Interpreting Fed Policy

[mash107]

But don't you think misallocation of resources are the entire cause for recessions? If the government is the sole reason these resources are misallocated to begin with, on a wider scale than just a sole entrepreneur screwing up, wouldn't allowing the market to properly allocate resources be the way to ensure recessions don't happen again? The problem lies in the boom, not the bust.

Even if it's your contention that the market sometimes are responsible for these mass misallocations, why are we not trying to limit the frequency of recessions by assuring no more takes place from what we can control-- the government?

 

[Toro]

But don't you think misallocation of resources are the entire cause for recessions? If the government is the sole reason these resources are misallocated to begin with, on a wider scale than just a sole entrepreneur screwing up, wouldn't allowing the market to properly allocate resources be the way to ensure recessions don't happen again? The problem lies in the boom, not the bust.

Even if it's your contention that the market sometimes are responsible for these mass misallocations, why are we not trying to limit the frequency of recessions by assuring no more takes place from what we can control-- the government?

I think that, in general, the roots of this mess have been caused by the Fed, which held the interest rate too low for too long. And I'm not even talking about this decade, when it seems obvious given the ultra-low interest rates 5-6 years ago. In the 1990s, Greenspan believed that productivity was higher than what was showing in the government statistics because he intuited that all the spending in computers must have been increasing productivity and the government statistics were wrong. In this sense, non-market controls absolutely distorted resource allocation. In fairness to Greenspan, however, Greenspan often set the Fed funds target based on what the futures market was forecasting the funds target to be.

But I do not think that the government is the sole reason for mis-allocation. The idea that financial companies could regulate themselves is nonsense IMHO, and has been proven to be dead wrong. Those who argued for de-regulation argued that financial companies would not take excessive risks since doing so would imperil their existence, and besides, they knew their risks better than the regulators.

The SEC allowed the five major brokers to disregard capital ratios in 2004. Brokers used to leveraged 12-15:1 debt to equity. Within a few years, leverage had risen to 30-40:1. This was purely driven by market forces. Why? Because investment banks pay their employees based on revenues. A typical i-bank pays out 50% of its revenues in compensation. If the amount of leverage you can use doubles from 15x equity to 30x equity, then you can double the amount of assets you keep on your balance sheet and the amount of revenue you generate. And, predictably, salaries on Wall Street skyrocketed. The starting salary for an investment banking associate at a top tier firm coming out of a top ranked MBA school was $325,000 in 2006. That's for a 28 year-old with 2-3 years work experience! When I came out of B-school in 1997, the highest salary was $150k, which was stunning at the time. But salaries doubled in 10 years, primarily because of leverage. Executive compensation rose even more such that a top executive could earn $10 million a year. The CFO at Morgan Stanley was paid $14 million for five months work after a new CEO came in and cleared out people he did not want. The CEOs of the major Wall Street firms routinely took home $30-$50 million a year. The average bonus at Goldman Sachs a few years ago was $3 million.

This is the conundrum for the free market doctrinaires. It is not that they argued that financial firms would never fail. Its that they argued they would not all partake in behavior that would lead to mass suicide. Yet, today, Wall Street no longer exists as we have known it. Why did the theory fail so spectacularly? Because those argued for de-regulation made a false assumption about human behavior. If you are making $3 million a year, if you work for a few years, you are set for life. The de-regulators argued that the firms would manage risk better. But if you are making $3 million a year - or $10 million or more as the people who ran the firms and made the decisions were making - what did you care what happens five or ten years from now? If the firms no longer exist, who cares? You're set.

And that's just the beginning. The models by which the firms' based their bets were dramatically flawed. The ratings agencies which were meant to be the watchdogs turned out to be lapdogs because it was more profitable to be so. And so on. I'd go into this further, but time does not permit.

One other point - there is an argument that the market should be allowed to correct and get out of the way and let it correct. I generally agree, but only to a point. Markets are frozen, and are absolutely wrong in pricing parts of the credit market. For example, some convertible bonds with the same standing in the capital structure of corporations as senior rated debt are being priced at yields 5% or higher than the senior debt, which is completely irrational. This freezing of the credit market is causing a self-reinforcing negative spiral which is further impairing financial institutions. Free market theory tells us that at such high spreads, capital would be flowing into the credit market to take advantage of these prices, which would narrow the spreads. This is happening, albeit slowly (and is being driven primarily because of government guarantees in the credit markets). Spreads will come in - eventually. However, this is causing extreme volatility in the economy. The higher the volatility, the higher the costs to the economy. This is taken straight from the theory of finance, which states the higher the volatility, the higher the required return. The higher the volatility in the economy, the higher the cost of capital in the economy. Allowing markets to collapse increases the long-term cost of capital in the economy.

