Stressed Out: Geithner’s Stress Test

Stress-Test-BookThis is a review of former US Treasury Secretary and Chair of the New York Federal Reserve Bank Timothy Geithner’s explanation of the financial crisis and its subsequent management (also posted at Amazon).

Though full of interesting perspectives, Geithner’s exposition seems more of a desire to preempt the writing of history with a rationalization of his policy choices than provide any insight into the reality of the crisis or how it has reconfigured the financial landscape for the worse. Not surprisingly, fellow liberal Paul Krugman’s critical review is not cited by the publishers.

Geithner’s view of the economy and the role of finance is colored by the myopic banker’s view of the credit system, but I guess we should have expected this from a Treasury Secretary whose only preparation for the job was as head of the NY Federal Reserve Bank.

Geithner believes the financial crisis was a liquidity crisis akin to a bank run. Geithner’s solution was calibrated to the Federal Reserve stepping in as the lender of last resort, a role which it performed admirably. But the payments breakdown was merely the symptom of the problem, not the cause. The cause was (and still is) insolvent balance sheets across the financial sector. And this insolvency can be traced back to bad policies: easy credit by Greenspan, Bernanke and Co. and the lack of banking oversight, by, well, guess who? Timothy Geithner at the head of the NY Fed.

A housing bubble fueled by easy credit and securitized mortgages led to balance sheets with mispriced assets for financial intermediaries the world over. In other words, the AAA-rated MBSs they were holding as capital reserves were only as good as the value of the underlying collateral: all those ridiculously priced houses leveraged on cheap credit. When people began to realize this, the run was on and the repo market froze, cascading across all the credit markets. This was an insolvency crisis reflected in a payments freeze. The Fed needed to stand in as lender of last resort and did so, with Geithner’s full support.

But then Geithner’s solution to the post-liquidity financial de-leveraging has been to make bankers whole and push the mispricing costs onto taxpayers, savers, homeowners, and lenders. AIG went into receivership, but all the counter parties from Goldman Sachs to European banks were paid back at par on their credit default swaps. This not only enriched, but sheltered bad actors like Goldman from accountability. This served Geithner’s Wall Street constituency rather well (not exactly the constituency of the US Treasury Secretary, which is a bit broader). This was “heads we win, tails you lose,” on a grand scale. Now the banking system is more concentrated than ever with systemic risk of another shock even more threatening. Meanwhile, Main Street business struggles to obtain credit to grow the real economy. Hence anemic job creation. I doubt the Stress Test assures an all-clear, except for certain favored banking actors who now have a virtual government guarantee as TooBigToFail.

Instead, the Fed and Treasury should have managed the deleveraging of the historical credit bubble until asset prices again reflected fundamental values rather than false confidence in monetary engineering. Like AIG, failed banks should have been restructured by the government and then sold off to profitable buyers.


Despite the self-congratulatory tone of the author, we are nowhere near writing the end of this story. The Fed has expanded its balance sheet by $3.5 trillion and is holding much of that in overvalued MBSs that it has purchased through Quantitative Easing. The policies have tried to inflate housing values in order to return these mortgages back to nominal face value, but the prices of houses are artificially being pumped up by Fed credits while housing fundamentals (median incomes) remain in the doldrums. The bubbles in financial markets are also a direct manifestation of Fed policy. The Fed knows that it can cover its bad assets by merely creating more credit liabilities. The final reckoning will likely be the depreciation of the US$ and the loss of real value to savers, lenders, and working people.

Krugman is right, Geithner and the Fed saved the world from a Great Depression (of their own making – thank you very much), but have invited even greater economic disaster in lost opportunity for the middle class.

The Anti-Political Blues


Back in the 1970s Lowell George of the band Little Feat penned a tune he called “Apolitical Blues,” which inspired the title of this post. If anything has changed politically since the Seventies, it’s that most Americans have become even more jaded with party politics and governing dysfunction. Blame who you will.

I’ll make a case here why our politics has become dysfunctional. First, I’ll argue this is a non-partisan issue (though I do have my ideological biases). If one is intellectually committed to one party or the other, I doubt I can do much to change your mind, but I will caution that partisan explanations are incomplete and largely inaccurate.

Before I begin, let’s get a temperature reading on the mood of the electorate. In a (very) recent Gallup poll, only 29% of those polled expressed any confidence in our current executive branch and only a piddling 7% have confidence in Congress (that would be both Houses of Congress – the House controlled by Republicans and the Senate controlled by Democrats). The Supreme Court only garners confidence from 30%.

As for party identification among voters, only 24% identify as Republicans, 28% as Democrats and 46% as Independents. So roughly half the country is not impressed with either party or their candidates. Ideology is different than partisanship, but are mostly coterminous for this exposition. Frankly, I can identify with the anti-party Independents, but will explain here why I mostly favor the Republican/conservative side.

My general contention is that the Republicans are a bit lost in the more recent past of Ronald Reagan. Reagan was the right man at the right time, but his legacy is probably due as much to Nixon’s and Carter’s failures than to the efficacy of his policies. If government destroys growth incentives long enough, any policy that reverses that is going to yield positive results. In this light, instead of blaming Bush, Obama should probably be thanking him for delivering the presidency to the Left. However, Republicans are not as lost as their opposition.

Democrats are trapped in a postwar world that no longer exists, exemplified by FDR’s New Deal and JFK’s unrealized promise. Not only are they lost, they are convinced they are found and filled with certitude regarding their policy preferences. But they are wrong, and being certain of their follies makes them dangerous.

