Topic: Finance, Banking & Monetary Policy

If There Were An Annual ‘Regulation Day’

As Iain Murray points out at National Review’s “Corner,” there’s no date on the calendar each year that reminds us, the way income tax filing day does, of the huge share of our economic labors that the government commands in the name of regulation. In part this is because the costs of regulation are even better disguised than those of taxation: while paycheck withholding may lull us into complacency about our income tax burden, it is downright transparent compared with the costs of regulation, which the ordinary citizen may never recognize when passed along in the form of higher utility bills or sluggish performance by some sector of the economy. Iain notes the good work done by his colleagues at the Competitive Enterprise Institute:

Regulations cost $1.75 trillion in compliance costs, according to the Small Business Administration. That’s greater than the record federal budget deficit — projected at $1.48 trillion for FY 2011 — and greater even than all corporate pretax profits. This is only one of many findings of the new edition of Wayne [Crews’] “Ten Thousand Commandments: An Annual Snapshot of the Federal Regulatory State,” a survey of the cost and compliance burden imposed by federal regulations.

As is now becoming evident, the Obama Administration is presiding over one of the most extraordinary expansions of regulation in all American history, in areas from health care to consumer finance, university governance to “obesity policy,” labor and employment law to the environment. Not all these developments originated with Obama appointees – some had their start under President George W. Bush or with lawmakers in Congress – but this administration has pursued stringent regulatory measures with extraordinary zeal, notwithstanding the odd feint to soothe business-sector misgivings.

Here are three more or less random samplings from recent days of the quiet momentum that’s built up in Washington toward a much bigger regulatory state:

  • Reflecting the historical development of the Food and Drug Administration, the introduction of new medical devices such as pacemakers and joint replacements is still somewhat less intensively regulated than the introduction of new pharmaceutical compounds. As Emory’s Paul Rubin relates at Truth on the Market, pressure is building in Washington to correct this supposed anomaly by intensifying the regulation of devices. As Rubin notes, “virtually all economists who have studied the FDA drug approval process have concluded that it causes serious harm by delaying drugs,” yet the premise of the new campaign for regulation “is that we should duplicate that harm with medical devices.”
  • Much of the new regulation of consumer finance has taken the form of rules governing what information lenders can ask for or consider about borrowers’ situation in extending credit. One such proposed rule, from the Federal Reserve, “would require credit card issuers to consider only a person’s independent income, and not the household’s income, when underwriting credit cards in an effort to protect young adults unable to repay debt.” Great big unforeseen consequence: many stay-at-home parents will now be unable to establish credit in their own names (via).
  • Among a slew of other high-profile regulations, the Environmental Protection Agency (EPA) has chosen this moment to demand very rapid new reductions in emissions from industrial boilers (“Boiler MACT” rules). Per ShopFloor, Thomas A. Fanning, who runs one of the nation’s largest electric utilities, the Southern Company, thinks trouble lies ahead:

    EPA has proposed Utility MACT rules under timelines that we believe will put the reliability and affordability of our nation’s power system at risk. EPA’s proposal will impact plants that are responsible for nearly 50 percent of total electricity generation in the United States. It imposes a three-year timeline for compliance, at a time when the industry is laboring to comply with a myriad of other EPA mandates. The result will be to reduce reserve margins—generating capacity that is available during times of high demand or plant outages—and to cause costs to soar. Lower reserve margins place customers at a risk for experiencing significant interruptions in electric service, and costs increases will ultimately be reflected in service rates, which will rise rapidly as utilities press ahead with retrofitting and projects to replace lost generating capacity due to plant retirements.

At least we’ll be able to avert brownouts by switching over readily to fracked-natural-gas, Alberta tar-sands, and latest-generation-nuclear options – or we would had all those options not been put under regulatory clouds as well.

Why Are Geithner and Bernanke Trying to Panic Financial Markets with Debt Limit Demagoguery?

By taking advantage of  “must-pass” pieces of legislation, Republicans have three chances this year to restrain the burden of government.  They didn’t do very well with the “CR fight” over appropriated spending for the rest of FY2011, which was their first opportunity. I was hoping for an extra-base hit off the fence, but the GOP was afraid of a government shutdown and negotiated from a position of weakness. As such, the best interpretation is that they eked out an infield single.

The next chance to impose fiscal discipline will be the debt limit. Currently, the federal government “only” has the authority to borrow $14.3 trillion (including bookkeeping entries such as the IOUs in the Social Security Trust Fund). This is a very big number, but America’s gross federal debt will hit that limit soon, perhaps May or June.

