Topic: Finance, Banking & Monetary Policy

Mismanaged States Blame Messenger

Mismanaged municipal and state governments around the country are finding a new target to blame for their own self-inflicted wounds:  the growing market for credit defaults swaps (CDS) on municipal debt.

A municipal credit default swap would be a derivative that pays off in the event of default by a specific state or a default on one of said state’s debt instruments.

As reported in today’s Wall Street Journal, a handful of state treasurers are demanding information from Wall Street firms on who exactly is “betting against” these states.

It should come as no surprise, except to state officials, that the major buyers of these CDS are the very bondholders investing in their state.  In fact the availability of municipal CDS will likely increase the demand for municipal debt.  Just speaking for myself, there’s no way I’d buy debt issued by California if I couldn’t at least hedge some of that credit risk

Of course states complain that “betting on a default creates a perception of risk,” as if there wasn’t already a widespread perception of risk to investing in municipal debt of certain states.  The states also express concern that adverse movements in the price of CDS could impact their credit ratings, and hence their cost of borrowing.  Given the slow speed of which credit ratings moved on sub-prime mortgage debt, I am not sure that cities and states have much to worry about rating agencies being “too aggressive”.  If these states had even a small understanding of how markets work, they’d understand the rating is just one element that goes into pricing.  Witness the large spread in yields of similarly rated debt.  No rating, or credit default swap price for that matter, is going to fool investors into believing that many American local and state governments are just anything other than mini versions of Greece.

The Case for Auditing the Fed

Recently, the Federal Reserve has significantly altered the procedures and goals that it had followed for decades. Rep. Ron Paul (R-TX) has introduced a bill calling for an audit of the Fed.

Remarkably, there is significant opposition to such oversight, and the political prospects for undertaking such an audit are relatively bleak. In a new paper, Cato scholar Arnold Kling examines the processes and outcomes on which an audit should focus, and looks at opposition to the audit:

We should document why the Fed took each step, what the expected results were, and whether those results were achieved. …The profit or loss of the Fed’s investments would provide a very helpful indicator of whether the Fed’s actions served the economy as a whole or merely transferred wealth from ordinary taxpayers to bank shareholders.

Read the whole thing.

The Greek Model

It was a good idea to get science and democracy from the ancient Greeks. It’s not such a good idea to get fiscal policy from the modern Greeks.

But that’s the way we’re headed.

Greece has a budget deficit of 13.6 percent. We’re not in that league – ours is only 10.6 percent, the highest level since 1945.

Greece has a public debt of 113 percent of GDP. We’re not there yet. But the 2009 Social Security and Medicare Trustees Reports show the combined unfunded liability of these two programs has reached nearly $107 trillion.

Under President Obama’s budget, debt held by the public would grow from $7.5 trillion (53 percent of GDP) at the end of 2009 to $20.3 trillion (90 percent of GDP) at the end of 2020. It could rise to 215 percent of GDP in 30 years. Welcome to Greece.

Here’s a graphic presentation of the official debt and real net liabilities of various countries, including the United States and Greece at the right. (From the Telegraph, apparently based on Jagadeesh Gokhale’s report.)


And here’s a Heritage Foundation chart on where the national debt is headed in the coming decade:

Paul Krugman wrote, “My prediction is that politicians will eventually be tempted to resolve the [fiscal] crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.” Now he was writing in 2003, when a different president was in office, but he was also warning about the possibility of a ten-year deficit of $3 trillion. Presumably the same warnings apply to today’s much larger deficit projections. And he was absolutely right to fear that government would turn to inflation as a supposed solution.

Hayek after 35 Years

Today I reread F. A. Hayek’s Nobel Lecture, “The Pretence of Knowledge.” Hayek was awarded the Nobel Memorial Prize in 1974 and delivered his lecture on December 11, 1974. I was amazed at how modern it was, and appropriate once again for the times.

