A few things to keep in mind during the coming days (amv)

by Peter Boettke

(1) While there may be macroeconomic problems, there are only microeconomic solutions;

(2) Microeconomics is about the structure of incentives and the quality, accuracy of the information (and its interpretation) that economic actors face and utilize in their context of action; The institutions of property, prices and profit/loss provide incentives and information to market participants;

(3) Economic life is a process of constant adaptations and adjustments to changing circumstances, and these adjustments primarily are guided by relative price shifts, the lure of profit, and the penalty of loss;

(4) Inflation is damaging, deflation is damaging --- as Mises once put it, trying to cure the problems created by one by following the other is analogous to someone after driving over a bystander with their car in an effort to try to fix things by backing up over them to undo the damage;

(5) Wealth creation results from realizing the gains from trade and the gains from innovation, not government investment.If there is no bailout, then the stock market will go down, more financial institutions will fail, and unemployment will rise. But resources will not go into a black-hole, they will be reallocated and utilized in alternative uses. To leave with some words of wisdom from Adam Smith:

"The natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principle that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often incumbers its operations; though the effect of these obstructions is always more or less either to encroach upon its freedom, or to diminish its security."

Source: Austrian Economist

Bailout failed in Congress (amv)

From Cochrane: Dear Congress.. (fg)

..

To the Speaker of the House of Representatives and the President pro tempore of the Senate:

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America's dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.

You find the complete list of subscribers here.

Most insightful analysis of financial crisis and the bailout (amv)

On the financial crisis: Mankiw, Rogoff, Merton, among others. 1:36h at Harvard. Watch here.

Kling's talking points for not doing a bailout (amv)

1. We don't need to bail out Wall Street to protect Main Street. All we have to do is make sure that sound borrowers, especially small businesses, have access to credit. Banks can do the job, although regulators may have to reduce capital requirements.

2. The mortgage securitization industry is brain-dead. If it does not revive on its own, we should not spend taxpayer money trying to resuscitate it.

3. The stock market seems to want a bailout. While I hope for higher stock prices, I think that public policy needs to take into account more than just daily fluctuations in the Dow. In 1971, the market gave a huge thumbs-up to wage and price controls, which turned out to have damaging economic effects that persisted for years.

Source: Econlog

What would Hayek say? (amv)

Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. . . . To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end. . . . It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression.We must not forget that, for the last six or eight years, monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown. (1932)

Therefore:

Let Them Fail by Peter Boettke

The market economy is a profit and LOSS system. Imprudent decisions do require correction --- if not by the individuals themselves, then by others who enter into the market in the hope of realizing the profit opportunities others are mistakeningly leaving on the table. This is how markets work; this is how markets self-correct. The self-correction properties of the market economy is perhaps the most important lesson of economic science (not an issue of faith) that must be communicated to the general public. Unfortunately, this fundamental truth of economic theory is one of the first casualty of crises.Firms enter and exit all the time in a vibrant market economy. During my days as an economist/Sovietologist one of the factoids I peppered my public talks with was the number of bankruptcies in NYC in one month in 1995 versus the number of bankruptcies in all of Russia from 1991 to 1995. The number in NYC swamped the number in Russia. Firms get driven from the market, executives who made poor decisions lose their jobs, and industries that no longer meet consumer demands become obsolete. Was it a crisis for water-carriers to be driven from the market by the innovation of indoor plumbing, or for the whaling industry in New Englad to be displaced when electric light became wide-spread.Resources do not disappear, they get reallocated. The market process is a mechanism for the continual re-evaluation and re-shuffling of scarce resources among alternative uses. This is what is meant when we refer to the market as a dynamic process of entrepreneurial discovery and learning.The most important "wisdom" of market process theory is to get out of the way of the process of adjustment. The poor decisions in one period must be penalized, the malinvestments made by businesses must be cleaned out, and the opportunities for hitherto unrecognized profit opportunities must be allowed to be exploited. Bailouts, regulations, taxes, redistribution, and inflation only hinder the ability of the market to self-correct.Besides the economics, there is also constitutional and ethical issues that should be considered when such sweeping legislation is proposed. Consider the classic essay "Not Yours to Give" by Davey Crockett. There is also a consequentialist issue at stake. A free society works best when the need for the policemen (read in this case regulator) is least. Individuals must be equiped to embrace the troubles of thinking and the cares of living if they are to live free as a self-governing citizenry.The consequences of our current policy path are dire in terms of economics, politics, and freedom.