So, yes, the government does mis-allocate resources. But markets are not always rational because humans are not always rational.

 

[BaronVonBigmeat]

Did you know that GDP per capita growth in the United States was higher in the 20th century than it was in the 19th century, and that it was higher in the second half of the 20th century than it was in the first half of the 20th century? The St Louis Fed has a great calculator that estimates per capita income in the United States. I'd find it but I'm lazy at the moment.

Did you know that a study from the American Tobacco Institute reveals that 4 out of 5 females believe that smoking makes a man look suave and sexy? Totally true.

(It might have a bit to do with the giant flood of immigrants in the 1800's. And the numbers for the first half of the 20th were badly marred by two huge wars and a decade long depression.)

Government spending is about a third of the economy. It has been for some time. Government spending accounts for between 30%-50% in all industrialized economies. Government spending is, and has been, a greater percentage of the economy than private investment for, if I recall correctly, decades. So to say that an economy is not built on government spending is factually incorrect.

Yes, you can base an economy on government spending, the USSR proved that. (You can also put square wheels on a go-kart, and it will move, sort of.) Unfortunately it is hard to truly prove that we would have been better off with 15%~20%, because we do not have the technology to turn time backwards and run and re-run the experiment where our leaders pass smaller budgets.

The role of the government in times of recession is to act as a counter-cyclical balance. In times of recession, the government should increase spending and act as a cushion to a declining economy. That does not mean that everything government does is wise and necessary. Far from it. But this economy has enormous problems, and it is the proper role of the government to act as a stabilizer when the private economy is contracting.

If you increase government spending, then you must burden the economy through some other means--taxing, borrowing, or inflating. There is no free lunch! It's like leaving your refrigerator door open to cool your kitchen, it doesn't work. How long has Japan been trying?

 

[Toro]

Yes, you can base an economy on government spending, the USSR proved that. (You can also put square wheels on a go-kart, and it will move, sort of.) Unfortunately it is hard to truly prove that we would have been better off with 15%~20%, because we do not have the technology to turn time backwards and run and re-run the experiment where our leaders pass smaller budgets.

I agree. Those on the other side of the theoretical spectrum argue that we would have been worse off had the government not spent what it did.

If you increase government spending, then you must burden the economy through some other means--taxing, borrowing, or inflating. There is no free lunch! It's like leaving your refrigerator door open to cool your kitchen, it doesn't work. How long has Japan been trying?

The model that Japan used to become the second largest economy in the world included a significant amount of government intervention and direction in the economy. There is definitely a problem now in that the domestic economy is sclerotic. However, the Japanese model gave its citizens one of the highest standards of living on earth.

Ideally, the counter-cyclical programs work most efficiently because they are counter-cyclical, meaning that the programs dissipate when the economy expands. The problem is that it is difficult for institutions to contract when their purpose is lessened.

 

[Care4all]

Well, the primary tool the fed has is the discount rate, which is currently, what, .5%? Do they lower it into negative territory? Given the inflation pressure, it is in real terms there already.

Right now, folks are trying to de leverage all at once. Good plan, but not when everyone else is doing it. Everyone is way too leverage already. Until the popular balance sheet is back in a rational place for most people, they are going to continue to deleverage.

What is leveraging and deleveraging? I still am clueless....i keep hoping that all of this will actually sink in, and make sense to me, (i read every one of Brian's or Paul's or zoomies's etc.'s posts about this...?) but so far.....I am failing.

care

 

[editec]

No. It is more of the same prescription that got us into this mess to begin with. Certainly did work well for us about eight years ago, didn't it? We should have taken our medicine at that time. But no ... we could not possibly have a recession. So the economy was reflated once again for short term benefit, only to result in a lot of pain less than eight years later. And here we are ...

If, and this is a big if, we are successful reflating one more time ... what do you think awaits us when the next bubble pops? I can tell you that it will be worse than if we allowed the economy to adjust on its own without significant government interference. You are simply trading a problem in the present for a bigger one down the road.

