Economic Policy Report Card: C-

Today’s headlines:

Still anemic: U.S. growth picks up to only 0.8%

U.S. economic growth between January and March was 0.8% compared to the same time frame a year ago. That’s better than the initial estimate of 0.5%, which came in April, but still pretty sluggish.

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US created 38,000 jobs in May vs. 162,000 expected

Job creation tumbled in May, with the economy adding just 38,000 positions, casting doubt on hopes for a stronger economic recovery as well as a Fed rate hike this summer.

The Labor Department also reported Friday that the headline unemployment fell to 4.7 percent. That rate does not include those who did not actively look for employment during the month or the underemployed who were working part time for economic reasons. A more encompassing rate that includes those groups held steady at 9.7 percent.

The drop in the unemployment rate was primarily due to a decline in the labor force participation rate, which fell to a 2016 low of 62.6 percent, a level near a four-decade low. The number of Americans not in the labor force surged to a record 94.7 million, an increase of 664,000.

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We’ve been predicting such disappointing results of ineffectual monetary and fiscal policies since this blog began back in August of 2011. And providing corroborating evidence along the way. Yet our policy experts continue to double-down on failed policies.

The problem is that when a nation inflates asset bubbles like we did with commodities, houses, stocks, and bonds over the past 20 years, there is no silver-lining policy correction that does not involve some  economic pain for the body politic. We had that awakening in 2008, but since then we have merely jumped on the same train by pumping out cheap credit for 8+ years.

Perhaps a medical metaphor works here. When prescribing antibiotics to combat an infection one can use small doses to avoid side-effects or one large overkill dose to knock-out the offending bacteria. The first treatment is the conservative, prudent approach that seeks a gradual recovery. The second risks a sudden shock to the system that kills off the infection so the patient can begin healing.

In medicine we’ve discovered that the gradual treatment can enable the bacteria to evolve and resist the antibiotics, making them ineffectual. In a nutshell, this is what we have done with economic policy, especially monetary policy that has distorted interest rates for more than 15 years.

The conservative approach marked by bailouts and government bail-ins has kept the patient flat on his back for 8 years. The more disciplined approach would have shocked the economy severely but gotten the patient out of the recovery room much quicker. We’ve seen that with other countries, like Iceland, that were forced to swallow their medicine in one quick dose.

But, of course, that would have meant a lot of politicians would have lost their cozy jobs. That may happen anyway after the next election.

Economic Thrill Rides

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The following is excerpted from an editorial in Barron’s by Thomas Donlan. (Full article Barrons. Subscription req’d)

Central planning that is intended to eliminate chaos eventually creates it. As Friedrich Hayek wrote in The Road to Serfdom, state economic planning is unavoidably arbitrary: “The more the state plans, the more difficult planning becomes for the individual.”

Among many examples of this principle: If a government tweaks money supply to hit targets for interest rates and exchange rates, it will provide stability in those things, but the economy will fluctuate. Or, if the government tries to guarantee general economic growth, as measured by employment, gross domestic product, consumer confidence, business investment, or all of them, rates of interest and exchange will fluctuate. Either way, the economy will be under control of an unstable, unpredictable thing that seeks order instead of liberty, and so can deliver neither.

We should see in the recent market chaos the economic chaos created by planning — not just in China but in the U.S. and Europe, as well. Markets are trying to follow political orders. In China, the government wanted to let markets have more influence over the value of money, until it observed the results and ordered a devaluation. In Europe, the promise to do “whatever it takes” to stabilize a rickety monetary union has perpetuated chaos.

Naturally, markets gyrate under pressure of the sort generated by the president of the New York Federal Reserve. From one side of his desk, he said he still hopes that the Fed will raise interest rates this year, while from the other side, he observed that the case for a rise “seems less compelling.”

The great danger in a market tremor is what people do about it. China, the U.S., and Europe have given too much power to their monetary authorities, relying on central bankers to sail against the winds of economic change. They believe economies respond predictably to tinkering with money markets.

Actually, economies respond to stimuli with booms and to tightening with busts, unless they don’t. As economist Ed Yardeni suggested at midweek, perhaps with tongue in cheek, “Another 2008 crisis is imminent eventually.”

All over the world, there are people who imagine themselves to be masters of the material universe. They are the greatest threat to liberty and prosperity.

I have been arguing for some time that this is how we should understand economic policy over the past 30+ years, often referred to as the Great Moderation. We’ve tried to guarantee economic growth as measured by nominal GDP, interest rates, employment, and price stability as measured by the CPI. The result has caused asset prices such as commodities, exchange rates, real estate, and precious metals to fluctuate quite widely and wildly.

Asset price fluctuations impose their own costs on people, often with arbitrary effects, like when you are forced to buy or sell a house (see chart below). Asset price support by the Fed has also greatly enriched those who own more assets, widening the economic inequality gaps. It is hardly an ideal state of affairs, nor one that can easily be justified on philosophical grounds.

Housing index

Don’t Bet (Against?) the House

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Fighting the Last War

By Rodney Johnson, Senior Editor, Economy & Markets

A problem with most humans is that we’re really bad at letting go of what happened yesterday. So too with nations.
When estimating potential threats, it’s easy for leaders to adapt to whatever happened in the latest conflict, developing their military accordingly.

Think of the U.S. after World War II. We built up land forces across Europe to guard against an invasion by the U.S.S.R. Later on in Vietnam we dove into jungle warfare, where tanks and mass forces were less useful.

We were set up to fight the last war, not the next one.

In our economy we do the same thing. We develop economic policies and responses that work great, as long as history repeats. When things stray from the script, we run into problems.

For six long years, the Fed has been fighting the last war.

