Saturday, December 31, 2011

Krugman on stimulus

I usually don't respond to Paul Krugman's blog posts. But last week he wrote about Stimulus and Ricardian Equivalence. The post gives a revealing view of his ideas, so it's worth making an exception.

Paul explains:
...think about what happens when a family buys a house with a 30-year mortgage.

Suppose that the family takes out a $100,000 home loan .... If the house is newly built, that’s $100,000 of spending that takes place in the economy. But the family has also taken on debt, and will presumably spend less because it knows that it has to pay off that debt.

But the debt won’t be paid off all at once — and there’s no reason to expect the family to cut its spending right now by $100,000. Its annual mortgage payment will be something like $6,000, so maybe you would expect a fall in spending by $6000; that offsets only a small fraction of the debt-financed purchase.
So, according to Paul, "Ricardian Equivalence," which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.
How could anyone who thought about this for even a minute — let alone someone with an economics training — get this wrong?
How indeed?

The answer is, we didn't, and Paul got this one wrong.

We all agree that "Ricardian Equivalence" is how the economy would and should work, if there were no "frictions," or other problems.  Yes, even Paul, who writes
It [Ricardian Equivalence] is a dubious doctrine even done right; many people are liquidity constrained, and very few people have the knowledge or inclination to estimate the impact of current government budgets on their lifetime tax liability.
Read that carefully for admission of the converse: if the economy is functioning right, if people are not "liquidity constrained," if people are smart enough to recognize that today's deficits mean tomorrow's taxes, then Ricardian equivalence does hold and stimulus doesn't work. (More careful discussion with a few more ifs  here, here and here.)

So according to Paul, the prediction of a properly functioning economy is that people who take out a $100,000 mortgage consume $100,000 less in the first year; that they do not do so is proof stimulus works.

But of course it is not!  People who take out a $100,000 mortgage with $6,000 payments per year should spend about ... $6,000 per year less on other things. Much of that $6,000 comes out of rent they are no longer paying on the house or apartment they moved out of, so there is not necessarily any change in their consumption of housing services. Some of the $6,000 goes to principal payments, which are a form of saving, allowing the household to put less in the bank. So, in fact they need not change consumption or saving at all!

In fact the classic view predicts exactly what common sense predicts: No, the family does not make radical $100,000 changes in its consumption plans thank you very much.

But what about the extra $100,000 of "spending"? Doesn't the new house contribute to "aggregate demand?" What, in the classic view, goes down by $100,000?

The question is not the family's spending, but where did the $100,000 come from, and what were they going to do with the money?

Most likely, someone was saving money, and put it in a bank. If this family didn't take out the loan, another family would have (perhaps at an infinitesimally lower interest rate) done so, and the economy would have built a different house. Or perhaps the money came from an investor in mortgage-backed securities, who would have built a factory instead. These are where the $100,000 offset in aggregate demand comes from, and why the family's decision to take out the mortgage need have no effect on aggregate demand.

Can something go wrong in that process?  Sure. That's what real analyses of stimulus think about. But those like myself who, reading theory and evidence, come to the conclusion that stimulus doesn't work well, do not come to that conclusion because we think the family will spend $100,000 less!

To me, this example illustrates beautifully how Krugman "got this wrong." He never asked where the $100,000 loan came from!  In his analysis of  government borrowing and spending, he does not ask, who lent the money to the government, and what were they planning to do with it otherwise.  People "with an economics training" are supposed to remember lesson one -- follow the money and pay attention to budget constraints. His stimulus is manna from heaven, not borrowed money.

Good advice to anyone: If you get up one morning with the brilliant insight, "Bob Lucas thinks that a family who takes out a $100,000 mortgage will reduce consumption by $100,000," have a cup of coffee, settle down and think, "Wait, Bob's a pretty smart guy. Did I get this wrong somehow?" before hurling insults Bob's way in the New York Times' blog section.

(Note, this is about Krugman's analysis, not stimulus in general. There are plenty of serious analyses of fiscal stimulus that do not make simple logical errors. The plausibility of their assumptions and how they fit the data is an interesting topic. For another day.)

PS: Why is it my new year's resolution not to respond to Krugman blog posts?

Really, what do you do with a guy who insults fellow economists, while admitting in writing that he doesn't even read the opeds and blog posts that are the cause for his insults (let alone their actual academic work, where ideas can be documented and defended)?  He often doesn't even link or name the articles he's criticizing so his readers can decide for themselves!

If you don't believe me, look here , here, here, here and... well, I could go on. Just search his column for anyone he disagrees with. (And dear New York Times, is there anyone left in the journalistic ethics or fact-checking department?)

The best answer to that sort of thing is silence. Which I resolve to maintain, along with that diet and hitting the gym....

Taking A Peek At 2012.

Everyone worth his/her salt is making projection about the 2012. There is almost unanimity in the blogosphere that Euro is going to crash and we will see a repeat of 2008/9. So everyone is bearish biased in varying degree. Doomsday drummers like ZH, Mish, Prechter  et all are having a field day predicting the coming demise of Eurozone and return of the civilization to the stone age. We are encouraged to buy guns, bullets and canned foods. In the mean time, readership surges, ad-revenue and subscriptions come pouring in. They or their sister companies sell bonds by the bucket and deposit the much maligned fiat currency in the same TBTF banks on which they heap scorn every day. Not a bad business model, eh?

Yes, the OECD nations have piled up Trillions upon Trillions of dollars of debt and they will find it more and more difficult to service those debts and sustain them. But it is not going to be one straight line down from here. Trading in the stock market is different from fundamental macro economic analysis. Just look at Japan. It has over 200% of debt to GDP ratio and yet the yen is stronger than ever. How do you explain that? If Greek drachma was in existence, I am sure it would have been severely weaker today as a result of the debt problem of Greece.  Then how come JPY is stronger despite Japan having the highest debt in the advanced world? Just shows that there is no straight answer and things are much more complicated than ZH can explain.

How do you explain then that the commercials are net long EURO is a massive way since Sept 2011? These are the big guns that move the market. They are building up the position slowly and will possibly continue to build up long positions. People like ZH, Mish and Prechter just help them, either willingly or unwillingly, to divert attention from the slow and steady built up of their long position, so that the retail continue to sell.

The following is a weekly chart of EURO.
If you compare these two charts, you will note that while EURO was going up from Jan 2011 till end of April 2011, the commercials were building up short positions.The commercials went long from September and Euro has reached its lowest of 2011. Basically the same point where it started the year. So what has changed if I may ask? Why are these people screaming end of EURO?

Also note that there is no immediate relation between price movement of EURO and long or short position of the commercials. But ultimately, price follows the action of the commercials and that is a long term play.
I am not implying that EURO will start going up from tomorrow as a trend change. All I am saying is that the end of the world does not appear to be in the calendar of 2012.

Look at what the commercials are doing with the SPX index futures. This is different from ES.
Compare this with the weekly chart of SPX.

Commercials were net short of SPX from January 2011 till 1st week of August 2011 while SPX went up. They were net long between Mid-August 2011 till Mid-October 2011 when the markets went down. So the commercials are way ahead of the curve. Now they are short again from end of October. So we can be sure that a down turn is coming. May not be tomorrow. But when that down turn comes, just know that it has been planned months and months in advance. That the coming downturn has got nothing to do with whatever nonsense ZH, Mish or Prechter is saying.

