Category Archives: Financial Crisis

What a coincidence! Maybe better policy can lead to faster growth.

It’s fascinating to see those commentators and economists, who insisted for nearly a decade that 2% was the best the U.S. could do, grapple with the apparent uptick in economic growth and improving labor markets. Secular stagnation, technological stagnation, financial recessions are different, better get used to the “new normal” – these were the explanations (excuses?) for the failure of the economy to recover from the Panic of 2008. Millions of Americans had permanently dropped out of the labor market, robots were taking their jobs, or (paradoxically) technology was impotent, an aging population meant the U.S. would never grow faster than 2% again, and a global dearth of demand meant the economy would be stuck for many years to come. Wages for most workers weren’t growing, and inequality increased because of monopolies or greed or . . . whatever – anything but a failure of policy to encourage growth. Only bigger government could restart the stagnating secular engine, but even then, don’t expect too much.

All of the sudden, however, we’re hearing stories of tight labor markets, and 2017 will likely exhibit the fastest growth for a calendar year since 2006. We think there are three key reasons for the 2017 uptick: (1) an abrupt cessation of the anti-growth policy avalanche; (2) dramatic policy improvements, such as wide-ranging regulatory reforms and a major tax overhaul; and (3) the beginnings of a tech-led productivity freshening.

As Adam Ozimek (@ModeledBehavior) writes:

It’s refreshing to hear a mainstream economist call out the massive failure of the last decade – a devastating “growth gap” that we’ve been railing against for many years (also, e.g., Beyond the New NormalTechnology and the Growth Imperative; Uncage the Economy; etc.). It’s more than a little odd, however, that Ozimek singles out for criticism several economists who were arguing that the economy could have been growing much faster, if we’d let it, and were suggesting policies that could help boost employment. Shouldn’t he specifically call out the stagnation apologists instead? Isn’t the “giant mistake,” as Ozimek calls it, the insistence the economy was growing as fast as possible and the arguments that diverted attention from bad policy, unnecessarily slow growth, stagnating wages, and a huge drop in employment?

Growth Gap - thru 3Q 2017

Many stagnationists are now searching for possible explanations for the nascent uptick. Some are looking toward a possible resurgence of technology and the idea that productivity growth might improve from its decade-long drop. Larry Summers says the apparent uptick is merely a “sugar high” that won’t last. But you can see many of the stagnationists labor to avoid any acknowledgement that better policy might be at the heart of economic improvement. (By the way, I’m thrilled that our tech-led “Productivity Boom” thesis is getting this attention. The recent converts, however, seem to say that a new tech-boom is now inevitable, when just months or weeks ago they said tech was over. I think the policy improvements of 2017 will accelerate technological innovation in many lagging sectors.)

It’s too early to know whether these encouraging signs are the beginning of a long-term growth acceleration. But it’s good to see lots of people finally acknowledge the depth of the growth gap and the higher innovative potential of the American economy.

Extraordinary admission

Last night on Charlie Rose, Treasury Secretary Tim Geithner made an extraordinary admission. Here’s the exchange:

Rose: “Looking back, what are the mistakes, and what should you have done more of? Where were your instincts right but you didn’t go far enough?”

Geithner: “There were three broad types of errors in policy. One was that monetary policy here and around the world was too loose for too long.  And, that created just this huge boom in asset prices; money chasing risk; people trying to get a higher return; that was just overwhelmingly powerful.” 

Rose: “Money was too easy.”

Geithner: “Money was too easy, yeah . . . . Real interest rates were very low for a long period of time . . . .”

There you have it. Pretty simple. And yet it is the first time I can recall that any U.S. executive branch official, spanning the Bush and Obama Administrations, has admitted monetary policy was even one factor, let alone the central factor, leading to the crash. This is very big stuff. (more…)

Comparing collapses … and recoveries

Good historical analysis from Mike Darda:

Here we should look to three historical examples where aggressive monetary expansion was wedded to an aggressive fiscal policy: the U.S. during the mid-1930s, Germany through the 1930s, and Japan in the early 2000s. In each case there was a recovery, although policy errors led to significant setbacks. These episodes can help assess U.S. growth prospects, and the risks to a sustainable recovery.

