Monday, March 1, 2010
A More Realistic View of Capitalism
A Silver Lining to the Financial Crisis: A More Realistic View of Capitalism
Two familiar scapegoats for the financial crisis---deregulation and bankers' bonuses--- don't appear to be responsible for the disaster.
By JEFFREY FRIEDMAN AND WLADIMIR KRAUS
From The American Enterprise Institute
No. 1, January 2010
A BBC poll conducted in twenty-seven countries found last month that only one in four Americans thinks that capitalism works well--and that this is the highest proportion of any country in the world. Only in America and in Pakistan, of all places, do more than 20 percent of the respond-ents think that capitalism works well; the average across the twenty-seven countries polled was only 11 percent. And 23 percent of those polled "feel that capitalism is fatally flawed, and a new economic system is needed." Majorities want their governments "to be more active in owning or directly controlling their country's major industries in 15 of the 27 countries." But "the most common view is that free-market capitalism has problems that can be addressed through regulation and reform--a view held by an average of 51 percent of more than 29,000 people polled."[1]
This is a measure of the intellectual toll taken by the financial crisis. But it is good news, in a way. As opinion researchers have long known, terms such as "capitalism" are dimly understood by most people (even by intellec-tuals), so the best way to interpret these results is as a repudiation of the status quo, which most people (inaccurately) call "capitalism" or "the free market."
In this light, the real problem lies not in the fact that so many people would like to see an entirely new system--a reasonable demand, once we understand what caused the crisis--but rather in the fact that a majority thinks that the remedy for the inadequacies of the status quo is "regulation and reform." The status quo can best be characterized as hyperregulated capitalism, and it was the regulatory elements, not the capitalist elements, that caused the financial crisis.
It is one thing to say that corporate America's compensation systems are flawed. It is quite another thing to say that this flaw caused the financial crisis.In short, people are right to be dissatisfied with prevailing economic arrangements. But they have been persuaded by their intellectual leaders--including, unfortunately, most defenders of "capitalism"--to think that the status quo is capitalism, rather than a system in which the most fundamental feature of capitalism--competition--has been seriously undermined by a thick layer of regulation laid over capitalism during the last 150 years. There is no better example of how misleading it is to blame "capitalism" for the resulting problems than in the case of the financial crisis, which was in fact a regulatory failure par excellence.
What Did Not Cause the Crisis
There are currently three points of consensus about what caused the crisis, one of which is indisputable, one of which is dubious, and one of which is incorrect. The incorrect and the dubious need to be cleared out of the way if we are to understand what really went wrong. So here are the three points of consensus, arranged from wrong, to probably wrong, to right:
Claim One: Financial Deregulation Caused the Crisis. This piece of the conventional wisdom is false. The indefatigable Peter J. Wallison has pointed out in an AEI Financial Services Outlook that the two aspects of financial deregulation that have been blamed for the crisis are mythical, not factual.[2]
First, the Gramm-Leach-Bliley Act of 1999,[3] which amended the Glass-Steagall Act of 1933,[4] did not erase the distinction between commercial banks, which take deposits and make loans and investments, and (the somewhat confusingly labeled) investment banks, which underwrite and trade securities. The 1999 act merely allowed both commercial and investment banks to be subsidiaries of a common holding company, but they remained subject to the same restrictions on the nature of their activities as before. These restrictions were loose in the case of investment banks but tight for commercial banks--and as we shall see, the crisis took place within the commercial banks. It is therefore crucial to recognize that, contrary to the claim many prominent economists and commentators have made, the 1999 act did not "repeal" Glass-Steagall, whose heavy regulatory framework on the activities of commercial banks remained on the books, as potent as ever.
The second part of the "deregulation" myth concerns credit default swaps, which truly were, and remain, unregulated. But as Wallison has shown in yet another AEI Financial Services Outlook,[5] subsequently expanded into an article in Critical Review,[6] credit default swaps did not mysteriously "interconnect" banks and increase systemic risk.
In essence, a credit default swap is a loss-protection insurance contract. This risk is swapped (for a fee) by the lender to a "counterparty"; the amount of the risk remains the same but has merely been transferred from the lender to the counterparty. This transfer no more increases overall risk levels than does a car insurance policy, which transfers risk from the driver to the insurance company. A credit default policy is often traded from one counterparty to another, so on a flow chart that followed the policy from hand to hand, all the counterparties might appear to be "interconnected." But this interconnection is historical only: past counterparties do not remain on the hook when they pass a policy to a new counterparty. There remain only two meaningfully connected parties--the ultimate insurer and the insured. Not surprisingly, then, Wallison demonstrates there is no evidence that credit default swaps contributed to the crisis.
Claim Two: Executive Compensation Systems at the Banks Caused the Crisis. This part of the conventional wisdom is doubtful at best. It is true that many publicly held American corporations, including banks, pay performance bonuses that may encourage excessive risk taking. The reason for this is a topic that cries out for exploration, as does any instance of manifestly irrational behavior by large numbers of businesses. An explanation that we find credible builds on the historical research of Amar Bhidé, who points out that starting in the 1930s, regulations issued by the Securities and Exchange Commission (SEC) made the close supervision of corporations by "insiders" who financed these companies--the dominant practice before the SEC regulations--impossible.[7] Since the 1930s, therefore, equity investors in most corporations have, by definition, been "outsiders" who have had to use publicly reported information to infer what is going on inside. In making these inferences, they rely on short-term, legally mandated heuristics for long-term performance, such as quarterly earnings reports. This gears publicly held corporations toward short-term gain, even at the price of long-term risk.
It is one thing, however, to say that corporate America's compensation systems are flawed, whether because of securities regulations or for some other reason. It is quite another thing to say that this flaw caused the financial crisis.
To date, there have been only two studies of the matter, the first of which found that the banks whose executives held the most stock in the bank lost the most money in the crisis--indicating that the executives did not engage in deliberate risk taking motivated by a quest for higher bonuses, as they would have been risking their own money.[8] A more recent study, however, by Ing-Haw Cheng, Harrison Hong, and Jose Scheinkman finds a positive correlation between risk taking and large bonus packages,[9] although this study has been criticized on the grounds that most of the risk taking found by the authors was among insurance companies, not banks.[10]
These two studies are important, regardless of their conflicting findings, because their authors recognize that different banks operated differently. But at the aggregate level, there is decisive evidence against the thesis that incentives to take risks caused the financial crisis. The evidence is this: 93 percent of all the mortgage-backed securities held by American banks either were issued by Fannie Mae or Freddie Mac, and were thus implicitly guaranteed by the U.S. Congress (as the American taxpayer soon found out), or were issued by investment banks and rated AAA by one of the three rating agencies: Moody's, Standard and Poor's, or Fitch.[11]
Never mind that these three private corporations had had a legally protected oligopoly since 1975, thanks to another SEC regulation.[12] Never mind, in short, that, protected from market competition, these companies' AAA ratings may have been so sloppy or so deliberately skewed that they understated the risk associated with mortgage-backed bonds. That aside, the oligopoly's ratings produced a concrete result: as is true of all bonds, AAA-rated bonds paid less than lower-rated (AA, A, BBB, etc.), supposedly riskier bonds. Bond investors always trade risk against returns. A high rating connotes safety and therefore always pays lower returns than lower-rated bonds pay--and there is no higher rating than AAA. If bankers were being lured by their banks' compensation systems into acquiring risky but lucrative assets--on the basis of which the bankers would have gotten bigger bonuses--then they should never have bought AAA bonds. Instead, they should always have bought higher-paying AA-, A-, or BBB-rated bonds, but they did so only 7 percent of the time.
Claim Three: The Fed's Low Interest Rates from 2001 to 2005 Financed the Housing Bubble That Led to the Crisis. This is the only element of the conventional wisdom that seems to rest on solid ground.13 But when it is cut loose from the other two elements of the conventional wisdom, it generates a puzzle: why did the bursting of the housing bubble cause a financial crisis, that is, a banking crisis?
This might not seem so puzzling at first: commercial banks made many of the mortgage loans that were financed by the Federal Reserve's low interest rates. But the financial crisis was not caused by mortgage defaults directly: it was caused by a sharp drop, in September 2008, in the market price of mortgage-backed bonds, in anticipation of their declining value as the bubble deflated. The first victims of the falling price of mortgage-backed bonds were Fannie and Freddie; in quick succession came the investment bank Lehman Brothers; and finally came the commercial banks--because they held so many mortgage-backed bonds, not mortgages. The question, then, is why the commercial banks held so many mortgage-backed bonds. If deregulation or the quest for high earnings, hence high compensation, did not cause the banks to buy these bonds, what did?
Regulatory Roots of the Financial Crisis
To answer this question, we have to turn in a direction that has been overlooked by the conventional wisdom: an obscure regulation called the recourse rule. The recourse rule was enacted by the Federal Reserve, the Federal Deposit Insurance Corporation, the Comptroller of the Currency, and the Office of Thrift Supervision in 2001.[14] It was an amendment to the international Basel Accords governing banks' capital holdings, and all over the world, these regulations appear to have contributed significantly both to the housing boom and to the financial crisis.
A bank's capital reserve represents funds that are not borrowed--funds that, therefore, need not eventually be paid back to someone, such as a bank's depositors. Thus, an important source of a bank's capital reserve is funds from selling shares of stock in a bank. These funds can be costly to acquire, as one expert has pointed out:
For corporations (including banks) not eligible for Subchapter S earnings pass-through treatment, the after-tax cost of equity capital, say 12 to 15 percent, is substantially greater than the after-tax cost of debt, which is generally in the 3 to 5 percent range.[15]
By reducing their capital holdings, banks can, at least in principle, increase their profitability.
But under the recourse rule, "well-capitalized" American commercial banks were required to spend 80 percent more capital on commercial loans, 80 percent more capital on corporate bonds, and 60 percent more capital on individual mortgages than they had to spend on asset-backed securities, including mortgage-backed bonds, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie. Specifically, $2 in capital was required for every $100 in mortgage-backed bonds, compared to $5 for the same amount in mortgage loans and $10 for the same amount in commercial loans.
One can readily see that the recourse rule was designed to steer banks' funds into "safe" assets, such as AAA mortgage-backed bonds. The fact that 93 percent of the banks' mortgage-backed securities were either AAA rated or were issued by a GSE shows that this is exactly what the rule accomplished.[16] Unfortunately, these bonds turned out not to be so safe. Without the recourse rule, however, there is no reason for portfolios of American banks to have been so heavily concentrated in mortgage-backed bonds.
No other category of investors except investment banks (which packaged mortgages into mortgage-backed securities, and thus were caught with huge inventories of both), no matter how highly leveraged--not hedge funds, not bond funds, not pension funds, not insurance companies--was as decimated as commercial banks by huge holdings of mortgage-backed bonds. But that is because the recourse rule covered commercial banks, not hedge funds or anyone else. If not for the recourse rule's privileging of mortgage-backed bonds, the burst housing bubble almost certainly would not have caused a banking crisis. The banking crisis, in turn, froze lending and caused the Great Recession.
Indeed, the recourse rule may have been a significant factor in pumping up the housing bubble itself. In 2001, $2.2 trillion in mortgages were originated; the figure leapt to $2.9 trillion in 2002, when the recourse rule took effect, and to $3.9 trillion in 2003 before declining to $2.9 trillion in 2004, $3.1 trillion in 2005, and $3 trillion in 2006, after which the bubble began to deflate.[17] Was there a connection between the recourse rule and the housing bubble?