This is what I call being unbiased. Trading  is serious business and modern economics is far more complex. So let us separate BS from trading. Hope this last post of 2011 will help explain my methods and approach to the market. Thank you for following me in Twitter (@BBFinanceblog). Please retweet to your family and friends and visit to profit from the world of finance.

Once again, wish you a very happy New Year.

William Blake art from The Book of Urizen

 William Blake etching with watercolor & ink (Tate collection).

Happy New Year

Bad policies are not enough to derail the most powerful economic engine the world has ever seen -- the US economy.

Here is where we are headed in 2012:

Higher stocks prices, lower bond prices.

A slowly expanding economy -- roughly 2 percent. Because of the way GDP is measured, the reported numbers will bounce around, but should average about 2 percent for 2012 as a whole.

China will stumble but recover. Bad government policy will be overcome by the hard work and entrepreneurial spirit of ordinary Chinese. China will continue to be on a roll.

Europe will sink further into the abyss. The failure to rationalize sovereign debt problems (meaning the failure to begin some managed default process) will mean negative economic growth in Europe for 2012. At the end of the day, it will turn out that Europe is less important than everyone thinks. Except for very isolated situations, Europe as an economic entity has been moribund for a generation. That situation will only become more obvious in 2012.

Emerging markets will plod along, but if you own emerging market stocks, you'll wish you had bet on the US market by year end (same as 2011).

Growing disparities in the Western economies between the haves and the have nots. But, not what you think. The "haves" in the Western economies are those with "protected" jobs -- public employees, teachers especially, people that work for Universities, heavily regulated industries,companies that are basically the government (Fannie, Freddie, etc.), and elected politicians.

The have-nots in the Western world are those in the bottom half of the income spectrum -- the aged, the young and poorly educated, the minorities. These folks are going to see their situation deteriorate more in 2012, mostly because of the impact of government policies that have built up over the past fifty years.

Inflation will begin to be significantly more visible in 2012, but runaway problems are still a couple of years or more down the road. It will feel good in 2012, but the seeds of future problems will be evident.

So, 2012 will be a plus year and will feel better for the "haves" than 2011.

Friday, December 30, 2011

Final Friday of 2011.

We ended the year almost exactly where we started it. 2010 year end SPX was at 1257 and 2011 year end SPX is also at 1257. And the whole year I was possibly the only one shouting that we are not going to see a repeat of 2008/9.

In between we had Euro crisis, tsunami in Japan, nuclear leak and radiation risk, uprising in Middle East, debt drama in Washington and countless stories of end of the world and collapse of the monetary system by doomsday prophets. I personally think that it not the debt of the world but the bomb of the mullahs which will tank DOW. But I also think that it will not happen in 2012. Don’t get me wrong. I think we will see DOW 5000 but I differ as to how and when we will reach there. In the mean time, there is money to be made on the long side as well.

Yesterday I wrote that the last trading day is going to be bit iffy. The market churned around in a small range and the selling occurred in the last 30 minutes.  Sort of cleaning the book. I would have been happy to get a green end but nonetheless, the uptrend is well intact. This rally started from 20th December and I am long from 19th. I am not happy with my position of TBT but otherwise I am OK. I think there are few more days in the coming week for this rally to complete its course.  On December 26, I wrote ( ) that a typical Santa rally consist of last five trading days of December and first two trading days of January.  If you look at the close-up of the last year (December 2010 – Mid-January 2011), most of the gains of 2011 came in the first fortnight of January.

I do not see any reason why it would be any different this year.

The short term cycle top is next week. So I will be playing it very fine. I will Tweet immediately to the readers whatever market action I take. On the other hand AUD is showing good promise with a target of 1.0325 next week.

So I am not very keen to go short immediately either. 

Not much should be read in today’s market action. It is just too much of a coincidence that the SPX closed exactly where it was at the end of 2010. Whoever believes in efficient market theory must also believe in tooth fairy.

For those who are fairly certain of the breakup of Euro, I have some news. The commercials are net long Euro in a massive way. We are likely to see a short squeeze sometimes in January which will hurt lots of bears.

So far as the recession in USA, I would present two news reports;
·         Baltic dry index is showing growth.

So let us trade what we see, not what we believe.  We cannot afford to be permanently long or short based on our bias. At least not I.

I take this opportunity to thank you for reading my blog and following me in Twitter (@BBFinanceblog). I hope you will continue reading and recommend it to your family and friends as well.  I wish you and your loved ones a very happy New Year. 

Last Trading Day Of The Year.

We are almost there. Another six hours and we will be done with 2011 stock trading. I expect the market to churn around, making lots of noise but not doing much. Few points up or down. Most likely we will end the year in positive. So nothing is to be taken seriously unless some earth shaking headline comes out of somewhere. At the point of writing this post, European markets are up nicely. So let us see what happens in USA.
In the mean time, you may want to read, enjoy and forget the following from Lee Adler. Just to demonstrate that liquidity is important. The views expressed are not my own and I do not necessarily subscribe to hyperbole. But it is nice to read and know what others are thinking.

The ECB is borrowing U.S. Dollars from the Fed to bailout European banks. And that is in addition to the Long Term Refinancing Operation (LTRO)
However, the "borrowing" is not called "borrowing."  It's called a "temporary U.S. dollar liquidity swap arrangement."  Yet it is really borrowing because it's going massively in one direction for the purpose of giving the ECB Dollars to lend to European banks, so the ECB can avoid lending more Euros. The ECB doesn't want to tarnish its "inflation fighting" reputation and further devalue the Euro. Instead, the Fed is taking billions of Euros as collateral for the Dollar swap.  
As Gerald P. O'Driscoll Jr., former vice president and economic advisor at the Federal Reserve Bank of Dallas, and senior fellow at the Cato Institute, wrote in the WSJ (The Federal Reserve's Covert Bailout of Europe): 
"The ECB would also prefer not to create boatloads of new euros, since it wants to keep its reputation as an inflation-fighter intact. To mitigate its euro lending, it borrows dollars to lend them to its banks. That keeps the supply of new euros down. This lending replaces dollar funding from U.S. banks and money-market institutions that are curtailing their lending to European banks—which need the dollars to finance trade, among other activities."
U.S. Banks and financial institutions do not want to lend European Banks more Dollars, and it would look bad for the Fed to do this unpopular lending directly, so the Fed has found an indirect route.  
"The two central banks are engaging in this roundabout procedure because each needs a fig leaf. The Fed was embarrassed by the revelations of its prior largess with foreign banks. It does not want the debt of foreign banks on its books. A currency swap with the ECB is not technically a loan."
In exchange for Euros as collateral, the ECB gets non-technically loaned Dollars which it then lends to European banks. The additional Dollars flowing to the EU banks enable the ECB not to release more Euros to the EU banks and into circulation. According to O'Driscoll, this "Byzantine financial arrangement" was designed perfectly to confuse people. 
"The Fed's support is in addition to the ECB's €489 billion ($638 billion) low-interest loans to 523 euro-zone banks last week. And if 2008 is any guide, the dollar swaps will again balloon to supplement the ECB's euro lending...
"The Fed had more than $600 billion of currency swaps on its books in the fall of 2008. Those draws were largely paid down by January 2010. As recently as a few weeks ago, the amount under the swap renewal agreement announced last summer was $2.4 billion. For the week ending Dec. 14, however, the amount jumped to $54 billion. For the week ending Dec. 21, the total went up by a little more than $8 billion. The aforementioned $33 billion three-month loan was not picked up because it was only booked by the ECB on Dec. 22, falling outside the Fed's reporting week. Notably, the Bank of Japan drew almost $5 billion in the most recent week. Could a bailout of Japanese banks be afoot? (All data come from the Federal Reserve Board H.4.1. release, the New York Fed's Swap Operations report, and the ECB website.)
"No matter the legalistic interpretation, the Fed is, working through the ECB, bailing out European banks and, indirectly, spendthrift European governments. It is difficult to count the number of things wrong with this arrangement." (The Federal Reserve's Covert Bailout of Europe)
Mr. O'Driscoll argued that the Fed has no authority to bailout Europe. (Although lack of authority has not stopped the Fed from acting in the past.) Ben Bernanke met with Republican senators on Dec. 14 to discuss the crisis in Europe. According to Sen. Lindsey Graham, Bernanke told reporters that the Fed did not have "the intention or the authority" to bailout Europe. Nevertheless, the week Bernanke claimed he was not going to conduct an EU bailout "the size of the swap lines to the ECB ballooned by around $52 billion." 
O'Driscoll also argued that swap arrangements "foster the moral hazards and distortions" resulting from government intervention in the credit markets. "Allowing the ECB to do the initial credit allocation—to favored banks and then, some hope, through further lending to spendthrift EU governments—does not make the problem better." Moreover, this is another example of the Fed's lack of transparency. Non-transparency is a consistent theme of the Fed, in spite of Bernanke's promises to provide more openness. Bernanke's statement just two weeks ago that the Fed had no intention of bailing out Europe is consistent with a long history of secrecy and deceptive behavior. 
Distinguishing between the swaps (camouflaged loans from the Fed to the ECB) and the LTRO (loans from the ECB to EU banks), Lee Adler explained, 

