Rah, rah Pat Buchanan

Pat Buchanan makes a strong argument against US imperialism. In particular, he points out that the outrageous defense budget is the only place that can be usefully cut amid stark budget choices.

Go Pat.

The small window of economic prosperity

I claim the current economy must fit within a small window of economic parameters to be sustainable. That window is reasonably low unemployment (say, <10% or so) and reasonably low inflation (say, between -2 and +10%) . Also, severe downturns in the stock market (such as the 40% drop this month) may make this window even smaller. If we fall outside this window we run the risk of a major systemic meltdown, and I hope and expect the financial centers are mindful of this problem. Here's my reasoning:

Fixed pensions are part of the economy. Social security is the biggest, but all manner of private and public pensions also fit within this system. These pensions require either taxes (for government fixed pensions) or investment growth (for private pensions and, for that matter, for endowment-based funding). If the stock market tanks that reduces government revenues for lack of capital gains taxes. California got hit very hard by this in 2001 when the flow of dot com cap gains stopped cold. Similarly, declining housing prices hurt city coffers hard.

But cap gains taxes are chump change. The real money is in income tax. As unemployment rises it eventually reaches a point where wages are depressed. Then income tax revenue gets a double whammy: fewer people making lower salaries. That puts a severe strain on either federal or state government budgets. Ordinarily, this running deficit may not be catastrophic, but the effect is unknown when major deficits are tacked on to the nation's $10 trillion debt.
If we're already running $600 billion yearly deficits and the budget balloons to $1.2 trillion yearly deficits, something's got to give. Bankrupt pension plans ensue triggering downstream problems.

A similar problem ensues with deflation (i.e. negative inflation). It's simply hard to fill the pension and general tax coffers which is problematic when servicing $10 trillion in debt.

Let's look at a different scenario. Say inflation runs hot: 10% a year for several years. This scenario is by no means pessimistic. Then the pensioners are squeezed however. Within 7 years real values are cut in half. Again, pensioners can't survive.

Essentially, our economy is built on an assumption of modest inflation and unemployment.

Financial Rashomon: one brief history of the financial crisis

A timeline for reference:

• 1997 - Brooksley Born warns Congress about unregulated derivative markets
• 1997 - The securitization of mortgages (MBS=mortgage-backed securities) begins by Fannie Mae and Freddie Mac providing a market for shaky CRA (Community Redevelopment Act) loans
  
• 1998 - Housing prices start to rise
  
• 2000 - The Internet Bubble bursts: trillions in market value lost
• 2000 - Greenspan starts lowering interest rates drastically to promote home ownership
• 2004 - SEC allows the 5 top investment banks to increase their leverage from 12:1 to 36:1
• 2005 - Dollar starts a plunge against the Euro, losing half its value in 2-3 years
  
• 2006 - Oil starts rising dramatically. Peak oil is implicated, but it appears that the pricing was driven by speculation AND the collapsing dollar
• 2006 - Housing reaches its top
• 2007 - Stock prices of several financial institutions reach all-time highs
  
• 2008 - Major financial institutions start failing, March: Bear Stearns, September: Fannie Mae, Freddie Mac, and Lehman
• 2008 - The Enron loophole is closed in July: prices pull back from high of $142 per barrel
  
• 2008 - Congress passes $800 bailout package in October, stocks fall 40% in two weeks.

In this scenario, the oil bubble was part speculation, part dollar collapse, and unknown smaller contribution of peak oil. At any rate, oil (and wheat) price surges were a distraction from the main event.

Also, in this scenario, sub-prime is a problem, but is not the major problem. It does appear that 1997 securitization of shaky mortgages initially triggered the rise in housing prices which started in 1998, but cannot account for the scope of the current problem. Rather the major problem is the excessive leverage starting in 2004 for MBS and other derivatives. It appears that only the 5 investment banks that sought, got and used the 36:1 leverage ratio were pulled into this mess, though obviously other commercial banks had their own difficulty.

In short, the banks went derivative crazy and formed a standard tulip-bulb internet-stock bubble. The complexity of the derivatives made them very difficult to value, but they were monetary instruments so the market assumed SOMEBODY had a handle on it. The trouble with this bubble is that the standard market losses from the bubble are exacerbated by a meltdown of the global financial infrastructure.