In an effort to bolster the housing sector after the subprime crisis, the Fed has held rates at record lows to make debt cheaper. At the same time, it gobbled up trillions of dollars’ worth of mortgage-backed securities, hoping to free up new capital to buy newly originated mortgages. The hope was that by getting the housing market back in gear, home builders would crank up production, and hundreds of thousands of new, middle class jobs in construction would appear.

But something strange happened on the way to economic recovery. Housing didn’t bounce right back.

In fact, the housing market kept falling for two more years as excess supply and the heavy weight of mortgage indebtedness worked through the system.

When real estate finally turned around in terms of prices paid and units sold, the gains weren’t exactly stellar. And as recent reports show, new home sales are growing, but not very quickly.

The annualized rate of new home sales in April was 517,000 units. That’s a far cry from February 2011’s level of 270,000 homes sold — the lowest in 50 years. But it’s light years away from July 2005’s staggering 1.389 million.

The Fed must be looking back at the mid-2000s with envy. However, today’s rate of new home sales isn’t the outlier; the high rate in the mid-2000s was.

After recording of new home sales began in 1963, they averaged 512,000 units through the rest of the 60s, then 656,000 in the 70s, and fell back to 610,000 in the 1980s. As the boomers plowed into the market in the 90s, new home sales jumped to 700,000, then took off with a bang in the 2000s with an average of 1.105 million per year. Among those data points, which one doesn’t belong?

So far this decade new home sales are averaging 382,000 units per year. Even when you consider the low rates of sale in 2010 and 2011, the move up from those years has been gradual.

The waning demand for new homes has naturally affected residential construction employment as well. Between mid-2006 and January 2011, that employment number dropped by almost half from just over one million, to 557,000. It’s picked up since, growing to 694,000 in April of this year, but is nowhere near what the Fed must have been hoping for as they printed trillions of dollars to prop up the sector.

It’s been clear for some time: By targeting housing with monetary policy, the Fed has been fighting the last war.

They pinned their hopes for an economic rebound on a resurgence in home building that would flow through to employment, leading to the creation of middle class jobs.

Instead, we experienced a rebound that simply brought building back near the long-run average of previous decades, excluding the bubble years of the 2000s.

Unfortunately for the millennial generation, who should be buying homes at a fast clip as they settle in for family life, many of the new homes coming to market are high-priced units. The average price of a new house in April was $297,000 — four times the average income of an American household.

With strict lending rules in place regarding debt-to-mortgage ratios, the new homes hitting the market today aren’t exactly geared toward the younger generation. They’re made for older workers with more income, or the thin slice of the millennial generation that can qualify for a home loan.

Either way, a spike in homebuilding doesn’t seem likely in the near future, which will keep a lid on employment in the sector, and continue to foil the plans of the Fed.

Piqued by Piketty?

“Money makes money. And the money that money makes makes more money.”

– Benjamin Franklin

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Over the past 18 months there’s been a gushing and gnashing over the book by French economist Thomas Piketty, Capital in the Twenty-first Century. I have to admit I’m a bit late to the party and am just getting around to reading (perusing?) it. (I have a good excuse – an 18 mo. old baby.)

Seems most of the feedback has been delineated by political ideology – the left embraces Piketty’s work and the right dismisses it. Perhaps we can pursue a non-ideological tack to dissect Piketty’s take on capitalism.

Piketty has been rightly praised for the work he has led on the collection of historical wealth and income data, and he generously offers this data to the world for future study. Most of the controversy involves his particular interpretation of these historical statistics, claiming that inequalities have reached the same levels as the roaring ’20s a century earlier. Depending on one’s measures and comparisons, that might be argued as true. The devil is in the details.

Piketty makes broad claims that inequality is inherent to the internal dynamics of capitalist markets and that the interim period – 1930s-1970s – was a reversal due to the wealth destruction of the Great Depression and WWII. Then he explicates his “law” of capital that the rate of return on capital (r) will always exceed the rate of economic growth (g), leading to ever narrower concentrations of wealth among the owners of capital. But this is too broad a brush.

We need to unbundle the capitalist wealth creating process and the dynamics of distribution in order to understand why the data looks the way it does. How, when and why does r exceed g and what are the distributional consequences? Piketty so far has not provided satisfying answers.

First, he defines capital as the stock of all assets held by private individuals, corporations and governments that can be traded in the market no matter whether these assets are being productive or not. This includes land, real estate and intellectual property rights as well as collectibles such as art and jewelry. Thus, there is no distinction made between financial or physical capital or non-productive real assets and thus no explanation for why different asset classes might experience varying growth rates and what that means for wealth and incomes. The return on capital does not always exceed the growth rate and will often drop precipitously over the business or trade cycle, as well as due to the falling marginal rate of return on existing investment. (Certainly r was negative for a considerable period of time during the Great Depression, the 70s stagnation and our recent Great Recession.) With his broad brush, Piketty ignores these insightful details.

Financial assets, as claims on real assets (a form of derivative really), often fluctuate more widely than real assets. Real asset classes that are illiquid, such as art and real estate, often don’t trade, thus making true value difficult to ascertain. Let us explain why this matters (see Figure I.1 below from Piketty’s dataset): The two periods that Piketty claims represent his conclusion on inequality (red circles) were both marked by financial asset bubbles fomented by easy credit bubbles (green squares). In both cases, when the credit crunch inevitably came, these asset prices adjusted quite drastically and quickly, erasing much of the wealth accumulated during the bubble (look at the wealth shares of the 1% over time – it’s quite a roller coaster ride). The difference today is that we have harnessed public credit to maintain these inflated asset prices. Let me make the difference plain: in the panic of 1929 and the early ’30s stock brokers jumped out of windows to their untimely deaths; after the panic of Lehman’s collapse, they jumped out with Federal Reserve-issued parachutes and landed safely on their yachts and vineyards.

