Monkeys & the Housing Bubble

Good news - monkeys would have taken option ARM and pay-as-you go mortgages too:

For more about Human Irrationality, check out Dan Ariely's blog and his book - Predictably Irrational.

Equilibrium Economics & DSGE

Many thanks to Greg Mankiw for posting the link on his blog to Robert Solow's prepared statement to the House Committee on Science and Technology Subcommittee on Investigations and Oversight - “Building a Science of Economics for the Real World."

I didn't realize it at the time, but I was introduced to the field of DSGE (Dynamic stochastic general equilibrium modeling) economics in part last year at the "Stimulus SmackDown: Can Deficit Spending Save the Economy?" hosted at the University of California - Davis where Michele Boldrin expressed his view from the vantage point of equilibrium economics, of which DSGE is a branch.

Why is does this matter?

Along with other explicit reasons to mistrust DSGE as a viable economic theory, Solow explains:

The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.

Much of today's political approach to economic cures focuses on reviving the Keynesian/government intervention approach. Robert Solow developed the Solow Eocnomic Growth Model (yes, that Solow...) and his economic standpoint falls on the opposite end of spectrum from Keynesians and New Keynesians.

It's reasonable to generalize about economic conditions and accept that there will be gaps and holes in describing how economic events and policies affect each individual participant. There's certainly no accounting for taste (as microeconomists often state) and how participants respond or are affected by each new macroeconomic condition may in fact change each time because of amultitude conscious and sub-conscious factors weighing decisions. While noble, the notion that modeling macroeconomic activity as a construct of measured individual decisions emits a certain arrogance that individual human behavior can be predicted and subsequently controlled through economic policy.

Solow, Friedman and scores of other free market economists have long shown the positive effects of less government intervention and empowering individuals to make their own economic decisions. While some will choose poorly and even irrationally, the aggregate optimizes their situation with any set of given constraints. Most importantly, I simply want the liberty to make such decisions. It's just not possible to predict how the individual, on an individual basis, will respond to conditions at any one point in time.

The complexities of individual choice border on infinite and have long been articulated. Nobel prize winner Hebert Simon published his paper "A Behavioral Model of Rational Choice" back in 1955 (and even used the housing market to illustrate his point...).

I'm not suggesting that DSGE economists are seeking to control behavior, but a general Keynesian approach that includes modeling nearly infinite variations for individual players just doesn't seem right.

Rational Optimism - Matt Ridley on TED.com

How humans' ability to conceptualize and capitalize on gains from trade leads to economic and societal progress:

http://www.ted.com/talks/lang/eng/matt_ridley_when_ideas_have_sex.html

Ridley references one of my favorite economics lessons from Uncle Milty - The Story of the Pencil - though he fails to cite Milton Friedman on the idea... Found that rather disappointing.

(Thanks to Paul Kedrosky's blog post for pointing out this video presentation.)

Howard Dean, Fiscal Conservative?

I was fortunate enough to attend the ASF 2010 Working Lunch, pretty good rubber chicken with a side of CNBC's Larry Kudlow moderating between Howard Dean and Newt Gingrich. Much to my surprise, Howard Dean appeared to show signs of fiscal conservatism and the willingness to speak with candor and criticisum about the Obama administration.

Couple of memorable points (paraphrased):

• "You can't have capitalism on the way up and socialism on the way down." - Newt Gingrich when about about US government invention into the financial markets.
• "I'll let Newt save his modesty - he's running." - Howard Dean answering for Gingrich when Gingrich was asked if he was gearing up for a 2012 Presidential run.
• "No way." - Howard Dean when asked by Kudlow if Hillary Clinton was preparing to oppose Obama in the 2012 Democratic primaries.
• "There's a 50/50 chance that the Republicans will pick up a majority in both the House and the Senate in the 2010 mid-term elections." - Newt Gingrich
• "About 45 Senate seats and 30-40 House seats." - Howard Dean's perspective.
• Dean & Kudlow agreed that they would not have re-appointed Ben Bernanke to the Federal Reserve. Gingrich said he would have.

Much to my own surprise, and maybe more to my initial disappointment, I found Dean to be lucid, intelligent, and seemingly likable. Gingrich has a knack for explaining complex issues with ease.

There was lots more said between the two throughout the 1:30 discussion, but the rest focused on the economy, unemployment, and health case. Nothing earth-shattering that you wouldn't expect to hear from either side.

I have a hunch that these two like and respect each other in real life. TV interviews and media outlets typically showcase the animosity between any two individuals of the two parties, but it seems that these two could sit down over a bottle of scotch for a complex, civilized, philosophical conversation about the ways to approach societal, government, and economic challenges. They don't hate each other - just mostly disagree on the basic way to approach issues. Maybe that is what I learned the most.

An Appreciation of Milton Friedman

I got into a Facebook conversation yesterday about capitalism and greed, and immediately thought about this excerpt of the Phil Donahue show, interviewing Milton Friedman back in the 1970s:

http://www.youtube.com/watch?v=RWsx1X8PV_A

And as is the beauty of YouTube, I also found this episode of the Charlie Rose show, taped just a day after Milton Friedman passed away a couple years ago. Great stuff:

http://www.youtube.com/watch?v=-pbHo_fQCFg&feature=fvw

"Inflation is a monetary phenomenon..."

