Why the World Wants Capitalism

In the forests of India, something exciting is going on. Villagers are regaining property taken from them when the British colonial authorities nationalized their forests. Just as exciting, in urban Kenya and elsewhere, people are doing away with the need for banks by exchanging and saving their money digitally. All over the world, poor people are discovering the blessings of bottom-up capitalism.

http://fee.org/freeman/world-s-poor-we-want-capitalism/

I repost this interesting article on economic development around the world, specifically in the poorest societies. The key words to note are property, ownership, and capital. Another key concept is control over that capital, constituting legal rights. The development and accumulation of capital assets (incl. human) also leads to the expansion of credit to leverage present capital into future capital.

Gee, maybe that’s why we call it capitalism, ya’ think?

ism

Money For Nothing?

TowerofPower

…there is now a nagging fear that credibility in central bankers is being lost. Investors, it seems, are losing confidence in the Fed.

You think? I believe the definition of insanity is to keep doing the same thing over and over and expecting a different result. It seems to me the Fed has sidelined itself and the future path of the economy will be determined by markets, and it won’t all be good. As Stockman says (see second article below), the global economy in many respects is at peak debt, thus the global private and public sectors are both struggling to de-leverage. The only borrowers are national governments and those speculating in asset markets.

Thus, the Fed’s efforts to boost inflation to 2% have been for naught and merely goosed asset markets and resource misallocation. For the global economy to re-balance from peak debt requires debts to be written down, something that occurs with bankruptcy accompanied by price deflation. Forestalling instead of managing these corrections only means a larger correction at some point in the future.

On another note, our experience is confirming the weakness of Friedman’s monetarism. Inflation is not purely a monetary phenomenon – more important, it is a behavioral one based on demographics and the perceived level of uncertainty and risk regarding the future of the economy and policy distortions.

Markets reflect the collective intelligence of humans; they’re not all stupid.

Why Wall Street’s Stimulus Junkies Weren’t Thrilled by the Fed’s Rate Decision

By Anthony Mirhaydari
It wasn’t supposed to be like this.

In a massively hyped Federal Reserve policy announcement Thursday — one that threatened to end the nearly seven-year experiment with interest rates near 0 percent and usher in the first rate hike since 2006 — Chair Janet Yellen and her cohorts gave Wall Street exactly what they wanted: No change, in line with futures market odds.

And yet stocks drifted lower, even as the action in the currency and commodities market was as expected, with the dollar falling hard and gold up 0.8 percent. Why?

Cutting to the quick: Investors, it seems, are losing confidence in the Fed.

While the Wall Street stimulus junkies should’ve been happy with the continuation of the status quo, there is now a nagging fear that credibility in central bankers is being lost — something that RBS’ Head of Macro Credit Research Alberto Gallo took to Twitter this afternoon to reiterate.

Moreover, the Summary of Economic Projections by Fed officials revealed that, at the median, policymakers now only expect a single rate hike by the end of 2015. The futures market is now pricing in a 49 percent chance of a hike at the December meeting (although Yellen noted that the October meeting was “live” and could result in a hike should markets and economic data improve).

But the kicker — the one that pushed large-cap stocks lower into the closing bell — was the appearance of a negative interest rate projection by a Fed policymaker on the newly released “dot plot.” Someone, it seems, expects federal funds policy rate to be in negative territory at the end of 2016. Four officials don’t expect any hikes this year at all.

Not only does this undermine confidence in the state of the economy, but it calls into question the efficacy of the Fed’s ultra-easy monetary policy stance that has been in place, to varying degrees, since 2008. Moving forward, it will be critical for the bulls to recover from Thursday’s intra-day selloff. The day’s action resulted in a very negative “shooting star” technical pattern that signals buying exhaustion and often precedes pullbacks.

In their statement, Federal Open Market Committee members fingered recent global economic weakness and financial market turbulence as giving reason to believe that inflation would take longer to return to their 2 percent target. So the new dot plot shows the median rate projection for the end of 2015 falling to 0.375 percent from 0.625 percent as of June; to 1.375 percent for 2016 vs. 1.625 percent before; and 2.625 percent for 2017 from 2.875 percent. The long-term neutral rate declined to 3.5 percent from 3.75 percent, signifying ongoing structural problems in the economy holding down its potential growth rate.

But a tree should be judged by the fruit it produces. In this case, median household incomes are stagnating despite all the Fed has already done, including three bond-buying programs and the “Operation Twist” maturity extension program. With corporate profits rolling over and global growth stagnating, people are wondering: Is this all the Fed and its central banking counterparts can do? Fresh threats, such as another possible debt ceiling showdown on Capitol Hill this autumn and an election in Greece, are approaching.

