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

How We Finance (Blow) Bubbles

stock_market_bubbleEconomist and fund manager John Hussman outlines some basic economic truths in his weekly market comment (full text here). All bubbles in history have one thing in common: excess liquidity (usually through credit creation but also through the acquisition of gold under the gold standard, or some other fungible commodity discovered in abundance, such as oil).

Excess liquidity funds all kinds of unproductive boondoggle investments, such as tulip bulbs and South Sea Island land speculation. Hussman outlines how the Fed, in consort with other central banks such as the BoJ and ECB, are pumping up our fragile global economy with credit created out of whole cloth.

On Friday (Oct 31), the Bank of Japan promised a fresh round of quantitative easing, prompting a collapse in the yen, a surge in the U.S. dollar, and marginal new highs in several stock market indices.

At present, the entire global financial system has been turned into a massive speculative carry trade. A carry trade involves buying some risky asset – regardless of price or valuation – so long as the current yield on that asset exceeds the short-term risk-free interest rate. Valuations don’t matter to carry-trade speculators, because the central feature of those trades is the expectation that the securities can be sold to some greater fool when the “spread” (the difference between the yield on the speculative asset and the risk-free interest rate) narrows. The strategy relies on the willingness of market participants to equate current yield (interest rate or dividend yield) with total return, ignoring the impact of price changes, or simply assuming that price changes in risky assets must be positive because low risk-free interest rates offer “no other choice” but to take risk.

The narrative of overvalued carry trades ending in collapse is one that winds through all of financial history in countries around the globe. Yet the pattern repeats because the allure of “reaching for yield” is so strong. Again, to reach for yield, regardless of price or value, is a form of myopia that not only equates yield with total return, but eventually demands the sudden and magical appearance of a crowd of greater fools in order to exit successfully. The mortgage bubble was fundamentally one enormous carry trade focused on mortgage backed securities. Currency crises around the world generally have a similar origin. At present, the high-yield debt markets and equity markets around the world are no different.

Hussman also explains why the Fed’s assumptions about liquidity by subsidizing zero interest rates are not yielding risk-taking investment:

The fact is that financial repression – suppressing nominal interest rates and attempting to drive real interest rates to negative levels – does nothing to help the real economy. This is certainly not a new revelation. In part, this fact can be understood by thinking about how interest rates are related to the productivity and quantity of real investment in the economy. 

…depressed real interest rates are symptomatic of a dearth of productive investment opportunities. When central banks respond by attempting to drive those real interest rates even lower to “stimulate” interest-sensitive spending such as housing or debt-financed real investment, they really only lower the bar to invite unproductive investment and speculative carry trades. 

Here we have the intuitive logic that eludes the Fed:

As the central bank creates more money and interest rates move lower, people don’t suddenly go out and consume goods and services, they simply reach for yield in more and more speculative assets such as mortgage debt, and junk debt, and equities. Consumers don’t consume just because their assets have taken a different form. Businesses don’t invest just because their assets have taken a different form. The only activities that are stimulated by zero interest rates are those where interest rates are the primary cost of doing business: financial transactions.

What central banks around the world seem to overlook is that by changing the mix of government liabilities that the public is forced to hold, away from bonds and toward currency and bank reserves, the only material outcome of QE is the distortion of financial markets, turning the global economy into one massive speculative carry trade. The monetary base, interest rates, and velocity are jointly determined, and absent some exogenous shock to velocity or interest rates, creating more base money simply results in that base money being turned over at a slower rate.

To sum up Hussman’s outlook he writes: From a full-cycle perspective, we continue to view present conditions as among the most hostile in history. 

That, my friends, is our central bank and Federal government at work.

The Bubble Economy Redux

cartoon-bubble-v31

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.

This Wild Market

stock-market-the-ride

This Wild Market

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

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

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

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

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

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

From the WSJ’s MoneyBeat:

Robert Shiller on What to Watch in This Wild Market

By Jason Zweig

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Prof. Shiller says both stories sound right to him.

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

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

Housing Casino Bosses

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

The Fed’s Mortgage Favoritism

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

By Jeffrey M. Lacker And John A. Weinberg

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

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

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

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

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

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

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

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

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

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

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

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

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

Creative Capitalism: Gates & Buffett

CreativeCapBook Review:

A noble effort that fails to converge on ideas…

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

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

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

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

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

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

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

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

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

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

Capitalism’s Everyman (woman!)

This is one of the most inspiring and uplifting stories I’ve ever read in the financial press (from Barrons, September 12). Stephanie Mucha has defied what all the policy experts in Washington and Wall St. claim: That one cannot participate in the success of capitalism at every income level through capital accumulation. This woman did not get rich through a salary wage, she got rich by accumulating and investing capital successfully. I can’t tell you how many policy experts I’ve heard state this is not possible. No, not everybody will be as successful, but the basic golden rule of working, saving, and investing prudently in capitalist enterprise is as sound as it ever was.