Indulgences & Seigniorage

(Note: My thoughts on this aren't completely formed, but I felt it important to record as a start to the formalization process...)

Trolling through TED.com, I came across Jay Walker's presentation about his Library of Human Imagination. One of the artifacts he displayed during his talk was a Gutenberg Bible (about 90 seconds into the video) - the first substantial book to be mass produced using the printing press. Walker shared some insight about the reason behind the Catholic Church's reproduction of the bible - it wasn't so much for individuals to read the bible for themselves. Instead, the Gutenberg Bibles were reproduced so the Church could sell "indulgences" to the masses in order to raise money. The Church was struggling for cash, so in a sense, they financed their operations by issuing indulgences as currency, eventually printing millions of these and distributing them. In economic terms, this is known as "seignorage.")

It was this action by the Church that led to Martin Luther's 95 Theses, questioning the Catholic Church's operations and motivations beginning the eventual downfall of the Catholic Church in Europe during the Renaissance Period.

An oft-cited definition of seigniorage - "The amount of real purchasing power that [a] government can extract from the public by printing money" - presented by Alex Cukierman, Sebastian Edwards and Guido Tabellini in their 1992 paper published in the American Economic Review - "Seigniorage and Political Instability." The abstract of his paper explains more:

The importance of seigniorage relative to other sources of government revenue differs markedly across countries. This paper tries to explain this regularity by studying a political model of tax reform. The model implies that countries with a more unstable and polarized political system will have more inefficient tax structures and, thus, will rely more heavily on seigniorage. This prediction of the model is tested on cross-sectional data for seventy countries. The authors find that, after controlling for other variables, political instability is positively associated with seigniorage. (my emphasis added)

Christopher Adam, Benno Ndulu, and Nii Kwaku Sowa also study effects of government seignorage in their 1996 article - "Liberalisation and Seigniorage revenue in Kenya, Ghana and Tanzania" - published in the Journal of Development Studies.

The revenue consists of two parts, the first flowing from the willingness of the private sector to hold government financial liabilities (which we shall refer to as the real balance effect) and the second part from the taxation through inflation of the outstanding stock of real balances (the inflation tax effect.) Seigniorage is particularly attractive in economies where the traditional tax base is narrow and the costs of other forms of revenue collection are high. Moreover, in economies where the policy regime limits the portfolio of domestic financial assets available to the private sector, for example where there are limited possibilities for currency substitution, the potential for raising seigniorage revenue may be expected to be high. In addition, by exploiting the high adjustment costs faced by the private sector in such economies, revenue can be increased in the short-run as holders of money are temporarily forced off their equilibrium money demand functions and obliged to hold higher than desired money balances. The higher the costs of adjustment, the greater the short run value of the 'surprise' revenue.

Breaking this down in parts:

• "the willingness of the private sector to hold government financial liabilities" - This refers to the issuance of US Treasury bills and bonds, in the current case, to finance deficit spending and debt.
• "taxation through inflation of the outstanding stock of real balances" - This refers to the decreased value of current debt due to inflationary effects from issuing new currency via seigniorage.
• "Seigniorage is particularly attractive in economies where the traditional tax base is narrow" - The United States faces the primary problem of a shrinking tax base. As this CBS News article from April 15, 2009 notes that an "astonishing 43.4 percent of Americans now pay zero or negative federal income taxes. The number of single or jointly-filing 'taxpayers' - the word must be applied sparingly - who pay no taxes or receive government handouts has reached 65.6 million, out of a total of 151 million.
• "the costs of other forms of revenue collection are high" - Other forms of revenue refers to income taxes or VATS. Certainly the US qualifies here.
• "economies where the policy regime limits the portfolio of domestic financial assets available to the private sector" - Congress (and the administration) is placing restrictions on securitization and considering other financial regulations under consideration. Using the housing market as example, it's the GSE's and the Federal reserve buying mortgage securities and loan portfolios, not the private sector as would be more efficient and economically sound.
• "revenue can be increased in the short-run ... The higher the costs of adjustment, the greater the short run value of the 'surprise' revenue." - The net result is a short-term bump in GDP to the long term detriment of the economy. That's what we saw in Q3, 2009.

As described in the Abstract of the Adam, Ndulu, Sowo article, the "implication is that countries that have relied on seigniorage revenue need to undertake deeper-than-anticipated fiscal adjustment in order to maintain macroeconomic balance following liberalisation programmes."

This is often why prominent economists and thought leaders (including Steve Forbes) advocate the United States returning to the gold standard - so that the US Dollar is backed by an intrinsically valuable item. Additionally, Forbes backs the "flat tax" to make revenue collection by the government simpler versus the current income tax system or proposed VAT included in tax proposals of the 111th Congress.