Source: The Austrian Economists

U.S. Banking Conditions and Performance (fg)

These two figures may give you an impression why banks are heavily interested in provision-based finanical products and yhe they followed this stragety rather than simply reyling on the "classical" maturity transformation. Although interest rate margins decreased secularily the last decade, returns on equity remained stable until recently. Thanks to mututal funds, credit products & Co.

Some common sense (amv)

Good Thing We Have No 'Steel Policy' by Don Boudreaux

Regarding the current financial turmoil....Suppose Uncle Sam were the monopoly supplier of steel in the same way that he is the monopoly supplier of money. A (largely) independent board of Very Smart People meets monthly to determine the nation's steel supply. If this board gets matters correct, the resulting price of steel prompts producers and consumers to use steel wisely. But if the board guesses wrongly and, say, increases the steel supply too much, the market will overuse steel. Products that would have been better made with aluminum or plastic, or not made at all, will instead be made with steel. And production plans made in anticipation of a continuing 'easy steel' policy will be disrupted if the board changes course.

Unless this steel board gets things right with superhuman regularity, the structure of the economy will be become grossly distorted over time. In addition, producers and investors will be forever anxious about upcoming decisions of the steel board.

We avoid this fate because steel is supplied by markets, with competitive producers and consumers adjusting daily to new information about changing opportunities and costs of using and manufacturing steel. No one worries about getting the steel supply right, for markets do that job remarkably well.

Unfortunately, the same isn't true for money. Its supply is determined consciously by a board. Unable to know and adjust to changes in people's demand for money - and subject always to political pressures to grease the economy with the snake oil of easy money - the Federal Reserve distorts the economy with its inevitably mistaken decisions on the supply of money. Asset bubbles are part of the price we pay for this primitive way of supplying money.

Markets should supply money just as they supply steel - and experience (for example, Scotland and Canada in the 19th century) shows that they do so when given the opportunity.

Source: Cafe Hayek

Horwitz on the bail-out disaster (amv)

Capitalists, Capitalism, and the Siren's Song of Stability by Steven Horwitz

The current crisis demonstrates more than almost anything in recent memory what I call 'Horwitz's First Law of Political Economy': namely that "no one hates capitalism more than capitalists." Aside from the fact, much discussed here, that the crisis itself was largely brought on by easy money policies and government interventions supported by and benefiting capitalists even as they were undermining capitalism as a system and the well-being of the citizenry, the debate over the bailouts also illustrates the principle quite well.

"The Market" (which, as Heyne, Boettke, and Prychitko note, is a particularly bad metaphor for millions of individual decisions) rallied late last week as the bailout plan was conceived and publicized. Today, as the plan has got some pushback (though not always for the right reasons), "The Market" has taken another dive. The explanation, I think, is that capitalists prefer the stability and predictability of the known over anything unknown, especially when it promises to socialize their losses on the rest of us. Capitalists have long despised the uncertainty and unpredictability of a truly free market and have frequently succeeded at using the state to reduce that uncertainty (see also Gabriel Kolko and other historians of the Progressive Era). Of course this has benefited them, but it has harmed the economy and the citizenry in the process.

One of the things market capitalism does best is enable us to peer through the fog of uncertainty that surrounds human action. Prices provide signals for capitalists to interpret to try to provide the goods and services people will want in the future. Profits tell them they've done well at it, losses tell them they haven't. The competitive process is how we learn what it is people want and how best to produce it - and who is best at doing so. Competition is, in Hayek's words, a "discovery procedure." Competition sucks if you're one of the competitors. It makes you have to constantly be on your toes, watching for new entrants, new innovations, and changes in the relevant variables. How much easier life would be in a more stable and predictable world where capitalists didn't have to serve the fickle consumer! If we cut short this discovery process, and especially the mechanism of profit and loss, the benefits to the capitalists will not come from behaving in ways that benefit the rest of us.