The Great Depression in the U.S. came in two stages, a downturn from 1929-33 in which real GDP collapsed by 26.5% and unemployment rose to 25% from 3%, and a relapse in 1937-1938, with a 3.4% decline in real GDP and a rise in unemployment to 19% from 14%.

The first stage of the depression was associated with a collapsing equity bubble (1929), protectionist tariff legislation (1930), contractionary monetary policy (1931) and a sharp rise in tax rates (1932). Between 1934 and 1937, however, there was a rapid recovery, in part due to the severity of the downturn that preceded it. Real GDP expanded by 9.5% per annum, while the unemployment rate fell 11 percentage points.

The recovery was spurred in no small part by monetary policy. In 1933-34, the dollar was devalued against gold to $35 per ounce from $20.67 per ounce, which allowed the Fed to push reserves into the banking system. This allowed the Fed to finance FDR’s deficits with the printing press. After falling at an average rate of 6.7% per year from 1930-33, the Consumer Price Index rose by an average 2.7% per year from 1934-37.

Info-tech = recovery

In testimony before Congress’s Joint Economic Committee today, Fed chairman Ben Bernanke noted that

In contrast to the somewhat better news in the household sector, the available indicators of business investment remain extremely weak.

But it is these key business sectors that are most important for a U.S. — and global — economic recovery. As important as stabilization of the housing sector is, we are not going to be led out of the recession by another housing boom. Nor should we desire that. We need real productivity-enhancing innovation, which is largely enabled by non-real estate investment and entrepreneurship.

Among the myriad policy actions being taken in Washington this year is a potential overhaul of our communications strategy, under the aegis of the FCC’s new Broadband “Notice of Inquiry.” The first goal of this plan should be to to encourage the continued investment in leading-edge information technologies. Broadband communications especially makes all our businesses in every sector more productive and also connects an ever larger number of citizens, especially those who may be struggling the most in this tough economy, to the wider world, improving their prospects for education, health, and new jobs in emerging industries.

Information and communications technology (ICT) accounts for an astounding 43% of non-structure U.S. capital investment, totaling $455 billion 2008. In this new FCC communications policy review, we should do everything possible to keep this huge source of American growth rolling. Any policy obstacles thrown into the path of our information industries would not only reduce this crucial component of absolute capital investment, which is already under strain, but also diminish and delay all the positive cascading follow-on effects of a more networked workforce and world.

Understanding leverage, volatility, and the crash

One can critique Nobel laureate Robert C. Merton’s work on a number of fronts, from the CAPM model to his involvement with the 1998 failure of Long Term Capital Management. And he still doesn’t get to the true source of the current crisis — monetary policy and an erratic U.S. dollar. But I found this MIT lecture useful in explaining how changes in asset prices can drive both instability and volatility in a highly non-linear, pro-cyclical way and confound all the risk and economic models. Merton also offers a simple method to swap risk and improve returns using right-way contracts. (Hat tip: Gordon Crovitz.)

Banking history . . . and future

The events of the last 18 months came so fast and furious, it’s often difficult to remember what in any other time would be singular historic moments, let alone the chronology of the financial meltdown. So Don Luskin does a great service reminding us about just one of many dramas from 2008 — the Wells Fargo acquisition of Wachovia. This week Wells reported a $3 billion profit for the first quarter, shocking the Nationalizers and Depresionistas. How did this happen? Weren’t all the banks supposed to be insolvent? Au contraire:

Last September, Wachovia was the last domino to fall in the horrific sequence of financial firm failures — Fannie MaeFreddie Mac, Lehman Brothers, Merrill Lynch, AIG, Washington Mutual, and finally Wachovia. The Federal Deposit Insurance Corporation forced its acquisition by Citigroup. The deal was that Citi would pay a measly $1 per share of Wachovia, and the FDIC would invest $12 billion and insure Citi against any losses above certain threshold.