Republicans say they will not raise the debt limit unless such legislation is accompanied by meaningful fiscal reforms. The political strategists in the Obama White House understandably want to blunt any GOP effort, so they are claiming that any delay in passing a “clean debt limit” will have catastrophic consequences. Specifically, they are using Treasury Secretary Tim Geithner and Federal Reserve Bank Chairman Ben Bernanke to create fear and uncertainty in financial markets.

Just a few days ago, for instance, the Treasury Secretary was fanning the flames of a financial meltdown, as noted by Bloomberg:

“Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover,” Geithner said. “For these reasons, default by the United States is unthinkable.”

The Fed Chairman also tried to pour gasoline on the fire. Here’s a passage from an article in the New York Times earlier this year:

Mr. Bernanke said the debt ceiling should not be used as a negotiating tactic, warning that even the possibility of the United States not being able to pay its creditors could create panic in the debt markets.

There are two problems with these statements from Geithner and Bernanke. First, it is a bit troubling that the Treasury Secretary and Fed Chairman are major players in a political battle. The Treasury Secretary, like the Attorney General, traditionally is supposed to be one of the more serious and non-political people in a  President’s cabinet. And the Fed Chairman is supposed to be completely independent, yet Bernanke is becoming a mouthpiece for Obama’s fiscal policy.

But let’s set aside this first concern and focus on the second problem, which is whether Geithner and Bernanke are being honest. Simply stated, does a failure to raise the debt limit mean default? According to a wide range of expert opinion, the answer is no.

Donald Marron, head of the Urban-Brookings Tax Policy Center and former Director of the Congressional Budget Office, explained what actually would happen in an article for CNN Money.

Our monthly bills average about $300 billion, while revenues are about $180 billion. If we hit the debt limit, the federal government would be able to pay only 60 cents of every dollar it should be paying. But even that does not mean that we will default on the public debt. Geithner would then choose which creditors to pay promptly and which to defer. …Geithner would undoubtedly keep making payments on the public debt, rolling over the outstanding principal and paying interest. Interest payments are relatively small, averaging about $20 billion per month, and paying them on time is essential to America’s enviable position in world capital markets.

And here is the analysis of Stan Collender, one of Washington’s elder statesman on budget issues (and definitely not a small-government conservative).

There is so much misinformation and grossly misleading talk about what will happen if the federal debt ceiling isn’t increased that, before any more unnecessary bloodcurdling language is used that increases everyone’s anxiety, it’s worth taking a few steps back from the edge. …if a standoff on raising the debt ceiling lasts for a significant amount of time, the alternatives to borrowing eventually may not be enough to provide the government with the cash it needs to meet its obligations. Even at that point, however, a default wouldn’t be automatic because payments to existing bondholders could be made the priority while payments to others could be delayed for months.

The Economist magazine also is nonplussed by the demagoguery coming from Washington.

Tim Geithner, the treasury secretary, sent Congress a letter on January 6th describing in gory detail the “catastrophic economic consequences” such an event would entail. …Even with no increase in the ceiling, the Treasury can easily service its existing debt; it is free to roll over maturing issues, and tax revenue covers monthly interest payments by a large multiple. But in that case it would have to postpone paying something else: tax refunds, Medicare or Medicaid payments, civil-service salaries, or Social Security (pensions) cheques.

There are countless other experts I could cite, but you get the point. The United States does not default if the debt limit remains at $14.3 trillion. The only exception to that statement is that default is possible if the Treasury Secretary makes a deliberate (and highly political) decision to not pay bondholders. And while Geithner obviously is willing to play politics, even he would be unlikely to take this step since it is generally believed that the Treasury Secretary may be personally liable if there is a default.

The purpose of this post is not to argue that the debt limit should never be raised. That would require an instant 40 percent reduction in the size of government. And while that may be music to my ears (and some people are making that argument), I have zero faith that politicians would let that happen. Instead, my goal is to help fiscal conservatives understand that Geithner and Bernanke are being dishonest and that they should not be afraid to hold firm in their demands for real reform in exchange for a debt limit increase.

Last but not least, with all this talk about the debt limit, it’s worth reminding everyone that deficits and debt are merely symptoms of too much government spending. As this video explains, spending is the disease and debt is merely one of the symptoms.

By the way, the final chance this year to impose spending restraint will be around October 1, when the 2011 fiscal year expires and the 2012 fiscal year begins. But I won’t be holding my breath for anything worthwhile if Republicans screw up on the debt limit just like they failed to achieve much on the CR fight.

