Topic: Finance, Banking & Monetary Policy

The Fraud From Basel

Despite every major US bank being declared by regulators as “well capitalized” prior to the financial crisis, we still found ourselves watching the government plow hundreds of billions of capital into said banks.  How can this be?  The answer is quite simple:  we were lied to.  Maybe that’s a little harsh, after all these banks did meet the regulatory definition of “well capitalized”.  But when push came to shove, market participants rightly ignored regulatory capital.  After all you cannot use things like “deferred tax losses” to pay your bills with.

It is hard to improve upon Martin Wolf’s observation in today’s Financial Times:  “This amount of equity is far below levels markets would impose if investors did not continue to expect governments to bail out creditors in a crisis.”  This point is best illustrated by the trend in bank capital over the last 100 years.  Back when banks were actually subject to market forces and were not explicitly subjected to government capital standards, they held significantly more capital.   In 1900 the average US bank capital ratio was close to 25%, now it’s closer to 5%.  The trend is unmistakable:  the more government has regulated bank capital, the less capital banks have ended up holding.

Despite the claims of the banking industry, what the bank regulators have just delivered with “Basel III” is simply another fraud upon the public and investors.  Any framework that continues to treat say Greek or Fannie Mae debt as largely risk-free is a sham.

The real solution is to first end the various government bailouts, guarantees and subsidies behind the banking system, subjecting bank creditors to actual losses, while also abandoning the charade that is capital regulation.   Sadly politicians (see the Dodd-Frank Act) and regulators continue to simply tweak a flawed and morally bankrupt system.

Oh, to Be Politically Favored!

Yesterday, the U.S. Department of Education released the latest student-loan default data, and along with it offered some good ol’ fashioned profit-bashing. Meanwhile, politically favored schools got off with nary a negative word.

The FY 2008 default rates certainly aren’t good. Overall, 7 percent of borrowers whose first payments were due between October 1, 2007, and September 30, 2008, had defaulted by September 30, 2009. And yes, for-profit schools had the highest rate out of non-profit private, public, and for-profit schools, which came in at 4 percent, 6 percent, and 11.6 percent, respectively.

To what did Secretary of Education Arne Duncan attribute these results? The overall default rate, he suggested, was but the sad consequence of ”many students…struggling to pay back their student loans during very difficult economic times.” The for-profit rate, however, had a very different cause: “[F]or-profit schools have profited and prospered thanks to federal dollars” and many have saddled “students with debt they cannot afford in exchange for degrees and certificates they cannot use.”

Already, you can see that for-profits are largely just an easy political target: All defaulting borrowers are portrayed as victims; wasteful, money-hoarding, non-profit institutions get no mention; and for-profits are painted as predators.

Of course, for-profits do have higher default rates, so maybe they really are predators.  But there’s more from yesterday…

At roughly the same time Duncan was dumping on for-profit schools, his boss was feting another subset of higher education: historically black colleges and universities (HBCUs). Indeed, he was kicking off National HBCU Week, and lauding the schools’ work. But guess what? While the Education Department doesn’t release default rates for HBCUs as a group, quickly pulling those schools’ data together and averaging their default rates indicates a rate even higher than for-profit schools:  almost 12 percent. Moreover, for four-year, private, non-profit HBCUs – which like for-profit colleges don’t get big state subsidies to help keep tuition artificially low – the default rate is nearly 13 percent.

So why no criticism by Duncan of HBCUs? Heck, why was his boss celebrating them?

Because they are politically favored, that’s why. Of course, this is in part because of their very important historical mission to furnish higher education to long-oppressed African Americans. It is also, though, because like all “non-profit” colleges and universities, HBCUs act as if their employees have no interest in higher salaries, nicer facilities, easier workloads – all the rewards that the people in not-for-profit schools give themselves instead of paying profits out to shareholders.  But there’s no evidence that people in HBCUs or other non-profit schools are any less self-interested than people working or investing in for-profit institutions. 

Why do I point this out? Not to pick on HBCUs, but to further illustrate the point that the attack on for-profit schools isn’t really about saving taxpayer dollars or protecting students, but going after the easiest target to demagogue – people honest about trying to benefit themselves as much as “the students.” It is also to illustrate, once again, that when we let government fund something, it is political calculus – not educational benefits, economic effectiveness, or what’s best for taxpayers – that ultimately drives the policies. Which is why government needs to get out of the higher ed business that it has made both bloated and, ultimately, a net drain on the economy.

Keynes Was Wrong on Stimulus, but the Keynesians Are Wrong on Just about Everything

Dana Milbank of the Washington Post wrote this weekend that critics of Keynesianism are somewhat akin to those who believe the earth is flat. He specifically cites the presumably malignant influence of the Cato Institute.