As for what comes next, Societe Generale Chief U.S. Economist Aneta Markowska suggests a replay of the late 2013 experience surrounding the beginning of the end of the QE3 bond-buying program: “Our scenario is reminiscent of 2013 when the ‘taper tantrum’ spooked the Fed in September, a government shutdown spooked the Committee in October, and the fog finally lifted by December when the taper was finally announced.”

If the Fed left rates unchanged, there were some new wrinkles in its statement. In explaining their decision, Fed officials elevated issues like global economic growth and the dollar’s valuation seemingly above its traditional mandate regarding labor market health. J.P. Morgan Chief U.S. Economist Michael Feroli believes investors shouldn’t read too much into the new factors being cited. In a paraphrase of the infamous rant by former Arizona Cardinals coach Dennis Green: Yellen is a dove. She is who we thought she was. And until higher inflation becomes a clear and present problem, this continual moving of the goalposts for Fed rate hikes — deferring until more data comes in — looks set to continue.

But that may no longer be enough to keep stocks happy.

——————-

Yellen-cheap-money

David Stockman is not a fan of the Fed. In fact he claims that the Fed is on a “jihad” against retirees and savers.

The former Reagan budget director and author of “The Great Deformation: The Corruption of Capitalism in America” visited Yahoo Finance ahead of the Fed announcement to discuss his predictions and the potential impact of today’s interest rate decision. “80 months of zero interest rates is downright crazy and it hasn’t helped the Main Street economy because we’re at peak debt,” he says.

Businesses in the U.S. are $12 trillion in debt. That’s $2 trillion more than before the crisis, but “all of it has gone into financial engineering—stock buybacks, mergers and acquisitions and so forth,” according to Stockman. “The jig is up; [the Fed] needs to get on with the business of allowing interest rates to find some normalized level.”

While Stockman believes that the Fed should absolutely raise rates today, he isn’t so sure that they will (Note: they did not). But even if they do, he says they’ll muddle the effect by saying “‘one and done’ or ‘we’re going to sit back and watch this thing unfold for the next two or three months.’”

This all fuels an inflationary bubble on Wall Street, according to Stockman. “This massive money printing we’ve had has never gotten out of the canyons of Wall Street. It’s sitting there as excess reserves.”

According to Stockman, the weakness of the U.S. economy has been due to a lack of investment over the past 15 years and inflated labor costs in America that can’t compete on a global scale. “Simply printing more money and keeping interest rates at zero do not help that problem.”

Zero interest policies, says Stockman, are leading to the global economic turmoil we are currently experiencing. “In the last 15 years China took its debt from $2 trillion to $28 trillion… it’s a house of cards with an enormous overcapacity and enormous speculation and gambling that is beginning to roll over,” he says. “It’s just the leading edge of a global deflation that I think is underway as a consequence of all this excess credit growth that we’ve had.”

If the Fed raises rates and doesn’t mince words there’s going to be a long-running market correction, says Stockman. If the Fed doesn’t raise rates there will be a short-term relief rally but eventually the markets will lose confidence in the central bank bubble and we’ll be in store for a “huge correction.”

This is My (Pent)House

broken-ladderIllustrative quote from Larry Katz, Harvard economics professor, which apparently has been making the rounds for awhile…

Think of the American economy as a large apartment block. A century ago – even 30 years ago – it was the object of envy. But in the last generation its character has changed. The penthouses at the top keep getting larger and larger. The apartments in the middle are feeling more and more squeezed and the basement has flooded. To round it off, the elevator is no longer working. That broken elevator is what gets people down the most.

The Ironies of ZIRP

fed-rate-zero

This is an excellent explanation of the behavioral illogic of Zero Interest Rate Policies being imposed by the major central banks of the world. If only they paid more attention to how they were increasing perceived risks and uncertainty in markets.

From Barrons:

Low Interest Rates: A Self-Defeating Strategy

Instead of encouraging spending and boosting the economy, low rates can lead people to squirrel more money away to meet their retirement or other goals.

April 17, 2015
When I think back on all the crap I learned in grad school, it’s a wonder I can think at all, to paraphrase Paul Simon. And that also goes for what was drummed into me as an undergraduate, way back when we used Kodachrome film to take photographs with Nikon cameras, instead of iPhones (and Eastman Kodak was among the elite 30 Dow industrials).Among those shibboleths was that low interest rates always stimulate the economy. Reduced borrowing costs make it easier for folks to buy houses and companies to invest and expand. Lower yields on savings cut the incentives for consumers to stash their cash in the banks like Scrooge and instead make them more inclined to go out and spend and have a good time. And all that spending should tend to push up prices and, in due time, set up the next cycle of rising rates.

And if interest rates ever hit zero, money would be free, which should mean the economy should be like an open bar—a real party. Then think about what would happen if rates went where they never had gone before—below zero percent and into negative territory. Lenders would be paying borrowers, rather than the other way around.