What we need to do is to stop punishing people who pursue such prudent strategies through our misguided tax code that rewards borrowing and spending money one has never earned. The biggest crime is to continue to convince people that such participation is not even worth trying. That’s what ZIRP, TBTF, and double and triple taxation of capital is doing to us all. Let’s encourage and defend the rights of the small public shareholder.

The second accolade for Mrs. Mucha is her desire to spread that capital around before she dies. She has done this through public charities, but there is no reason not to pursue good by providing angel capital to potential entrepreneurs who hope to create something of lasting value. The venture capital industry is not the only channel. The sustainability of capitalism derives from the constant recycling of capital. I’d have to say Buffett and Gates could learn a thing or two from Stephanie Mucha.

The Oracle of Buffalo

A 97-year-old former VA nurse, Stephanie Mucha lived frugally and invested wisely. Now she’s giving away over $5 million.

Our image of who is rich is often at odds with reality. Consider Stephanie T. Mucha, 97, who remembers the 1929 stock market crash. The Buffalo, N.Y., resident worked as a licensed practical nurse for more than four decades, and has parlayed her humble earnings into a Penta-size portfolio. In recent years, she has given away $3 million—and she still has $2.5 million left. Her goal: to give away a total of $6 million before she dies.Mucha was no debutante. She dropped out of high school and worked as a maid, helping her parents hold on to their house during the Great Depression. Later, she worked for 44 years at the Buffalo Veterans Affairs Medical Center, where she was one of 100 civilians to receive the Purple Heart. Mucha earned $23,000 a year when she retired in 1994.When she was 25, her father, afraid she’d be an old maid, matched her up with Joseph Mucha, a machinist 26 years her senior who emigrated from Poland at age 18. Joseph earned $6,000 a year when he retired around 1958. By the time he passed away in 1985, the couple’s portfolio was worth roughly $300,000.

The Muchas invested without the help of Wall Street. Some 30 years ago a broker advised them to sell their Intel shares (ticker INTC); after that, they ignored his advice. But gifted investors, always on the lookout for ideas, often make their own luck. Mucha was working in the VA hospital when Wilson Greatbatch, a local inventor, implanted a pacemaker in a dying dog. In about 10 minutes, the dog’s tail started to wag; a little later, it sat up and walked around.

“I came home and said to my husband, ‘I saw a dead dog come to life.’ ” What she had seen was a demonstration of the first implantable cardiac pacemaker. The device was licensed in 1961 to Medtronic (MDT). In around 1964, the Muchas spent $255.50 to purchase 50 shares at $5.11. By the time she donated a portion of the shares in 2007, the position had grown to $459,000. She still owns about 300 shares, at $66.

Hard work and frugality also contributed to the Muchas’ success. They created three apartments in their house, one to live in and two to rent out. The Muchas, who weren’t able to have children, owned only one car. After her husband’s death, Mucha sold her diamond ring and wedding band for $2,700, investing the proceeds. She also rented out a room in her apartment for $15 a night to women visiting their sick husbands at the VA hospital. She invested the estimated $25,000 she earned over 20 years from that rental in the market.

A fan of Jeremy Siegel’s book Stocks for the Long Run, she held on to her stocks in both up and down cycles. She also realized that women tend to outlive men, so they need to know how to invest. “Women need to learn how to use their money so it outlasts them.” She waited until she was 70 to start collecting Social Security, and now collects about $40,000 a year from Social Security and her VA pension, plus $675 a month from a renter.

Mucha doesn’t have a computer. She has an Ameritrade account that gives her free trades over the phone, reinvests her dividends, and sends her five research reports a month. She reads The Wall Street Journal every day, along with Barron’s, Forbes, the Economist, and the New York Times, and watches CNBC and Bloomberg. As for picking stocks, she recalls her husband saying, “You can’t build without nuts and bolts.” With that in mind, in recent years she has bought Precision Castparts (PCP), Snap-on (SNA), and Illinois Tool Works (ITW).

Age has caught up with her a bit, but it hasn’t dimmed her wits. Mucha’s portfolio made 11% last year, but when she learned her accountant’s portfolio made 36%, she gave his financial advisor a call. “I wanted to see if I was doing the right things,” she says. Larry Stolzenburg of Sandhill Investment Management in Buffalo now manages her portfolio. “Stephanie’s portfolio was one of the best I’ve seen,” he says. “It was well balanced and thought out. I almost offered her a job.”

Mucha, who never spent a dime of her investment capital, has put $1 million in trust each for the Kosciuszko Foundation, which helped her husband when he immigrated to the U.S.; the University at Buffalo’s School of Arts and Sciences, because it has a Polish studies program; and the School of Engineering, as her husband had wanted to be an engineer. This month, she plans to make a donation to the School of Medicine and Biomedical Sciences. She has also earmarked money for the schools of nursing and dentistry.

