated benefit versus diffuse harm” also known as the problem of special interests. Decision makers help small groups who care about narrow issues and whose “special interests” invest substantial resources to be better heard through lobbying, public relations and campaign support. The special interests benefit while the associated costs and consequences are spread broadly through the rest of the population. With individuals bearing a comparatively small extra burden, they are less motivated or able to fight in Washington.

David has in four short paragraphs perfectly surmised what it took me 4 separate blog postings. I will concede, I dug further into the psychology of the transmission mechanism of psychoanlaysis being applied to the link between product and consumers and how it has evolved over time not only in that link but how politicians now use the same mechanism to connect politics[product] to voters [consumers.]

On a regular basis I read financial news and am incensed by how it is spun. I talk at length with former business school professors and we vent together. However, when I talk to some one like a parent or a colleague in the law profession, I only receive glazed over eyes.

There are two factors at work: A) information overload B) esoteric nature of the finance industry.

I have already posted at length about information overload. My money quote that I keep chanting in a mantra is: it was Herbert Simon though who posited a long time ago "...in an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it..." This is very similar to the idea that by reducing people to desires you can stop them from thinking about how policies are affecting them. Dancing with the Stars, 30Rock, Celebrity news all stop people from thinking about how they just donated 2,300 to Government Sachs and its colleagues to pay out, at Goldman alone, 23 Billion to its employees.

The esoteric nature of finance. So any normal Joe who did not graduate with a finance degree, MBA or an economics degree, is involved in her every day life that revolves not around finance, but what ever it is that pays the bills. Everyone can have an opinion on whether on not to raise taxes, or pursue certain domestic policies but not everyone will have an opinion on Negative Amortizing Interest Only Mortgages, or Collateralized Debt Obligations.

Thus, my hope is that my new arsenal of information on public relations and spin that I will be able to better engage my non-finance friends and family to better explain why the issues are important to everyone not just the people with vested interests in finance and financial policy.

Call it for what it is. It has more names than Satan. Call it plundering. Call it pillaging. Call it extortion, Call it fraud. Call it racketeering. Call it the financial raping of the middle class. Call it criminal. Consider the following. Middle class never consented to this financial rape. They vehemently protested it when the gov’t first proposed a $700 bailout of the financial system called TARP in Septermber 2008. Yet what did Congress and our government do? They went ahead and did it anyway. This boils down to one thing, taxation without representation. Our votes do not matter anymore.

Be outraged. Do not go softly into the night. Scream into the tempest. People voted in Obama for change, if you feel he has not effected it, then you must create your own.

The Waning Threat of Deflation versus Two Easy-Money Pieces

2009-10-21T12:56:00.013-04:00

I swear I had to read the latest James C Cooper piece in BusinessWeek twice just to be sure what I was reading. So I thought about doing a comparison to various academics and their current surveys of economic conditions, one was Paul Krugman's latest piece. This would provide a look to see where consensus was and where it was not, so I could gauge which argument(s) I found to have a more solid foundation.

James, an alumnus from NC State where he received his bachelors and masters degree, shows that Personal Consumption Expenditures declined from a year ago by 0.5% or 0.0005. He attributes most of this to the drop in gasoline prices. Here is the table from the BEA release.

Click to enlarge

As you can read from the chart his argument is correct. The index declined 23.7% in the energy good/services subcategory in the same time period.

However, now we can contrast this with Mr. Krugman's, with a BA from Yale in Economics followed by a PHD in Economics from MIT, evidence. He looks at the similar indicator formed from the Consumer Price Index. It also has a total value and one excluding energy and food prices because of their noted volatility. However, in this version instead of removing food and energy totally, he chooses to trim the data, that is remove the most volatile price movements to get to a "core" price movement. Here is the chart.

Click to enlarge

Here we can see the quarterly data from the 1st and 2nd quarter plus the data from September. So you can see the total annualized CPI for the three periods, in order, are: 1.5%, 3.3% and 2.0%. However, if you trim out the volatile prices, depending on the amount trimmed you usually what is basically a horizontal asymptote and those are: 2.3%, 1.0% and 0.5%, a clear downward trend. In fact if you look at James's chart it shows the same information, that both core and the more volatile are in a downward trend. So we have to separate pieces of data that suggest inflation will not be a concern moving forward.

The title of the chart even states in full caps CORE INFLATION WILL CONTINUE TO DRIFT LOWER. So rationally you could think that Mr Cooper and Mr Krugman are on the same page. "This suggests that disinflation is proceeding rapidly. And a falling inflation rate, possibly even deflation, means that a zero interest rate is less expansionary than it seems."

James, however, entitles his piece The Waning Threat of Deflation?!?!

It seems to me and anyone looking at these charts that are provided as evidence that deflation is on its way.

James bases his assertion on a few observations: inventories may have been cut too deeply along with capital spending (investment) and payrolls. He argues that inventory restocking, the actual fall of capital stock which affects the denominator in capacity utilization therefore utilization rates could increase faster in a recovery, and the fact that 6% productivity is unsustainable, thus new employees will need to be added. I would argue that the latter is the most important in James's arsenal as Consumption provides 70% of GDP, however a person cannot be a consumer without a job.

Luckily, just this morning I was reading a post by James Hamilton, a PHD and Masters in Economics from UC-Berkley, about unemployment and inflation. He found that by running a model of two year average of inflation and inflation expectation he could arrive at a very high correlation. Here is his chart.
Click to enlarge

His chart shows that inflation is still falling off a cliff and until unemployment turns, not just the stemming of jobless claims but actual growth of jobs that inflation will continue to fall. From his words, "but the forecast of the model for the average inflation rate between 2009:Q4 and 2011:Q4 is -0.5%." Again reiterating that without jobs no growth of GDP is sustainable, thus no inflation.

Finally, there is my new favorite graph. Median Duration of Unemployment. That is to say unemployment is not a bad thing per se, there is a natural creative destruction as employees from a dying industry like paper sales move to a more dynamic industry like alternative energy or health care. Unemployment is bad however when the economy cannot quickly move applicable skill sets, like sales of paper to sales of solar panels. Both require knowledge of a product and industry so they should be quick substitutes but when the economy is not doing this task people stay unemployed for long bouts of time. This, of course, impinges on growth. Let us see what the current outlook looks like.

Highest ever since it has been tracked.

The Fed has to act as training wheels for the US economy. It must support and guide the economy into growth but even as growth resumes it must not remove it stimulus too soon or relapse will occur. I do not believe Bernanke will remove stimulus until unemployment falls below 7%.

So in conclusion, I am not certain what James's article is about at all. He states that inflation will allow the Fed leeway to raise rates but does not specify how inflation will be brought about except for plausible stories without an econometric model to show how inflation will be transmitted. Merely stating that an inventory build or utilization rate climbing by decreasing the stock of capital does not guarantee sustainable growth based on an organic recovery. One of the major lessons for Bernanke as a student of the Depression was that the removal of stimulus in 1936 and 1937 caused the economy to crash in 1938. Then again James was the chief economist of the American Forest and Paper Association.

Public Realtions Part IV

2009-10-20T14:30:00.007-04:00

I thought I might piece together parts III and IV but when I reviewed my notes Part IV is the largest by far. There is a lot of ground to cover to reach the conclusion. I will also do one last post on how these ideas are affecting society today.

The most salient point from the previous post is that, "the most important thing in anyone and everyone's lives was to be fulfilled and that was all that really mattered."Of course, it was the job of capitalism to foster the fulfillment of its consumers. If we remember back to the original post though it was understood that this was merely a function of social control. Where this process takes an even more dangerous turn, and a suboptimal one at that, is when politicians use these same psychoanalytical techniques to run their campaigns.

There is a great segment when septuagenarian Edward Bernays appears on the David Letterman show and states people will believe me more if you call me doctor. Bernays initial ideas were that it was good to reach out and stroke the deep emotional yearnings of individuals to make them more confident, powerful and fearful so that they may be controlled.

Now in Great Britain Matthew Freud gave public relations a make over and it became glamorous. Mr Freud was able to engage in very similar activities that Bernays pioneered in the inter-war period. He worked to place ads in interviews with celebrities and also by "purchasing" the editorial pages of the press. The press was outraged and thought this was a corruption of their profession, but still the pages of the editorial sections were filled with pictures of products and specific mentions of the product in the text. It was a part of a sweeping changing in the UK to allow business to take over the role of government in fulfilling the needs of the people and was seen as a new and better democratic process.

Across the pond in America, Reagan was moving against against the government's role in fulfilling its people's need by targeting programs to support welfare. His pitch was that individuals did not need to throw their hard earned money away to people who did not want to work.

Both of these are examples of how focus groups were changing the game for politicians. It was now accepted that people did like to be a part of groups but also retained their individual characteristics. This individual had been trained by Corporate America to make demands for their hard earned dollars. Now with their votes these same consumers could, as they did with business, make politicians cater to their demands. The 1980s was leaving the left side of the political spectrum behind as the left's focus had always been on bettering society for all. In a very similar fashion to what Stanford Research Institute proclaimed the left in Britain was polling well on helping save the community. People openly stated in polls that they would vote for the left. Yet their self interests lay with the proposals that the conservatives were making. Ultimately, as predicted, the conservatives were with whom the voters cast their lot.

Then came the Clinton campaign. The campaign made extensive use of polling of swing voters and tailoring their message to fit their beliefs. The campaign found that voters only wished to support taxes for programs that personally benefited them, so the campaign responded with a middle class tax cut promise. This promise was going to be funded by cutting defense spending (the peace dividend) and raising taxes on the rich. Clinton won election in 1992. However, he quickly found out that the budget deficit was worse than feared and the bond market would not support additional borrowing to fund the tax cuts. The stymied executive office instead tried a new tact to lift the public by appeals to genuine ideals of society and community. Needless to say, the voters felt betrayed. In 1994 Bill Clinton's party was swept out of office in the both houses of the legislature, who ran on a platform of tax cuts funded by cutting welfare programs via the Welfare-to-Work initiative. It seemed certain that Clinton would be a one term president.

Clinton hired Dick Morris to save his "butt." Dick proposed that a transformation of politics needed to be undertaken and to treat voters like consumers, answering to their whims and fulfilling them. Surveys were sent out to identify swing voters and then personal questions were asked of the swing voters to determine their lifestyle. Policies were then enacted that would make the swing voters feel more secure in their lifestyle via "small bore" politics. Traditional issues were dropped in favor of minutiae like the v-chip or school uniforms. Also Clinton's leisure time would be spent doing activities that appealed to swing voters such as hunting or fixing up his home. This created a divide between Clinton's wonks and Dick Morris.

The wonk's argument in the White House went something like this:

What's the point if you have no mandate to be re-elected?

What's the point of having a mandate if you cannot get re-elected? Isn't the point getting re-elected?

In a show of deference to power, suburbanites were now controlling the domestic policy of the United States. However, it should be noted that this new form of democracy was pandering to the unthought about and primitive desires that satisfy individuals. It was discussed before that having people's desires be in control is not the same as having rational people in control. That this is just a guise to control the masses via their own whims.

Britain followed suit with the Tony Blair campaign. The feeling in the UK at the time was now that individuals were not exploited by the free market. Instead that the free market caters to individuals and fulfills their needs. However, this also hollows out the political channel as a means of power and leaves a larger slice of power in the hands of businesses and entrenched interests. Bernays proclaimed in his Democra-city that this new form of democracy was superior because the power was not swayed by politics or ideologies. The argument against this idea was that this was a democracy that controlled its citizens by reducing its active citizenry into passive consumers who are delivered "feel-good" treats.

It should also be noted that what works for business may not be the best manner to conduct political actions. Politics can now be described as a bewildering maze of desires because people's opinion changes at the drop of a hat just like in business, "the (product) market had forever changed from needs-based to a market of unlimited and ever changing desires."Fine, that is why there is Adidas, Reebox, New Balance, Nike, etc. However, for politicians there is no way to plan an agenda because the dynamic changes drastically and schizophrenically. An example of this was the railroads in Great Britain. During a campaign people were polled as to how important this issue was to them. The answer was not at all. Now after a series of accidents, delays and poorer service the politicians are being blamed for not investing sooner.

So instead of having an honest conversation people only want more public services and to pay less. There is no leadership where a politician can say, "Here are my beliefs, we should cut this service and I will cut taxes that fund this service. I pledge to do this wisely and judiciously. If you believe in this idea and in me, than you should vote for me." Or the converse, "We should offer this service to you and people like you in the community and it will cost more in taxes to do so. I pledge to use the money wisely to achieve these ends. If you believe in this idea and in me, than I should have your vote." However, what the political system is instead producing is a fear of having a rational discussion with the masses about a politician's coherent political opinion.

The final plea of the program is for individuals to think beyond themselves and how they have been trained by business. That people are more than "feel-good" machines and not slaves to their desires. If we are these things and cannot move beyond these ideas then it would be best to dissolve the government and allow businesses to sate our desires. As individuals move away from their consumer side, politicians will have to engage them with a rational deliberation that respects the individuals abilities to form rational opinions on what is best for society.

Public Relations Part III

2009-10-20T11:38:00.014-04:00

The third section of the film shows the move away from repression of the self. Wilhelm Reich moved in opposition to Freud's view that humans are violent, uncontrolled, war-like, raging infernos of emotions. Reich believed that suppressing the original impulse inside a human is what causes the distortions that creates a violent, uncontrolled, war-like, raging inferno of emotions. He was ostracized and marginalized by the psychoanalytic community. He eventual was jailed and died and so the Freudians thought they had won.

However in the 1960s people began to learn how businesses were using focus groups as a way to lower their psychological defenses and felt they were being manipulated. This idea especially became prevalent around the era of the Vietnam war. The people were recoiling from the idea that as consumers they were being kept docile so the government could wage war in Vietnam. They now wanted to reject the idea that their feelings and identities were expressed through their product choices. So they fought the law and the law won. The biggest event was the actions at Kent State where four students were murdered by the National Guard. To remove the policeman from inside their head the people would need to internalize their actions and make changes on a personal level. Thus, they embraced Wilhelm Reich and the Freudians lost.

Fritz Perls and the Eselan Institute stepped in to teach people to engage in semi-public self revelations to take control of their inner demons. Through ownership of who a person truly was they could enact self control. This of course went too far when they held racism seminars and when they turned a nun convent into a lesbian convent. It did bring about a change in how consumers behaved and with the help of the pill, the sexual revolution.

"Freedom's just another word for nothin' left to do.
Nothin' ain't worth nothin' but it's free."
~Grateful Dead cover Me and Bobby McGee

Mass production needed social conformity to be executed. People instead were leaving behind the cookie cutter ideas of the Protestant work ethic and the save for a rainy day. Now consumers would live for the moment. At the core of the idea was a new form of self expressionism. Now Werner Erhard stepped in to take the torch from Eselan and began mass producing individuals. The seminars he held proposed that people could be anything that they wanted. When you peeled away the layers of societal conduct and mores and arrived at the core of a human being there was nothing. "It was empty and meaningless but it was empty and meaningless that it was empty and meaningless... all the rules and constrictions were gone and all that remained was nothing. This is very powerful idea because it is freedom." From this tabula rasa you could create and invent a life by yourself instead of using school and family and friends to shape you. You could now be what you want to be. The most important thing in anyone and everyone's lives was to be fulfilled and that was all that really mattered. Thus, the political movement died along with an idea of society because only the individual mattered.

Now with this void of how to express yourself capitalism steps in to help people become what they wanted to be. Instead of top down from Madison Avenue to you. Instead it would come from bottom up, from you to businesses, via the Stanford Research Institute. Using ideas from Abraham Maslow and his hierarchy of needs, businesses could now track the desires of self-actualizers (the highest level in the hierarchy.) They would then segment these self-actualizers and make customized solutions for these individuals via lifestyle marketing. The rise of computers, logistics and supply chain management made it possible for businesses to do smaller runs with more customized options for consumers. Stanford found that if the product agreed with the values of the self-actualizers they would purchase the product no matter what they consciously stated their actions would be. Unfortunately, this also worked with politicians as well.

At the time when individualism was being stressed ever more by the population, along came Reagan and Thatcher to try to remove government influence and allow the people to make decisions. It was thought that socially conscience people would not vote conservatively. Inside the campaigns of Thatcher and Reagan their respective wonks disagreed with the directions the campaigns were taking. It did not matter. Stanford was correct and both Conservatives won elections.

This also marked a new era for the focus group. Instead of producing a product and then figuring out the way to make people buy it, restated as enticing people to buy a limited range of goods, now focus groups would create the ideas for goods. It would then be produced for them. Business took the creed of the self-actualized individual and agreed with it and then helped her achieve her goal. Non-conformity which was viewed as a threat now became a huge opportunity because the market had forever changed from needs-based to a market of unlimited and ever changing desires.

The Gervais Principle, Or The Office According to “The Office”

2009-10-20T11:22:00.002-04:00

I am reprinting this in its entirety because it is amazing and I want to never forget it. However, if you like it you should probably click the link to the original posting.
http://www.ribbonfarm.com/2009/10/07/the-gervais-principle-or-the-office-according-to-the-office/

by Venkat on October 7, 2009

My neighbor introduced me to The Office back in 2005. Since then, I’ve watched every episode of both the British and American versions. I’ve watched the show obsessively because I’ve been unable to figure out what makes it so devastatingly effective, and elevates it so far above the likes of Dilbert and Office Space. Until now, that is. Now, after four years, I’ve finally figured the show out. The Office is not a random series of cynical gags aimed at momentarily alleviating the existential despair of low-level grunts. It is a fully-realized theory of management that falsifies 83.8% of the business section of the bookstore. The theory begins with Hugh MacLeod’s well-known cartoon, Company Hierarchy (below), and its cornerstone is something I will call The Gervais Principle, which supersedes both the Peter Principle and its successor, The Dilbert Principle. Outside of the comic aisle, the only major and significant works consistent with the Gervais Principle are The Organization Man and Images of Organization. (p.s. Slashdotters: I just posted a welcome/intro to this blog and some responses here).

I’ll need to lay just a little bit of groundwork (lest you think this whole post is a riff based on cartoons) before I can get to the principle and my interpretation of The Office. I’ll be basing this entire article on the American version of the show, which is more fully developed than the original British version, though the original is perhaps more satisfyingly bleak. Keep in mind that this is an interpretation of The Office as management science; the truth in the art. Literary/artistic critics don’t really seem to get it (Slate’s Dana Stevens, for instance is content to merely to pigeonhole it as “one of the funniest, saddest, wisest TV comedy series of all time.”) I’ll have some passing comments to offer on the comedy and art of it all, but this is primarily about the truths revealed by the show, pursued with Dwight-like earnestness.