Now, let’s explain.

Both parties are rooted in the past and are failing because the economic landscape has changed. Republicans (and Reaganomics) are wedded to an economic truth that wealth is created by productive investment and hard work, with resources allocated by accurate market price signals. With these conditions, one can expect positive economic growth. But again, the economic landscape has changed and the most significant changes are technology, globalization, and demographics. These changes have tilted the playing field so that most of the gains to economic growth accrue to those who own productive assets or for some other reason have landed in the winners’ circle in a winner-take-all economy. (Say, like Michael Jordan or Cher – this is not to say they don’t deserve their lucrative fame.)

It also means that those whose incomes are dependent on their labor have lost ground. This is reflected in the unequal distributions of income and wealth. The growth mantra is meant to drown out the politics of inequality, but it never will. In our present policy configuration, we have widened the inequality gaps. For example, in seeking to reignite real growth, Fed policy has greatly enriched the “haves” vs. the “have-nots,” and there is nothing in economic or moral theory that justifies this. It is a matter of power and influence over policy.

The redeeming factor of all this is that we can learn and compensate for these policies without abandoning the principles of free markets and free peoples. In fact, these policies violate these principles. At some point the Republican Party will learn that what matters as much as economic growth is managing creative destruction in a dynamic society.

Things are not so encouraging across the ideological divide. Democrats focus almost exclusively on the politics of inequality and state redistribution. Punished for ignoring the imperatives of economic growth, they have turned to the postwar European model of state corporatism, at a time when this model is failing in Europe. In order to tax and redistribute according to political “fairness” (there is no such thing), there must be something to tax. (Thankfully, it was the Soviets who taught us this – unfortunately for the Russians.) So Democrats have decided they must corral big business, big labor, and big government to support their policy agenda. Thus, Obama’s main partners in policy, besides national labor organizations, have been big healthcare, big insurance, and big financial/banking corporations. With fewer players at the negotiating table (and no messy democracy), the state can manage society and insure “fairness” (again, there is no such thing in politics). The result is a society that grows gradually poorer as regulations, government intervention, tax policy, and political redistribution hampers the real economy and leads to gross distortions in the allocation of resources. The changing landscape of technology, globalization, and demographics will turn this policy strategy into a disaster.

To summarize, Republican policies lead to start and stop growth cycles, while Democratic policies lead to gradual stagnation and arbitrariness of results. The first goes in the right direction, but needs better calibration; the latter goes in the wrong direction and needs to be reversed.

So, anti-political blues, yes. But insanity, please no.














US Dollar Value under Management by the Federal Reserve


Eye-opening graph.

Fed advocates will argue that dollar depreciation over this period has also led to more than twenty times growth in wages and incomes. But the uncertainty of currency values does not affect all sectors uniformly and arbitrarily creates winners and losers. So, the growth in incomes has come at the expense of savers and older Americans living on fixed income pensions. It has greatly favored those who have done little except borrow to buy financial assets and real estate. So the question is: do we want an economy of ‘four walls and a roof’ or one of productive factories? The first is a depreciating asset, the second an appreciating asset.

As James Rickards puts it in his book, Currency Wars: “The effect of creating undeserving winners and losers is to distort investment decision making, cause misallocation of capital, create asset bubbles, and increase income inequality. Inefficiency and unfairness are the real costs of failing to maintain price stability.”

More pointedly he writes:

The U.S. Federal Reserve System is the most powerful central bank in history and the dominant force in the U.S. economy today. The Fed is often described as possessing a dual mandate to provide price stability and to reduce unemployment. The Fed is also expected to act as a lender of last resort in a financial panic and is required to regulate banks, especially those deemed “too big to fail.” In addition, the Fed represents the United States at multilateral central-bank meeting venues such as the G20 and the Bank for International Settlements, and conducts transactions using the Treasury’s gold hoard. The Fed has been given new mandates under the Dodd-Frank reform legislation of 2010 as well. The “dual” mandate is more like a hydra-headed monster.

From its creation in 1913, the most important Fed mandate has been to maintain the purchasing power of the dollar; however, since 1913 the dollar has lost over 95 percent of its value. Put differently, it takes twenty dollars today to buy what one dollar would buy in 1913. Imagine an investment manager losing 95 percent of a client’s money to get a sense of how effectively the Fed has performed its primary task.

There is also an implication in the pro-Fed position that gradual inflation is necessary in order to grow the economy – an analogy to greasing the machine. But that is conjecture and disproven by robust growth during the latter half of the 19th century while we experienced mild deflation.  As I have argued in Common Cent$, economic growth is a function of technology and population growth through increased labor productivity. Manipulating price values through monetary policy does little to promote long-term stable growth and only aggravates unfair economic inequality. It seems it takes a long time for each generation to discover this truth.

The Effect of Monetary Policy on the Real Economy or Who Moved (Stole?) My Cheese???


The Fed can’t do much to grow the economy and create wealth, but it can do an awful lot to screw it all up. Remember the iron-clad rule: a healthy economy must have 2-4% real positive interest rates. Currently ours are at zero or in negative territory.

The following excerpt is a repost from Charles Hugh Smith’s blog Of Two Minds.

Innovation and the Fed

Innovation is often a meaningless buzzword (think “financial innovation”), but it is also the key driver of wealth creation in the real economy.

