Topic: Finance, Banking & Monetary Policy

Time to Think about the Gold Standard?

Back in 2007, presidential candidate Ron Paul generated a lot of talk, especially among libertarians, about monetary policy, the Federal Reserve, and the gold standard. As a longtime believer in sound money, I was surprised to discover how many smart young libertarians thought that talk of the gold standard was nutty. And perhaps more surprised to discover that they thought it was unnecessary now that the problem of central banking had been solved. As two of them wrote when I asked about their objections,

“The gold standard is the solution to no actual problem that is of concern to anyone. I think it’s a mistake to take a relatively professional and independent central bank for granted, but we have one. Inflation is low and predictable. The monetary climate is stable and amenable to savings and investment, etc.”

“What’s the beef with the Fed?  By my estimation, it’s been one of the most effective, restrained government agencies over the last twenty five years.  They’ve dramatically reduced the volatility of the business cycle while achieving low, reasonably constant inflation.” 

Well. How’s that confidence in central banking looking now? I’m reminded of Murray Rothbard’s comment in 1975 about what the era of Vietnam, Watergate, and stagflation had done to trust in government:

Twenty years ago, the historian Cecelia Kenyon, writing of the Anti-Federalist opponents of the adoption of the U.S. Constitution, chided them for being “men of little faith” – little faith, that is, in a strong central government. It is hard to think of anyone having such unexamined faith in government today.

Partly in response to such criticisms of the gold standard, in February 2008 Cato published a paper by Professor Lawrence H. White, “Is the Gold Standard Still the Gold Standard among Monetary Systems?” White argued:

The gold standard is not a flawless monetary system. Neither is the fiat money alternative. In light of historical evidence about the comparative magnitude of these flaws, however, the gold standard is a policy option that deserves serious consideration.

In a study covering many decades in a large sample of countries, Federal Reserve Bank economists found that “money growth and inflation are higher” under fiat standards than under gold and silver standards.

A gold standard does not guarantee perfect steadiness in the growth of the money supply, but historical comparison shows that it has provided more moderate and steadier money growth in practice than the present-day alternative, politically empowering a central banking committee to determine growth in the stock of fiat money. From the perspective of limiting money growth appropriately, the gold standard is far from a crazy idea.

And he quoted a devastating line from an essay (p. 104) by Peter Bernholz:

A study of about 30 currencies shows that there has not been a single case of a currency freely manipulated by its government or central bank since 1700 which enjoyed price stability for at least 30 years running.

In February 2008 White’s study didn’t get much attention. Most people still thought the Greenspan-Bernanke Fed was doing a great job, so why talk about alternatives to fiat money? But now, after the crash of 2008 and the growing realization that Dow 14000 was the product of a cheap-money boom that led to the inevitable bust, maybe it’s time to think about the gold standard or other constraints on politicized money creation.

Switzerland, Austria, and Luxembourg Defend Financial Privacy…and Get Support from the Czech Republic

The Birmingham Star reports on how Switzerland, Austria, and Luxembourg are defending their human rights policies of protecting financial privacy:

Switzerland, Luxembourg and Austria are fighting attempts to put them on blacklist for being tax havens and over-secretive in banking rules. Luxembourg officials hosted discussions with the Swiss and Austrian finance ministers over the weekend, resulting in a demand for involvement in talks on the issue prior to the G20 summit next month. Luxembourg treasury officials said the small European group wanted to be involved in the debates about bank secrecy which were currently being discussed in meetings to which they did not belong, such as the G20.

Equally important, the Czech Republic is standing up for the sovereign right of jurisdictions to have strong human rights laws. The Finance Minister correctly explains that Switzerland’s laws should not be sacrificed on the altar of bigger government. The EU Business reports:

Czech Foreign Minister Karel Schwarzenberg defended Switzerland on Sunday against threats by EU member states to put it on a tax haven blacklist, saying sovereignty is “worth more” than lost taxes. “Certainly tax coffers here and there miss out on a couple of million euros… The independence of a country and the traditions of an independent, neutral Switzerland is however worth more than that,” Schwarzenberg said. “Why must one spoil that at all cost?” he added in an interview with the Swiss newspaper NZZ am Sonntag. The Czech Republic holds the rotating presidency of the European Union, and Switzerland has come under intense pressure in recent months over its banking secrecy laws.