You build an economy on savings and investment. Not government spending and discouragement of saving.

Brian

What do you think happens if we do nothing, Brian?

What happens to American when everybody's mortgage is below water?

What happens to American when the rate of unemployment is 50% and greater?

You think that people are going to go quietyly into the night becuase that's how the game is played and they, though no fault of their own, just happen to be the losers?

Do you think I am my roomates are going to starve peacefully, just because these bankers fucked up again?

What these people are desperately trying to do is prevent that.

What your Austrians neglect to realize is what happens when that dust settles.

 

[Toro]

What is leveraging and deleveraging? I still am clueless....i keep hoping that all of this will actually sink in, and make sense to me, (i read every one of Brian's or Paul's or zoomies's etc.'s posts about this...?) but so far.....I am failing.

care

Deleveraging means decreasing the amount of debt in the economy.

 

[Paulie]

But Toro, don't we as consumers in the market also have a bit of a responsibility to keep ourselves from enabling the greed of the companies?

Those companies can only leverage themselves as far as we can do business with them, theoretically. We didn't have to take out $350,000 mortgages when we only needed $200,000. We didn't HAVE to own homes, we WANTED to own homes, and we did whatever we felt like doing to own them. We didn't HAVE to run our credit cards up to $30,000. We didn't HAVE to own a Wii. We didn't HAVE to buy a brand new SUV, when all some of us really needed was a sedan that ran well. It's not just the fault of the companies for loaning excessively.

I realize that not EVERYONE will act rationally ALL the time, but there's simply no excuse for how we've acted as consumers for the past 50+ years, specifically the last 10.

 

[mash107]

But Toro, don't we as consumers in the market also have a bit of a responsibility to keep ourselves from enabling the greed of the companies?

Those companies can only leverage themselves as far as we can do business with them, theoretically. We didn't have to take out $350,000 mortgages when we only needed $200,000. We didn't HAVE to own homes, we WANTED to own homes, and we did whatever we felt like doing to own them. We didn't HAVE to run our credit cards up to $30,000. We didn't HAVE to own a Wii. We didn't HAVE to buy a brand new SUV, when all some of us really needed was a sedan that ran well. It's not just the fault of the companies for loaning excessively.

I realize that not EVERYONE will act rationally ALL the time, but there's simply no excuse for how we've acted as consumers for the past 50+ years, specifically the last 10.

Government sure does trick people into spending credit when they don't want to with artificially low interest rates. If someone spiked a punchbowl, you don't blame the kid, you blame the person that spiked it.

 

[gonegolfin]

What do you think happens if we do nothing, Brian?

We get a difficult cleansing of the economic excesses that will be less severe than if the government continues with its massive and inefficient targeted fiscal intervention. And thus far ... it is the insolvent banks that have benefited from this intervention, while pulling the wool over the eyes of US citizens.

What your Austrians neglect to realize is what happens when that dust settles.

No ... with all due respect, what you are failing to grasp here is that we are creating a bigger problems for ourselves. I want the path with the least amount of pain and the soundest foundation with which to facilitate the next real economic expansion (as opposed to a false one ... such as the last eight years).

Do you not realize what the interventions (which pale in comparison to what is currently being attempted) earlier in the decade have created? We should have taken our medicine then, allowed the excesses to be purged from the system, encouraged saving, and slogged through what would have been a difficult recession (but not a depression). If we would have done that, we would not be in the position we are in today.

Now we find ourselves read to "cure" this problem by spending money we do not have ... going considerably further into debt, trashing the Central Bank's balance sheet, and making some very noteworthy creditors quite angry (China, for example, is dumping its Agency debt). And this also does not account for the stunning moral hazard problems the interventions have created.

Have you noticed how each downturn in the business cycle over the last twenty years (or so) has required increasing amounts of liquidity and stimulus to reflate and get things moving again? We are now scraping the bottom of the barrel and responsible fiscal management is necessary.

Brian

 

[gonegolfin]

Government spending in specific areas is not only a proper foundation of our economy but a critical one. Government spending (within reason) on education and infrastructure are critical components of economic development and growth.

Government spending of money that we do not have with the goal of extricating ourselves from yet another downturn is simply irresponsible and setting up a more catastrophic fall in the future.

This is a value judgment.