This is precisely why those of us concerned with preserving whatever bits of capitalism we have left should be largely ignoring "The Market's" response to the various bailout plans. What's good for GM or the financial sector is not necessarily what's good for America. In fact what's good for America, might be very, very bad for the financial sector.

The desire for stability and predictability has been the calling card of dirigisme regimes since the dawn of capitalism, whether they called themselves "socialist", "fascist", or just plain "interventionist." It is but a thinly disguised power grab by those who own the means of production, and who will profit at our expense, rather than profiting by serving us better. "Stability" is a siren song that we must do our best to ignore, lest we enable them make an even bigger mess than they already have.

Source: The Austrian Economists

Kling's open letter to Bernanke (amv)

Dear Ben,

The Wall Street Journal reports,

"If it doesn't pass, then heaven help us all," responded Mr. Paulson

He is referring to legislation to authorize the next round of bailout activity by the Treasury, with rules, methods and accountability all to be determined. You should oppose this legislation. It is an attempt to avert a financial meltdown by means of a political and fiscal meltdown.

I fear you may be seeing this crisis through the lens of the Great Depression. Then, the wave of bank failures was an element in the severity of the downturn. However, keep in mind that there is still controversy over the relative weights of various causes of the Depression, and not everyone is convinced that bank failures per se were the main factor.

Today, it is clear that the U.S. financial sector needs to shrink. As another one of your former classmates, Ken Rogoff, has pointed out, the financial sector has accounted for an unusually large share of corporate profits in recent years. It is time for this country to shift talent and capital elsewhere. In order for that to happen, some firms in the industry need to tighten their belts, some weaker firms need to merge with stronger firms, and the weakest firms need to fail. As tempting as it is to intervene in this process to try to make it more orderly, dislocation is inevitable, and intervention may only make it worse.

We have excesses. Too many housing units. Too many "homeowners" who don't have equity in their homes and never did. Too many banks and financial institutions. The excesses need to be worked out by the markets.

Henry Paulson is not the first strong Treasury Secretary to appear in a crisis. John Connally held that job in the Nixon Administration, In response to a run on the dollar, he abandoned the Bretton Woods agreement and introduced wage and price controls. In the short term, this was well received, and it allowed the economy to rebound in time for Nixon's re-election. In the long run, it was a disaster, ultimately unleashing virulent inflation and, as oil prices rose, leading to the painful disorder of rationing and lines at gasoline stations.

Connally's cure was worse than the disease. I strongly suspect that Paulson's cure will prove similarly harmful.

My suggestion to you is that you get out of your financial industry cocoon for a while. Talk to people who are concerned about the direction that policy is taking, including former colleagues of yours in academia. A Central Banker should stand up to fear-mongering. Even when it comes from a Treasury Secretary.

Source: here

Check this too.

Why Paulson is wrong (amv)

Here, I still had some hope that government defined a limit beyond which it wouldn't go. Finally! Now, all hopes are gone. Prof. Zingales tells us why:

"The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it ill succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. Remember that in the Savings and Loan crisis, the government had to bail out those institutions because the deposits were federally insured. But in
this case the government does not have do bail out the debtholders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from the Paulson RTC.

[...] Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.

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

Last, Latest, Young Investors (fg)

Or: Who takes the losses when a bubble bursts and who learns the lessons?

Well, everbody knows it: there are ups and downs in financial markets, excess positive and negative returns, gains and losses, pessimism and optimism - and in the end, at least on average, market efficiency holds.

Well, everbody knows: too much leverage may do damage to financial markets and balance sheets; we all heard about the balance sheet and credit channel of monetary policy.

Well, everybody knows: when the bubbles burst, somebody has to take the losses since only few can leave the wave before it crashes.

