Archives: March, 2008

Tyler Cowen Thinks Frozen Markets Justify Tougher Regulations?

In a New York Times piece of March 23, “It’s Hard to Thaw Frozen Markets,” Tyler Cowen concludes that “regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions.” That conclusion follows from a surprisingly innocent confidence in regulation in general and capital requirements in particular. But it also follows from a faulty analysis of the situation.

Cowen writes, “What is distinctive today is the drying up of market liquidity — the inability to buy and sell financial assets — caused by a lack of good information about asset values… .The results have been a form of financial gridlock.”

To explain this alleged “drying up” process he says, “Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.” Cowen thinks “market prices have been drained of their informational value” in “many asset markets.”

With the possible exception of mortgage-backed securities, that seems fanciful if not absurd. The spread between junk bonds and Treasury widened mainly because Treasury yields fell, but there is massive trading in such bonds. Sales of nonfinancial commercial paper have grown briskly this year, and so have sales of financial paper aside from the “asset-backed” variety. There may be little trading of mortgage-backed securities, but that just suggest many owners (unlike, say, e-Trade) are in no hurry to sell at prices low enough to attract borrowers.

This poses a temporary problem for mark-to-market accounting (and Basle’s bureaucratic capital standards), but this seems a failure of accounting rather than markets. Cowen asks “why seek ‘fire sale’ prices when you might lose your job for doing so?” I would ask, “Why seek ‘fire sale’ prices if (unlike Bear Stearns) you are in a position to wait for a better deal once the market calms down?” Cowen says, “Only so many financial institutions have the size and expertise to buy up low-quality assets in large quantities.” But large holdings can often be sold in smaller batches. And we don’t know who might have bought Bear Stearns, warts and all, were it not for favoritism the Fed and Treasury showed to a single bidder (who was shamed into quintupling the offer).

Liquidity refers to the ease with which various assets can be converted to cash without dropping the value of the asset. Hedge fund managers bought gold on margin at $1000 may find it is less liquid than they expected. But what seems terrible to sellers of marked-down assets (e.g., of Las Vegas condos) can seem wonderful to buyers.

Most people think “liquidity drying up” means banks have cut back on lending, which is demonstrably false – bank loans are growing at a 10-11% annual rate since August, and much faster for C&I loans. Consumers and small businesses were never dependent on mortgage-backed IOUs.

There is no “financial gridlock” for most assets, even real estate (31% of household wealth). Auctions for foreclosed properties are drawing plenty of bids.

Mr. Cowen thinks “investors are instead flocking to the safest of assets, like Treasury bills.” Smart investors shun long-term Treasuries and are flocking to stocks, particularly U.S. stocks. The S&P 500 is down less than 10% this year – much better (in dollars) than most other markets, including Europe and China.

Tyler says, “Every step of the way, the pricing of [Bear Stearns] stock has surprised the market.” Really? It didn’t surprise the shorts, who owned a fourth of the shares. I own the SKF exchange fund (ultra-short financials) which, ironically, fell sharply a couple of days after Bear was sold out by omniscient and kindly government regulators.

Nobody ever said housing was a liquid asset, but even housing is far more liquid than the doomsday crowd imagines. The OFHEO index shows that home prices increased in all but 11 states between the fourth quarters of 2006 and 2007. Home prices fell 4% to 7% in California, Nevada, Florida and Michigan, but home prices rose 4% to 9% in 16 other states—most of which are not even counted in the widely-cited Case-Shiller index (which gives California a 27% weight).

The only problem with financial markets is that information is never free, and it sometimes takes time to discover market-clearing prices. The solution is not more regulations, but more patience.

Capital requirements, on the other hand, can cause very serious problems. The 1988 Basle Accord on capital requirements was a heavy-handed reaction to the 1982 LDC debt crisis. It was also one reason Japan’s monetary base shrunk by 2.8% a year in 1991-92 – the start of a period some U.S. journalists are now foolishly comparing to the restoration of sanity in coastal housing prices.

As I explained ten years ago, Basle “required that by the end of 1992 banks had to maintain capital equal to a minimum of 8 percent of risk-adjusted assets, where risk just happened to be defined in a way that favored government bonds over business loans… . Did relatively higher capital ratios in the United States and Great Britain mean they were less exposed than Japan to LDC default? On the contrary, even in the late eighties outstanding LDC loans still amounted to 93-199 percent of the capital of the largest U.S. banks, and as much as 82 percent for British banks, but only 55 percent for Japan. American banks seemed to have more capital. But unlike Japan, all of the capital of U.S. banks, and sometimes much more, was exposed to LDC default.”