From The Whyte School to The Gervais Principle

Hugh MacLeod’s cartoon is a pitch-perfect symbol of an unorthodox school of management based on the axiom that organizations don’t suffer pathologies; they are intrinsically pathological constructs. Idealized organizations are not perfect. They are perfectly pathological. So while most most management literature is about striving relentlessly towards an ideal by executing organization theories completely, this school, which I’ll call the Whyte school, would recommend that you do the bare minimum organizing to prevent chaos, and then stop. Let a natural, if declawed, individualist Darwinism operate beyond that point. The result is the MacLeod hierarchy. It may be horrible, but like democracy, it is the best you can do.

The “sociopath” layer comprises the Darwinian/Protestant Ethic will-to-power types who drive an organization to function despite itself. The “clueless” layer is what Whyte called the “Organization Man,” but the archetype inhabiting the middle has evolved a good deal since Whyte wrote his book (in the fifties). The losers are not social losers (as in the opposite of “cool”), but people who have struck bad bargains economically – giving up capitalist striving for steady paychecks. I am not making this connection up. Consider this passage from OM (I haven’t yet gotten to this part in my ongoing series about the book):

Of all organization men, the true executive is the one who remains most suspicious of The Organization. If there is one thing that characterizes him, it is a fierce desire to control his own destiny and, deep down, he resents yielding that control to The Organization, no matter how velvety its grip… he wants to dominate, not be dominated…Many people from the great reaches of middle management can become true believers in The Organization…But the most able are not vouchsafed this solace.

Back then, Whyte was extremely pessimistic. He saw signs that in the struggle for dominance between the sociopaths (whom he admired as the ones actually making the organization effective despite itself) and the middle-management Organization Man, the latter was winning. He was wrong, but not in the way you’d think. The Sociopaths defeated the Organization Men and turned them into The Clueless not by reforming the organization, but by creating a meta-culture of Darwinism in the economy: one based on job-hopping, mergers, acquisitions, layoffs, cataclysmic reorganizations, outsourcing, unforgiving start-up ecosystems, and brutal corporate raiding. In this terrifying meta-world of the Titans, the Organization Man became the Clueless Man. Today, any time an organization grows too brittle, bureaucratic and disconnected from reality, it is simply killed, torn apart and cannibalized, rather than reformed. The result is the modern creative-destructive life cycle of the firm, which I’ll call the MacLeod Life Cycle.

A sociopath-entrepreneur with an idea recruits just enough losers to kick off the cycle. As it grows it requires a clueless layer to turn it into a controlled reaction rather than a runaway explosion. Eventually, as value hits diminishing returns, both the sociopaths and losers make their exits, and the clueless start to dominate. Finally, the hollow brittle shell collapses on itself and anything of value is recycled by the sociopaths according to meta-firm logic.

MacLeod’s “Loser” layer had me puzzled for a long time, because I was interpreting it in cultural terms: the kind of person you call a “loser.” While some may be losers in that sense too, they are primarily losers in the economic sense: those who have, for various reasons, made (or been forced to make) a bad economic bargain: they’ve given up some potential for long-term economic liberty (as capitalists) for short-term economic stability. Traded freedom for a paycheck in short. They actually produce, but are not compensated in proportion to the value they create (since their compensation is set by sociopaths operating under conditions of serious moral hazard). They mortgage their lives away, and hope to die before their money runs out. The good news is that losers have two ways out, which we’ll get to later: turning sociopath or turning into bare-minimum performers. The losers destined for cluelessness do not have a choice.

Based on the MacLeod lifecycle, we can also separate the three layers based on the timing of their entry and exit into organizations. The sociopaths enter and exit organizations at will, at any stage, and do whatever it takes to come out on top. The contribute creativity in early stages of a organization’s life, neurotic leadership in the middle stages, and cold-bloodedness in the later stages, where they drive decisions like mergers, acquisitions and layoffs that others are too scared or too compassionate to drive. The are also the ones capable of equally impersonally exploiting a young idea for growth in the beginning, killing one good idea to concentrate resources on another at maturity, and milking an end-of-life idea through harvest-and-exit market strategies.

The Losers like to feel good about their lives. They are the happiness seekers, rather than will-to-power players, and enter and exit reactively, in response to the meta-Darwinian trends in the economy. But they have no more loyalty to the firm than the sociopaths. They do have a loyalty to individual people, and a commitment to finding fulfillment through work when they can, and coasting when they cannot.

The Clueless are the ones who lack the competence to circulate freely through the economy (unlike sociopaths and losers), and build up a perverse sense of loyalty to the firm, even when events make it abundantly clear that the firm is not loyal to them. To sustain themselves, they must be capable of fashioning elaborate delusions based on idealized notions of the firm — the perfectly pathological entities we mentioned. Unless squeezed out by forces they cannot resist, they hang on as long as possible, long after both sociopaths and losers have left (in Douglas Adams’ vicious history of our planet, humanity was founded by a spaceship full of the Clueless, sent here by scheming Sociopaths). When cast adrift in the open ocean, they are the ones most likely to be utterly destroyed.

Which brings us to our main idea. How both the pyramid and its lifecycle are animated. The dynamics are governed by the Newton’s Law of organizations: the Gervais Principle.

The Gervais Principle and Its Consequences

The Gervais Principle is this:

Sociopaths, in their own best interests, knowingly promote over-performing losers into middle-management, groom under-performing losers into sociopaths, and leave the average bare-minimum-effort losers to fend for themselves.

The Gervais principle differs from the Peter Principle, which it superficially resembles. The Peter Principle states that all people are promoted to the level of their incompetence. It is based on the assumption that future promotions are based on past performance. The Peter Principle is wrong for the simple reason that executives aren’t that stupid, and because there isn’t that much room in an upward-narrowing pyramid. They know what it takes for a promotion candidate to perform at the “to” level. So if they are promoting people beyond their competence anyway, under conditions of opportunity scarcity, there must be a good reason.

Scott Adams, seeing a different flaw in the Peter Principle, proposed the Dilbert Principle: that companies tend to systematically promote their least-competent employees to middle management to limit the damage they can do. This again is untrue. The Gervais principle predicts the exact opposite: that the most competent ones will be promoted to middle management. Michael Scott was a star salesman before he become a clueless middle manager. The least competent employees (but not all of them — only certain enlightened incompetents) will be promoted not to middle management, but fast-tracked through to senior management. To the sociopath level.

And in case you are wondering, the unenlightened under-performers get fired.

Let me illustrate the logic and implications of the principle with examples from the show.

The Career of the Clueless

In Season Three, the Dunder-Mifflin executives decide to merge the Stamford and Scranton branches, laying off much of the latter, including Michael Scott. His counterpart, the competent-sociopath Stamford branch manager, whose promotion is the premise of the re-org, opportunistically leverages his impending promotion into an executive position at a competitor, leaving the c0mpany in disarray. The Dunder-Mifflin executives, forced to deal with the fallout, cynically play out the now-illogical re-org anyway, shutting down Stamford and leaving Michael with the merged branch instead. The executives (David Wallace and Jan Levinson-Gould) are obviously completely aware of Michael’s utter incompetence. But their calculations are obvious: giving Michael the expanded branch allows them to claim short-term success and buy time to maneuver out of having to personally suffer longer-term consequences.

Jim’s remark on the drama is revealing. Comparing Michael to his exiting sociopath peer he says: “Whatever you say about Michael, he would never have done something like this,” a testament to Michael’s determinedly deluded loyalty to the company that will never be loyal to him. We can safely assume that Michael’s previous promotion to regional manager occurred under similar circumstances of callous short-term calculations by sociopaths.

So why is promoting over-performing losers logical? The simple reason is that if you over-perform at the loser level, it is clear that you are an idiot. You’ve already made a bad bargain, and now you’re delivering more value than you need to, making your bargain even worse. Unless you very quickly demonstrate that you know your own value by successfully negotiating more money and/or power, you are marked out as an exploitable clueless loser. At one point, Daryl, angling for a raise, learns to his astonishment that the raise he is asking for would make his salary higher than Michael’s. Michael hasn’t negotiated a better deal in 14 years. Daryl — a minimum-effort loser with strains of sociopath — doesn’t miss a step. He convinces and coaches Michael into asking for his own raise, so he can get his.

A loser who can be suckered into bad bargains is set to become one of the clueless. That’s why they are promoted: they are worth even more as clueless pawns in the middle than as direct producers at the bottom, where the average, rationally-disengaged loser will do. At the bottom, the overperformers can merely add a predictable amount of value. In the middle they can be used by the sociopaths to escape the consequences of high-risk machinations like re-orgs.

The Career of the Sociopath

The example of the “fast-track the under-performing” part of the principle is Ryan, the intern. He tests himself quickly and rapidly learns and accepts that he is incompetent as a salesman. But he is a born pragmatist-sociopath with the drive, ambition, daring and lack of principles to make it to the top. So rather than waste time trying to get good at sales, he slips into a wait-watch-grab opportunist mode. But he isn’t checked out — he is engaged, but in an experimental way, probing for his opening. The difference between him and the average checked-out loser is illustrated in one brilliant scene early in his career. He suggests, during a group stacking effort in the warehouse, that they form a bucket brigade to work more efficiently. The minimum-effort loser Stanley tells him coldly, “this here is a run-out-the-clock situation.” The line could apply to Stanley’s entire life.

Stanley’s response shows both his intelligence and clear-eyed self-awareness of his loser-bargain with the company. He therefore acts according to a mix of self-preservation and minimum-effort coasting instincts. The same is true of everybody else in the loser layer with the exception of the over-performers: Dwight and Andy (and in his earlier incarnation as a salesperson, Michael).

The future sociopath must be an under-performer at the bottom. Like the average loser, he recognizes that the bargain is a really bad one. Unlike the risk-averse loser though, he does not try to make the best of a bad situation by doing enough to get by. He has no intention of just getting by. He very quickly figures out — through experiments and fast failures — that the loser game is not worth becoming good at. He then severely under-performs in order to free up energy to concentrate on maneuvering an upward exit. He knows his under-performance is not sustainable, but he has no intention of becoming a lifetime-loser employee anyway. He takes the calculated risk that he’ll find a way up before he is fired for incompetence.

Ryan’s character displays this path brilliantly. When Michael’s boss and dominatrix-lover Jan suffers a psychotic descent into madness, her boss, the uber-sociopath David Wallace, has no great hopes of a good outcome. Setting up yet another band-aid move, he calls up Michael for an interview to take up Jan’s spot. But when the rest of the office learns of Michael’s impending interview (during Michael’s farcical attempts at using a Survivor style contest to choose his successor, which predictably, only Dwight takes seriously), the true sociopaths act. Jim and his sociopath girlfriend Karen instantly call up David and announce their candidacies for the same position. Unknown to them, Ryan, the intern-turned-rookie has also spotted the opportunity. The outcome is spectacular: Ryan gets the job, Michael loses, Karen gets the Utica branch, and Jim — who still has not yet completely embraced his inner sociopath — returns to Scranton. We learn later — as the Gervais principle would predict — that David Wallace never seriously considered Michael more than a temporary last resort. Much later, in a deposition during Jan’s lawsuit against the company, he reveals that Michael was never a serious candidate.

The Career of the Loser

The career of the loser is the easiest to understand. Having made a bad bargain, and not marked for either clueless or sociopath trajectories, he or she must make the best of a bad situation. The most rational thing to do is slack off and do the minimum necessary. Doing more would be a clueless thing to do. Doing less would take the high-energy machinations of the sociopath, since it sets up self-imposed “up or out” time pressure. So the coasting-loser — really not a loser at all if you think about it — pays his dues, does not ask for much, and finds meaning in his life elsewhere. For Stanley it is crossword puzzles. For Angela it is a colorless Martha-Stewartish religious life. For Kevin, it is his rock band. For Kelly, it is mindless airhead pop-culture distractions. Pam has her painting ambitions. Meredith is an alcoholic slut. Oscar has his active gay lifestyle. Creed, a walking freak-show, marches to the beat of his own obscure different drum (he is the most rationally checked-out of all the losers).

If you leave out the clear marked-for-clueless characters like Dwight and Andy, you are left with the two most interesting characters in the show: the will-he-won’t-he sociopath-in-the-making, Jim, and the strange Toby. Toby is a curious case — intellectually a sociopath, but without the energy or ambition to be an active sociopath. More about these two later.

The Emergence of the MacLeod Hierarchy

Dastardly as all this sounds, it is actually pretty efficient, given the inevitability of the MacLeod hierarchy and life cycle. The sociopaths know that the only way to make an organization capable of survival is to buffer the intense chemistry between the producer-losers and the leader-sociopaths with enough clueless padding in the middle to mitigate the risks of business. Without it, the company would explode like a nuclear bomb, rather than generate power steadily like a reactor. On the other hand, the business wouldn’t survive very long without enough people actually thinking in cold, calculating ways. The average-performing , mostly-disengaged losers can create diminishing-margins profitability, but not sustainable performance or growth. You need a steady supply of sociopaths for that, and you cannot waste time moving them slowly up the ranks, especially since the standard promotion/development path is primarily designed to maneuver the clueless into position wherever they are needed. The sociopaths must be freed up as much as possible to actually run the business, with or without official titles.

So Ryan floats directly to the top, where he does what is expected of him — lead a bold strategic gamble by building an online sales channel operation (which Dwight competes with in a brilliantly Quixotic episode). As with any big strategic move, the operation has its risks, and fails. And here we find that Ryan is still not quite experienced enough as a sociopath. He foolishly goes the Enron route, attempting to cook the books to avoid failure, and is found out and arrested. A true master sociopath like David Wallace would instead have spotted the impending failure, promoted a Michael to take over (who would obviously be so gratified at being given a new white-elephant title that he would not have seen disaster looming), and have him take the blame for the inevitable failure. Completely legal and efficient.

But Ryan isn’t done yet. In the last season, he played himself back into the game, and as of the last episode, had started a college football gambling fund that sounds suspiciously like the LTCM trading strategies of Messrs. Black, Scholes and Mertens.

The Organization as Psychic Prison

Which brings us to the other major management book that is consistent with the Gervais Principle. Images of Organization, Gareth Morgan’s magisterial study of the metaphors through which we understand organizations. Of the eight systemic metaphors in the book, the one that is most relevant here is the metaphor of an organization as a psychic prison. The image is derived from Plato’s allegory of the cave, which I won’t get into here. Suffice it to say that it divides people into those who get how the world really works (the sociopaths and the self-aware slacker losers) and those who don’t (the over-performer losers and the clueless in the middle).

This is where Gervais has broken new ground, primarily because as an artist, he is interested in the subjective experience of being clueless. For your everyday sociopath, it is sufficient to label someone clueless and work around them. What Gervais managed to create is a very compelling portrait of the clueless, a work of art with real business value.

Here is the ultimate explanation of Michael Scott’s (and David Brent’s) careers: they are put into a position of having to explain their own apparent, unexpected and unexamined success. It is easy to explain failure. Random success is harder. Remember, they are promoted primarily as passive pawns to either allow the sociopaths to escape the risks of their actions, or to make way for the sociopaths to move up faster. They are presented with an interesting bit of cognitive dissonance: being nominally given greater power, but in reality being safely shunted away from the pathways of power. They must choose to either construct false narratives or decline apparent opportunities.

The clueless resolve this dissonance by choosing to believe in the reality of the organization. Not everybody is capable of this level of suspension of disbelief. Both Ricky Gervais (David Brent) and Steve Carrel (Michael Scott) play the brilliantly-drawn characters perfectly. The most visible sign of their capacity for self-delusion is their complete inability to generate an original thought. They quote movie lines, lyrics and perform terrible impersonations (at one point Michael goes, “You talking to me?” a line he attributes, in a masterful display of confusion, to “Al Pacino, Raging Bull“). For much of what he needs to say, he gropes for empty business phrases, deploying them with staggering incompetence. When Michael talks, he is attempting, like a child, to copy the flawless buzzspeak spoken by sociopaths like Jan and David Wallace. He is oblivious to the fact that the sociopaths use buzzspeak as a coded language with which to simultaneously sustain the (necessary) delusions of the clueless and communicate with each other.

It is not just the sociopaths who conspire to sustain Michael’s delusions. So do the checked-out losers, sometimes out of kindness, and sometimes out of self-interest. In one particularly perfect summing up, Oscar describes the impending “Dundees” award ceremony (a veritable monument to the consensual enablement of Michael’s delusions) as “like a child’s birthday party, he is having a lot of fun, and you just have to go and play along.” (I may be misremembering the exact line)

But Michael isn’t entirely a puppet. Buried under layers of denial is a clear understanding of his own, hopeless, powerless life, which makes him marginally more clued-in than say, Dwight. His response is frenetic and desperate manipulation of the drama of false validation that has been set up for his benefit. Some of this is with the knowing consent of his enablers. Like experienced improv-comics, within limits, the rest of the Office follows the rule of agreement in the Theater of Michael (in a brilliant piece of meta-commentary, in one episode we get to see Michael at his own impossibly bad worst in his real improv class, where he ruins every single sketch).

But Michael’s grand narrative requires constant, exhausting work to keep up. He must amplify and rope in even the most minor piece of validation into the service of his script. When, in a moment of weakness, Jim shares a genuine confidence with him, Michael is so thrilled that he turns the moment into a deep imaginary friendship, practically becoming a stalker, even mimicking Jim’s hairstyle. At the other end, he over-represses even the slightest potential dent to his self-image. His is a thin-skinnedness gone crazy. Reality is sealed away with psychotic urgency, but to do so, he must first scout it out with equal urgency. And so, when Jim (in the first true sociopath move of his career) engineers a private meeting with the visiting David Wallace to carve out a promotion, Michael first tries to break into the meeting. When politely turned away, he instantly switches scripts and pretends he is too busy and that he is the one who can’t attend. And then he sneaks into the meeting room anyway, first with various excuses, and finally by hiding in a Trojan-Horse cheese cart.

This sort of ability to work hard to sustain the theater of his own delusions, half-aware that he is doing so, is what makes Michael a genuine candidate for promotion to the ranks of the Clueless. Dwight is interesting precisely because he lacks Michael’s capacity for this pathological meta-cognition, and the ability to offer semi-believable scripts that others can at least help bolster. Dwight is not talented enough at cluelessness to ever be promoted.