"The USD swaps totaled almost 84 billion so far, while the ECB lent a net of $289 billion in the LTRO last week after rollovers.
"All central banks create money. That is their function. How they do it, whether by direct lending to government through direct purchase of government debt, or through lending to private institutions or purchasing private debt is a matter of a nuanced difference regarding the conduits through which the money flows into the financial system, the markets, and the economy. It’s a question of targeting.
"The biggest difference between the Fed and the ECB is that the ECB has always lent to all the European banks. Until 2007, the Fed only conducted operations with Primary Dealers. From 2007 to 2010 the Fed had direct operations with a variety of financial institutions. Since QE2, the Fed has gone back to dealing only with the PDs."
Apparently not anymore. The Fed is now using currency swaps to lend to the ECB which is taking the Dollars and lending them to European banks in exchange for a new, and more broadly defined types of collateral. As discussed in this week's Stock World Weekly, Money for Nothing and Your Debt for Free, the ECB's latest LTRO "is making it possible for eurozone member states to sell assets such as government buildings to banks, whereupon the banks turn the properties into asset-backed securities which are then pledged as collateral for borrowing from the ECB... WSE's Russ Winter observed, the ECB just was handed a gigantic can of worms. The ECB balance sheet is now up to $3.5 trillion USD...
“Illustrating the nature of this circular transaction, Bloomberg reports that Unicredit and Intesa, two insolvent Italian banks are using “state guaranteed bonds” as $52 billion collateral to throw at the ECB. So rather than even using actual Italian sovereigns, the ECB accepts something more nebulous down the food chain...”
Here's a chart Lee sent me from the ECB's website showing the expansion of assets on the ECB's balance sheet. The numbers on the y-axis are in millions, so the assets are rapidly approaching 2.75 trillion Euros (around 3.5 trillion Dollars).

Lee concluded, "The Fed has opened an unlimited credit line with the ECB and other central banks for which it has so far lent billions of Dollars, with Euros as collateral. The Fed is bailing out European banks; that's not in dispute. The ECB is the guarantor and the conduit, but the banks are the recipients of the bailout, and the Fed's balance sheet is expanding as a result of the loans to the ECB."
Stay tuned. Lee is going to describe how the US Government bond market collapses, and thus, the world ends, shortly.

Another Economist Off The Rails

Laura d'Andrea Tyson has now joined the chorus of academic economists spouting economic nonsense. (Although Tyson is more a politico and a professional board sitter these days and is definitely one of the 1%).

Tyson has a piece in today's NYTimes attacking the Wyden-Ryan proposal to reform medicare that would move medicare more into the free market. Tyson notes that the cost of medicare, in the past ten years (and especially in the last three years) has grown more slowly than private insurance. That is an absurd comparison.

Medicare grows by whatever it's budget is and that's that. Private insurance is beset by changes in state legislation (and virtually every state has dramatically altered it's health insurance rules making them more expensive by mandate) in the past ten years. Tyson also seems relatively unconcerned that medicare has a $ 66 Trillion unfunded liability into the future while private insurance has a zero unfunded liability into the future.

Tyson's argument is like saying if I buy now, pay later, then the cost is zero.

Reading Tyson's piece in today's NYTimes is one more trip down the anti-capitalism roadway that so many "star" economists seem to have taken. Economics to these folks is more about have the right politics than about economic logic and economic facts.

Before medicare came into existence, health care was cheap and plentiful and health insurance cost almost nothing. Go back and read newspapers and articles about health care in the world pre-1964 and you will find that health care was a backburner issue. Health care did not become a major problem until the last thirty years and most of our problems with health care provision have to do with too much government, not too little.

The free market is the best way to allocate a scarce resource. Subsidies for the less affluent are a humane way to deal with poverty and low income families. Entitlements for Warren Buffett and Bill Gates are a prescription for disaster and result in a $ 66 Trillion unfunded liability. Where are economists when we really need them?

Thursday, December 29, 2011

Gold and Investment

Most thoughtful observers realize that the US and the major Western economies are going to have significant inflation at some point. It is unlikely that politicians will ever deal forthrightly with the entitlement issues and the only thing left is to monetize the debt -- print money -- and hope that rampant inflation will destroy the value of the outstanding sovereign debt. An interesting future.

The conclusion that some draw is that gold (and perhaps other precious metals) should thrive in a world of out-of-control inflation and the absence of a safe haven asset. It is an appealing idea and gold has done well in recent years, until recent months.

But, how do you value gold? or silver? Normally things have some alternative use. But the prices of gold and silver are way beyond any alternative use value. Gold could trade anywhere -- up or down. There is no way of establishing a value for gold.

Should gold be a part of a diversified portfolio? No. But gold mining companies should.

Which brings us to the Hedge Fund industry in 2011. The hedge fund industry has stubbed it's toe big time by holding outsize positions in gold and in gold stocks. Why? What "expertise" that is worth paying money for leads a hedge fund to take a huge long position in gold? What are the analytics? Is it simply that Europe is imploding and the US is next? Is that it?

Is their some serious analytics behind the huge gold positions taken by hedge funds in 2011 or is this simply the herd instinct speculating in something with a bubble-like recent history?