Even if markets for a few risky, exotic U.S. securities appears “frozen” for a short while, that is far less problematic than imposing stern, politicized regulation over a wide array of assets and institutions.

Standards and Choice, Going Head-to-Head

Two months ago, the Manhattan Institute’s Sol Stern ignited an educational firestorm when he declared that, contrary to his past hopes, school choice cannot save American education. Only a focus on classrooms and curricula can do that, he argued, going so far as to laud a “thought experiment” that found a dictatorship with a “rich curriculum” preferable to universal school choice.

Even before Stern’s article went online the responses came fast and furious, especially from people at Cato. Afterward, it generated even more heat, pulling folks from all sides into the debate. For the most part, though, the dispute has been fought long-distance, with combatants hurling op-eds and blog entries at each other. But that is about to change…

On April 16, Cato will be hosting a policy forum putting Mr. Stern, Cato’s Andrew Coulson, Gary Huggins of the Aspen Institute’s Commission on No Child Left Behind, and University of Texas at San Antonio economics professor John Merrifield on the same stage to debate the big question: Is school choice enough to fix American education, or are government standards the key?

On April 16, the big debate comes to Cato. Sign up here to attend!

Hillary’s Experience

I wrote two months ago that I thought that Hillary Clinton “can credibly claim to be the best-prepared presidential candidate since Franklin D. Roosevelt in 1940: she spent eight years in the White House, seeing the way politics and policies work from the eye of the storm. ” But in the past couple of weeks her attempts to press this argument have not worked out very well. The Washington Post awarded her a full “four Pinocchios” for telling a real whopper about coming under sniper fire when she went to Bosnia.  David Trimble, former First Minister of Northern Ireland, scoffed at her claims to have been directly involved in peace negotiations there. And Gregory Craig, former Clinton White House counsel, also dismissed her claims to have played a leading role in any specific foreign policy issue.

Which is hardly surprising for a first lady. It was a mistake for Hillary to pick two minor foreign policy issues and claim to have been the key player, rather than to emphasize her experience in being at her husband’s side as he dealt with a whole range of issues. And that I do think is significant. It’s the kind of experience that makes Washington graybeards feel that people like Don Rumsfeld and Dick Cheney, who have been both elected officials and White House chief of staff, would be admirably prepared to be president.

First ladies typically pursue a “first lady’s agenda” and of course talk to their husbands at night in the family quarters. I do think that more than any other first lady, Hillary was in the room when decisions were being made–more like Bobby Kennedy than Jackie. She saw the pressures on a president, the ways a president balances politics and policy, the consequences of decisions made under pressure. That’s valuable experience, far more significant than visiting 79 countries to tour historical sites and deliver prepared speeches on women’s rights.

Another Washington Post article manages to undermine most of her specific claims but does include this defense from Mike McCurry, which I think finally gets it right:

Yet she lived through those episodes with a vantage point few get. “I would not say she was sitting there planning cruise missile attacks,” said former White House press secretary Michael McCurry, who supports her candidacy. “But you’re there and you see and you understand the requirements of leadership… . Having lived through it even as a spouse, you absorb a lot.”

None of this should be construed as an endorsement of Hillary Clinton. Experience – or charisma – devoted to the wrong aims is not exactly an appealing prospect. But I think it’s valuble to focus on just what kind of experience Senator Clinton can really claim.

Newseum Opens April 11th - Will it Keep Up?

The new Newseum opens April 11th, and its an impressive project in many respects.

It’s a striking but tasteful modern building, with the text of the First Amendment inscribed on its front. The location on Pennsylvania Avenue close to the Capitol has a defiant quality that I admire.

As I walked past yesterday, I observed its display along the sidewalk of current front pages from newspapers around the country and world. It’s a tribute to the importance and vibrancy of the newsgathering enterprise and free speech. Tourists were gathered along the front of the building taking in the headlines.