Is There More

You bet. We haven’t even scratched the surface. Dwight, Jim, and Toby each deserve an entire essay. Michael and Ryan probably deserve one each as well, in addition to my quick sketches here. And there are other principles, lemmas and sundry theoretical constructs. But I’ll hold off. Maybe there aren’t as many Office watchers among this blog’s readers as I imagine. You guys tell me if you want more.

I’ll conclude with one thought: Gervais deserves Nobel prizes in both literature and economics.

Public Relations Part II

2009-10-19T09:35:00.008-04:00

The second installment of this series was not nearly as impressive as the first. Then again, only The Godfather Part II and The Empire Strikes Back really ever made something of batting second in the line up, so it was not unexpected.

Basically this episode tracks the rise and fall of psychoanalysis. It shows how Anna Freud built upon her father Sigmund's ideas and decided that instead of just presenting why people behaved in the manner in which they did, she would be able to better these people through analysis and understanding. These inner drives would be controlled by conforming to the rules of society, these affirmations would then strengthen the ego to control its irrational counterpart, the id.

This of course turns out to be a bad idea. Anna's original patients suffered mental breakdowns, alcoholism and one committed suicide in Anna's house. These ideas also lead the CIA to brain wash people and also for Marilyn Monroe to commit suicide after living with her psychoanalyst's family. This created a crisis for psychoanalysts, in that society began to question why psychoanalysis had become so prevalent and powerful.

Underlying these set backs was still the notion of control of the masses and shaping good democratic citizens. After WWII and the fear in the elite of the irrational man, psychoanalysis centers were created all over the country. Some were marriage guidance counselors and other were social workers who would advise families and individuals about what normal behavior was and how to control the latent danger that was inside them. The analysts themselves never questioned that their techniques could do anything but good, not understanding that there would be trade offs between the latent feelings inside their patients and the new model citizen ideas they were trying to instill.

Two of the biggest developments in the post-war environment were the focus group and banana republics.

Focus Groups

Ernest Dichter created the Institute for Motivation Research where he proposed and enacted psychoanalysis of products. His idea was to use the self image of the customer and her underlying motivations could be talked about freely just like in a psychoanalysis session. He would then analyze and understand the true non-verbalized motivations of the consumer, be it sexual, psychological or sociological issues of status and power. Thus, the birth of the focus group.

The first big break through was with Betty Crocker and their line of instant consumer foods. When consumers were surveyed they affirmed that the would appreciate the convenience of the food but at the point of sale they would not actually buy the instant mixes.

During the psychoanalysis of the focus group Dichter understood that the women actually felt guilt about the ease and convenience of the product, that is they wanted to make the process easier on themselves but they would feel guilty about it. So Dichter added a participation element with a symbol. Even though the product would taste just as well with a freeze dried egg already mixed into the mix, he proposed Betty Crocker remove the egg and let the house wife add it herself. By mixing in the egg, this added participation for the wife and let her believe she was offering a gift to her spouse. Sales subsequently soared.

Psychoanalysis started working with businesses to make connections, like Betty Crocker, with their customer. The analysts believed that the products would sate inner desires and add elements of commonality amongst members of the community. Further, as the consumers identified with products and built a self-identity around them this would improve self-image and make the consumer feel more secure in their choices. Thus, all of society would be improved as consumers were self-actualized by products. However, again no one asked if it was wrong to give people what they wanted by breaking down their psychological self-defenses.

Bernays and the Banana Republics

The Cold War. America already had a fear of Communists dating back to the Bolshevik Revolution but now they had the bomb and America's politicians needed public relations to control America's psyche. At first the politicians wished to minimize the threat, but after Bernays was brought in this idea was reversed. He decided to use the threat as a control device. By instilling fear in the populace politicians could offer guidance from above. Bernays masterstroke this time was with United Fruit and Guatemala.

United Fruit's interests in Guatemala were being threatened by a popularly elected social democratic government. Bernays framed this government as a threat to American values and further that this threat was at America's doorstep in the Western hemisphere. Bernays had journalists flow to Guatemala to meet the recently ousted, not from a coup but from elections, former political leaders. These politicians called the new government Communists and a United Fruit conspired riot broke out, calling for freedom. Finally, a group started by Bernays back stateside insinuated that the Soviets were using Guatemala as a Soviet outpost and launching point into the Americas.

The CIA acted swiftly in creating a coup d'etat. This involved a terror campaign and the dropping of bombs on Guatemalan citizens. United Fruit organized Soviet literature that was found in the capitol building as the elected government officials fled the country. All of this was done under the guise that the interests of business and democracy were in the interest of the masses. Bernays again talked of engineering of consent because people could not handle the truth and so he forced people to choose what he wanted them to choose.

Wrap Up
There was a backlash that people were maladjusted. New voices cried that the sickness of society, if there was such a thing, was at the societal level and not internally. The brands, gadgets, products created to sate desires ultimately lead to empty prosperity. The social norms that were prescribed to the maladjusted citizens include terrible ideas. How can the thoughts of societal norms include intolerance, economic inequality and civil rights for the few. I leave you with these same ideas ML King decried in a speech given at Western Michigan in 1963 about Social Justice.

There are certain technical words within every academic discipline that soon become stereotypes and cliches. Modern psychology has a word that is probably used more than any other word in modern psychology. It is the word "maladjusted." This word is the ringing cry to modern child psychology. Certainly, we all want to avoid the maladjusted life. In order to have real adjustment within our personalities, we all want the well-adjusted life in order to avoid neurosis, schizophrenic personalities.

But I say to you, my friends, as I move to my conclusion, there are certain things in our nation and in the world which I am proud to be maladjusted and which I hope all men of good-will will be maladjusted until the good societies realize. I say very honestly that I never intend to become adjusted to segregation and discrimination. I never intend to become adjusted to religious bigotry. I never intend to adjust myself to economic conditions that will take necessities from the many to give luxuries to the few.

Public Relations Part I

2009-10-17T10:44:00.008-04:00

So it begins...

The other day while reading about how shocking it is that more Americans are not rallying against the return to the status quo that is taking place in the financial industry, an astute observer linked to a video series online called The Century of the Self.

Don't worry the first 10 seconds are a little scrambled as it looks like some one ripped this from a VCR recording. VCR? Well it was a machine that played videotapes, which were very similar to cassette tapes in that you could record on certain types videos from your television. My grandmother vividly remembers watching two or three Nintendo video games instead of Dr Zhivago, but I digress.

So I started watching and then I started note taking and below is what I have garnered from watching two of the four parts (they are each an hour long.)

In the beginning there was Freud. Freud gave his young nephew a copy of his book called "General Introduction to Psychoanalysis" This nephew was Edward Bernays and he worked on the PR effort for the US during the First Great War. One of his key messages that he created was that the US was not restoring old monarchies but bringing democracy to Europe. He attended the peace talks with Woodrow Wilson and emerged with a slogan "Making the World Safe for Democracy." After the war he wondered, and would soon make himself rich upon, whether the same type of propaganda/persuasion employed during the war and peace talks could also be equally applied in peacetime.

In a later in life interview with Mr. Bernays he casually states that the Germans had used the word propaganda and now it was tainted, thus, he coined a new term called public relations. The idea that information is power was certainly very relevant to Mr. Bernays. However, he also knew that the information could be coached in such a way as to elicit the desired response despite what logical conclusion could be drawn from it. This was a key understanding of his uncle's work.

One of his first clients was the American Tobacco Company. His task was to find a way to break the male originated taboo of public smoking for women. As Big Tobacco noted, they lost half the target market due to this social taboo. Bernays turned to AA Brill who told him and ATC that cigarettes represented the male penis and male sexual power. Brill continued, stating they would need a way to connect cigarettes as a way of challenging male power by giving women their own penises.

This is where Bernays makes his money. During the NYC Easter parade, Bernays had female models stash cigarettes on their person and at a designated time to light them up and begin smoking. Then he informed the press that Suffragettes were going to light up cigarettes in public as a protest of voting rights and that the cigarettes were "Torches of Freedom." The symbolic gesture, the phrase, the emotion and the memory all tied together as one in the American psyche. The Torches of Freedom ran in major newspapers and soon the sale of cigarettes began to rise. Women found them socially acceptable and felt that smoking made them more powerful and independent. You read that right, a product, a consumption habit (unhealthy at that), was signaling to other people status and power. Bernays had proven what Freud has insinuated that you can produce irrational behavior in people by fulfilling deeper needs and desires.

This method became Bernays masterstroke that he would employ over and over again for businesses. It was called the tie in and it would be the machine that drove the "engineering of consent." One example is of Cosmopolitan magazine (a customer) and he would place advertisements next to specific articles or interviews, which would be one of his other clients, say an actress. In the pictures of the interview she would be wearing or consuming the product. Then in the next movie she filmed she would also be using the product. These powerful images of an attractive person, leading an attractive life filled with products that everyday citizens could also enjoy marked a new era in consumerism.

In the days before the war products were sold on a basis of practical value. Industry worried that once you had sated people's needs that there would be fewer profits as you would then only be replacing obsolescence. Bernays was now showing a new way for the consumer to buy, to have their desires out shadow their needs. He was changing the focus from the clothing to how the clothing made you feel. Also implicit in this was the idea that consumerism helped the country as well. This is because products could fill the voids of everyday life by appealing to the desires and fears of the masses. By keeping these consumption machines happy, which would also keep them docile. It was now as though products were giving people "feel-good" medicine and thus initiating social control. So instead of using social institutions to control people, you could answer their desires and upon sating the desires, the elite could then go about ruling the country.

Some additional acts Bernays pioneered include: product placement in movies, selling cars as symbols of male sexual power, paying doctors to state a product was healthy or recommended (an apple a day...), having fashion shows at department stores with models.

This became especially relevant once the Bolshevik revolution in Russia. The idea that humans could make rational decisions was being crushed as Moscow and St Petersburg burned. This was not the only piece of evidence. As the Great Depression began and ran its course the new consumer Bernays created died. Then the Second Great War ended and the aftermath including the Holocaust very much convinced those in power that humans are dangerous and needed to be controlled.

A closer look at National Socialism was enlightening. Here were normal every day citizens wielded as a weapon by the leadership. The messages were spun in a way to channel the feelings of the masses. Analysts would look at the situation noting that libidinal forces were repressed in deference to the leadership, but it created violence. This violence was then directed outside the group. Even though this behavior should be considered irrational the social norms instituted by the Nazis outweighed what an earnest human being might deem correct.

Later, during a controlled experiment in which 29 participants were actors, 30 people would have to decide which of two lines shown were longer. At first the actors would choose the correct one and of course the experimentee would as well. Then after about 10 different sets, the actors would choose the shorter line. The lone real person, would hesitate, take longer to decide, may at first fight it, but eventually succumb and choose the shorter line to achieve group consensus.

jupiter and the infinite beyond

2009-10-15T23:28:00.003-04:00

Nice shot from Mars of Earth & Moon and also Jupiter and some moons in the same frame.

H/T Gizmodo

AD & AS: 1st AD then AS and finally in concert

2009-10-14T10:36:00.007-04:00

1st of a three part series. 1st we consider the AD & AS model. Then the AD curve is explored in depth. Then the AS curve is explored in depth. Finally, we use them in concert to explain the economy.

More models... this one is different from the rest. When we view this chart we can see the equilibrium between price and output. That is to say, the AS curve represents the total quantity of goods and services firms are willing to provide at each point along the price level continuum. The AD line shows how much people, businesses, the government and foreigners would wish to buy at each price point. The equilibrium clears this market. As I said this is different from a microview graph because there cannot be a substitution to another good, this is the economy on a whole. So if ice cream prices rises one cannot just substitute frozen yogurt.

The AD curve slopes downward. Consider the equation

Y = C + I + G + NX

So that each factor will affect how much output is created by an economy. We can consider C + G together because both are consumption expenditures the only difference is one is for the public and the other is the government. Say for instance that the entire economy only make ice cream. You make two dollars and the government taxes you a dollar. The cost of ice cream is a dollar. So that you and the government can each have one cone. If the price of ice cream were to fall to 25 cents you would still have your dollar but now you could purchase 4 ice cream cones. So when the price level falls you have more purchasing power, as does the government. Now in a real economy the price level dropping will entice you to consume more, in our hypothetical economy you might tire of more ice cream quickly or develop diabetes and thus an aversion to sweets. The converse is true, when the price level rises, the value of the dollar falls which will reduce your wealth, consumption and the quantity of goods and services demanded.

Here we can see the chart of price level. As the price level drops from P1 to P2 the quantity of goods and services increases from Q1 to Q2.

The price level will also affect interest rates and thus investment. The effect is because imagine you are a household from above in the ice cream economy. Maybe you desire to only purchase one cone of Ice cream a year, thus the drop in price of ice cream from a dollar to 25 cents frees up 75 cents. Since more ice cream wouldn't give you any more marginal satisfaction you instead lend out your 75 cents. You might put it in a certificate of deposit, buy a bond or place it in a savings account with the bank. These three choices are all the same you would be lending the money out or giving the money to a bank to lend out for you. This, in aggregate, will drive interest rates lower. This then has a secondary effect in which because the interest rate is lowered more firms and households will borrow to purchase assets, plants & equipment for businesses and cars & houses for households. Again price level rising would have the opposite effect of raising the interest rate (less deposits), reducing investment and spending.

Exports
Since the interest rate is lowered by the mechanisms described above this will cause investors to seek higher returns from abroad. As these investors buy foreign currency to purchase investments in yuan, euros and Australian dollars this will increase the supply of US dollars in the exchange market. The increase supply will drive down the exchange rate against this basket of currencies. Since the dollar will now purchase less foreign currency than it follows that the US dollar will buy less foreign goods as well. As a corollary this will make US goods less expensive compared to comparable goods delivered by foreign countries, so net exports will increase. This will increase the demand for US goods and services. In reverse, a higher price level increase the interest rate, the dollar increases in value and the appreciated dollar will lower net exports (increase imports and decrease exports) which decreases the demand for US goods and services.

These are three reasons why the AD curve slopes downward but it can shift too.

We can also look at the variables C, I, G and NX to show why the AD curve would shift.

C - Consumption - consumption patterns could change. For instance, household wealth could fall because of a falling stock market and housing prices falling more in line with what a rental market could support. This would cause consumers as a whole to demand less services and goods at any price level, thus shifting the curve leftward.

I - Investment - if firms become pessimistic about future business conditions this will cause them collectively to invest less in plant and equipment. This also would shift the AD curve leftward. The government does have two tools in which to affect businesses' collective decision, it can employ fiscal or monetary stimulus. On the fiscal side it could lower taxes, of course in the current situation lowering taxes will not do as much because businesses will be employing NOLs (net operating losses) over the next few years and thus their tax burden will be less or zero anyways thus negating the positive effect this might have. The other tool is monetary policy, the Federal Reserve can increase the money supply thus lowering the rate of interest, which will encourage households and firms to invest, thus shifting the curve to the right combating the leftward shift of the gloomy outlook.

G - Government - any shift in purchasing plans of the US government will shift the curve. If the government decides to spend less this will shift the curve leftward, if it decides to spend more it will shift the curve rightward. There are two ways the government can spend, it can either lower taxes while keeping it spending the same running a deficit. Or it can keep taxes the same and spend more, both have the same effect. Unfortunately, Republicans only like the former and Democrats only the latter even though while in office both do the same, that is run deficits.

NX - Net Exports - NX is tricky because it has two variables affecting: the desire of the rest of the world to purchase US goods and also people and firms moving their wealth into and out of the US economy. On the first if China grows at 10% this year, all things else being equal, it will import more goods from the US. This will cause NX to shift outward. Because of this people and firms may sell their US dollar assets and use US dollars to purchase Yuan. This will depress the US dollar and cause NX to shift outward even further. However, should a recession occur in China the reverse would occur, the NX curve would shift inward because of less demand and the flight of capital from China to the US would strengthen the US dollar making imports less expensive and shifting the AD curve further inward.

Next we consider AS.

Economic Survey October 2009

2009-10-11T11:06:00.011-04:00

I considered digging my Businessweek out of the trash for an easy layup of a post, but instead I wanted to look at a survey of some current economic data points.

1st I saw this at Calculated Risk earlier this week. I highly, highly recommend his blog. He does some analysis but he always has good data and charts for the periodic economic reports that various government agencies generate each month. This is the JOLTS survey.

from Calculated Risk
What's important to note here is how the graph works with the blue line and the green & red bars being the most important. The green and red make up the loss of jobs. The green is persons who have quit and the red is the layoffs. The blue is the amount of hires. Obviously when the blue line is above the green and red column the economy is adding jobs.

When I read the chart it is telling me the turnover in the economy is slowing. Both hiring and loss of labor is slowing down and there is also structural unemployment as workers switch from housing and finance related careers to healthcare and government roles. People are not leaving their jobs for new opportunities, it seems as everyone is hunkered down. This is especially bad for young people who are trying to enter the workplace with their new degree (Bachelors and Masters) in hand. As the turnover falls people are not advancing upwards creating new entry level jobs. Some anecdotal evidence is here, and here.

The yellow line represents job openings. Obviously more data points would be helpful, this survey was only begun in 2000 but job openings at its lowest level does not portend well for the economy.

Second on my economic survey is the trade data. Again Calculated Risk did the heavy lifting with the charts.

1st We look at it on an absolute level. The drop in trade is breathtaking. However, the economy has also grown in the past 15 so we should look at this data in real terms as well. I should probably do this myself but I am lazy and will just tell you that it isn't any worse than it was in 2002 in "real" terms as a percentage of GDP. Here is a chart I found after a minute of Googling.

Here is my updated chart from the BEA.

So it reaches about 5% and has now contracted back and expected to do so in the near term. However, the near term means about 5 years. Here is what happened this month.

via Calculated Risk
You should enlarge the chart to get a good feel for it. Here Calculated Risk has shown the deficit in goods/services with oil removed, oil by itself and then the total. So even though the data point is improved overall (blue line) it was because oil was cheaper in this month. We actually imported more goods/services. [The removal of oil is because of this line of thinking: oil will be whatever it has to be because it the lubricant of the economy, so we should remove it to see what the underlying consumer is actually doing.]

Maybe a few brown shoots but I still don't see the green shoots.

