Dunkin' Donuts Lies

The popular coffee brand, Dunkin' Donuts, claims in their advertisements, “America runs on Dunkin’” They lie. America buys their coffee with credit cards; America runs on debt. I don’t need to tell you that America is riddled with debt, private and public. Anyone who has watched the news since health care reform was passed has heard that America can’t handle the cost. Everyone knows about the cost of the Iraq war (in dollars). Everyone knows about the rising cost of social security and Medicare as the baby-boomers approach retirement. People also know about all the foreclosures. Debt currently makes up very high 80% of GDP.

This is why the banks were bailed out; credit is the lifeblood of America and strong banks enable our lifestyles. For anyone to buy a home, they must take out a loan from the bank. Nobody has $200,000 in cash to buy a house. But what would happen if there were no banks to loan out money? No one would be able to buy a house, which if you believe in the free market, would drive the cost of housing down considerably. There is nothing inherent to the construction of homes that requires they cost so much.

The news makes it sound as if rising real estate prices are a sign of strength. We don’t need higher housing prices; people are so quick to forget that rising prices are a bubble. I stand here before you and say, “Housing prices are still inflated!” If people can’t afford houses, then they cost too much. That’s how every other commodity in the world works. It’s just supply and demand.

The problem is that there are so many outstanding loans made from the peak of the housing bubble that any readjustment of housing prices to lower, more reasonable levels, would send the majority of America underwater. Everyone would owe more than their homes were worth and would either default or restructure their loans. This would absolutely obliterate the banking system, because they are invested in your homes. With the banks completely destroyed, credit markets would seize to exist and you could only buy your coffee with cash.

What happens after that is open to interpretation. Either the invisible hand of the free market distributes bread in a fair manner or every industry that isn’t McDonalds loses profitability and we have 40% unemployment (also known as the Great Depression). So next time you wonder why the Government uses inflationary monetary policy, it’s because our banks invested at the peak of an asset bubble making any realignment crippling and destructive.

Credit Default Swamps

Since the whole Greece debacle, there has been a lot of talk about Credit Default Swaps (aka CDRs). Many European officials believe that CDRs exasperated problems in the Eurozone by allowing investors to speculate against Greece and other struggling members of the EU. Although there is still some debate on what impact CDRs had on the situation, there seems to be growing consensus that CDRs need to be regulated.

First lets look at what CDRs actually are. In the simplest of terms, they are bond insurance. For example, if I buy a Canadian bond, and I’m worried that Canada will default on their debt (and therefore won’t be able to pay me once the bond matures), I can buy a CDR, which will pay me in the event that Canada defaults. For investors, it can be a good way to hedge.

As is the nature of insurance, CDRs for certain bonds are costlier than others. To insure a Canadian bond would be cheap since the risk is minimal with Canada’s mature and reasonably well to do economy. Insuring a bond from some tumultuous nation with a weak economy will cost a good deal. This is why the cost of a CDR is how some people measure economic strength.

Unlike most forms of insurance, you aren’t required to own the underlying asset. For example, if I believe that Canada will default on its debt; I can buy a CDR and profit if Canada defaults. Unlike my first example, this situation doesn’t involve burning money on the bonds themselves, which makes the whole ordeal more profitable. These are called “naked” swaps.

The best way for me to articulate how demented the concept of “naked” swaps are is to give a little hypothetical. Imagine that you were never required to own underlying assets for any form of insurance. People could speculate about everything. I hear there’s a hurricane coming to Louisiana; I’m going to buy flood insurance for thousands of homes in New Orleans. I could buy insurance for every Asian woman’s’ car in the US. Geico commercials instead of selling you on the idea of saving money would have that annoying little lizard saying, “Buy ‘teenagers in sports cars’ insurance right here.” I could go and buy life insurance policies for nearly dead people. (Although that is sort of happening already.)

The major consequence of my hypothetical is that it would make insurance too expensive. Speculation about the quality of Asian women drivers would price them off the road. Speculation about flooding in New Orleans would price people out of their homes. Buying insurance for things you don’t own isn’t insurance. It’s gambling, which is a perfectly fine activity, but it isn’t something financial intermediaries should be involved with.

CDRs are one of the major reasons for AIG’s collapse, “The credit default swaps on this kind of CDO account for the lion's share of AIG's problems with default insurance.” If AIG wants to sell CDRs they should be able to, but just like Geico and every other insurance company, AIG should have to make sure people actually own the assets they’re insuring before they sell it to them.