Back On Track

I laid out the case for continued uptrend in my last night’s report. And here we are, back on track to the cycle high sometime next week. ( )

Tomorrow is going to be bit iffy. On one hand, retail investors will sell their underperforming stocks to book capital loss; on the other hand many fund managers will attempt to buy stocks that have done well in order to make their balance sheet look pretty. I think there is a nice term for that kind of things; “window-dressing”.  For many of these managers, hanging on to their jobs is more important than the best interest of the unit holders. No wonder then that $135 billion have supposedly gone out of US Equity Mutual Funds. It seems 34 of the last 35 weeks have shown an outflow.

I personally think that the mutual funds have outlived their utility. They underperform the market and charge more to the unit holders. With the introduction of various ETFs, why would anyone put their money in mutual fund? May be ten year down the line, there will be no mutual funds. Good riddance!

I think tomorrow will still be a green day to end the year on a positive note.  Apart from my cycle analysis and other predictive tools, which indicate continuation of the uptrend, it has also to do with that “window dressing” effect.  You may be aware of something funny called the “Weekend Effect”.  The "weekend effect" is the name given to the phenomenon that U.S. stock prices are lower at market opening on Monday than they were at close of business on Friday. This is also known as the "Monday effect".  Kenneth R. French, currently the Carl E. and Catherine M. Heidt professor of finance at the Tuck School of Business at Dartmouth College, was one of the first economists to identify this phenomenon, in 1980. His research, published in the Journal of Financial Economics, showed that average returns for Mondays were lower than those for the rest of the week, and were often negative. Much has changed between that research and now and it should be taken with a pinch of salt in the normal course. But we are talking of Santa rally which is a different thing altogether. All these form a part of behavioural finance and have been subject of many research papers over the years. Successful trading is a serious business.

I am waiting for TBT to make a good progress and may be that wishful thinking will be rewarded in January. The other major story for the day was the hammering in the price of gold. Zerohedge has been paddling gold vigorously for many months now and I wonder what kind of investment strategy they are following. I do not think we are done with selling in precious metal by any long shot.
That is the bottom line for today. Stay safe and stay focused. Thank you for your continued support and following. Please join me in Twitter (@BBFinanceblog) and invite your friends and family to join as well, if you think it will benefit them. Visit regularly to profit from the world of finance. 

Lao Tzu on prediction

Those who have knowledge, don't predict. Those who predict, don't have knowledge. - Lao Tzu. $$Thu Dec 29 21:08:13 via web

The Fed's Mission Impossible

A Wall Street Journal Op-Ed  reviewing the latest  Fed's proposal (press release) to regulate big banks -- and, soon, everyone else. Here's the much more fun introduction, which we had to cut for space,
Imagine that your brother-in-law and his 5 buddies are heading for Las Vegas. Again. You already cosigned the refi on his house, and it was only a last-minute wire to the bail bondsman that got him out of the slammer last time.

So, you’re going to have another little kitchen-table talk about “the rules.” This time, no lending to your buddies (“limits on credit exposure”). No buying rounds of drinks (“limit dividend payouts and bonuses”). And for God’s sake, don’t lose it all on one silly bet (“stress test”). Keep some cash for the flight home (“liquidity provisions.”) No pawning the wife’s engagement ring for one last double-or-nothing (“leverage limits”). And if I hear there’s trouble, I’m going to come out myself and make sure you don’t overdo it. (“Early remediation”)

Sure, he says, with a twinkle in his eye. Because you both know he’s got your credit card, and you’re not going to let your sister live in poverty (“systemically important”). And you can’t talk about her dumping this lug (“breaking up the big banks”), or at least stopping these Vegas trips (“Volker Rule”), not unless you want to sleep on the couch for a month (“Dodd Frank”).
On to the real oped:

The Fed's Mission Impossible

The Federal Reserve last week announced its new "Enhanced Prudential Standards and Early Remediation Requirements" for big banks, as required by the Dodd-Frank law. You have to pity the poor Fed because it faces an impossible task.

The Fed's proposal opens with an eloquent ode to the evils of too-big-to-fail and moral hazard. And then it spends 168 pages describing exactly how it's going to stop any large financial institution from ever failing again.

More capital is at least a step in the right direction. But the Fed's capital proposals don't go nearly far enough. Putting less than one investor dollar at risk for every 10 borrowed dollars seems laughably low when we're guaranteeing the debts. With a 50-50 chance of a banking tsunami coming across the Atlantic from Europe, you wonder why the Fed is allowing any dividends at all.

But there's nothing here to solve the deeper problems. The last generation of smart MBAs got around capital requirements by pooling risky assets into "AAA" securities that had lower risk weights, and then putting those securities in special-purpose vehicles with off-balance-sheet credit guarantees. VoilĂ ! Same risk, no capital. I can't wait to see what they come up with this time. Diligently following risk weights, European banks built capital ratios by selling good loans and keeping "risk-free" sovereign debt.

The Fed's proposed "credit limits" are a revealing mess. They seem simple and obvious—big banks can't bet more than 10% of their equity on a single counterparty.

But on second thought, it's not so obvious. This wasn't the problem we had in 2008. Banks didn't fail because they lent to other banks. We had a classic run: Investors pulled money from banks that lost a lot on mortgage-backed securities. Yes, banks take too much risk. But they have no incentive to take stupid undiversified counterparty risk.

Credit limits are not so simple either. Suppose you buy a $100 Bank of America bond. OK, you have $100 at risk, though usually there is some recovery in default. But what if they give you $102 of collateral, yet that collateral might be hard to sell or stuck in court for a while? How does a regulator measure that risk? Or what if loans from A to B are funneled through shell company C using derivatives? Ten percent of equity is less than 1% of assets, and a tiny fraction of gross exposures, so measuring it right will matter a lot.
How does the Fed address these problems? Read the 22 pages of overview with 39 separate explicit questions. Translation: Help! We have no idea how to measure and regulate "credit exposure" for modern banks.

The Fed's proposed "triggers" for "early remediation" are interesting attempts to regulate the Fed, not the banks. The Fed recognizes that last time "while supervisors had the discretion to act more quickly, they did not consistently do so." Triggers will force the machinery to action.

Or will they? You're a regulator facing a bank in trouble. If you label it in trouble, you will start a panic in markets. This is the inherent contradiction—your job is to prop up banks, not cause runs. We'll see.
The Fed goes on to a chilling list of "corporate governance" rules, gems such as: "The covered company's board of directors (or the risk committee) must oversee the covered company's liquidity risk management processes . . . [and] determine whether each line or product has created any unanticipated liquidity risk." Well, duh, isn't that what boards do? Why must this be written into federal regulations, with force and penalty of law?

The Fed's proposal exemplifies what a recent editorial in these pages described as Washington's "badly written bad rules." Everything under the sun gets regulated, with no attempt to measure benefits or costs. Sure, as the Fed make clear, Dodd-Frank is to blame, but it could fight back just a bit.

Big picture time. Is any of this going to work?

For 70 years, our government has sought to stop crises by guaranteeing more and more debts, explicitly with deposit insurance, or informally with predictable too-big-to-fail bailouts. Guaranteeing debts gives obvious incentives to gamble at taxpayer expense, so we try to limit risks with regulation. But big banks still have every incentive to avoid, evade and financial-engineer their way around the rules, and they have lots of lawyers, lobbyists and ex-politicians to pressure regulators to use their wide discretion. The government has lost this arms race time and time again. Will this new round of rules, and greater discretionary supervision, finally stop too big to fail?