Income-USA-1910-2010Piketty’s graph does highlight a concern here. The massive crash in asset prices and capital incomes after 1940 was surely due to the destruction of WWII when high property values in Europe became worthless. The central banks of the world have done their utmost to prevent such a crash after 2008, but one can still manage a price correction to reassert pre-bubble values. Admittedly, this is difficult to do with debt and requires a lot of bankruptcy that needs to be managed. But instead we’ve reflated the bubble asset prices at the high end, and with them the high incomes derived from capital. Life is good when you’re the king (or the Fed chairperson).

Second, we should understand that housing is playing an outsized role in our recent widening of wealth inequality. Housing policy rewarded real estate investments over other investments during the long credit bubble that accompanied the maturation of the baby boom generation (green square on right). This gave the housing sector a double stimulus: rising demand plus a generous tax preference. When housing wealth is stripped from the current distribution of capital, wealth inequality appears much flatter (see Rognlie).

So, rather than some immutable law of capitalism, perhaps Piketty has identified an artifact of short-sighted policy, especially by central banks and government housing policy. In our recent financial market “correction,” these asset prices have not really corrected, as de-leveraging of private credit (mostly in the FIRE sector) has merely been assumed by public credits. The Fed has expanded its balance sheet by about $4.5 trillion and the Treasury has increased the total debt by almost $8 trillion. With all that liquidity sloshing around, the rich have gotten richer because of their ownership of capital assets, both real and financial, while economic growth and employment have stagnated because of de-leveraging and the uncertainty of price distortions keyed off a deliberately depressed interest rate. These monetary and fiscal policies have greatly aggravated inequality and created the more serious problem of allowing those with inflated financial assets to trade them for more permanent real assets, thus narrowing the control over these real asset classes. In the distant past this was called feudalism and we risk recreating such class distinctions.

Nevertheless, Piketty hits on some key truths about the workings of capitalism, none of which are really new but are worth reiterating. First, we call it CAPITAL-ism for a reason – it depends on the accumulation and productive deployment of capital in order to create wealth. To quote Ben Franklin: “Money makes money. And the money that money makes makes more money.”

For the same reason we don’t call it LABOR-ism, because capitalism is about successful risk-taking and our property rights legal system assigns risks and returns to a priori ownership claims. For too long we’ve understood the distributional mechanism of capitalism to be wage incomes, when an increasing share of that distribution is remitted through capital ownership claims on profits. Technology and globalization has only amplified this trend. In addition, a mature capitalist society with an aging demographic depends on an increasing share of rents earned by accumulated capital.

The growing disparity of wage incomes can be largely traced to incomes associated with financial capital, such as in the FIRE sector, and by winner-take-all, or superstar, markets in many professions such as entertainment and sports, but also among corporate managerial elites. In a free and just society this inequality needs to be addressed, but turning back to a laborist model of economic development would mean turning back the tides of trade and freedom.

Rather, we need to promote capital accumulation across the broadest stretch of the population. This simple graph of the relationship between physical capital per worker and income shows the symbiosis between these two factors of production – we merely need to cease dividing them into their antagonistic corners through misguided tax policy.

capital-income – from David Weil, Economic Growth.

In addition, we need policies that promote long-term risk-taking and risk management and de-emphasize short-term asset trading. A return to saving and prudent investment will require disciplinary constraints on credit policy, something we’ve lost with too much central bank discretion over monetary policy. The question is how will we attain that discipline with a fiat monetary regime that allows credit creation according to the policy whims of the central bank and the Treasury?

The answers to inequality are not simple and certainly more complex than Piketty’s retrograde and admittedly unworkable proposal of taxing capital for redistribution by the state. The leftist appeal of this argument readily embraces the idea that wealth in private hands is somehow more easily abused than wealth in the hands of politicians and bureaucrats. Tell that to the victims of statism across former Soviet societies. Instead, wealth should be enjoyed by the widest possible swath of the citizenry to be earned by the sweat of their brows and the liberated ingenuity of their imaginations. As I presented in an earlier post, Billie Holiday makes the most insightful observation when it comes to our capitalist society: “God Bless the Child that’s got his own.”

The Sinister Evolution Of Our Modern Banking System

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Repost from Peak Prosperity blog. (Link to podcast and blog here.)

Because we’re all about those banks, ’bout those banks…
Saturday, January 31, 2015

I quit Wall Street and decided that it was time to talk more about what was going on inside it, as it had changed. It had become far more sinister and far more dangerous. ~ Nomi Prins

Today, the ‘revolving door’ connecting our political and financial systems is evident to anyone with eyes. But this entwined relationship between Washington DC and Wall Street is nothing new, predating even the formation of the Federal Reserve.

To chronicle the evolution to where we find ourselves today, we welcome Nomi Prins, Wall Street veteran turned financial industry reformist, and author of the excellent expose All The Presidents Bankers.

In this well-detailed interview, Nomi goes into depth of the rationale and process behind the creation of the Federal Reserve, and more important, how its mandate — and the behavior of the banking system overall — metastasized into the every-banker-for-himself regime of sanctioned theft we now live with.

Chris Martenson:   To me, it couldn’t have been more obviously obscene then in 2010, and I believe maybe 2009, right after the big banks had been handed just vast, huge, very favorable handouts and bailouts during the Great Recession — and then they handed themselves record bonuses. I thought optically that was just horrible. As somebody who was inside the banking system: Are they that tone deaf? What’s behind that sort of behavior?

Nomi Prins:   Indeed, they have become very isolated.