I don't know what the answer to all of this is. I do know that rigorous academic work clearly shows that a government's use of seigniorage leads to long term pain for an economy and that current policies under pursuit work in strong opposition to these economic findings - financing government programs such as the American Recovery and Reinvestment Act, the proposed health care reform legislation, TARP, TALF, and others.

The questions that persists in my mind - is the government selling indulgences to get us out of economic purgatory only to cause a future collapse of our financial system? Watching Walker's presentation on TED.com sparked an immediate parallel in my mind that I can only hope is a result of my background as a history major and Catholic, and not founded on real economic principles. I sure hope I'm wrong on the one.

Greenspan on "This Week" with George Stephanopoulos

Was fortunate to flip on the TV the morning to catch Alan Greenspan on "This Week" with George Stephanopoulos. Here are some key statements during the interview with some additional explanation in parenthesis that I've added.

• The economy loses skills with elongated unemployment (When workers are not working and keeping up with new technology, new processes, and deploying new innovation, the skills of the worker deteriorate and fall further behind competition in the global economy.)
  

• Just after the financial crash, business (defined as economic participants) expected production and consumptions levels to fall off far more than they did. This spurred business to cut employment and production more than could have been economically supported. As a result, we're getting "horrendous" labor productivity numbers, meaning that the output per worker is declining.
  

• On unemployment, Greenspan noted that unless there are more than 100,000 new jobs a month, the unemployment rate will not improve.

• On government intervention and the stimulus package, the focus should continue to be on trying to get the economy going, but don't be counterproductive. As Greenspan stated, "we're in a recovery, his is what a recovery looks like. Looking back after this is over, we'll see ups and downs on a graph but look right through them right through them." The stimulus package is only 40% spent, so before considering a second package, the remainder (Evan Bayh on Fox News Sunday with Chris Wallace said he would have liked to have the stimulus go into effect sooner.)

• On GDP growth, Greenspan predicted 2.5% GDP growth in the third quarter and sees the numbers coming in higher than that once the estimates and revisions are completed. We're getting close to end of job loss, "but this is not the same as unemployment going done. We'll get to 10% barrier and stay there for a little while."

• On temporary actions, he feels that measures such as extended unemployment benefits are needed in the short term and is not a stimulus activity but may have some stimulus effects.

• On health care, the real problem exists in health care because of the huge fiscal hole as seen in Medicare. There is significant issuance of treasury bonds to finance the budget deficit. Historically we have kept our debt well below the borrowing capacity but that cushion is being tested which will affect LT interest rates. "Budget neutral is not adequate, weed to have address the long term."
  

Rules for Changing Rules - Romer on TED.com

I came across this presentation Paul Romer, Stanford economist (and a former employer). He discusses the idea of creating "Charter Cities" in developing countries that would enable the local population to choose migration and participation in the Charter City while providing a motive of profit for international firms to set up shop.

Using Hong Kong and Singapore as successful examples, it's important to consider cities like Brasilia that have not been so fortuate. During my time in Kazakhstan, I frequently visited Astana, the new capital city under development there and worked on an urban planning project that examined educational resources, infrastructure, and growth planning.

This is where the "rules for changing rules" becomes vital to the success of the Charter City Romer is proposing. When left to isolated government bureaucrats unwilling or unable to grasp the necessary conditions for economic growth, these Charter Cities will assuredly fail. But, if we can reach a level of true ideological understanding and implement proven theories of city and urban planning, there is certainly promise for this concept.

Check out the video presentation on TED.com here.

Even Google is Paranoid!

Given Google's new found paranoia, it gives me a certain amount of comfort to know that the laws of the free market and capitalism are still alive and well, even during a time where government programs and institutions are pushing a more socialist environment on the social side of our country's development.

Back in September, I wrote "Viva Monopoly!" about the importance of monopolies in a free economy. They offer an incentive for free enterprise to efficiently capitalize on a new innovation. Seems Google is noticing that annoying little dog nipping at it's heels:

http://valleywag.gawker.com/5291274/googles-new-paranoia

John Hussman on the Banking & Housing Markets

From John Hussman, of Hussman Funds, this article provides one of the most lucid descriptions of why the poorly constructed (I hate using the word "toxic"...) mortgage assets on bank balance sheets pose such as problem, and a clear set of solutions that would probably work if implemented. Hussman explains why allowing the banks to charge the negative assets to existing bank bondholders instead of using government cash infusions is a more natural plan, and why we're not even close to getting out of the woods in the housing market:

http://hussmanfunds.com/wmc/wmc090330.htm

Geithner on George Stephanopoulos

Watching the George Stephanopoulos show this morning (I'm not sure why, but....), but here are some notes from the interview:

• "People with ideas still want to come to the United States."
• "We need banks to take risk again - take a chance again on providing credit to that business..."
• After Stephanopoulos introduced Paul Krugman's comments that the Geithner plan is financial hocus pocus - "This is a conservative structure to have the private investor with the government sharing the risk."
• Stephanopoulos asked how much is left in TARP? - "$135 billion in uncommitted, including money coming back from banks that are stronger than thought and are not in need to the money originally allocated to them."
• On inflation that could be caused by printing money to finance the federal actions - "We'll never have hyperinflation. Increased money supply will not cause hyperinflation."
• Government has historically taken too long to assist in recovery, and pulled out of recovery mode too soon as soon as a glimmer of light was seen - Japan and Sweden in the 1990s, the United States Savings & Loans crisis, and the Great Depression.
• "Right now, we're about where we thought we'd be."
• "Damage from this situation is brutal, indiscriminate."
• "The market will not solve this. The error is not doing enough."