Currently my trading model has longs in equities emerging and domestic, real estate US and ROW, bonds both emerging and domestic, gold. Shorts are in commodities and managed futures. However, I expect that this stance will not last very far into the new year.

BusinessWeek, just put my subscription on hold

2009-10-09T15:55:00.007-04:00

Cooper's article again lacked any whiff of rational thought and underlying facts to support his thesis but an even more egregious article was penned by Ben Levishon and Mark Scott. (Editor's note: don't click the link to the article unless you want some cheesy advertisement to queue up and start playing. WTF is that?) I imagine the penning of this article took place after a long three martini afternoon at the Delmonico.

I won't bore you with the details of the article but here is the handy dandy chart (which I had to re-create because they don't include it in their online article version. Seriously, WTF?)

Notice damage, pay extra, fewer choices, cost rising.

Notice now: may affect, may ..., could rise

So based on something they overheard while watching a monkey wrestling match at Delmonico even then they could not bring themselves to state that these reforms will actually affect any pricing. "I don't know what we are yelling about... Loud Noises!!"

Derivatives
They did find a partner whose firm represents JP Morgan Chase, ABN Amoro, Barclay's and BNP Paribas to state "it won't make it any easier for companies and investors to dig out of the recession." So they quickly put that in their sub-head on their collateral damage chart, except the editor made them add the caveat "may."

The authors then pen this gem "Credit Default Swaps - blew up, prompting huge loses at insurer American International Group and other companies. The reforms are meant to prevent another disaster." The thing is though, they did not blow up, in fact CDS's were the only market actively trading during the entire crisis. What did happen was that AIG posted no collateral for the CDS trades they initiated. They "wrote" these contracts meaning they would take in premium periodically over the life of the contract and if the underlying security defaulted then they would have to pay out.

Well some of their contracts triggered and then they need to pay those claims out. Then their counterparties demanded that they start posting collateral for CDS they underwrote. This created a $180 billion dollar hole in AIG's balance sheet almost over night. It was not the instrument!! It was that unlike contracts that trade at the CME, the Merc, NYMEX where you have to post collateral when contracts go against you, there was no action you could take against AIG until it was too late, thus the run on the company.

The authors continue "Exchange-based derivatives cut into cash reserves. Under current requirements, companies have to fork over 3% of a contract's value as collateral up front in case the transaction goes south." Well, we already talked about that above. Their argued flaw is actually the enhancement that will prevent AIG-type companies from blowing up!!! Avoiding collateral charges because of their AAA ratings is not reasonable. This idea ensures that counterparty exposures can be nipped in the bud when companies bet wrongly in the derivative markets.

So there goes one of the boys arguments.

"The changes could also make derivatives a less effective tool for controlling expenses. Derivatives sold over the counter are tailored to a company's individual needs, while exchange-traded contracts are standardized."

The regulators are treading lightly. They want safety for the financial system, but also not to deter consenting adults from making contracts. The hope is to move CDS contracts to the exchanges where there are more safeguards. Thus far, regulators only want to move standardized contracts to the exchanges. Tailored CDS solutions will still be allowed if that is what a client needs. However, it will be out in the open and very transparent that companies will take on a huge counterparty risk if it chooses a non-exchange traded contract.

Another one bites the dust and now for the nail in the coffin.

Here is the real reason the shills are heading their masters' calls. From Satyajit Das "Derivatives by their inherent nature are also have a Mr.Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity. The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible."

Commodities
From the article, "In light of the changes, financial firms are pulling back on some commodity offerings for small investors...Barclays Wealth recently told high-net-worth clients to ditch exchange-traded funds that focus on commodities in favor of hedge funds and other alternatives that invest in this area."

This is probably a sane idea as well from Barclays. There is a must read article from David Merkel about investors in Commodity ETFs are being snookered.

Here is the money quote for those short on time. "One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple. “Buy the front month futures contract, and roll to the second month contract before the front month expires.” Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy. So, what do the other investors do? They take the opposite side of the trade early, in order to make it more expensive to do the roll. Buy the second month contract, and short the first. As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract. What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market."

Too bad, so sad. No real problem there accept small investors may be better protected from ETFs that do not work as advertised.

Oh no the dread of all publishers who publish an honest-to-god hold-in-your-hand periodical, there is only two paragraphs left!!!!

High-Frequency Trading

"The technique [high-frequency trading] has been controversial of late as big trading firms have booked billions in profits while their clients' portfolios have dwindled."

The Daily Show With Jon Stewart

Mon - Thurs 11p / 10c

Cash Cow - High-Frequency Trading

www.thedailyshow.com

Daily Show
Full Episodes

Political Humor

Ron Paul Interview

Well that was fun but seriously HFT is not a bad thing. It's much worse.

Commissions have gone down for trading. The spread may have lessened as Professor Lo points out. However, someone is paying for the spread and it is the retail investors. Now, back in the old days there was a market maker and he took the spread. He has now been pushed aside by the HFT supercomputers since they both perform the same function. However, investors and traders were willing to pay the spread to the market maker for liquidity. So when you bought the market maker sold; if you sold he bought. With the HFT there is no guarantee or onus of guaranteeing liquidity. If the bots do not want to play no one can make them. Thus, liquidity can be withdrawn from the system overnight and liquid positions may not be based on the, relatively [may be this is a mixed metaphor], solid pillar the trader believes them to be. There is a lot of information at this website.

So all in all not bad for BW, they missed on all three accounts.

Analysis, analysis everywhere but not a drop of think

2009-10-09T11:18:00.009-04:00

So I stopped by my favorite, well one of my favorite, spots on the Internet. The S&P500 estimates website and was pleasantly surprised that it now had a spot on revenues. As an aside I am also working on a retail sales spreadsheet but the slog is slow, this is to show how pricing power is declining. So let me put up what S&P has on revenues.

Click to enlarge.
Below their data set I just wanted to see the data expressed in a level with the beginning of September 2008 as 1. Thus, Revenues at this point are 39.02% below where they were at this time last year.

Then I took a stab at valuing the index based upon expected earnings both operating (excludes write-offs and write-downs) and reported earnings. I used the Baa Corp Bond Yield as the discount rate. For the exit year I used both a P/E of 15 and also a straight line growth of 5% with inflation running at 3%. Here is what I found.

So what is going on in the market looks rational. Based on my crude estimates the index could be overvalued by over 25% or it could be dead on. Bulls versus bears and all that jazz. But this where I draw back to my first chart with revenues. That is, cost cutting can only do so much to hold on to earnings. Are there any other risks to earnings besides the micro factors affecting the companies that collectively make up the index? Then I remembered this chart from Credit Suisse

I first saw this from John Mauldin years ago. Now astute viewers may argue that this is not a big problem. They will reason that it says Option Adjustable Rate and since rates have fallen since these mortgages were underwritten that this will actually be a boon to homeowners. Well, yes and no. It is true that mortgage rates have lowered and when they "reset" it will be to lower rates. However, a portion of these are "recasting." Recast means that the person who took the mortgage took a interest only option, or a "pick-a-pay, " which means that even if the rate is resetting lower because the person will now be responsible for principal as well interest will see their payment jump, sometimes double or triple what they have been paying. This is because the principal has never been actually touched by the monthly mortgage payment or in some cases it has actually grown because of negative amortization. So the proportion of these loans will be key.

Click to enlarge

Basically it states that "Of the $189 billion securitized Option ARM loans outstanding, 88% have yet to experience a recast event ... Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize." I'll outsource to my favorite chihuahua "Ren: ...he's DEAD! DEAD YOU EEDIOT! YOU KNOW WHAT DEAD IS? JUST LIKE WE'LL BE IF WE DON'T GET OUT OF 'ERE!"

Now let's have a look at that chart again.

The coming crisis will be about as a big as the subprime crisis. However, because the economy will be a lot weaker than it was when subprime hit this could portend a double dip recession where we take out the March lows before we finally have cleansed the system. I am not suggesting guns and bottled water but gold... it may finally be the time where gold as a store of value takes center stage in your investment portfolio.

Debt-Market Paralysis Deepens Credit Drought

2009-10-07T11:44:00.003-04:00

Good to see MSM media covering a topic I covered over a month ago.

So I'll do a reprint plus add in my nifty chart of the financial system.

This is similar to Paul Krugman's chart found here.

Here is the re-post in italics. Below I will add some notes from the NY Times post.

I was on the Federal Reserve website checking out the major holders of debt in the United States historically. Both charts that I created show basically the same data. The first though shows the difference in the amount of debt over time, though it is nominal terms not real terms. The second just illustrates more lucidly the amount allocated to each type of provider. There were no data from earlier, but we can generalize that the banking system in the Great Depression looked a lot more like the 1943 data than the 2003's data points.

So it is obvious that the financial system has evolved, not in the Victorian sense that evolution necessarily means for the better, just that it has mutated. Securitized pools which do not exist in the data until the end of the 1980's come to make up over 30% of debt extended in its halycon days of 2003. A securitized pool is a pool of debt instruments for instance mortgages, or credit card debt, or automobile debt, or just general loans. These are sold to investors, usually pension funds, mutual funds, etc. The idea is that these instruments should be safe but yield more than comparable government bonds or AAA corporate bonds. These pools also allow the end borrower to borrow more cheaply than had investors not bid up the price they would pay for these structures.

The reason to make the distinction between the two eras or even to look back at how the debt market has evolved is that the response of the players should be different as well. When a bank in the 1920s and 1930s funded itself via deposits and then constructed a loan portfolio of assets it was subject to a risk of concentration. The first part of the concentration risk was that since there was no FDIC the deposits were not insured, so if all the people of the town came asking for their money at the same time there would not be enough cash in the vault to meet their claims. The second risk that stems from the first, was that if the financial system was in dire enough shape for people to be asking for their cash deposits back it meant that the economic system was in arrears as well with unemployment sure to follow. Thus, the loan portfolio (mortgages, small business loans) concentrated in the area in which the bank was would probably not pay back all the cash flows it was expected to generate. These are the reasons that the social safety net was constructed with unemployment insurance and deposit insurance.

So, what can be expected of the banks to do now? Well, banks will keep on doing what they have been doing. Making loans where it is profitable to do so and winding down bad loans. It is instead the securitized pools that worry me. Some of those pools were brought back onto the originating banks balance sheets, which then ties up their regulatory capital, thus decreasing their lending. Now a securitized deal cannot even be done without a guarantee from the Federal Government backing it. If we lop off the 25% of debt structure of the United States it will be hard to recover back to normal and "normal earnings and revenues." It's what PIMCO has been saying for awhile now that a new normal may be in store.

I echo thoughts from Mr Krugman. When you have a business model that relies upon investors who then rely upon rating agencies there has to be a lot of trust. When a bank makes a loan either student, credit card, mortgage, it knows its customer, or at least tries to understand it. When the loan is extended through securitization the role of the bank know falls upon the investors. Since there are multitudes of underlying mortgages or loans that make up the pool the investors rely upon the originator to have made honest assessments and to diversify the holdings. Secondly, the investor relied upon the rating agencies to act as a safeguard in reviewing these same pools to ensure they were well diversified and that they were actual assets to back up the loans. During the boom neither of these ideas were true for the banks or the rating agencies. Of course, this market is now dead.

Now as I see it there is a two fold crisis. On the one hand there is no trust, so no one wishes to lend. [The decrease in securities lending and also bank lending] On the second hand no one wishes to borrow either. People do not want to borrow to purchase a home that may continue to lose value. They do not want to borrow to obtain a MBA that will have no job offer at the end of their two year commitment. There has to be an outside stimulus of aggregate demand to shift resources from the defunct housing market to the now unemployment dole to the next engine of growth.

In my state of mind, the weakening dollar is a good thing. It will stimulate export growth and also retard imports. It will make the creation of renewable energy devices, fresh water desalinization created here rather than China. It will be our next bubble to invest in!!!

Private Equity, my version of the neverending story

2009-10-06T20:38:00.010-04:00

Nobody likes Private Equity, never have and never will. The hedge funds hate them because they make similar amounts but their structure prevents investor runs on the funds, unlike the ones that occur to a hedge fund. The i-bankers hate them because they have more freedom and make more money than they do. The regulators hate them because they operate outside their grasp. People hate them because the tippy-top make more money than Peru in a given year and almost everyone in the industry, at minimum, makes more than 3x what a median American household makes. For these reasons, and many, many more PE tries to keep a low profile. However, if you want to do the research you can find out about them their deal history, their portfolio companies, and anything else you might ponder. Dartmouth's Tuck School of Business has a dedicated unit writing up case studies and training talent for these firms. Of course, Harvard, Stanford and Chicago train plenty of MBAs who end up in PE, either by starting a firm or joining one. Still, the only thing that ends up in main stream media are the giant takeovers and the blow ups, which represent a very small and an even smaller proportion of the deals done.

The latest missive continues the trend of large takeovers and blow ups to again portray the industry in poor light. To help, I will refute some of the misunderstandings and bring about the industry in lay terms.

Imagine a house. Now imagine you want to buy that house. If you are unlike Bill Gates, you will more than likely require financing. Now the current owner's financing may be completely different from your idea of what an ideal capital structure may be. The mortgage may have already been paid off, or they may only own 25% equity if the had recently purchased it. This does not matter because you will pay them the agreed sales price and then can institute your own capital structure. For instance, once the sales agreement is negotiated stating you would pay 100,000 for the house. If it was the latter situation (25% equity), 75,000 would go to pay down the mortgage lender and 25,000 of equity would go to the former owners. Now your financing may be something like 50% cash and 50% mortgage from your local bank. The bank lends you money because it knows if you do not pay than it can reclaim the house from you, that is the mortgage is collateralized.

Most LBOs are like mortgages where the new owners put down 20% equity and borrow the last 80% from banks, or shadow banks (sophisticated debt investors) using the assets of the firm as collateral. After the mortgage is paid down, does not have to be all the way, you can sell it. The purchaser (PE firm) will make money in several ways: the equity appreciation (less debt in the capital structure), multiple expansion ( the next buyer will pay you more than you paid for the home.) That's basically all there is to private equity. Just like a 68% of Americans have done when purchasing their home, Private equity firms use collateralized loans.

Of course just like Americans found out, PE firms' portfolio companies can still end up underwater trying to live the American dream.

1st let me flesh out an idea about how the cycle of a portfolio company works. Ever see the movie Ronin. Well, Robert DeNiro's character never walked into a place he couldn't get out of. That's exactly how PE firms think. From day one they are thinking about the exit. (plenty of good work here.) Basically, there are a few ways PE firms will end their involvement with one of their portfolio companies.

Merger with a public company, including a reverse merger where the public entity merges into the private entity
Acquisition, this can be from a conglomerate, a competitor, or to another PE firm
IPO, sell the shares to the public
private placement, where a few large institutions purchase the company or a portion of it

So instead of this paragraph sounding ominous "... as part of an agreement by its current owners to sell the company — the seventh time it has been sold in a little more than two decades — all after being owned for short periods by a parade of different investment groups, known as private equity firms, which try to buy undervalued companies, mostly with borrowed money." You can see that this is just one of the ways that a PE firm exits. It just so happens that each time it was to a financial buyer instead of a strategic purchase from a firm like Sealy or Tempurpedic.

The article then speaks about dividend recapitalization. Here I can agree with the article's thrust that this action is a very dangerous game to play. However, the General Partner of the PE firm, may be at a time where his investors are looking for a return. What this action does is bring money back immediately to the LPs (investors of the PE firm) but also gives them a call option should the firm continue to shed its debt with its operational cash flow. The new debt though has to be sold to someone and that entity or entities may require some agreements, or covenants, that restrict the flexibility of the firm. This is, as the article insinuates, akin to taking out a second mortgage. Plus, as in the case of Simmons, the company can become over-levered in an economic environment that is unfavorable thus tipping the portfolio company into bankruptcy. With no recourse to follow back up to the PE firm, this leaves a bad taste in the mouths of all the people mentioned in paragraph one.

As always, the financial intermediaries will make money as long as transactions are going on. So of course investment banks made money as underwriters of debt and of IPOs. Articles like these love to point this out when the company fails but the i-banks also make money when these firms succeed as well.

The rest of the article could be about any firm, any where in the current economic environment. The cheap debt era ended, consumers have cut back and employees who were looking for a lifetime commitment are in the best of cases receiving a severance on their way out the door.

From the article, "because they pile debt onto the companies they buy, the firms free up their own cash, allowing them to make additional investments and increase their potential profits."

This is in so many ways wrong. The PE firms do not hold cash, they hold commitments from their limited partners (LPs/investors.) When they find a firm to purchase they hold a capital call and the LPs are supposed to provide the cash necessary to support the capital structure the GP (general partner) thinks is best suited for the targeted firm given its micro- and macro-economic environment. So never will a PE firm pony up 100% of the cash to buy a firm, just to then lard it down with debt, given the new acquisition its best shot but just playing the coin flip of heads I win, tails you lose. Intense projections, which are corroborated by the retained management, are devised. The capital structure is tested for revenue drops and unexpected shocks. The management is encouraged by the PE firm because they will also have a stake in the new capital structure along with the PE firm. So everyone works together to make the most amount of money for the equity holders of the new firm.

As I stated above there are a few ways in which to make money in the PE process, the two already mentioned because they fell in with the house analogy are debt repayment and multiple expansion. The third however is the generation of cash flow. The PE firm's staff are highly trained management, process innovators, former industry titans and financiers who know how to change a business model from one that may putter along into a well oiled machine. The business model has to be that way to ensure enough leeway to make bond coupon payments from the debt the company has taken on.

Any cash taken out of the portfolio company is returned to the partners of the PE firm, either the General or the Limited Partners according to their agreement and how far along they are in the agreement. If this is the first cash generating investment it would more than likely all be going to the LPs. If it was the last 80% would go to the LPs and 20% to the GP. None of this money is used to make new investments.

The remaining piece of the article tends to hone on the two points, the dividend recapitalization and the fall of Simmons market & thus the company. I would point out one more thing, the dividend recap was oversubscribed. The investors buying this "home equity loan" knew what it was being used for and thought with all the cheap debt and the solid business model that Simmons could handle it and be able to pay them back. Unfortunately they were wrong. The human interest portion of the article while touching and sad as Schumpterian creative destruction takes hold, shows how the executives were trying to save the company. Whereas the employee remarks there were no more Christmas parties, I say, well that means that the factory can make payroll for the next week instead.