This isn’t some alternate universe, but rather what’s actually happening in Europe. As The Wall Street Journal reported last week, some borrowers in Spain had the rates on their mortgages fall below zero, which meant the bank owed them money. That comes as approximately one-third of all European government bonds carry negative yields.

Those are mainly short-to-intermediate maturities whose yields have followed the European Central Bank’s minus 0.20% deposit rate into negative territory. But, by week’s end, the benchmark 10-year German bund yield seemed inexorably headed below zero, as it set another record closing low of 0.073%, according to Tradeweb. At that return, investors would double their money in a mere 1,000 years.

But the boom that the textbooks predict is nowhere in evidence. That’s not a surprise to Jason Hsu, vice chairman and co-founder of Research Affiliates and also a card-carrying Ph.D. and adjunct professor at UCLA. As a frequent visitor to Japan over more than a decade, he’s had a chance to observe firsthand the effect of near-zero interest rates.

In the complete opposite of what classical economics teaches, low returns actually have induced Japanese consumers to spend less, he says. As the aging population saves more to get to a threshold of assets needed for retirement, firms seeing no spending are loath to spend, invest, or hire. “This is a bad spiral that never was predicted,” Jason explains (appropriately enough, over a sushi lunch).

This had always been assumed to reflect both the demographics and cultural traits of Japan. But that world view will have to be revised, as there’s evidence of the same thing happening in Europe, he adds, with Germans reacting to zero interest rates by saving more. This behavioral dimension helps explain the tepid payoff from the unprecedented “financial repression” that has taken interest rates to zero and below.

The restraints on spending from forcing savers to save more in a low-rate environment has been a theme sounded by a number of critics, including David Einhorn, the head of Greenlight Capital, a hedge fund. At a recent Grant’s Interest Rate Observer conference, he quoted Raghuram Rajan, the head of India’s central bank, who, in a lecture at the Bank for International Settlements in 2013, spoke of the plight of someone nearing retirement and facing losses on savings (from two bear markets this century) and low prospective returns. That “can imply low real interest rates are contractionary—savers put more aside as interest rates fall in order to meet the savings they think they will need when they retire.” Indeed, according to a widely cited estimate by Swiss Re, U.S. savers have foregone some $470 billion in interest earnings since 2008.

That conundrum was quantified in a report by David P. Goldman, head of Americas research at Reorient Capital in Hong Kong. A saver who accumulates assets for retirement through stocks would want to “annuitize” or convert that wealth into a stream of income for retirement. “But the amount of income investors can expect to receive from an equity portfolio converted into bonds actually has fallen over the past 18 years,” he writes.

At the peak of the stock market in 2000, Goldman calculates that one unit of the Standard & Poor’s 500 annually earned the real equivalent of $1,900 (adjusted for inflation, in 1982 dollars) when invested in Baa (medium-grade) corporate bonds. At the market’s recovery in 2007, one unit of the S&P would earn $1,300; now, it’s only $1,100.

The same goes for home prices. A house bought for $500,000 in 2000 and sold today and reinvested in Baa bonds would yield $16,000 annually in 1982 dollars, versus $22,000 when it was bought 15 years ago. Bottom line: “Assets have soared, but the prospective interest on these assets has shrunk.”

Which means that even the affluent top 20% of Americans (who accounted for 61% of domestic consumption in 2012, up from 53%, according to data cited by Goldman) who actually have assets are more cautious about spending than a naïve view of the wealth effect might suggest, he concludes.

To be fair, what we learned about interest rates and the economy were predicated on “normal” levels. A decline in mortgage rates from, say, 7% to 5% could reliably be counted on to set off a rebound. That would lower the monthly payment on a $300,000, 30-year loan by nearly 25%, to around $1,600 from $2,000. First-time home buyers then might qualify to get into a house; the sellers could trade up to nicer digs; those who stayed put could refinance and cut their payment or take down more money to pay off other debt or spend on a car, boat, or college tuition.

It may be that, as interest rates—which represent the time value of money [plus the risk premium for uncertain outcomes]—approach zero, their impact is distorted, just as time is distorted as the speed of light is approached, according to Einstein.

Financial repression that has depressed rates to levels that are unprecedented in history is having unpredictable effects, which shouldn’t be entirely unexpected. Even if we didn’t learn about them in school.

The Swiss Bail

Swiss-National-Bank-Chappatte_200115

This is a good, succinct explanation of the significance of the Swiss National Bank action to cease printing money and what’s in store for the central bank policies of the world.

Quote from asset manager Axel Merk:

Ultimately, central banks are just sipping from a straw in the ocean. I did not invent that term. Our senior economic advisor, Bill Poole, who is the former president of the St. Louis Federal Reserve taught us this: that central banks are effective as long as there is credibility.