Each mortgage-backed bond promised, to the bond holders, principal and interest payments drawn from thousands of mortgages. The more mortgage-backed bonds were bought, the more mortgages had to be written. The artificial demand for mortgage-backed bonds created by the recourse rule may therefore explain why, as the decade wore on and the pool of credit-worthy borrowers who made traditional down payments dried up, banks and mortgage specialists lowered their lending standards and made the terms of their mortgages more generous. The resulting mortgages would soon be sold to Fannie, Freddie, or an investment bank for securitization into bonds. (Between the middle of 2001 and the beginning of 2002, mortgage securitization jumped from about $20 billion to $50 billion per quarter, peaking at nearly $150 billion per quarter in 2006.)[18]
The recourse rule did not apply outside the United States, but the first set of Basel accords on bank capital, adopted in 1988,[19] included provisions for even more profitable forms of "capital arbitrage" through off-balance-sheet entities such as structured investment vehicles (SIVs), which were used extensively in Europe. Moreover, in 2006, a second set of bank-capital accords, "Basel II," began to be implemented outside the United States. Basel II took essentially the same approach as the recourse rule, encouraging foreign banks to acquire mortgage-backed securities, just as in the United States.[20]
Here, then, we may have the genesis of the global financial crisis. If so, it turns out to have been caused by the very device--regulation--to which most people now, as they did throughout the twentieth century, look for the "reform" of capitalism. But is it really capitalism when it is so heavily regulated?
Regulation as a Source of Systemic Risk
It is true that capitalists--bankers--who took advantage of the recourse rule turned out to be making a grievous mistake. But not all capitalists made this mistake, and that is where the story gets interesting.
Recall the findings of Cheng, Hong, and Scheinkman, who detected more risk taking among ¬individual banks that paid high bonuses. We contrasted this finding against the aggregate behavior of (commercial) banks, which chose the less-lucrative, less-risky GSE-issued or AAA-rated mortgage-backed bonds favored by the recourse rule 93 percent of the time. The aggregate finding suggests that executive compensation practices did not cause the crisis and that the recourse rule did. But the findings by Cheng et al. remind us that aggregate figures obscure differences in behavior among individual business firms. Indeed, there is a word for "differences in behavior among individual business firms": competition.
Consider the contrast between Citigroup and one of its main competitors, JP Morgan Chase. Citi jumped into mortgage-backed bonds with both feet, putting them on its balance sheet through the recourse rule but also buying them off-balance-sheet through SIVs, of which Citi created seven of the sixteen in the United States (there were forty-one in Europe). Citi even established a separate unit to securitize its own mortgages. Meanwhile, JP Morgan lost billions of dollars in potential revenue for years in order to avoid mortgage securitization.[21] JP Morgan's Jamie Dimon was among those who recognized the danger; Citigroup's Chuck Prince apparently recognized the danger but calculated the odds of disaster as lower than the profits to be made from taking advantage of Basel I (which sanctioned SIVs) and the recourse rule.
What explains this diverse behavior is that the ¬individual bankers in question had different perceptions of the magnitude of the risk. In unregulated markets, that kind of diversity of viewpoints is precisely what makes capitalism work. One capitalist thinks that profit can be made, and loss avoided, by pursuing strategy A; another, by pursuing strategy B. The heterogeneous strategies of different capitalists compete with each other, and the better ideas produce more profits than losses.
That, from an analytical perspective, is competition. From the same perspective, competition is at the core of any rigorous definition of "capitalism." Competition is what gives capitalism its only conceivable economic advantages, as compared either to regulation or to the "whole new economic system" that many people have tried to envision ever since capitalism--with its inequalities, its waste, and its many other inadequacies--burst into public consciousness during the Industrial Revolution. To ask why we need competition, then, is to ask why we need capitalism.
Our answer is as follows. In a complex world like ours, nobody really knows what will succeed until it is tried. Competition, which pits entrepreneurs' divergent ideas against each other, is the only way to test these ideas through anything but the highly unreliable process of verbal debate (in which the debaters' competing ideas cannot be simultaneously tested against each other in the real world, instead of in the imaginations of their audience).
Competition among capitalists sorts out which of their ideas actually please real-world consumers and which of them are displeasing--however appealing the ideas might have seemed on the drawing board. And competition among capitalists also sorts out which ideas for how to avoid loss are good ones and which ideas for avoiding loss are bad. Thus, competition has the net effect of spreading society's bets among different, fallible ideas about where profit--and loss--might be located and of testing them against reality. For this reason, herd behavior among capitalists is a genuine threat to its "competitive advantage." If capitalists stop acting heterogeneously--if they compete through imitation, rather than innovation--the risk of systemic failure increases, unless all of the capitalists happen to be placing their chips on the right idea.
Capitalism will probably always be prone to asset bubbles and other manifestations of homogeneous behavior, but only because it is part of human nature for people to go along with the crowd. This is a risk that can be mitigated but not eliminated. But capitalism has a unique feature, competition, that does mitigate it by both encouraging and taking advantage of heterogeneous behavior, that is, innovation.
Homogeneity, on the other hand, is the ineradicable curse of socialism, in which the community as a whole, through its elected (or self-appointed) representatives, decides on the allocation of resources. One plan is imposed on all, as thoroughly as if everyone spontaneously decided to join a herd.[22] And we maintain that homogeneity is also the problem with regulation. Regulations, by their very nature, align the behavior of those being regulated with the ideas of those doing the regulating. Regulations are like mandatory instructions for herd behavior, automatically increasing systemic risk.
The recourse rule, Basel I, and Basel II loaded the dice in favor of the regulators' ideas about prudent banking. These regulations imposed a new profitability gradient over all bankers' risk/return calculations, conferring 80 percent capital relief on banks that bought GSE-issued or highly rated mortgage-backed bonds rather than commercial loans or corporate bonds, and 60 percent relief for banks that traded their individual mortgages for those "safe" mortgage-backed bonds. Only bankers with the most extreme perceptions of the downside, such as JP Morgan's Jamie Dimon, escaped unharmed.
Bank-capital regulations inadvertently made the banking system more vulnerable to the regulators' errors. But this is what all regulations do. Whether by forbidding one activity or encouraging a different one, the whole point of regulation is, after all, to change the behavior of those being regulated. And the direction of change is, obviously, the one the regulators think is wise.
Perhaps, then, we do need a new economic system: capitalism. The Basel rules, the recourse rule, the oligopoly-conferring regulations of the SEC--these regulations cover a tiny fraction of the millions of pages of the Federal Register and its state, local, and international counterparts. And each of the hundreds of thousands of regulations filling those pages chips away at the heterogeneous competitive behavior that constitutes the best reason for capitalism. If one is looking for the cause of a systemic failure in our highly regulated economy, it makes more sense, at least initially, to look to the laws that govern the whole system, rather than reflexively blaming what has now become "capitalism" in name only.
How Conservatives Get Capitalism Wrong
If our argument has been correct, then the Great Recession was a regulatory failure, not a failure of capitalism. But it is also an occasion for a rethinking of capitalism--by both its conservative defenders and its liberal critics.
Let us start with conservatives, many of whom make the mistake of extolling the brilliance, wisdom, or heroism of capitalists. They forget that for every Jamie Dimon, there is a Chuck Prince. Capitalists are as fallible as anyone else. Collectively, they possess no superior powers; their lucky guesses, no matter how well informed, are still guesses. Everyone can see this in the wake of the crisis. Paeans to capitalist genius will no longer do.
Seventy-three percent of the successful entrepreneurs recently surveyed by the Ewing Marion Kauffman Foundation said luck was an important factor in their success.[23] These successful capitalists' own assessments happen to track the standard liberal view. The main point made by John Rawls--the great philosopher whom conservatives love to loathe but hate to read--was that good luck, including even the good luck to develop a strong work ethic, confers no moral claim. Winners of the genetic lottery, Rawls said, are not thereby entitled to be rewarded. Liberals are right to notice that good luck explains many capitalists' success, and that bad luck--accidents of birth--condemn millions to lives of misery. Conservatives who close their eyes to the accidental element in wealth and poverty make themselves appear both heartless and clueless.
In addition to their unfortunate romanticizing of capitalists, conservatives have erred by adopting the economists' standard explanation for the success of capitalism: self-interest. Self-interest is supposed to ¬provide the "magic of the market," but we can safely assume that Chuck Prince was every bit as self-interested as Jamie Dimon. Both of them had equally strong incentives to save their banks, but that did not help Citigroup. Armen Alchian, an economist at the University of California, Los Angeles, showed in 1950 that capitalism would succeed even if capitalists were not motivated by self-interest. And the fact is that many successful -capitalists, such as the founders of Google and Whole Foods, were not motivated by self-interest.[24]
Unfortunately, economists have only grown more obsessed with self-interest--that is, "incentives"--since 1950. This has led many conservatives to embrace the idea that "greed is good"--a woeful misreading of Adam Smith. Smith's parable of the baker, to whose benevolence we do not appeal when we buy our bread, is actually a lesson in unintended consequences, not in the wonders of greed. Even if the baker intends merely to make money, he can do so only by providing his customers with bread. In his case, greed is indeed good. But that does not mean that greed is always good and benevolence bad, nor that all bakers are in it solely for the money. Nor does it mean that greed accounts for the success of capitalism.
How Liberals Get Capitalism Wrong
Liberals are right to see through the usual conservative defenses of capitalism, but they are wrong on the big picture. They fail to notice that there is more to capitalism than luck and greed: there is competition--the saving grace of the whole system; the device that turns good luck to social advantage; and, when undisturbed, the source of capitalism's systemic strength.
Competition is the engine that turns the talents of the lucky to the service of all. A baker who offers moldy or bland bread can be driven from the field by a competitor offering a better product. That is the message of Adam Smith. The successful baker, no matter how greedy his motive for baking bread, must unintentionally mimic the very actions an altruistic Rawlsian philosopher would prescribe. The reason is the competitive nature of the capitalist system; the motives of individual capitalists are irrelevant. Competition puts capitalists' different motives, like their different ideas, to the acid test of consumer satisfaction. This tends to give consumers what they want--or at least what they think they want--and it diversifies a capitalist society's investment portfolio. Capitalism thus mitigates both human greed and human fallibility. This is an amazing achievement, but there is nothing magical about it.
Now consider again the alternatives liberals tend to favor--either the regulation of capitalism or its replacement by something more democratic, like an idealized socialism. Since regulators' or citizens' ideas would then be imposed on the whole economy at once, they could not be put to the competitive test--any more than the conflicting arguments of debaters, the conflicting promises of politicians, or the conflicting forecasts of budget analysts can be tested. If the citizens' or the regulators' ideas happen to be good ones, we all gain; if they happen to be bad, we all lose.
The whole system crashed when the financial regulators' ideas about prudent banking backfired, but such failures are inevitable unless modern societies are so ¬simple that the solutions to social and economic problems will be self-evident to a generalist voter, or even a specialist regulator. That modern societies really are that simple is, in truth, the hidden assumption of modern politics. This is why political conflicts get so ugly: neither side can understand why their adversaries oppose what "self-evidently" should be done, so both sides ascribe evil motives to each other. But the financial crisis has exposed this simplistic view of the world for what it is. In the wake of the crisis, nobody can plausibly deny anymore that modern societies are bafflingly complex. The solutions to social and economic problems are thereby unlikely to be self-evident. The theories that seem so obviously true to voters or regulators may turn out to be disastrously false--unless regulators or citizens are infallible.
That surely would be magical. But there is no more magic to politics than there is to markets. The question raised by the ongoing intellectual contest between socialism and capitalism, and the ongoing practical battle between regulation and competition, is how best to guard against human frailties: By putting all our eggs in one politically decided basket? Or by spreading our bets through the only practical means available: competition?
Mr. Friedman is the editor of the journal Critical Review and of Causes of the Financial Crisis (University of Pennsylvania Press, forthcoming in 2010). Mr. Kraus is coauthoring, with Friedman, Engineering the Perfect Storm: How Reasonable Regulations Caused the Financial Crisis (University of Pennsylvania Press, forthcoming in 2011).
Two familiar scapegoats for the financial crisis---deregulation and bankers' bonuses--- don't appear to be responsible for the disaster.