Did THL error, yes. Did employees suffer, yes. Is this what THL predicted or wanted as an outcome? No. That they may have gleaned their principal back is not what their LPs want. In fact when they raise their next fund the LPs will remember that in this investment they were returned their principal and not a return on the principal. The fact is at the end of the day the bondholders (including the ones who lent the "second mortgage,") will try to make a new go of it. The only thing changing will be the owners of the company. I predict that consumers will still be enjoying Simmons mattresses years from now.

“How Economists Are Missing Another One,” or Not

2009-10-06T19:34:00.005-04:00

The worst thing I have ever read. It completely lacks an understanding of savings, investment and how the capital markets work. It does include enough facts that it seems plausible but I am still baffled as to how this was printed at The Big Picture at 10:18 AM 10/6/2009.

First, I would like to state that yes shares are traded on the secondary market and that people or corporations buying these shares are not really inserting new capital into a company unless they are buying an IPO or a seasoned offering. The reason this is done is to buy portions of current and future earnings that will be ultimately be returned to the shareholders through dividends, stock repurchases by the company or selling it to another entity who wishes to diversify their holdings and have a claim on the company’s earnings.

The “quelle horror” of total return versus dividends is because there is a tax benefit for shareholders in that dividends are taxed as ordinary income in the year received. However, when the corporation buys backs it shares and thus concentrates the earnings to the surviving shareholders; the shareholder can either choose to sell some of his holdings back to the company for income or hold on and be taxed later on. The taxation all depends on the shareholder’s preference. This is why total return is a better mark than dividends.

The argument that companies can create money is ridiculous. The Federal Reserve is the only entity that can create money using the banking system multiplier and open market purchases. There are newer tools but I won’t bore you with them now. This bold statement is made but then later on in the essay the author then decides that it isn’t really creating money it is shifting money from savers to investors, which is exactly the raison d’etre of the financial system. I would liken this to being angry with the sun because it basks us with sunlight every morning.

The paper fortune that you describe Bill Gates has is because each of those shares he has includes a claim of the near monopoly pricing and therefore earnings of Microsoft. If everyone traded in their laptop for an iPhone than guess what; those shares would drop in value not because they were worthless to begin with but because the future earnings of Microsoft would be in peril. Thus, the incendiary remark that it is a legal form of counterfeiting is placed in there only to excite the automatons. The whole piece reeks of this economic populism. For instance, “Despite Wall Street claims, retirement plans invest little in companies. Instead, the plans buy stock that insiders sell, thus transferring middle class savings to the richest people in the country and increasing the wealth gap.” While it may be true that entrepreneurs are benefiting by selling shares in their enterprises to the common man, they are not doing so without giving the common man a claim against any and all future income that the corporation may receive.

I cannot even fathom how the author comes up with the idea, let alone the evidence, that “These LBO outfits acquire a company with strong assets including cash but low stock prices; sell some of the assets; close down operations and eliminate jobs to cut costs; extract the cash with dividends; borrow large amounts to pay for the process; and sell the companies back on the market in a weakened condition.” If the “hulk” of the company was in such a “weakened” position than who would purchase it? This assumes that the i-bankers underwriting the IPOs are snake oil salesman and that this is done with the tacit agreement from the SEC. Both of these statements may still be true, however, at the end of the day the buyer of these IPO shares has to have done due diligence and expects to earn a return not a bankruptcy.

Here is a report by a Harvard and Chicago professor about the job loss at private equity firms. http://www.google.com/url?sa=t&source=web&ct=res&cd=3&url=http%3A%2F%2Fwww.scribd.com%2Fdoc%2F6310387%2FThe-Global-Economic-Impact-of-Private-Equity-Report-2008&ei=IMTLSvmnH4HJlAeJpZ3NBQ&usg=AFQjCNGSVZJhpNyCtj3hqJV7eh2-9aT8WA&sig2=pY8dkmJL8mhJ1Yb_gGLXEg

If no time read the article by Andrew Sorkin of the Times describing that paper and its results here. http://www.nytimes.com/2008/01/25/business/worldbusiness/25davos.html

Both find little evidence that private equity firms do more firings than is necessary to clear dead wood than any other firm. “[Portfolio companies] compared with those public companies with similar junk debt ratings, buyout [portfolio] companies defaulted at half the rate.” Tends to show that PE firms are more adept at managing a fiscal crisis than their public counter-parties. I will agree that the behemoth pe firms can have their incentive structured skewed to earn management fees and transaction advisory fees, ahem KKR, but the majority of funds and the GPs only make money once it has been all returned to the LPs. (indeed the carried interest doesn’t start until the principal and the management fees are returned.)

After that section though I have no quips with the analysis. The boomers turning from buyers to sellers is a valid argument, especially in the face of the liquidity crisis cum solvency crisis of the past few years. If on a whole investor’s risk appetites switch to shorter duration investments for income generation or just in cash or cash-like equivalents than yes the stock market could tank as there would be more supply than demand. But markets have a funny way of clearing. So if investors preferences do change to more income producing investments, I believe stock buybacks might be accelerated to decrease the supply of stock shares outstanding. Alternatively, the government may change its rules, as it is want do when a large portion of voters now need dividends, having capital gains and dividends receive the same tax treatment. This in turn would shift CFOs to go back to offering dividends with its excess cash instead of share buybacks, which would make the author happy?

Finally, I should think in concurrence with the author that baby boomers who planned on having twenty plus years of retirement may instead be more realistic and work later on into life, thus, decreasing the amount of time in which they have to live off of their investments.

I apologize for being so shrill to begin with, but there is some good analysis in this piece, it’s just that there is a ton of rhetoric contained in this piece that has been refuted.

I am re-posting this below because now I cannot find this anywhere on the internet. Here is a screen grab from my RSS feeder.