The depressing scenario is that the six big banks will use this massive regulation as an anticompetitive fortress. We will have the same six big banks 30 years from now, spurred to even greater size with continuing subsidies, cheap Fed-provided financing, the government guarantee, and occasional bailouts. And a financial system as innovative as the phone company, circa 1965.

The only hope I see is that nimble, new small-enough-to-fail competitors will spring up and rebuild the financial system. But this is faint hope in the face of the vast discretionary powers in last year's Dodd-Frank financial legislation and the Fed's rules, which allow the government to step in whenever they decide that a financial risk is "systemically important."

What is not "systemically important?" How I can I build a new financial company that demonstrably causes no "systemic" danger—and is therefore not subject to the Fed's onslaught of regulation, discretionary supervision and "remediation"? How can I assure my creditors that they will receive the legal protections of bankruptcy court, and not be dragged into some arbitrary and politicized "resolution"?

The Dodd-Frank legislation never defines "systemic" or, more importantly, its absence. Under the law, the Financial Stability Council can just "determine" that any company might have "serious adverse effects on financial stability." They can consider any "factors that the Council deems appropriate." The Fed proposes to subject any company to "other requirements or restrictions" if it thinks existing rules do not "sufficiently mitigate risks to U.S. financial stability."

There is nothing to say that a risk to "financial stability" can't be, for example, taking profits away from the big six, or a failure that takes money away from an influential voting bloc. Don't laugh: Life insurance companies were bailed out in 2009 at least in part so they could keep up payments on guaranteed-return retirement products.

The Fed does not propose any such limit to its powers or describe how it will encourage a financial system free of too-big-to-fail firms. The Fed's report has instead a searching inquiry on how it can expand its powers, and how it can begin "designating" and regulating companies beyond the big banks.

If we are going to get out of the guarantee-regulate-bailout trap, we must legally define what is not too big, and what can, will and must—by absence of legal authority—fail. If the government won't break up too-big-to-fail banks, we must at least allow competition to do it.

Wednesday, December 28, 2011

Professor Cochrane and Dodd-Frank

Professor John Cochrane of the University of Chicago opines today on the implementation of "too big to fail" in the Dodd-Frank legislation in the Wall Street Journal. As Professor Cochrane notes, the Dodd-Frank structure has nothing to do with the problems that beset the financial industry in the 2008 collapse but instead empowers arbitrary control of the US financial institutions by an unelected bureaucracy, accountable to no one.

Cochrane, correctly, redirects our attention to the stifling impact the Dodd-Frank "reforms" are having on our financial system and, as a result, on our economy. Economic stagnation by design. That's the Dodd-Frank regime.

The spirit of Dodd-Frank has breathed life into an anti-lending campaign by bank regulators the past two years. The result -- a bifurcation in the lending market. For those who don't need credit, it is available in abundance. For those who need credit, it is prohibited by the activities of the regulators. Obama could change this, but he chooses not to.

The time to tighten lending standards is during the boom, not during the bust. Tightening lightening standards during the bust just prolongs the bust. Why isn't that obvious?

Nightly Report. December 28, 2011

I am kicking myself at the back for violating my own trading principals. I have been writing for the last three days that a correction is expected and necessary for further up move. And yet I did not take profit and re-enter at a lower level like I did during the last pullback. Most likely I was complacent or I did not properly estimate the size of the correction. Just proves that every now and then the market shows you who the boss is. We all do our song and dance to win the heart of a fickle sweetheart but there is no guarantee. One momentary lapse of concentration, one deviation from the trading principles and we end up flat on the back. Luckily for me, there was no actual loss, but I feel that I have missed out on an opportunity.

Two things I was and am fairly confident of. I believe SPX will be near 1300 or exceed it during this cycle and a correction was needed / on the way before we reach that target. So now that we have the correction, next four days should be in line with the projection. I work with many parameters. Cycle analysis, TA, sentiment analysis, liquidity flow, market noise analysis, and different time frames and so on, so forth. So far, notwithstanding the 1.2% correction in SPX I think we are on course for a high next week.  The correction of today should not derail that conclusion. Let me present few TA which everyone can apprehend.

First the daily chart of SPX.

It seems the correction stopped on the sloping tend line.

Next is the NYMO.

We have drawn another trend line through the sloping tops of the NYMO and here also the correction has stopped well above the line.

NASI is showing that the trend is intact.

Also let us look at the seasonality factor again.

I will be drawing your attention to this chart few more times next week as well. As you can see, the market behavior is consistent with the seasonality factor. There were no external factors disturbing the market today. This correction was totally expected and now we can move forward. I will continue with my analysis and I will come back with further post at night if I think I have found anything serious which will make me change my mind about the market tomorrow.

Also remember, today was a Major Distribution Day and in the normal course the day after is green. Add to that the seasonality factor.

Last thing for the day is gold. If you recall my last post on gold ( ) I mentioned that if GLD breaks the long term trend line, there may be additional problem for gold.

As you can see, GLD broke that line today, although still half in. And it is much oversold. So again, we may see some near term bounce but when the stock market tops next week and starts major correction, we may see more downward pressure in gold.

Once again, thank you for following me in Twitter.(@BBFinanceblog) I know lots of you have  great following, so please retweet to your friends and followers. Let more people benefit. Visit regularly and profit from the World of Finance.

Tuesday, December 27, 2011

Nightly Report. December 27, 2011

Tonight’s report will be short as nothing much has changed from last week and not much action in the market either.

I wrote on December 23 that I am expecting a minor correction by December 27, 2011.                                ( )  Although we had a slight dip in DIJA, the SPX and Nasdaq ended the day in Green. Tomorrow morning would be the only last chance of a dip before we go flying higher. I added a tiny little bit to my existing long position as I was waiting for a bigger pull back which did not arrive. Let us see how tomorrow unfurls. However one more buy signal was initiated today, as follows:

As you can see, this has been a very reliable indicator in the past and should run at least for few more days. This is a lagging indicator and is just a confirmation of the existing trend.

AUD is continuing with its continuation pattern and is possibly setting up a base for the spring forward. I expect AUD to move up-to 1.0265 in the next two days and finally test 1.0370 before getting rejected. That will also signal the time to close the entire long positions. The funny thing is, I do not even trade forex.

During my intraday tweet I mentioned that I am disappointed with TBT. I know for sure that US Bonds are on a downward cycle but it is not being reflected in the price of TBT. I hope it also races through the gate in the next few trading days.

Once again, I urge readers not to be biased. The concept of bull vs. bear exists only in the mind of retail investors and traders. For the big boyz, no such silly difference exists. They can be both at different time, sometime switching sides multiple times in a day. Very soon, may be within seven trading days, we will also change our costume and wear the bearskin.

We have sowed the seeds for this trading cycle; the fruits are hanging and getting ready for harvesting. Till the time is ripe, let us be patient. You cannot force the grain to ripen before its time, nor can you open the door of the microwave oven before that slice of pizza has been heated up properly. Try it yourself and you will know what I am talking about.

I am extremely thankful for your show of support and for following me in Twitter (@BBFinanceblog). Till I set up a Facebook page for the blog, the Twitter is going to be my major way of communicating with my readers. Please forward this to your friends and family, who might benefit from unbiased trading. Visit regularly to profit from the world of finance.