Corporate Responsibility

One plausible report, of unknown credibility, says that Treasury intends to ignore the CEO pay restrictions imposed on EESA. The issue is not itself important since executive pay did not cause the crisis, but serves as a useful point of departure to discuss who should bear the costs of the crisis. In short, both the overly risky investment strategy and out-sized executive pay are failures of ownership.

I argue, therefore, that shareholders should bear the primary costs, but criminal charges may be appropriate for both executives and boards of directors. My reasoning is straightforward: ownership is responsible for ensuring that management is doing the right thing. If ownership lets management unwisely risk the entire value of the company they should pay the price (first).

Apparently three days before filing bankruptcy, Lehman's board approved $100 million in executive payouts. As long as it doesn't affect the US taxpayer I see no need to intervene in
this nonsense. On the other hand, if there's criminal culpability involved, as seems likely if not probable, I encourage prosecution.

Surprises thus far in the financial crisis

Brandishing comparisons to the great depression and, less frequently but perhaps more persuasively, the panic of 1873, pundits have been blathering at the mouth but not saying much useful about the economic crisis.

It appears we're headed for a global recession/depression. Aggregate US wealth has contracted by $10-$20 trillion in the past year, with analogous drops in other countries (particularly in the past couple weeks). Several major differences between the economy now and the economy of 1929 (or earlier) argue AGAINST the notion of using the Great Depression as a lens to understand what's in store for the economy.

Three things surprise me about this crisis so far:

• It is truly global. The mortgage problems are largely a U.S. situation, yet the problems in the US have spread ("when the U.S. economy catches a cold" the world economy gets pneumonia). Given the decline of US economic hegemony and some conditions local to the US (falling dollar, housing crisis) it's rather surprising that the world economy has been hit so hard. True, European banks seem to have bought some of the problem mortgage-based securities, but still the global nature of the problem is a surprise.
• Deflation not inflation. For those of us who believe in only spending money you have, it seems that the $10 trillion national debt and the urge to create money out of thin air (as Ron Paul and others say), would have an inflationary effect, but this does not SEEM to be the case yet. Crude oil prices are dropping, for example, although some have noted that the drop in crude oil prices started when Congress closed the Enron loophole in July. Perhaps the vaporization of $10-$20 trillion in U.S. wealth has a deflationary effect. Did I just say that?
  
• The "big boys" may be big but there not that smart. One reason Goldman is doing so well is that they hedged on the mortgage problem before it spun out of control. Nevertheless, the Investment banks, the commercial banks, the Fed, and the Treasury all seem to have consistently misunderstood the nature and extent of the problem. Even Warren Buffet and Paul Krugman don't seem to be acquitting themselves well in this regard. How could the smart investment banking crew have failed to understand the simple notion that bad mortgages that have been securitized do not become good mortgages. The free market is based on assumptions of rationality. Wall Street is renowned for having smart people, but greed apparently over-rode pure rationality and, in the absence of market transparency (where investors could rightfully judge the worth of these mortgage-based securities), the free market is simply not free.
  

A slideshow

This is a good slideshow by Sequoia Capital, a VC firm.

Some excellent graphs about the economy and business. Ignore the VC-specific stuff (past, say slide 33).

My favorites are:

• slide 6 DOW and inflation over time
  
• slide 13 distribution of mortgage types at 2002, 2007
  
• slide 14 home prices over time
  
• slide 19 comparison to Japan
  
• slide 25 (MEWs: Mortgage Equity Withdrawals)
  

Debate #2

Actually, it was just debate #1 repeated with questions from the audience instead of a moderator.

In general nothing interesting happened. McCain said some more nonsense, but let me criticize Obama in greater detail.

Obama didn't seem inclined to follow the rules of the debate (much more so than McCain). An unattractive Palin-like attribute.

Further, did you catch the part where Obama said the US economy is strong? Sounds an awful lot like McCain's "fundamentals of the economy are strong" line for which Obama criticized McCain.

Obama also seemed disinterested in allowing for the possibility that the economy will get weaker before it gets stronger. He seemed needlessly naive there, apparently trying to avoid a phantom political missstep of negative talk of the economy.

In general, both Obama and McCain seemed woefully out of touch with the general public. And it still disappoints me that there is noone representing any of the wide range of viewpoints that says the threshold for war should be much higher than Iraq and/or the United States should not be the policeman to the world. (this view encompasses Kucinich, Paul, Pat Buchanan, Dorr's Rebellion and K).