Keynes was right, and in this case it’s probably for the better: Keynes didn’t live to see the Republicans of 2010 portray him as some sort of Marxist revolutionary. …These men get their economic firepower from conservative think tanks such as the Cato Institute… What’s with the hate for Maynard? Perhaps these Republicans don’t realize that some of their tax-cut proposals are as “Keynesian” as Obama’s program. There’s a fierce dispute about how best to respond to the economic crisis – Tax cuts? Deficit spending? Monetary intervention? – but the argument is largely premised on the Keynesian view that government should somehow boost demand in a recession. …With so much of Keynesian theory universally embraced, Republican denunciation of him has a flat-earth feel to it. …There is an alternative to such “Keynesian experiments,” however. The government could do nothing, and let the human misery continue. By rejecting the “Keynesian playbook,” this is what Republicans are really proposing.

Milbank makes some good points, particularly when noting the hypocrisy of Republicans. Bush’s 2001 tax cuts were largely Keynesian in their design, which is one of the reasons why the economy was sluggish until the supply-side tax cuts were implemented in 2003. Bush pushed through another Keynesian package in 2008, and many GOPers on Capitol Hill often erroneously use Keynesian logic even when talking about good policies such as lower marginal tax rates.

But the thrust of Milbank’s column is wrong. He is wrong in claiming that Keynesian economics works, and he is wrong is claming that it is the only option. Regarding the first point, there is no successful example of Keynesian economics. It didn’t work for Hoover and Roosevelt in the 1930s. It didn’t work for Japan in the 1990s. It didn’t work for Bush in 2001 or 2008, and it didn’t work for Obama. The reason, as explained in this video, is that Keynesian economics seeks to transform saving into consumption. But a recession or depression exists when national income is falling. Shifting how some of that income is used does not solve the problem.

This is why free market policies are the best response to an economic downturn. Lower marginal tax rates. Reductions in the burden of government spending. Eliminating needless regulations and red tape. Getting rid of trade barriers. These are the policies that work when the economy is weak. But they’re also desirable policies when the economy is strong. In other words, there is no magic formula for dealing with a downturn. But there are policies that improve the economy’s performance, regardless of short-term economic conditions. Equally important, supporters of economic liberalization also point out that misguided government policies (especially bad monetary policy by the Federal Reserve) almost always are responsible for downturns. And wouldn’t it be better to adopt reforms that prevent downturns rather than engage in futile stimulus schemes once downturns begin?

None of this means that Keynes was a bad economist. Indeed, it’s very important to draw a distinction between Keynes, who was wrong on a couple of things, and today’s Keynesians, who are wrong about almost everything. Keynes, for instance, was an early proponent of the Laffer Curve, writing that, “Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.”

Keynes also seemed to understand the importance of limiting the size of government. He wrote that, “25 percent taxation is about the limit of what is easily borne.” It’s not clear whether he was referring to marginal tax rates or the tax burden as a share of economic output, but in either case it obviously implies an upper limit to the size of government (especially since he did not believe in permanent deficits).

If modern Keynesians had the same insights, government policy today would not be nearly as destructive.

Laura Tyson’s Confused Case for a Second Stimulus

I was a bit critical of Laura Tyson’s New York Times article on “Why We Need a Second Stimulus.” Apparently I wasn’t nearly critical enough.

The Nation and National Public Radio are advising President Obama to “stop listening to infrastructure-phobic advisers like Larry Summers and start taking counsel from Laura Tyson, a member of his Economic Recovery Advisory Board who argues that $1 trillion in infrastructure investment is needed over the next five years.”

At The Atlantic, senior editor (and Boston Globe columnist) Joshua Green thinks Laura Tyson’s article “underscored what a loss it is for the Obama administration that it couldn’t manage to find a place for her on its economic team.” Mr. Green can’t imagine why a Berkeley professor who wants to add an extra trillion to federal spending wouldn’t be the ideal budget director.

In the article that so impressed Mr. Green, Tyson wrote, “The primary cause of the [current] labor market crisis is a collapse in private demand… By late 2009, in response to unprecedented fiscal and monetary stimulus, household and business spending began to recover. But by the second quarter of this year, economic growth had slowed to 1.6 percent.”

Combining “fiscal and monetary stimulus” in a single phrase is a clumsy way to conceal the irrelevance of   “fiscal stimulus” (debt-financed federal spending) to GDP growth in 2009. Fiscal stimulus means the Treasury sells more bonds. Monetary stimulus means the Fed buys more bonds. To discuss those transactions as if they had the same effect is just another mysterious Keynesian incantation.  