Why Bank Stocks Rose on Bernanke’s Remarks

In a CNBC spot with Steve Liesman & Erin Burnett, I tried to explain why investors in bank stocks had good reason to be pleased with part of Fed Chairman Ben Bernanke’s speech.  Judging by the response of Steve and Erin, and others on CNBC over the following day,  I must not have been persuasive.

For clarification, I am quoting the exact language from Bernanke’s talk, with my emphasis added.

My main point is that Bernanke admitted that when it comes to the “financial crisis” of some big banks, this is largely an artifact of unduly harsh regulation being applied at the worst possible time:

There is some evidence that capital standards, accounting rules, and other regulations have made the financial sector excessively procyclical–that is, they lead financial institutions to ease credit in booms and tighten credit in downturns more than is justified by changes in the creditworthiness of borrowers, thereby intensifying cyclical changes.

For example, capital regulations require that banks’ capital ratios meet or exceed fixed minimum standards for the bank to be considered safe and sound by regulators. Because banks typically find raising capital to be difficult in economic downturns or periods of financial stress, their best means of boosting their regulatory capital ratios during difficult periods may be to reduce new lending, perhaps more so than is justified by the credit environment. We should review capital regulations to ensure that they are appropriately forward-looking…

Bernanke emphasized the regulators’ dangerous habit of raising capital requirements and loan loss reserves simply because of a strict mark-to-market misinterpretation of the “fair value” of mortgage-backed securities.

He noted that:

Determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loan loss reserves over the cycle. As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency.

The key here is Bernanke’s criticism of the rigid use of Basel capital standards, not mark-to-market information per se (which would be harmless if it did not trigger foolish regulations). When combined with Barney Frank’s similar comments on the same day, it begins to look as though sensible economics might finally take priority over dubious bookkeeping.

Solve the Financial Crisis (and Make Some Serious Money)

Peter Van Doren and I have been puzzling over this very interesting NYT op-ed on home foreclosures by Yale economist John Geanakoplos and Boston University law professor Susan Koniak. If G&K’s story is right, then shouldn’t there be an opportunity for some clever financiers to help struggling homeowners keep their houses, help banks and other investors repair their balance sheets — and the financiers could help themselves to piles of cash in the process?

G&K argue that all three parties to a home mortgage — the homeowner, the lender, and the loan servicer who works as a go-between — currently face grim financial prospects:

  • Many homeowners are “underwater” — that is, they owe more on their mortgages than their homes are now worth. According to First American Core Logic, some 20% of mortgages were underwater as of December 2008. The percentage varies greatly from state to state, with 55% of mortgages underwater in Nevada, but only 7% in New York. The homeowners who are underwater include not just those who purchased with little down payment, but also many people who put down the traditional 20 percent when they bought in 2005 or 2006, at the peak of the real estate bubble. According to Case-Shiller index data, house prices nationwide have fallen 27% (as of December) from their May 2006 peak. Some local markets have experienced more dramatic declines, highlighted by Phoenix’s 46% slide. Rental prices are now far below many homeowners’ monthly mortgage payments, and lots of underwater homeowners will have to make payments for years before they have some equity stake in their homes. Many of those homeowners would rather default and risk foreclosure. G&K’s op-ed includes this figure showing that defaults increase dramatically as homeowners sink further and further underwater. Given their current options, default is rational.
  • The mortgage lender faces heavy losses if the home enters foreclosure. According to G&K, ”the subprime bond market now trades as if it expects only 25 percent back on a loan when there is a foreclosure.”
  • The servicer also is at risk. According to G&K, the servicer is obligated to continue paying the lender its monthly payment even if the borrower is in default. That obligation only lifts at foreclosure.

Because of the servicer’s obligation, the servicer has strong incentive to push for quick foreclosure. However, the homeowner and the mortgage lender would likely benefit from a loan modification — even a significant write-down of principal — because that would keep the homeowner in his house and it would deliver a better return to the lender than the 75% loss from foreclosure. G&K thus argue that government, instead of continuing to bail out the banking industry and struggling homeowners (and putting taxpayers on the hook for hundreds of billions of dollars), should simply require that the lenders write down the mortgage principal.