The Federal Reserve could be shut down and all its asset bubbles could pop, and innovations in energy, agriculture, transportation, education, media, medicine, etc. would continue to impact the availability and abundance of what really matters in the real world:  energy, knowledge, water, food, and opportunity, to name a few off the top of a long list.

It is rather striking, isn’t it? The supposedly omnipotent Fed has virtually no positive role in the key driver of wealth creation.  On the contrary, the Fed’s policies have had an actively negative influence, as its monetary manipulations have distorted the investment landscape so drastically that capital pours into unproductive speculative bubbles rather than into productive innovation because the return on Fed-backed speculation is higher and the risk is lower (recall the Fed’s $16 trillion bailout of banks; including guarantees, the total aid extended by the Fed exceeded $23 trillion; the landscape looks different when the Fed has your back).

Profits from speculative gambling in malinvestments are yours to keep, while losses are either transferred to the public or buried in the Fed’s balance sheet. Why bother seeking real-world returns earned from real innovations?

Apologists within the Fed Cargo Cult’s gloomy hut (repetitive chanting can be heard through the thin walls—humba, humba, aggregate demand!) claim that the Fed’s financial repression of interest rates boosts innovation by making money cheap for innovators to borrow.

But this is precisely backward: cheap money fuels unproductive speculative bubbles and siphons resources away from innovation, while high interest rates reward innovation and punish malinvestments and financial gambling.

Two thought experiments illustrate the dynamics:

The Free Lunch

Let’s say J.Q. Public has the opportunity to borrow $1 billion at 0% interest rate from the Federal Reserve.  It costs absolutely nothing to keep the $1 billion. How careful will J.Q. be with the $1 billion? There’s a casino open; why not bet a few thousand dollars at roulette? Actually, why not bet a couple of million? If J.Q. loses the entire $1 billion, there’s no recourse for the lender, while J.Q. gets to keep the winnings (if any).

With essentially free money, there is little incentive to seek out long-term real-world investments that might pay off in the future, and every incentive to seek financial carry trades that generate short-term profits with little risk. In other words, if you can borrow money at 1%, then shifting the funds around the world to lend at 4% generates a 3% return with modest risk.  Since 3% guaranteed return beats the uncertain return of investing in innovative real-world companies, the carry trade is the compellingly superior choice.

The Square Meal

If we can only borrow money at an annual rate of 10%, there aren’t many carry trades available, and those that are available are very high-risk. At 10%, we have to sharpen our pencils and select the very best investments that offer the highest returns for the risk.

Let’s say you’re an entrepreneur and it costs 10% per annum to borrow money to pursue a business opportunity. The only investments that make sense at this rate are the ones with outstanding risk-return characteristics.

In other words, cheap money doesn’t incentivize risky investments in high-return innovation; it incentivizes carry trades and financial speculation, which actively siphon off talent and capital that could have been applied to real-world enterprises.  High real interest rates force entrepreneurs to choose the best investments, a process that favors high-risk, high-return innovations. [Casino Cap note: remember the rule.]

Avoiding the Bill

The Fed isn’t supporting innovation in the real economy; rather, it is actively widening the moat that protects the banking sector from disruptive innovation.

Thanks to innovations in technology, it is now possible to bypass borrowing entirely and raise money for innovative ventures with crowdsourcing. It doesn’t take much insight to look ahead and see that the crowdsourcing model could expand to the point that the economy no longer needs Too Big to Fail Banks at all: Virtually all lending, from commercial paper to home mortgages, could be crowdsourced, managed, and exchanged online.

This sort of real financial innovation is anathema to the Federal Reserve, of course, as its primary task (beneath the PR about maintaining stable prices and employment) is enriching and empowering the banks.

There are only two ways to deal with innovation: either dig a wider regulatory moat to protect your cartel, monopoly, or fiefdom from disruptive innovation, or get on the right side of innovation and evolve amidst the inevitable disruption.

Unfortunately for centralized institutions like the Fed, innovation always jumps the moat and disrupts the Status Quo, despite its frantic efforts to protect the perquisites of those skimming cartel-rentier profits as a droit de seigneur.

Money Delusions


The following is from this week’s Barrons:

Why the Fed Wants Higher Prices

It’s trying to exploit the power of positive wealth effects.


An important issue that the Fed has not discussed in detail is the idea that rising asset values in housing and the stock market will translate into more economic activity, and a speedier economic recovery—the impact of wealth effects.

Wealth effects are determined by changes in asset prices. In the U.S., two asset classes determine the intensity of wealth effects. They are housing prices and the stock market. (Read the rest of the article here.)


Mr. Kotok is likely correct in explaining why the Fed wants higher housing and stock prices, but neglects to mention the negative externalities of its policies. Seeking positive wealth effects by recapitalizing asset prices is like putting the cart before the horse: rising incomes drive asset prices, not the reverse, so asset price increases that depart from fundamental income flows are unsustainable, as every financial analyst knows.

Through QE4ever and interest rates subsidies, the Fed is hoping for real gains from money illusion, much like it tried with an inflationary bias in the 1970s with the Philips Curve. The ultimate consequences are hidden at first, but all asset bubbles generated by leveraged credit are built on hot air, overconfidence, and moral hazard. When the tipping point is reached the subsequent busts explode like a pin-pricked party balloon.