Thornton Parker is the author of “What If Boomers Can’t Retire? How to Build Real Security, Not Phantom Wealth” and has worked for the Department of Commerce and the Executive Office of the President. He focuses on retirement plans and investing in stocks to solve the ongoing Social Security problem. He defines phantom wealth as “the returns from corporate stocks that are based on market prices” as opposed to real wealth that is based on “work, earnings, and solid accomplishments, instead of just hopes.”

~~~~

Paul Krugman explained, in “How Did Economists Get It So Wrong” (The New York Times Magazine, September 6, 2009) how economists’ oversimplifying assumptions and models led to the present crisis by hiding important realities of the financial system and the real economy. He also described differences between the “salt water” economists at universities along the Atlantic and Pacific coasts and the “fresh water” economists of the Middle West, particularly the University of Chicago.

Today’s crisis grew out of problems on the credit and consumption sides of the economy. This essay builds on Krugman’s article and explains why problems on the equity and production sides, that few economists, political leaders, or corporate executives seem to understand or are willing to admit, are likely to cause another crisis.

Most salt water economists agree that creating jobs on Main Street is important. That will require extensive private sector investments, but the term “investment” has several meanings that can hide the different ways that stocks can affect jobs, wealth distribution, and the economy. The differences stem from three aspects of stock investments; types of investment, investors’ objectives, and stock flows.

Types of stock investments

Stock investments are productive or parasitic. The line between them can be fuzzy sometimes, but the differences are usually clear. Productive investments, which are called direct investments when made in other countries, provide capital to start and expand businesses in the real economy. They pay for the things, knowledge, and services that a company needs to operate. Young companies that are intended to become large need productive investments that usually come from the founders, their friends and families, and early stage investors such as angels and venture capitalists who take active interests. Because investments in these young companies involve many risks and are hard to liquidate, the companies depend on stock and rarely borrow very much. If they are successful, they may raise more productive capital from an initial public offering (IPO) and maybe from secondary offerings. If they continue to grow and establish a credit record, they may borrow money for productive investments, but equity capital is required for most early stage development.

In contrast, most stock purchases by individuals and institutional investors are parasitic investments because the buyers just want their money to grow. They are not interested in who gets their money or how it is used. They may buy stock of specific companies or they may buy shares of mutual and exchange traded funds that in turn buy companies’ stock. In any case, their money goes to the former stockholders, not to the companies. These are parasitic investments because they contribute little to the companies but piggy-back the productive investments that others have already made. And as will be discussed, they may be harmful and lead to eliminating rather than creating Main Street jobs.

Investors’ objectives

Five primary reasons for obtaining stock are for control of a company; to receive current income from its operations; for price gains; to store future purchasing power; and to create money. Company founders typically believe they know best how to manage their new enterprise, so they take large blocks of stock before the IPO in order to retain control. Similarly, outsiders who want to influence or take over a company may buy large amounts of its stock on secondary markets.

Income from dividends used to be a major reason to buy stock for the long term, but in the early 1980s, emphasis shifted to “total returns” which were dominated by price gains. S&P 500 Stock Index data show that 1981 was the last year after 1925 when the sum of all dividends paid was greater than the gains. The shift was profitable for Wall Street and coincided with the emergence of 401(k) retirement plans which emphasized growing portfolio values. Now, most stock purchases are for short term gains.

Retirement plans are the dominant stock buyers today, and their purpose is to build future purchasing power. But the plans have hurt Main Street and have fatal flaws which will be discussed below.

Finally, despite the general understanding that companies issue stock to raise money, their main reason is literally to create a form of money.

Stock flows

Individual and institutional investors buy most of their stock on the New York Stock Exchange, the NASDAQ and other secondary markets. Only small amounts of stock are bought directly from companies through public offerings. My analyses of Federal Reserve Flow of Funds Data indicate that after companies have their IPOs, most of their shares come to secondary markets when insiders sell them. This will be discussed below because it has major wealth distribution and other effects that few people understand, economists ignore, and those who benefit try to keep from being discussed.

Creating money with stocks

The reckless expansion of credit that led to over-consumption and the housing bubble has been widely discussed, but comparable mistakes with stock are being ignored. Creating money is the best place to start applying the three aspects of stock investments listed above (types of investment, investors’ objectives, and stock flows) to show how stocks can affect jobs, wealth distribution, and the economy.

It is natural for the founders of a company to want to keep control of their baby, so they can easily justify taking large blocks of stock before the IPO. Right after the IPO, however, all shares are treated as being worth the market price and if the founders took enough, their paper fortunes can make them rich in a day. Most recent fortunes have been made by (figuratively) printing stock certificates and passing them as money in what amounts to a legal form of counterfeiting. Few economists or public officials have recognized how this process expands the money supply while reducing the national savings rate, and almost no data are published to track it. Entrepreneurs need incentives to take risks, but there are serious questions about how large the incentives should be and how they should be taxed.

Insiders convert their paper fortunes into cash by selling the stock. Aggregate data for this are scarce, but it is how most stocks come into the market. The efficient-market hypothesis (EMH) does not consider how insiders drip feed stock into the market, pacing the sales to maximize their returns while not overly depressing the market.

Bill Gates, the richest person in the world, is the extreme example of this. He took 45% of the Microsoft stock before the company went public in 1986 and has been selling ever since. During the first eight months of 2009, he sold 60 million shares for a total of $1.2 billion. He more than recovered his investment from his first sale during the IPO, so all of his receipts are profit and are now taxed as capital gains at 15%. He still had 713 million shares as of August 18, 2009, which at the average price he received this year is a paper fortune of more than $14.7 billion. Like many other companies, a primary goal of Microsoft is to create personal fortunes using its stock, and at one time there were an estimated 10,000 “Microsoft millionaires.”

Retirement plans

Retirement plans exist to provide earnings streams to retirees. After 1982, Wall Street began promoting stocks as retirement investments by emphasizing their “total returns” which are driven by stock price growth more than dividend payments. Largely as a result of this change, stock prices were inflated in terms of their price-to-dividends and price-to-earnings ratios until the market peak in early 2000. Today, retirement plans of all types own nearly two thirds of the publicly-held stock traded on U.S. markets, but three important points are being overlooked.

First, as retirement plans bought stocks, almost no one asked where the stocks were coming from and where the retirement savings were going; or to put it another way, if stocks were such good long term investments, who was selling them and why? The answer, which few people including economists and political leaders seem to know, is that insiders like Bill Gates and his associates sold most of the stocks that the plans bought in order to convert their paper fortunes into cash. Despite Wall Street claims, retirement plans invest little in companies. Instead, the plans buy stock that insiders sell, thus transferring middle class savings to the richest people in the country and increasing the wealth gap.

The second point is that except for small amounts that some pension plans put into venture capital funds, nearly all stock investments by retirement plans are parasitic. As money flows in to plan managers who are expected to make it grow, they buy stocks and pass the pressure for growth on to companies. The companies respond by cutting costs, downsizing, outsourcing, laying off domestic employees, abandoning communities, promoting globalization, and going global themselves, all to inflate stock prices.

A recent example of these harmful effects grew out of the search for higher returns by pension systems. When stock prices stopped rising, they turned to “alternative investments,” including miss-named private equity funds which are actually leveraged buy-out operations. These LBO outfits acquire a company with strong assets including cash but low stock prices; sell some of the assets; close down operations and eliminate jobs to cut costs; extract the cash with dividends; borrow large amounts to pay for the process; and sell the companies back on the market in a weakened condition. The LBO outfits and pension plans are the winners, while companies, their employees, and their communities are the obvious losers. Less obvious are the companies that have learned not to look healthy enough to attract LBO attention.

The net effect of retirement plans’ buying insiders’ stock and parasitic investing has been to shrink both the production side of the economy and the middle class. The shrinkage was partly hidden while borrowing financed the housing bubble and excess consumption. Now, the country is trying to end the recession and create jobs, but the production side of the economy is crippled. Rebuilding it will require massive productive investments in companies and even new industries to create jobs that will be harder to export. People are being advised to save more for their retirements, but almost none of their savings that will be handled by retirement plans or Wall Street will become available for the productive, equity investments that will be needed to create jobs.

The third overlooked point about stock-based retirement plans that is until their stocks are sold, their portfolio values are just phantom wealth that can simply vanish, as it has done twice in the past ten years. Whether or not the plans can be successful will be determined by the demand for stocks and supply offered for sale when boomers want to retire. This leads to the fundamental flaws in stock-based retirement plans.

Retirement plan flaws can lead to another crisis

One of the worst things that could happen in the near future would be for stock prices to return to their former heights because that would restore confidence in stock-based retirement plans. These plans have eight fundamental flaws.

They are built on a stocks-for-retirement cycle. Most baby boomers are in the front, or buying half of the cycle, and to receive retirement incomes, they will have to shift to selling their stocks for substantial gains in the back half. This makes the cycle a national Ponzi scheme because returns to early investors (boomers) must come from money paid in by later investors (younger workers), not from companies as dividends.
When boomers gradually shift from buying stocks to selling them, the primary domestic buyers will have to be the younger workers that some believe will not be able to sustain Social Security in its present form. Stock-based plans and Social Security are joined at the hip by the same demographics—if stock based plans can work, there will be no Social Security problem, but if Social Security can’t work, neither can the stock-based plans. Despite urgings to boomers to save more and buy stock, their plans will be determined as much by the saving and stock-buying habits of younger workers as by the boomers’ own actions.
There has been a symbiosis between corporate insiders and boomers’ retirement plans. The plans wanted the insiders’ stocks and the insiders wanted the boomers’ money. As the boomers’ plans shift from buying to selling, the relationship will end and they will have to compete with insiders who will still be selling. This will add more downward pressure to stock prices in what may become a sustained bear market.
Boomers are told to plan to stretch their stock sales over many years, but if there is a serious bear market, some of them may decide to get out quickly and save what they can. This, of course, would feed the bear.
Boomers’ retirement plans that will have to sell stock suffer from the fallacy of composition; while some might be able to build and store future purchasing power individually, all of them can not do it collectively. Retirement income cannot be stored for a whole generation. It is a flow that can only come from other flows like employee and company earnings, which is why there appears to be a Social Security problem.
If there were an accepted due diligence analysis or feasibility study that explains how the boomers’ stocks-for-retirement cycle can be expected to work, Wall Street would quote it like a mantra. But there is no such document, so when asked, Wall Street changes the subject.
The plans are based on the same mistake of anticipating ever higher asset prices that led to the housing bubble. There is no accepted explanation of how stock prices can increase more than the economy grows for several generations, but this must happen for younger workers to pay adequate prices for the boomers’ stocks and then sell them at a profit to pay for their own retirements.
In a 2002 paper titled “Demography and the Long-Run Predictability of the Stock Market,” John Geanakoplos of Yale and two salt water associates from the West Coast explained that there has been a close relationship between stock prices as represented by price-earnings ratios and the ratio of young and old adults in the population. They predict a long bear market when boomers switch to selling.

The termination of thousands of company pension plans and the sorry shape of many state and local plans are evidence of these flaws. Any one of these flaws should be enough to make economists, corporate and government officials, and Wall Street question boomers’ plans before they all fail. But instead of asking questions, they avoid them.

What’s left?

Like fractals, the picture is similar at any level of detail. Few boomers have saved nearly enough to hope to retire for many years; despite Wall Street predictions, their stock-based retirement plans have done little for the past ten years; their savings in houses have declined; and ultimately the stock portion of their retirement plans are likely to fail as many pension plans are failing now. Many boomers will have to work more years than previous generations.

Governments typically approach employment problems with training programs, but unless jobs are created, training will be useless. Massive, productive investments must be made in new industries to create the middle class jobs with adequate pay and benefits that boomers, those who lost their jobs in the recession, and younger workers coming into the labor force will need. But these are just the kinds of investments and jobs that institutional investors, including retirement plans, have been forcing companies to avoid or eliminate. Further, Wall Street is devoted almost entirely to helping wealthy people speculate with parasitic investments and is not equipped to provide the equity capital needed to make the productive investments.

Today, attention is being paid to problems on the credit and consumption sides of the economy, but regardless of when the recession formally ends, America’s recovery and long range prosperity will be limited by problems on the equity and production sides. These problems will be harder to fix than the ones being considered now because they are more subtle; few people understand them; the fixes will require far more complex changes to the financial system; governments have reached their borrowing limits; and Wall Street will deny them and may delay action until it is too late to avoid a another crisis

But problems on Main Street, which Wall Street helped to create and many economists are missing, will not just go away and it is impossible to explain how the economy can regain its strength unless it is based on a strong Main Street.

tipparker@mac.com

Serial Drivel

2009-10-03T11:03:00.016-04:00

I usually breeze through BusinessWeek in about 10 minutes, just trying to sense the flavor of what MSM is cooking. But this week I could not just bypass this article without adding a comment, or two, or three. So below is the article with my notes attached.

There's an old saying in economic forecasting: The consensus is always wrong. But which way? The average forecast of the 52 economists surveyed by Blue Chip Economic Indicators calls for growth in real gross domestic product of 2.7% over the next four quarters, with the annual rate in any single quarter no greater than 3%. This early in the recovery, it's tough to argue that the consensus is either too pessimistic or too optimistic, but one thing is clear. The herd does not think the past tendency of strong recoveries to follow deep recessions will hold true this time. For example, in the first year after the severe slumps in 1973-75 and 1981-82, real GDP grew 6.2% and 7.7%, respectively.

The herd. The author uses the word herd to generate an impression of herd behavior or herd thinking. Too caught up in being like everyone else to see what is really occurring. Fine.

The correlation between the depth of recessions and the strength of recoveries over the last nine business cycles is unmistakable. It relates to the extent of the cuts businesses make in output, payrolls, and inventories. It also reflects the amount of pent-up demand created as consumers and businesses postpone spending. Like a rubber band, the economy snaps back in proportion to how far it was pulled down, as consumers finally upgrade old laptops and buy new clothes, and businesses replace inventories and worn-out equipment.

As he does not posit which business cycles, I will just assume he is talking about NBER's marking of recessions. But why stop there, why not 10; why not the just the last few? Do the 9 really represent what has occurred in this cycle? How about we make a comparison of this cycle to what previously occurred to see if we can rely upon a snapback, v-shaped, pent-up demand recovery that he posits.

Look in the last chart you can see cash for clunkers. However, there is much more in the CFR's report. Suffice to say I am not completely convinced that we can rely on the data from the past 9 cycles to be representative of what has happened and what might happen next. But I will continue to read with open mind in hopes of being persuaded.

If the consensus is right, the economy's departure from past experience would be striking. Economist Robert J. Barbera at the research and trading firm ITG (ITG) notes that after each of the past nine recessions, deep or shallow, real GDP has never required more than three quarters to regain its peak level prior to the downturn. If GDP staged a full recovery over the next three quarters, the economy would grow at a 5.4% annual rate. Even stretched over four quarters, the pace would still be 4.1%.

Again you must accept the wisdom that this is a normal recession just like in 1990, 2001 1981, etc. to then follow the conclusion that growth will be even better than the forecasters median expectation.

The common argument is that the usual rebound effect will be limited by the aftershock of the financial crisis: Credit growth is plunging, because households need to unload debt and save more amid lost wealth and tight credit, limiting the business sector's response. However, that's no sure thing. Data on credit flows are not particularly useful for predicting the strength of a recovery, according to economists at Barclays Capital. They note that in the strong upturns of the 1970s and 1980s, consumer spending accelerated well before the upturn in consumer credit.

My counter-factuals would be: A)that in the 1970's and 1980s Baby Boomers were entering the workforce, and for each one who entered there were more behind him/her coming. Thus, staking your place was fine, you could "buy-the-dips." Now however, those same leaders will be leading the way into retirement. The first Boomers are 63 now and in their mind's eye have been targeting the good life once they hit the Social Security mark. Now however, they will have to either work longer or save more if they hope to maintain their lifestyle. B) Also while the analyst at Barclays argue that credit may not be the major concern, as businesses have hoarded cash to survive this liquidity and solvency crisis. What should be a concern is CapEx spending.

CapEx has been dropping sequentially and year on year. So where are these revenues to come from if no one is engaged in attempting to grow their top line? The companies have done well to keep their profits up by annihilating their variable costs (labor.) So still not quite convinced but there is still more to come.

Early in recoveries, the growth of household income is a more important impetus to spending than credit. As job losses fade, pay from wages and salaries, about 60% of aftertax income, will turn up, as it did in July for the first time in nine months. Also, a lot of spending is done by households and businesses that either don't need to borrow or have good credit quality.

Aha! He has seen the light, it is hiring that will bring everyone back into spending! Let's look at the latest jobs report to see how great the job situation is going, the one that will bring us to above trend growth over the next 9 months.

Wait, what is this. The BLS stating that they have overestimated how many jobs have been lost over the past 20 months. It is actually 824,000 worse, which adds an additional .6% to the already abysmal 9.83% U-3 unemployment. Though it can be said that unemployment is not per se a bad thing when it is short term. It is only when it is long term unemployment that indicates a major problem with the economy.

That is structural unemployment is the highest it has been in 40 years! I am sure this is just a normal recession so the snap back should be starting any moment now. I wonder if I should mention that there is large proportion of part time employees who will have their hours increased before a firm begins to re-hire which can be seen in the hours worked survey from the BLS as well.

The recovery's oomph will also turn on how much income households feel they need to put away to eliminate debt and restore nest eggs. A rising saving rate weighs heavily on the growth of consumer spending. However, with savings in the second quarter already at 5% of aftertax income, up from 1.2% in early 2008, the saving rate may be about as high as it needs to go to give households the cushion they want.

So since we have established that all the rehiring because of all the revenue opportunities that companies are witnessing, we can then posit that consumers will go back to their prolific ways in spending our way to success. No mention of that as an open economy and the world's reserve currency that national savings will equal investment plus net capital outflows. Since the US dollar is in fact the world's dollar and that countries must use it as a store of wealth and a medium of exchange, which, of course, keeps the savings rate in the US artificially low since domestic investment is funded by foreigners allowing us to borrow freely from them. However, it does not state why consumers after being wounded with a 14 trillion dollar loss of wealth would want to continue to live paycheck to paycheck instead of saving for a rainy day. Please continue...

Historically, saving behavior loosely tracks the ratio of household income to wealth. As that ratio rises, in this case because of plunging stock prices and home values, so does the savings rate. By the second quarter the ratio had risen to the levels of the early 1990s, when the saving rate was about 6%, close to where it is now. Moreover, households in the second quarter recovered $2 trillion of the $14 trillion in net worth lost during the recession, and rising stock and home prices imply another gain of about $2 trillion this quarter.

The author now describes how savings is calculated and then undermines his argument by stating that the saving rate in a seemingly artificial manner dropped because of the rebound in the stock market. So we should actually look at the flow of funds report to see if savings increased not by its proportion but actually cash on cash over the preceding quarter. Here is the latest data 1219.9 followed by last quarter 1311.4 and the quarter a year back 1425.9. Since the economy has shrunk the savings rate shot up despite lower numbers. Although it must be said to save you have to pay off your creditors first.

So far, the raft of surprisingly positive data in recent weeks supports the more upbeat recovery scenario. In particular, the index of leading indicators, a composite of 10 gauges that tends to foreshadow recessions and recoveries, has turned up sharply. Since March the index has grown at an 11.7% annual rate, the fastest five-month pace since the 1981-82 recession.

The ten components of the Leading Economic Index include:

Average weekly hours worked by manufacturing workers - negative
Average number of initial applications for unemployment insurance - negative
Amount of manufacturers' new orders for consumer goods and materials - negative
Amount of manufacterers' new orders for capital goods unrelated to defense - negative
Speed of delivery of new merchandise to vendors from suppliers - positive
Amount of new building permits for residential buildings - positive
The S&P 500 stock index - positive
Inflation-adjusted money supply (M2) - negative
Spread between long and short interest rates (i.e. the yield curve) - positive
Consumer expectations - positive

So the positives from the reports are that monetary policy has effectively lifted the spread and the stock market. This has caused consumers to feel a bit better that the economic situation is not getting worse but is stabilizing. The new building permits has risen from a depressed level because of the cash for houses government initiative. However, on the whole no one is hiring, no one is adding more hours to the work week, no one is ordering more capital to build revenues. Seems a bit like a two sided report, everything that the government can touch is being held up by it and the rest is just wishful thinking.

For now, none of this will change the minds of the more pessimistic forecasters. However, the historical pattern is on the side of the optimists.

We finally agree. The analysis is sloppy. He does try to convey that he weighed both arguments for pessimism and optimism but it is not at all as thorough as it should be. I would have felt much better if he tried to dig further into his bullish arguments by explaining what portion of the LEI that he felt gave the economy the best bet. Was it the stock market? If so than his logic circles in this manner: the LEI is going up because the stock market has gone up therefore the stock market is going to continue to go up because the LEI presages it. Huh?

Economists do it with models! Part 2

2009-09-30T17:15:00.011-04:00

This post involves a lot of pictures from PowerPoint. I will add notes to each image.

The above picture shows a "normal" supply and demand curve. National savings (the supply) will increase with an increase in the real interest rate. Thus it slopes upward. Investment and NCO acting as the demand component works in the opposite manner. As The real interest rate rises the amount of loanable funds is low, lower and the quantity rises, thus it slopes downwards. ( Loanable funds are usually used to invest in capital assets, either at home or abroad, thus its relation to I + NCO)

The demand curve (in blue) represents the demand for dollars which is 100% correlated to NX. We know that NX must equal NCO from earlier discussions. Imagine you buying that BMW again. You are giving BMW US dollars but they must pay their labor in Euros. So what do they do with their US dollars, probably buying a factory in South Carolina, otherwise known as purchasing a capital asset.