What central banks have done is to try to make risky assets appear less risky, so that investors are encouraged or coerced into taking more risks. Because you get no interest or you are penalized for holding cash, you’ve got to go out and buy risky assets. You’ve got to go out and buy junk bonds. You have to go out and go out and buy equities.

The equity market volatility, until not long ago, has been very low. When volatility is low, investors are encouraged to buy something that is historically risky because it is no longer risky, right?

But as the Swiss National Bank has shown, risk can come back with a vengeance. The same thing can happen of course, in any other market. If the Federal Reserve wants to pursue an “exit” to its intervention, if it wants to go down this path, well, volatility is going to come back.

Everything else equal, it means asset prices have to be priced lower. That is the problem if you base an economic recovery exclusively on asset price inflation. We are going to have our hands full trying to kind of move on from here. In that context, what the Swiss National Bank has done is it is just a canary in the coal mine that there will be more trouble ahead.

The Politics of Polarization

tugofwar

I watched an interesting debate aired by PBS over political polarization in American politics. The debate actually focused solely on the partisan/ideological divide as it pitted “right against left” in its panels and choice of participants. You can view the debate here.

I found some truths and falsehoods presented on this issue. First, I would agree with George Will that partisan opposition is fundamental to the design of the US electoral and governing system. We have two parties so that issues can be reduced to simple dichotomous choices where the choice that prevails can be said to represent a majority of the nation’s citizens and thereby claim a mandate, whether that be weak or strong. Polarization today is evenly matched in a 50-50 nation, which makes elections highly contentious and volatile. It also makes it hard to claim a mandate, and rightly so.

The left-liberal argument seems to be that electoral polarization causes government dysfunction, but this is exactly the purpose: to challenge one side’s view of “good” government by forcing majorities and supermajorities in elections and governance. One discussant claimed that gridlock did not express the “will of the people” because of large scale disenfranchisement of minority groups. Whether disenfranchisement is salient or not, this is not what the data show to be driving polarization. In fact, if one controls for race, for instance measuring only white people, we find the same polarization patterns exist.

Matt Kibbe argues that the system is experiencing upheaval due to information technology that opens the political process in many ways that challenge the old guard. In other words, the political and media elites no longer control the show and are understandably upset with their loss of hegemony. This paints our political dysfunction as an insider-outsider, populist-elite conflict that has tilted toward the outsiders. I’m not sure it has, beyond informing the outsiders just how outside the process they are. The apparent result has been widespread dissatisfaction with the governing status quo, but that doesn’t drive polarization as much as blame-gaming.

But the debate focused on the narrow ideological differences between left and right, whereas most of the polity does not adopt pure ideological or partisan identities. The fastest growing group of voters identify as independent and non-affiliated. So, we are still left with the question of what is driving polarization and we need to answer that question before we have a chance of understanding it. One problem is that the proffered answers usually support one’s political agenda rather than truth.

One need only to look at the correct maps of election results to understand that polarization exists and it is largely a geographic phenomenon. 2004countymap-final2The Red State-Blue State narrative is not quite accurate as the real divide is obviously urban-rural, as illustrated by county election maps. This is confirmed with robust statistical results from recent presidential elections. As one moves from the urban core to the rural periphery, the share of the vote by county moves monotonically from Democrat to Republican. This fact has given rise to those bizarre and amusing subcultural characteristics of opposing voting groups: Republicans own guns, go to church, drive pick-up trucks, and listen to country western, while Democrats drink lattes at Starbucks, drive hybrids, and listen to rap and hip hop. There’s some truth to these stereotypes that feed our amusement, but these lifestyle choices do not drive political preferences, they coincide with political preferences. There’s a big difference, because when identity drives politics, there is little room for compromise.

This coincidence has become salient because both parties have tailored their party platforms to appeal to rural or urban voters. In other words, the parties have created political identities, not voters. We can observe the reality in the suburbs, where cultural caricatures are harder to apply. The true divisions in American politics these days are pretty much the same as those divisions that have existed over the past two hundred plus years: rural regions have different policy preferences than urban, metropolitan regions. The data show that these preferences also correlate with household and family formation, specifically marriage vs. singles and single heads of household. Population density of the county along with the share of married and female heads of households explains roughly two-thirds of party voting preferences in elections today. These differences in preferences have existed in societies throughout history and across countries, so they don’t present any different challenge to our democracy today. The real problem lies in the final third of the explanation for polarization, which is ideology or political philosophy.

Unfortunately, this conflict is usually misrepresented by self-interested parties. So the real challenge we face are the myths promoted by those elites who study and propagandize politics. This would include both parties, the political class, and most of the mainstream media elites. It would also include self-interested parties that exert great influence over the funding of politics, such as major corporations, the banking system, and public unions. This PBS debate exposes the tendency of experts to perpetuate these myths for reasons best known to them.