Ron Paul's New Cloths

In one of the most indescribable moments in Congressional history, Ben Bernanke and Ron Paul looked deep into each other's eyes and a black hole was formed somewhere in the universe. I'm pretty sure that about 45% of the time Congress is in session is spent listening to Ron Paul rant about the Fed but this rant was special because Ben Bernanke was right there to respond.

Here is a video link to the confrontation. It begins with Ron Paul giving a barely coherent speech about the Fed. He makes several obvious points about inflation and a lack of transparency. He tries to respond to criticisms of his bill that would allow Congress to audit the Fed in what vaguely resembles a series of statements. He then accuses the Fed of making loans to Saddam Hussein during the 80's. He also claims that the Watergate scandal was conducted with money from the Fed.

Ben Bernanke's reaction is priceless: “These specific allegations you've made I think are absolutely bizarre." Is there a better word than “bizarre” to describe Paul's allegations? Bernanke tells Paul that full transcripts of all Fed meetings are released after 5 years and that the Fed is actually reasonably transparent.

Paul then tries to make a point about a lack of transparency by saying that the Fed could be conducting a bailout of Greece, as we speak, and nobody would know. Ron Paul then directly asks if Bernanke has spoken to European officials about buying Greek debt and Bernanke says he hasn't. Then Paul asks if the Fed could buy Greek debt if they wanted to. Then, in my favorite moment of this whole exchange, at 4:53, Ben Bernanke looks over his shoulder to the person behind him as if to say, “Is this guy actually insane?!?! Does he even have a real point to make?!?!” Bernanke being the politician that he is, offers his denials over any claim that he is going to buy Greek debt and the conversation is essentially over.

Then in another classic Congressional moment, (Classic Congressional Moments vol. 1 to be released on DVD next fall) Barney Frank says sarcastically that the committee will conduct a full examination of the Fed's supposed involvement with Saddam and Watergate.

Now here's my take, Ron Paul is a doctor. He went to medical school and is surely an intelligent man. I have nothing bad to say about him personally but he is by no means an economist. His philosophy is simplistic and reactionary. Accusing the Fed of funding Saddam is totally believable if you're cynical and even if it's false, those same cynics will cry out, “Dr. Paul is a hero for saying the truth man.” But what good does it do? Paul wastes the committee's time promoting his own simplistic message, making wild accusations and asking irreverent questions and is called a hero on the Internet.

The great thing about the moment Ben Bernanke looked over his shoulder was that it really said everything. It was the emperor's new cloths to Bernanke. Dr. Paul has a huge amount of support around the country. He's set fund raising records. He's gotten bills passed through congress and he's done it without being coherent or offering a serious message. What is this man's appeal; what am I missing here?

The Ghost Of Paul Samuelson

I stumbled upon an interview with the late Paul Samuelson that I found interesting. In particular, I thought his comments on Economic textbooks shed some light on a serious problem with the field. “[M]y book came along and swept the field, and set a pattern so that every time somebody -- this is just scuttlebutt -- so that every time some economics textbook writer sued another textbook writer for plagiarism, it never got anywhere because the judge would just say, 'it's all Samuelson lite,' so to speak.”

I’ve heard this before; every macroeconomic textbook is Samuelson’s. If it isn’t, it is derived from Samuelson’s. The consequence of this is that every macro book is the same or at the very least, makes the same arguments and as a result, everyone who studies from these books, which is everyone, thinks the economy works one way.
Because everyone in the world of Economics went to the same ten schools and read the same textbooks, they all think the similarly and that is very bad, because if there is any flaw in the common knowledge, there’s nobody to notice. Samuelson points out, “The macro book…I went through the index to look for liquidity trap. It wasn't there!” No wonder nobody saw the liquidity trap coming.

Another belief of mine that Samuelson confirmed is that our good friend Alan Greenspan is an ideologue. “You can take the boy out of the cult but you can't take the cult out of the boy. He actually had instruction, probably pinned on the wall: 'Nothing from this office should go forth which discredits the capitalist system. Greed is good.'” That’s one hell of a quote.

Ron Paul’s Wet Dream May Come To Fruition

Ben Bernanke passed the Senate and can now start his second term. It wasn’t pretty but Bernanke made it out alive. The WSJ article about Bernanke’s approval was laced with comments about the Fed losing its credibility. It was filled with quotes from angry senators talking about translucency and accountability, and it all sounds nice.