AUD In The Morning.

I expect a quite start , may be a bit lower opening for the day. Understandable after a long holiday. And nothing goes up in one straight line. But European markets are in positive after Asia closed in marginal red. AUD has been in a consolidated pattern for much of yesterday. To get an idea of what is expected of AUD, I enclosed the following two charts.
I wrote last week that I expect some weakness on December 27 or December 28, but any weakness should be minor. I would like to add to my long position on weakness.

Friedrich Hayek on Keynes (1978 interview)

F.A. Hayek discusses John Maynard Keynes in this 1978 interview clip.

More Goofball Economics

Today's NY Times has yet another economist in action. Nancy Folbre, whose byline in today's blog puts her at University of Massachusetts as an "economics professor," argues that "...most ordinary people understand that the incentives built into the global capitalist system tend to reward some very bad behaviors." She then goes on to list things like "dumping waste products into the environment" and other capitalistic ills.

That would suggest that where there is no capitalism, there must be no real environmental damage. Is she kidding? The non-capitalist countries lead the league in environmental pollution. Try breathing the air in a typical non-capitalist country. I guess Professor Folbre doesn't travel much.

So, what does Professor Folbre recommend? She cites "calls for changes to articles of incorporation that would allow companies to pursue social missions without fear of shareholder litigation." What a great idea! Who would buy stocks with the knowledge that companies could toss company assets down the chute in pursuit of whatever "social mission" that Professor Folbre approves of? Do we all agree what a "social mission" is? Is my social mission the same as your social mission?

What is truly unbelievable is that Professor Folbre teaches young minds about economics. No mention in her blog today that only countries with capitalism can afford professors who indulge in this kind of nonsense. Countries without capitalism and who pursue "social missions" are mired in poverty, corruption, and, yes, environmental degradation. The non-capitalist countries don't have the luxury of blog-writing economics professors who detest capitalism.

Monday, December 26, 2011

So, What Is A Santa Rally?

We have been talking about a Santa Rally and many readers may be wondering what that really means. Simply put, it is a seasonally proven rally when the stock market forges ahead in the last five (5) trading days of the year and the first two (2) trading days of the New Year. This seven days rally propels the market in a higher orbit and is a general indication of the health of the stock market. May be you can read the following;

I have been shouting the whole year that irrespective of what Robert Prechter and Zerohedge is saying, we are going to see a doomsday scenario anytime soon in 2011. There may be volatility but that is just a trading opportunity.  90% of the trading is done by the 50 largest investment bankers of the world. These bankers, also called Too Big To Fail (TBTF) bankers, have no other source of making profit, apart from the speculative profit. Their traditional source of income is almost gone. They are saddled with huge bad assets in their books. The only way they can survive is by making money through other revenue. So they generate these huge up and down waves. They buy at the bottom, create a rally, sell high and then start the cycle all over again. I have a feeling, Zerohedge is just an instrument in the hands of the TBTF bankers to create that fear and panic where the retail always sell short and are unable to take advantage of the rally. I may be wrong. May be those good folks are being manipulated to act like a bonehead. But either way, they are not very smart traders, contrary to what they would like us to believe.

Take this current rally for e.g. I have seen people selling, getting short from 1255 level in SPX. Just because SPX rallied from 1202, does not mean that we have sell now. The following is an actual conversation from one board. I have deleted the names for confidentiality;

“I am trading rydex only funds. I went 30% short on friday close. expecting a pullback as per your earlier report. Now you are expecting 1310/1290 so I am thinking of going long 70 % / short 30% next tuesday. If there is any pullback I close short and go long 100% as we are expecting higher high.

Question - 1. Below which price you think we should close out longs.

I would like to see how you are thinking/planning your trades as per your technical edge.  I do understand this are all probbality and nothing is gauranteed. Its more to see inside masters brain. I dont day trade so have to plan ahead of time.

thanks “

Pity this guy because he did not use his own brain and went short when he should not have.

 Every indicator tells us that more upside ahead. Seasonality is solidly backing us. No bond issue in Europe till the 2nd week of January. Volumes are light. Why would you short now? We would rather short the market at the end of the 1st week of January, when seasonality tells us that the market will correct itself.  But folks have been brainwashed to believe in the end of the world story. The irony is, bear market comes at the height of euphoria.  It never comes with announcements.

In various boards I see newbie traders, eager to make a quick buck, all excited about the coming fall of the stock market. The statistics tell us that 4 out of 5 retail traders will underperform the market. One of the major reasons of underperformance is to come to the trading arena with a bias or pre-defined mindset and expect the market to confirm to that bias. It never happens.  Market does opposite of what you would expect.
We still have this last trading week and the next to wrap up this rally and we will take it up from there. Just remember, the days of buy and hold investment type is gone forever.  As a retail investor, trader, we can still make decent money playing the game even if it is rigged. Occasionally we will lose, but if the winning percentages are higher than losing, then we should be feeling good.

I have started this blog as a part of my doing good karma. I do not ask for donations, I do not want you to click on ad to generate adsense revenue. In fact, I use Adblock and suggest everyone to use it.  I only want more and more people to be successful trader and donate a percentage of their profit to any charity of their choice. I will continue with this blog, only if I see continuing and growing interest from readers. If you think you are benefiting from my analysis and calls, I urge you to forward this blog ( ) to all your friends and family, tell them why you like it and bring in more and more readers.  Without growing and sufficient interest, it is just a waste of my time. So dear readers, please do your good karma and encourage others to join my Twitter (@BBFinanceblog). That will keep me motivated.
See you tomorrow.

Health economics by anecdote

In a big-think post  "Is capitalism sustainable" on Project Syndicate, Ken Rogoff put in this little zinger
A third problem is the provision and distribution of medical care, a market that fails to satisfy several of the basic requirements necessary for the price mechanism to produce economic efficiency, beginning with the difficulty that consumers have in assessing the quality of their treatment.
Ok, a difficulty of the blogging/oped medium is that you have to keep things short, and I too hate to be quoted for little snippets out of context...But, really, Et tu Ken?

It's hard to know if the car mechanic is doing a good job. Get ready for the Federal takeover of the car industry. I can't tell B grade exterior from A grade interior plywood, so we need a Federal takeover of home rehab. Vets and dentists operate outside of the mass of stifling health care and insurance regulation, so I guess they're in for the treatment next.

Is it really that much harder to assess the quality of treatment for all health care than the other services we receive? For all medical care, not just extreme cases? Actually, my doctor complains that everyone who comes in has spent a week on the internet and knows too much about treatment options. The internet is ushering in a grand era of star ratings and consumer information.

Where is the evidence? Just this sort of armchair argument has been used for centuries (remember the guilds?) to justify competition-stifling regulation of all sorts of businesses.  Milton Friedman's PhD thesis showed that licensing doctors was good for raising doctor's salaries, but didn't do much for the quality of health care. (His later essay on health economics is still a classic.)

And as always, the real argument for the free market is not that the market is perfect, but that the government is usually far worse. Do we have any evidence that government regulators assess the quality of care better than the people whose lives and money are at stake? Is there any vaguely plausible way that the small asymmetric information in health care justifies the monstrous system we have constructed?

Rant over. But really, there is a lot of harm passing around anecdotes like these as if they are agreed-on economic facts, representing both documentation and a serious cost-benefit tradeoff of viable alternatives. 