By JEFFREY FRIEDMAN AND WLADIMIR KRAUS
From The American Enterprise Institute
No. 1, January 2010
A BBC poll conducted in twenty-seven countries found last month that only one in four Americans thinks that capitalism works well--and that this is the highest proportion of any country in the world. Only in America and in Pakistan, of all places, do more than 20 percent of the respond-ents think that capitalism works well; the average across the twenty-seven countries polled was only 11 percent. And 23 percent of those polled "feel that capitalism is fatally flawed, and a new economic system is needed." Majorities want their governments "to be more active in owning or directly controlling their country's major industries in 15 of the 27 countries." But "the most common view is that free-market capitalism has problems that can be addressed through regulation and reform--a view held by an average of 51 percent of more than 29,000 people polled."[1]
This is a measure of the intellectual toll taken by the financial crisis. But it is good news, in a way. As opinion researchers have long known, terms such as "capitalism" are dimly understood by most people (even by intellec-tuals), so the best way to interpret these results is as a repudiation of the status quo, which most people (inaccurately) call "capitalism" or "the free market."
In this light, the real problem lies not in the fact that so many people would like to see an entirely new system--a reasonable demand, once we understand what caused the crisis--but rather in the fact that a majority thinks that the remedy for the inadequacies of the status quo is "regulation and reform." The status quo can best be characterized as hyperregulated capitalism, and it was the regulatory elements, not the capitalist elements, that caused the financial crisis.
It is one thing to say that corporate America's compensation systems are flawed. It is quite another thing to say that this flaw caused the financial crisis.In short, people are right to be dissatisfied with prevailing economic arrangements. But they have been persuaded by their intellectual leaders--including, unfortunately, most defenders of "capitalism"--to think that the status quo is capitalism, rather than a system in which the most fundamental feature of capitalism--competition--has been seriously undermined by a thick layer of regulation laid over capitalism during the last 150 years. There is no better example of how misleading it is to blame "capitalism" for the resulting problems than in the case of the financial crisis, which was in fact a regulatory failure par excellence.
What Did Not Cause the Crisis
There are currently three points of consensus about what caused the crisis, one of which is indisputable, one of which is dubious, and one of which is incorrect. The incorrect and the dubious need to be cleared out of the way if we are to understand what really went wrong. So here are the three points of consensus, arranged from wrong, to probably wrong, to right:
Claim One: Financial Deregulation Caused the Crisis. This piece of the conventional wisdom is false. The indefatigable Peter J. Wallison has pointed out in an AEI Financial Services Outlook that the two aspects of financial deregulation that have been blamed for the crisis are mythical, not factual.[2]
First, the Gramm-Leach-Bliley Act of 1999,[3] which amended the Glass-Steagall Act of 1933,[4] did not erase the distinction between commercial banks, which take deposits and make loans and investments, and (the somewhat confusingly labeled) investment banks, which underwrite and trade securities. The 1999 act merely allowed both commercial and investment banks to be subsidiaries of a common holding company, but they remained subject to the same restrictions on the nature of their activities as before. These restrictions were loose in the case of investment banks but tight for commercial banks--and as we shall see, the crisis took place within the commercial banks. It is therefore crucial to recognize that, contrary to the claim many prominent economists and commentators have made, the 1999 act did not "repeal" Glass-Steagall, whose heavy regulatory framework on the activities of commercial banks remained on the books, as potent as ever.
The second part of the "deregulation" myth concerns credit default swaps, which truly were, and remain, unregulated. But as Wallison has shown in yet another AEI Financial Services Outlook,[5] subsequently expanded into an article in Critical Review,[6] credit default swaps did not mysteriously "interconnect" banks and increase systemic risk.
In essence, a credit default swap is a loss-protection insurance contract. This risk is swapped (for a fee) by the lender to a "counterparty"; the amount of the risk remains the same but has merely been transferred from the lender to the counterparty. This transfer no more increases overall risk levels than does a car insurance policy, which transfers risk from the driver to the insurance company. A credit default policy is often traded from one counterparty to another, so on a flow chart that followed the policy from hand to hand, all the counterparties might appear to be "interconnected." But this interconnection is historical only: past counterparties do not remain on the hook when they pass a policy to a new counterparty. There remain only two meaningfully connected parties--the ultimate insurer and the insured. Not surprisingly, then, Wallison demonstrates there is no evidence that credit default swaps contributed to the crisis.
Claim Two: Executive Compensation Systems at the Banks Caused the Crisis. This part of the conventional wisdom is doubtful at best. It is true that many publicly held American corporations, including banks, pay performance bonuses that may encourage excessive risk taking. The reason for this is a topic that cries out for exploration, as does any instance of manifestly irrational behavior by large numbers of businesses. An explanation that we find credible builds on the historical research of Amar Bhidé, who points out that starting in the 1930s, regulations issued by the Securities and Exchange Commission (SEC) made the close supervision of corporations by "insiders" who financed these companies--the dominant practice before the SEC regulations--impossible.[7] Since the 1930s, therefore, equity investors in most corporations have, by definition, been "outsiders" who have had to use publicly reported information to infer what is going on inside. In making these inferences, they rely on short-term, legally mandated heuristics for long-term performance, such as quarterly earnings reports. This gears publicly held corporations toward short-term gain, even at the price of long-term risk.
It is one thing, however, to say that corporate America's compensation systems are flawed, whether because of securities regulations or for some other reason. It is quite another thing to say that this flaw caused the financial crisis.
To date, there have been only two studies of the matter, the first of which found that the banks whose executives held the most stock in the bank lost the most money in the crisis--indicating that the executives did not engage in deliberate risk taking motivated by a quest for higher bonuses, as they would have been risking their own money.[8] A more recent study, however, by Ing-Haw Cheng, Harrison Hong, and Jose Scheinkman finds a positive correlation between risk taking and large bonus packages,[9] although this study has been criticized on the grounds that most of the risk taking found by the authors was among insurance companies, not banks.[10]
These two studies are important, regardless of their conflicting findings, because their authors recognize that different banks operated differently. But at the aggregate level, there is decisive evidence against the thesis that incentives to take risks caused the financial crisis. The evidence is this: 93 percent of all the mortgage-backed securities held by American banks either were issued by Fannie Mae or Freddie Mac, and were thus implicitly guaranteed by the U.S. Congress (as the American taxpayer soon found out), or were issued by investment banks and rated AAA by one of the three rating agencies: Moody's, Standard and Poor's, or Fitch.[11]
Never mind that these three private corporations had had a legally protected oligopoly since 1975, thanks to another SEC regulation.[12] Never mind, in short, that, protected from market competition, these companies' AAA ratings may have been so sloppy or so deliberately skewed that they understated the risk associated with mortgage-backed bonds. That aside, the oligopoly's ratings produced a concrete result: as is true of all bonds, AAA-rated bonds paid less than lower-rated (AA, A, BBB, etc.), supposedly riskier bonds. Bond investors always trade risk against returns. A high rating connotes safety and therefore always pays lower returns than lower-rated bonds pay--and there is no higher rating than AAA. If bankers were being lured by their banks' compensation systems into acquiring risky but lucrative assets--on the basis of which the bankers would have gotten bigger bonuses--then they should never have bought AAA bonds. Instead, they should always have bought higher-paying AA-, A-, or BBB-rated bonds, but they did so only 7 percent of the time.
Claim Three: The Fed's Low Interest Rates from 2001 to 2005 Financed the Housing Bubble That Led to the Crisis. This is the only element of the conventional wisdom that seems to rest on solid ground.13 But when it is cut loose from the other two elements of the conventional wisdom, it generates a puzzle: why did the bursting of the housing bubble cause a financial crisis, that is, a banking crisis?
This might not seem so puzzling at first: commercial banks made many of the mortgage loans that were financed by the Federal Reserve's low interest rates. But the financial crisis was not caused by mortgage defaults directly: it was caused by a sharp drop, in September 2008, in the market price of mortgage-backed bonds, in anticipation of their declining value as the bubble deflated. The first victims of the falling price of mortgage-backed bonds were Fannie and Freddie; in quick succession came the investment bank Lehman Brothers; and finally came the commercial banks--because they held so many mortgage-backed bonds, not mortgages. The question, then, is why the commercial banks held so many mortgage-backed bonds. If deregulation or the quest for high earnings, hence high compensation, did not cause the banks to buy these bonds, what did?
Regulatory Roots of the Financial Crisis
To answer this question, we have to turn in a direction that has been overlooked by the conventional wisdom: an obscure regulation called the recourse rule. The recourse rule was enacted by the Federal Reserve, the Federal Deposit Insurance Corporation, the Comptroller of the Currency, and the Office of Thrift Supervision in 2001.[14] It was an amendment to the international Basel Accords governing banks' capital holdings, and all over the world, these regulations appear to have contributed significantly both to the housing boom and to the financial crisis.
A bank's capital reserve represents funds that are not borrowed--funds that, therefore, need not eventually be paid back to someone, such as a bank's depositors. Thus, an important source of a bank's capital reserve is funds from selling shares of stock in a bank. These funds can be costly to acquire, as one expert has pointed out:
For corporations (including banks) not eligible for Subchapter S earnings pass-through treatment, the after-tax cost of equity capital, say 12 to 15 percent, is substantially greater than the after-tax cost of debt, which is generally in the 3 to 5 percent range.[15]
By reducing their capital holdings, banks can, at least in principle, increase their profitability.
But under the recourse rule, "well-capitalized" American commercial banks were required to spend 80 percent more capital on commercial loans, 80 percent more capital on corporate bonds, and 60 percent more capital on individual mortgages than they had to spend on asset-backed securities, including mortgage-backed bonds, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie. Specifically, $2 in capital was required for every $100 in mortgage-backed bonds, compared to $5 for the same amount in mortgage loans and $10 for the same amount in commercial loans.
One can readily see that the recourse rule was designed to steer banks' funds into "safe" assets, such as AAA mortgage-backed bonds. The fact that 93 percent of the banks' mortgage-backed securities were either AAA rated or were issued by a GSE shows that this is exactly what the rule accomplished.[16] Unfortunately, these bonds turned out not to be so safe. Without the recourse rule, however, there is no reason for portfolios of American banks to have been so heavily concentrated in mortgage-backed bonds.
No other category of investors except investment banks (which packaged mortgages into mortgage-backed securities, and thus were caught with huge inventories of both), no matter how highly leveraged--not hedge funds, not bond funds, not pension funds, not insurance companies--was as decimated as commercial banks by huge holdings of mortgage-backed bonds. But that is because the recourse rule covered commercial banks, not hedge funds or anyone else. If not for the recourse rule's privileging of mortgage-backed bonds, the burst housing bubble almost certainly would not have caused a banking crisis. The banking crisis, in turn, froze lending and caused the Great Recession.
Indeed, the recourse rule may have been a significant factor in pumping up the housing bubble itself. In 2001, $2.2 trillion in mortgages were originated; the figure leapt to $2.9 trillion in 2002, when the recourse rule took effect, and to $3.9 trillion in 2003 before declining to $2.9 trillion in 2004, $3.1 trillion in 2005, and $3 trillion in 2006, after which the bubble began to deflate.[17] Was there a connection between the recourse rule and the housing bubble?
Each mortgage-backed bond promised, to the bond holders, principal and interest payments drawn from thousands of mortgages. The more mortgage-backed bonds were bought, the more mortgages had to be written. The artificial demand for mortgage-backed bonds created by the recourse rule may therefore explain why, as the decade wore on and the pool of credit-worthy borrowers who made traditional down payments dried up, banks and mortgage specialists lowered their lending standards and made the terms of their mortgages more generous. The resulting mortgages would soon be sold to Fannie, Freddie, or an investment bank for securitization into bonds. (Between the middle of 2001 and the beginning of 2002, mortgage securitization jumped from about $20 billion to $50 billion per quarter, peaking at nearly $150 billion per quarter in 2006.)[18]
The recourse rule did not apply outside the United States, but the first set of Basel accords on bank capital, adopted in 1988,[19] included provisions for even more profitable forms of "capital arbitrage" through off-balance-sheet entities such as structured investment vehicles (SIVs), which were used extensively in Europe. Moreover, in 2006, a second set of bank-capital accords, "Basel II," began to be implemented outside the United States. Basel II took essentially the same approach as the recourse rule, encouraging foreign banks to acquire mortgage-backed securities, just as in the United States.[20]
Here, then, we may have the genesis of the global financial crisis. If so, it turns out to have been caused by the very device--regulation--to which most people now, as they did throughout the twentieth century, look for the "reform" of capitalism. But is it really capitalism when it is so heavily regulated?