The real exchange rate will be where this market is in equilibrium. The supply curve is vertical because the Quantity of Dollars is not affected by the real exchange rate, it is affected by the real interest rate. The amount of NX will affect the demand for dollars which are necessary to make transactions between foreign countries. When the exchange rate is lower will stimulate a demand for dollars, thus the demand curve slopes downward.

The real rate of interest will affect NCO. If the rate is low in relation to the Euro then more funds will leave the country. When the rate is higher (relatively) in the US then funds will flow back into the country.

The NCO graph ties together the demand for dollars/real exchange rate graph and the loanable funds/real interest rate graphs so that analysis of policy decisions can be made.

This example shows China as the home country. It wishes to lessen its trade balance by removing its subsidy to Chinese export companies. By decreasing the amount of net exports no matter what the exchange causes the demand for Yuan to fall (move leftward.) The real exchange rate drops to R2, however, it does not affect the amount of capital leaving the country. (note this example assumes that the Yuan is a fully convertible currency) NCO is only affected by changes in the real rate of interest in relation to the rest of the world.

A second example where the US is the home country. How would it be affected by having the Chinese purchase less Treasury securities? First we would see NCO increase, which would cause the domestic real interest rate to rise. This would have a secondary affect of...

Increasing the supply of dollars in the foreign exchange market. The increase in dollars would lower the real exchange rate. All in all the US would export more, import less due to the change in exchange rate. It would also save more as the real rate of interest would rise.

I added that if this had been undertaken in an orderly fashion after the dot-bomb debacle, perhaps instead of invading Iraq, there might not have been such a huge financial crisis with its epicenter in the US housing market. Instead the Chinese have continued to purchase US treasury securities keeping the real rate of interest low. This allowed a borrowing binge and an asset price appreciation in the United States housing market. Instead of appropriating the funds in more productive sectors, citizens were buying and flipping houses back and forth to each other in a Ponzi-esque fashion.

You can also imagine this set of graphs analyzing government budgets, ( a deficit will draw down on the supply of loanable funds, crowding out private investment), trade policy (quotas help one industry at the expense of all exporting industries via a higher exchange rate) and Capital Crises (it is the same analysis of China pulling its investment example from above.)

Economists do it with models! Part 1

2009-09-30T16:53:00.000-04:00

The last time we used a model we were looking at a hypothetical closed-economy. The model previously proposed was the market for loanable funds and now we can do the same analysis again with the new tools that we built in the preceding posts.

So now we go back to our Savings and Investment identity, S = I and add on NCO. Therefore,
S = I + NCO

Remember what S (national savings) consists of, which is public and private savings or

(Y - t - C) + (t - G) = S = I + NCO
Private Savings + Public Savings = National Savings = Investment and Net Capital Outflow

As we discussed last time NCO should be affected by real interest rates which behaves in the following fashion. As the real interest rate rises this encourages more people to save and less people to invest. The higher rates cost people & businesses more money to borrow to finance a project so instead they can just earn a rate of return by saving it. The higher borrowing costs create a hurdle rate that makes businesses take on the fewer projects that can meet this barrier.

Now though we have the added variable of real interest rates worldwide. So we should consider how those rates will affect financial flows. Note that this is a model and may not explain what currently happens in all places at all times. In fact what I am about to say next does not at all reflect the reality in America for the past 30 years.

So you have capital either located at home (I) or abroad (NCO). Savings will then purchase capital in either places. However, NCO can be positive or negative and will thus have an affect on the market for loanable funds in the following manner (usually): When NCO > 0, NX is greater than zero and we purchase capital abroad which increases the demand for loanable funds thus keeping real interest rates down. Conversely, when NCO <> 0, while NX < 0. How can this be so? Well as the nations that export to the US garner a bunch of dollars the countries then use their US Dollars to buy US debt.

Let's dig a little deeper into this and introduce a time differential. So in a closed economy the only way for a country to increase its investment is to increase savings. That is because S = I. In an open economy because S = I + NCO the domestic citizens do not have to raise their savings to fund investment. So if the US decides to build a nuclear plant it could import the parts from France and also borrow the funds in Euros. This will increase America's Investment (I) while increasing its NCO as well. We could also term NCO as the current account, as in the current account deficit. The reason this works is because the French have decided to save more so that the resources to build the plant are freed up for America. This is a time differential or in the jargon of economists it is an intertemporal trade, in that America imports present consumption (borrowing from the French) and exports future consumption (when it pays off the French.)

This is how the American consumer was able to spend so prolifically over the past 30 years because we kept buying present consumption and paying for it with IOUs (Treasury securities) that Asia snapped up. Because of the perceived weakness of the political and economic systems the Asians were willing to save more than their American counterpart and give up higher returns for two reasons: A) their economies relied upon the US consumer buying their goods, that is their own economies could not consume as much per capita as Americans because of the lack of a social safety net & B) the US dollar is a store of wealth and unit of exchange in the global economy.

I'll end here and begin again with the model.

Too small to bail has a nice ring to it - Breakingviews

2009-09-29T16:03:00.008-04:00

I agree with the sentiment and the main thrust of the article but, there always is a but, it seems to make a small mistake. First the synopsis: the banking industry is seeing larger losses at the larger banks, the systematically important banks caused the financial crisis because of the interconnectedness, smaller banks have thus far outperformed their larger brethren, however larger banks lend out more of their deposits thus getting vital credit out to the financial system, one last caveat is that the larger banks employed more mark to market and thus we may see more & larger (relatively) losses on smaller banks financial statements later in the cycle.

From the article But there is a wrinkle. Small banks lent out a smaller percentage of their customers’ deposits — 83.11 percent in the second quarter, to be exact — than the big banks, which converted 94.24 percent of deposits into loans, according to SNL Financial.

That’s a meaningful difference. If all banks in the United States kept their loan-to-deposit ratios in line with smaller banks, some $830 billion less credit on total deposits of $7.54 trillion would reach American businesses and consumers than if all banks adopted the big banks’ lending ratio.

My bone is with the larger banks lending out more of their deposits. You see on the face this statement is correct, prima facie for you latin lovers. However, deposits are only one form of liability for a bank. (quick note: bank loans are assets for banks and bank deposits are liabilities for banks. Banks will also issue debt as a longer or shorter liability.) So that is where the bone is. Larger banks will have better access to the capital markets; thus, these banks can lend out more money because the liability side of their balance sheet will be larger than a bank who cannot issue debt as cheaply or as in abundance as its larger cousin. Here is the information directly from the horse's mouth, otherwise known as the FDIC.

In this case there is no story. Banks larger than 10B in assets lend out only 58.19% of their liabilities. Smaller banks lend out 70.13%. If you divide it by smaller banks being less than 1B than these banks lend out 75.26% of their assets and the banks larger than that lend out 60.32% of their assets. What is the story here?

Well the story is B.S. or as I say in front of my niece baloney, not to be confused with bologna a delicious treat for children.

The truth is that if all the banks lent out at the rate small banks are currently doing there would be more credit in the system. Don't know if that is necessarily a good thing, but the idea is on much more solid ground than the sloppy analysis from the article.

Open note to my congressman

2009-09-27T17:01:00.001-04:00

Below in bold is a note I forwarded to my congressman. I also included a link to a more eloquent argument than my own, which is below in italics. I would urge you to send forward the italicized argument to your own congressman (especially if it is one of the following names who make up the financial service committee:
Rep. Barney Frank, MA
Rep. Paul E. Kanjorski, PA
Rep. Maxine Waters, CA
Rep. Carolyn B. Maloney, NY
Rep. Luis V. Gutierrez, IL
Rep. Nydia M. Velázquez, NY
Rep. Melvin L. Watt, NC
Rep. Gary L. Ackerman, NY
Rep. Brad Sherman, CA
Rep. Gregory W. Meeks, NY
Rep. Dennis Moore, KS
Rep. Michael E. Capuano, MA
Rep. Rubén Hinojosa, TX
Rep. William Lacy Clay, MO
Rep. Carolyn McCarthy, NY
Rep. Joe Baca, CA
Rep. Stephen F. Lynch, MA
Rep. Brad Miller, NC
Rep. David Scott, GA
Rep. Al Green, TX
Rep. Emanuel Cleaver, MO
Rep. Melissa L. Bean, IL
Rep. Gwen Moore, WI
Rep. Paul W. Hodes, NH
Rep. Keith Ellison, MN
Rep. Ron Klein, FL
Rep. Charles Wilson, OH
Rep. Ed Perlmutter, CO
Rep. Joe Donnelly, IN
Rep. Bill Foster, IL
Rep. Andre Carson, IN
Rep. Jackie Speier, CA
Rep. Travis Childers, MS
Rep. Walt Minnick, ID
Rep. John Adler, NJ
Rep. Mary Jo Kilroy, OH
Rep. Steve Driehaus, OH
Rep. Suzanne Kosmas, FL
Rep. Alan Grayson, FL
Rep. Jim Himes, CT
Rep. Gary Peters, MI
Rep. Dan Maffei, NY

Republican Members

Rep. Spencer Bachus, AL
Rep. Michael N. Castle, DE
Rep. Peter King, NY
Rep. Edward R. Royce, CA
Rep. Frank D. Lucas, OK
Rep. Ron Paul, TX
Rep. Donald A. Manzullo, IL
Rep. Walter B. Jones , NC
Rep. Judy Biggert, IL
Rep. Gary G. Miller, CA
Rep. Shelley Moore Capito, WV
Rep. Jeb Hensarling, TX
Rep. Scott Garrett, NJ
Rep. J. Gresham Barrett, SC
Rep. Jim Gerlach, PA
Rep. Randy Neugebauer, TX
Rep. Tom Price, GA
Rep. Patrick T. McHenry, NC
Rep. John Campbell, CA
Rep. Adam Putnam, FL
Rep. Michele Bachmann, MN
Rep. Kenny Marchant, TX
Rep. Thaddeus McCotter, MI
Rep. Kevin McCarthy, CA
Rep. Bill Posey, FL
Rep. Lynn Jenkins, KS
Rep. Christopher Lee, NY
Rep. Erik Paulsen, MN
Rep. Leonard Lance, NJ

Mr Frank, I am sure your aides have alerted you to this article as your name appears in it but I thought I might forward it along with a plea.

I have an undergraduate economics degree. I have a Masters of Business Administration in Finance. I have worked for financial services companies; negotiated contracts that were 20 pages deep, which were filled with hereafters and proper uses of semi-colons. So I can read a credit card disclosure or a savings account disclosure, but that is not the point. The point is that these products and their requisite disclosures are supposed to be easy and not required two degrees and 40 free minutes to wade through the nuances of how the contract will function when there are multiple variables at play. As Mr. Waldman eloquently argues below disclosure is not a transfer of information. Pages of dead trees layered upon each other in a type that is credibly said to be legible because font sizes are regulated does not mean that they are understandable to a lay person.

That is what I plead to you as a reasonable person, to instate a prudent person act that recognizes the information asymmetries exist that include benefits which are opaque and do not favor your constituents. One of the key arguments that I have studied over the length of this financial crisis that beset the global economy is that improved transparency and education could enhance outcomes.

However, it was Herbert Simon though who posited a long time ago "...in an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it..."

So per se, literacy in any subject is a good thing but the amount of information and the subjects are too consuming for any one person to master while maintaining their day job.

Thank you for your time and please reconsider your position,
Harry Coleman

Vanilla is a commodity

Do we have no fight left in us at all? Mike Konczal and Kevin Drum are excellent as always, but must we really write eulogies? Is one of the best regulatory proposals so far dead just because a single well-bought congressman says so?

Extracting the vanilla from the CFPA is not, as Felix Salmon put it "the beginning of the end of meaningful regulatory reform". It is the end of the end. Vanilla products were the only part of the CFPA proposal that was likely to stay effective for more than a brief period, that would be resistant to the games banks play. All the rest will be subject to off-news-cycle negotiation and evasion, the usual lion-and-mouse game where regulators are the rodents but it's the rest of us that get swallowed.

Wall Street's favorite comedian-politician, Barney Frank, was very savvy in framing the debate over the issue with his well-placed mischaracterization of vanilla products as "anti-market". That is bass-ackwards. The vanilla option is pro-market, because it is procompetitive. Of course, that is precisely why banks hate it: Vanilla products would turn basic financial services into a commodity business, and force providers to compete on price.

Ezra Klein is suitably depressed, but he's wrong when he writes that "the 'plain vanilla' provision was never likely to do that much." Vanilla products would be very popular, which is why they are so threatening. Financial services are an area where markets not only fail due to informational problems, but where participants are very aware of that failure. Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic "lemons" problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don't take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.

The price of assuring that one is not taken advantage of by financial service providers is not participating in the modern economy. You cannot have a job, because payments are by check or direct deposit. You cannot buy a home or a car, because for the vast majority, those purchases require financing. Try travelling with only cash for plane tickets, hotel rooms, and car rentals. People will "voluntarily" participate in markets rigged against them for the privilege of being normal. And we do, every day.

But define a reliable vanilla option, and the dynamic flips on its head. Instead of tolerating rent-extraction as a cost of participation, consumers put up with one-size-fits-all products in exchange for peace of mind. Most consumers benefit very little from exotic product features, and I suspect that many are made deeply nervous by the complex contracts they can neither negotiate nor understand, but nevertheless must sign. Vanilla financial products would be extensively vetted and and their characteristics would soon become widely known. Inevitable malfunctions would be loudly discussed in the halls of Congress, rather than hushed-up in rigged private arbitrations. Vanilla products would face discipline both from private markets (no one is suggesting we forbid other flavors) and from a very public political process. Politics and markets are both deeply flawed, but they are flawed in different ways, and we should take advantage of that. In Arnold Kling's lexicon, a market in which vanilla and exotic financial products coexist and compete offers the benefits both of exit and of voice.

Rather than being anti-market, vanilla financial products would help correct very clear market failures that arise from imperfect information and high search costs. It is the status quo that is anti-market.

I'm sympathetic to the principled libertarian objection to having the government require that private parties offer a product they otherwise might not. No one should be forced to offer vanilla financial products. Small-enough-to-fail boutiques should be free to offer only the products they wish. However, if an institution wishes to avail itself of government-provided deposit insurance or to access Fed borrowing facilities, it is perfectly legitimate for the government to set requirements. The government can choose not to offer its safety net to institutions that don't offer vanilla products, just as banks currently choose not to offer me a credit card unless I sign up to binding arbitration and unilateral contract changes. I fail to see why one is coercive and the other not. (The government has no monopoly on deposit insurance. Private insurers are free to provide similar insurance, and do so for many financial service companies already.)

An Economist anonobloggeer has some peculiar non-compliments about the vanilla products proposal:

The vanilla offering seems to be intended to substitute for sophistication or research on the part of the customer, but I'm just not sure that's a good way to approach the issue. As best I can tell, the vanilla plan wouldn't mandate the price of the simple option; just because a bank would have to offer a vanilla mortgage loan doesn't mean it would have to offer a competitive vanilla mortgage loan. If that's the case, banks could easily use high rates on the simple products to steer individuals toward the complex offerings. Or, the vanilla rule could actually serve to direct bank collusion toward high-priced, high-margin products.

Just because a commodity exchange standardizes the quality of corn that must be delivered into a futures contract doesn't mean that any seller has to offer corn at a good price. So true! But sellers that offer commodities at above market prices don't usually find buyers. Since vanilla financial products would be commodities, banks would have to universally collude to offer them at inflated prices in order to bilk consumers. Competing vanilla project offerings would (at least they should) vary only on a single dimension (e.g. an interest rate). Points, fees, penalties, etc. would be homogeneous or uniformly pegged to the core price. Banks are very, very good at forming tacit cartels, but colluding on complicated terms and conditions is easier and less likely to attract the antitrust authorities than fixing a headline price.

More from the econoanonoblogger:

To me it seems like the more effective solution would be to require that financial institutions explain, in detail, each and every fee they are assessing (or might potentially assess) to customers. That would inform consumers of what's going on in the monthly bill, and it would create an incentive to reduce the number and complexity of fees, as lengthy explanations would be a hassle for all involved and would reduce business.

One of the great errors in modern policy is to confuse disclosure with information. It is not the case, currently, that banks secretly take your money without itemizing the charge on some statement. (Sometimes when they take your money they call it "service fee" or something equally nondescriptive, and it'd be nice if that practice went away.) Rather, banks intentionally define contracts in such a way that the cost to many customers of understanding and competitively shopping all the dimensions of the product seems higher than the cost of terminating the search and signing the dotted line. More detailed disclosure doesn't eliminate, and can sometimes exacerbate, the real information costs customers face, which derive from the complexity of the required analysis and lack of information about alternatives, not from an absence of product data. Of that we all have pages, with more arriving every month. You might think there'd be a market for ostentatious simplicity, and there might be. But no bank's lawyers would sign off on a single page, 12 point text, no-extratextual-incorporation-or-unilateral-modification contract. When routine contracts get more complex than that, it's just gibberish competing with gibberish for people who have lives. Some financial products are necessarily complex. But one way of managing complexity is standardization. It may be worth it for consumers to carefully study the one contract they will probably sign in a way that it would not be worth poring through 100 freeform contracts, 99 of which they will never sign.

The most serious objection I know to vanilla financial products is that they would be harmful precisely because they would catastrophically succeed. The theory is that nothing is more dangerous than a commodified bank, and the evidence is May Day, 1975, when the SEC ended fixed stock trading fees in the brokerage industry. Some commentators (e.g. Barry Eichengreen) claim that by eliminating a stable, cushy profit center, the May Day deregulation forced gentle investment banks to become hungry innovators, that the financial system has grown progressively less stable because under cut-throat competition risk-takers dominate (until they self-destruct and take the rest of us down with 'em). I don't buy the May Day story, but for the sake of argument, let's suppose it's true. Let's suppose that, in the name of stability, the best policy would be to ensure banks easy profits so that they needn't dabble in dangerous things. Then two conclusions follow:

1. If we are going to strike a policy bargain whereunder banks get a nice sinecure in exchange for a promise of stodgy mellowness, it seems reasonable that they should commit to the stodgy mellowness. Dull, subsidized banks should be heavily regulated banks, or, to use the term of art, "narrow banks".

2. If we are going to impose a regime that ensures bank profitability, we ought to do so in a reasonably equitable way. Business models that hide profit generators in complex contracts, or that extract fees especially from the disorganized and naive, are not reasonable instruments of public policy for keeping banks healthy. If we do go with the coddled but heavily regulated model of banking (not my preference!), and we're not willing to have the Treasury end the capitalist charade and just cut checks to its payment-systems subcontractors, then a decent approach would be to have narrow banks offer only vanilla products and provide monopoly rents by putting floors under fees and ceilings above deposit interest rates (as existed in the US until the 1980s). Under either a competitive or "regulated utility" model, the fairness and informational case for defining standardized vanilla products remains compelling.

I think people like Barney Frank, when they try to sleep at night, have been sold on the "we need healthy banks, so let's protect their profit centers" story, although they'd never admit to it while scoring points comparing powerless people with furniture. I wonder if it even occurs to Mr. Frank that maybe something serious should be demanded of banks in return for state protection of market power at the expense of the weak and disorganized. But then Mr. Frank has already gotten very much in return.

Not so much M&A but the trouble with financial disclosures and consent.

NCO and NX correlation. Or, alternatively, One more than the model

2009-09-24T14:24:00.006-04:00

Can't wait my next post will be titled economists do it with models. Now though, I have one more idea to bring about and it is pretty much the same idea as real interest rates or real purchasing power. Now it is real versus nominal exchange rates. As a well known economist said Par- tee! (OK it was Bart Simpson)

Nominal exchange rates would be the ones when you check in to a foreign country. I go to Thailand and the bank will give me 33.69 baht for every OG G-Dub I give them. Probably not as there will be a bid-ask spread, so the bank can make their crumbs off of me and some other schnook.

To complicate matters you can express the rate in two ways that both mean the same thing. That is, you can express it in your home currency per foreign currency or you can do it the opposite with foreign currency per your dollar. Unfortunately, places use them interchangeably or if it has become established market practice than it can go either way. If you follow the link you can see that Great Britain's pounds and the European Union's Euros are both quoted as X dollars per 1 unit of either of them. On the other hand most other currencies are quoted as X _____ per dollar.

Now then there is kind of a sticky point which needs bearing out. So if I say that the dollar has appreciated with regard to the Canadian Loonie, that is one dollar will now by more loonies. One could erroneously believe that because you have more loonies you can buy more things, thus the Loonie has appreciated. This is wrong. The fact is that it now takes more Loonies to buy the same American dollar. If you want to remove the dollar from the equation think about it this way. I have an apple grown in upstate NY that I am going to sell to a Canadian. Yesterday I sold an apple for .9 Loonies. Now today because the dollar appreciated, it will cost a Canadian a full Loonie to buy my apple. Thus, the Canadians have lost purchasing power.

Now to determine the real exchange rate we must observe another input, similarly to the example just provided. We need to put goods into the equation. So the Canadian from above is considering purchasing an apple. He can buy one from a Canadian farmer or an American one, and both apples have the same quality. To determine which price is best he must Use this formula:

Real exchange rate = (Nominal Exchange Rate x Domestic Price)/Foreign Price.

Let us state that the nominal exchange rate is 1.1 Loonies per dollar, the price of the Canadian apple is 1.0 and the American apple is 1.23.

Entering those variables into the equation we find:

Real exchange rate = (1.1 x 1)/1.23 = 0.89 Canadian apples per American apple. This real exchange rate will decide how much a country imports and exports. That is, economists look at price levels on a whole to decide how exchange rates should move to reflect the underlying trading reality.

So if you were interested in taking a medical vacation to Thailand, you might base your decision by using the real exchange rate. You would compare the price of a surgery stay in your hometown measured in dollars and compare it to the cost of the medical stay in Thailand in baht and then include the exchange rate between the two countries.

An interesting side shoot of this has been work done by The Economist magazine. They have what they call the Big Mac index. Positing that McDonald's is a large multinational and that the inputs to a Big Mac are the same the world over, the Big Mac Index should work to predict real exchange rates and tell you what countries' currency is over or under-valued.

So what this chart does is tell you America is the base case. A Big Mac costs $3.57 locally. It then compares the price in local currency and then it does the conversion for you by using the local currency price and converting it into dollars per the exchange rate. This can then be compared to the actual exchange rate for nationwide goods/services giving the reader a proxy for over and under-valued currencies. As of this edition of the index July 16, 2009 the worst place for Americans to spend their dollars is in Norway or Switzerland whose currencies are overvalued by 72 and 68%, respectively. The best places to spend your Uncle Sam's would be in Asia with Hong Kong, China, Malaysia and other leading the pack.

One reason this occurred in such a specific region, excluding the Ukraines of the world, it is theorized is that China pursues a mercantilist trade policy to keep its currency value down (dollars can buy more Yuan than they should) and other mercantilist countries, like the rest of Asia follow suit. This creates a large instability because to keep these currency valuations down the countries respective NCO must follow their NX up. Thus, they must purchase lots of US dollars. This intertwines the economies of Asia and America to a degree with which a contortionist could be proud.

These last three paragraphs and the chart have been using an idea called both purchasing power parity and the law of one price. I start with the latter.

The law of one price states that goods traded in different places must be priced the same otherwise arbitrageurs would buy in the cheaper market and sell in the other market. Imagine a tycoon buying up Big Macs in China to ship them over to the US. Of course, there is more to the argument than that, prices can differ slightly as there would be shipping and spoilage charges incurred in practicing this arbitrage. Because of the law of one price, which applies to currencies as well as Big Macs, it follows that a US dollar should trade for the same in all markets and we reach purchasing power parity. From these two ideas we can then see that nominal exchange rates should reflect the price levels ratios of any two countries.