Then Wells came on the scene. It offered to buy Wachovia for $7 a share and told the FDIC that it didn’t need any investment or any guarantees. Believe it or not, Citi had the gall to sue to block Wells’ offer even though in every dimension it was superior for Wachovia stakeholders and for the American taxpayer.

You have to wonder what the FDIC was thinking in the first place. Citi had to take two huge capital injections from the U.S. Treasury under the TARP program in order to survive, and it had to have the Federal Reserve guarantee $300 billion of its toxic assets. So what was the point in having a bank that screwed up take over Wachovia?

Inquiring minds want to know. Maybe Wachovia wasn’t in trouble at all in September. Maybe it was always the diamond in the rough that it now so clearly is in Wells’ hands, and the whole idea was really to prop up Citi with Wachovia, not prop up Wachovia with Citi.

But now, even though Wells was conservative and well-managed during the boom, and could help lead the way out of the crash, it is nonetheless forced to comply with all the silly restrictions imposed by Treasury’s TARP.

no good deed goes unpunished. Back in October when Treasury Secretary Henry Paulson first implemented the new TARP program, he forced every major bank — including Wells — to take TARP money whether they wanted it or not. Wells Chairman Richard Kovacevich told Paulson no, but the Treasury Secretary said it was Wells’ patriotic duty to take the taxpayers’ money like all the rest. So Wells played the good soldier and took the money.

And now it’s sorry it did. Now, because it took government money it didn’t even want, its executives have been made subject to new compensation restrictions enacted by Congress and enforced retroactively. The idea was to make sure that the risk-happy fools who created the financial crisis in the first place now don’t benefit at taxpayer expense — but surely Wells shouldn’t be punished: it was one of the good guys.

Wells’ Kovacevich isn’t shy about complaining. In a speech last month, he said “Is this America — when you do what your government asks you to do and then retroactively you also have additional conditions? If we were not forced to take the TARP money, we would have been able to raise private capital at that time.”

Kovacevich isn’t fond of the Treasury’s latest rescue schemes either,  especially the “stress tests” to be applied to the 19 largest banks including Wells. He said, “We do stress tests all the time on all of our portfolios. We share those stress tests with our regulators. It is absolutely asinine…”

This crash is going to look much different upon reflection, isn’t it?

Diagnosing a meltdown: the CDS slide

Good analysis from, of all people, George Soros. The credit default swap (CDS)/no uptick/mark-to-market/regulatory capital interplay has been a killer. 

the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. . . .

The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.

Washington: Over the edge

Michael Lewis diagnosing political insanity as only he can:

1) To the political process all big numbers look alike; above a certain number the money becomes purely symbolic. The general public has no ability to feel the relative weight of 173 billion and 165 million. You can generate as much political action and public anger over millions as you can over billions. Maybe more: the larger the number the more abstract it becomes and, therefore, the easier to ignore. (The trillions we owe foreigners, for example.) (more…)

Bob and weave, bait and switch

Must reading from The Wall Street Journal on the never-ending AIG bailout and the political shenanigans and multi-billion-dollar cover-ups that go far beyond $165 million in contractual bonuses.

Taxpayers have already put up $173 billion, or more than a thousand times the amount of those bonuses, to fund the government’s AIG “rescue.” This federal takeover, never approved by AIG shareholders, uses the firm as a conduit to bail out other institutions.

China: Implosion or innovation?

Yet another remarkable dispatch from James Fallows on China’s attempts to navigate the global financial crisis. His conclusions:

(1) the Chinese people are less likely to revolt en masse in bad times than is often suspected. Even now, things are a lot better than ever before.  Fallows quotes one Shanxi province party official:

Do you understand? If it had not been for Deng Xiaoping, I would be behind an ox in a field right now. . . . Do you understand? My mother has bound feet

(2) China has at least a very good shot at achieving a truly innovative economy. Listing several new high-tech firms producing the best voice-recognition software he’s ever seen and some of the world’s most advanced batteries for everything from iPhones to new electric cars, Fallows writes: 

In Beijing, in Shanghai, in Shenzhen, and elsewhere, I’ve recently visited companies that are trying to use the disruption of this moment to enter wholly new markets and do what so few Chinese firms have yet done: make high-tech, high-value products that bring high rewards.