But I don’t read newspapers. I get my news from a wide array of sources almost entirely online. Sooner or later, I thought as I walked, some state is going to punch a hole in the Newseum’s display, as the state will no longer have a newspaper. Soon enough, most people will get their news in new formats - as I do - from sources and in media of all kinds: blogs, email, traditional news outlets’ online editions, and so on.

Will the decline of the newspaper mislead people into thinking that our vibrant tradition of newsgathering and reporting is on the wane? It’s something to think about.

The “founding partners” of the Newseum are some of the oldest of the old-school establishment media figures. (Good for them, by the way, for supporting this worthy venture.) They and the Newseum’s leadership may think that things are changing for the worse when they’re changing for the better - when news is all around us, in dozens of different formats, provided by tens of thousands of subject-matter experts and on-scene reporters with true local knowledge.

The Newseum’s planned exhibits include room for new media, but by and large they lean toward exalting the newsgathering industry. That industry has had an important role, no question, but I think it is a role that will diminish over time. I hope the Newseum will actively pursue reporting on all the news, not just the news that’s fit to print.

The Fed’s “Central Planning” Woes

Given the financial/regulatory system that we have – which is a very important pre-condition – I grant the Fed and Treasury a TEMPORARY “coordinating” role to help tide over the current crisis.  However, the initiatives and actions implemented so far appear unlikely to succeed.

I agree only with its role in the Bear buyout by JPMorgan.  It is, by nature, a one-time action that does not protect Bear’s shareholders and operators but protects the financial system from unraveling further – similar to it’s actions re: LTCM. Even if it is repeated for another investment bank, it does not raise the issue of moral hazard because no such bank wants to end up like Bear.

However, the Fed’s new and almost direct support of mortgage backed securities through its primary dealers introduces another moral-hazard potential – likely to be a huge problem down the road, and especially because of the interest rate policy it is adopting.

Interest rate cuts are being overdone. Large cuts are continuing the Fed’s past mistakes of introducing greater uncertainty in market participants’ expectations. It is using the wrong (inflation fighting) tool to achieve its goal of systemic stability which has arisen from poorer visibility of asset quality. The added uncertainty will prolong the resolution of current credit/liquidity shortages.

The longer that credit/liquidity problems last, the more likely is the introduction of PERMANENT new financial market regulations – which would hinder efficient operation – in the very function that is key to resolving current credit shortage problems – the generation of price information.

Finally, Prof. Cowen’s recent NYT oped (“It’s Hard to Thaw a Frozen Market”) compares market pricing under capitalist and socialist systems.  In brief, the argument is that socialist systems’ poor market pricing abilities appear to be reflected in the current credit-market woes of the American “capitalist” system. This comparison appears misplaced to me. The general U.S. economy may be relatively free and capitalist – but financial and credit markets are not quite so free.

Current credit market problems are not the result of pure and free market operation/competition.  We have a fiat currency whose supply and purchasing power is controlled by Fed interest rate policies. And it appears to have made serious mistakes in the process. This involves larger issues of whether asset prices should be objects for setting Fed policy and whether and how the Fed should respond to supply/oil shocks. Fundamentally, however, financial market participants naturally don’t look to “the free” market to set their expectations about the dollar’s future purchasing power. Those expectations are set by a “central planner” – the Fed.

Stupid Government Tricks

When I go to New York, I often ride the subways up and down Manhattan. Each ride costs $2. Usually I pay $10 for a MetroCard and get a $2 bonus, so you get six rides for the price of five. But on my most recent trip, to give a speech at the Manhattan Institute, I arrived at Penn Station and went to buy my $10 MetroCard–only to discover that the bonus is now $1.50 instead of $2. But what good is that? Now I get five rides for the price of five, and I have a card with $1.50 on it that won’t get me another ride. When I mentioned this discovery to one of the numerate journalists on John Stossel’s team at ABC News, he instantly pointed out that you have to buy four cards before you get your full bonus. After you buy four cards, you can get three bonus rides (instead of the four bonus rides on four cards under the old system). But meanwhile, you have to hold on to each card and trade it in for a new card, unlike the old system where you used the card up and discarded it.

It’s not the price increase that bothered me. I realize that each subway ride is heavily subsidized (less so in New York than in other cities), so I can hardly object to a price increase. It’s just the poke in the eye of promising me a bonus if I spend $10 at once, and then making that bonus extremely difficult to actually realize. And to think that some people want to turn our medical care over to such a system.

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