Our anemic jobless recovery reflects the fact that prices have been distorted for more than a decade while the time value of money has been driven to zero and held there by a feckless monetary policy. Asset speculation has benefited to the detriment of work, saving, and investment. This cannot end well and Mr. Bernanke has proven again and again that he is no sage when it comes to predicting and managing the future.

Understanding Risk Really Matters


This is an excellent topic to mull over. Risk-taking is the foundation of all innovation and wealth creation. From the WSJ, comments below…

Risk-Averse Culture Infects U.S. Workers, Entrepreneurs


Americans have long taken pride in their willingness to bet it all on a dream. But that risk-taking spirit appears to be fading.

Fewer Americans are changing jobs. Companies are hoarding more cash. And the proportion of new businesses has fallen. The result? A less dynamic economy.

Three long-running trends suggest the U.S. economy has turned soft on risk: Companies add jobs more slowly, even in good times. Investors put less money into new ventures. And, more broadly, Americans start fewer businesses and are less inclined to change jobs or move for new opportunities.

The revival of the housing market has been all over the news in the past weeks but as MarketWatch’s Jim Jelter explains, there are three other areas of the economy that are doing better than you think.

The changes reflect broader, more permanent shifts, including an aging population and the new dominance of large corporations in many industries. They also may help explain the increasingly sluggish economic recoveries after the past three recessions, experts said.

“The U.S. has succeeded in part because of its dynamism, its high pace of job creation and destruction, and its high pace of churning of workers,” said John Haltiwanger, a University of Maryland economist who has studied the decline in American entrepreneurship. “The pessimistic view is we’ve lost our mojo.”

Companies that gamble on new ideas are more likely to fail, but also more likely to hit it big. Entrepreneurs face long odds, but those that achieve success create jobs for many others.

As important, say economists, are small acts of risk-taking: workers who quit their jobs to find better ones, companies that expand payrolls and families that move from sluggish economic regions to ones with low unemployment rates.

Multiplied across the U.S. economy, these acts of faith and ambition help speed money, talent and resources to where they are needed.

Of course, too much risk-taking can be dangerous, as the financial crisis showed. And with the stock market soaring, some types of risk are displaying signs of a strong pos-tcrisis rebound. Indeed, the Federal Reserve said it was watching for signs that easy-money policies are leading investors to take excessive risks.

Playing It Safe

But a broad cross section of U.S. economists, from a range of academic disciplines and political persuasions, agree that a specific and necessary kind of risk-taking is on the decline. Historically, risk-taking that supports high rates of churn—lots of hiring and firing, company formation and destruction—gives economies more flexibility to adapt to changing markets.

Maxim Schillebeeckx is the kind of ambitious young American who has long propelled the U.S. economy. A 28-year-old doctoral student in genetics at Washington University in St. Louis, Mr. Schillebeeckx also has a graduate degree in economics. He helped create a student-led consulting firm to provide scientific advice to local startups.

But despite his enthusiasm for entrepreneurship and his experience in startups, Mr. Schillebeeckx said he planned to look for the safety of work in consulting or private equity, rather than launch his own company or work for a new venture.

“I’m pretty risk averse, personally,” Mr. Schillebeeckx said. “On the entrepreneurial side, you have to be willing to jump off the deep end.”

Mr. Haltiwanger and other economists said this decline in risk-taking—both by companies and individuals—has coincided with a broader slowing of the U.S. economy, particularly for new jobs.

In the eight recessions from the end of World War II through the end of the 1980s, it took the U.S. a little more than 20 months, on average, for employment to return to its pre-recession peak. But after the relatively shallow recession of the early 1990s, it took 32 months for payrolls to rebound fully.

After the even milder recession of 2001, it took four years. Today, nearly four years after the end of the last recession, employment has yet to reach its pre-crisis peak.

Economists have proposed various explanations for the series of slower rebounds, including the rise of outsourcing and automation that have allowed companies to produce more with fewer workers.

Pockets of the U.S. economy still burn with a risk-taking spirit. Google, Apple and Facebook reshaped the technology sector, creating new categories of products and services. Energy companies and their investors bet billions of dollars on new drilling techniques that have unlocked new reserves of domestic oil and natural gas. Such coastal cities as San Francisco and Boston, and college towns like Boulder, Colo., and Austin, Texas, boast vibrant communities of entrepreneurs and investors.

But risk-taking seems more concentrated than years past, by industry and by region, said Dane Stangler, director of research and policy at the Ewing Marion Kauffman Foundation, a Kansas City, Mo., nonprofit that studies entrepreneurship.

“We absolutely see geographic divergence,” he said. “We’ve got these hotbeds of startups, but you just don’t see the same level of activity in other areas of the country.”

That is a problem for regions left behind. Cities with high levels of entrepreneurial activity had significantly better job growth than those that relied more heavily on existing businesses, according to findings by Harvard economist Edward Glaeser and two colleagues that were published last year.

Entrepreneurship is a numbers game that draws a handful of winners from a crowd of participants, Mr. Haltiwanger said. He and other researchers have found that a relatively small number of fast-growing companies create a disproportionate number of new jobs. But such companies are almost impossible to identify ahead of time.

Little about Sam Walton’s Bentonville, Ark., five-and-dime store suggested Wal-Mart would one day become the world’s leading retail chain. Little about Jeff Bezos’s online bookstore suggested Amazon’s future as the Web’s biggest commercial hub.

The problem with fewer Americans starting businesses is that there are fewer chances for the next Amazon or Wal-Mart—or even the successful small- or medium-size business.