These largely mirror my own views. In fact I couldn’t help but notice Fallows’ concluding sentences:

Many Chinese companies will fail or make mistakes under today’s intense pressure. But many are using the moment to prepare for their next advance. The question for Americans to think about is how we are using the same moment.

Here were the final sentences of my economic history of China’s 30-year rise, released during last summer’s Beijing Olympics:

What seems undeniable is that the next hundred years will be a Chinese century. The biggest question for politicians and business leaders in the U.S. is whether, through a recommitment to entrepreneurial capitalism, it will be another American century as well.

Market up markedly after mark-to-market falls

Stock markets are up markedly after word spread the last few days that we would finally — finally — get some relief from mark-to-market, or “fair value,” accounting. The Financial Accounting Standards Board today, in a hearing before the House Finance Committee, promised new guidance on FAS 157 in the next few weeks. Many financial stocks are up 50-100% or more since Warren Buffett and many lawmakers commented on the need for reform at the start of the week.

The real credit, however, goes to Brian Wesbury, who’s been pounding away and comments on video here. To Steve Forbes, with his bold Wall Street Journal op-ed that opened the floodgates on the matter last week. And to David Malpass, who identified the mark-to-market problem over a year ago in early 2008.

The S&P 500 is up more than 10% since mark-to-market reform looked possible.

The S&P 500 is up more than 10% since mark-to-market reform looked possible.

Follow FDR just this once

Bravo, Steve Forbes!

What is most astounding about President Barack Obama’s radical economic recovery program isn’t its breadth, but its continuation of the most destructive policies of the Bush administration. These Bush policies were in themselves repudiations of Franklin Delano Roosevelt, Mr. Obama’s hero.

The most disastrous Bush policy that Mr. Obama is perpetuating is mark-to-market or “fair value” accounting for banks, insurance companies and other financial institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down. […]

Mark-to-market accounting is the principle reason why our financial system is in a meltdown. The destructiveness of mark-to-market — which was in force before the Great Depression — is why FDR suspended it in 1938. It was unnecessarily destroying banks.

Meltdown in Iceland

Michael Lewis does it again, telling the story of little Iceland’s collapse with all the comedy required to endure such tragic times.

There’s a charming lack of financial experience in Icelandic financial-policymaking circles. The minister for business affairs is a philosopher. The finance minister is a veterinarian. The Central Bank governor is a poet.

But don’t feel bad, Iceland. Our central bankers and finance ministers are trained monetary geniuses. And they can match your meltdown any day of the week.

Black swans? Or black crows?

Nassim Taleb is moving along just fine with an elegant critique of banking’s misaligned incentives . . .

In fact, the incentive scheme commonly in place does the exact opposite of what an “incentive” system should be about: it encourages a certain class of risk-hiding and deferred blow-up. It is the reason banks have never made money in the history of banking, losing the equivalent of all their past profits periodically – while bankers strike it rich. Furthermore, it is that incentive scheme that got us in the current mess.

Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses.

. . . But then, after showing how easy it is for bank management to capture short-term gains without worrying about long-term risks, Taleb concludes that 

This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks.

It’s a big leap from misaligned incentives to only the government can run banks. Doesn’t the expert theoretician of the highly improbable Black Swan understand that highly centralized governments are most often the cause of devastating Black Swan events? The only difference being: we shouldn’t really even call them Black Swans in the case of government failure. These events are not uncommon or unpredictable. The inherent difficulty and high-frequency failure of highly centralized bureaucracies managing dynamic systems is so common and predictable, in fact, that we might call them Black Crows. 