Dr. Ron Paul’s bill passed the House of Representatives that would allow the General Accountability Office to audit the Fed. There some talk that Congress wants all the Fed’s bankers to be presidentially appointed and approved by Congress. This all sounds nice. It really does. Accountability, translucency: these are nice words.

Head of the Federal Reserve Bank of Dallas, Richard Fisher wrote an interesting Op-Ed in the WSJ about this subject. His feeling is that making the Fed less autonomous would turn the central bank into a highly politicized inflationary monster. Bankers would pander to Congress in the hopes of keeping their jobs, instead of looking out for “Main Street.”

Fisher touches on an important part of this issue but doesn’t outright say it: accountability and translucency don’t really matter if it’s Congress that’s holding you accountable. Is it really better to have an incompetent, imbecilic body with no macroeconomic expertise control the most powerful central bank in the world? Fisher’s argument is a little less valid. He argues that Congress will demand the Fed print away all of their problems and lead to massive inflation. He’s just using scare tactics to further his point, which is unnecessary since he has a valid point to make.

There is a reason this bill is picking up steam though. It is the inverse of the old phrase, “If it ain’t broke, don’t fix it.” In this case, “If it’s clearly broken, just do something.” The Fed has been increasingly autonomous for the last 40 years and it didn’t work. Greenspan ran the Fed without anyone second-guessing him anywhere along the way. Bernanke ran the Fed and didn’t see the bubble and there was no one else around to notice the bubble either. One of the major flaws of the Fed is that everyone there thinks the same way so nobody ever notices a mistake. Every Fed chairman has been an ideologue and this is a problem. The answer however, is not Congress.

Teaching Bernanke A Lesson

So the Democrats in Massachusetts provide the world with another unlikeable, dull politician (list of Massachusetts’ Democrats whom I don’t want to have a beer with: Kerry, John; Dukakis, Michael; Affleck, Ben) and manage to lose Ted Kennedy’s ancient senate seat. The fallout from this is probably overblown, and there is no need for me to go into depth about why since it’s been talked about in pretty great length. The thing I find interesting is how this affects Mr. Bernanke’s reconfirmation.

It seems as though Bernanke will pass the Senate, but not without getting dragged through the mud first. (To the left I have an image of what Bernanke will experience.) Senators of both parties will point out how Bernanke failed to predict the financial crisis and how he has made many other mistakes. Despite these just criticisms Bernanke will pass and for one reason: where are you going to find someone better than Bernanke?

Paul Krugman has talked about this on his blog and mentions the idea of Paul Volcker taking his old position back. But Krugman essentially admits that he has no clue what Volcker would do differently policy-wise. At the end of the day, what is the Senate gonna do? Not pass Bernanke? Then what? Obama nominates someone else who has less impressive credentials and follows the same ideology as Bernanke and the senate passes him for the sake of change.

If the Senate wants to influence the economy, get Bernanke in and out as quickly as you can and pass Barney Frank’s finance reform. If you have issues with the Federal Reserve, pass Dr. Paul’s bill allowing Congress to audit the Federal Reserve. Criticizing Bernanke if you have no other realistic options is just a waste of energy. If Bernanke is capable of learning a lesson, he learned it some time ago.

Poking Fun At Paul Krugman

I sat at home researching some info about Japan in the 90’s since it seemed relevant to our current crisis and I was going to write something about Japan (still will) and I stumbled upon a series of things Paul Krugman wrote in the 90’s (back when he worked at MIT) about Japan. To no one’s surprise, his solution to Japan’s problems was to simply print more money, a plan he continues to advocate for here and now. I generally like Krugman but it occurred to me that he is an ideologue. He seems to live by strict neo-Keynesian code, which made me wonder: does Krugman apply his neo-Keynesian ideals to all facets of life?

Here is a little dialogue from Krugman’s home life:

Mrs. Krugman: Honey the sink is broken.
Paul: Oh, we should print more money then.
Mrs. Krugman: How would that fix the sink?
Paul: Because people have money illusion; it’s all here in this book. (Pulls out copy of General Theory of Employment, Interest and Money) Have you read this yet like I asked? And for that matter, have you been printing money like I asked?
Mrs. Krugman: No, but Little Billy didn’t do so well on his latest report card.
Paul: Did you tell him to print more money?
Mrs. Krugman: No…
Paul: I’ll go talk to him then.
Billy: Hi dad, how are you?
Paul: Never mind me, are you printing more money at school like I told you to?
Billy: No…
Paul: Well no wonder your grades aren’t good, you have to print more money.
Billy: Why?
Paul: Because people have money illusion; it’s all here in this book. (Pulls out copy of General Theory of Employment, Interest and Money) Have you read this yet like I asked?
Billy: I’m seven.
Paul: Oh please, if you need me, I’ll be in the garage printing money while repeatedly texting Ben Bernanke trying to convince him to print more money.