But is government action needed? Couldn’t some private actors accomplish the same thing — and make some serious scratch in the process?

A financial wizard with sufficient backing could approach a troubled lender and offer, say, 50% of the original loan amount in order to take some of the toxic mortgages off the lender’s hands. Now, the lender won’t be happy with selling at a 50% loss, but that certainly beats a 75% loss, so the lender would grudgingly agree. The financial wizard would then approach the homeowner and offer to write down the mortgage principal to, say, 60% on condition that the homeowner purchase mortgage insurance. The homeowner should jump at the offer because it would put him back above water, purchasing a home that’s worth more than its debt. Finally, the financial wizard would get the servicer to release its control over the loan, because the servicer would want to be freed from the risk of having to cover the payments to the lender. The financial wizard would then pocket a cool 10% of the original mortgage’s value.

That is not chump change. G&K estimate some 8 million homes could be foreclosed upon in the coming years. Assume the original mortgage on each of those houses is $199,025 (95% of the median sale price of new U.S. homes in January 2004, about halfway up the bubble); that 10% would represent almost $160 billion.

Of course, if the bank proves recalcitrant and demands more than 50%, or the homeowner demands a write-down of more than 40% or he’ll walk away, that would cut into the profits. And the financial wizard would have to cover his costs and possible risk premiums. Still, at least in theory, there would seem to be a significant pile of money on the table.

So why isn’t this happening? Are there no money-loving financial wizards out there?

To some extent, they are. Last week, the NYT reported that some former Countrywide executives have formed a firm called PennyMac that, with financial backing from hedge funds and other investors, purchases toxic mortgages from insolvent banks at low prices, modifies the loans to increase homeowners’ likelihood of making payments, and profits from the rekindled mortgage revenue stream. In the particular case reported in the NYT, PennyMac paid 38 cents on the dollar. But PennyMac seems like very small potatoes compared to the $160 billion that may be on the table. And the banks were forced to sell the loans because they had been taken over by the FDIC.

So why aren’t there more firms doing what PennyMac is doing, or following the strategy that Peter and I have laid out above? And why aren’t banks lining up to offload their toxic mortgages (or to do the write-downs themselves and pocket the 10%)? Peter and I can think of three possible reasons:

  1. As G&K note in their op-ed, banks and other investors who’re currently saddled with toxic assets may be waiting for some form of government rescue that would enable them to recoup far more than the 50% or so that would be offered by our financial wizards.
  2. Banks are keeping bad mortgages on their books at values much higher than the 25 to 40 cents on the dollar observed in the rare sales of troubled assets, and so the banks are unwilling to sell the assets for 50 cents on the dollar. (Remember that PennyMac is purchasing assets from banks that have been taken over by the FDIC — in other words, these are forced sales.) The banks (and their managers) may strongly prefer to keep the assets on their books rather than sell them at a 50% loss.
  3. The transaction costs involved in this scheme (e.g., analyzing the toxic assets to determine which ones to buy, negotiating with the delinquent and at-risk homeowners) are prohibitively large.

Government can address (1) by committing not to bail out the investors. Unfortunately, it’s unclear how reliable that commitment would be, especially given government actions so far in this financial crisis.

Fixing (2) is difficult. Accounting rules could be changed to force the banks to lower their book values for bad mortgages, but it would be difficult to get that accounting change passed quickly. Besides, some accounting experts argue that, in stressful times, accounting rules should have more wiggle room rather than less.

As for (3), the PennyMac guys claim that the work is difficult. But c’mon, there could be a $160 billion payday for the guys who can figure it out.

So, come on you money-loving financial wizards: your country needs you!

Bailouts, Big Spending and Bull

John Stossel joined economists from around the country Thursday at the Cato Institute for a taping of a 20/20 special that will air Friday March 13 called “Bailouts, Big Spending and Bull.”

The segment is based on Reason TV’s Drew Carey Project, and examines  “bailouts, medical marijuana, universal preschool, private highways, border walls, and the myth of the struggling middle class.”