As for what the government should do now, I think the government generally is responding appropriately, though some aspects are bothersome. I think the more appropriate concern is what the government will do after the crisis is over.

It is a judgement based on what has worked and what has not worked in the past. It also happens to be a common sense judgement.

And obviously I disagree with you. The government is responding in ways that are extremely harmful to the currency, inefficient (wasteful), targeting specific beneficiaries, harmful to the long term prospects of the economy, and elevates moral hazard to a new level. And to top it all off, they are doing it by the seat of their pants.

I think one of two things happens here if government fiscal intervention continues and fiscal responsibility is not exercised ...

1) The reflation is somewhat successful in that we do not fall into depression. We get 3 -> 6 years of the worst economic expansion in our country's history (eclipsing the depths of the last "expansion" earlier this decade), following what will continue for a period of time to be a hard recession (but not a depression). We then fall off of the cliff with what will be the worst recession the globe has ever seen (a long drawn out depression).

2) The reflation is not successful and we enter a long drawn out depression in the next 18 months.

I think current events are validating Hyman Minsky after all.

The Fed is the chief arsonist.

Brian

 

[Toro]

It is a judgement based on what has worked and what has not worked in the past. It also happens to be a common sense judgement.

Look, I tend to defer to the market. On the few other forums I frequent, I'm usually taking the "market knows best" approach. However, when one says "based on what has worked," one ignores the fact that activist governments in northern Europe have provided one of the highest standards of living on the planet while the Asian governments have been very interventionist in pulling their economies from amongst the poorest in the world to a fairly significant level of wealth.

The Austrian school of economics is based on dogma and philosophy. In this sense, it is no different than Marxism, which is also based on dogma and philosophy. That's fine, but it is what it is, and dogma and ideology are limiting in our understanding of the world around us. That does not mean it is all wrong, of course. I happen to think that the Austrians are right about inflation - inflation is not the general rise in prices but is the excess creation of money and that rising price levels are symptomatic of this fact. This is bang on, and the Austrians are right and the conventional economists are wrong. However, that does not mean that everything is correct, and I vehemently disagree that the market is always the most efficient and fairest manner in which to allocate resources. I've said it before and I'll say it again - the market creates the most wealth for the most people most of the time. It does not create all the wealth for all the people all of the time.

 

[gonegolfin]

The Austrian school of economics is based on dogma and philosophy. In this sense, it is no different than Marxism, which is also based on dogma and philosophy. That's fine, but it is what it is, and dogma and ideology are limiting in our understanding of the world around us. That does not mean it is all wrong, of course. I happen to think that the Austrians are right about inflation - inflation is not the general rise in prices but is the excess creation of money and that rising price levels are symptomatic of this fact. This is bang on, and the Austrians are right and the conventional economists are wrong. However, that does not mean that everything is correct,

I am not decided on all of what AE has to offer. But AE is correct w/respect to government intervention and spending to solve economic ills and grow the economy. We do not "cure" this problem by spending money we do not have ... going considerably further into debt, trashing the Central Bank's balance sheet, targeting specific beneficiaries, making some very noteworthy creditors quite angry (risking substantial dollar reserves coming back to our shores), and elevating moral hazard to a new level. These policies continue to be enacted and we continue to find ourselves with worsening downturns along with worsening expansions. It will end badly.

Brian

 

[Toro]

I am not decided on all of what AE has to offer. But AE is correct w/respect to government intervention and spending to solve economic ills and grow the economy. We do not "cure" this problem by spending money we do not have ... going considerably further into debt,

But Brian, why do you assume that using debt is bad? Corporations use debt. Is that bad? Consumers use debt to finance home and car purchases. Is this bad?

I am not saying that everything government spends on is good - far from it. However, why would one make a broad-sweeping statement about not going into debt when other entities and individuals do the exact same thing?

Saying that government should not go into debt during a time of economic contraction is tantamount to saying that an individual should not go into debt when they are unemployed. If you have no job and have to feed your family, don't have enough savings but have a credit line, is it better to let your family starve and be thrown onto the street? Is it immoral to tap the credit line so you can feed and shelter your children?

 

[Paulie]

Here's a good question..

If government spending is working so well for Europe and Asia, why does it seem to be working so badly for us?

Are we really content with going through 5 year boom and bust cycles? It's obvious the citizens of the US are too stupid collectively, to learn from the mistakes of the previous cycles. Maybe that's why we can't make our government spending work to our advantage in the long run.