Tyson claims there is “too little appreciation for how stimulus spending has helped stabilize the economy and how more of the right kind of government spending could boost job creation and economic growth.” She wants much more spending on unemployment benefits (a paradoxical definition of a jobs program) and on aid to state and local governments (where unemployment rates are relatively low). 

To argue for more borrowing and spending, however, Tyson cannot credit monetary policy for helping the recovery. Because she explicitly advocates much more spending on “unemployment benefits and aid to state governments” (not just “infrastructure”), Tyson has to demonstrate that changes in federal spending (not Fed policy) explain why the economy appeared to be recovering in late 2009 but faltering by the second quarter of 2010. It is not enough to allude to simulations from Mark Zandi’s famously incorrect forecasting model, as the CEA and CBO have done. Tyson needs to show us a fact or two. She didn’t even try. She even got the size of Obama’s stimulus bill wrong, citing last year’s antiquated $787 billion figure that the Congressional Budget Office (CBO) has revised twice since January.

In reality, the 2009 stimulus bill was mostly about extending unemployment benefits, expanding Medicaid, dispensing small checks (refundable tax credits) and other schemes to rob Peter and pay Paul. Such transfer payments add nothing to GDP; they just discourage work. The increase in federal nondefense purchases (such as ”shovel-ready” projects) contributed only two-tenths of one percent (0.2) to the change in GDP in 2009. That was no larger than in 2008 when the Recovery Act did not exist. And even that trivial sum is merely an accounting gain rather than a net economic gain, because federal borrowing is no free lunch. The reason Keynesian accounting is no substitute for economics is that governments can only spend what Danny DeVito called “OPM” (other peoples’ money). To claim that such spending is a net addition to “aggregate demand” is to ignore those other people — namely, current and future taxpayers.

The timing of Obama’s so-called stimulus spending has been totally inconsistent with Tyson’s description of how the economy supposedly responded in the past and present, and why she expects growth to slow by a percentage point or two next year unless the feds spend more on multi-year jobless benefits and deficit-sharing with the states. In its latest whitewash, the CBO “now estimates that the total impact over the 2009–2019 period will amount to $814 billion. Close to half of that impact is estimated to occur in fiscal year 2010, and about 70 percent of ARRA’s budgetary impact will have been realized by the close of that fiscal year.” With half of the spending in fiscal 2010 and 30 percent in 2011 and beyond, that means just 20 percent of the $814 billion ($163 billion) had been spent by the end of October 2009. Yet it was in late 2009 when Tyson claims the stimulus had the most impact. 

Tyson worries that “by next year, the [fiscal] stimulus will end.”  That’s wrong too. The CBO estimates that 30 percent of the spending ($244 billion) will occur in fiscal 2011 (January to October) and beyond to 2019.

Unfortunately, Ms. Tyson’s reference to the second quarter’s GDP is entirely unrelated to her diagnosis of the problem as being “a collapse in private demand.” GDP does not measure private demand because it subtracts imports. Yet spending on imports is just as much a part of “demand” as is spending on domestic goods and services. Real gross domestic purchases increased at a 4.9 percent annual rate in the second quarter, up from 3.9 percent in the first. Neither figure suggests any paucity of private spending.

The second quarter surge in imports (which largely accounts for the wide gap between domestic purchases and GDP) looks like a statistical fluke. “Real” imports appeared to rise so much mainly because import prices supposedly fell at a 9.5 percent annual rate (which means a 2.38 percent rise in the quarter, multiplied by four to get the annual rate). By contrast, import prices rose at a 14.6 percent annual rate in the first quarter and at a 24.8 percent rate in the fourth quarter of 2009. Those figures say more about the folly of converting smallish price changes into annual rates than they do about the real economy. Besides, imports fell 2.1 percent in July and exports rose 1.8%, so the questionable second quarter trade figures did not indicate a lasting trend.

Tyson did not bother to figure out how large the first stimulus bill was, or when the borrowed loot was spent. She did not bother to look up the negligible contribution of federal spending to recent changes in GDP, and she confused GDP with domestic demand. 

The press kept telling us that Tyson was almost certain to replace Peter Orszag as OMB director, and then to replace Christina Romer as head of the Council of Economic Advisers. Yet such plums keep slipping from her fingers, to the dismay of her fans at The Nation, NPR and The Atlantic. This is rare evidence of good judgment from the Obama White House.

A Fannie Mae for Intrastructure?