“She’s a fantastic, smart person,” says Alex Storozynski, president emeritus and a trustee of the Kosciuszko Foundation. In addition to the $1 million donation, Storozynski says she has given him dietary tips, like eating chia seeds and almond butter. Advice to live by, no doubt.

The Lingering, Hidden Costs of the Bank Bailout

pigs

Bravo. Reprinted from the WSJ:

Why is growth so anemic? New economic activity has been discouraged. Here are some ways to change that.

The rescue of incumbent investors in the government bailout of the largest U.S. banks in the autumn of 2008 has been widely viewed as unfair, as indeed it was in applying different rules to different players. The bailout through the Troubled Asset Relief Program has been justified by the Federal Reserve and Treasury as preventing a financial collapse of the economy.The rescue, however, had a hidden cost for the economy that is difficult to quantify but can be crippling. New economic activity is hobbled if it is not freed from the burden of sharing its return with investors who bore risks that failed. [‘Heads we win, tails you lose’ is also immoral by any traditional definition of the concept.] The demand for new economic activity is enlarged when its return does not have to be shared with former claimants protected from the consequences of their risk-taking. This is the function of bankruptcy in an economic system organized on loss as well as profit principles of motivation.Financial failure and the restructuring of assets and liabilities motivates new capital to flow directly into new enterprise activity at the cutting edge of technology—the source of new products, output and employment which in turn provide new growth and recovery. Requiring new investment to share its return with failed predecessors is tantamount to having required Henry Ford to share the return from investment in his new horseless carriage with the carriage makers, livery stables and horse-breeding farms that his innovation would render obsolete.This burden on new investment helps explain the historically weak recovery since the “Great Recession” officially ended in June 2009, and the recent downturn in gross-domestic-product growth. The GDP growth rate for all of 2013 was just 1.9%, and in the first quarter of 2014 it declined at a seasonally adjusted annual rate of 2.9%.

With only two balance-sheet crises in the U.S. in the past 80 years, 1929-33 and 2007-09, we have little experience against which to test alternative policies and economic responses. Japan and Sweden are examples of economies that followed distinct pathways after crises in the early 1990s. In Japan the economy floundered in slow growth for over two decades; Sweden recovered much more quickly. The difference can be attributed to following different policies in the treatment of severe bank distress.

Japan’s real-estate market suffered a major decline in the early 1990s. Home prices peaked in the fall of 1990 and fell by 25% in two years. By 2004 they had fallen 65%. Meanwhile, nonperforming loans continued to escalate throughout this 14-year period.

Japanese policy permitted banks to carry mortgage loans at book value regardless of their accumulating loss. Loans were expanded to existing borrowers to enable them to continue to meet their mortgage payments. This response could be rationalized as “smoothing out the bump.” Bank investors were protected from failure by stretching out any ultimate return on their investment, relying on a presumed recovery from new growth that never materialized. This accounting cover-up was coupled with government deficit spending—tax revenues declined and expenditures rose—as a means of stimulating economic growth that was delayed into the future.

From the beginning Japan was caught in the black hole of too much negative equity. The banks, burdened with large inventories of bad loans, geared down into debt reduction mode, reluctant to incur more debt, much as their household mortgage customers were mired in underwater mortgages and reluctant to spend. The result was a decade of lost growth that stretched into and absorbed a second decade of dismal performance. The policy cure—save the banks and their incumbent investors—created the sink that exceeded the pull of recovery forces.

Sweden’s response to deep recession in the early 1990s was the opposite of Japan’s: Bank shareholders were required to absorb loan losses, although the government financed enough of the bank losses on bad assets to protect bank bondholders from default. This was a mistake: Bondholders assumed the risk of default, and a bank’s failure should have required bondholder “haircuts” if needed. Nevertheless, the result was recovery from a severe downturn. By 1994 Sweden’s loan losses had bottomed out and lending began a slow recovery that accelerated after 1999.

The political process will always favor prominent incumbent investors. They are visible; they contribute to election campaigns; they assist in the choice of secretaries of Treasury and advisers and they suffer badly from balance-sheet crises like the Great Recession and the Great Depression. Invisible are the investors whose capital will flow into the new economic activity that constitutes the recovery.

Growth in both employment and output depends vitally on new and young companies. Unfortunately, U.S. firms face exceptionally high corporate income-tax rates, the highest in the developed world at 35%, which hobbles growth and investment. Now the Obama administration is going after firms that reincorporate overseas for tax purposes. Last week Treasury Secretary Jack Lew wrote a letter to the chairman of the House Ways and Means Committee urging Congress to “enact legislation immediately . . . to shut down this abuse of our tax system.”

