Friedrich Hayek made the important point that, in order to have a free society, people must be governed by the rule of law, not the rule of man. Rule of law means that the rules are fixed and applied equally in all cases, to all people. Rule of man means discretion - rules are not fixed, but are applied differently based on the individual(s) applying the rules.
The U.S. is ostensibly a "rule of law" country. In many instances, this has not been the case. I want to highlight a few recent cases where the rule of man has prevailed over the rule of law. Most recently is the BP case, where the company was bludgeoned out of $20 billion. No matter what you think of the BP case, there is no law that says a company whose equipment breaks has to set a relief fund. In fact, it seems to be that liability in the oil industry is capped at $75 million. Naturally, there is now a push to raise that liability cap. Imagine that!
The finance industry is an ongoing field of government involvement. An example of rule of man here is the fact that there was a "pay czar." There is no pre-existing rule that says "people in the finance industry should be paid X, or according to formula Y." This pay business only came up because of the bank panic and subsequent recession. This is purely rule of man since the rules are based entirely on an emotional response to recent events.
Finally, there is the GM takeover. You know - Government Motors. If any more evidence is required that the 'rule of man' rules this country, I don't know what it is beyond nationalization of a huge company.
What is the danger of the rule of man? Not to be too alarmist about it, but I think Prof. Thomas Sowell is onto something: http://jewishworldreview.com/cols/sowell062210.php3
Thursday, June 24, 2010
Saturday, May 8, 2010
Too Loose for Too Long...
I've read numerous times that the Fed Funds rate was kept "too low for too long" after the tech bubble burst. Academics, business people, pundits, and even some Fed officials have said this. And, in retrospect, that's to be expected. One can say, once the data is in, that mistakes were made. The question is, is the lesson we can learn from the mistake applicable to future circumstances?
The main issue here is, I think, whether Fed officials (the FOMC) can know when the Fed Funds rate is too low not in retrospect but in the moment. The "Taylor rule," of John Taylor, appears to be a guide. At least, one can know if the Fed Funds rate is low relative to what the Taylor rule would suggest. The problem isn't whether the Fed Funds rate is relatively low compared to the Taylor rule, though. The problem is whether the Fed Funds rate is relatively low (or high) compared to the interest rate set by the market. But that issue brings me to my next point, which is a parallel of the above.
The discussions around "too low for too long" remind me of discussions regarding the existence of an asset price bubble. First, bubbles are always claimed to have existed once the bubble has burst. A quick, but untestable, definition of a bubble is typically stated as unreasonably high asset prices. The question, of course, is what are the fundamentals that drive the price, and has the price become detached from its long-run relationship with the fundamentals? Speaking as a financial economist, bubbles are difficult to test for, and the methods used are numerous.
The parallel between the "too low for too long" and asset bubbles is this: easy to identify in hindsight, but very difficult to identify in the moment. The problem is that it is "in the moment" that is important. Many pundits and other writers have wondered why "we didn't see this coming." Of course, it is well known now that many economists and other people did see "this" coming. The issue was that policy makers were not listening to the nay-sayers. So the first problem is identification, and the second problem is convincing people that the current situation is untenable.
I think that we are again in a period where the Fed has manipulated the Fed Funds rate to a point that is too low, kept it there too long, and that stock prices and, yes, real estate prices are overly inflated. Greece is the harbinger of doom.
The main issue here is, I think, whether Fed officials (the FOMC) can know when the Fed Funds rate is too low not in retrospect but in the moment. The "Taylor rule," of John Taylor, appears to be a guide. At least, one can know if the Fed Funds rate is low relative to what the Taylor rule would suggest. The problem isn't whether the Fed Funds rate is relatively low compared to the Taylor rule, though. The problem is whether the Fed Funds rate is relatively low (or high) compared to the interest rate set by the market. But that issue brings me to my next point, which is a parallel of the above.
The discussions around "too low for too long" remind me of discussions regarding the existence of an asset price bubble. First, bubbles are always claimed to have existed once the bubble has burst. A quick, but untestable, definition of a bubble is typically stated as unreasonably high asset prices. The question, of course, is what are the fundamentals that drive the price, and has the price become detached from its long-run relationship with the fundamentals? Speaking as a financial economist, bubbles are difficult to test for, and the methods used are numerous.
