Topic: Finance, Banking & Monetary Policy

An Alternative to the United States of Permanent Receivership

If you have not seen this essay [.pdf] already, it is well worth your time. Zingales ends the essay:

The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation
is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

The next 50 years? Perhaps. Markets deal with risk through deterrence. Individuals and firms take risks and gain or lose from their decisions. The gain or loss comes after the decision. If individuals and firms are protected from losses through taxpayer interventions, deterrence against bad risks cannot work. Risks are dealt with prior to a decision rather than afterwards. The government is charged with preventing unwise risk-taking before any decisions are made. Government officials come to have a veto over choices by private actors.

In this way, the United States of permanent receivership becomes in theory, and more and more in practice, a state of control over private decisions.

When to Worry about Moral Hazard?

In three different, recent op-eds, I’ve read that only during boom times should we worry about moral hazard — the idea that some actor will engage in overly risky behavior because he believes that he’ll be bailed out if the risk goes bad. The most recent op-ed to say this is Charles Goodhart’s, in today’s FT

OK, I did worry about moral hazard in 1998 when stock prices peaked. And again in 2006 during the housing price boom. 

Question: Instead of worrying, when is it time to “do” something about moral hazard? 

It seems the answer is never. During boom times, no one asks for government to play Good Samaritan. And during a bust — like now — when there’s opportunity to tell negligent investors to “go swim in the lake,” we’re told, well, the time to worry about moral hazard is during boom times! 

That’s another reason to call moral hazard the ”Samaritan’s Dilemma.”

Fannie and Freddie: Socialist from the Start

When the Cato Institute was founded in 1977 one of the first things the board of directors did was set a policy that we would not accept government funding. A simple libertarian principle, really, that money forcibly extracted from people who do not agree with our approach to public policy should not have to fund it. For 32 years, that has been our policy. In 1995 I received a letter from John Buckley, a v.p. for communications at Fannie Mae informing me of the good news that Cato was going to receive a $100,000 grant from his institution. I wrote back, Thanks, but no thanks, we have a policy against receiving money from government institutions like Fannie Mae. Boy, did I ever get a nasty letter back from Buckley stating that in no way was Fannie Mae a government entity.

The surprise GOP landslide in 1994 had apparently scared the hell out of the overpaid bureaucrats at Fannie Mae and they had decided to start funding market-oriented groups as opposed to the regulatory-oriented groups they had favored for all of their existence. Their judgment about what the new GOP majority would do turned out to be as flawed as their judgment about subprime mortgages. Anyway, if you ever wondered why Fannie Mae and Freddie Mac have over 11,000 employees and $5 trillion in mortgages, it is because of the implicit (now explicit) federal guarantee. That guarantee sucked in money that in a free market would have gone to truly private firms. It led to the enormous salaries (and then consulting gigs) and the sloppy attention to whether or not loans could be repaid. So when I hear talking heads on TV this morning claiming socialism is alive and well in America by virtue of the federal takeover of Fannie and Freddie, I think, please, Fannie and Freddie have always been socialist institutions. This is not a market failure as so many are now claiming. It is a government failure, pure and simple.

I am proud that Cato rejected that $100,000 grant.

Bailout Nation

“If only we had a Republican administration in office, none of this would have happened,” my friend Deroy Murdock emailed me this morning. He meant the nationalization of two large companies, of course, though he could have been talking about a trillion-dollar spending increase, the expansion of entitlements, the federalization of education, or indeed the great leap forward to the imperial presidency.

But the bailout of Fannie Mae and Freddie Mac is another giant step toward government control of the economy. NPR reported this morning that the government takeover “could turn out to be a smart one.” Yes, if you think nationalization of the means of production just might work. The government is writing a blank check on the taxpayers. It might cost nothing, it might cost $25 billion, it might end up costing trillions of dollars, given the size of Fannie Mae and Freddie Mac’s portfolios and the risk of further large declines in housing prices.

And speaking of the imperial presidency–all these huge new powers and expenditures are being conducted without any sanction from Congress and with little public debate. This isn’t Venezuela, but the executive branch is certainly expanding its powers on its own authority. If only President Bush would put his new powers to a public referendum, maybe a Yon Goicoechea could arise to block them. Certainly no Friedman Prize candidate has stood up in Congress.