Regulation as a Source of Systemic Risk
It is true that capitalists--bankers--who took advantage of the recourse rule turned out to be making a grievous mistake. But not all capitalists made this mistake, and that is where the story gets interesting.
Recall the findings of Cheng, Hong, and Scheinkman, who detected more risk taking among ¬individual banks that paid high bonuses. We contrasted this finding against the aggregate behavior of (commercial) banks, which chose the less-lucrative, less-risky GSE-issued or AAA-rated mortgage-backed bonds favored by the recourse rule 93 percent of the time. The aggregate finding suggests that executive compensation practices did not cause the crisis and that the recourse rule did. But the findings by Cheng et al. remind us that aggregate figures obscure differences in behavior among individual business firms. Indeed, there is a word for "differences in behavior among individual business firms": competition.
Consider the contrast between Citigroup and one of its main competitors, JP Morgan Chase. Citi jumped into mortgage-backed bonds with both feet, putting them on its balance sheet through the recourse rule but also buying them off-balance-sheet through SIVs, of which Citi created seven of the sixteen in the United States (there were forty-one in Europe). Citi even established a separate unit to securitize its own mortgages. Meanwhile, JP Morgan lost billions of dollars in potential revenue for years in order to avoid mortgage securitization.[21] JP Morgan's Jamie Dimon was among those who recognized the danger; Citigroup's Chuck Prince apparently recognized the danger but calculated the odds of disaster as lower than the profits to be made from taking advantage of Basel I (which sanctioned SIVs) and the recourse rule.
What explains this diverse behavior is that the ¬individual bankers in question had different perceptions of the magnitude of the risk. In unregulated markets, that kind of diversity of viewpoints is precisely what makes capitalism work. One capitalist thinks that profit can be made, and loss avoided, by pursuing strategy A; another, by pursuing strategy B. The heterogeneous strategies of different capitalists compete with each other, and the better ideas produce more profits than losses.
That, from an analytical perspective, is competition. From the same perspective, competition is at the core of any rigorous definition of "capitalism." Competition is what gives capitalism its only conceivable economic advantages, as compared either to regulation or to the "whole new economic system" that many people have tried to envision ever since capitalism--with its inequalities, its waste, and its many other inadequacies--burst into public consciousness during the Industrial Revolution. To ask why we need competition, then, is to ask why we need capitalism.
Our answer is as follows. In a complex world like ours, nobody really knows what will succeed until it is tried. Competition, which pits entrepreneurs' divergent ideas against each other, is the only way to test these ideas through anything but the highly unreliable process of verbal debate (in which the debaters' competing ideas cannot be simultaneously tested against each other in the real world, instead of in the imaginations of their audience).
Competition among capitalists sorts out which of their ideas actually please real-world consumers and which of them are displeasing--however appealing the ideas might have seemed on the drawing board. And competition among capitalists also sorts out which ideas for how to avoid loss are good ones and which ideas for avoiding loss are bad. Thus, competition has the net effect of spreading society's bets among different, fallible ideas about where profit--and loss--might be located and of testing them against reality. For this reason, herd behavior among capitalists is a genuine threat to its "competitive advantage." If capitalists stop acting heterogeneously--if they compete through imitation, rather than innovation--the risk of systemic failure increases, unless all of the capitalists happen to be placing their chips on the right idea.
Capitalism will probably always be prone to asset bubbles and other manifestations of homogeneous behavior, but only because it is part of human nature for people to go along with the crowd. This is a risk that can be mitigated but not eliminated. But capitalism has a unique feature, competition, that does mitigate it by both encouraging and taking advantage of heterogeneous behavior, that is, innovation.
Homogeneity, on the other hand, is the ineradicable curse of socialism, in which the community as a whole, through its elected (or self-appointed) representatives, decides on the allocation of resources. One plan is imposed on all, as thoroughly as if everyone spontaneously decided to join a herd.[22] And we maintain that homogeneity is also the problem with regulation. Regulations, by their very nature, align the behavior of those being regulated with the ideas of those doing the regulating. Regulations are like mandatory instructions for herd behavior, automatically increasing systemic risk.
The recourse rule, Basel I, and Basel II loaded the dice in favor of the regulators' ideas about prudent banking. These regulations imposed a new profitability gradient over all bankers' risk/return calculations, conferring 80 percent capital relief on banks that bought GSE-issued or highly rated mortgage-backed bonds rather than commercial loans or corporate bonds, and 60 percent relief for banks that traded their individual mortgages for those "safe" mortgage-backed bonds. Only bankers with the most extreme perceptions of the downside, such as JP Morgan's Jamie Dimon, escaped unharmed.
Bank-capital regulations inadvertently made the banking system more vulnerable to the regulators' errors. But this is what all regulations do. Whether by forbidding one activity or encouraging a different one, the whole point of regulation is, after all, to change the behavior of those being regulated. And the direction of change is, obviously, the one the regulators think is wise.
Perhaps, then, we do need a new economic system: capitalism. The Basel rules, the recourse rule, the oligopoly-conferring regulations of the SEC--these regulations cover a tiny fraction of the millions of pages of the Federal Register and its state, local, and international counterparts. And each of the hundreds of thousands of regulations filling those pages chips away at the heterogeneous competitive behavior that constitutes the best reason for capitalism. If one is looking for the cause of a systemic failure in our highly regulated economy, it makes more sense, at least initially, to look to the laws that govern the whole system, rather than reflexively blaming what has now become "capitalism" in name only.
How Conservatives Get Capitalism Wrong
If our argument has been correct, then the Great Recession was a regulatory failure, not a failure of capitalism. But it is also an occasion for a rethinking of capitalism--by both its conservative defenders and its liberal critics.
Let us start with conservatives, many of whom make the mistake of extolling the brilliance, wisdom, or heroism of capitalists. They forget that for every Jamie Dimon, there is a Chuck Prince. Capitalists are as fallible as anyone else. Collectively, they possess no superior powers; their lucky guesses, no matter how well informed, are still guesses. Everyone can see this in the wake of the crisis. Paeans to capitalist genius will no longer do.
Seventy-three percent of the successful entrepreneurs recently surveyed by the Ewing Marion Kauffman Foundation said luck was an important factor in their success.[23] These successful capitalists' own assessments happen to track the standard liberal view. The main point made by John Rawls--the great philosopher whom conservatives love to loathe but hate to read--was that good luck, including even the good luck to develop a strong work ethic, confers no moral claim. Winners of the genetic lottery, Rawls said, are not thereby entitled to be rewarded. Liberals are right to notice that good luck explains many capitalists' success, and that bad luck--accidents of birth--condemn millions to lives of misery. Conservatives who close their eyes to the accidental element in wealth and poverty make themselves appear both heartless and clueless.
In addition to their unfortunate romanticizing of capitalists, conservatives have erred by adopting the economists' standard explanation for the success of capitalism: self-interest. Self-interest is supposed to ¬provide the "magic of the market," but we can safely assume that Chuck Prince was every bit as self-interested as Jamie Dimon. Both of them had equally strong incentives to save their banks, but that did not help Citigroup. Armen Alchian, an economist at the University of California, Los Angeles, showed in 1950 that capitalism would succeed even if capitalists were not motivated by self-interest. And the fact is that many successful -capitalists, such as the founders of Google and Whole Foods, were not motivated by self-interest.[24]
Unfortunately, economists have only grown more obsessed with self-interest--that is, "incentives"--since 1950. This has led many conservatives to embrace the idea that "greed is good"--a woeful misreading of Adam Smith. Smith's parable of the baker, to whose benevolence we do not appeal when we buy our bread, is actually a lesson in unintended consequences, not in the wonders of greed. Even if the baker intends merely to make money, he can do so only by providing his customers with bread. In his case, greed is indeed good. But that does not mean that greed is always good and benevolence bad, nor that all bakers are in it solely for the money. Nor does it mean that greed accounts for the success of capitalism.
How Liberals Get Capitalism Wrong
Liberals are right to see through the usual conservative defenses of capitalism, but they are wrong on the big picture. They fail to notice that there is more to capitalism than luck and greed: there is competition--the saving grace of the whole system; the device that turns good luck to social advantage; and, when undisturbed, the source of capitalism's systemic strength.
Competition is the engine that turns the talents of the lucky to the service of all. A baker who offers moldy or bland bread can be driven from the field by a competitor offering a better product. That is the message of Adam Smith. The successful baker, no matter how greedy his motive for baking bread, must unintentionally mimic the very actions an altruistic Rawlsian philosopher would prescribe. The reason is the competitive nature of the capitalist system; the motives of individual capitalists are irrelevant. Competition puts capitalists' different motives, like their different ideas, to the acid test of consumer satisfaction. This tends to give consumers what they want--or at least what they think they want--and it diversifies a capitalist society's investment portfolio. Capitalism thus mitigates both human greed and human fallibility. This is an amazing achievement, but there is nothing magical about it.
Now consider again the alternatives liberals tend to favor--either the regulation of capitalism or its replacement by something more democratic, like an idealized socialism. Since regulators' or citizens' ideas would then be imposed on the whole economy at once, they could not be put to the competitive test--any more than the conflicting arguments of debaters, the conflicting promises of politicians, or the conflicting forecasts of budget analysts can be tested. If the citizens' or the regulators' ideas happen to be good ones, we all gain; if they happen to be bad, we all lose.
The whole system crashed when the financial regulators' ideas about prudent banking backfired, but such failures are inevitable unless modern societies are so ¬simple that the solutions to social and economic problems will be self-evident to a generalist voter, or even a specialist regulator. That modern societies really are that simple is, in truth, the hidden assumption of modern politics. This is why political conflicts get so ugly: neither side can understand why their adversaries oppose what "self-evidently" should be done, so both sides ascribe evil motives to each other. But the financial crisis has exposed this simplistic view of the world for what it is. In the wake of the crisis, nobody can plausibly deny anymore that modern societies are bafflingly complex. The solutions to social and economic problems are thereby unlikely to be self-evident. The theories that seem so obviously true to voters or regulators may turn out to be disastrously false--unless regulators or citizens are infallible.
That surely would be magical. But there is no more magic to politics than there is to markets. The question raised by the ongoing intellectual contest between socialism and capitalism, and the ongoing practical battle between regulation and competition, is how best to guard against human frailties: By putting all our eggs in one politically decided basket? Or by spreading our bets through the only practical means available: competition?
Mr. Friedman is the editor of the journal Critical Review and of Causes of the Financial Crisis (University of Pennsylvania Press, forthcoming in 2010). Mr. Kraus is coauthoring, with Friedman, Engineering the Perfect Storm: How Reasonable Regulations Caused the Financial Crisis (University of Pennsylvania Press, forthcoming in 2011).
Advice to House Dems
Advice to House Dems: Get It in Writing
Where health care stands in the House and Senate.
JOHN FUND
Some clarity on where the latest Democratic push to pass health care is going came over the weekend.
House Majority Whip Steny Hoyer told CBS he believes the House must "go first" to pass a health care bill -- namely the version the Senate approved on Christmas Eve. That contradicts the House leadership's previous insistence that the Senate must go first because House Democrats didn't want to vote on an unpopular bill only to see it die in the procedural maelstrom of the Senate -- as happened with last year's climate change bill.
Aides report that House leaders are now contemplating insisting that key Senate leaders, or perhaps even 51 Democratic Senators, sign a letter attesting to the fact that the Senate will use budget reconciliation procedures to ram through a bill to the liking of House liberals. Such a letter wouldn't be legally binding, of course, but would give assurances to nervous House members.
No one should underestimate Ms. Pelosi's task, despite her prowess in strong-arming members. "I just don't know where they get the votes in the House," Pennsylvania Rep. Jason Altmire, a Democrat who voted against the health care bill, told Politico.com. "It's a huge challenge because . . . the people who voted 'yes' would love a second bite at the apple to vote 'no' this time because they went home and had an unpleasant experience as a result of their 'yes' vote. I don't know if there is anybody who voted 'no' that regrets it."