This is precisely the opposite of what U.S. policy makers should be doing. To encourage investment, the U.S. needs to lower its corporate rates by at least 10 percentage points and reduce the incentive to escape the out-of-line and unreasonably high corporate tax rate. Ideally, since young firms generally reinvest their profits in production and jobs, such taxes should fall only on business income after it is paid out to individuals. As long as business income is being reinvested it is growing new income for all.

There are no quick fixes. What we can do is reduce bureaucratic and tax barriers to the emergence and growth of new economic enterprises, which hold the keys to a real economic recovery.

Mr. Smith, a recipient of the 2002 Nobel Prize in economics, is a professor at Chapman University and the author, along with Steven D. Gjerstad, of the new book “Rethinking Housing Bubbles” (Cambridge University Press).

Unemployment or Financial Stability?

see-sawI think I’d opt for some more stability to encourage fundamental growth in the real economy rather than virtual growth in the money economy. Again, zero interest rates are a sign of a debilitating sickness in the economy – the patient is not recovering.

Reposted from the WSJ:

Investors Heed the Fed at Their Peril

If booming asset prices go bust, the central bank’s credibility would be severely damaged. 

Federal Reserve Chair Janet Yellen in her testimony on Capitol Hill this week was candid, as she has been in the past, in telling lawmakers that the biggest economic risk she sees facing the country is the possible emergence of a new permanent class of unemployed workers.

To head off this possibility, the Fed is holding monetary policy accommodative longer than traditional monetary models would recommend. Opinions on the wisdom of this policy are split, but the Fed’s openness about its policy is heralded almost universally as a desirable development.

We are not so sure.

In today’s world the heads of the central bank determine what is immediately deemed common knowledge, and only investors with long time horizons (and a strong stomach) can resist their pronouncements. Ms. Yellen sees considerable labor-market slack, believes this will hold down inflation, and therefore pronounces that the Fed’s near-zero interest-rate policy will continue far into the future. The conventional wisdom is that low rates and low inflation are consistent with an environment in which asset prices rise, so that is what has happened.

This is now the third episode in the past 15 years in which asset-price growth has significantly outstripped income growth. From 1997 to 2000, the net worth of American households rose 40% while national income grew 20%, and in 2002-07, net worth grew 60% as national income grew 30%. Asset prices corrected after each of these rapid increases.

Over the past two years, net worth has grown more than 20% (a similar annual pace as the past two episodes) during a period when national income struggled to grow 6%—and interest rates are still near zero. When the Federal Reserve signals that monetary conditions will remain easy, behavior shifts and a self-fulfilling rise in asset prices is the result.

On Tuesday the Fed stated in its semiannual Monetary Policy Report that valuations were “substantially stretched” in some sectors like biotechnology and social media. Ultimately, however, asset prices should reflect expectations of future income, making them vulnerable to correction when they become too high relative to income.

A problem of having too much certainty on monetary policy is that once the market has come to accept the Fed’s views, changes in the story can be unnecessarily disruptive. Harvard economist Jeremy Stein, a former Fed governor and its leading thinker on financial stability before returning to teaching at the end of May, articulated in his final speech why the Fed’s change in rhetoric in the spring of 2013 was so disruptive.

Mr. Stein noted that a number of investors perceived that quantitative easing would essentially last forever, and they repositioned abruptly when then Fed Chairman Ben Bernanke suggested the program could be finished in a year’s time. The Fed is not responsible for investors who take losses, but the centrality of monetary policy to investment returns leads people to put too much weight on their predictions of Fed actions and too little on fundamental analysis of individual investments.

Mr. Stein warned that “the market is not a single person” and that there might be a similar event if the Fed alters its view on interest rates. This is the big risk for the market now. Ms. Yellen has successfully defined conventional wisdom as a future in which the Fed keeps overnight rates near zero even while inflation and employment approach their respective targets. Indeed, the success of the Fed’s communications in convincing investors that rates will remain low has contributed to low volatility across asset classes, encouraging yet higher valuations. If there is less slack than the Fed believes, monetary accommodation will reverse at a more rapid pace than markets expect.

Imagine a swimmer drifting easily with an ocean current who suddenly discovers he is a long way from shore. Asset prices could be in for a sharp correction. If the U.S. economy were to go through another asset bust cycle, the Fed’s credibility would be severely damaged, and its strategy on reducing unemployment would backfire.

Many monetary experts refer to the 2000 equity crash as a benign event. But the unemployment rate rose by 2½ percentage points after the decline, and the monetary policy response to that rise in unemployment contributed to the housing bubble and the 2008 financial crisis. The Fed will not achieve the stability that it seeks until financial stability concerns are given an equal weight when determining monetary policy.

Financial Crisis Amnesia

 

AENeumann

Alex Pollock, quoted from the WSJ:

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

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

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

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

Full article (subscription req’d.)

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