Milton Ezrati at the IMN Distressed Investment Summit

Milton Ezrati, Lead Economist at Lord Abbott, opened Information Management Network “Distressed Investment Summit: Credit Crunch Investment Strategies for Institutional Investors” conference on Monday. From his viewpoint, the market is running on emotion, which is covering up current market fundamentals. And the market ran on emotion over the last couple of years, which previously covered up really bad fundamentals. But the markets have over-reacted and are pricing assets to fear instead of to value. And the markets are slowly recovering from the emotion-based marking. Got all that?

Ezrati illustrated his point of view with a few examples:

• The TED Spread: Has historically bubbled around 25-30 basis points. It rose to 460 basis points in November 2008 and has since dropped down to 100 basis points - still not back to normal, but recovering.
• Credit Spreads: Junk bonds, which normally trade around 500-600 basis points, reached 2100 basis points but have fallen to 1500-1700 basis points.
• Merrill Lynch: In their sale to Bank of America, mortgage assets were priced at $0.22/$1, indicating that 78% of assets are worthless; yet 60% of sub-prime borrowers are current (and this doesn’t even count the intrinsic value of the properties themselves…)
  

In discussing today’s market as compared to the Great Depression, Ezrati offered some salient points:

• There was no bank deposit insurance then.
• There was no unemployment insurance then.
• Unemployment rose to 30% during the Depression, versus 8.1% now
• 9000 banks went bust during the Depression, versus 40 banks now.
  

Other key points from his address:

• Worker Productivity rose in Q4-2008, even with the massive layoffs in the economy. (Those numbers have since been revised to show a -0.4% downturn in productivity, but given the sharp increase in unemployment in Q4, this value seems to indicate that productivity is still ahead of employment declines.)
• Personal Savings have risen to nearly $600 billion from nearly $0 in 2007. (You can verify this at the Bureau of Economic Analysis.)
• While the current government’s actions may create an inflationary environment, he is not forecasting any inflation at this time.
• When asked about China’s role in financing our debt, Ezrati likened the situation to a manufacturing company subsidizing a customer at a loss, only to gain when selling the end product. As long as China continues to run an export-oriented economy, then they have little choice but to finance US debt because of their reliance on the US for its economic base.
• When asked about drawing an analogy between Japan plight in the 1990s to the current U.S. situation, Ezrati cited that Japan’s government failed to acknowledge bad debt at the start (versus the mark-to-market requirements in the U.S.), that Japan’s sub-prime debt was non-paying (versus a 60% repayment rate in the U.S.), and there was not much of a corporate debt market in Japan (borrowers had to go to a bank for a loan). So overall, Ezrati indicated that the current situation in the U.S. does not compare to that of Japan’s a decade ago.
  

Overall, Ezrati saw reasons for abatement in the market’s negative direction, but as you might expect, hedged that with a little caution that future economic events such as inflation could hamper recovery in the intermediate.

Paul Volcker on Bank vs. Hedge Fund Risk-Taking

Paul Volcker, former Federal Reserve Chairman regarding risk profiles of banks vs. hedge funds:

"Maybe we ought to have a two-tiered financial system," Mr. Volcker said at conference at New York University's Stern School of Business. Banks "should not be taking extraordinary risks in the marketplace."

This is the basic premise of the financial system. Bank are inherently supposed to be risk-averse institutions, as discussed in this article about the US government's interference in the free market.

The rest of Mr. Volcker's comments are in the rest of the article on HedgeWorld.com.

Recap: "Stimulus SmackDown: Can Deficit Spending Save the Economy?"

It wasn’t Ali-Frazier or even Hagler-Hearns, but the live debate hosted by University of California-Davis Institute of Government Affairs last night between Michele Boldrin of the CATO Institute and Washington Univeristy and J. Bradford DeLong of UC-Berkeley – “Stimulus SmackDown: Can Deficit Spending Save the Economy?” - proved entertaining nonetheless. As you might conjecture based on their institutional affiliations, DeLong argued in support of the recent U.S. economic stimulus bill while Boldrin vociferously argued against it.

Here’s a recap of the action:

Bradford DeLong

DeLong is a self-professed economic historian, and specifically denies that he is a macroeconomist. (That seemed to be a theme throughout the evening…) His approach to the economic stimulus package is a simple one, and one heard frequently throughout political circles – the patient is bleeding, therefore we need to apply a bandage. While that bandage will not heal the severed artery, we should focus on triage first and long-term solutions later.