Vacation Is Over

My vacation is over and I'll have a couple of new posts this week, I promise.

The Castration of Ben Bernanke

The New York Times reported recently that Ben Bernanke believes, “Regulation is the best way to prevent financial speculation from getting out of hand and throwing the economy in a new crisis.” This is understandable especially from Bernanke's position. Time's “Man of the Year” makes major decisions in the hopes of fixing the economy but finds that Wall Street's speculations about his actions ultimately have a greater impact than his actual actions, which is probably very frustrating. He keeps interest rates low in the hopes of getting banks to lend money to small businesses and stimulate the economy, but instead, banks hold onto their cash because of speculation that the Fed will raise interest rates in the future. Then in the future, if he doesn't raise interest rates, people will still fear that he will raise interest rates even farther into the future and the cycle continues.

In a sense, Bernanke is completely powerless. It is eerily similar to Japan and the “Lost Decade.” The Lost Decade isn't cool like the Lost Generation but rather a frightening period in Japan's recent history. In 1989, in the middle of gigantic asset price bubble, Japan's central bank raised interest rates to counteract speculating and the aforementioned bubble. The high interest rates acted as a very large needle which popped the bubble and led to a stock market crash, real state market crash and then several government bailout of Japanese banks. Sound familiar? I know that this comparison is hardly groundbreaking. Obama warned about the potential Lost Decade less than a month after his inauguration. What I want to show is how little an impact the central bank has in both cases.

Paul Krugman wrote Japan's economics problems of the 90's were, "simply because its consumers and investors do not spend enough." Krugman, as you might imagine, felt that this could be assuaged just by printing more money. Although it seems to me that the high savings rate among the Japanese is too ingrained in Japanese culture for a simple monetary policy tweak to fix. Japan tried to encourage spending by giving out non-savable tax refunds but the Japanese simply used the refund to buy their essentials and saved the money they would have used for their essentials.

Not to sound fatalistic but you can't make people behave a certain way. If the Japanese don't understand the Paradox of Frugality then you can't make them and even if they do understand the concept, there's still the "rat choice" issue. Samuel Popkin explains, "Everybody’s business is nobody’s business. If everyone spends an additional hour evaluating the candidates, we all benefit from a better-informed electorate. If everyone but me spends the hour evaluating the candidates and I spend it choosing where to invest my savings, I will get a better return on my investments as well as a better government."

Consider Popkin's example but think in terms of the Paradox of Frugality. If everyone spends more money then we all benefit from a strong, stimulated economy. If everyone spends but me, then I benefit from the strong, stimulated economy and I benefit from my extra savings. It's for predicaments like this that government exists. Government coerces people into paying taxes so that everyone has to contribute to things like defense. If everyone contributes money to an army we all benefit from the extra defense, if everyone but me contributes then I benefit from the defense and the extra money. So government makes people contribute for these universal causes because they wouldn't be feasible otherwise. It is the business of government to prevent those who try and take advantage of others collective goodwill.

Now Ben Bernanke is trying to do a similar thing, get Americans to spend money. More specifically, he's trying to get banks to loan money to small businesses to hire people to spend money, but he's having trouble. The banks simply won't loan out money. The Fed has done all you can ask. They're giving the banks easy money to loan but the banks just pocket it.

Bernanke is almost powerless. All he can do his is try to encourage positive economic behavior; he can't actually make it happen. This is why Bernanke wants regulation; he wants to be able to control things. If he can give easy money to the banks then he should be able to make them give loans. He wants a government mandate that says, "Do what Ben says." He won't get the regulation he wants because all of the easy money he's given the banks stimulates the stock market, which a lot of people believe is a economic litmus test, and people will believe the economy is fine and won't need any new tweaks. But be wary because the easy money and the obsession with stock prices is what got us here in the first place. If we come out of this financial crisis without learning a lesson, we'll be doomed to repeat history.