The parallel between the "too low for too long" and asset bubbles is this: easy to identify in hindsight, but very difficult to identify in the moment. The problem is that it is "in the moment" that is important. Many pundits and other writers have wondered why "we didn't see this coming." Of course, it is well known now that many economists and other people did see "this" coming. The issue was that policy makers were not listening to the nay-sayers. So the first problem is identification, and the second problem is convincing people that the current situation is untenable.
I think that we are again in a period where the Fed has manipulated the Fed Funds rate to a point that is too low, kept it there too long, and that stock prices and, yes, real estate prices are overly inflated. Greece is the harbinger of doom.
Wednesday, May 5, 2010
Before Reform
I guess I've discovered that responding to others' blog posts isn't going to be satisfying anymore. I've read many things about financial reform, some of which makes sense. A lot doesn't. There's a couple of issues that need to be sorted out before "reform" of any kind can take place.
1) Too Big to Fail (TBTF) : Can we please get a working definition on this other than "really big." Boatloads of companies have a high market cap - does that make them too big to fail? If so, what constitutes failure? If MMM loses 10% of its value in, say, a month, will the federal government decide they need to intervene because MMM is too big to fail? Obviously, this is foolishness. I mean for the example to show that size isn't the sole criterion here.
During the crisis, as TBTF was getting tossed around a new nomenclature grew up that tacitly allowed the Fed and TARP and other bailout operations to give money to non-large banks: too Interconnected to fail. Here I'm even more lost. What do I do, count the number of trading partners a bank has? What makes a bank interconnected? I get that Goldman Sachs is the counterparty to a huge amount of trades - so yes they're interconnected. But GS is also in the habit of being really smart. I'm willing to bet that a lot time is spent managing risk, and making sure the trades that expose them to some risks are offset by other trades. So, yes, they have a lot of trading partners - but that does not make them an inherently risky operation.
2) Beyong defining TBTF, or TITF, I would love a definition of "systemic risk." This seems to be related to TITF. Systemic risk, defined in a singularly unhelpful way, would be: "XYZ poses a risk to the system." I guess that means that if a bank fails then this could cause a ripple effect in the banking system and cause a whole bunch of banks to fail. I'm not certain what the failure mechanism is supposed to be: counterparty problems? animal spirits? Or how about regulator panic?
Counterparty risk is faced all the time in trading. That's why, for exchange-traded derivatives, the clearinghouse is the counterparty. The clearinghouse is A) large and B) is pretty much position-neutral on net, since it's the counterparty to longs and shorts on the same products. But, some firms welcome the counterparty risk and use it as a source of (potential) returns. Usually, counterparty risk is fairly singular - one or two of your trading partners might become distressed at any given time, and you'll lose money on some trades. The problem turns up when a whole bunch of your trading partners become distressed at once. But then the question is why did all these firms encounter problems at the same time?
My point here is that a firm isn't an inherent systemic risk just because it has a lot of trading partners. It may, however, be a conduit for risk transference if there is a shock to the economic system. But then, how is that different from any large industrial firm that has numerous suppliers and customers?
I'm afraid we have a long way to go before we can get to some genuine reform. I will have more to say on a variety of issues in future posts - like CDS and standardization, and the institutionalization of TBTF.
1) Too Big to Fail (TBTF) : Can we please get a working definition on this other than "really big." Boatloads of companies have a high market cap - does that make them too big to fail? If so, what constitutes failure? If MMM loses 10% of its value in, say, a month, will the federal government decide they need to intervene because MMM is too big to fail? Obviously, this is foolishness. I mean for the example to show that size isn't the sole criterion here.
During the crisis, as TBTF was getting tossed around a new nomenclature grew up that tacitly allowed the Fed and TARP and other bailout operations to give money to non-large banks: too Interconnected to fail. Here I'm even more lost. What do I do, count the number of trading partners a bank has? What makes a bank interconnected? I get that Goldman Sachs is the counterparty to a huge amount of trades - so yes they're interconnected. But GS is also in the habit of being really smart. I'm willing to bet that a lot time is spent managing risk, and making sure the trades that expose them to some risks are offset by other trades. So, yes, they have a lot of trading partners - but that does not make them an inherently risky operation.