Mr. Will is correct that the driving force of the polarization we speak of today is ideology over the proper role of government in democratic society. I would have to say that the burden of proof on this rests with the pro-government advocates on the left, as the status quo ante for the US has been limited government that is constitutionally proscribed. The burden of small government proponents has been to meet the demands of democratic society without shifting the sphere of private life to the public sector. One cannot merely say such demands are illegitimate because legitimacy is a function of what a democratic polity demands within the constraints of constitutionalism. If voters demand economic security, the task is to help meet that demand in the most efficient and just manner possible, which usually doesn’t mean creating another universal entitlement program. An old Chinese proverb illustrates this perfectly: better to teach a hungry man to fish than give him a fish to eat.

Eric Liu seems to understand this, though he also appears too willing to fall back on the default of government-driven solutions by expanding public goods. Instead of really addressing the issue Mr. Will presents, the opposing discussants resort to claiming the question of bigger or smaller government is a false dichotomy. Intellectually, perhaps, but practically it seems to be the simple dichotomy that our political system was designed to distill and resolve. The petty and personal nature of our political conflict is merely a manifestation of this inability to reconcile these opposing positions. Personally, I am convinced it can be done, but it starts with understanding the true nature of our politics that puts to the test many of the belief systems we hold so dear.

This Wild Market

stock-market-the-ride

This Wild Market

Perhaps we can figure out what’s going on in the markets today if we read between the lines.  Prof. Shiller explains that “…the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. Which means that CAPE today is largely a reflection of the Greater Fool Theory of investment.

Then Mr. Shiller states that “[t]oday’s level “might be high relative to history, but how do we know that history hasn’t changed?”

I would guess that history has changed. Starting when the dollar and all other currencies became free floating in 1971, empowering central banks to create credit at will according to political dictates. This credit creation has occurred simultaneously with the expansion of the global labor supply in concert with new technology, both of which have depressed inflationary price signals, permitting central banks to continue their credit expansion at little apparent cost. It’s all good, as the shadow bankers might say.

But the less obvious result has been volatility of asset prices that we see reflected in the 30 year transition of financial markets toward trading away from new productive capital investment. This is how the hedge fund industry has blossomed.

The value of financial assets has departed from cash flow fundamentals and the result is markets that pop one day and deflate the next, depending on the sentiment of the moment, rather than underlying economic fundamentals. We’ve created greater price uncertainty in the economy that hampers productive long-term investment and concentrates the rewards in a shrinking cohort of lucky asset holders. This violates the most basic theory of financial management under uncertainty, which is stability through diversification.

This history was not inevitable, it was deliberately pursued under faulty intellectual models of our market society.

From the WSJ’s MoneyBeat:

Robert Shiller on What to Watch in This Wild Market

By Jason Zweig

You would have to be crazy to think the stock market isn’t crazy.

In three tumultuous days this week, the Dow Jones Industrial Average dived 273 points, then jumped up 275 points, then dropped 335 points.

But you might be even crazier if you think you know exactly when to get out of the market.

Few people understand that better than Robert Shiller, the Yale University finance professor who shared the Nobel Prize in economics last year for his research documenting that stock prices fluctuate far more than logic can justify—and who is renowned for telling people when to get out of the market.

Prof. Shiller predicted the collapse of both the technology-stock bubble in 2000 and the real-estate boom in the late 2000s. And he developed a measure of long-term stock valuation that many professional investors rely on.

Yet the central message that emerges from three conversations with Prof. Shiller over the past few weeks isn’t a cocksure forecast; it is a deep humility in the face of irreducible uncertainty.

Many analysts have warned lately that Prof. Shiller’s long-term stock-pricing indicator is dangerously high by historical standards.

Known as the “cyclically adjusted price/earnings ratio,” or CAPE, Prof. Shiller’s measure is based on the current market price of the S&P 500-stock index, divided by its average earnings over the past 10 years, both adjusted for inflation. It stands at nearly 26, well above the long-term average of about 16.

If only things were that simple, Prof. Shiller says.

“The market is supposed to estimate the value of earnings,” he explains, “but the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. So the long-term average is “highly psychological,” he says. “You can’t derive what it should be.”

Even though the CAPE measure looks back to 1871, using data that predates the S&P 500, it is unstable. Over the 30 years ending in 1910, CAPE averaged 17; over the next three decades, 12.7; over the 30 years after that, 15.7. For the past three decades it has averaged 23.4.

Today’s level “might be high relative to history,” Prof. Shiller says, “but how do we know that history hasn’t changed?”

So, he says, CAPE “has more probability of predicting actual declines or dramatic increases” when the measure is at an “extreme high or extreme low.” For instance, CAPE exceeded 32 in September 1929, right before the Great Crash, and 44 in December 1999, just before the technology bubble burst. And it sank below 7 in the summer of 1982, on the eve of a 17-year bull market.