That's why many House Democrats took heart from last week's Wall Street Journal report that the Obama administration was preparing a fallback "Plan B" in case comprehensive health care can't make it through both houses. Democratic leaders deny such a plan is in the works, but then you can't expect them to acknowledge a fallback until it's absolutely clear that passing a sweeping bill is no longer a realistic prospect.
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Fly Now, Pay Later
Fiscal policy gone wild.
BY Irwin M. Stelzer
“Watch what we do, not what we say,” President Nixon’s attorney general told the press. Unfortunately for both men, the press eventually did that, and we got the first of the “gates:” Watergate. The consequences for President Obama of watching what he does rather than what he says will be less dire, but nevertheless revealing.
Americans overwhelmingly say that their main concern is jobs, and that they are satisfied with their current health care arrangements. In response, an allegedly chastened President Obama “pivoted,” and says his primary concern from now on will be job creation, which will take priority over his controversial plan to radically change the nation’s health care system.
Yet, last week he backed a $15 billion job-creation bill, which passed the Senate, and a $1 trillion health care bill. Since the federal balance sheet is already under huge pressure, this set of priorities tells us that the Obama administration intends to concentrate available resources on transforming the economy -- a long-term, permanent restructuring of the health care and energy sectors that was planned long before the failure of Lehman Brothers triggered the financial mess Obama inherited.
Not that the president will try to rein in stimulus spending: more is in the pipeline. Which is why Federal Reserve Board chairman Ben Bernanke warned congress last week that although it is too soon to turn off stimulus spending, it must address the structural deficit -- the red ink that will continue to flow even when the economy has recovered. Bernanke says that structural deficit will run somewhere between 4 percent and 7 percent of GDP, well above the sustainable level of 2.5 percent - 3 percent or less. He also told the assembled congressional committee -- television coverage insures good attendance by committee members -- that if the congress and the president don’t soon plan to attack the structural deficit, the market might decide that enough is enough, and interest rates would rise.
Investors are watching not only the size of the federal deficit, but of state deficits as well, since they are guessing that in the end the federal government will not allow state governments to go bust. Instead, if the states can’t satisfy their creditors, the federal government will take their $146 billion of debts onto its own balance sheet, raising its deficit to 11.6 percent of GDP. And that doesn’t count the $1,000 billion funding gap in state pension reserves.
But austerity is for later. Now, policy makers and politicians worry that the economic recovery is showing signs of premature ageing. New home sales fell in January to an all-time low annual rate of 309,000 units. Mortgage applications plummeted. The number of loans past due by 30 days is the second highest on record. In short, the important housing sector is still struggling.
Janet Yellin, president of the San Francisco Federal Reserve Bank, doesn’t see the economy hitting its full stride until 2013. Bernanke is predicting “low rates of resource utilization” -- econospeak for high unemployment and unused factories -- and “an increasing incidence of long-term unemployment” for some time to come. And he worries that commercial property loans that are unlikely to be repaid will bring down more small and medium banks. The number of banks on the Federal Deposit Insurance Corporation’s “problem” list stood at 702 at the end of last year, up from 252 a year earlier.
Given news of this sort, it should come as no surprise that consumer confidence is plunging: Consumers’ assessment of current economic conditions is at its lowest level in 27 years. Add to gloomy consumers banks that don’t want to lend or businesses that don’t want to borrow (depends who you talk to), businesses that are reluctant to hire, and an anti-business government, and there is reason enough for worry. President Obama did attempt to rebut those who accuse him of having little faith in market capitalism by spending part of last week trying to reassure business leaders -- primarily heads of the nation’s largest companies -- that he is not a socialist, that he is deeply committed to the private enterprise system, and that his plans to raise taxes on foreign earnings, on banks, and on “the wealthy” are merely a rebalancing of inequities introduced by his predecessor. One top White House economist tells me that he spends a considerable amount of energy damping down the president’s anti-business rhetoric.
Any hope for an export-led recovery seems to be receding as European growth stalls, several countries are being forced to institute austerity programs, and turmoil in the market for sovereign debt drives interest rates higher. Even China, which American businessmen have for decades seen as a huge potential market for their products, is reining in credit to cool the economy, and persists in an import-unfriendly set of policies.
All of this has produced an important change in policies. Scrooge has become Lady Bountiful: The International Monetary Fund, long famous for prescribing austerity as the medicine for ailing economies, now warns that it is too soon to start reining in budget deficits. Bernanke more or less agrees, although he wants the U.S. to begin formulating plans to reduce the structural deficit once anti-recession spending winds down. This is music to the ears of politicians such as Barack Obama and British Prime Minister Gordon Brown, both presiding over massive deficits, both facing elections, both unwilling to cut spending just yet, if ever.
The rating agencies and investors in sovereign debt are less enchanted with the newly blessed profligacy, and it may well be that in the end the bond markets will dictate policy by forcing interest rates up to growth-stifling levels unless the government cuts its deficit. Recall that James Carville, one of Bill Clinton’s advisers, frustrated at his inability to get his spending programs adopted, lamented, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
For now, it is safe to assume that the government will keep on spending, deficits will continue rising, and the Fed will keep interest rates low. That delicious, heady cocktail of loose fiscal policy -- congress is busily drafting more stimulus bills as you read this -- and easy monetary policy will, Bernanke says, produce growth of 3 percent - 3.5 percent this year, and 4 percent next year. With little inflation. Rather like the old airline slogan, “Fly now, pay later.”
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).
Fiscal policy gone wild.
BY Irwin M. Stelzer
“Watch what we do, not what we say,” President Nixon’s attorney general told the press. Unfortunately for both men, the press eventually did that, and we got the first of the “gates:” Watergate. The consequences for President Obama of watching what he does rather than what he says will be less dire, but nevertheless revealing.
Americans overwhelmingly say that their main concern is jobs, and that they are satisfied with their current health care arrangements. In response, an allegedly chastened President Obama “pivoted,” and says his primary concern from now on will be job creation, which will take priority over his controversial plan to radically change the nation’s health care system.
Yet, last week he backed a $15 billion job-creation bill, which passed the Senate, and a $1 trillion health care bill. Since the federal balance sheet is already under huge pressure, this set of priorities tells us that the Obama administration intends to concentrate available resources on transforming the economy -- a long-term, permanent restructuring of the health care and energy sectors that was planned long before the failure of Lehman Brothers triggered the financial mess Obama inherited.
Not that the president will try to rein in stimulus spending: more is in the pipeline. Which is why Federal Reserve Board chairman Ben Bernanke warned congress last week that although it is too soon to turn off stimulus spending, it must address the structural deficit -- the red ink that will continue to flow even when the economy has recovered. Bernanke says that structural deficit will run somewhere between 4 percent and 7 percent of GDP, well above the sustainable level of 2.5 percent - 3 percent or less. He also told the assembled congressional committee -- television coverage insures good attendance by committee members -- that if the congress and the president don’t soon plan to attack the structural deficit, the market might decide that enough is enough, and interest rates would rise.
Investors are watching not only the size of the federal deficit, but of state deficits as well, since they are guessing that in the end the federal government will not allow state governments to go bust. Instead, if the states can’t satisfy their creditors, the federal government will take their $146 billion of debts onto its own balance sheet, raising its deficit to 11.6 percent of GDP. And that doesn’t count the $1,000 billion funding gap in state pension reserves.
But austerity is for later. Now, policy makers and politicians worry that the economic recovery is showing signs of premature ageing. New home sales fell in January to an all-time low annual rate of 309,000 units. Mortgage applications plummeted. The number of loans past due by 30 days is the second highest on record. In short, the important housing sector is still struggling.
Janet Yellin, president of the San Francisco Federal Reserve Bank, doesn’t see the economy hitting its full stride until 2013. Bernanke is predicting “low rates of resource utilization” -- econospeak for high unemployment and unused factories -- and “an increasing incidence of long-term unemployment” for some time to come. And he worries that commercial property loans that are unlikely to be repaid will bring down more small and medium banks. The number of banks on the Federal Deposit Insurance Corporation’s “problem” list stood at 702 at the end of last year, up from 252 a year earlier.
Given news of this sort, it should come as no surprise that consumer confidence is plunging: Consumers’ assessment of current economic conditions is at its lowest level in 27 years. Add to gloomy consumers banks that don’t want to lend or businesses that don’t want to borrow (depends who you talk to), businesses that are reluctant to hire, and an anti-business government, and there is reason enough for worry. President Obama did attempt to rebut those who accuse him of having little faith in market capitalism by spending part of last week trying to reassure business leaders -- primarily heads of the nation’s largest companies -- that he is not a socialist, that he is deeply committed to the private enterprise system, and that his plans to raise taxes on foreign earnings, on banks, and on “the wealthy” are merely a rebalancing of inequities introduced by his predecessor. One top White House economist tells me that he spends a considerable amount of energy damping down the president’s anti-business rhetoric.
Any hope for an export-led recovery seems to be receding as European growth stalls, several countries are being forced to institute austerity programs, and turmoil in the market for sovereign debt drives interest rates higher. Even China, which American businessmen have for decades seen as a huge potential market for their products, is reining in credit to cool the economy, and persists in an import-unfriendly set of policies.
All of this has produced an important change in policies. Scrooge has become Lady Bountiful: The International Monetary Fund, long famous for prescribing austerity as the medicine for ailing economies, now warns that it is too soon to start reining in budget deficits. Bernanke more or less agrees, although he wants the U.S. to begin formulating plans to reduce the structural deficit once anti-recession spending winds down. This is music to the ears of politicians such as Barack Obama and British Prime Minister Gordon Brown, both presiding over massive deficits, both facing elections, both unwilling to cut spending just yet, if ever.
The rating agencies and investors in sovereign debt are less enchanted with the newly blessed profligacy, and it may well be that in the end the bond markets will dictate policy by forcing interest rates up to growth-stifling levels unless the government cuts its deficit. Recall that James Carville, one of Bill Clinton’s advisers, frustrated at his inability to get his spending programs adopted, lamented, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
For now, it is safe to assume that the government will keep on spending, deficits will continue rising, and the Fed will keep interest rates low. That delicious, heady cocktail of loose fiscal policy -- congress is busily drafting more stimulus bills as you read this -- and easy monetary policy will, Bernanke says, produce growth of 3 percent - 3.5 percent this year, and 4 percent next year. With little inflation. Rather like the old airline slogan, “Fly now, pay later.”
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).
Politics as Make-Believe
Politics as Make-Believe
By Robert Samuelson
WASHINGTON -- There is a make-believe quality to modern American politics: People -- and this applies across the political spectrum -- say things that are stupid, misleading or unattainable and think (or pretend) that these very same things are desirable, candid and realistic. A disconnect between the language of politics and the nation's actual problems is growing. The politics of the budget offer a splendid example.
On the right, we have conservatives clamoring for tax cuts when, as a practical matter, today's massive budget deficits preclude permanent new tax cuts. With present policies and a decent economic recovery, the federal government could easily spend $12 trillion more than it collects in taxes from 2009 to 2020, reckons the Congressional Budget Office. So before reducing taxes, the tax cut advocates need to identify hundreds of billions of annual spending reductions -- or accept huge and hazardous annual deficits. Naturally, a comprehensive list of spending cuts is nowhere in sight.
On the left, President Obama and Democrats have spent the last year arguing that, despite the government's massive deficits and overspending, they can responsibly propose even more spending. Future deficits are to be ignored (present deficits, to be sure, partially reflect the economic slump). The proposal is "responsible" because it's "paid for" through new taxes and spending cuts. Even if these financing sources were completely believable (they aren't), the logic is that the government can undertake new spending before dealing with the consequences of old spending. Of course, most households and businesses can't do this.
Politicians can, because it's all make-believe. They pretend to deal with budget deficits when they aren't. Just recently, the Democratic Congress passed a new version of the "pay-go" budget rule. Under pay-go, if Congress cuts taxes or increases spending beyond present policies, it must find offsets by raising taxes or cutting spending elsewhere. This seems a prudent discipline, and Obama bragged about being "responsible."