It began with the period before the 1970s when different people were rising to leadership in banks, and worsened in the 80s when we started seeing people who had more sociopathic tendencies or less ability to appreciate the idea of the public’s economic stability being beneficial to growing their institutions. They no longer viewed it as necessary.

And with the advent of the larger futures market, the options market, the derivatives market, and all the off-shore elements of banking that were able to be developed, so much capital was now available and off of the books that the idea of maintaining some sort of a connection to stability policy — or even to whatever the Presidency might want — dissolved. At the same time, all the Presidents that were involved in running the country around that time didn’t ask or require accountability towards financial stability from them.

So there was a bunch of things that were happening at the same time, and that’s why the media does a poor job of critiquing this because they’re not looking at all the strands. None of this is simple. A lot of things happened at the same time to create these kinds of shifts. On the one hand, you have no restraint: you don’t have the Gold Standard anymore, so you have less of a strain on having something physical be reserved against your leverage. You now have this ability of petrodollars being recycled. You have the ability to leverage more debt. You have less humility. You have a more technologically-advanced, less transparent global financial system, so you can make and hide money easier. And then you have ascendancies of leadership in banks and in the government that are OK with all this, and allow it to fester.

It’s all defended as some sort of example of a free market and competition — “the best gets the best”, and so forth — when the reality is it just destabilizes the entire system and creates an artificiality. We see central banks supporting all of this mess, as opposed to figuring out what the exit policy is — which none of them have a clue about. That’s really where we’ve evolved to.

Listen to the entire podcast.

Why Ownership Matters

TheOwnershipSociety

A little over a decade ago, in 2004 to be exact, the subject of ownership in democratic capitalist society was raised as a national political issue. Attribution goes to President George W. Bush, as he was campaigning for a second term, when he stated, “…if you own something, you have a vital stake in the future of our country. The more ownership there is in America, the more vitality there is in America, and the more people have a vital stake in the future of this country.” He called his vision The Ownership Society and it became the theme of his campaign. Naturally, his political opponents pounced on the idea, deriding it as the You’re-On-Your-Own Society, with the catchy acronym of “YO-YO.”

At the time I found the original statement to be more profound than was probably intended by its conservative proponents. My doubts were confirmed when the focus soon narrowed to the Holy Grail of residential home ownership, which was experiencing a boom due to policies favored by both parties that powered a historic bubble based on cheap credit and lowered lending standards. In the final capitulation to politics, the ownership agenda was reduced to, and attacked as, a naked partisan strategy to privatize entitlements, primarily to carve away support for liberal Democratic proponents of the social welfare state.

However, I don’t see ownership as a partisan issue, or even an ideological one, despite the fact that our political class certainly does. Instead, I see it as a theoretical and empirical issue that goes far beyond policy or politics to encompass economics, psychology, moral philosophy, and evolution.

For reasons that will become apparent, I will define this discussion to the ownership of financial capital. The ownership and control of capital assets is essential in the age of capital for two main reasons: first, it enables people to diversify against the risks of change; and two, the establishment of ownership rights is how the market and our legal system determine the distribution of returns to those aforementioned risks. Thus, ownership rights serve to determine the distribution of both a priori risks of, and a posteriori returns to, uncertain change.

Managing Risk

The best way to illustrate these two assertions is with the analogy of a roulette game. Imagine that several players with equal stakes gather around the roulette table. They wager their ownership stakes according to different risk preferences, some playing single numbers (highly risky) down to those who play black or red, odd or even (less risky). After each turn of the wheel the winners receive pay-offs or absorb losses in proportion to the odds ratios, or risks, of their strategies. In other words, if one played a single number or a row of numbers that hit while another played a red or black, the first would receive a much larger pay-off because she would have taken a much higher risk of loss. What we see if we examine the odds ratios of all the different plays on the roulette table is that the risk-adjusted rates of return of all strategies are essentially equal (and favor the casino ever so slightly). If the return/risk ratios are all the same, the only way to increase one’s return is to increase one’s risks and manage them successfully. This risk-return trade-off is the foundation of finance theory.

Behavioral studies show that we are uniformly loss averse. Since we cannot know the future, uncertainty and the risk of loss is inherent to our existence (although every tomorrow also offers hope for new opportunities). The best way to insure against losses due to unpredictable risks is through diversified pooling. We do this when we buy auto or homeowners insurance. These insurance pools are in fact diversified portfolios of capital assets. Likewise, ‘saving for a rainy day’ is a form of self-insurance. Due to the asymmetric information of insurance, certain problems arise that we call moral hazard and adverse selection. Moral hazard is when the beneficiary of the insurance changes risk-taking behavior because they are insured. This is like someone who drives recklessly because they have insurance to cover the cost of an accident. However, if the insurance issuer knew the person was going to change their risk behavior it would demand higher premiums. Adverse selection is when good risks opt out of an insurance pool with bad risks, causing the risk pool to become more risky and require ever higher premiums until the pool breaks down. Because we know our own risk-taking behavior better than anyone else, both of these insurance problems result from asymmetric information.

We can see that self-insurance doesn’t not suffer from asymmetric information because we are essentially insuring ourselves, so the incentive to drive recklessly is irrational. For this reason, self-insurance incurs no agency costs and is by far more efficient than insurance pooling. But to self-insure, i.e. save for a rainy day, we must accumulate assets to diversify in a portfolio. Thus, asset ownership is essential.

A second analogy—the scientific principle of natural selection and species adaptation—reinforces the importance of risk diversification. Nature constantly adapts to unpredictable change and the imperatives for survival by promoting diversification. Biodiversity is nature’s way of achieving a sustainable ecological balance and we can imagine human societies are certainly subject to the same survival imperatives.