We can do much better than nationalizing the banks. Boards should obviously reform compensation practices. Today’s shareholders have been mostly wiped out. The shareholders of the “next banks” won’t soon forget. But most crucially we should amend the wildly incoherent monetary policy regime that does more than any other private or government action to misalign incentives. During credit bubbles, dollars are easily vacuumed up by the financial industry. In a very real sense, they would be irresponsible not to exploit the Fed’s explicit free-lunch program of accommodation “for a considerable period.” Remember, Chairman Greenspan virtually ordered Wall Street to lever up.

A stable currency is the ultimate disciplinarian, the incentive aligner par excellence.

Update: See Taleb and Nobel psychologist/behavioral economist Daniel Kahneman discuss these topics at length here.

Mark to Mayhem, Part IX

Brian Wesbury and Bob Stein make yet another strong argument against the mark-to-market accounting regime:

The history seems clear. Mark-to-market accounting existed in the Great Depression, and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.

Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look what happened.

Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.

The “Gaussian copula” crash

Wired profiles the formula that killed Wall Street.

Kessler may be crazy. But mark-to-market’s absurd.

Of the Treasury’s long-awaited non-plan bank plan, Andy Kessler writes, “Mr. Geithner should instead use his ‘stress test’ and nationalize the dead banks via the FDIC — but only for a day or so.”


strip out all the toxic assets and put them into a holding tank inside the Treasury. . . .  inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here’s the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately.

Some $6 trillion in income taxes were paid by individuals in 2006, 2007 and 2008. On a pro-forma basis, send out those 10 billion shares of each bank to taxpayers. They paid for the recapitalization.

Each taxpayer would get about $100 worth of stock for each $1,000 of taxes paid. Of course, each taxpayer has the ability to sell these shares on the open market, maybe at $40, maybe $20, maybe $80. It depends on management, their vision, how much additional capital they are willing to raise, the dividend they declare, etc. Meanwhile, the toxic assets sitting inside the Treasury will have residual value and the proceeds from their eventual sale, I believe, will more than offset the capital injected. That would benefit all citizens, not the managements and shareholders who blew up the banking system in the first place.

Is Kessler crazy? Well, maybe. In his own creative and boisterous way. But not nearly so crazy as Washington’s fumble-bumble these last few months. I’d much prefer Kessler’s out-of-the-box plan to D.C.’s muddle.

What becomes clearer every day is that all the government’s efforts, from the AIG “bailout” to TARP 1.0 and TARP 2.0 onward, have essentially been efforts to get around the terribly destructive interaction of “mark-to-market” accounting and regulatory capital requirements. A few keen observers — David Malpass (I), Brian Wesbury (I, II, IIIIV), Steve Forbes (I, II) — have made this point from the start. But the government and most economists clung stubbornly to “fair value” in an apparent attempt not to “let the banks off the hook.” 

But what a time for an attack of conscience, a principled stand for supposed accounting purity! We’ll spend trillions and totally alter the nation’s financial landscape, but a minor (though powerful and free!) accounting change — relaxing mark-to-market — is a bridge too far? Explain that one. (more…)

Quote of the Day

“This is the killer quote from Geithner’s speech: ‘We are exploring a range of different structures for this program, and will seek input from market participants and the public as we design it.’ In other words, we have a plan to have a plan. Ouch.”

— James Pethokoukis, February 10, 2009

Catastrophe? Or just a recession?

Alan Reynolds pushes back against the idea that we are in a crisis-verging-on-“catastrophe.” Here’s his chart comparing some bad recessions:

(Alan Reynolds; New York Post)

(Alan Reynolds; New York Post)

“Paulson to China: I don’t blame you. Really.”

The WSJ’s RealTimeEconomics blog reports on Hank Paulson’s clarification to the Chinese over his recent serial blaming of “global imbalances” as the cause of the financial crash.

“In assessing the financial market crisis, I have repeatedly and consistently targeted the vast majority of my criticism at problems in the United States, particularly our flawed and outdated regulatory structure,” Xinhua quoted Mr. Paulson as saying. “Whenever I have commented on global imbalances, it has been against that backdrop and I have gone out of my way to say that no single country is to blame for the imbalances.”

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