Today’s level, Prof. Shiller argues, isn’t extreme enough to justify a strong conclusion. So, he says, he and his wife still have about 50% of their portfolio in stocks.

On Thursday, as the Dow fell more than 300 points, Prof. Shiller told me, “The market has gone up for five years now and has gotten quite high, but I’m not selling yet.” He advises investors to monitor not just the level of the market, but the “stories that people tell” about the market. If a sudden consensus about economic stagnation forms, that could be a dangerous “turning point,” he says.

Based on new research he has done into industry sectors, he says, he is “slightly overweight” in health-care and industrial stocks.

The third edition of Prof. Shiller’s book “Irrational Exuberance,” coming out in February, will feature a chapter on bonds.

Is the bond market, as some investors have suggested, a bubble bound to burst?

“A bubble is a product of feedback from positive price changes that create a ‘new era’ ambience in which people think increasingly that prices will go up forever,” Prof. Shiller says.

Today’s bond market, he adds, “is just the opposite of a new-era ambience.” Instead, the demand for bonds is driven by “an underlying angst” about the slow recovery and pessimism about the future. “That’s not a bubble,” he says.

It also is worth considering where Prof. Shiller gets his knack for seeing what others overlook—the kind of gift that the renowned hedge-fund manager Michael Steinhardt has called “variant perception.”

Prof. Shiller is an unconventional thinker who relishes investigating ideas that other people regard as eccentric or unrewarding. “I don’t fit in so well,” he says, shrugging. “I’m socialized differently somehow.”

Prof. Shiller—and his wife, Ginny, a clinical psychologist—suspect that he has “a touch” of attention deficit hyperactivity disorder. “I’m very distractible, although I can be highly focused on tasks that interest me,” he says.

It is that intensity of thinking that leads to rare big insights—and to the recognition that, as he puts it, “a lot of fundamental problems aren’t really soluble.”

One friend recalls meeting him for lunch in New Haven; afterward, Prof. Shiller offered to give him a lift to the train station. But, the friend recalls, “Bob couldn’t find his car. He couldn’t remember where he had parked it.”

“Bob came into my office one day in the early 2000s,” his colleague, Yale finance professor William Goetzmann, told me. “He said, ‘I think we are in a real-estate bubble.’ I listened to him and said, ‘Hmm, that’s interesting,’ and when he left, I went right back to whatever research I was doing.” Prof. Shiller went on to produce the first serious warnings that the housing market would collapse.

Prof. Shiller says both stories sound right to him.

I reached him by phone earlier this month after he had missed an earlier appointment to speak. “I was awaiting your call,” he said, “but somehow never heard the phone ring.” Later he clarified that he might have left his cellphone in the next room but wasn’t sure.

It isn’t hard to imagine him sitting there, oblivious to the ringing phone and every other sight and sound, lost in contemplation of big ideas.

Housing Casino Bosses

HeliBenWhat we have here is a clear case of market manipulation and price distortion with arbitrary effects across the economy. Specifically, “when the central bank buys private assets, it can tilt the playing field toward some borrowers at the expense of others, affecting the allocation of credit.” The result is neither fair, nor is it economically efficient. “It is as if the Fed has provided off-budget funding for home-mortgage borrowers, financed by selling U.S. Treasury debt to the public.” If you bought or lent against an overpriced asset, send a thank you note to the Fed. If you’re hoping to buy one of those overpriced assets and looking for a lender, you know who Scrooge is. From the WSJ:

The Fed’s Mortgage Favoritism

When the central bank buys private assets, it distorts markets and undermines its claim to independence.

By Jeffrey M. Lacker And John A. Weinberg

Oct. 7, 2014 6:42 p.m. ET

Modern central banks enjoy extraordinary independence, typically operating free from political interference. That has proved critical for price stability in recent decades, but it puts central banks in a perpetually precarious position. Central-bank legitimacy will wane without boundaries on tools used for credit-market intervention.

Since 2009 the Fed has acquired $1.7 trillion in mortgage-backed securities underwritten by Fannie Mae and Freddie Mac , the mortgage companies now under government conservatorship. Housing finance was at the heart of the financial crisis, and these purchases began in early 2009 out of concern for the stability of the housing-finance system. Mortgage markets have since stabilized, but the purchases have resumed, with more than $800 billion accumulated since September 2012.

We were skeptical of the need for the purchase of mortgage assets, even in 2009, believing that the Fed could achieve its goals through the purchase of Treasury securities alone. Now, as the Fed looks to raise the federal-funds rate and other short-term interest rates to more normal levels, that normalization should include a plan to sell these assets at a predictable pace, so that we can minimize our distortion of credit markets. The Federal Open Market Committee’s recent statement of normalization principles did not include such a plan. For this reason, the first author, an FOMC participant, was unwilling to support the principles.