But the point is, it doesn't work for us. Even if it DOES somehow work if utilized correctly, and that's a big IF, it doesn't work for us. Our leaders are either too stupid to get it right, or they're screwing it up on purpose for whatever reasons. There doesn't seem to be a better explanation as to why we keep getting it wrong.

 

[Paulie]

Is it immoral to tap the credit line so you can feed and shelter your children?

Therein lies the dilemma.

Should it be government's responsibility to collectively indebt the taxpayers, to bailout failures caused by bad risk-taking?

It seems to take "general welfare of the US" a bit to the extreme.

 

[Zoomie1980]

But Brian, why do you assume that using debt is bad? Corporations use debt. Is that bad? Consumers use debt to finance home and car purchases. Is this bad?

I am not saying that everything government spends on is good - far from it. However, why would one make a broad-sweeping statement about not going into debt when other entities and individuals do the exact same thing?

Saying that government should not go into debt during a time of economic contraction is tantamount to saying that an individual should not go into debt when they are unemployed. If you have no job and have to feed your family, don't have enough savings but have a credit line, is it better to let your family starve and be thrown onto the street? Is it immoral to tap the credit line so you can feed and shelter your children?

I remember back when people were moaning about the TENS of billions of dollars of debt the Reagan defense buildup was going to burden our children and grandchildren with. Hell, we could pay that entire debt in a few weeks now!!! And we did cave in the Soviet Empire with that one....

In 20 years we will have to use scientific notation to describe the budget. Debt will be measured in hundreds of TRILLIONS of dollars and in 30 in QUADRILLIONS....

 

[Toro]

Therein lies the dilemma.

Should it be government's responsibility to collectively indebt the taxpayers, to bailout failures caused by bad risk-taking?

It seems to take "general welfare of the US" a bit to the extreme.

Perhaps. But does it apply to welfare and unemployment insurance? If, for no fault of their own, people are being fired because their company can no longer tap credit - as is happening today - is it moral that innocent people must pay the burdens of those who profited from the risk-taking?

 

[gonegolfin]

But Brian, why do you assume that using debt is bad? Corporations use debt. Is that bad? Consumers use debt to finance home and car purchases. Is this bad?

Not all debt is bad. Too much is bad and consistently relying on increasing levels of debt and government spending to engineer ourselves out of recession is bad. And as I have explained, it has not been working. Our subsequent expansions have been progressively shorter and shallower. We need to save more to build a stronger economy, not spend more.

Relying on increasing levels of debt and spending is not the formula of success for corporations.

I am not saying that everything government spends on is good - far from it. However, why would one make a broad-sweeping statement about not going into debt when other entities and individuals do the exact same thing?

I did not make a broad-sweeping statement about going into debt. I am referring to the irresponsible excess being enacted by the government. It has gotten to the point where foreign nations are rumbling about future US borrowings, from foreign official institutions, being denominated in foreign currency. We have not run a responsible fiscal ship. And nowhere did I excuse other entities and individuals from similar fiscal irresponsibility.

And to think that the government is going to spend its way out of this economic mess without creating further mess in the future is pure folly.

Saying that government should not go into debt during a time of economic contraction is tantamount to saying that an individual should not go into debt when they are unemployed. If you have no job and have to feed your family, don't have enough savings but have a credit line, is it better to let your family starve and be thrown onto the street?

No it is not the same. There is plenty of spending in this country that is not necessary to keep "food on the table". Spending must be cut during these times and saving must be increased. Not the opposite. Additionally, savings must not be discouraged, which is exactly what is happening.

Is it immoral to tap the credit line so you can feed and shelter your children?

No. It is immoral to saddle our children with increasingly burdensome fiscal problems.

Brian

 

[Toro]

No it is not the same. There is plenty of spending in this country that is not necessary to keep "food on the table". Spending must be cut during these times and saving must be increased. Not the opposite. More importantly, savings must not be discouraged, which is exactly what is happening.

I agree with much of what you are saying. However, it is necessary for the government to spend to keep some people from starving and being thrown onto the street.

I would also say that encouraging people to save now is not the optimal macro solution, though they are going to anyways, and rationally so. The best time to encourage savings was two years ago. However, we are now confronted with the paradox of thrift.

Over time, the savings rate of the US has to rise. However, savings can go too high, as they are currently in Japan.