What he didn't say is that this new pay-go contains huge exceptions. These include the renewal of most of the Bush tax cuts, revisions of the alternative minimum tax, higher Medicare reimbursements for doctors, and overhaul of the estate tax. Over the next decade, these exceptions could be worth about $2.5 trillion, says Marc Goldwein of the Committee for a Responsible Federal Budget.
Or take the 18-member presidential bipartisan budget commission (10 Democrats and eight Republicans) charged with reining in the long-term deficits. If 14 members agree on a deficit-reduction package, Democratic congressional leaders have said they'd put the plan to an up-or-down vote. The obstacles to agreement are considerable. But if they're overcome -- and if Congress accepts the package -- you might reasonably conclude that, finally, we'd be suppressing chronic deficits. Not so.
The commission's official task is more modest: It's to eliminate the deficit in 2015, disregarding interest payments. This makes a big difference. By the administration's projections, the budget deficit in 2015 will total $752 billion. Of that, interest payments represent $571 billion. Even if the commission succeeds, the deficit would exceed half a trillion dollars. It would almost certainly grow in future years.
Governing is about making choices. By contrast, the la-la politics of both left and right evade choices and substitute for them pleasing fictional visions. Despite a theoretical argument for focusing on the non-interest deficit, it's mostly an excuse for expediency. It spares the commission from grappling with the huge growth of Social Security and Medicare -- the main causes for expanding federal spending and deficits. Similarly, the right's crusade for more tax cuts conveniently ignores the savage cuts in these programs that would be required to justify lower taxes.
The common denominator is a triumph of electioneering over governing. Every campaign is an exercise in make-believe. All the good ideas and good people lie on one side. All the "special interests," barbarians and dangerous ideas lie on the other. There's no room for the real world's messy ambiguities, discomforting contradictions and unpopular choices. But to govern successfully, leaders must confront precisely those ambiguities, contradictions and choices.
The make-believe of campaigns now increasingly shapes the process of governing. Whether this reflects cable TV and the Internet -- which reward the harsh hostility of extreme partisanship -- or the precarious balance between the two parties or something else is hard to say. But the disconnect between policy and the real world is harmful. Proposals tend to be constructed more for their public relations effects than for their capacity to solve actual problems.
The result is a paradox. This electioneering style of governing strives to bolster politicians' popularity. But it does the opposite. Because partisan rhetoric creates exaggerated expectations of what government can do, people across the ideological spectrum are routinely disillusioned. Because actual problems fester -- and people see that -- public trust of political leaders erodes.
By Robert Samuelson
WASHINGTON -- There is a make-believe quality to modern American politics: People -- and this applies across the political spectrum -- say things that are stupid, misleading or unattainable and think (or pretend) that these very same things are desirable, candid and realistic. A disconnect between the language of politics and the nation's actual problems is growing. The politics of the budget offer a splendid example.
On the right, we have conservatives clamoring for tax cuts when, as a practical matter, today's massive budget deficits preclude permanent new tax cuts. With present policies and a decent economic recovery, the federal government could easily spend $12 trillion more than it collects in taxes from 2009 to 2020, reckons the Congressional Budget Office. So before reducing taxes, the tax cut advocates need to identify hundreds of billions of annual spending reductions -- or accept huge and hazardous annual deficits. Naturally, a comprehensive list of spending cuts is nowhere in sight.
On the left, President Obama and Democrats have spent the last year arguing that, despite the government's massive deficits and overspending, they can responsibly propose even more spending. Future deficits are to be ignored (present deficits, to be sure, partially reflect the economic slump). The proposal is "responsible" because it's "paid for" through new taxes and spending cuts. Even if these financing sources were completely believable (they aren't), the logic is that the government can undertake new spending before dealing with the consequences of old spending. Of course, most households and businesses can't do this.
Politicians can, because it's all make-believe. They pretend to deal with budget deficits when they aren't. Just recently, the Democratic Congress passed a new version of the "pay-go" budget rule. Under pay-go, if Congress cuts taxes or increases spending beyond present policies, it must find offsets by raising taxes or cutting spending elsewhere. This seems a prudent discipline, and Obama bragged about being "responsible."
What he didn't say is that this new pay-go contains huge exceptions. These include the renewal of most of the Bush tax cuts, revisions of the alternative minimum tax, higher Medicare reimbursements for doctors, and overhaul of the estate tax. Over the next decade, these exceptions could be worth about $2.5 trillion, says Marc Goldwein of the Committee for a Responsible Federal Budget.
Or take the 18-member presidential bipartisan budget commission (10 Democrats and eight Republicans) charged with reining in the long-term deficits. If 14 members agree on a deficit-reduction package, Democratic congressional leaders have said they'd put the plan to an up-or-down vote. The obstacles to agreement are considerable. But if they're overcome -- and if Congress accepts the package -- you might reasonably conclude that, finally, we'd be suppressing chronic deficits. Not so.
The commission's official task is more modest: It's to eliminate the deficit in 2015, disregarding interest payments. This makes a big difference. By the administration's projections, the budget deficit in 2015 will total $752 billion. Of that, interest payments represent $571 billion. Even if the commission succeeds, the deficit would exceed half a trillion dollars. It would almost certainly grow in future years.
Governing is about making choices. By contrast, the la-la politics of both left and right evade choices and substitute for them pleasing fictional visions. Despite a theoretical argument for focusing on the non-interest deficit, it's mostly an excuse for expediency. It spares the commission from grappling with the huge growth of Social Security and Medicare -- the main causes for expanding federal spending and deficits. Similarly, the right's crusade for more tax cuts conveniently ignores the savage cuts in these programs that would be required to justify lower taxes.
The common denominator is a triumph of electioneering over governing. Every campaign is an exercise in make-believe. All the good ideas and good people lie on one side. All the "special interests," barbarians and dangerous ideas lie on the other. There's no room for the real world's messy ambiguities, discomforting contradictions and unpopular choices. But to govern successfully, leaders must confront precisely those ambiguities, contradictions and choices.
The make-believe of campaigns now increasingly shapes the process of governing. Whether this reflects cable TV and the Internet -- which reward the harsh hostility of extreme partisanship -- or the precarious balance between the two parties or something else is hard to say. But the disconnect between policy and the real world is harmful. Proposals tend to be constructed more for their public relations effects than for their capacity to solve actual problems.
The result is a paradox. This electioneering style of governing strives to bolster politicians' popularity. But it does the opposite. Because partisan rhetoric creates exaggerated expectations of what government can do, people across the ideological spectrum are routinely disillusioned. Because actual problems fester -- and people see that -- public trust of political leaders erodes.
Chile's earthquake
In need of repair
Chile counts the cost of a devastating earthquake and makes plans for recovery
RELIEF was the initial reaction in Chile to what seemed relatively limited damage given the scale of the earthquake that shook the centre and south of the country in the early hours of Saturday February 27th. That picture has been replaced gradually by dismay as the full extent of the cost begins to emerge. By Sunday evening, the number of confirmed deaths had reached over 700 and is still likely to rise, according to President Michelle Bachelet. This is still a low toll, however, for a quake of 8.8magnitude, one of the largest in the world since 1900.
Felt throughout almost all the country, the quake hit most strongly in six central regions, from the capital, Santiago, and the nearby port of Valparaiso in central Chile to the city of Temuco in the Araucanía region of the south. These parts of the country are home to about 60% of Chile's 17m inhabitants and account for around 70% its GDP. An estimated 1.5m homes are thought to have been damaged and around a third may have to be demolished.
The greatest damage and loss of life, however, appears to have been caused not by the earthquake itself but by a subsequent tidal wave that washed over fishing towns on the coast of south-central Chile. In one such town, Constitución, rescue workers found over 300 bodies on Sunday. Much of the only town in the Juan Fernández archipelago in the Pacific Ocean, which belongs to Chile and is best-known as the place where Robinson Crusoe was marooned, was also destroyed.
Chile has developed an efficient disaster-response system to cope with what Ms Bachelet has described as “a history plagued with natural disasters”. However, looters, particularly in the southern city of Concepción and other nearby towns, have dented the image of a country swinging into action to relieve its suffering people. Though some looters may have merely been in search of scarce food and water others were out for what they could take. As a result, on Sunday, the government imposed a curfew in some of the worst-affected areas.
The earthquake struck just as the Chilean economy was beginning to recover after an estimated contraction of 0.9% in 2009. The after-effects will hamper the exports that drive the country's growth. Copper, Chile's biggest earner abroad, is produced mainly in the north of the country which was unscathed. But damage to ports further south may hamper shipments of forestry products, including wood pulp, while exports of fruit, now at the height of the harvest season in the southern hemisphere, will face delays as a result of damage to the main roads of central Chile.
Despite the earthquake’s likely impact on growth in the first and, possibly, the second quarter, it may actually provide a boost for the economy in the medium term as the government spends heavily to repair the damage. This is welcome news for the country’s president-elect, Sebastián Piñera, who is set to take office on March 11th and was voted in on an ambitious promise of average economic growth of 6% annually over his four-year term.
Until assessment of the damage is complete, it is hard to estimate the cost of reconstruction. Eqecat, an American catastrophe-management company, has suggested that it could total as much as $30 billion, equivalent to 20% of Chile’s GDP in 2009. Part of the cost can readily be financed out of the public purse, drawing on savings accumulated while copper price boomed between 2005 and 2008.
However, Mr Piñera, who has indentified increased private investment as one of the most important components of higher growth, has indicated that the government will not do all the work. He expects Chilean companies to play an important role in the reconstruction through a “Lift Chile” plan, which he outlined on Sunday. This may well include a revival of a public-works-concession scheme that Chile successfully launched in the mid-1990s precisely to build many of the motorways that were damaged by Saturday’s earthquake.The balance of economic power
East or famine
Asia’s economic weight in the world has risen, but by less than commonly assumed
THE idea that the world’s economic centre of gravity is moving eastward is not new. But the global financial crisis, many argue, has given the shift in economic power from America and western Europe to Asia a big shove. Emerging Asia rebounded from recession much faster than the developed world; its banking systems and debt dynamics (see article) are much healthier. In 2009 China overtook Germany to become the world’s biggest exporter. On one measure it now looks likely to become the world’s biggest economy within ten years. But just how far has power really tilted towards Asia?
The region has certainly become more important to bankers and businessmen, accounting for a record share of many companies’ profits last year. Several senior executives have relocated to Asia, the latest being HSBC’s chief executive, Michael Geoghegan, who officially moved from London to Hong Kong on February 1st. Since 1995 Asia’s real GDP (even including less sprightly Japan) has grown more than twice as fast as that of America or western Europe. Morgan Stanley forecasts that it will grow by an average of 7% this year and next, compared with 3% for America and 1.2% for western Europe.
Yet a closer look at the figures suggests that the shift in economic power from West to East can be exaggerated. Thanks partly to falling currencies, Asia’s total share of world GDP (in nominal terms at market exchange rates) has actually slipped, from 29% in 1995 to 27% last year (see chart 1). In 2009 Asia’s total GDP exceeded America’s but was still slightly smaller than western Europe’s (although it could overtake the latter this year). To put it another way, the output of the rich West is still almost twice as big as that of the East.
As for the popular belief that Asian producers are grabbing an ever-larger slice of exports, the region’s 31% share of world exports last year was not much higher than in 1995 (28%) and remains smaller than western Europe’s. Indeed, the shift towards Asia appears to have slowed, not quickened. Its share of world output and exports surged during the 1980s and early 1990s. Although China’s share has grown since then, this has been largely offset by the decline in Japan, whose share of output and exports has halved.
What about Asia’s financial muscle? Asian stockmarkets account for 34% of global market capitalisation, ahead of both America (33%) and Europe (27%). Asian central banks also hold two-thirds of all foreign-exchange reserves. That sounds impressive, but their influence over global financial markets is more modest, because official reserves account for only around 5% of the world’s total stash of financial assets. The bulk of private-sector wealth still lies in the West. The fact that Asian currencies make up only 3% of total foreign-exchange reserves indicates how far Asia still lags in financial matters.