Gas Prices, Speculation, and the Price of Tea in China

With gasoline in the United States moving toward (and in some places, above) $4 a gallon and motorists understandably unhappy, there is a growing desire to blame someone for the high prices.

Previous gas price spikes in 2006 and 2008 brought blame on ”Big Oil” (meaning firms like Exxon-Mobil, BP, Royal Dutch/Shell, et al., which really are just mid-sized oil — but whatever), the Bush administration and Republicans, environmentalists, and the federal government. But 2011 offers a new leader in the blame game: speculators. From Capitol Hill lawmakers, to business columnists, to activist websites, to letters to the editor and hyper-forwarded emails, people are calling out trading in the oil and gasoline futures markets, aka ”speculation,” and demanding that government do something about it.

The problem is, I haven’t seen any of these folks offer a coherent explanation for how speculation drives up the price at the pump. And I doubt any is forthcoming.

The speculation-blamers’ story is simple enough: Investors sign futures contracts in oil and gasoline — traditionally, agreeing to a price today for oil or gas that will be delivered weeks or months in the future (and that probably has yet to be pumped out of the ground or refined). But, speculation-blamers say, the investors are running amok, paying outrageous prices for the futures. Those prices then affect oil and gasoline sales today, driving up prices at the pump.

Worse, they say, many of the futures are just paper transactions: the traders don’t have oil or gas to sell, nor do they intend to take delivery of it. Instead, when the future closes (that is, reaches its end-date), then one of the two counterparties will simply pay the other the difference between the agreement’s price and the actual market price on the closing day. For instance, if Smith Investments and Jones Investments signed a six-month future for one barrel of oil at $100, with Smith taking the “short” position (believing that oil’s price will be less than $100 six months from now) and Jones taking the “long” position (believing the price will be above $100), and six months from now oil is selling for $80, then Jones will pay Smith $20. Vice-versa if oil’s price is $120. (In fact, most futures today are settled in cash, even if one of the counterparties is somehow involved in oil production or use.)

On first blush, the speculation-blamers’ story makes sense: Surely, the price for future delivery of oil or gasoline will affect the price for present-day delivery. And all the paper-transaction stuff just seems devious and dangerous — shrewd Wall Street investors are hosing Main Street again!

But think more carefully about the story, and it begins to unravel.

Futures prices for some commodity like oil or gasoline can affect current prices — but if and only if those futures cause producers, consumers, or stockpilers (i.e., people who buy and hold commodities for future sale, aka speculators) to change their behavior in some way that would affect supply and demand today. For instance, if the federal government were to announce that it’s going to buy a lot of gold in six months at a price much higher than what it sells at now, stockpilers would likely respond by buying and storing gold today in anticipation of selling it to Uncle Sam later, at a profit. This would push up prices today.

However, commodities that are costly to store are less likely to experience this because speculators will have to factor in the storage cost, which could make the strategy risky and unprofitable. For instance, roses are inexpensive most of the year, but are very expensive around Valentine’s Day. The reason for this (in part) is that roses harvested in August can’t be stored cheaply and sold on Valentine’s Day. A “rose future” signed in August but closing in February won’t have much effect on August rose prices.

Interestingly, oil and gasoline are more like roses than gold. Oil and gas don’t spoil (at least, not to the extent roses do), but they’re expensive to store — petroleum is heavy, dirty, emits fumes, and is combustible. For that reason, not a lot of oil or gasoline is stockpiled for the long term (beyond the Strategic Petroleum Reserve). With that said, there has been some building of oil stockpiles in recent weeks, but it’s not dramatically higher than the stockpiling usually seen prior to the summer driving season – and gasoline stocks have been declining.

What about the devious-seeming paper transactions? One prominent speculation-blamer, The Street contributor Dan Dicker, derisively compares this investing to gambling. OK, but what does that have to do with the price of gasoline at the pump? If you and I were to bet on the Capitals-Rangers series, our bet wouldn’t affect the outcome of the series. Likewise, I don’t see how a bet on the future price of oil between two investors would affect the price of oil today (or in the future for that matter) because their paper transaction would not affect the supply or demand for oil today.

So what is driving the gasoline price spike? It seems far more likely that it is the result of a combination of the following:

  1. Uprisings in the Middle East could spread to mega-exporters Saudi Arabia and Iran, which has resulted in an implicit risk premium on oil and oil products.
  2. Japanese recovery efforts from the March 11 earthquake and tsunami are drawing heavily on petroleum.
  3. China and India are using more energy as their economies recover from the global recession.