Like President Bush before him, Obama has a knack for taking the worst ideas of his opponents and making them his own.  It is truly bipartisanship in the worst of ways (think Sarbanes-Oxley, the TARP or No Child Left Behind).  The newest example is the President’s proposed “infrastructure bank.”  A bill along those lines was introduced a few years ago by then Senator Hagel, although the idea is far from new.

First, let’s get out of the way the myth that we have been “under-funding” intrastructure.  Take the largest, and usually most popular, piece:  transportation.  Over the last decade, transportation spending at all levels of government has increased over 70 percent.  One can debate if that money has been spent wisely, but there’s no doubt we’ve been spending an ever-increasing amount on infrastructure - so there goes one rationale for an infrastructure bank.

The real rationale for an infrastructure bank is to transfer the risk of default away from investors, bankers and local/state governments onto the federal taxpayer, but to do so in such a manner that the taxpayer has no idea what they are on the hook for.

If there are truly great projects out there that will pay their own way, then they should have no trouble getting private funding.

Of course, we will be told that the bank will charge an interest rate sufficient to cover losses and that the taxpayer won’t be on the hook.  Again, if it is charging an appropriate rate, then why does the bank need to be chartered (and backed) by the taxpayer?  We’ve heard this story before…with Social Security, flood insurance, FHA, Fannie/Freddie…the list goes on, that all of these programs would pay their own way and never cost the taxpayer a dime.  If there are truly outstanding infrastructure needs, then appropriate the money and pay for them.  An infrastructure bank is just another way to allow Wall Street to line its pockets while leaving the risk with the taxpayer.  If bankers aren’t willing to actually take the risks, then why exactly do we need them?

Economic Problems Won’t Be Solved by Education Stimulus, Either

Mark Calabria does a fine job dismantling Laura Tyson’s argument that we need another stimulus to spur private demand and revive the comatose economy. I would just caution against the one thing he could be construed as implicitly supporting: more federal funding for education.

I don’t dispute that there are mismatches between employers’ needs and potential employees’ skills, but the solution to the problem is not still more money going to education. As I and others have argued – especially the Pope Center’s George Leef, in a deft takedown of a recent workforce study – lobbing sacks of taxpayer dough at education will mainly enrich schools and their employees while making our resource-blowing education system even less efficient. Indeed, we already have far more bachelor’s degree holders than we have jobs for them, and the Labor Department projects that the greatest number of new jobs in the next decade will require only on-the-job training (see Table 2). And skills retraining? There are big problems there, too, with people often training for jobs that for numerous reasons they cannot get.

Putting more taxpayer money into “education” is one of those sweet sounding ideas that few people can ever resist, but which produces continually rotten outcomes. So even when it comes to education – shrill objections about “de-skilling” and being “anti-education” notwithstanding – the best thing to do for the economy is to let money stay with taxpayers and allow them to consume education as they would anything else: according to their individual priorities and abilities, which they know better than anyone else.

Tyson’s Keynesian Confusion

UC-Berkeley Professor, and former Clinton economic advisor, Laura Tyson lays out why she believes we need a second stimulus.   Her op-ed is a worthwhile read for understanding the basic assumptions behind modern Keynesian thinking.

Foremost among those assumptions is a belief we are in a recession due to “a collapse in private demand.”    In Professor Tyson’s world, if only everyone would buy more, everything would be OK (starts to sound a lot like President Bush in 2002).  But what exactly has been going on with private demand?  Judged by private personal consumption expenditures, it is actually up and higher than at any point during the boom, after reaching bottom in the Spring of 2009.

The following chart, from the St. Louis Federal Reserve, nicely illustrates the direction in private demand.

So if Tyson’s narrative that weak demand is holding back employment is false, or at least incomplete, then what is holding back unemployment?  In a word:  Investment.

Unlike consumption, which has largely rebounded, investment today is about 20% below its peak.  Of course we should keep in mind, that peak was a bubble.  The good news is that investment in such things a equipment and software, are slowly, but steadily, climbing back.  The real drag on investments is from the construction industry, particularly residential, which is still down about 50% from its peak. 

What most of this suggests to me is that unemployment is being driven mainly by a mismatch between skills of the unemployed and available job openings.  You simply cannot, overnight, turn a construction worker into a nurse or computer programmer.  Tyson seems to half-way recognize this when she argues for stimulus to be directed into education, although she only seems to be talking about future skills mismatch and ignores the mismatch facing the economy today.  For if increased aggregate demand is all we need today to reduce unemployment, then wouldn’t the same hold true for future unemployment, removing the need for educational funding?

At the end of the day, what we need to get employment increasing is to create an environment where business feel confident to invest.