Sharing the Rewards

If we not only want to protect ourselves from unpredictable risks of loss but also want to share in the returns to capitalist success, we must accumulate capital assets through ownership, put them at risk, and manage those risks successfully. Establishing the policies and complementary institutions, both private and public, to facilitate this process is actually the primary policy challenge of a free democratic society. In this sense, George Bush and his critics were both right: One must take an ownership stake in America to reap her benefits, and in so doing, one assumes the risk of loss and the obligation to manage that risk successfully.

Critics of this view might ask why capitalist profits are not more justly distributed through the payment of input costs, such as labor. The problem is exactly that: labor is an input cost that must be minimized under the profit incentive in order for the enterprise to succeed in a competitive environment. With access to a world supply of labor, the dynamics of capitalism exert constant downward pressure on wages. Laborists have long sought to use countervailing political power to constrain capital, but this strategy conflicts with the globalization of free trade among sovereign nations. In an open global economy with mobile capital and immobile labor, capital has strategic dominance over labor in simple game theoretic terms. Capital can move instantaneously, withdraw, or lie dormant indefinitely.

Labor’s argument is also undermined by the fact that if workers take no explicit residual risk in the enterprise, they have no defensible ownership claim to a share in the residual profits of success. Fixed labor contracts, in effect, assign risk and thus profits to owners in return for lower, and, hopefully, more secure and stable compensation. But under fixed labor contracts, firm losses are largely, and unjustly, borne by the unemployed, who are not fairly compensated for these hidden risks in good times.

For these reasons, I believe it is a misguided political strategy to pit labor against capital in an adversarial relationship. The solution is for labor to participate in capitalist enterprise as owners as well as workers. Risk then is more broadly shared across all stakeholders rather than borne by the weakest members of the labor force.

Equally important is the policy demand to share the returns of capitalism more broadly. There has been growing public criticism of market capitalism due to cronyism and widening economic inequality. A quick analysis of the distribution of wealth and income will confirm that much of this inequality can be attributed to the benefits accruing to those who own and control financial capital. Corporate elites get rich off stock options as part of their compensation packages. Employees of successful tech start-ups become fabulously wealthy due to their equity participation, not salaries. More important, financial markets concentrate the rewards to success, especially through the use of debt leverage. Federal Reserve financial repression that keeps interest rates near zero has rewarded borrowers and asset holders while penalizing savers and workers. Enhancing labor skills through education can only mitigate these trends to a point. In capitalism today, it is essential to own and control financial capital.

Financing Adaptation and Innovation

The analogy to nature’s biodiversity suggested above is more consequential than may appear. Diversification helps species survive, but it does this by enhancing the ability to adapt successfully. Natural adaptation is synonymous with human discovery and innovation. There is a branch of social psychology that focuses on the science of human creativity and innovation and draws from the lessons of natural adaptation. In a seminal article in 1960, the psychologist Donald Campbell argued that creative thought depends on a two-fold procedure he called blind variation and selective retention (BVSR). Blind variation refers to undirected change, much like unpredictable mutation in genetics. Selective retention refers to the replication of successful change. His argument suggests that creative innovation frequently relies on novelty and surprise, as well as utility.

What does this mean in the context of technological innovation and discovery? It means that many creative discoveries in the sciences and the humanities result from unintended consequences and not deliberate, intentional efforts. In other words, discoveries often come out of the blue; creativity is magical in that it cannot be so much cajoled by deliberate effort as just being allowed to happen under the right conditions. A creative artist knows this well from experience. This research has implications for how we can stimulate economic innovation by sowing the seeds of risk-taking capital far and wide in order to reap the benefits of creativity and discovery. It also suggests the limits of directed risk-taking through the public sector or through the bottlenecks of private venture capital. The next new big thing (or just very successful small thing) is more likely to come out of a garage or kitchen and not be financed by either the state or the financial sector. More likely it will be financed by personal relationships referred to as angel financing. Broadening the accumulation and ownership of financial capital helps to broaden the reach of angel investment to fund unorthodox risk-taking.

Agency

There is an ubiquitous weakness inherent to economic systems of specialization and exchange, alluded to above in the insurance case, that is referred to as the “agency problem.” When a principal hires an agent, such as a sales agent or a manager, there is always a potential conflict of interest between the principal and the agent, which can end up being quite costly to the principal. This agency problem was recognized by Adam Smith and more recently by those who study industrial organization and the public corporation. Managers often have material interests that diverge from the principal owners, i.e., shareholders and other stakeholders of the corporation.

This agency problem can never be perfectly eliminated (except through small sole proprietorships), but economic efficiency demands that the costs be minimized by aligning the interests of all stakeholders. This has been at the root of the use of stock options and profit participation in compensation. It’s called having “skin in the game, ” but too frequently the game is played with somebody else’s skin. The abuse of stock options merely points out the pitfalls of misunderstanding the nature of ownership and control. Equity financed with other peoples’ money is not a good way to eliminate conflicts of interest and minimize risk behavior. A recent article in The Economist points to the relative success of family-owned private firms that minimize agency costs. But for the large corporation to grow through needed access to outside capital, minimizing agency costs requires transparency and close monitoring of owners’ interests. This will require the checks and balances of competing agents, such as an independent board that represents various stakeholders’ interests to management. I would suggest that this offers a positive role for organized labor—to represent their worker/shareholders so that their interests align with public shareholders in ownership and control.