All of this exacerbates the underlying problem: World demand for oil is very strong at most any price, but supply can’t be ramped up quickly in response to demand (because it takes about a decade to bring a new oil field online). In economic parlance, this means that both supply and demand are “price-inelastic,” which in turn means that even little problems can have a big effect on price (fortunately, in either direction). To understand this better, see this short paper.

Now, I admit, I’m no Wall Street wizard, and perhaps the Dan Dickers of the world know something that I don’t. But, so far, I haven’t seen them present a sound explanation for their claim that speculation is to blame for high gas prices. When I read their comments, I think of the old retort, “What’s that got to do with the price of tea in China?” So the next time one of these folks starts in, we need to get him to clearly explain how “speculation” affects the price at the pump.

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.

Do We Need China to Fund Our Mortgage Market?

Earlier this week I repeatedly heard the claim that if the federal government does not guarantee credit risk in the mortgage market, foreigners won’t buy U.S. mortgage-related debt.  Before we test whether that claim is true, let’s first determine just how important are foreign investors in the U.S. mortgage market.

For the most part, foreign investors do not hold U.S. mortgages directly, but either hold Fannie and Freddie debt and mortgage-backed securities (MBS) or hold private-label MBS.  As the private-label securities lack a government guarantee, we can ignore that segment of the market.  The chart below depicts the percentage share of foreign ownership of these securities in recent years:

The chart illustrates that, at times (particularly around the peak of the recent housing bubble), foreign investors have been large providers of capital to the GSEs.  In 2007, over 20% of GSE debt was held outside the United States, double the percentage from only a few years earlier.  The increase was driven almost exclusively by purchases by foreign governments (mostly central banks for the purpose of currency manipulation).  In 2007, this amounted to just over $1.5 trillion. 

However, if we went back and looked at a year prior to the super-heated housing market — say 2003 — then this total is about $650 billion.  Given that U.S. commercial banks now have about $1 trillion in cash sitting on their balance sheets, it appears that domestic sources could completely fund the U.S. mortgage market without any foreign funds.

But let’s say we want to keep the option of living beyond our means and have the rest of the world fund a large part of our mortgage market.  Would they?  Given that foreign investors currently hold over $5.4 trillion in U.S. corporate bonds and equities (not all guaranteed by the U.S. taxpayer), I think it’s fair to assume that these foreign investors have some appetite for U.S.  assets. 

Now does that mean foreigners would buy the debt of massively leveraged, mismanaged mortgage companies subject to constant political-cronyism, without some guarantee?  Probably not.  But then, it strikes me that a better way to attract foreign investment into the U.S. mortgage market is to deal with those issues, rather than paper over those problems with a taxpayer-funded guarantee. 

It is also worth noting that when we most needed foreign support for the U.S. mortgage market, in 2008, foreign investors were dumping Fannie and Freddie debt in significant amounts.  And obviously I think we’d prefer that the Chinese Central Bank stop using the purchase of Fannie and Freddie debt to depress the value of their own currency.

Homeownership and Mortgage Debt

One of the rationales commonly given for massively subsidizing our mortgage market is that without such homeownership would be out of reach for many households.  Such a rationale implies that more debt should be associated with more homeownership.   (Let’s set aside the obvious, how are you actually an owner without any equity?)

But is that the case.  The chart below compares the homeownership rate with the average debt-to-value ratio of U.S. households.  (Data on debt-to-value is from the Fed’s Flow of Funds and homeownership is from the Census Bureau).

By 1960, the homeownership rate was already over 60%, yet debt-to-value was less than 30%, half of the current value.  Even in 1990, when homeownership reached over 64%, debt-to-value was still under 40%.  From 1990 until today, the percentage of mortgage debt to value increased by over 50%, all to gain a 2 percentage point increase in homeownership.  So it seems the story of the last 20 years has been a massive increase in home debt with very little increase in actual homeownership rates.  The converse should also hold:  reducing homeowner leverage should have little, if any, impact on homeownership rates.

Another Day in the Life of the IRS

A previous post of mine at International Liberty addressed the debate over whether Republicans should trim the IRS’s budget. The following case study should convince everyone that the answer is a resounding yes.

First, some background from a Joe Nocera column in the New York Times. The federal government made a rather troubling decision a few years ago to investigate, prosecute, and ultimately imprison a random home-loan borrower named Charlie Engle for the crime of mortgage fraud.