The “rise of Asia” is no myth, however. GDP figures converted at market exchange rates understate Asia’s real expansion. Many currencies tumbled during the Asian financial crisis in the late 1990s, slashing the dollar value of their economies. Japan’s nominal GDP has been squeezed by deflation. More importantly, prices of many domestic products, from housing to haircuts, are always cheaper in low-income countries, implying that households’ real spending power is bigger.
If GDP is instead measured at purchasing-power parity (PPP) to take account of these lower prices, Asia’s share of the world economy has risen more steadily, from 18% in 1980 to 27% in 1995 and 34% in 2009. By this gauge, Asia’s economy will probably exceed the combined sum of America’s and Europe’s within four years. In PPP terms, three of the world’s four biggest economies (China, Japan and India) are already in Asia, and Asia has accounted for half of the world’s GDP growth over the past decade.
Some economists claim that PPP measures exaggerate Asia’s economic clout. What really matters to Western firms is consumer spending in plain dollar terms. Although over three-fifths of the world’s population live in Asia, they only account for just over one-fifth of global private consumption, much less than America’s 30% share. But official figures almost certainly understate consumer spending in emerging Asia, because of the poor statistical coverage of spending on services. Figures from the Economist Intelligence Unit, a sister company of The Economist, suggest that Asia accounts for around one-third of world retail sales. Asia is now the biggest market for many products, accounting for 35% of all car sales last year and 43% of mobile phones. Asia guzzles 35% of the world’s energy, up from 26% in 1995. It has accounted for two-thirds of the increase in world energy demand since 2000.
Many Western firms are more interested in Asia’s capital spending than its consumption, and here Asia is undoubtedly the giant. In 2009, 40% of global investment (at market exchange rates) took place in Asia, as much as in America and Europe combined. In finance, Asian firms launched eight of the ten biggest initial public offerings (IPOs) in 2009 and more than twice as much capital was raised through IPOs in China and Hong Kong last year as in America.
Winston Churchill once said: “The longer you can look back, the farther you can look forward.” The new economic order is in fact a resurgence of a very old one. Asia accounted for over half of world output for 18 of the past 20 centuries (see chart 2). And its importance will only increase in the coming years. Rich countries’ growth rates are likely to be squeezed over the next decade as huge household debts dampen spending, and soaring government debt and higher taxes blunt incentives to work and invest. In contrast, growth in emerging Asia (almost four-fifths of the region’s total output) is likely to remain strong. Robust growth should also give governments in emerging Asian economies the confidence to let their currencies rise, which would further boost the relative size of their economies in dollar terms.
By 2020 Asia could well produce half of some big Western multinationals’ sales and profits, up from a typical proportion of 20-25% today. Asian staff eagerly await the day when they can fix the times for international conference calls, so Europeans and Americans have to put up with after-midnight discussions with the Beijing office. That may be the best test of whether economic power has really shifted east.Sterling jitters
Politics and the pound
Sterling jitters
Political doubts provoke a sharp fall in sterling
CURRENCY markets can move fast when traders have the bit between their teeth, but today’s fall in the value of sterling was remarkable. When London’s markets closed on February 26th, the pound was worth $1.52 and €1.12. Sterling was trading a bit lower when they opened again on March 1st, but by late morning it had plunged under $1.48 and €1.10. By late afternoon the pound had clawed back some of that lost ground, but was still below $1.50 and €1.11 (see chart).
Some traders linked the sharp fall to plans by Prudential, a British insurance firm, to purchase the Asian operations of AIG, an American insurance giant, at a cost of $35 billion. But the main reason for sterling’s sudden plunge was political. The markets now fear that Britain’s general election, due by June 3rd at the latest, will not see a strong Conservative government elected with an effective mandate to sort out the public finances—or indeed any clear result. That loss of confidence is sapping sterling.
For the past year, Britain has stood out for all the wrong fiscal reasons. This year’s deficit is forecast by the IMF to be 13.2% of GDP, the highest among the G20 economies. The build-up of government debt will be second only to Japan’s between 2007 and 2014.
Despite these ugly trends, investors were forbearing because Britain still had some things going for it. The starting-point for public debt – 44% of GDP in 2007 - was low compared with other big economies. And the average maturity of gilts is exceptionally long (14 years), which means that the government has to repay (and thus refinance) much less of its outstanding debt each year than other countries with shorter maturities.
Perhaps most important, Britain has a strong state. Its first-past-the-post electoral system generally delivers a decisive result. That authority has allowed governments to push through painful fiscal retrenchment in the past, most recently under the Tories in the 1990s after a previous budgetary blowout, though the peak deficit then of just under 8% of GDP seems modest by comparison with today’s.
But that forbearance has been temporary and conditional. The period of notice expires after the election. The condition has been that a new government then produces a credible plan to put the public finances on to a sustainable path.
Now that outcome is looking less likely. Although the Conservatives started the year with a healthy poll lead, it has been narrowing. A survey published on February 28th showed that it had fallen to just two percentage points. The Tories labour under a disadvantage in Britain’s electoral system, such that they are generally reckoned to need a national lead of around ten points in order to ensure an overall majority. A lead of just two would mean that Gordon Brown’s incumbent Labour party, rather than the Conservatives, would emerge as the biggest single party.
That prediction is far from certain, not least since the Tories are reported to be doing rather better in the specific constituencies which will decide the election. But on current polling, the likelihood of a hung parliament, in which no party has an outright majority, is increasing. Investors fear that an indecisive result will not produce the determined effort to mend the public finances that is needed.
Such fears may be exaggerated, in that whichever party (or parties) end up in power will have to deal with the deficit – and take account of market reaction. Moreover, sterling is not the most obvious candidate for a currency crisis, mainly because it has already had one, falling by 30% on a trade-weighted basis between mid-2007 and the end of 2008, after which it picked up a bit and then stabilised. But the fears among investors are real. And, in a further unpredictable feedback, they may now start to influence the election itself.How to Create 3 Million Jobs
How to Create 3 Million Jobs With Pencil, Ruler: Kevin Hassett
Commentary by Kevin Hassett
March 1 (Bloomberg) -- The way Washington works, something is true today if we thought it was true yesterday and the day before.
This is great news for bad ideas. Once a career government official hard-wires a belief into the bureaucracy, it is there forever.
This helps explain the mess we are in. An ossified regulator sets up a stiff and inflexible regime of rules, confident it will be effective. Those being regulated adjust their behavior and get away with economic murder.
Likewise in fiscal policy, the tyranny of dead ideas funnels taxpayer dollars toward ineffective programs. The best example is the $862 billion economic stimulus.
Last week the Congressional Budget Office reported that the stimulus enacted a year ago created 1.4 million to 3 million full-time-equivalent jobs in the fourth quarter. The CBO drew heavily on commercial forecasting models and the macroeconomic model used by the Federal Reserve.
Both of these old-school Keynesian models, by the CBO’s own admission, “tend to predict greater economic effects” from legislation like last year’s stimulus.
As the CBO put it, the range of estimated job creation was “intended to encompass most economists’ views and thereby reflect the uncertainty involved in such estimates.”
Really?
Let’s pause for a short history.
Era of Models
Back in the 1960s, economists thought that large Keynesian models like those relied upon by the CBO could enable them to simulate with great precision the response of the economy to different policies. After an explosion of model building, activity in this area ground to halt, not because the perfect model was developed, but because the effort was convincingly discredited.
I received my Ph.D. in the 1980s from the University of Pennsylvania, which was a center of macro model building in the 1960s and 1970s. By my time there, such modeling had become no more than a footnote in the graduate curriculum.
The large-scale Keynesian forecasting models were discarded by most of the profession because they didn’t work. One of the first to demonstrate this was Charles R. Nelson of the University of Chicago, who in 1972 showed that forecasts based on simple extrapolations significantly outperformed theory-laden macroeconomic models in competitions.
‘So Inaccurate’
About a decade later, Virginia Tech economist Richard Ashley performed a similar exercise that found the big macro models “so inaccurate that simple extrapolation of historical trends is superior for forecasts more than a couple of quarters ahead.” To paraphrase Ashley, all you need to outperform the fancy models is a ruler and a pencil.
Economists went on to refine techniques that correlate the way things move with each other over time, relying on hard evidence rather than Keynesian theory. These techniques generally find that policies like last year’s stimulus have much smaller effects than the macro models would suggest.
Yet the analysis of job creation of the stimulus bill essentially ignores this vast literature.
Here is the best sign of how bad it is. Last month, one of the leaders of the macroeconomics profession, Robert Barro of Harvard University, wrote a piece for the Wall Street Journal that drew on his own experience studying the response of the economy to fiscal policy.
Lower GDP
Barro has been one of the primary contributors to the macroeconomic time-series literature that has tried to estimate effects from observed economic data, rather than assume effects, as Keynesian models do. He is a lock to win a Nobel Prize someday. Barro wrote that his work suggests that the stimulus increased output last year by about 0.8 percent -- an estimate below the range that the CBO claimed would characterize the breadth of views of economists.
If the stimulus gave a smaller boost in gross domestic product, it also created fewer jobs.
Rather than rely on large-scale computer models that are filled with tenuous assumptions to simulate what might have happened, a better approach is simply to let the data speak. Many countries, including the U.S., have tried economic stimulus measures. We can study the evidence of what happened.
The CBO’s estimate range, which would have been correct in 1969, is silly today. Its analysis is based almost exclusively on speculation within the context of old-fashioned Keynesian models. The fact that these effects are inconsistent with actual experience, as captured by analysis like Barro’s, is inexcusably ignored.
CBO’s Rosy View
When political leaders ask the CBO what will happen if a big stimulus bill is adopted, they get an intellectually indefensible, rosy scenario. If you wonder why the stimulus was so large, perhaps it’s because the CBO told Democrats that it would be so good. The fact is, our giant, ineffective stimulus was designed for economic models that were discarded when Richard Nixon was president.
It’s a safe bet that if 8-year-old Sasha Obama ever becomes president like her father, the bureaucracy will still be using the same models.Sex Addicts
Sex Addicts Give New Impetus to Job Creation: Caroline Baum
March 1 (Bloomberg) -- Congress is itching to spend more money to create jobs. The House of Representatives passed a $154 billion bill in December while the Senate voted for a smaller, $15 billion measure last week.
Why spend more of the taxpayer’s money when the political classes have what it takes to generate organic job growth? Between sexual dalliances (Republicans) and financial hanky-panky (Democrats), our elected representatives can do for overall employment what Tiger Woods did for the consulting industry.
A species known as “crisis reputation adviser” evolved to coach Tiger on his televised apology and interpret his body language (wooden) for the rest of us.
Politicians should adapt that model and use their own indiscretions to create the jobs of tomorrow. Here are a few possibilities:
1. Appalachian Trail Guide
When South Carolina Governor Mark Sanford disappeared into the arms of his Latin soul mate in June, he told his wife and staff he was hiking the Appalachian Trail. His actual destination was Buenos Aires.
Every politician should have an opportunity “to clear his head,” as Sanford’s communications director told the press when his boss was incommunicado for four days. Sanford’s wrong turn is a strong argument for beefing up staff at the National Park Service -- for those who really want to take a hike before the wife insists on it.
2. Spanish-as-a-Second-Language Teacher
New York Congressman Charles Rangel, chairman of the tax-writing Ways and Means Committee, can’t seem to get his own income taxes right. He failed to report $75,000 of rental income on a Dominican Republic villa he purchased with a tax-free loan, just two of many ethical lapses for which he’s being investigated. (Last week, the House Ethics Committee gave him a slap on the wrist for accepting corporate-sponsored trips.)
Rangel blamed “cultural and language barriers” for his failure to understand the financing arrangements for his beach house. (I bet he understood “zero percent financing” in a variety of languages.)
Spanish is the primary language of half the members of his congressional district, which includes Harlem, according to the New York Times. What’s more, his Web site can be translated into Spanish with “two clicks of a computer mouse,” the Times said. (Actually it’s only one click.)
Sorry, Charlie.