The 1970s were terrible times: stop-go demand management policies had produced stagflation that would continue for the rest of the decade.  Hayek said that “we have indeed at the moment little cause for pride: as a profession we have made a mess of things.” He charged that the mess had been produced by policies the majority of economists “recommended and even urged governments to pursue.”

The focus of his lecture was on scientism and how its errors had led economists and the Western economies to where they found themselves at that moment.  What was the chief theoretical error? It was “the belief that we can permanently assure full employment by maintaining total money expenditure at an appropriate level.” The “Pretence of Knowledge” was that economists had or could ever have the knowledge required to do that.

What was the correct theory of the cause of widespread unemployment? It is “the existence of discrepancies between the distribution of demand among the different goods and services and the allocation of labour and other resources among the production of those outputs.” We call such discrepancies a coordination failure.

The coordination failure cannot be resolved by stimulating demand because spending is always on particular goods and services.  There is no aggregate out put on which to spend money. Aggregate demand and supply are categories of a model with no empirical counterparts.

Unless economists can solve the knowledge problem, they have no way of aligning spending with actual preferences.  Stimulus policies are more likely to aggravate as alleviate the problem.

Indeed, it was stimulus that caused the coordination failure.  Hayek outlined his theory succinctly in one paragraph.

  • Monetary injections into particular markets stimulate demand only temporarily.
  • Labor and other resources are drawn into the stimulated activities [think housing, 2002-07].
  • Once the monetary stimulus ceases or merely slows, the production and employment cannot be maintained.
  • Only if monetary stimulus or accelerated (once expectations come into play) can the new pattern of production and employment be maintained.

The consequence of monetary stimulus is “a distribution of employment which can be maintained only by a rate of inflation which would rapidly lead to a disorganization of all economic activity.”

The lecture is worth reading by those who have not done so, and rereading by those who have.

[Cross-posted at Thinkmarkets.]

The IMF Is Urging Governments to Impose Regulatory and Tax Cartels to Benefit Politicians

Price fixing is illegal in the private sector, but unfortunately there are no rules against schemes by politicians to create oligopolies in order to prop up bad government policy. The latest example comes from the bureaucrats at the International Monetary Fund, who are conspiring with national governments to impose higher taxes and regulations on the banking sector. The pampered bureaucrats at the IMF (who get tax-free salaries while advocating higher taxes on the rest of us) say these policies are needed because of bailouts, yet such an approach would institutionalize moral hazard by exacerbating the government-created problem of “too big to fail.”

But what is particularly disturbing about the latest IMF scheme is that the international bureaucracy wants to coerce all nations into imposing high taxes and excessive regulation. The bureaucrats realize that if some nations are allowed to have free markets, jobs and investment would flow to those countries and expose the foolishness of the bad policy being advocated elsewhere by the IMF. Here’s a brief excerpt from a report in the Wall Street Journal:

Mr. Strauss-Kahn said there was broad agreement on the need for consensus and coordination in the reform of the global financial sector. “Even if they don’t follow exactly the same rule, they have to follow rules which will not be in conflict,” he said. He said there were still major differences of opinion on how to proceed, saying that countries whose banking systems didn’t need taxpayer bailouts weren’t willing to impose extra taxation on their banks now, to create a cushion against further financial shocks. …Mr. Strauss-Kahn said the overriding goal was to prevent “regulatory arbitrage”—the migration of banks to places where the burden of tax and regulation is lightest. He said countries with tighter regulation of banks might be able to justify not imposing new taxes.

I’ve been annoyingly repetitious on the importance of making governments compete with each other, largely because the evidence showing that jurisdictional rivalry is a very effective force for good policy around the world. I’ve done videos showing the benefits of tax competition, videos making the economic and moral case for tax havens, and videos exposing the myths and demagoguery of those who want to undermine tax competition. I’ve traveled around the world to fight the international bureaucracies, and even been threatened with arrest for helping low-tax nations resist being bullied by high-tax nations. Simply stated, we need jurisdictional competition so that politicians know that taxpayers can escape fiscal oppression. In the absence of external competition, politicians are like fiscal alcoholics who are unable to resist the temptation to over-tax and over-spend.