(I've written a bit more on free-market heath insurance here. ) 

All the world's troubles in 10 minutes

Last month, John Taylor asked me to give some  lunch-time remarks at a conference on "Restoring Economic Growth" at the Hoover institution. "Oh," said John, "Just talk about what's going on in Europe and how to fix the U.S. economy. Keep it to about 10 minutes." As any economist knows, it's easy to talk for an hour and nearly impossible to talk for 10 minutes. Then I looked at my fellow panelists, who turned out to be George Schultz and Alan Greenspan. Heady company, I feel like a kid again.

The euro crisis,some emerging thoughts on how to create a run-free financial system, a review of why everything on the current policy agenda does not have a prayer of working, and a note of cation to economists'  collective habit of jumping from bright idea to policy. (There is a permanent version on my webpage)

In case you’re not reading the papers, we’re in financial crisis 3.0, a run on European banks stemming from their sovereign debt losses.

This is not high finance. European banks have been failing on sovereign debt since Edward III stiffed the Perruzzi in 1353. This is not a “multiple equilibrium,” a run of self-confirming expectations. People are simply getting out of the way of sovereign default, since it’s pretty clear that governments are at the end of the bailout rope.

By dutiful application of bad ideas and wishful thinking, the Europeans have turned a simple sovereign restructuring into a currency crisis, a fiscal crisis, a banking crisis, and now a political crisis. They could have had a lovely currency union without fiscal union. The meter in Paris measures length. The Euro in Frankfurt measures value. And sovereigns default, just like companies. They could do what George Schulz beautifully called the “simple obvious” things, and return to the kind of strong growth that would let them pay off large debts. Alas, the ECB is full in, both buying debt and lending to banks who buy debt, so now a sharp euro inflation – which is just a more damaging and wider sovereign default -- seems like the most likely outcome.

How did we get here? Financial crises are runs. No run, no “crisis.” People just lose money as in the tech bust. (Let me quickly plug here Darrell Duffie’s “Failure Mechanics of Dealer Banks.” This wonderful article explains exactly how our financial crisis was a run in dealer banks.)

For nearly 100 years we have tried to stop runs with government guarantees -- deposit insurance, generous lender of last resort, and bailouts. That stops runs, but leads to huge moral hazard. Giving a banker a bailout guarantee is like giving a teenager keys to the car and a case of whisky. So, we appoint regulators who are supposed to stop the banks from taking risks, in a hopeless arms race against smart MBAs, lawyers and lobbyists who try to get around the regulation, and though we allow – nay, we encourage and subsidize –expansion of run-prone assets.

In Dodd-Frank, the US simply doubled down our bets on this regime. The colossal failure of Europe’s regulators to deal with something so simple and transparent as looming sovereign risk hints how well it will work. (European banks have all along been allowed to hold sovereign debt at face value, with zero capital requirement. It’s perfectly safe, right?)

The guarantee – regulate - bailout regime ends eventually, when the needed bailouts exceed governments’ fiscal resources. That’s where Europe is now. And the US is not immune. Sooner or later markets will question the tens of trillions of our government’s guarantees, on top of already unsustainable deficits.

What financial system will we reconstruct from the ashes? The only possible answer seems to me, to go back to the beginning. We’ll have to reconstruct a financial system purged of run-prone assets, and the pretense that nobody holds risk. Don’t subsidize short-term debt with a tax shield and regulatory preference; tax it; or ban it for anything close to “too big to fail.” Fix the contractual flaws that make shadow-bank liabilities prone to runs.

Here we are in a golden moment, because technology can circumvent the standard objections. It is said that people need liquid assets, and banks must borrow short and lend long to provide such assets. But now, you could pay for coffee with an electronic transfer of mutual fund shares. The fund could hold stocks, or mortgage backed securities. Nobody ever ran on a (floating-NAV) mutual fund. With instant communication, liquidity need no longer coincide with fixed value and first-come first-serve guarantees. We also now have interest-paying reserves. The government can supply as many liquid assets as anyone wants with no inflation. We can live the Friedman rule.

Short-term debt is the key to government crises as well. Greece is not in trouble because it can’t borrow one year’s deficits. It’s in trouble because it can’t roll over existing debt. Governments can be financed by coupon-only bonds with no principal repayment, thereby eliminating rollover risk and crises. The new European treaty, along with wishing governments would mend their spending ways, should at least insist on long-maturity debt.

You may say this is radical. But the guarantee – regulate – bailout regime will soon be gone. There really is no choice. The only reason to keep the old regime is to keep the subsidies and bailouts coming. Which of course is what the banks want.

On to the US: Why are we stagnating? I don’t know. I don’t think anyone knows, really. That’s why we’re here at this fascinating conference.

Nothing on the conventional macro policy agenda reflects a clue why we’re stagnating. Score policy by whether its implicit diagnosis of the problem makes any sense: The “jobs” bill. Even if there were a ghost of a chance of building new roads and schools in less than two years, do we have 9% unemployment because we stopped spending on roads & schools? No. Do we have 9% unemployment because we fired lots of state workers? No.

Taxing the rich is the new hot idea. But do we have 9% unemployment – of anything but tax lawyers and lobbyists -- because the capital gains rate is too low? Besides, in this room we know that total marginal rates matter, not just average Federal income taxes of Warren Buffet. Greg Mankiw figured his marginal tax rate at 93% including Federal, state, local, and estate taxes. And even he forgot about sales, excise, and corporate taxes. Is 93% too low, and the cause of unemployment?

The Fed is debating QE3. Or is it 5? And promising zero interest rates all the way to the third year of the Malia Obama administration. All to lower long rates 10 basis points through some segmented-market magic. But do we really have 9% unemployment because 3% mortgages with 3% inflation are strangling the economy from lack of credit? Or because the market is screaming for 3 year bonds, but Treasury issued at 10 years instead? Or because 1.5 trillion of excess reserves aren’t enough to mediate transactions?

I posed this question to a somewhat dovish Federal Reserve Bank president recently. He answered succinctly, “Aggregate demand is inadequate. We fill it. ” Really? That’s at least coherent. I read the same model as an undergraduate. But as a diagnosis, it seems an awfully simplistic uni-causal, uni-dimensional view of prosperity. Medieval doctors had four humors, not just one.

Of course in some sense we are still suffering the impact of the 2008 financial crisis. Reinhart and Rogoff are endlessly quoted that recessions following financial crises are longer. But why? That observation could just mean that policy responses to financial crises are particularly wrongheaded.

In sum, the patient is having a heart attack. The doctors are debating whether to give him a double espresso or a nip of brandy. And most likely, the espresso is decaf and the brandy watered.

So what if this really is not a “macro” problem? What if this is Lee Ohanian’s 1937 – not about money, short term interest rates, taxes, inadequately stimulating (!) deficits, but a disease of tax rates, social programs that pay people not to work, and a “war on business.” Perhaps this is the beginning of eurosclerosis. (See Bob Lucas’s brilliant Millman lecture for a chilling exposition of this view).

If so, the problem is heart disease. If so, macro tools cannot help. If so, the answer is “Get out of the way.”