As long as the Caribbean holds an allure for the multihome-owning members of Congress, Spanish language instruction should be required of all freshmen.
3. DNA Diaper Swiper
Former North Carolina Democratic Senator John Edwards got caught in a pack o’ lies (and on camera) trying to conceal his affair with Rielle Hunter, a “campaign videographer” --another potential job-growth category -- and a child he fathered by her.
Andrew Young, who was a top campaign aide to Edwards during the 2008 Democratic presidential primaries, says his boss asked him to swipe a dirty diaper from the baby so Edwards could perform a DNA test to determine paternity.
With more family values Republicans getting caught with their pants down (Senators John Ensign and David Vitter come to mind), the opportunities to harness the synergies between technology and trysting, and create entire new industries, are endless.
4. Character Coach
Just as Republicans excel at preaching moral values and living their lives by lesser standards, Democrats rail against income inequality as they pad their pockets.
It takes a committee chairman, however, to rise to the level of a Chris Dodd, who heads the Senate Banking Committee.
As a designated “friend of Angelo” -- Angelo Mozilo, former chief executive of Countrywide -- Dodd was given sweetheart mortgage deals on various properties.
Countrywide was Fannie Mae’s biggest mortgage supplier. The Banking Committee has oversight responsibility for Fannie Mae and Freddie Mac, two government-sponsored housing finance agencies Republicans wanted to rein in -- before they collapsed. You don’t need a sharp pencil to connect those dots.
Dodd’s other real estate transaction, the purchase of a cottage on 10 acres on Ireland’s West Coast, reeked so badly of swapping political and financial favors his approval rating slumped. The senior senator from Connecticut decided in January not to seek re-election this year.
Character isn’t Dodd’s strong suit. He and his 534 colleagues in the Senate and House could all use some therapy, a 12-step program or character coaching.
My Name Is Tiger
Tiger has the means and the motivation to check himself into a sex addiction clinic to get help with his image, I mean, disorder. With more generous health-care benefits promised with ObamaCare, lawmakers may have the same access to treatment.
The current version of the Diagnostic and Statistical Manual of Mental Disorders, DSM-IV, published by the American Psychiatric Association, does not recognize sex addiction as a diagnosis. If the eagerly awaited publication of DSM-V in 2013 designates new categories of addiction, politicians will have another excuse, besides denial, for their sexual and financial indiscretions: It wasn’t my fault.
Then again, most of them use that one already.U.S. Consumer Spending Increases
U.S. Consumer Spending Increases More Than Forecast (Update3)
By Timothy R. Homan
March 1 (Bloomberg) -- Spending by U.S. consumers increased in January for a fourth consecutive month, a sign that the biggest part of the economy may contribute more to growth in coming months.
The 0.5 percent increase in purchases was more than anticipated and followed a 0.3 percent gain in December that was larger than previously estimated, Commerce Department figures showed today in Washington. Incomes climbed 0.1 percent, short of expectations and reflecting declines in dividends and interest.
Retailers such as Home Depot Inc. and Macy’s Inc. are forecasting rising sales this year, even as they don’t foresee a robust economic recovery. An unemployment rate that’s projected to average 9.8 percent this year may restrain household purchases, which account for about 70 percent of the economy.
“It’s a good start” for the year, said Brian Bethune, chief financial economist at IHS Global Insight in Lexington, Massachusetts, who correctly forecast the increase in purchases. Still, he said, “consumption is not going to be the driver” of economic growth.
Stock-index futures maintained earlier gains following the report. The contract on the Standard & Poor’s 500 Index rose 0.4 percent to 1,107.7 at 9:05 a.m. in New York. Treasury securities were little changed.
Exceeds Forecast
The median estimate of 61 economists surveyed called for a 0.4 percent increase in spending, after an originally reported gain of 0.2 percent the prior month. Projections ranged from gains of 0.2 percent to 0.6 percent.
The increase in incomes followed a 0.3 percent advance in December. The median forecast of economists surveyed anticipated a 0.4 percent gain. Wages and salaries climbed 0.4 percent in January, the most since April, after increasing 0.1 percent the prior month. Interest payments fell 0.3 percent while dividends declined 3 percent.
Disposable income, or the money left over after taxes, dropped 0.4 percent, the largest decrease since July, reflecting an increase in federal non-withheld income taxes.
Today’s report showed stable prices. The inflation gauge tied to spending patterns rose 2.1 percent from January 2009, less than the 2.2 percent survey median forecast.
The Federal Reserve’s preferred price measure, which excludes food and fuel, was unchanged in January from the previous month and was up 1.4 percent from a year earlier.
Adjusted for inflation, spending climbed 0.3 percent following a 0.1 percent rise the prior month.
Because the increase in spending was larger than the gain in incomes, the savings rate fell to 3.3 percent, the lowest level since October 2008, from 4.2 percent the prior month.
Broad-Based Gains
Inflation-adjusted spending on durable goods, such as autos, furniture, and other long-lasting items, climbed 0.7 percent in January after rising 0.6 percent the prior month.
Purchases of non-durable goods increased 0.8 percent, and spending on services, which account for almost 60 percent of all outlays, increased 0.1 percent.
The economy grew at a 5.9 percent annual rate in the fourth quarter, the fastest pace in six years, figures from the Commerce Department showed last week. Consumer spending slowed to a 1.7 percent pace, from 2.8 percent the previous three months.
Home Depot is among companies projecting stronger sales.
“We recognize that we have more work to do as a company and that the economy is not out of the woods yet, particularly in our market, so we’re not projecting robust growth,” Home Depot Chairman and Chief Executive Officer Frank Blake said on a Feb. 23 conference call with analysts.Chile Deploys Soldiers to Quell Looting
Chile Deploys Soldiers to Quell Looting After Quake (Update2)
By James Attwood and Michael Smith
March 1 (Bloomberg) -- Chile deployed security forces to quell looting in the country’s second-largest city, Concepcion, as rescue workers struggled to reach survivors near the epicenter of an 8.8-magnitude earthquake that killed at least 700 people.
Buildings in the city of Concepcion were reduced to rubble by the Feb. 27 temblor while a tsunami that followed swamped a port town 15 kilometers away on the Pacific Ocean coastline. Patrol units rounded up people who violated an overnight curfew. Police fired teargas at looters in a supermarket.
Chile’s main stock index plunged the most in more than a year, before paring some losses, as officials surveyed destruction from the massive pre-dawn quake, which severed the country’s main highway and damaged an estimated 1.5 million homes. Chile’s government has appealed to the United Nations and the international community for assistance, seeking mobile bridges, satellite phones, electric generators, salt-water purification systems and field kitchens.
“We’re faced with a natural event the likes of which none of us have experienced in our lifetime,” said Edmundo Perez- Yoma, Chile’s interior minister.
Authorities are setting up field hospitals and providing additional rescue workers to the areas most affected by the quake, President Michelle Bachelet told reporters yesterday. The army is deploying about 10,000 troops, Defense Minister Francisco Vidal said.
Economic Cost
The total economic cost may be as much as $30 billion, or about 15 percent of the country’s gross domestic product, according to estimates by disaster-scenario modeler Eqecat Inc. Finance Minister Andres Velasco said it was too early to estimate the cost of the damage.
Chile’s economic recovery will be hurt by the earthquake, Bank of America said today in a report, cutting its forecast for economic growth this year to 4 percent from a previous estimate of 4.7 percent.
Central Bank President Jose De Gregorio said Chile’s monetary policy will remain expansive in the aftermath of the quake, telling reporters that policy makers will help the government find “appropriate” financing to pay for rebuilding.
Velasco said reconstruction could be funded partly by the country’s $14.7 billion rainy-day fiscal savings fund assembled through windfall copper profits.
Copper Savings
“Chile has saved for a very long time in order to have the savings to be able to face situations like this,” he told reporters. He said Chile can pay for relief efforts without taking extra budget measures or seeking legislative approval.
Stringent building codes and the most highly engineered building inventory in Latin America helped mitigate damage, said Boston-based Air Worldwide, a catastrophe modeling firm that estimated more than $2 billion in insured losses for insurers.
More than 50 aftershocks followed the earthquake, which was stronger than the one in Haiti on Jan. 12 that may have killed 300,000 people. Fear of further quakes bringing down damaged buildings has Chileans sleeping outside and in their cars.
Bachelet declared a “state of catastrophe.” She said about 2 million people have been affected by the earthquake that the USGS said was the world’s fifth strongest since 1900. It carried a force 500 times stronger than the magnitude 7.0 earthquake that last month devastated Haiti, in terms of the energy released, according to the USGS.
The Chilean Air Force is ferrying rescue workers, police and other security forces in hourly flights 270 miles (434 kilometers) southwest of the capital Santiago to Concepcion, an industrial and university city with almost 1 million people. Residents struggled to retrieve mud-caked possessions and deal with lack of access to water, power or food.
Fishing Boats
About a dozen people were crowded over a fuel tank of a destroyed gas station, siphoning fuel with bottles strapped to poles. Neighborhood residents sitting by bonfires kept watch for thieves outside their destroyed homes. In the nearby port town of Talcahuano, fishing boats were left strewn through the town.
Juan Soto and his brother were aboard their sardine fishing boat when the quake struck, shaking the vessel violently before the receding sea dragged them 200 meters offshore, he said. They watched a tsunami wave they estimated to be 10 meters to 15 meters high devastate the area. Soto’s wife and four children took shelter in a village 75 kilometers away after the sea surge destroyed the family home.
‘I Lost Everything’
“I lost everything,” Soto, 45, said from the town, where hundreds of people sleep in tarps and tents in the surrounding hills. “I have nothing left except the clothes I’m wearing right now. This is a catastrophe that will take years for us to recover from.”
Chile’s largest naval base at Talcahuano suffered at least $1 billion in damage from the quake and may take years to rebuild, said Admiral Eduardo Gonzalez, commander of the navy.
“This is the worst disaster to strike the Chilean navy in its history,” Gonzalez said in an interview from the destroyed docks of the base.
Secretary of State Hillary Clinton will visit Santiago tomorrow morning as part of a planned five-country tour of Latin America this week, spokesman Philippe Reines said. “We want to show America’s support for the people of Chile while mindful of the realities on the ground,” Reines said yesterday.
Stocks Drop
The Ipsa stock index dropped 1.4 percent at 2:24 p.m. New York time and earlier lost 2.9 percent, the most intraday since Dec. 1, 2008. Chile’s peso was little changed, recovering from an earlier plunge.
Chile is the world’s largest producer of copper and at least four copper mines responsible for 16 percent of the country’s output halted operations after the quake struck. Copper for May delivery gained as much as 20.3 cents, or 6.2 percent, to $3.4870 a pound, before trading at $3.3450 at 1:26 p.m. New York time, in electronic trading on the Comex division of the New York Mercantile Exchange.
Most of Chile’s copper deposits and port facilities are in the northern half of the country and had no reports of damage. These include Escondida, the world’s largest copper mine, operated by BHP Billiton Ltd. and in which Rio Tinto Group is a shareholder.
The 90-second temblor severed the Pan-American highway, the country’s main thoroughfare, at several points south of Santiago. Authorities have set up detours in an attempt to get traffic moving again.
An estimated 1.5 million homes may have been damaged, a third of them severely, Housing Minister Patricia Poblete said. In towns closer to the epicenter, including Curico and Talca, more than 80 percent of buildings were flattened, CHV Television reported.
Weakened Buildings
In Maipu, a Santiago neighborhood five miles south of the presidential palace, a four-story apartment building was leaning halfway over, its support columns sheared off on one side by the earthquake’s force. Aftershocks have weakened the building to the point of collapse.
Felipe Gonzalez, 32, fled in his boxer shorts, holding his 18-month-old daughter in his arms as the pieces of the building fell around him, “I could hear the building collapsing behind as I ran out,” Gonzalez said. “With every aftershock, it collapses even more.”
Police won’t let Gonzalez or others go inside to get any of their possessions. “They say it’s too dangerous,” he said. “Everything I have is in there, but I’ll never see it again.”
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