Property Rights, Morality, and the Law

Because English common law was established to protect property, ownership is the linchpin of our contracts legal system: we assign losses or gains in transactions according to the legal ownership of tangible assets. We even have a maxim that says, “ownership is nine-tenths of the law.” The relevant principle is equity, in every meaningful legal, moral, and accounting sense of the word. The moral implication of the finance law of risk and reward should be apparent: those who bear the equity risk of the enterprise assume the losses of failure or reap the gains of success. The importance of equity claims can also be illustrated through accounting principles: on the income statement, input costs such as labor reduce profits that accrue to equity; on the balance sheet, labor contracts are a liability that reduce residual equity of the firm. A labor union that seeks excessive wage rents by controlling the supply of labor is actually using politics to exploit rents from the owners of capital. But if workers participate in equity, they merely shift claims from the cost to the profit side of the income statement and from the liability to the asset side of the balance sheet, all the while aligning their interests with the overall success of the enterprise. As implied, with their own “skin in the game,” they also share more of the risk.

Lastly, the legal statutes for business equity are consistent with the criminal code that states that the innocent shall not pay for the crimes of the guilty. In this light we can see that political cronyism that privatizes gains but shifts losses to taxpayers is not only an abrogation of ownership rights, it is a violation of the moral spirit of the law.

In summation, I have argued that capitalist ownership matters for the following reasons:
1. Accumulation of capital assets for self-insurance, minimizing risk through asset diversification, and reducing the need for after-tax entitlement transfers;
2. Sharing the benefits of capitalist success by broadening participation in the market economy. These benefits feed back into future consumption and investment demand while reducing the inequality generated by finance;
3. Broadening the sources of finance capital, helping to fund adaptation and innovation;
4. Reducing agency costs by aligning interests of stakeholders in capitalist risk-taking enterprise;
5. Reaffirming the moral and legal basis of equity and the law of risk and return through transparency and accountability.

These five reasons illustrate why ownership and control is an essential component of a free society. The ultimate challenge to an organic entity, whether a species or a civilization, is to adapt successfully to constant change. In economic terms, we need to harness the forces of change and adaptation for the long-run sustainability of the economy and security of society. There certainly are other social systems that attempt the same by eschewing private ownership and imposing top-down control, such as authoritarianism, national socialism or fascism, and communism. But none of these systems are able to assert the primacy of individual freedom and security that we hold inextricably entwined. To empower ownership is to advance freedom, to facilitate risk management under uncertainty, to spur adaptation and innovation, to affirm equity and justice, and ultimately, to foster peace and prosperity.

On the other hand, without ownership, we get feudalism:

feudalism-1percent

The Bubble Economy Redux

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Good article. A little sunshine goes a long way. The reason QE hasn’t caused inflation is because of massive disinflationary forces around the world unleashed by excessive credit and debt creation. People won’t borrow at low interest rates if they already have too much debt, they merely refinance. Banks also do not want to lend in an uncertain monetary environment with distorted prices of collateral, so they leave their excess reserves idle or buy Treasury bonds and earn the difference.

But QE HAS generated much asset price inflation in real and financial assets, hence the booms in select housing, land, art, and financial markets. The Fed thus has caused relative price distortion that is greatly impeding long-term risk-taking, production, and job creation. Is this a secret? I think not. Time for a reckoning of monetary and fiscal policy.

From the National Review Online:

The Other Bubble

Some highly placed people don’t want a serious discussion of quantitative easing.

By Amity Shlaes

Back in the late 1990s and right up to 2007, journalists occasionally wondered about two big enterprises called Fannie Mae and Freddie Mac. Fannie had come out of an obscure period of American history, the New Deal. Freddie had been created more recently, but no one could explain quite how. The official job of the pair was to provide liquidity in the housing sector in various ways, including creating a secondary market in securities backed by mortgage loans. Whatever Fan and Fred did, their form seemed a contradictory hybrid: On the one hand they were “private.” On the other hand their bonds sold at a premium over other bonds, suggesting that the Treasury or the Fed would always bail them out. These “government-sponsored enterprises,” as they were known, were both growing. Logic suggested that the more they grew, the more bailing them out would rattle markets.

Yet if a reporter took a stab at explaining these mystery entities in a story, or even merely spotlighted them, that reporter paid for it. Fannie and Freddie’s big executives, credentialed power brokers from both parties, hopped on the Shuttle and came to New York to bully the newspaper into shutting up. The executives suggested the journalists weren’t bright enough to appreciate the financial mechanics of Fannie or Freddie. This brazen effort at intimidation was unusual. Even senior editors could recall nothing like it — unless they were old enough to have met with a Teamster.

Those writers who experienced this finger-wagging and strong-arming in the conference room will never forget the queasy feeling they engendered. Fannie and Freddie’s lobbyists did not succeed in muzzling big news. From time to time, even after such a visit, editors ordered up and reporters wrote articles probing the GSEs. But when it came to big, sustained investigations, most newspapers turned to easier topics. When, much later, Fannie and Freddie proved to have been ticking time bombs and set off the financial crisis, the reporters told themselves that the very blatancy of the effort to intimidate should have tipped them off. They vowed to respond differently should that queasy feeling ever return.

Well, queasy is back. And this time, the strong arm belongs not to the boss of the company, Janet Yellen of the Fed, but to a media supporter, Paul Krugman of the New York Times. Unlike the old Fan and Fred execs, Krugman isn’t administering his punishment in the privacy of a conference room but rather in his columns and blogs. Example: This week, the professor’s target was actually another man qualified to be a professor, Cliff Asness, a University of Chicago Ph.D. who does his own academic work. Asness also runs tens of billions at a hedge fund, a fact that suggests he has thought about interest rates and the Fed quite a bit. To Asness Krugman wrote: “But if you’re one of those people who don’t have time to understand the monetary debate, I have a simple piece of advice: Don’t lecture the chairman of the Fed on monetary policy.”