This is why the IMF’s new scheme should be rejected. It is not the job of international bureaucracies to interfere with the sovereign right of nations to determine their own tax and regulatory policies. If France and Germany want to adopt statist policies, they should have that right. Heck, Obama wants America to make similar mistakes. But Hong Kong, Switzerland, the Cayman Islands, and other market-oriented jurisdictions should not be coerced into adopting the same misguided policies.

Don’t Be Fooled — GM Is Still Government Motors

General Motors chairman Ed Whitacre is appearing in ads on all the Sunday morning shows repeating the message of his Wall Street Journal op-ed, titled “The GM Bailout: Paid Back in Full,” and the company’s full-page newspaper ads:

We’re proud to announce: We’ve repaid our government loan. In full. With interest. Five years ahead of the original schedule.

But wait: In the Wall Street Journal, Whitacre says the company has made a $5.8 billion payment to the governments of the United States and Canada. But don’t I recall that the GM bailout was $50 billion? Shikha Dalmia of the Reason Foundation explains the whole story in Forbes: First, part of the bailout went into an “escrow fund,” and that government money is being used to pay back the small part of the bailout that was officially a loan. Second, GM is asking for another $10 billion loan to retool its plants to meet the stiffer Corporate Average Fuel Economy standards, and paying back one government loan – with other government money – will make it easier to get another government loan.

And finally, of course, most of the bailout money was transferred to GM in return for a 60 percent stake in the company. And the taxpayers will get that money back if and when GM becomes a publicly traded company again, provided that the company’s market capitalization is eventually higher than it’s ever been in history. Don’t hold your breath.

These are called GM ads, but they could just as well be called BS ads.

SEC Incompetence

There has been much speculation that the Securities and Exchange Commission (SEC) released its charges against Goldman Sachs on the eve of a Senate vote on new finance regulation in order to help Democrats win that vote.  Perhaps that theory is wrong: It now looks more likely that the SEC timed its Goldman case in order to divert attention away from two SEC inspector general (IG) reports criticizing the commission.

In one of the reports, the SEC IG found that several of the top staffers at the SEC were spending their days surfing the web for porn, rather than looking for securities fraud.  One senior manager spent almost 8 hours a day looking a porn, getting to the point where he even filled up his government issued hard-drive with porn.  His actions were not some isolated incident.  Over 30 employees were found to have regularly used SEC computers to download and view porn.  Some of the senior employees had salaries as high as $222,000 a year.  Sounds like nice work, if you can get it.

But the porn charges are the least of the SEC’s worries.  Also released was the IG’s report on the SEC’s failure to stop the Stanford Ponzi scheme.  The report shows a clear pattern of incompetence at the SEC.  Given the SEC’s failure to act on the Madoff scheme, and the repeated warnings about Stanford, one has to wonder how good SEC investogators are at discovering fraud if they don’t even pursue the clear-cut cases brought to them.

The IG report does help explain the SEC’s poor track record.  The SEC’s head of enforcement made it very clear that the staff was “to bring more Wall Street types of cases.”  Perhaps ones like the recent Goldman case?  The head of enforcement even goes so far as to ask the staff working on the Stanford case, “What are you bringing these cases for?”  Clearly the SEC only seems to care about fraud if its catches a big headline.  Since the SEC was first warned about Stanford, investors placed about $8 billion more into the Ponzi scheme, far more than the damages alleged in the Goldman case.

If anything should expose the current financial regulatory bill being debated in the Senate as a fraud, it should be the fact that it leaves the SEC still standing.  Even worse, it reduces Congressional oversight of the SEC by removing it from the appropriations process.