Mr. Engle is far from blameless in this saga, but I noted in another post that it was rather odd that the government would target a nobody while letting all the big fish swim away. This episode certainly paints a picture of a government that has one set of rules for ordinary people, but an entirely different set of rules for the political elite and those who make big campaign contributions to that ruling class.

But I also noted that I’m not a lawyer or legal expert and was unsure about the degree to which the big players actually broke laws, or whether they simply made stupid business decisions (often encouraged by bad government policy).

The most upsetting part of the story, though, is how the government wound up targeting Mr. Engle. It turns out that an IRS agent, Robert Norlander, must have been competing for the IRS’s Bully-of-the-Year Award because here are some of the things he did:

  • Norlander decided to snoop into Engle’s affairs because he saw a film about him training for a marathon. In other words, there was no probable cause, no reasonable suspicion, nothing. Just the perverse decision of an IRS bully to go after someone.
  • Norlander admitted a pattern of thuggish behavior, stating that he will snoop into someone’s private life simply because that person drives an expensive car.
  • Norlander continued to investigate and persecute Engle, subjecting him to undercover surveillance, even though his tax returns showed no wrongdoing.
  • Norlander even engaged in “dumpster dives” to look for evidence of wrongdoing in Mr. Engle’s garbage. Keep in mind that there is no probable cause, no reasonable suspicion, and Engle’s tax returns were legit.
  • Norlander used a sleazy KGB tactic by sending an attractive woman to flirt with Mr. Engle in hopes of getting him to somehow admit to a crime.
  • Norlander failed to find any evidence of a tax crime. He couldn’t even hit Engle with a money-laundering offense. But the undercover agent who was part of the “honey trap” was wearing a wire and supposedly got Engle to admit to mortgage fraud and Norlander used that extremely flimsy evidence to justify a Justice Department case against Engle.

In other words, this whole thing has a terrible stench. Assuming the details in the story are accurate, we have an IRS agent engaging in a random vendetta against someone, and then apparently justifying his jihad by figuring out how to nail the guy on a very weak charge of mortgage fraud. I would describe Norlander as a “rogue agent,” but apparently this behavior is business-as-usual at the IRS.

Here are the relevant passages from Nocera’s column:

Mr. Engle received $30,000 for his participation. The film, “Running the Sahara,” was released in the fall of 2008. Eventually, it caught the attention of Robert W. Nordlander, a special agent for the Internal Revenue Service. As Mr. Nordlander later told the grand jury, “Being the special agent that I am, I was wondering, how does a guy train for this because most people have to work from nine to five and it’s very difficult to train for this part-time.” (He also told the grand jurors that sometimes, when he sees somebody driving a Ferrari, he’ll check to see if they make enough money to afford it. When I called Mr. Nordlander and others at the I.R.S. to ask whether this was an appropriate way to choose subjects for criminal tax investigations, my questions were met with a stone wall of silence.) Mr. Engle’s tax records showed that while his actual income was substantial, his taxable income was quite small, in part because he had a large tax-loss carry forward, due to a business deal he’d been involved in several years earlier. (Mr. Nordlander would later inform the grand jury only of his much lower taxable income, which made it seem more suspicious.) Still convinced that Mr. Engle must be hiding income, Mr. Nordlander did undercover surveillance and took “Dumpster dives” into Mr. Engle’s garbage. He mainly discovered that Mr. Engle lived modestly. In March 2009, still unsatisfied, Mr. Nordlander persuaded his superiors to send an attractive female undercover agent, Ellen Burrows, to meet Mr. Engle and see if she could get him to say something incriminating. In the course of several flirtatious encounters, she asked him about his investments. …Unbeknownst to Mr. Engle, Ms. Burrows was wearing a wire. …No tax charges were ever brought, even though that was Mr. Nordlander’s original rationale. Money laundering, the suspicion of which was needed to justify the undercover sting, was a nonissue as well. As for that “confession” to Ms. Burrows, take a closer look. It really isn’t a confession at all. Mr. Engle is confessing to his mortgage broker’s sins, not his own.

Stories like this explain why I’m a libertarian.

As George Washington supposedly said, ”Government is not reason; it is not eloquence; it is force. Like fire, it is a dangerous servant and a fearful master.” Unfortunately, thanks to bad laws and thuggish bureaucrats, government is definitely now our master and no longer just a servant. The IRS is a grim example of this phenomenon. President Obama, not surprisingly, wants to increase their budget.