People hate this answer. They want to know “what would you do?” What’s the bold new plan? What’s the big new idea? Where is the new Keynes? They want FDR, jutting his chin out, leading us from the fear of fear itself. Alas, the microeconomy is a garden, not an army. It grows with property rights, rule of law, simple and non-distorting taxes, transparent rules-based regulations, a functional education system; all of George’s “simple obvious steps,” not the Big Plan for the political campaign of a Great Leader.

You need to weed a garden, not just pour on the latest fertilizer. Our garden is full of weeds. Yes, it was full of weeds before, but at least we know that pulling the weeds helps.

Or maybe not. This conference, and our fellow economists, are chock full of brilliant new ideas both macro and micro. But how do we apply new ideas? Here I think we economists are often a bit arrogant. The step from “wow my last paper is cool” to “the government should spend a trillion dollars on my idea” seems to take about 15 minutes. 10 in Cambridge.

Compare the scientific evidence on fiscal stimulus to that on global warming . Even if you’re a skeptic, compared to global warming, our evidence for stimulus -- including coherent theory and decisive empirical work -- is on the level of “hey, it’s pretty hot outside.” And compared to mortgage modification plans, strange “unconventional” monetary policy, the latest creative fix-the-banks plan, and huge labor market interventions, even stimulus is well-documented.

There are new ideas and great new ideas. But there are also bad new ideas, lots of warmed over bad old ideas, and good ideas that happen to be wrong. We don’t know which is which. If we apply anything like the standards we would demand of anyone else’s trillion-dollar government policy to our new ideas, the result for policy, now, must again be, stick with what works and the stuff we know is broken and get out of the way.

But keep working on those new ideas!

Sunday, December 25, 2011

How to destroy the middle class

In a splendid recent editorial piece, The New York Times  distilled every bad idea floating around the liberal policy agenda.

A few choice moments:
"Economic growth alone, ... would not be enough to restore the middle class"..."To lift wages requires generous tax credits for low earners, a higher minimum wage, and guaranteed health care" ... "Job training efforts" 
That is, after all, how our ancestors got off the farm.
"...the [jobs] bill recently filibustered by Republicans would have created an estimated 1.9 million jobs in 2012."
I didn't know the tooth fairy was making economic "estimates" these days.
..."unrelenting political pressure for principal write-downs of underwater loans, expanded refinancings for borrowers in high-rate loans, and forbearance for unemployed homeowners." 
Econ 101 quiz. What happens to the unemployment rate if you don't have to pay your mortgage so long as you don't get a job?
"..all forms of income to be taxed at the same rates"
That means dividends and capital gains at the 39.5%  rate. Well, at least it's consistent. If you don't believe in saving and investment, taxing the heck out of them should do the trick.  
 "a financial transactions tax."..."high-end tax increases.. to control the deficit"....  "public education, Social Security, unions, child care, affirmative action and, not least, campaign finance reform"
Read on, (how to destroy the) "Middle Class Agenda" at the New York Times

A continent of bad ideas

Why does noone see that Europe can have a nice currency union without fiscal union? I tried to put together this and some of the other bad ideas that I think are clouding the euro crisis debate in this post on the IGM/Bloomberg "business class" blog.

By artful application of bad ideas, Europe has taken a plain-vanilla sovereign restructuring and turned it into a banking crisis, a currency crisis, a fiscal crisis, and now a political crisis..

Read more here

More Nonsense from Academic Economists

Peter Diamond (MIT) and Emmanuel Saez (Berkeley) recently published an article in The Journal of Economic Perspectives (Fall 2011 issue) entitled: "The Case for a Progressive Tax: From Basic Research to Public Policy." This article exhibits the total absurdity of modern academic economic research.

The point of the article is to show the "scientific" case for progressive taxes. Their conclusion: the highest marginal income tax rates should approach 80 percent! That is the conclusion of Diamond-Saez so-called science.

Here are a few of the assumptions in this "science:"

1. "Because the government values redistribution, the social marginal value of consumption to top bracket taxpayers ...can be ignored..."

Transalation: rich people don't value income at all so they won't miss it if it is taxed away. (Note this is an assumption!) You might wonder how Diamond and Saez know what "the government values" (or what that expression even means). They don't elaborate. They just make the statement "...the government values..." and then they fill in the blanks. Must be nice.

Here's another "scientific" assumption:

2. "Since the goal of the marginal rates on very high income incomes is to get revenue in order to hold down taxes on lower earners, this equation does not depend on the total revenue needs of the government."

Translation: regardless of whether government spends anything we should tax rich people at the highest possible marginal rate so that we can redistribute income.

3. "..the tax avoidance or evasion component of the elasticity e is not an immutable parameter and can be reduced through base broadening and tax enforcement."

Translation: By eliminating all deductions and exemptions and taxing capital gains and all other forms of revenue to high income tax payers as ordinary income, we can eliminate any tendency to avoid taxes.

Turns out this is utter nonsense. All the wealthy have to do is borrow the necessary money to live their lifestyle and not show any income at all -- ordinary or capital income. Consider Warren Buffet. He could just borrow $ 100 million per year and live on that without showing any income for tax purposes at all. Diamond and Saez are probably unaware that high income folks borrow, so they have ignored this among the myriad other things this "scientific" study has ignored.

Or, alternatively, high income folks could move to a country with more rational policies regarding income taxes. Diamond and Saez did not consider that possibility. Perhaps, they should talk to the states of California and New York to discover whether high marginal rates drive people away.

Here's the ridiculous conclusion of this "scientific" paper: "Thus we have identified basic research findings that we find relevant in thinking about practical tax setting......the case for higher rates at the top appears robust in the context of this model."

The above is what passes for economic research in modern academia, along with the argument that increasing minimum wages increase employment. Next, I guess we will be reading about how enacting maximum home price laws will revive the housing market. You can't make this stuff up. This is why tuition levels are going through the support this nonsense.

Saturday, December 24, 2011

The Poverty of "Economics"

An article in this morning's NYTimes by Catherine Rampell outlines the minimum wage increases that are coming on the 1st of January in eight states. As if lower income employees don't have enough problems this Christmas season, leave it to politicians (and economists) to make their lives worse.

The minimum wage increases will take place in Arizona, Colorado, Florida, Montana, Ohio, Oregon, Vermont and Washington. Note that some of these states are controlled by Republicans, some by Democrats. This is bi-partisan mischief.

Imagine that these same states passed a law saying that a gallon of milk can't be sold for less than $ 10 per gallon. Would dozens of economists step forward with studies showing that milk consumption would be unaffected by this kind of law? Would there be a bi-partisan consensus that a minimum price of milk is a good idea and would promote milk drinking? But, precisely this kind of absurd reasoning is brought forward to defend minimum wage laws (and their increases). Economists are notorious for putting forward their partisan political views as if they were science.

Minimum wage laws are an infringement on the freedom of contract and they deny job opportunities to people who need them. Those who might wish to work free as a way of gaining skills are legally prohibited from doing so. Those with skill sets below the minimum wage level would like to have a job at a lower wage (rather than no job at all), but are forbidden by law to have that first step up the ladder.

Why not just pass a law saying that poor people should be required to stay poor by law? That would have an effect similar to that of minimum wage laws. Economists and politicians who support minimum wage legislation should be ashamed of themselves. Perhaps we should pass a law saying that economists should be paid $ 10,000 per hour or otherwise be forbidden to work. Then, perhaps, economists would begin to understand the pernicious effects of minimum wage laws.