One interesting fallacy that can be exposed in this model is expressed in the following idea first proposed by Larry Summers. People get so tied up into this idea of parity that imagine we have two bottles of ketchup that measure 12 ounces a piece. Then we have a third ketchup bottle from the same brand that measures 24 ounces. Economists will get so caught up in making sure that the two smaller bottles price together reflects the cost of the larger bottle. This causes a problem in that ... can you guess ...

that one is not looking into whether the input prices are over or under-valued. This is especially prevalent in financial assets and may be the reason we had such a spectacular blow off in 2008 in the financial sector. Everyone kept taking note of the fact that one house with 2400 square feet cost exactly double a house with 1200 square feet keeping all other factors constant. No one asked whether the price of the smaller home should have been selling for 3 times as much as the place could be rented for over the period of the mortgage.

Real Interest Rates and Net Capital Outflow

2009-09-23T13:18:00.009-04:00

Last post I was talking about the identity of Net Exports equaling Net Capital Outflow or in fancy math NX=NCO. I stopped the post short because I wanted to talk about real interest rates before proceeding to build a model for how NCO affects NX and vice versa.

Intuitively NCO will be affected by the real interest rate in the domestic country (wherever you are currently) and the real interest rate in the foreign country with whom you are doing trade. But what exactly is the real interest rate and how does it differ from the nominal interest rates? Well to answer the last question first the real interest rate is the nominal interest rate adjusted for inflation. A man named Fisher first studied and brought this effect to the attention of the economic community.

One more thought on why you should care about nominal interest rates versus real ones. Nominal interest rates affect how much interest your money earns over time. Real interest rates however will track how much purchasing power your money gains or loses over time. Its the same as when we talked about inflation here.

To figure out the relationship for real interest rates, nominal interest rates and inflation we will need three variables. Fisher used r, i and π. Basically he said that i =r + π. However, to really get at the derivation we need to add one to each term. So it should be written as

(1 + i)= (1 + r) * (1 +π)

So then depending on what you know it easy to derive the unknown, usually this will be the real rate of interest. So we can put

((1 + i)/(1 + π)) - 1 = r

So if you know that your savings account gained 4 % last year and CPI calculated by the BLS raised by 2%, we can deduce that the real rate of interest is 1.96%. So your purchasing power of your account moving from 100 to 104, really netted you an increase of about 1.96 dollars of increased purchasing power.

Now back to the beginnings of a model. So now we have a model of the the economy where:
Y = GDP
C = Consumption
G = Government Purchases
I = Investments
NX = Net Exports (Exports - Imports)

Y= C + G + I + NX

So before when it was a closed economy we could just state that Savings equals Investment. Now with our new variables, or toys, or tools (which ever you prefer) we should investigate how NCO and NX are affected by real interest rates.

In the early post we reformed our formula to look like this:

Y - C - G = I and S = Y - C - G

but as I said we will now add NX. So it looks like this:

Y - C - G = I + NX

Thus we can state that Savings equals Investments plus Net Exports, or

S = I + NX and we know that NX = NCO, therefore

S = I + NCO

So it becomes apparent that the entire reason we use the term net capital outflow is because national savings will equal domestic investments plus net capital outflow.

We can theorize what happens in some different circumstances. So if Savings is greater than domestic investments, I, then its capital will be exiting the country through NCO. Restated that the country is buying assets abroad. On the other hand when Savings is less than domestic investment it is because foreign capital is helping meet the demand of domestic investment by purchasing our assets.

One last way of viewing this is through the Net Exports account. So if Germany (domestic) is running a trade surplus by selling more goods to foreign countries than it buys (NX +) than its capital must be leaving its country to purchase foreign assets (NCO +). Likewise when New Zealand purchases more foreign goods than it sells(NX -), it must then sell its assets to bring in capital (NCO -).

Finally, we should consider how a current account deficit should work and whether it is a good or bad thing. So the current account deficit occurs when we import more than we sell, thus our net capital account decreases and the current account deficit widens. But there are a couple of variables at play. Is the current account increasing because investment has increased as a percentage of GDP? Or is the current account growing because the government is running a budget deficit, thus dis-saving for the domestic economy. (S = (Y - t - C) + (t - G), where an increase in G keeping everything else static will decrease national savings) Both of these situations put the deficit in completely different lights.

NX, what I've been missing

2009-09-21T19:32:00.006-04:00

So, quite a few of my posts were about the model of the economy with no imports or exports. This was so that I could more easily investigate nuances of taxation, savings and investments. However, as most economies are not closed off to each other the model is only good for introductory looks at an economy. So to add to our burden we must now investigate the flow of goods and its effects on money and monetary policy.

1st the basics
Exports - goods/services produced domestically that are sold to foreign countries
Imports - goods/services produced abroad and consumed domestically.
Net Exports - the positive or negative value when comparing a country's imports and exports. If it imports more than it exports it has a trade deficit.

Conversely, if it exports more than it imports it has a trade surplus. This is called a country's trade balance. There are numerous factors that affect why a country should run a deficit or surplus some include:

exchange rates
tax policies
wealth of citizens
price of goods
and, preference of citizens

The above chart shows the US trade balances from 1960 to 2008. The blue area is when the US ran a trade surplus and the red area is when it has run a trade deficit. The purple area is the null area where imports and exports equal each other. (Also in later years it is merely the exports as imports dwarf exports from 1976 onwards.) It is plainly obvious that the trade has become an increasingly large proportion of the economy. It is also true that the imports have become a larger portion of the economy than exports, you can draw your own reasons from the ones listed above as to why imports have grown more rapidly than exports.

Most economists would posit that trade has increased because of the better supply chains that have been initiated from standardized Twenty-foot equivalent units, that can be transferred onto trains, ships and trucks almost effortlessly, to universal product codes have helped make the world a global economy. Telecommunications and technology have intertwined to support the logistics of multinational corporations. Increasingly technocrats have listened to economists' advice that free trade will bring gains to all sides. All have contributed to why trade has grown to a larger portion of GDP.

There is another way that countries trade with each other and it is with financial instruments. A term called net capital outflow (NCO) works exactly like NX. So instead of an import it would be a purchase of a financial asset by a foreigner; conversely a purchase of a financial asset by a US citizen would be an export. So when a foreigner purchases either a factory or US treasury bill that represents a decrease in net capital outflow. The purchase of a factory would be a foreign direct investment and the purchase of the treasury security would be a foreign portfolio investment.

The reason it is important to consider NCO and NX together is that they form an identity, that is, NCO=NX and vice versa. They must equal each other. Here is an example to help think about why it is so.

Say you purchase a BMW from Germany, you even make a vacation of it. So you bring an import to the United States and in exchange you give the German company US dollars. That is net exports have decreased for the United States and decreased the net capital outflow.

Now BMW cannot use the US dollars to pay their employees. So maybe they would instead use their new dollars to buy an automobile assembly robot in the United States. This would increase the net capital outflow of the US and also increase exports, thereby increasing NX.

Tomorrow I will explore how this affects savings and then work on a model to show how this is affected by real interest rates.

Serial Inflation or the cost of inflation

2009-09-21T17:23:00.005-04:00

Everyone knows that inflation is a bad thing; deflation may be worse but neither is desirable. What central banks shoot for is price stability, so that businesses and consumers can plan accordingly to maximize their utility. However, it was Mark Twain that said “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”

What do I mean? Well, inflation may be the cruelest tax but the drop in purchasing power may not be all that it is cracked up to be. See that is why people dislike inflation. It is ingrained in their head that if the dollar loses value, that their dollar purchases less goods and services. This is a bad thing, no? Here is their evidence.

Pretty rough. Since the advent of the Federal Reserve, the private bank has eroded each Americans wealth by 93.4%. The thinking described must advances a theory that American standard of living has dropped in step with the fall of the dollar. However, I don't remember seeing any HDTV, MRI machines, air conditioners during the 1913 period in my history textbooks. Not seeing these items is not direct proof per se, but until I see one I will assume they weren't prevalent, at least to the degree that they are today.

Another way of saying this would be that, the dollar is used to purchase goods and services. People provide goods and services at their job. Thus, the price level rising (the dollar's value declining) tends to net out because the inflation that drives down the purchasing power is also being inflated in the person's offered labor.

One last way of putting this is by numerical example. The CPI index states that inflation rose by 3% last year, (made up.) Last year, you received a 3% raise, so net net you are even. You have not lost purchasing power; your yearly bonus helps safeguard your standard of living.

**Addendum**
I re-read my post and it makes sense but I wanted to add flavor and nuance to the argument. So I needed a multi-year argument to further convince you. So I went and grabbed the Census department's median income in current (nominal) dollars and in real terms as well. I also added the BLS CPI price levels matching set of data from 1975 to 2008 year end.

So first I took a compound annual growth rate for both series, to bring about a unified number so that an apple to apple comparison could be made. To do this I took the last year of my data for each set and divided it by the initial year. I then raised it to 1 over the number of years difference, which is 1/33 years. I then subtracted by one to end up with a annual growth rate percentage. For median income it was 4.49% and for the CPI price level data it was 4.39%. What these two figures mean is that over the period between 1975 and 2008 on average, that is linearly, median income outpaced inflation (what the CPI price levels measure.) You may then draw the conclusion that standards of living have risen because income has outpaced inflation.

If you still do not believe me the Census bureau in the same data set provides the median income in real terms. From 1975 to 2008 the "real" amount of annual wealth accumulation has risen from $42,936 to $50,303. Meaning most households can purchase more than they could back in 1975, thus their standard of living has increased. (Note: I use median income because average income can be skewed by the Bill Gates-s of the world. Ever hear the quip, when Bill Gates walks into the room on average we are all billionaires?)

Though the fallacy should relieve you, inflation still does have an effect and can lower your standard of living in other ways. One is called shoe leather cost. It is the affect, where you have to change your paycheck into a store of value. That is instead of placing your paycheck into a demand deposit account, you because of your knowledge of inflation instead place your funds into a money market account. Now though you have to transfer funds back to the demand deposit account when you go to the restaurant or take the children to the amusement park. This isn't bad in the United States. However, imagine you were in Zimbabwe last year where inflation ran at 36,000%. The cost of your meal would be more the longer you ate, so I am positive that the Zimbabwe equivalent of McDonald's did brisk business last year.

Another is an effect called the menu effect, after restaurant menus. It means that businesses set prices and are reluctant to change them. Again our low inflation environment makes the effect a bit myopic but if inflation ran at a higher rate, businesses would be forced to change their "menu" more often so as to not be burned by their margin contraction as their inputs cost more while their own prices stayed the same.

Finally, there is one last way in which inflation can hurt you and it is in investing. Hypothetically, you buy a share of GM in 1971 for 100 dollars. Now almost 40 years later, after counting for splits the stock is worth 300 dollars. You would be assessed a capital gain tax on 200 dollars at a 20% rate. Here is where inflation stings. Look at the chart above. The dollar was worth 24 cents. Now it is worth 4.6 cents. It has lost almost 6 times its value. Meaning your 100 1971 dollars could buy almost 600 dollars today. So in fact your capital gain is not real, you have lost 50% of your money over the time period. Yet you are still taxed 40 dollars because taxes are assessed nominally and not indexed. Ouch!

Debt, is this not the Great Depression?

2009-09-10T11:14:00.004-04:00

I was on the Federal Reserve website checking out the major holders of debt in the United States historically. Both charts that I created show basically the same data. The first though shows the difference in the amount of debt over time, though it is nominal terms not real terms. The second just illustrates more lucidly the amount allocated to each type of provider. There were no data from earlier, but we can generalize that the banking system in the Great Depression looked a lot more like the 1943 data than the 2003's data points.

So it is obvious that the financial system has evolved, not in the Victorian sense that evolution necessarily means for the better, just that it has mutated. Securitized pools which do not exist in the data until the end of the 1980's come to make up over 30% of debt extended in its halycon days of 2003. A securitized pool is a pool of debt instruments for instance mortgages, or credit card debt, or automobile debt, or just general loans. These are sold to investors, usually pension funds, mutual funds, etc. The idea is that these instruments should be safe but yield more than comparable government bonds or AAA corporate bonds. These pools also allow the end borrower to borrow more cheaply than had investors not bid up the price they would pay for these structures.

The reason to make the distinction between the two eras or even to look back at how the debt market has evolved is that the response of the players should be different as well. When a bank in the 1920s and 1930s funded itself via deposits and then constructed a loan portfolio of assets it was subject to a risk of concentration. The first part of the concentration risk was that since there was no FDIC the deposits were not insured, so if all the people of the town came asking for their money at the same time there would not be enough cash in the vault to meet their claims. The second risk that stems from the first, was that if the financial system was in dire enough shape for people to be asking for their cash deposits back it meant that the economic system was in arrears as well with unemployment sure to follow. Thus, the loan portfolio (mortgages, small business loans) concentrated in the area in which the bank was would probably not pay back all the cash flows it was expected to generate. These are the reasons that the social safety net was constructed with unemployment insurance and deposit insurance.

So, what can be expected of the banks to do now? Well, banks will keep on doing what they have been doing. Making loans where it is profitable to do so and winding down bad loans. It is instead the securitized pools that worry me. Some of those pools were brought back onto the originating banks balance sheets, which then ties up their regulatory capital, thus decreasing their lending. Now a securitized deal cannot even be done without a guarantee from the Federal Government backing it. If we lop off the 25% of debt structure of the United States it will be hard to recover back to normal and "normal earnings and revenues." It's what PIMCO has been saying for awhile now that a new normal may be in store.

Inflation

2009-09-09T12:31:00.005-04:00

The quantity theory of money describes inflation and has a long history dating back to thinkers in the Renaissance. Coepernicus among others noted that as gold arrived from the New World the price of goods rose. Thus the theory expounds that there is a positive relationship between increases in the money supply and prices of goods and services.

An easy example would be coffee. Imagine a Dunkin Donuts as it started in the 1950s, it charged a nickel. Now to buy that same cup of joe it costs 2 pieces of silver ($2.00.) Is it because the coffee is better, or because people enjoy it more? Nope, according to the theory, your dollar's value is less, so before a 20th of a dollar got you some warm goodness now it costs two. So how did the dollar come to be valued less? Isn't monetary policy off the gold standard?

It wouldn't be economics if supply and demand were not involved. The money supply is based on the Federal Reserve through its operations including its open market operations. Again, it buys bonds to increase the money supply and it sells them to decrease the money supply. For the next example it is assumed that the Federal Reserve keeps the money supply constant. The money demand however is controlled by people. Some factors that affect how much money people want to hold are: that availability of credit through credit cards, the availability of withdrawing funds either through an ATM or from a bank's teller. Underlying this idea though is the cost of goods/services because as they are priced higher than people must carry more cash for daily transactions. Since the people carry higher balances with higher prices than the demand for money is greater.

Here is a chart.

The blue line is the fixed money supply. The Red line is the Money Demand. The demand line curves downward because as the value of money falls or conversely the price level is higher people desire a larger quantity of money. The equilibrium is shown by the dotted line it is where the price level and the value of money intersect.

Now as the Fed performs open market operations, say buying treasury bonds, it will increase the money supply. The next chart shows the money supply parallel shifting out (from blue to orange.) This cause the value of money to fall and thus price levels to rise.

It is important to note that the fundamental economy has not been affected by this injection of money. The capital level has not changed, the labor productivity has not changed, knowledge is static, everything in short is held constant. However, because there is now more money chasing the same amount of goods then prices must therefore rise.

This brings up another point, that prices should not matter or restated that there exists a monetary neutrality. If prices double, then so should wages because the inputs for the good/services include labor, thus everything should be equal in the long run.

Now back to MV=PY or V=(PY/M) so the velocity of money should equal the price level times real output divided by the quantity of money. During most times V is stable, however, during financial crises this does not have to be so.

The Federal Reserve

2009-09-03T14:15:00.004-04:00

I have been searching, fruitlessly, for a chart depicting the year on year change in price levels before the Federal Reserve and since its creation in the early 1910s. I cannot find it and will instead describe it. It shows a noise chart above and below zero. In the beginning the variance is large if it were a seismograph it would be showing an earthquake. (Shown above) As the Federal Reserve is instituted the variations shrink and adhere more closely to a long-term trend. The chart shows why the Federal Reserve exists and why interest rates are not allowed to freely float.

The Federal Reserve is made up of 12 regional banks and a board of directors. The regional banks are tasked with regulating and keeping the banking system healthy. These banks also act as a lender of last resort or the banks’ bank. The Board has a distinctive but related task to control the country’s money supply. The Board of Governors plus 5 regional bank presidents together make up the Federal Open Market Committee. 4 of the bank presidents rotate, as the New York bank always has a spot.

The committee controls the money supply in three ways:
A) By buying and selling bonds via the open market operations,
B) Reserve requirements, and
C) The discount rate

A) Open Market Operations - When it buys bonds it adds new money to the financial system and when it sells bonds it takes away money from the financial system. This seems counterintuitive but view it from the viewpoint of a bank. When the bank sells its bond to the Federal Reserve it now has cash instead. It can then lend this cash out. However, when the Federal Reserve sells bonds the bank must use its cash to purchase the bonds and thus loses the ability to lend out the money it purchased the bond with.

B) Reserve requirements – regulations on the minimum amount of “cash” reserves a bank must hold against customer deposits. This affects the money supply because if the banks have to hold more in reserve the banks then have less to lend out. Vice versa, lowering the requirement allows banks to loan out more money.

Here is how it works:
Bank A
Assets
Reserves 100.00
Liabilities
Deposits 100.00

This is if there was a 100% reserve requirement. Obviously this is untenable as the banks could only keep the money safe, as a warehouse. No entity would undertake this responsibility, as there would be no profit. So the banking system consists of a “fractional reserve system,” which only means that a fraction of each dollar of deposits is actually held at the bank. The rest is loaned out, which is a banking asset, to create profit for the bank.

Bank A
Assets
Reserves: 20.00
Loans: 80.00
Total: 100.00
Liabilities
Deposits: 100.00
Total: 100.00

Thus, seemingly the banks has created money, in an earlier post we said that money was currency plus demand deposits. So 80 + 100 = $180. However, it must be said that the economy is not wealthier, there is just more money or liquidity. This is because those 80 dollars of loans, though bank assets, are liabilities to entities that undertake them.

The process does not end here though. If the person, who took the $80 loan, maybe did not have an immediate need for the funds, so he deposited it at his bank.

Bank B
Assets
Reserves: 16.00
Loans: 64.00
Total: 80.00
Liabilities
Deposits: 80.00
Total: 80.00

This iterative process can be completed ad infitnitum, so as a general solution we can take the initial deposit and divide it by the reserve requirement ratio. So $100 divided by 20/100= 500. Thus, the money multiplier at this reserve requirement will be 5.

C) The Discount Rate – Acting as the banks’ bank it loans out reserves to bank who find them short of the reserve requirement. Picture the end of the day and a customer comes in at 4:30 PM and withdraws 10 dollars of deposits from Bank A. Bank A would still have 80 dollars worth of loans but now only 10 dollars of reserves. It would need to find 10 dollars of reserves to meet the Federal Reserve’s requirement. It thus can go to the Fed and borrow the 10 dollars at the discount rate. Then it would to try and unwind one of its loans to rid itself of the borrowings from the discount window.

Bank A (after 10 dollar withdrawal)
Assets
Reserves: 10.00
Borrowed: 10.00
Loans: 80.00
Total: 100.00
Liabilities
Deposits: 90.00
Borrowings: 10.00
Total: 100.00

The discount rate follows the laws of supply and demand. So when the rate is high banks wants to borrow less and when the rate is low the banks are more willing to borrow. Finally, this also acts as insurance against a bank run, as the banks can borrow from the discount window freely, thus generating the liquidity to survive a financial crisis like in 2008 and in 1987.

Greg Mankiw in his Principles of Economics points to two major problems with controlling the money supply through these three mechanisms. First, the Fed cannot control how much money people will want to hold on deposit with banks. Thus, a bank run can have systemic effects on the money supply. Secondly, the Fed cannot control how much the banks lend. Unlike China, you cannot force the banks to underwrite loans that the banks deem too risky given a current economic situation.

These two forces have been a key puzzle for economist over the past century. It is described by a simple equation M x V= P x Y, where:

M= quantity of money
V= velocity; the link between money, price and output
P= price level
Y= aggregate income or GDP

In the short run V and Y can be held constant thus the price level would be affected only by the money supply. This is how Milton Friedman came out with the proclamation that “inflation is always and everywhere a monetary phenomenon.”

However, as we have experienced lately the Federal Reserve and the Treasury have instituted a number of initiatives to increase the money supply and velocity but velocity has only declined to negate their works. I will expand on this in the next post on Inflation.

Money, it's what you want?

2009-09-03T13:34:00.004-04:00

Why? The money we use today, the pieces of green paper with some old dudes on it, funny symbols and words, and pictures of architecture is essentially worthless, fiat. Why do we exchange them for goods and services, that is, why can you give them to a cashier at Starbucks and receive a latte?

There are three basic functions of money: medium of exchange, unit of account and store of value. Medium of exchange is the most obvious. Imagine that instead of money we had a barter system. You would create a pair of socks and you would then try and find me a person who needed socks. Then of course I would need to be able to give something back to you that we felt equaled the value of the socks. Basically you needed to have a "double coincidence of wants." Money obviates the above situation by its ability to be freely substituted for goods and services. Thus, you can sell your socks for money and then use your money to buy a bushel of grapes without having to find someone who had a need for socks and owned a bushel of grapes.

It also works as a yardstick, like an inch of a foot. It makes it easy to compare two relatively different goods or services into like terms. So having a maid clean your house is equal to 10 car washes. Instead we would just say that the maid's services cost 100 dollars and a car wash is 10 dollars.

Finally, it holds value. When the Starbucks or the sock maker takes the cash, they can delay their consumption to a later period. Thus, money can be a holder of wealth.

Here is where money becomes tricky though. It is enough to look in your piggy bank and see a collection of metallic coins and the occasional two-dollar bill which is money, but what else is money? How about the money in your checking account known as a demand deposit? What about CDs. or savings or money market accounts? There are several definitions of money as categorized by the Federal Reserve. M2 is probably the most appropriate measure. It includes:

demand deposits - checking accounts
traveler's checks
other checkable deposits -
currency
savings deposits
short time deposits
money market funds
various accounts