2) Beyong defining TBTF, or TITF, I would love a definition of "systemic risk." This seems to be related to TITF. Systemic risk, defined in a singularly unhelpful way, would be: "XYZ poses a risk to the system." I guess that means that if a bank fails then this could cause a ripple effect in the banking system and cause a whole bunch of banks to fail. I'm not certain what the failure mechanism is supposed to be: counterparty problems? animal spirits? Or how about regulator panic?
Counterparty risk is faced all the time in trading. That's why, for exchange-traded derivatives, the clearinghouse is the counterparty. The clearinghouse is A) large and B) is pretty much position-neutral on net, since it's the counterparty to longs and shorts on the same products. But, some firms welcome the counterparty risk and use it as a source of (potential) returns. Usually, counterparty risk is fairly singular - one or two of your trading partners might become distressed at any given time, and you'll lose money on some trades. The problem turns up when a whole bunch of your trading partners become distressed at once. But then the question is why did all these firms encounter problems at the same time?
My point here is that a firm isn't an inherent systemic risk just because it has a lot of trading partners. It may, however, be a conduit for risk transference if there is a shock to the economic system. But then, how is that different from any large industrial firm that has numerous suppliers and customers?
I'm afraid we have a long way to go before we can get to some genuine reform. I will have more to say on a variety of issues in future posts - like CDS and standardization, and the institutionalization of TBTF.
Saturday, March 6, 2010
Savings and Household Wealth
Looking at graphs of the S&P 500 and other stock indices, one is quickly struck by the fact that the index level is not much changed from its level about one decade ago, around the time the tech bubble was getting rolling. Okay, in the mean time we had some serious ups and downs, so the volatility was there, but capital gains over the period were zero. If you did buy and hold 'till now returns are coming only from dividends. Certainly some portfolios have gained wealth on net over this period, but others have lost, and in the aggregate wealth gains were zero.
What does that mean for the wealth generated during that period? Was any of it real? Since a great deal of the GDP growth in the period was due to consumption growth, fueled by negative savings (borrowing), I would suggest that aggregate wealth generated was attributable to lenders. When borrowed funds are primarily used for consumption, though, the money used to pay back the funds must come from future income, and money used for consumption doesn't contribute to growth, real future income probably wasn't growing.
So any gains to wealth over the past decade have come at the expense of future income. Given that future income wasn't growing in real terms, future household wealth should be expected to decrease. I think people are beginning to realize this, and it is causing people to be quite scared for the future at this time.
What does that mean for the wealth generated during that period? Was any of it real? Since a great deal of the GDP growth in the period was due to consumption growth, fueled by negative savings (borrowing), I would suggest that aggregate wealth generated was attributable to lenders. When borrowed funds are primarily used for consumption, though, the money used to pay back the funds must come from future income, and money used for consumption doesn't contribute to growth, real future income probably wasn't growing.
So any gains to wealth over the past decade have come at the expense of future income. Given that future income wasn't growing in real terms, future household wealth should be expected to decrease. I think people are beginning to realize this, and it is causing people to be quite scared for the future at this time.
Friday, January 8, 2010
Narrow-mindedness
Well, I was having more discussions with more people about more things. And I was struck by just how narrow-minded highly educated people really are. And it may be that education has little to do with openness to challenging your own world-view. Education may be, to paraphrase some wise philosopher, just a way of buttressing your own prejudices. By the way, so no one thinks I'm holier than thou, I include myself in this as well - most of my reading supports hypotheses I already accept.
But the main difference between me and most academics I encounter is this: my willingness to present data and to dig deeply into data presented to me. I won't simply gather data to support my current argument. I gather data about the entire issue and let those data tell the story. Yes, the data may be flawed or incomplete. The data about various elements of the issue may simply not be available. But that means for those elements the appropriate mind-set is: "I don't know. We need to investigate further."
In our policy making, we need to be data driven and move slowly and without prejudice. And if the discussions I participate in and observe are any indication of peoples' thoughts regarding policy making, ideology trumps data and that is very very dangerous.
