Fannie and Freddie no Longer Run to Minimize Taxpayer Losses

MarketWatch reports of Fannie Mae and Freddie Mac getting new marching orders from the US government:

Regulators initially restricted Fannie and Freddie's growth when they seized control. To "promote stability" and lower mortgage costs to borrowers, Treasury Secretary Henry Paulson said the two companies would be allowed to "modestly increase'' their mortgage portfolios to as much as $1.7 trillion through the end of next year and said they would no longer be run "to maximize shareholder returns."

Since no returns of any kind are to be expected in a little while, the last sentence should actually be translated to a more accurate wording: They are no longer run to minimize shareholder losses. And "shareholder" now practically means the US government. Isn't that nice and reassuring. And a good way to promote the "free market".

Moral Factors in the Free Market

There is a very interesting review in Time magazine of an article, from a forthcoming Oxford University Press book, titled "The Recession of 2008: The Moral Factor — A Jewish Law Analysis.", by Aaron Levine, who is both a rabbi and an economics professor.

The article comes up with a pro-regulatory stance that has its basis on the ancient principles of Judeo-Christian ethics, including not putting a stumbling-block before the blind (economically so in this case), disclosure (of hidden flaws) and over-charging.

That economics professors start to discuss ethics is a much needed step towards creating a principled compromise between freedom and moral restrictions in the prevailing "free market" ideology.

The old adage of "no freedom without responsibility" has been greatly manifested by the current financial crisis. The free agents in a marketplace are suddenly not so free after all, when confronted with margin calls. If one does not act in a responsible way, one's freedom will we taken away, one way or another.

In our usual feelings of self-importance and entitlement, we could take a word from Abraham Lincoln: "I like to see a man proud of the place in which he lives. I like to see a man live so his place will be proud of him."

Cyclic History in Action

Finance professionals have had quite a negative attitudes to talk of paralles between the current situation and that prior to the Great Depression of the 1930's. Now that such comparisons are starting to appear in many mainstream publications, Scott Reynolds Nelson, a professor of history, in a guest post in iTulip.com, makes a claim that the 1930's depression is not the correct parallel with the current situation. Instead he makes direct parallels with the Real Great Depression that started with the panic of 1873. (Hat tip to Tim of The Mess That Greenspan Made)

When commentators invoke 1929, I am dubious. According to most historians and economists, that depression had more to do with overlarge factory inventories, a stock-market crash, and Germany's inability to pay back war debts, which then led to continuing strain on British gold reserves. None of those factors is really an issue now. Contemporary industries have very sensitive controls for trimming production as consumption declines; our current stock-market dip followed bank problems that emerged more than a year ago; and there are no serious international problems with gold reserves, simply because banks no longer peg their lending to them.

In fact, the current economic woes look a lot like what my 96-year-old grandmother still calls "the real Great Depression." She pinched pennies in the 1930s, but she says that times were not nearly so bad as the depression her grandparents went through. That crash came in 1873 and lasted more than four years. It looks much more like our current crisis.

He also provides a nice lithograph from 1875 that shows the get-rich-quick attitude of the time as people chasing bubbles that are blown by a devil-looking character. I have reproduced the lithograph here in a less compressed format from the US Library of Congress.



He also draws analogies to the global imbalances caused by unequal cost factors across the global marketplace.

Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export train loads of wheat to abroad.

[...]

The echoes of the past in the current problems with residential mortgages trouble me. Loans after about 2001 were issued to first-time home buyers who signed up for adjustable rate mortgages they could likely never pay off, even in the best of times. Real-estate speculators, hoping to flip properties, overextended themselves, assuming that home prices would keep climbing. [...] As in 1873, a complex financial pyramid rested on a pinhead. Banks are hoarding cash. Banks that hoard cash do not make short-term loans. Businesses large and small now face a potential dearth of short-term credit to buy raw materials, ship their products, and keep goods on shelves.

Wow. I hope that he is not proven right in this assessment.

Blowback from Economic Black Ops?

I've been reading John Perkins' book "Confessions of an Economic Hit Man". It has made me think how much the oversized financial trouble in the economies of the developed world is at least partly an instance of blowback from economic operations that were initiated in the 1970's.

Perkins claims in his book that he was approached by people from the NSA in the beginning of his career as an economist in a big energy engineering company. (Chas. T. Main, now part of The Parsons Corp.). He was encouraged by the government people and his superiors to produce overly optimistic economic forecasts to encourage foreign governments to take huge amounts of debt for oversized development projects. The aim of this was to bring nations into debtor relationships with the US and the World Bank, thus retaining significant political control.

One paragraph in a chapter that is otherwise focused on the problems of modern Ecuador lit up a lingering thought that had been floating around my head for some time:

"During those tree decades, thousands of men and women participated in bringing Ecuador to the tenuous position it found itself in at the beginning of the millennium. Some of them, like me, had been aware of what they were doing, but the vast majority had merely performed the tasks they had been taught in business, engineering, and law schools, or had followed the lead of bosses in my mold, who demonstrated the system by their own greedy example and through rewards and punishments calculated to perpetuate it. Such participants saw the parts they played as benign, at worst; in the most optimistic view, they were helping an impoverished nation." [emphasis mine]

If this "operation" was as widespread as Mr. Perkins claims, it might actually have had an influence in the behaviour of underlings that observed their bosses coming up with and encouraging the most hyper-optimistic assumptions of economic development.