“It just means that there are fewer new companies that are creating jobs, fewer new companies that are competing for workers,” said Lina Khan, an economist who has studied the decline in entrepreneurship for the New America Foundation, a Washington think tank. “Traditionally being able to start your own business has been a path to upward mobility.”

Fewer Americans are choosing that path. In 1982, new companies—those in business less than five years—made up roughly half of all U.S. businesses, according to census data. By 2011, they accounted for just over a third. Over the same period, the share of the labor force working at new companies fell to 11% from more than 20%.

Both trends predate the recession and have continued in the recovery.

Investors, meanwhile, appear to be losing enthusiasm for startups. Total venture capital invested in the U.S. fell nearly 10% last year and has yet to return to its pre-recession peak, said PricewaterhouseCoopers.

The share of capital going to new business ventures has fallen even faster, PricewaterhouseCoopers data show, and is more concentrated: Silicon Valley took 40% of venture funding in 2012, up from about 30% in the late 1990s.

The decline in risk-taking is reflected in U.S. migration: Americans move less often, with rates of interstate migration falling for at least 20 years, according to census data. They also have less workplace wanderlust: 53% of adults last year held the same job for at least five years, up from 46% in 1996, according to the Labor Department. The share of workers who voluntarily left their jobs in a given year plummeted to 16.1% in 2009 from 25.2% in 2006 and remains well below prerecession levels, Labor Department data show.

Economists at the Federal Reserve Board of Governors found the falling rate of interstate migration over the long-term correlated strongly with the decline in job changes. In other words, Fed researchers said, people are moving less because they are changing jobs less.

Recent declines in moving may be tied to the collapse of the housing market, which left millions of homeowners owing more than their homes were worth, making it harder to relocate. But the longer trend predated the latest housing bust. Researchers have proposed such explanations as changing demographics and two-income households, which could make it harder for families to move.

Companies, too, are taking fewer risks. Rather than expanding payrolls, for example, they are keeping more cash on hand—5.7% of their assets at the end of 2012, up from under 3% three decades earlier, said the Federal Reserve, a rise that accelerated after the recession. Workers are hired more slowly, particularly at newer companies, Labor Department data show.

Andy Gugar opened Mercado’s restaurant in Tyler, Texas, in 1987, with a second location a year later. By the early 2000s, the chain, known as Posados Café, had a dozen locations in Texas and Louisiana.

Since then, expansion has slowed. The chain now has 16 locations and brings in about $38 million per year in sales. Scott Nordon, Posados’s chief operating officer, said the chain might one day reach 20 or 25 restaurants but was in no rush.

“We don’t want to have 100 stores,” he said. “There’s no pressure for us to grow. If we see an opportunity, guess what, we’re going to take advantage of it. But if it doesn’t, we’re content.”

The conservative strategy predates the recession, Mr. Nordon said, but the financial crisis and the current weak economy have reinforced the view. The company plans to pay off debts over the next four years and will fund any expansion with cash. “Longevity is the name of the game,” he said.

Economists aren’t sure what is behind the decline in risk-taking. Among the possible explanations are the rising cost of health care, which makes it riskier to quit a job and more expensive to hire more employees; increased state and local licensing requirements that serve as barriers to newcomers—one recent study found that roughly 29% of U.S. employees required a government license or certificate in 2008, up from less than 5% in the 1950s; and immigration rules that deter would-be entrepreneurs from other countries.

An aging population is also cited. Young people are more prone to start companies or move for jobs. But the slowdown in risk-taking began before the baby boom generation began to retire. [Blogger Note: But we would expect a demographic slowdown in risk-taking to start long before retirement when the median age of baby boomers passed through the middle aged productivity years. In other words, long before 2008] And even younger workers change jobs less often.

One barrier for prospective entrepreneurs may be the growing dominance of large corporations in nearly every industry, which make it tough for new ventures to gain a foothold. A small bookstore no longer needs just a better selection or a friendlier staff than the crosstown competition—it also has to compete with national chains and, increasingly, such Internet retailers as Amazon. [This is winner-take-all consolidation.]

For the first time since such records have been kept, the Census found in 2008 that more Americans worked for big businesses—those with at least 500 workers—than small ones. The trend has continued since.

The work of running family businesses has also scared off younger generations, said Henry Hutcheson, president of Family Business USA, which advises these businesses.

“The lure and ease of joining a blue chip firm, where you get a good job and a decent salary, just seems to be overwhelming,” he said. “People are saying, ‘I can go take over my dad’s garden center and I can go run this thing and work seven days a week and be there from dawn until dusk, or I can go manage a Home Depot and they’re going to pay me $150,000 and I’ll get weekends and vacation.’ ”

Tony Raney faced that choice. Until a year ago, Mr. Raney worked for the small chain of appliance stores his family operates in Wilkesboro, N.C. After watching his stepfather work nights and weekends, Mr. Raney had second thoughts, especially since national chains offered lower prices. “It’s a lot riskier to be an independent business owner,” he said. “Big business is out to get you.”

A year ago, Mr. Raney left the family business for a data-entry job at a national appraisal firm. “I feel safer,” he said. “I have no desire to show up and be the head of the corporation. I just want to show up and do the job.”


