Tag: capital

Fed Toys with Ratcheting Up the Credit Crunch

When the Basel I accords, mandating higher capital-asset ratios for banks, were introduced in 1988, they were embraced by the administration of President George H.W. Bush. With higher capital-asset ratios came a sharp slowdown in the money supply growth rate and—unfortunately for President George H. W. Bush and his re-election campaign—a mild recession from July 1990 through March 1991.

Now, we have Basel III and its higher capital-asset ratio requirements being imposed on banks in the middle of a weak, drawn-out economic recovery. This is one of the major reasons why the recovery is so anemic.

How could this be? Well, banks produce bank money, which accounts for roughly 85% of the total U.S. money supply (M4). Mandated increases in bank capital requirements result in contractions in bank money, and thus in the total money supply.

Here’s how it works:

While the higher capital-asset ratios that are required by Basel III are intended to strengthen banks (and economies), these higher capital requirements destroy money. Under the Basel III regime, banks will have to increase their capital-asset ratios. They can do this by either boosting capital or shrinking assets. If banks shrink their assets, their deposit liabilities will decline. In consequence, money balances will be destroyed.

So, paradoxically, the drive to deleverage banks and shrink their balance sheets, in the name of making banks safer, destroys money balances. This, in turn, dents company liquidity and asset prices. It also reduces spending relative to where it would have been without higher capital-asset ratios.

The other way to increase a bank’s capital-asset ratio is by raising new capital. This, too, destroys money. When an investor purchases newly-issued bank equity, the investor exchanges funds from a bank account for new shares. This reduces deposit liabilities in the banking system and wipes out money.

We now learn that the Fed, using the cover of the Dodd-Frank legislation, is toying with the idea of forcing foreign banks that operate in the United States to hold billions of dollars of additional capital  (read: increase their capital-asset ratios).

This will make the credit crunch “crunchier” and throw the U.S. economy into an even more vulnerable position.  The last thing the Fed should be doing is squeezing the banks and tightening the screws on the production of bank money.

When Is $28,000 per Pupil Not Enough?

…Apparently, when you are the District of Columbia public school system. The Washington Times reports today on a candle-light vigil beseeching the federal government for extra cash for new computers. The group organizing the vigil, OurDC, shares this “horror story” from former technology teacher Toval Rolston:

I’ve been in D.C. schools where the computers are so antiquated that you can’t even download a basic pdf file; our children don’t have the tools to compete in today’s high tech world.

The twin implications of this plea are that DC schools are underfunded and that more money will actually be spent wisely. The first statement is false and the second is decidedly unlikely. The last time I calculated total spending on K-12 education in DC, from the official budget documents, it came out to over $28,000 per pupil (the linked post points to a spreadsheet with all the numbers).

How do you manage to spend $28,000 per pupil and not manage to keep your computer hardware up to date? Or, for that matter, manage to have among the worst academic performance in the country? Maybe, just maybe, it has something to do with not being capable, or perhaps even inclined, to spend the money on what works.

The Washington Times, by the way, points out that OurDC is headquartered at the same address as the Service Employees International Union. Go figure.

The Fatal Conceit Continues

President Barack Obama recently sat down with the Today Show’s Ann Curry to discuss jobs and private sector hiring.  Curry asked him why during a time of “record profits” for corporations they had only spent 2% more toward hiring new workers but 26% percent more on new equipment.

Obama explained how structural economic changes have shifted businesses toward using more equipment and technology, explaining how “businesses have learned to be more efficient with fewer workers” in response to the recession. He provided some examples: “You see it when you go to a bank and you use an ATM, you don’t go to a bank teller, or you go to the airport and you’re using a kiosk instead of checking in at the gate.”

Much coverage of the interview falsely claimed that Obama blamed technology, or ATMs for high unemployment. This is simply untrue. He did not claim that technology is driving unemployment, but instead that employment is changing as technology increases the productivity of labor.

The interview did reveal that his alleged solution to the problem is more government control of the economy, administered by a panel of experts: “What we have to do now, and this is what the jobs council is all about, is identifying where the jobs for the future are going to be, how do we make sure that there’s a match between what people are getting trained for and the jobs that exist, how do we make sure that capital is flowing in those places with the greatest opportunity.” This may sound good in theory, yet the question remains: how does he know where the jobs of the future are going to be, and how can he determine which job training will prove most valuable, and how can he know which areas have the greatest opportunity, and how can he know where to send capital?