Today’s economic environment now reaches far beyond a housing bubble – it’s clearly spilled over into other parts of the economy, so focusing solutions more broadly to include infrastructure projects, health care reform, and monetary allocations to individual states is an approach consistent with our economic challenges. It’s okay to increase the deficit now to achieve a surplus later. We should be spending more and taxing less in the short term to pull us out of today’s emergency.

DeLong argued that empirical studies show that when one industry gets motivated and decides to spend, it can turn an entire economy. In this case, the stimulus plan is a decision by society to spend and that “the government’s money is as good as anyone’s. It is a reasonable and intelligent thing to take this action on our own behalf.” That said, DeLong acquiesced that an economic stimulus package does not equate to long term economic growth, but continued to emphasize is argument on triage first, operation later.

DeLong supports the “Ackerlof’s approach” to taming the economy. (George Ackerlof won the 2001 Nobel Prize in Economics for his contributions to psychology in the marketplace and has recently written a new book – “Animal Spirits.”) DeLong also argued that the Swedish Banking Model deployed in the 1990’s is sound approach that should be considered in the United States.

His presentation was short and to the point – do something now and deal with the consequences once the economy is recovering. We are facing significant economic problems now, and something needs to be done immediately to stem the tide of ongoing negative economic trends.

Michele Boldrin

Boldrin is a general equilibrium economist, which means that he focuses on the microeconomic side of supply and demand – equilibrium models starting from individuals and firms, then aggregating into macroeconomic analysis (whereas macroeconomics tend to take an “top-down” aggregated approach to economics.) As Boldrin put it, macroeconomists “suffer from the aggregate.”

He likened the approach of economic stimulus to that of rock-climbing – rushing to decisions serves to detriment of the participant. The notion that “We have to do something!” will ultimately weaken the economy even further. “Even the Bush tax cuts - $400? They avoided the real economic problem.” The real problem lies in the financial markets and overall structural dynamics of the economy.

Boldrin focused two primary arguments against the stimulus package in its current form. First, he cited empirical evidence that show increases in public spending do not have a multiplier effect on the economy. That is, when government spends, the economy feels only the net effects of the primary spending – there is not downstream multiplier effect. In fact, he maintained that the Keynesian multiplier for government spending was perhaps less than 1. Several prominent economists share this perspective, including Robert Barro and Bob Hall and Susan Woodward. Of course, other leading economists such as Valerie Ramey and Christina and David Romer contest that the government multiplier is greater than 1. Shocking -economists don’t agree on something. (Christina Romer is the Chair of Obama’s Council of Economic Advisors, perhaps for good reason based on her research findings.)

Boldrin also showed correlation empirics from several of the G7 countries - France, Germany, Canada, Italy, and Japan – which all indicate that there is no correlation between public spending and Gross National Product for any of these countries. He also clearly stated that his issue is not with the general concept of government spending, but whether it is useful for economic stimulus. He cautioned the Obama administration on shrouding political aims under the guise of economic stimulus. Quick spending does not help the acute.

For example, what about increased health care spending that is included in the stimulus package? This is an industry currently with rising employment according to the January 2009 U.S. Bureau of Labor Statistics, so two outcomes will be evident from these spending increases. First, we’ll end up paying higher wages to the current labor market in the health care industry. Second the “hammer and nail guy” in Las Vegas will not benefit from the stimulus because he won’t become a nurse by year’s end. Yes, there are provisions for creating a health IT system, but relative to the other allocations in the stimulus plan, they account for a small part of the overall allocation to the health care stimulus line items.

In a related argument, Boldrin argued that focusing the economic stimulus on spurring demand for durable goods such as automobiles and housing (which generally require credit, and in turn, require fixing the credit market) will only increase employment in the production of that good in those industries – it does not create overall employment. (This is the general equilibrium economist showcasing his traits.) If we focus on stimulating demand in the industries hardest hit by the recession, we are going to be pushing for the purchase of SUVs and houses in Nevada. Isn’t that how we got here in the first place? (DeLong believes the labor is more flexible than Boldrin, even using the example of the person redoing his bathroom who was a janitor just two months ago. Labor mobility is a hotly debated topic among labor economists.)

The problem with increased spending now is that history shows that we do not decrease the spending later. There is never guarantee that these government programs will be cut later. “Pay-as-you-go” as is proposed is not the same as cutting spending and taxes in the longer term. “Pay-as-you-go” can simply mean increased taxes in the longer term to pay for these social programs now inserted into annual government expenditures.

Boldrin often took the debate away from the straight “Yea or Nay” on the economic stimulus package and focused his attention on the state of the U.S. financial system, again examining the effects of public spending on economic growth, illustrating the cases of Japan in the 1990s and Chile in the 1980s. Japan took the approach of fiscal spending for many years and created a “zombie state” in banking. Japan’s long-term economic growth struggles throughout the 1990s are well-documented. Alternately, the solutions of the Chilean banking crisis in the early 1980s focused on cleansing the banks and swiftly as possible. Boldrin supported taking the latter approach, and said that we need to purge the leadership of the banking sector - “keeping the same guys is a bad idea.” When credit crunch creates the problem, you need to start with the banks first.