This analysis ignores some of the direct policy causes that adversely affect risk-taking behavior. Such policies include:

  1. Greater uncertainty over government tax, regulatory, and monetary policies;
  2. Increased capital taxes, lowering risk-adjusted hurdle rates of return and decreasing capital accumulation;
  3. Low interest rates that distort prices across the economy, enable excessive borrowing and asset speculation, but decrease savings accumulation and seed capital;
  4. A government subsidized housing bubble that has hampered labor mobility;
  5. Increased employer healthcare costs;
  6. Higher corporate taxes in a competitive world market;
  7. Political failure to address entitlement reform.

The list is not exhausted. Combined with demographic changes, globalized labor supplies, political cronyism, and excessive public sector spending, is it any wonder that people have tamped down on their animal spirits? As this blog has documented extensively, misguided central bank policy has turned investment risk-taking into casino gambling on asset speculation. Things won’t really improve until we normalize our market economy and policymakers are taking us farther afield.

Unforgettable Economics Lessons in Tombstone

The lessons of history are there for us to learn…

Economics One

Last night Yang Jisheng was awarded the 2012 Hayek Prize for his book Tombstone about the Chinese famine of 1958-1962.  It’s an amazing book. It starts with Yang Jisheng returning home as a teenager to find a ghost town, trees stripped of bark, roots pulled up, ponds drained, and his father dying of starvation. He thought at the time that his father’s death was an isolated incident, only later learning that tens of millions died of starvation and that government policy was the cause.

Then you read about the Xinyang Incident: people tortured for simply suggesting that the crop yields were lower than exaggerated projections. Those projections led government to take the grain from the farmers who grew it and let many starve; and there are the horrific stories of cannibalism.

You also find out what life was like as a member of a communal kitchen. With free meals people…

View original post 198 more words

Pundits and Prognosticators

Great graphic, reprinted from Charles Hugh Martin’s blog. The last pronouncement (#20 by FDR) is quite chilling (and not in a good way)!

1. “We will not have any more crashes in our time.” – John Maynard Keynes in 1927 (1)

2. “I cannot help but raise a dissenting voice to statements that we are living in a fool’s paradise, and that prosperity in this country must necessarily diminish and recede in the near future.” – E. H. H. Simmons, President, New York Stock Exchange, January 12, 1928

“There will be no interruption of our permanent prosperity.” – Myron E. Forbes, President, Pierce Arrow Motor Car Co., January 12, 1928 (2)

3. “No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time. In the domestic field there is tranquility and contentment…and the highest record of years of prosperity. In the foreign field there is peace, the goodwill which comes from mutual understanding.” – Calvin Coolidge December 4, 1928 (3)

4. “There may be a recession in stock prices, but not anything in the nature of a crash.” – Irving Fisher, leading U.S. economist , New York Times, Sept. 5, 1929 (4)

5. “Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months.” – Irving Fisher, Ph.D. in economics, Oct. 17, 1929

“This crash is not going to have much effect on business.” – Arthur Reynolds, Chairman of Continental Illinois Bank of Chicago, October 24, 1929

“There will be no repetition of the break of yesterday… I have no fear of another comparable decline.” – Arthur W. Loasby (President of the Equitable Trust Company), quoted in NYT, Friday, October 25, 1929

“We feel that fundamentally Wall Street is sound, and that for people who can afford to pay for them outright, good stocks are cheap at these prices.” – Goodbody and Company market-letter quoted in The New York Times, Friday, October 25, 1929 (5)

6. “This is the time to buy stocks. This is the time to recall the words of the late J. P. Morgan… that any man who is bearish on America will go broke. Within a few days there is likely to be a bear panic rather than a bull panic. Many of the low prices as a result of this hysterical selling are not likely to be reached again in many years.” – R. W. McNeel, market analyst, as quoted in the New York Herald Tribune, October 30, 1929

“Buying of sound, seasoned issues now will not be regretted.” – E. A. Pearce market letter quoted in the New York Herald Tribune, October 30, 1929

“Some pretty intelligent people are now buying stocks… Unless we are to have a panic — which no one seriously believes, stocks have hit bottom.” – R. W. McNeal, financial analyst in October 1929 (6)

7. “The decline is in paper values, not in tangible goods and services… America is now in the eighth year of prosperity as commercially defined. The former great periods of prosperity in America averaged eleven years. On this basis we now have three more years to go before the tailspin.” – Stuart Chase (American economist and author), NY Herald Tribune, November 1, 1929

“Hysteria has now disappeared from Wall Street.” – The Times of London, November 2, 1929

“The Wall Street crash doesn’t mean that there will be any general or serious business depression… For six years American business has been diverting a substantial part of its attention, its energies and its resources on the speculative game… Now that irrelevant, alien and hazardous adventure is over. Business has come home again, back to its job, providentially unscathed, sound in wind and limb, financially stronger than ever before.” – Business Week, November 2, 1929

“…despite its severity, we believe that the slump in stock prices will prove an intermediate movement and not the precursor of a business depression such as would entail prolonged further liquidation…” – Harvard Economic Society (HES), November 2, 1929 (7)

8. “…a serious depression seems improbable; [we expect] recovery of business next spring, with further improvement in the fall.”- HES, November 10, 1929

“The end of the decline of the Stock Market will probably not be long, only a few more days at most.” – Irving Fisher, Professor of Economics at Yale University, November 14, 1929

“In most of the cities and towns of this country, this Wall Street panic will have no effect.” – Paul Block (President of the Block newspaper chain), editorial, November 15, 1929

“Financial storm definitely passed.” – Bernard Baruch, cablegram to Winston Churchill, November 15, 1929 (8)