What triggered Krugman’s pulling some kind of imagined rank on Asness was that Asness, along with me and others, signed a letter a few years ago suggesting that Fed policy might be off, and that inflation might result. Well, inflation hasn’t come on a big scale, apparently. Or not yet. Still, a lot of us remain comfortable with that letter, since we figure someone in the world ought always to warn about the possibility of inflation. Even if what the Fed is doing is not inflationary, the arbitrary fashion in which our central bank responds to markets betrays a lack of concern about inflation. And that behavior by monetary authorities is enough to make markets expect inflation in future.

Besides, the Fed cannot keep interest rates this low forever. As former Fed governor Larry Lindsey notes, the cycle of quantitative easing has become predictable: “QE1 ends. Stock market sells off. QE2 begins. Then, QE2 ends. Stock market sells off. Operation Twist starts to be soon followed by a full-blown start of QE3. Now here we are in October and QE3 is finally winding down. This time it was ‘tapered’ rather than abruptly ended. Still, stock market sells off.” Concludes Lindsey: “Whenever the Fed withdraws a stimulus it is going to be painful. Whenever officials flinch and ease because of the pain it just becomes harder next time.”

Given all the confusion, it would surely be useful have a vigorous debate on the Federal Reserve law and Fed policy — one that includes all kinds of arguments, and in which nobody calls anybody a “wing nut.” One that asks whether stock prices or, for that matter, housing prices may reflect inflation or deflation, or whether the dollar will always behave the way it does now. The authorities’ response — “We’re smart, so be quiet” — suggests that the greatest bubble of all bubbles may be the bubble of credibility of central bankers. Whenever that one pops, the whole world will feel queasy.

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.

The Esoterica of Monetary Policy

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Okay, this discussion is guaranteed to put the average American to sleep. The notable signal is that the Fed has no plans to shrink its balance sheet and will remain a major holder of US housing mortgages into the indefinite future. Since when was the Fed appointed to actively manage the US real estate market?

The irony is that our lives are being run through this monetary policy mill. Most citizens will discover this long after the fact. From the WSJ:

Behind the Fed’s Dovish Turn on Rates

After sending hawkish signals in July, the Federal Open Market Committee has softened its tone.

The battle at the Federal Open Market Committee is now on. Score the previous meeting in late July for the inflation hawks, but last week’s meeting went for the doves, who are more worried about jobs. I haven’t discussed the meetings with any Fed officials, but here’s my reading of what has been going on.

In the statement following July’s FOMC meeting, Federal Reserve Chair Janet Yellen went to great lengths to placate the hawks with several language changes (but no policy changes). Instead of emphasizing that “inflation has been running below” the Fed’s 2% target, as the committee had been saying, the statement observed that “inflation has moved somewhat closer” to 2%. And instead of calling the unemployment rate “elevated,” it switched to the less ominous phrase “significant underutilization of labor.” Such subtleties matter at the Fed, and markets took note of the more hawkish tilt.

The hawks were not placated. Because voting rights rotate among the reserve bank presidents, this year’s voters include only two real hawks. One of the them— Charles Plosser of the Philadelphia Fed—dissented from the Fed’s statement that low interest rates would be maintained “for a considerable time after the asset-purchase program ends,” making the July vote 9-1. The other— Richard Fisher of the Dallas Fed—did not dissent formally, but had three days earlier made his disagreement known in these pages.

Last week Ms. Yellen gave no ground. The committee’s hawks would like the phrase “significant underutilization of labor” removed from the statement. The Fed kept it. They want the FOMC to stop declaring that interest rates will remain at their current superlow levels “for a considerable time” after asset purchases end next month. The Yellen-led majority refused. The hawks want the Fed to stop saying that it expects to keep interest rates low “for some time” after the economy returns to normal. The Fed didn’t. And there were a few more details, all pointing in the same dovish direction.

Mr. Plosser dissented again, and this time Mr. Fisher joined him, making the FOMC vote 8-2. There almost certainly would have been more dissents if other hawks could vote. At a consensus-based institution like the Fed, this constitutes deep division.

Yet another indicator of rampant disagreement appeared in the famous—to Fed watchers—”dots diagram,” where each committee member is represented by a dot showing where he or she thinks the federal-funds rate should be in the future. Opinions on where the rate should be at the end of 2015 range from near zero all the way to 3%. The range is even wider for the end of 2016: from 0.25-0.50% to 4%. This is a remarkable degree of disagreement.

The Fed also released a new set of “principles and plans” for bringing monetary policy back to normal, finally replacing the principles it published in 2011, which said, among other things, that some balance-sheet shrinkage would come before interest-rate hikes. These new principles are rather vague, but Jeffrey Lacker of the Richmond Fed, another hawk, refused to sign on.

Fed watchers learned two main things from the new plans. First, that as the Fed “exits,” it will not rely heavily on what are called “overnight reverse repurchase agreements”—in plain English, borrowing in the money markets. Rather, it will do such borrowing “only to the extent necessary and will phase it out when it is no longer needed.” Market specialists had been all aflutter about this issue, some thinking it would become the Fed’s primary instrument.

Second, while the FOMC still “intends” to exit without any outright asset sales from its huge portfolio, it hedged on that principle in several ways. For example, it said it “does not anticipate” selling any mortgage-backed securities, which prompted Mr. Lacker’s dissent. Furthermore, the FOMC didn’t mention selling Treasurys at all.

Regarding current monetary policy, the most notable and perhaps puzzling change in the Fed’s official forecast was less optimism about real GDP growth in 2015. In its previous forecast, the “central tendency” among FOMC members was about 3.1%. Now the central tendency is about 2.8%. Not exactly an earth-shattering change. But as these things go, that’s a pretty big revision in six weeks, and it isn’t clear where the newfound pessimism came from. It does, however, suggest less urgency about raising rates.