But the Fannie-Freddie takeover is not the only bailout in the works these days. There was the Bear Stearns bailout back in March. Which might not be considered a real bailout, as Bear Stearns shareholders lost most of their investment, though it was certainly a then-unprecedented assertion of federal power. Arnold Kling noted in April that the housing bill, at least, was a pure bailout for homebuilders. Now the Big Two and a Half automobile makers are asking for $50 billion of federal help. (Didn’t we already bail out Chrysler once? How many bailouts does one company get?) And now Congress is talking about “a second economic stimulus package, totaling $50 billion in the form of money for infrastructure projects, relief for state governments struggling with rising Medicaid costs, home heating assistance for the Northeast and upper Midwest, and disaster relief for the Gulf Coast and the Midwestern flood zone.” And Transportation Secretary Mary Peters wants “an $8 billion infusion” for the federal highway trust fund. It’s a good thing that the federal government is so flush with money these days, or we might be risking a large deficit.

Capitalism is a system of profit and loss. It works because each person and each company, in seeking its own interest, is led “as if by an invisible hand” to supply goods and services that others want. Companies that satisfy consumers prosper. Companies that can’t produce goods that consumers want–like Chrysler, repeatedly–suffer and sometimes go out of business. The failures are often painful. But as Dwight Lee and Richard McKenzie wrote in their book Failure and Progress (or at least in this column based on the book), “Economic failure is to the economy what physical pain is to the body. No one enjoys pain, but without it the body would lack the information needed to maintain its health.” Government subsidies to prevent business failure simply keep pouring money into businesses that are relatively unsuccessful at satisfying consumer desires. They are, among other things, censorship of vitally needed information. Employees, entrepreneurs, and investors need to know where their money and talent are most valuable. Profits and losses are key indicators of that.

When businesses make bad decisions, they should suffer economic losses. That’s how we keep the system honest and productive. Caroline Baum of Bloomberg points out that the bailout for subprime borrowers involved helping people to stay in homes that they couldn’t afford, in many cases because they misled lenders or connived with lenders who knew they could package and resell bad mortgages. When governments make bad decisions, they should not pour good money after bad. Instead, they should try to repeal burdensome regulations, privatize functions that ought to be private, and be willing to sell purchases they shouldn’t have made, even at a loss.

Plenty of people had warned about the problems of Fannie Mae and Freddie Mac. As Arnold Kling notes in a new Cato Briefing Paper, the current crisis ” may have been the most avoidable financial crisis in history.” Treasury Secretary Larry Summers was one of those Cassandras back in 1999. So was Lawrence J. White in a 2004 Cato Policy Analysis calling for privatization, or failing that, a clear removal of the federal guarantee for the two companies. Instead, Congress and successive administrations continued to push Fannie and Freddie to get bigger and to buy mortgages that were in clear jeopardy of default. And now, having created this crisis, the federal government proposes not to wind down the overextended companies but to take them over so they can get all the benefits of crack federal financial management. Kling proposes a better exit strategy.

A Falling Oil Price Is NOT Lower Inflation

I recently explained that, “If [the price of] oil keeps falling, then headline inflation will drop below the ex-energy rate, and the ex-energy rate will itself drop thanks to cheaper transportation and petrochemicals.”  This followed my equally controversial (at the time) June 3 column, “Get Ready for the Oil-Price Drop.”

Blogger Stefan Karlsson thought I had said “inflation is not a problem.”  Huh?

What I said was that a monthly or year-to-year increase in the overall CPI “gives us a fair picture of what has happened to the cost of living over the past month or year. But it’s near-useless for telling us where inflation is headed in the future.” 

I offered a graph and several examples. The price of oil fell this February, for instance, and that month’s CPI was unchanged - zero.  Did that mean inflation was zero?  Of course not. Should the Fed have eased that month because oil prices fell?  Of course not.  So why couldn’t reporters follow that same common sense when oil prices spiked in June?

The May 1991 CPI was 5 percent from a year earlier, I noted, “but it dropped to 2.9 percent within five months, as oil fell 35.3 percent.” When that happens again this year, it will not mean inflation is any less of a problem than it is right now.  It will just mean the price of oil came down.