With regard to the Swedish model introduced by DeLong, Boldrin agreed because Sweden exercised fiscal constraint in lowering taxes and spending – not the basis on the U.S. economic stimulus package.

Selected Audience Questions

“If there is true slack in the labor market (unused capacity), and we assume that the social cost of the infrastructure and other social programs included in the stimulus package equals long-term social benefit, doesn’t that mean that building a bridge or school now means getting that public works project at a bargain because spending more now means less spending later?"

DeLong : Agreed.

Boldrin: Yes, but we must mandate that when government costs rise now, they must be cut down the road and there is evidence in our economic and political history that these cuts do not occur.

Macroeconomics suffers from too many assumptions – flexible prices, labor and capital mobility, the efficient market hypothesis, rational expectations theory, perfect information, perfect competition, and many others. Isn’t basing policy decision on macroeconomic theory a flawed approach given the complexity of our economic environment?

Both DeLong and Boldrin agreed with this point. DeLong went on to say that the most relevant lectures he attended were that of Charles Kindleberger, who wrote “Manias, Panics, and Crashes,” which is consistent with his support of Ackerlof’s plan for the economy.

Boldrin went on to say that the New Keynesians (such as DeLong, Obama, and Christina Romer) suffer from the same problem. There is too much “master of the universe” – that Greenspan or Bernanke or the government can move some levers and we’ll all become rich. Economics is too complex to assume singular actions can move the economy. There are technology shocks, demand shocks, energy shocks, changes in productivity, and other exogenous effects that are constantly affecting the economy.

When did the Great Depression end and why?

DeLong used this question to further support the need for emergency spending. He stated that the Great Depression ended briefly in 1937 when the United States started to show signs of recovery in 1935 and 1936. Roosevelt ended many of the public works programs such as the WPA and the economy slipped back into negative territory – Delong felt that FDR released government intervention to soon. Then World War II arose and the increased war-time spending further bolstered the economy through even more government spending, and eventually pulled us back to stability in the mid-1940s. Using this logic, it’s very clear that government spending pulled the United States out of the Great Depression.

Final Takeaways

I attended the “Smackdown” expecting to side with Bradford DeLong based on his blog entries over recent weeks about the overall meltdown of the economy. I must admit, he’s done a good job hiding his Keynesian tendencies…

I was left with a statement from Boldrin that ultimately strengthened my viewpoint against the vastness of the stimulus package (Admittedly, I went into the event biased against the broad provisions included in the bill such as the health care and other social provisions…):

“What happens when we come back in six months with 12% unemployment and are having the same debate? Will the response be – ‘We have to do something!’?”

-------

[The entire debate was videotaped and should be available at www.iga.ucdavis.edu in the next day or so.]

The "Housing Rescue" by the numbers

The Obama administration released the details of the housing rescue today, and the WSJ put together a nice "Fact Sheet" that I just reviewed.

Here's the money reward if you purchased a home you could not afford, or were a lender that eschewed the standard practice of lending to credit-worth people:

Servicers that modify loans according to the guidelines will receive an up-front fee of $1,000 for each modification, plus “pay for success” fees on still-performing loans of $1,000 per year.

Homeowners who make their payments on time are eligible for up to $1,000 of principal reduction payments each year for up to five years.

Here's what it means:

• Borrowers will be given a $5000 as reward for paying their refinanced mortgages on time. The rest of us just get to continue living in the house we bought.
• Lenders will be given $6000 for modifying a loan that otherwise would have defaulted.
  

Gee... thanks...

Using the mortgage calculator on BankRate.com, suppose a $300,000 mortgage balance paid over 25 years at 8% interest, which assumes the new interest rate after the initial 5-year period adjustment of a 30-year, 5-year ARM mortgage contract. The monthly payment comes to $2315/month (not including taxes, insurance, and other monthly fees included in the monthly housing payment.)

Now, assume that a refinanced rate of 4.5% for the life of the loan. The new monthly payment drops to $1667/month - a difference of $648/month, or $7778/year. Keep in mind that both the borrower and the lender can each earn $1000/year, reducing the lender's "loss" to $6778 and subsidizing about 5% of the borrowers total annual payments for the initial five-year period. I say "loss" because this is a net gain for the lender versus the borrower defaulting completely on the loan.

Here's the good news that I can see from this program. Will this make a difference for most people that aren’t able to make their mortgage payments at the $2315/month? What's the elasticity of the borrower's willingness or ability to pay based on the 27% reduction? I'm guessing that these borrowers that will refinance are likely to miss at least one payment each year, even at the lower modified monthly payment amount. So the offer becomes void (until Congress inserts some exception to the rule... "You get points for trying...)

It probably will make a difference for some people who have had their hours cut at work or have lost a part-time job that was supplementing income. But for rest, I suspect that making mortgage payments was likely a binary condition - either you're paying or you're not. And if you're not, the 27% reduction isn't going to enable you to make the payments.