The median FOMC member now thinks the federal-funds rate should be between 1.25% and 1.5% by the end of next year, and between 2.75% and 3% by the end of 2016. Both are higher than before, and a bit higher than traders expect.

One way to make sense of all this is to say, as some have, that the Fed may wait a little longer but then raise rates more rapidly once it starts. Perhaps. Another interpretation is that the Fed is projecting faster rate hikes because it is underestimating how strongly bond traders will push long-term interest rates up once Fed hikes begin. The central bank has underestimated market reactions before.

The Roots of Cronyism

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We have a revolving door between Wall Street and Washington regulators. This is why it seems that the tail of the financial industry wags the dog of the real economy, or why the interests of Wall St. dominate those of Main St. Past time for real change. An article by two academics printed in the WSJ:

The Federal Reserve’s Too Cozy Relations With Banks

Working at the Fed shouldn’t be an audition for a Wall Street job. Waiting periods and other reforms are needed.

The Federal Reserve was established in 1914 as independent of the president and Congress—and for good reason. The Fed’s founders understood that politicians had to be blocked from using monetary policy to juice the economy before elections. Extensive research supports the wisdom of the Fed’s political independence; monetary policy works best when it is insulated from the vagaries of election cycles.The problem is that while the Fed is largely independent of politicians, it is intimately connected, and even answerable, to the financial institutions that it is supposed to regulate.Consider the board of directors of the Federal Reserve Banks. Nine directors oversee each of the 12 Federal Reserve Banks. Private banks choose six of the nine. The other three are typically the CEOs of major corporations or executives at other financial institutions, such as private-equity firms.Fed presidents are also deeply tied to financial institutions. For example, the current president of the New York Fed (the most important of the Fed’s 12 regional banks) was at Goldman Sachs before taking over the Fed. His predecessor is now president of the private-equity firm Warburg Pincus; his predecessor went to Merrill Lynch after the Fed; and his predecessor is now at Goldman Sachs.

A growing body of academic research indicates that the stock market values these bank-Fed connections. A 2013National Bureau of Economic Research paper by Daron Acemoglu, Simon Johnson, Amir Kermani, James Kwak and Todd Mitton, “The Value of Connections in Turbulent Times: Evidence from the United States,” provides a case in point. In November 2008, when it was announced that then-New York Fed President Timothy Geithner would be nominated for Treasury secretary, the stock prices of financial firms with which he had close personal connections soared relative to those of other financial firms. Those same stock prices plummeted when his nomination briefly ran into problems over his taxes.

Markets might be right about the value of close relations with the Fed. A paper recently presented at the NBER by Anna Cieslak, Adair Morse and Annette Vissing-Jorgensen —titled “Stock Returns over the FOMC Cycle“—finds evidence suggesting that the Fed has been leaking information. Senior Fed officials regularly gather between their highly publicized Federal Open Market Committee meetings to discuss monetary policy. Although the information from these lesser-known meetings is not released to the public until weeks later, the authors found that stock prices respond immediately after the meetings, suggesting that people and financial institutions are trading and possibly profiting on information contained in those meetings.

Cozy bank-Fed relationships are especially important for financial regulation and crisis management. We pursue these topics in our books “Fragile by Design: The Political Origins of Banking Crises and Scarce Credit” (which Mr. Haber wrote with Charles Calomiris ) and “Guardians of Finance: Making Regulators Work for Us” (which Mr. Levine wrote with James Barth and Gerard Caprio ).

There are too many examples to list here, but the Fed’s response to the 2007-08 subprime mortgage crisis is illustrative. We do not question the Fed’s rescue of the banks to protect the economy from a potentially catastrophic collapse of the financial system.

We do, however, stress that in the months and years leading up to the crisis, the Fed did nothing to curtail the run-up in risky lending that caused the crisis. We also point out that when the Fed finally acted, it not only rescued the banks, it also bailed out their shareholders as well as the executives who had helped steer the banks and country into the crisis. In contrast, when the government rescued General Motors, it forced shareholders and bondholders to take huge financial losses and executives to be fired.

The Fed’s multibillion-dollar assistance to financial institutions—including lending commitments to Citigroup and Bank of America, supporting J.P. Morgan‘s purchase of Bear Stearns, rescuing AIG and through that aid to Goldman Sachs and many others—occurred without transparency. After Bloomberg News filed a Freedom of Information Act request in 2008 regarding the Fed’s actions, Congress urged the Fed to comply. The Fed refused and fought all the way to the Supreme Court—which in 2011 ordered it to release the records. When the Fed finally complied, it provided thousands of pages in a non-searchable PDF format, making it difficult to piece together the relevant facts.

What to do? A few simple reforms would be helpful. First, the tight links between the Fed and the financial-services industry could be weakened by reconsidering the number of Fed directors appointed by banks. Second, Fed officials should be required to agree to a waiting period—perhaps as long as five years—after leaving the Fed to take a position at a financial-services firm. Fed officials should not be auditioning for jobs on Wall Street.

Third, there should be greater transparency and oversight of the Fed’s role as a financial regulator. Congress should establish mechanisms—including a group of experts with the authority to demand information from the Fed and the capabilities to assess Fed performance.

Such reforms will not be a panacea: They will not address the extensive reach of finance into the political process of drafting and implementing financial regulations. But they represent principled first steps.

Mr. Haber is a professor of political science at Stanford University and a senior fellow at the Hoover Institution. Mr. Levine is a professor of business at the University of California, Berkeley.

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