But the main difference between me and most academics I encounter is this: my willingness to present data and to dig deeply into data presented to me. I won't simply gather data to support my current argument. I gather data about the entire issue and let those data tell the story. Yes, the data may be flawed or incomplete. The data about various elements of the issue may simply not be available. But that means for those elements the appropriate mind-set is: "I don't know. We need to investigate further."
In our policy making, we need to be data driven and move slowly and without prejudice. And if the discussions I participate in and observe are any indication of peoples' thoughts regarding policy making, ideology trumps data and that is very very dangerous.
Friday, January 1, 2010
Thoughts on American Pessimism
Some recent polls have suggested most Americans believe the 1st decade of the 21st century to be the worst decade in the past 50 years. The polls appear to ask people the source of this belief, and most people point to 9/11. However, I think that there is a more pernicious and creeping source behind this pessimism. Americans now are less responsible for the content and direction of their lives than in the history of the country.
Think about how much of American life is regulated and directed by government at all levels, from cradle to grave. The hospital in which you are born may be a state hospital, but even if private the funding for the hospital is affected by government regulations (e.g. it is organized as a non-profit for tax purposes; you pay for your procedure through a combination of self-pay and employer-based insurance).
Growing up, your education is either through a public school or a private school that the state has allowed to exist (e.g. charter school). No matter the choice, your parents and/or the community around you pay property taxes to finance schools. You can even start going for day care and "early childhood education" quite early on in life, again government/tax financed. If private ones exist, they must generally be licensed by the state.
Once you enter the work world, income is taxed, goods you purchase are taxes (remember, you pay the corporate income tax through the price of goods and services consumed), and there are a variety of payroll taxes. These payroll taxes go to things like social security and unemployment insurance - two social welfare constructs that further reduce peoples' responsibility for the future. Part of taxes are also directed to equalization payments, like tax credits or welfare, which also reduce peoples' responsibility for their own choices.
There is an argument for a social safety net, and there is a duty to protect the weakest members of society. But all of this removal of personal responsibility for those who are capable of running their own lives is long-run damaging. It is, I believe, the source of American pessimism. We've gotten to the point where we expect another entity, usually a government or one of its agents, to solve our problems. This removes the feeling of accomplishment and success, so crucial to happiness.
Another problem with such high government involvement is the crowding out of communities that used to exist to help people who got 'in a bad way.' Fraternals, mutuals, etc. have shrunk to be almost nothing, a distant memory for some, an unknown for most. I hesitate to say "secularization" here, because many of the communities were not religious in nature. But a sense of belonging to the larger community has diminished a great deal and I think this also has a lot to do with a sense of disconnection and general malaise.
Think about how much of American life is regulated and directed by government at all levels, from cradle to grave. The hospital in which you are born may be a state hospital, but even if private the funding for the hospital is affected by government regulations (e.g. it is organized as a non-profit for tax purposes; you pay for your procedure through a combination of self-pay and employer-based insurance).
Growing up, your education is either through a public school or a private school that the state has allowed to exist (e.g. charter school). No matter the choice, your parents and/or the community around you pay property taxes to finance schools. You can even start going for day care and "early childhood education" quite early on in life, again government/tax financed. If private ones exist, they must generally be licensed by the state.
Once you enter the work world, income is taxed, goods you purchase are taxes (remember, you pay the corporate income tax through the price of goods and services consumed), and there are a variety of payroll taxes. These payroll taxes go to things like social security and unemployment insurance - two social welfare constructs that further reduce peoples' responsibility for the future. Part of taxes are also directed to equalization payments, like tax credits or welfare, which also reduce peoples' responsibility for their own choices.
There is an argument for a social safety net, and there is a duty to protect the weakest members of society. But all of this removal of personal responsibility for those who are capable of running their own lives is long-run damaging. It is, I believe, the source of American pessimism. We've gotten to the point where we expect another entity, usually a government or one of its agents, to solve our problems. This removes the feeling of accomplishment and success, so crucial to happiness.