What about paying people $5000 and to go into foreclosure instead? Those that can't pay won't, so instead of delaying the inevitable, fast-track the foreclosures, and let the market clear faster so we can get on with the recovery.

The United States, Collectivism & Radar Guns

As the market continues to unravel and the socialist agenda of the current political administration moves farther along its path, my source of solace has been the late, great Milton Friedman. "Uncle Milty," as he's known throughout economic circles, had much to say regarding socialism, the government's constraint on markets, and American business.

Socialism in the United States

Back in a 1975 interview hosted by Richard Heffner on "The Open Mind," Friedman stated that the natural order of mankind is movement toward socialism. Human nature pulls us toward group behavior and collectivism, and while well-intended, we often establish laws and regulations in haste whose end result rarely (if ever) meets their initial objectives. It's natural for people to look to a central authority to establish rules and guidelines designed to protect their interests and propagate desirable behavior. If a condition or situation arises that negatively affects a minority group (that is numerically, not racially per se...), the initial response is to say - "That's terrible - there ought to be a law."

(The interview referenced here was conducted in 1975. Discussion topics focused on individual freedoms and the inefficiency of strong government intervention to solve social and economic issues. Here's a link to the 30 minute interview.)

In economic and financial circles, Milton maintained that free markets and permitting individuals to pursue their own self-interests is the most efficient way for societies to operate. This is clearly results in a duplicitous state of being - we know that the pursuit of individual self-interest is more efficient means to maximizing outcomes, yet our human tendencies move us to collectivism and socialism. Most importantly, the implementation of regulatory burdens by our socialist self results in exactly the opposite of its intended effect. As Friedman illustrated, consider any social program introduced by government - minimum wage laws, protective tariffs, or welfare. In every case, these enacted social programs resulted in ultimately hurting the very minority groups they are intended to protect, and can be proven to have done so using the most rudimentary technical economic models.

The long term effects of continued regulations and government intervention will lead us to the path of socialism, and eventually tyranny and serfdom under the weight of self-imposed governance. Friedman shared the view of Friedrick Hayek, who authored "Road to Serfdom" earlier in the 20th century. Given these natural human tendencies, Friedman estimated that there was only a 15-35% chance that we, as Americans, had the posterity to avoid complete socialism by taking the proactive measures necessary to enable individual freedom and resist our natural tendencies for collectivism, a state that which would evolve to the condition of serfdom and tyranny.

Fortunately, as Friedman explained, there are two situations that support the maintenance and protection of a free society. The first is government's inability to operate efficiently. As Friedman put it - "you almost never spend other people's money as carefully as you spend your own." Individually, we can examine nearly every social program at the most cursory level and quickly see the massive waste involved with its implementation. The second is the American commitment to finding loopholes and to circumventing laws.

The Housing Market: A Textbook Case of Government Inefficiency

The Community Reinvestment Act was enacted in 1977 and designed to encourage depository institutions (banks) to meet the credit needs of the communities in which they operate, with credit including home mortgages. In 1992, then-President Clinton signed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 which eventually authorized and capitalized Fannie Mae to purchase mortgage loans granted by banks to credit-risky individuals as a means to expand home ownership opportunities to low- and moderate-income individuals. Sounds noble - enabling the financial market to provide credit and mortgages to individuals that they would normally reject under financial guidelines. But what were the long-term net results?

The banking institution is inherently risk averse. They have liquidity guidelines that require cash to be readily available to the depositors. Traditionally, banks required a 20% down payment for home purchases and approved only those individuals with credit-worthy histories. There are sophisticated, mature industries along the risk spectrum – Hedge Funds, Private Equity Funds, Venture Capitalists, and industry-specific investment funds and private investors. Banks are not part of this cohort.

When banks were coerced into participating in higher risk activities, their response was to dispense of these risky loans in the form of mortgage-backed securities (MBS) to those in the marketplace better poised to take higher risks with the objective of higher returns. Seeing a demand for these assets, the banks accommodated by increasing the supply of risking loans. The mortgage broker industry, including firms such as DiTech, Ameriquest, and Countrywide, saw an opportunity to facilitate these loans on behalf of the banks, providing an avenue to banks to increase the supply of these MBS to meet the increased demand. Eventually, as is clear now, we see that many of the high-risk borrowers are unable to repay the mortgage payments due, are moving into default, or are going into foreclosure. This is causing a major increase in the available housing supply and reducing the housing market's equilibrium price.

As prices continue to fall and interest rates adjust upwards, more and more high-risk individuals are either deciding not to make their mortgage payments in protest of their poor decision-making process to purchase an over-priced asset, or are simply unable to continue making mortgage payments at today's adjusted interest rates. Shocking revelation - those with poor credit don't pay their bills or live beyond their means. This adds to the housing supply, further exerting downward price pressure on homes. "Wait a minute," you say, "when prices fall, shouldn't that mean that more people should be able to afford a home, especially those in the low and moderate income brackets?" Yes, the should... But now that banks are restricting access to credit to meet more traditional criteria, even restricting credit access to those that meet traditional credit ratings such as a +700 FICO score and 20% down payment available. Lending levels have fallen drastically, and thus those especially in the low to moderate income bracket are unable to receive approval for home purchases because the market for high-risk MBS dissipated.