9. “I see nothing in the present situation that is either menacing or warrants pessimism… I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress.” – Andrew W. Mellon, U.S. Secretary of the Treasury December 31, 1929

“I am convinced that through these measures we have reestablished confidence.” – Herbert Hoover, December 1929

“[1930 will be] a splendid employment year.” – U.S. Dept. of Labor, New Year’s Forecast, December 1929 (9)

10. “For the immediate future, at least, the outlook (stocks) is bright.” – Irving Fisher, Ph.D. in Economics, in early 1930 (10)

11. “…there are indications that the severest phase of the recession is over…” – Harvard Economic Society (HES) Jan 18, 1930 (11)

12. “There is nothing in the situation to be disturbed about.” – Secretary of the Treasury Andrew Mellon, Feb 1930 (12)

13. “The spring of 1930 marks the end of a period of grave concern… American business is steadily coming back to a normal level of prosperity.” – Julius Barnes, head of Hoover’s National Business Survey Conference, Mar 16, 1930

“…the outlook continues favorable…” – HES Mar 29, 1930 (13)

14. “…the outlook is favorable…” – HES Apr 19, 1930 (14)

15. “While the crash only took place six months ago, I am convinced we have now passed through the worst — and with continued unity of effort we shall rapidly recover. There has been no significant bank or industrial failure. That danger, too, is safely behind us.” – Herbert Hoover, President of the United States, May 1, 1930

“…by May or June the spring recovery forecast in our letters of last December and November should clearly be apparent…” – HES May 17, 1930

“Gentleman, you have come sixty days too late. The depression is over.” – Herbert Hoover, responding to a delegation requesting a public works program to help speed the recovery, June 1930 (15)

16. “…irregular and conflicting movements of business should soon give way to a sustained recovery…” – HES June 28, 1930 (16)

17. “…the present depression has about spent its force…” – HES, Aug 30, 1930 (17)

18. “We are now near the end of the declining phase of the depression.” – HES Nov 15, 1930 (18)

19. “Stabilization at [present] levels is clearly possible.” – HES Oct 31, 1931 (19)

20. “All safe deposit boxes in banks or financial institutions have been sealed… and may only be opened in the presence of an agent of the I.R.S.” – President F.D. Roosevelt, 1933 (20)

Stockman Again









This time he makes a bit of sense…excerpted from a book review in the WSJ:

“The Great Deformation” is more than a polemic aimed at government check-writing. Mr. Stockman, who has been mostly unhappy with both Democratic and Republican policies for three decades, is appalled by the ruling class’s belief that economic prosperity flows from “macromanagement by the state, rather than from free market interaction.” Everywhere he sees sweetheart deals between government and industry, often engineered by lobbyists. The energy sector in particular he views as a sewer of subsidy and false “green” promises. Meanwhile, corporate America enters into reckless deals in part because borrowing is much too cheap, thanks to skewed tax and monetary policies.

As for the real-estate and banking crash of 2008, Mr. Stockman makes the case that nearly every policy response made things worse. He derides the interventions by Henry Paulson, Mr. Bush’s Treasury secretary, as “a de facto coup d’etat by Wall Street, resulting in Washington’s embrace of any expedient necessary to keep the financial bubble going—and no matter how offensive it was to every historic principle of free markets, sound money, and fiscal rectitude.” The too-big-to-fail doctrine, he believes, allows bad actors to thrive at taxpayer expense. The auto industry didn’t need $20 billion in federal money, Mr. Stockman says; it needed “a cold bath of free-market house cleaning.” As for the Federal Reserve, he claims that in 2008 it was guilty of “spraying an alphabet soup of liquidity injections in every direction”—a cheap-money strategy that Ben Bernanke is still employing five years later to prop up stock-market valuations.

There is something tonic about all this angry complaint, and “The Great Deformation”—though about twice as long as it needs to be—is a welcome thrashing of the ruling classes in both parties. Economic elites in Washington and on Wall Street routinely pat themselves on the back and tell us that, five years after the meltdown, their “quick and decisive” interventions prevented a 1929-style collapse. Mr. Stockman isn’t buying it. “The Main Street banking system was never in serious jeopardy, ATMs were not going dark, the money market industry was not imploding,” he writes. The smaller banks in 2008, he notes, had more than $2 trillion in safe assets on their books.

It may well be that the danger of a return to 1929 was grossly exaggerated. Whether policy makers should have assumed it was—in the midst of a panic—is an open question. The challenge for Mr. Stockman, and for free marketers in general, is to make the case that the American economy would be in better shape today if we hadn’t borrowed $5 trillion and bailed out Wall Street investment banks, the insurer AIG and General Motors—let alone home buyers with toxic mortgages. But even if a modest bailout was justified to rescue the soundness of the financial system, Mr. Stockman’s essential critique is accurate: that Fed and federal officials sheltered malefactors from gargantuan losses and made current taxpayers—and future ones—pick up the tab.

What is true is that today we have a kind of “deformed” capitalism, with private gains and socialized losses. Mr. Stockman says that it is too late to change things and that a crash is unavoidable. He has been wrong before. We can only hope that he is wrong again.