Another problem with such high government involvement is the crowding out of communities that used to exist to help people who got 'in a bad way.' Fraternals, mutuals, etc. have shrunk to be almost nothing, a distant memory for some, an unknown for most. I hesitate to say "secularization" here, because many of the communities were not religious in nature. But a sense of belonging to the larger community has diminished a great deal and I think this also has a lot to do with a sense of disconnection and general malaise.
Friday, December 18, 2009
Economic Freedom and Quality of Life
I'm in favor of improving the lot of life for everyone the world over. I think a lot of people are. The disagreements occur regarding the best means for improving people's quality of life. How do we best help people move from poverty to wealth? To move from starvation to satiety, from satiety to abundance?
Some believe that governmental intervention is an absolute requirement - the welfare state, social democracy, call it what you will. These people, from what I can tell, believe that a free market will not help all people to improve their lot - only some people. This is an ongoing argument, but I don't think they are correct. I have all kinds of reasons to think that, but I will only offer one element here that I haven't seen elsewhere.
I was discussing this point with a fellow the other day, and I pointed out the importance of economic freedom for development. He then forwarded me the Economist's Quality of Life index and said that economic freedom was unimportant for quality of life. Well sir, that's just not so.
The Economist's Quality of Life index is from 2005 - I don't think they maintain a time series. So, I grabbed the Heritage Foundation's Index of Economic Freedom (which they have from the early 1990s to 2009) and matched them up. Turns out the correlation between the two indices is 70%. That ain't not bad.
There are methodological differences that can explain the lack of a higher correlation, though. First, the Quality of Life index includes climate and geography, stuff that economic freedom can't change. And, frankly, has little or any relationship with. The Quality of Life index also includes a "community life" measure, which is equal to one if the country has high church involvement /or/ trade union membership. Obviously this latter works against labor freedom. The rest of the elements, like health, material well being, political stability, and political freedom tend to be consistent with ideas captured by the economic freedom index.
I have a serious objection to how the economist captures community life - the church side I can see. Trade unions though? What have these got to do with community life? They foster an atmosphere of exclusion and elitism, not inclusion and camaraderie. Surely there must be better ways of measuring community life. How about volunteer hours/person? Museums, art galleries, and other art projects add to a spirit of community too. I'm not sure how to measure all this, but I'm sure others have good ideas here.
Anyway, the long and short of it: economic freedom and quality of life are positively correlated. To me, this is not surprising. Hopefully this will cause people who think more governmental control is the answer to poverty to think twice.
Some believe that governmental intervention is an absolute requirement - the welfare state, social democracy, call it what you will. These people, from what I can tell, believe that a free market will not help all people to improve their lot - only some people. This is an ongoing argument, but I don't think they are correct. I have all kinds of reasons to think that, but I will only offer one element here that I haven't seen elsewhere.
I was discussing this point with a fellow the other day, and I pointed out the importance of economic freedom for development. He then forwarded me the Economist's Quality of Life index and said that economic freedom was unimportant for quality of life. Well sir, that's just not so.
The Economist's Quality of Life index is from 2005 - I don't think they maintain a time series. So, I grabbed the Heritage Foundation's Index of Economic Freedom (which they have from the early 1990s to 2009) and matched them up. Turns out the correlation between the two indices is 70%. That ain't not bad.
There are methodological differences that can explain the lack of a higher correlation, though. First, the Quality of Life index includes climate and geography, stuff that economic freedom can't change. And, frankly, has little or any relationship with. The Quality of Life index also includes a "community life" measure, which is equal to one if the country has high church involvement /or/ trade union membership. Obviously this latter works against labor freedom. The rest of the elements, like health, material well being, political stability, and political freedom tend to be consistent with ideas captured by the economic freedom index.
I have a serious objection to how the economist captures community life - the church side I can see. Trade unions though? What have these got to do with community life? They foster an atmosphere of exclusion and elitism, not inclusion and camaraderie. Surely there must be better ways of measuring community life. How about volunteer hours/person? Museums, art galleries, and other art projects add to a spirit of community too. I'm not sure how to measure all this, but I'm sure others have good ideas here.
Anyway, the long and short of it: economic freedom and quality of life are positively correlated. To me, this is not surprising. Hopefully this will cause people who think more governmental control is the answer to poverty to think twice.
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