This case illustrates exactly what Friedman stated - the same rules and regulations designed to promote home ownership has worked to the ultimate detriment of those they were intended to help. The "greed of banks and Wall Street" didn't create the housing market crisis. These market players acted exactly as they should under the rules of game placed upon them by government regulation.

And what makes greed so bad in the first place (Gordan Gecko notwithstanding)? Even Uncle Milty favored greed in its pure sense. Ask Phil Donahue what he thought after this interview with Friedman.

Baseball, Apple Pie & Avoiding the Law

The second salvation that we have as Americans to avoid complete socialism lies in our burning desire to take mulligans and interpret 55 to mean 64 on the highway.

With the monetary allocations to the bank bailout initiatives, it's been a popular mandate to require that CEOs of banks receiving bailout funding may not receive a salary about $500,000. Even with the newly-imposed executive compensation limits, there's evidence of loopholes. Check out this story in the LA Times.

And what about the new tax plan designed to pay for nationalized health care by taxing those earning more than $250,000 per year? Check out this article from the Associated Press. The tax plan is designed to increase government revenues by taxing the "rich." The net result - the "rich" decide to work less and pay fewer taxes. It's better to make $249,999 than it is to earn $250,000. Only the government could invent such as system that would actually encourage Americans to work less. Why would someone opt to earn less than more? Because it's in his individual self-interest to do so. The net result in weighing higher taxes on the wealthy? Lower revenues - the exact opposite result from the original objective.

These simple cases highlight that regardless of the laws and regulations instituted under a socialist agenda, Americans will find a way around the regulations. However, it's vital to understand the long-term effects of placing these institutional burdens on an economy. Finding a loophole comes with a cost as time, legal counsel, and accounting fees to name a few. These transactional costs eat into the ability for individuals and the marketplace to act efficiently. Slowly the regulations erode the foundation of a free marketplace, only to have it crumble beneath itself under the weight of collectivism.

Life, Liberty & The Pursuit of Happiness

Economic freedom is difficult to achieve and maintain. That's why individuals throughout the course of history have died to enjoy and preserve freedom. That's why Cubans try to swim 90 miles to Florida. That's why we all recognize the image of Tiananmen Square from 20 years ago.

It's difficult to take personally responsibility for your actions and outcomes, and easy to blame the rules of game for your failures. But it's those failures that spawn new efforts and eventual gains. I'd rather have the choice of failing 1000 times than abetting the singular failure of our free market system in America. How about you?

Milton Friedman on "The Open Mind"

In researching for an article under development, I found these outstanding video interviews with Milton Friedman, hosted by Richard Heffner on "The Open Mind." This was a television series started back in 1956. Both interviews are approximately 30 minutes long.

The first interview was conducted in 1975. Discussion topics focused on individual freedoms and the inefficiency of strong government intervention to solve social and economic issues:

http://www.youtube.com/watch?v=JfdRpyfEmBE&feature=related

Friedman went on to win his Nobel Prize in Economics in 1976. Heffner followed up in 1977 with the second part of the interview:

http://www.theopenmind.tv/tom/searcharchive_episode_output.asp?id=493

Milton Friedman on Phil Donahue (1979)

Heard this on the radio on Friday -

http://www.youtube.com/watch?v=RWsx1X8PV_A

This is the reason that Milton Friedman won a Nobel Prize in Economics. Taped in 1979, think about the parallels that we're hearing in today's economic and political activity.

Let's stop with the talk about redistributing wealth as a means to solve our our personal economic and social situations.

American Business

I sat in a Starbucks today in Fort Washington, PA, checking email between meetings while on the road. At the table next to me were with two gentleman and a woman. The woman was a sales rep for ice cream shop supplies - ice cream mixes, ice cream cones, yogurt, etc. One guy was the owner/operator and the other was the managing partner.

After the 20 minutes that I eavesdropped on the conversation, she took the order, filled out the paperwork, and set up the account. "Diane" was so professional from start to finish - I actually went out to the parking lot when she left to compliment her.

Here's the best part - while sitting there and watching the two guys talk about their new ice cream shop this Spring, sharing the floor plan with Diane, and oozing excitement about the new venture, it gave me a certain sense of comfort and faith in the American businessman.

Despite Washington D.C.'s best efforts to waste a trillion dollars, the stock market's obvious disdain for the current economic situation, and the constant negative media that bombards every hour, here are two guys sitting in Fort Washington, PA - completely oblivious and thinking of nothing but their ice cream shop in a Starbucks when it's 40 degrees and windy outside.

This is why America is great.

Geithner on Lending Levels

And switching over Timothy Geithner's speech this afternoon... He stated that the program proposed is to (paraphrasing) "insure that lending would be greater than without government intervention."

Read: We're putting money in the market so that we can spur lending and open the credit markets.

That's what I thought they were trying to do.