The Fed’s MBS holdings go well beyond what is required to conduct monetary policy, even with interest rates near zero. The Federal Reserve has two main policy mandates: price stability and maximum employment. In the past, the pursuit of higher employment has sometimes led the Fed (and other central banks) to sacrifice monetary stability for the short-term employment gains that easier policy can provide. This sacrifice can bring unfortunate consequences such as the double-digit inflation seen in the 1960s and 1970s.

But during the Great Moderation—the period of relatively favorable economic conditions in the 1980s and 1990s—a consensus emerged that, over time, the central bank’s effect on employment and other real economic variables is limited. Instead, the central bank’s unique capability is to anchor the longer-term behavior of the price level. Governments came to see that entrusting monetary policy to an institution with substantial day-to-day independence could help overcome the inflationary bias that short-term electoral pressures can impart.

The independence of the central bank cannot be boundless, however. In a democracy, the central bank must be accountable for performance against its legislated macroeconomic goals. What is essential for operational independence is the central bank’s ability to manage the quantity of money it supplies—that is, the monetary liabilities on its balance sheet—because this is how modern central banks influence short-term interest rates.

A balance sheet has two sides, though, and it is the asset side that can be problematic. When the Fed buys Treasury securities, any interest-rate effects will flow evenly to all private borrowers, since all credit markets are ultimately linked to the risk-free yields on Treasurys. But when the central bank buys private assets, it can tilt the playing field toward some borrowers at the expense of others, affecting the allocation of credit.

If the Fed’s MBS holdings are of any direct consequence, they favor home-mortgage borrowers by putting downward pressure on mortgage rates. This increases the interest rates faced by other borrowers, compared with holding an equivalent amount of Treasurys. It is as if the Fed has provided off-budget funding for home-mortgage borrowers, financed by selling U.S. Treasury debt to the public.

Such interference in the allocation of credit is an inappropriate use of the central bank’s asset portfolio. It is not necessary for conducting monetary policy, and it involves distributional choices that should be made through the democratic process and carried out by fiscal authorities, not at the discretion of an independent central bank.

Some will say that central bank credit-market interventions reflect an age-old role as “lender of last resort.” But this expression historically referred to policies aimed at increasing the supply of paper notes when the demand for notes surged during episodes of financial turmoil. Today, fluctuations in the demand for central bank money can easily be accommodated through open-market purchases of Treasury securities. Expansive lending powers raise credit-allocation concerns similar to those raised by the purchase of private assets.

Moreover, Federal Reserve actions in the recent crisis bore little resemblance to the historical concept of a lender of last resort. While these actions were intended to preserve the stability of the financial system, they may have actually promoted greater fragility. Ambiguous boundaries around Fed credit-market intervention create expectations of intervention in future crises, dampening incentives for the private sector to monitor risk-taking and seek out stable funding arrangements.

Central bank operational independence is a unique institutional privilege. While such independence is vitally important to preserving monetary stability, it is likely to prove unstable—both politically and economically—without clear boundaries. Central bank actions that alter the allocation of credit blur those boundaries and endanger the stability the Fed was designed to ensure.

Creative Capitalism: Gates & Buffett

CreativeCapBook Review:

A noble effort that fails to converge on ideas…

There are basically two teams in this match of ideas, with several participants trying to referee. On one side are the economists by trade, who are very skeptical about non-market criteria in economics. On the other side are the non-economists who believe the art and science of economics needs to be broadened, but are unclear on how this can be accomplished. Notably, I found the most refreshing approach of the many experts participating in the blog offered by perhaps its youngest contributor – the student Kyle Chauvin – who argued how we need to expand the reach of traditional, or profit, capitalism, not only around the world but to the overlooked corners of the developed world as well.

Unfortunately, the two sides never really converge in this debate and I suppose that may be why the conversation has disappeared from public discourse. Both sides accept some common premises that need to be challenged in order to break out of the box we find ourselves in on these issues.

These premises derive from the neoclassical school of economic theory that laid the foundation for general equilibrium theory in macroeconomics. Specifically, actors within the economy are classified according to a loose application of factor analysis, so we have workers, entrepreneurs and small business owners, corporate firms and managers, investors, savers, lenders, borrowers, consumers, and political actors. Then we lump these categories into producers, savers, and investors on one side versus consumers, workers, and borrowers on the other. The consensus seems to settle on the idea that some people produce and so policy should empower this production. Then successful producers can be taxed by political actors, and/or encouraged by philanthropy, to redistribute the wealth to non-producers for reasons that range from compassion to demand stimulus.