Check your local listings for exact air time.

stossel20-20_030409_5320stossel20-20_030409_52871Photos by Kelly Anne Creazzo

The Bridge to Your Wallet

The Bridge to Your WalletThe airwaves and Intertubes are filled with images of this bridge in Missouri – the first transportation project in the nation to be funded through the stimulus bill signed by president Obama last month. In their coverage of this project, the media uniformly point to the jobs it has created for local workers, and neglect to reflect on its economic costs.

As Doug Bandow pointed out in his earlier post, even Congress’s own Budget Office expects the stimulus to shrink our economy in the long term. And the CBO’s analysis is arguably too rosy, neglecting the crucial psychological effect of Washington’s unprecedented spending spree on American consumers.

An NBC/WSJ public opinion poll found in January that “60 percent say they’re concerned that the government will spend too much money in trying to stimulate the economy, ultimately increasing the size of the debt.” That’s up from 57 percent who were already terrified by Bailout Mania back in November of 2008. What do people do when they’re scared about the state of the economy? They. Stop. Spending.

Supporters of bailouts and “stimuli” imagine that they can overcome consumers’ tight-fistedness in the short term, but they fail to realize that each new lavish increase in federal spending makes taxpayers more nervous about their ability to repay the ballooning federal debt and about the future of the U.S. economy. So while the Bridge to Your Wallet may have created a handful of local construction jobs in Missouri, it is almost certainly costing many others around the nation.

Cautious taxpayers look at that bridge project, at the mind-boggling accumulation of federal bailouts and stimuli and the biggest federal budget in history, and they cancel major purchases and family vacations. They eat at home instead of supporting their local restaurants. They do exactly the opposite of what the president and Congress are expecting.

If the media insist on doing more stories about the Bridge to Your Wallet, they should look at the polling and spending data showing how Washington’s spending spree is scaring the public into spending less – defeating the very purpose of the stimulus. They should interview restaurant and hotel owners and ask them just how economically stimulated they feel at the moment.

A ‘Stimulus’ Bill that Makes Us Worse Off

Even after being in Washington for nearly three decades, I still occasionally marvel at the stupidity and foolishness of the denizens of Capitol Hill.  Like the recent “stimulus” bill.  There’s no doubt that it is waste and abuse personified, much of it derived from the standard big-spending liberal wish list.  But we were told that wouldn’t matter, since spending, any spending, is what was necessary to get the economy moving.

But it turns out that even the Congressional Budget Office–the legislative branch’s own analytical agency–figures the legislation will make us worse in the long-term.  On Monday CBO reaffirmed its earlier conclusion:

In contrast to its positive near-term macroeconomic effects, the legislation will reduce output slightly in the long run, CBO estimates. The principal channel for that effect, which would also arise from other proposals to provide short-term economic stimulus by increasing government spending or reducing revenues, is that the law will result in an increase in government debt. To the extent that people hold their wealth as government bonds rather than in a form that can be used to finance private investment, the increased debt will tend to reduce the stock of productive private capital. In economic parlance, the debt will “crowd out” private investment. (Crowding out is unlikely to occur in the short run under current conditions, because most firms are lowering investment in response to reduced demand, which stimulus can offset in part.) CBO’s basic assumption is that, in the long run, each dollar of additional debt crowds out about a third of a dollar’s worth of private domestic capital (with the remainder of the rise in debt offset by increases in private saving and inflows of foreign capital). Because of uncertainty about the degree of crowding out, however, CBO has incorporated both more and less crowding out into its range of estimates of the long-run effects of the stimulus legislation.

Since CBO expects the U.S. to return to full employment, the impact of the lower GDP will be lower wages:

The reduction in GDP is therefore estimated to be reflected in lower wages rather than lower employment, as workers will be slightly less productive because the capital stock is slightly smaller.

So, we are going massively into debt and mortgaging the future of the young for the purpose of … shrinking the economy!  Workers will find themselves paying higher taxes to fund wasteful spending while … earning less!  No wonder Washington is such an alien place to most Americans.  Even after spending most of my adult life here, I still don’t get it.