It is not likely that the President’s Council on Jobs and Competitiveness, made up of about two dozen bright and capable business men and women, will have sufficient knowledge either to determine where capital should flow or where the future jobs will be, or what job training will be best rewarded. Private investors, risking their own capital, cannot consistently predict what markets will succeed or which technologies will flourish. How can we expect a council of political appointees wagering other people’s money to do any better?

Nobel laureate FA Hayek discussed the problems associated with central economic planning in his seminal American Economic Review article, “The Use of Knowledge in Society” and in his book The Fatal Conceit. Hayek argued that the economy is a very complex system, fueled by the knowledge and actions of millions of independent actors. Hayek warned that any plan to centrally control production would be doomed to inevitable failure because central planners lack sufficient information to ensure that supply equals demand in every market in the economy. The abysmal standard of living and collapse of the Soviet Union validated Hayek’s theory of the impossibility of planning something as complex as a country’s economy.

Clearly, Obama is not suggesting anything nearly as extreme as centrally planned production. Nevertheless, President Obama makes his assumptions clear in this interview that he believes this jobs council holds the capacity to gain sufficient knowledge to help guide capital investments and encourage job creation in the areas they identify. Instead of having our President and a few smart individuals making decisions with limited information, we could allow the market mechanism, made up of millions of individual decision markers, to transmit the information and knowledge necessary for market actors to guide capital appropriately.

For President Obama to assume that he and or his council have the knowledge sufficient to make these determinations is a fatal conceit.

Reckless IRS Regulation Would Put Foreign Tax Law over American Tax Law and Drive Investment out of the United States

I’m not a big fan of the IRS, but usually I blame politicians for America’s corrupt, unfair, and punitive tax system. Sometimes, though, the tax bureaucrats run amok and earn their reputation as America’s most despised bureaucracy.

Here’s an example. Earlier this year, the Internal Revenue Service proposed a regulation that would force American banks to become deputy tax collectors for foreign governments. Specifically, they would be required to report any interest they pay to accounts held by nonresident aliens (a term used for foreigners who live abroad).

The IRS issued this proposal, even though Congress repeatedly has voted not to tax this income because of an understandable desire to attract job-creating capital to the U.S. economy. In other words, the IRS is acting like a rogue bureaucracy, seeking to overturn laws enacted through the democratic process.

But that’s just the tip of the iceberg. The IRS’s interest-reporting regulation also threatens the stability of the American banking system, makes America less attractive for foreign investors, and weakens the human rights of people who live under corrupt and tyrannical governments.

This video outlines five specific reasons why the IRS regulation is bad news and should be withdrawn.

I’m not sure what upsets me most. As a believer in honest and lawful government, it is outrageous that the IRS is abusing the regulatory process to pursue an ideological agenda that is contrary to 90 years of congressional law. But I guess we shouldn’t be surprised to see this kind of policy from the IRS with Obama in the White House. After all, this Administration already is using the EPA in a dubious scheme to impose costly global warming rules even though Congress decided not to approve Obama’s misguided legislation.

As an economist, however, I worry about the impact on the U.S. banking sector and the risks for the overall economy. Foreigners invest lots of money in the American economy, more than $10 trillion according to Commerce Department data. This money boosts our financial markets and creates untold numbers of jobs. We don’t know how much of the capital will leave if the regulation is implemented, but even the loss of a couple of hundred billion dollars would be bad news considering the weak recovery and shaky financial sector.

As a decent human being, I’m also angry that Obama’s IRS is undermining the human rights of foreigners who use the American financial system as a safe haven. Countless people protect their assets in America because of corruption, expropriation, instability, persecution, discrimination, and crime in their home countries. The only silver lining is that these people will simply move their money to safer jurisdictions, such as Panama, the Cayman Islands, Hong Kong, or Switzerland, if the regulation is implemented. That’s great news for them, but bad news for the U.S. economy.

In pushing this regulation, the IRS even disregarded rule-making procedures adopted during the Clinton Administration. But all this is explained in the video, so let’s close this post with a link to a somewhat naughty - but very appropriate - joke about the IRS.