Capital accumulation and equity ownership in capitalist enterprise is an essential form of participation in the modern global market economy. Concomitant with ownership is the question of control in governance and risk management as the flip side of profit. But instead of focusing on how wealth is created and distributed through these market structures and institutions, we insist on dividing capital from labor and then try to redistribute the outcomes by political calculus, or by corporate largess. This is industrial age capitalism and such a mode of production will never accomplish what we hope to through creative capitalism. (I do agree with Clive Cook that we need a better term—maybe Inclusive Capitalism or the Singularity, to borrow from Ray Kurzweil.)

The problems that corporate social responsibility (CSR) seeks to address are rooted in the skewed distribution of productive resources across society, widening the gap between the haves and the have-nots. But taxing the haves to give to the have-nots is a self-defeating form of compassion. We should try to adhere to the Chinese proverb about teaching a hungry man to fish so that he eats for a lifetime. This can be put most plainly by asking the following question: If corporations work solely to enrich shareholders, then why aren’t we all shareholders? To widen the economic net even more, why aren’t all enterprise stakeholders shareholders?

Equity participation may also be the most viable way to promote “recognition” as a complement to profit maximization, as stakeholders have a broader range of interests, of which immediate profits is only one. This idea also focuses our attention on the real problem of free societies: agency failures and governance. Market economies depend on a multiplicity of agent-principal relationships in economic enterprises and political institutions. The abuse of these relationships is the mark of cronyism that dominates public attitudes toward “undemocratic” capitalism these days. This is not an easy problem to solve, but suffice to say equity ownership, control, and risk management must be as open, transparent, and competitive as possible. This is the only way to confirm that these relationships are accepted as just.

The only sustainable solution to world poverty and the skewed distribution of resources is the creation of a worldwide, self-sufficient, productive middle class. This is as necessary for democratic politics as it is for economics. For the middle class to grow, it needs access to resources, mostly financial capital and technology these days.

We can point to the history of land homesteading that built the American Midwest, and just recently, the idea floated by Michigan’s governor to promote homesteading in Detroit for foreigners. Society’s resources need to be spread far and wide in order to reap the benefits of innovation and adaptation, while maximizing the utilization of these resources. The financial imperative of capital is to maximize return, but the socioeconomic objective seeks to do so by combining capital with labor. This flies a bit in the face of the efficiency argument that some people are better at managing risk and creating wealth, so specialization of function should favor the risk managers on Wall Street. The problem is that we never know where to find the successful entrepreneurs and job creating small businesses of the future, only those of the past. And Wall St. only considers those who manage to squeeze through the narrow access door.

Without angel capital provided by family relations who merely saved and accumulated their personal wealth, many enterprises would never see the light of day. At the early stages, venture capital money is too costly or unavailable. This story is repeated across the economy, yet today’s concentration of capital in venture firms, hedge funds, private equity, buyout firms, major bank holding companies, etc. narrows capital access to those who already have it. The proliferation of ideas must be forced through this bottleneck, to what end? Better that individuals, families, small group networks, etc. are empowered by policy to accumulate their own capital to put at risk in entrepreneurial ventures. After all, sometimes the idea is not so sexy and may be nothing more than a new restaurant idea or a better mousetrap. In a world where the future is unknown, we can’t lock ourselves into narrow investment models built on the past. Likewise, we should not underestimate the ancillary growth Microsoft seeded by enriching its own shareholders.

The key point, which cannot be overemphasized, is that broad capital accumulation achieves double the impact of other policy options. First, it helps finance ideas, innovation and entrepreneurial risk-taking that will increase labor utilization, spreading the risks and benefits of economic growth. Second, accumulated financial assets, or savings, help mitigate economic risks of unemployment, health, and retirement through self-insurance. This reduces political demands on the state’s safety-nets and the tax and redistributive policies on productive effort that hampers economic growth. Essentially, policies that promote broad-based capital accumulation are a win-win for all citizens of a democratic capitalist society.

Financial Crisis Amnesia

 

AENeumann

Alex Pollock, quoted from the WSJ:

It is now five years since the end of the most recent U.S. financial crisis of 2007-09. Stocks have made record highs, junk bonds and leveraged loans have boomed, house prices have risen, and already there are cries for lower credit standards on mortgages to “increase access.”

Meanwhile, in vivid contrast to the Swiss central bank, which marks its investments to market, the Federal Reserve has designed its own regulatory accounting so that it will never have to recognize any losses on its $4 trillion portfolio of long-term bonds and mortgage securities.

Who remembers that such “special” accounting is exactly what the Federal Home Loan Bank Board designed in the 1980s to hide losses in savings and loans? Who remembers that there even was a Federal Home Loan Bank Board, which for its manifold financial sins was abolished in 1989?

It is 25 years since 1989. Who remembers how severe the multiple financial crises of the 1980s were?

Full article (subscription req’d.)

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