China and the dangers of unbalanced growth


The article below reiterates one of the basic economic truths explained in Political Economy Simplified, which is that growth requires a cyclical balance between consumption and savings; borrowing and investment. China is producing more exports than the world can consume, especially by the de-leveraging developed economies. China’s growth path is essentially too steep to keep up and so will correct to a more sustainable path. This is what happened with the credit bubble in the US as well. China is attempting to turbo-charge both consumption and investment at the same time by excessive borrowing, just like the US did in the 2000s.

Fundamentally, the economy runs on four wheels: consumption, saving, investment and production. If either of these gets out of sync with the others, the vehicle will sputter and crash. Interest rates are normally what keeps it all together, but we’ve been distorting those worldwide for the past two decades. Such mismanagement will demand a reckoning, and more of the same merely delays the inevitable.

From the WSJ:

China Has Its Own Debt Bomb

Not unlike the U.S. in 2008, China is at the end of a credit binge that won’t end well.


Six years ago, Chinese Premier Wen Jiabao cautioned that China’s economy is “unstable, unbalanced, uncoordinated and unsustainable.” China has since doubled down on the economic model that prompted his concern.

Mr. Wen spoke out in an attempt to change the course of an economy dangerously dependent on one lever to generate growth: heavy investment in the roads, factories and other infrastructure that have helped make China a manufacturing superpower. Then along came the 2008 global financial crisis. To keep China’s economy growing, panicked officials launched a half-trillion-dollar stimulus and ordered banks to fund a new wave of investment. Investment has risen as a share of gross domestic product to 48%—a record for any large country—from 43%.

Even more staggering is the amount of credit that China unleashed to finance this investment boom. Since 2007, the amount of new credit generated annually has more than quadrupled to $2.75 trillion in the 12 months through January this year. Last year, roughly half of the new loans came from the “shadow banking system,” private lenders and credit suppliers outside formal lending channels. These outfits lend to borrowers—often local governments pushing increasingly low-quality infrastructure projects—who have run into trouble paying their bank loans.

Since 2008, China’s total public and private debt has exploded to more than 200% of GDP—an unprecedented level for any developing country. Yet the overwhelming consensus still sees little risk to the financial system or to economic growth in China.

That view ignores the strong evidence of studies launched since 2008 in a belated attempt by the major global financial institutions to understand the origin of financial crises. The key, more than the level of debt, is the rate of increase in debt—particularly private debt. (Private debt in China includes all kinds of quasi-state borrowers, such as local governments and state-owned corporations.)

On the most important measures of this rate, China is now in the flashing-red zone. The first measure comes from the Bank of International Settlements, which found that if private debt as a share of GDP accelerates to a level 6% higher than its trend over the previous decade, the acceleration is an early warning of serious financial distress. In China, private debt as a share of GDP is now 12% above its previous trend, and above the peak levels seen before credit crises hit Japan in 1989, Korea in 1997, the U.S. in 2007 and Spain in 2008.

The second measure comes from the International Monetary Fund, which found that if private credit grows faster than the economy for three to five years, the increasing ratio of private credit to GDP usually signals financial distress. In China, private credit has been growing much faster than the economy since 2008, and the ratio of private credit to GDP has risen by 50 percentage points to 180%, an increase similar to what the U.S. and Japan witnessed before their most recent financial woes.

The bullish consensus seems to think these laws of financial gravity don’t apply to China. The bulls say that bank crises typically begin when foreign creditors start to demand their money, and China owes very little to foreigners. Yet in an August 2012 National Bureau of Economic Research paper titled “The Great Leveraging,” University of Virginia economist Alan Taylor examined the 79 major financial crises in advanced economies over the past 140 years and found that they are just as likely in countries that rely on domestic savings and owe little to foreign creditors.

The bulls also argue that China can afford to write off bad debts because it sits on more than $3 trillion in foreign-exchange reserves as well as huge domestic savings. However, while some other Asian nations with high savings and few foreign liabilities did avoid bank crises following credit booms, they nonetheless saw economic growth slow sharply.

Following credit booms in the early 1970s and the late 1980s, Japan used its vast financial resources to put troubled lenders on life support. Debt clogged the system and productivity declined. Once the increase in credit peaked, growth fell sharply over the next five years: to 3% from 8% in the 1970s and to 1% from 4% in the 1980s. In Taiwan, following a similar cycle in the early 1990s, the average annual growth rate fell to 6%.

Even if China dodges a financial crisis, then, it is not likely to dodge a slowdown in its increasingly debt-clogged economy. Through 2007, creating a dollar of economic growth in China required just over a dollar of debt. Since then it has taken three dollars of debt to generate a dollar of growth. This is what you normally see in the late stages of a credit binge, as more debt goes to increasingly less productive investments. In China, exports and manufacturing are slowing as more money flows into real-estate speculation. About a third of the bank loans in China are now for real estate, or are backed by real estate, roughly similar to U.S. levels in 2007.

For China to find a more stable growth model, most experts agree that the country needs to balance its investments by promoting greater consumption. The catch is that consumption has been growing at 8% a year for the past decade—faster than in previous miracle economies like Japan’s and as fast as it can grow without triggering inflation. Yet consumption is still falling as a share of GDP because investment has been growing even faster.

So rebalancing requires China to cut back on investment and on the rate of increase in debt, which would mean accepting a rate of growth as low as 5% to 6%, well below the current official rate of 8%. In other investment-led, high-growth nations, from Brazil in the 1970s to Malaysia in the 1990s, economic growth typically fell by half in the decade after investment peaked. The alternative is that China tries to sustain an unrealistic growth target, by piling more debt on an already powerful debt bomb.