What I wrote is backed by recent research within the Federal Reserve:

  • Todd Clark of the Kansas City Fed found “the CPI ex-energy offers statistically significant explanatory power for future [headline] inflation.” 
  • Robert Rich and Charles Steindel of the New York Fed found “the ex-energy measure generally maintained its better forecasting record for … inflation over the longer sample period.”
  • On a closely related topic, Rajeev Dhawan and Karsten Jeske of the Atlanta Fed found that “using headline inflation” to guide Fed policy “appears to be a bad idea, both in terms of the output drop and the inflation impact.” 

Those who thought the Fed should have raised interest rates in June because oil prices pushed the CPI up will soon be logically obliged to say the Fed should keep interest rates low or lower just because falling oil prices will be pushing the CPI down.  I agree with Dhawan and Jeske on this.  I think the Fed should and will raise the (fed funds and discount) interest rates on bank reserves.  But I won’t revise that opinion with every up and down in the price of oil.

Disclosure: I own shares in an ETF that shorts oil (DUG) and a mutual fund than shorts precious metals (SPPIX).  This is called putting your money where your mouth is. SPPIX was $16.81 on July 18 when my inflation article appeared, but up 26% to $21.22 by August 5.

Fannie and Freddie

Paul Gigot has an outstanding piece on Fannie Mae and Freddie Mac today in the WSJ. “The abiding lesson here is what happens when you combine private profit with government power.” Exactly.

Here’s what I said about the twin-headed hydra in my 2005 Downsizing the Federal Government:

Federal taxpayers also face financial exposure from the mortgage giants Fannie Mae and Freddie Mac. These ‘government-sponsored enterprises’ are private firms, but taxpayers might become responsible for their debts because of their close ties to the government. The value of these ties created an implicit federal subsidy of $23 billion in 2003. The large size of GSEs threatens to create a major financial crisis should they run into trouble. Balance sheet liabilities of the housing GSEs grew from $374 billion in 1992 to $2.5 trillion by 2003.

A benefit of fully privatizing the GSEs would be to end the corrupting ties that these entities have with the federal establishment. Fannie Mae’s expansive executive suites are filled with political cronies receiving excessive salaries. They spend their time handing out campaign contributions to protect the agency’s subsidies.

Federal Reserve Chairman Alan Greenspan and others have argued that Fannie and Freddie need to be subject to more regulatory control because they pose a threat to financial market stability. But a better solution is to make these and other GSEs play by the same rules as other businesses, and to end the distortions caused by federal subsidies. The federal government should completely sever the ties with Fannie, Freddie, and the other GSEs.

My analysis sadly proved to be correct, and my policy solution is more needed than ever.

‘Ballooning Commodities’?

“The S&P GSCI commodities index is up 73% in the past 12 months,” writes Edward Hadas of breakingviews.com in The Wall Street Journal.

The author goes on to speculate about speculation, concluding, “This bubble could get bigger still.” Unfortunately, he assumes the S&P commodity index (which is shown in a graph) demonstrates a huge ongoing boom in the prices of commodities in general. In reality, all the index shows is that oil prices doubled over the past year and that most of that increase happened in the past four months. Energy commodities (mainly crude oil) account for 78 percent of the S&P GSCI commodity index.

The price of crude oil rose from $100 a barrel on March 4 to $136 on July 8, so the energy-dominated S&P GSCI index naturally soared too.

What happens to the widely reported “commodities boom” if you leave out oil? Look at The Economist’s index of 25 farm and industrial commodities, which excludes oil. The Economist’s commodity price index fell from 271.9 on March 4 to 265.6 on July 8.

It is on the basis of such fatally flawed evidence as the S&P commodity index that Congress has been trying to bully the Commodities Futures Trading Commission into bullying U.S. commodity traders to stop some sort of “commodity boom.”

The dollar was also quite stable during the past four months, contrary to numerous angry and overconfident Journal editorials about the alleged commodity boom being caused by the supposedly falling dollar. The Fed’s broad index of the dollar’s value was 95.97 on February 28 and 95.97 on July 8.