Recent research shows that it's mainly young portfolio managers who try to ride the bubble; meanwhile more experienced managers wait until the bubble bursts to invest in assets. Taken together, the facts are consistent with the popular view that inexperienced investors are susceptible to buy assets with inflated prices druing bubble periods:

We use mutual fund manager data from the technology bubble to examine the hypothesis that inexperienced investors play a role in the formation of asset price bubbles. Using age as a proxy for managers' investment experience, we find that around the peak of the technology bubble, mutual funds run by younger managers are more heavily invested in technology stocks, relative to their style benchmarks, than their older colleagues. Furthermore, young managers, but not old managers, exhibit trend-chasing behavior in their technology stock investments. As a result, young managers increase their technology holdings during the run-up, and decrease them during the downturn. Both results are in line with the behavior of inexperienced investors in experimental asset markets. The economic significance of young managers' actions is amplified by large inflows into their funds prior to the peak in technology stock prices.

You find the paper on the NBER website. It is written by Greenwood and Nagel. It may also give an idea why we economists often wonder why in general investors do not learn lessons from past exuberances (since we often do not see it in the data) and young traders may play a significant role in that process.

Obama fights for sh**** jobs (amv)

Obama Promises To Stop America's Shitty Jobs From Going Overseas

The last 10 days (amv)

"The last 10 days have been the most remarkable period of government intervention into the financial system since the Great Depression." The anatomy of intervention: here.

Don't ban naked short-selling! (amv)

"There is very little evidence that stock market speculation has been an important contributing factor to the present financial crisis.

Law abiding stock market speculation contributes to market liquidity, making markets more allocatively efficient.

If the SEC is to be criticized for its handling of naked short selling, the agency should be criticized for caving to political pressure to ban the practice not for having been tardy in doing so. Short selling is a key component in maintaining market liquidity and naked short selling differs but little in this regard from standard short selling: “In permissible short selling, the party owed shares is the security lender (who used to own the shares before lending them for short selling), while the party owning the shares is the new buyer. In naked short selling, the party owed the shares is the new buyer, while the party owning the shares is (still) the current owner. The buyer in both cases is the same, so the price should not be different. The only difference is who acts as the effective lender of the security: in permissible short selling, the lender is the current owner; in naked short selling, the new owner acts as the effective lender. From a price perspective, it is difficult to see how that matters.” In short, the hysteria over naked short selling is, well, hysterics.

Even if naked short selling were a problem, it is not in any way related to the present financial crisis: ” Repeat after me: The trouble is not with short-sellers. The trouble is not with short-sellers. The trouble is with an over-levered financial system built on a house of cards comprised of under-collateralized toxic paper that was applauded all the way up by “housing is the American dream” nutters who couldn’t see that vast expansions in thinly-traded credit are a path to economic ruin.”

The uptick rule provided that a security generally could be sold “at a price above the price at which the immediately preceding sale was effected, or at the last sale price if it is higher than the last different price.” It was ineffectual in regulating short selling, did not prevent manipulation, and reduced market liquidity. It was a dumb rule whose time had come and gone. It died unlamented and unloved.

There is very little the SEC could have done to prevent the present financial sector problems. Sub-prime mortgages, commercial banking practices, use of the Fed discount window, and so on are all way outside the scope of the SEC’s jurisidiction."

HT Prof. Stephen Bainbridge

UPDATE: It's too late!

A money market fund busts! A money market fund! (amv)

"Reserve Primary Fund, the firm that basically invented the idea of a money market fund back in 1970 just saw its shares fall below $1 a share, which is about as close as money market funds get to going bust. This is the first time this has happened to a money market fund in fifteen years. The firm had almost $800 million in Lehman notes and commercial paper, now valued at $0. Money market funds borrow short and lend long (relatively speaking); once investors noticed all that toxic paper, things went south rapidly. This is only the second money market fund in US history to break the buck, which tells you just how worried you should be about the contagion of this mess."

HT: Megan McArdle

A really good job by Bernanke and Paulson (amv)

The Government Stood Firm. Was It the Right Call?

The source: Real Time Economics

The teaser: "The bottom line from the Fed: While it will was willing to take a pragmatic and expansive approach to preserving market stability, there are limits to its willingness to bail out firms that the market needs to understand. Its strategy: Let Lehman go and make sure primary dealers have lots of liquidity. That kept with the central bank’s lender-of-last resort authority and became a step toward extricating itself from the bailout game."

The rest: [...]

US Election 2008 (amv)

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