Farm Subsidies Benefit Landowners

Almost half of America’s farmland is operated by someone other than the owner. Critics of farm subsidies often point to examples of famous wealthy landowners receiving handouts as a reason to end the federal government’s agriculture gravy train. Notable recipients have included Ted Turner, Larry Flynt, Charles Schwab, and numerous members of Congress.

While policymakers justify their support for farm subsidies in the name of “protecting farmers,” a new academic study describes how landowners are often the real winners. Farm subsidies get “capitalized” into the price of farm land, pushing up land prices. As a result, those farmers who lease land from landowners at the inflated prices end up having a substantial share of their subsidy benefits effectively canceled out.

From the paper:

In all, the results confirm that government payments exert a significant effect on land values. The (marginal) rates of capitalization suggest that in the current policy context, a dollar in benefits typically raises land values by $13-$30 per acre, with the response differing substantially across different types of policies. This response certainly suggests that agents expect these benefits to be sustained for some time. In terms of the implications for the distribution of farm program benefits, our results confirm that a substantial share of the benefits is captured by landowners.

The authors’ conclude that the rhetoric exhibited by supporters of farm subsidies doesn’t always match the reality:

Policy rhetoric often justifies Farm Bill expenditures with the argument that impoverished farmers are in need of governmental support to remain in business. This view is pervasive outside of Washington. For example, consider the annual “Farm Aid” events intended to draw attention to the plight of the American farmer. Our analysis challenges this view. We demonstrate that land owners capture substantial benefits from agricultural policy. This is particularly problematic given that in many cases land owners are distinct from the farmers whose plight we are told we should be concerned with.

See this Cato essay for more on agriculture subsidies.

Does CRA Undermine Bank Safety?

A recent policy forum here at Cato discussed the role of the Community Reinvestment Act (CRA) in the financial crisis.  While the forum focused on the federal push for ever expanding homeownership to marginal borrowers, the analysis did not touch directly upon the question of whether CRA lending undermines bank safety.

Fortunately this is a question that one economist at the Federal Reserve Bank of Dallas bothered to ask.  While his research findings were available before the crisis, they were clearly ignored.

In a peer-reviewed published article, appearing in the journal Economic Inquiry, economist Jeff Gunther concludes that there is “evidence to suggest that a greater focus on lending in low-income neighborhoods helps CRA ratings but comes at the expense of safety and soundness.”  Specifically he finds an inverse relationship between CRA ratings and safety/soundness, as measured by CAMEL ratings.

In another study Gunther finds that increases in bank capital are associated with an increase substandard CRA ratings.  Apparently bank CRA examiners prefer that capital to be lend out, rather than serve as a cushion in times of financial distress.

Given the current attempts in Washington to expand CRA, it seems some people never learn.  One can always argue over how CRA should work, but the evidence is quite clear how it has worked, once again proving: there’s no free lunch.

Geithner Ignores Bailout History

Perhaps the biggest problem with the Obama plan to “reform” our financial system is the impact it would have on the market perception surrounding “too big to fail” institutions.  In identifying some companies as “too big to fail” holders of debt in those companies would assume that they would be made whole if those companies failed.  After all, that is what we did for the debt-holders in Fannie, Freddie, AIG, and Bear.  Both former Secretary Paulson and Geithner appear under the impression that moral hazard only applies to equity, despite debt constituting more than 90% of the capital structure of the typical financial firm.

Geithner believes he’s found a way to solve this problem - he’ll just tell everyone that there isn’t an implicit subsidy, and there won’t be a list of “too big to fail” companies.  Great, why didn’t I think of that.  After all, the constant refrain in Washington over the years that Fannie and Freddie weren’t getting an implicit subsidy really prepared the markets for their demise.

Even more bizarre is Geithner’s assertion that the government can force these institutions to hold higher capital, maintain more liquidity and be subjected to greater supervision, all without anyone knowing who exactly these companies are.  Does the Secretary truly believe that these companies’ securities disclosures won’t include the amount of capital they are holding?  Whether there is an official list or not is besides the question, market participants will be able to infer that list from publicly available information and the actions of regulators. 

One has to wonder whether Geithner spent any of his time at the NY Fed actually watching how markets work.  Before we continue down the path of financial reform, maybe it would be useful for our Treasury Secretary to take a few weeks off to study what got us into this mess.  We’ve already been down this road of denying implicit subsidies and then providing them after the fact. Maybe it’s time to try something different.