Because people do not just stay at a single job, untold numbers of workers might have participated in operations that were led by people secretly but intentionally working towards creating financial hardship. These people would take this behaviour as the normal way to do business. Some of those people that had early in their careers in the 1970's unwittingly worked in such projects are now on the very top of the business world.

The stream of thought in the financial world that just like that crosses straight over into hubris has been somewhat a mystery to me. This explanation, though only partial at best, is a very tempting one.

Naturally such operations could not be single-handedly responsible for the psyche of a whole generation. But it could have produced an additional amount of cultural acceptance for seemingly short-sighted practices of financial overreach.

It is, of course, also perfectly feasible that Perkins' book is not completely honest, but an elaborate attempt at trying to clean his own image. It can be a drag on one's conscience to witness the economic ruins left behind by sloppy or self-serving economic assessments.

Perkins' writing style does have a certain bit of self-centredness. (I was a hit man, but a conscious one.) The story also project an image of a person with such a level of cognitive dissonance that makes it somewhat hard to believe. Perkins' possible exaggerations of his moral discomfort in the early years doesn't necessarily mean that he is lying about the alleged government collusion.

As an idea, especially knowing of other operations of the US intelligence apparatus, the situation described by Perkins has some credibility. If these operations did indeed happen, a part of the financial trouble today can surely be ascribed to blowback from these (hopefully foregone) misdeeds.

Are the Liquidationists Starting to Raise their Heads?

Princeton economist and NY Times columnist Paul Krugman makes an excellent point in his NY Times blog:

Ken [Rogoff] tells us that

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast.

And then he calls for

a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels

Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen — which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to “trend”?

Ken Rogoff's point can be understood in a more limited sense. We do need an actual reduction in the relative size of the financial sector, which has grown way out of its intrinsic value. But that doesn't mean that economic activity in itself should slow down.

The transition from financial labour to more productive uses does entail some amount of higher unemployment. It does take some time for all the extra mortgage professionals to find a more productive employment. But this process of adjustment has started to happen on its own. There is no need (anymore) to help it on by excessive tightening of monetary controls.

The instinctive reaction to long dormant inflationary pressure that is suddenly fully revealed is quite similar to a person in a rocket that has been launched in a gigantic thrust and is comfortably looking at the sky (growing asset prices). Then the upward momentum runs out (we are entering a permanently high plateu...). The rocket turns towards the earth (existing stimulus moves from assets to commodities).

Now what is the appropriate response? Some people have just only come to realize that we are way too high and heading downwards. Their instincts are saying: If we keep the thrusters on, we will crash into the earth.

But this is a wrong reaction. This parable is completely bogus. The "thrusters" have not been on for a while. And we are not in a rocket in which the thrusters are always behind us. What we have is closer to a hot air balloon (pun intended). The burners were on for too long when we left the ground.

Monetary stimulus works quite like the torch in a hot air balloon. It has no immediate effect on the level of lifting force. Instead it builds up a reserve of lifting force quite like the temperature in a balloon.

And we do need some extra lift to keep us from falling straight to the ground. We can not, and should not try to keep permanently high, or we risk running out of fuel. But we do need to slow down the fall.

But fall we will. The global imbalances are too great. But we should not try to accelerate these inevitable changes. They will manifest by themselves. We should try to land as fast as we safely can without running out of fuel.

Some people have been looking to the clouds far above, and have only recently come to realize how very far we actually are from the ground below. For some of these people the immediate reaction to the sudden realization is "full speed down!". This is the liquidationist viewpoint. "Puncture the bubble!". It could have been fine in the beginning (and some have been calling it as it is), but will result in a very hard landing if rigorously applied at this "altitude".

Our current altitude is a matter of reality. We have a massively out-of-size financial sector and a global economy that is quite heavily out of whack. Some people think that this condition can be kept forever. But should we attempt that, we would surely run out of fuel. We are actually quite close to that situation. And it would result in a crash just as devastating as the liquidationist approach, only somewhat later.

What we have is a pretty tricky situation. We should not aim for a permanent bubble. And we should not aim for immediate deflation. We should aim for a steady brisk pace of continuous adjustment until the financial "industry" is the size of its actual utility, productive labour has the value that it should, and people would by paid around the globe according to their actual productivity.

In that sense Ken Rogoff is right. We do need to head down. But we do need to head down by careful administration of the torch. Not by letting the balloon completely deflate.

And Paul Krugman is exactly right. There is no sense in underutilization of labour and capital. Closing down factories and cutting down production produces nothing but poverty. Collectively we can't keep wealthy just by holding cash or government bonds.

The currently low interest rates are more a function of people wanting to hold secure government bonds than any sign of excessively "loose" monetary policy. The Federal Reserve has actually been withdrawing money in its open market operations. The overall liquidity has been stagnant, while the money has been pumped back into the system through various special lending facilities.

Unfortunately US monetary policy is now quite irrelevant. Bank accounts are primarily made of promissory notes, and cash is just a tiny fraction. When banks stop lending, the money supply shrinks on each payment that the public makes to banks, including interest and equity injections.

Money came from thin air, and to the same place it disappears. And the less there are actual deposits, the less banks have any need for cash, and the harder it is to try to slow down the collapsing bubble through monetary policy action. The zero interest limit (and running out of "fuel") awaits.

Mechanical Economists and the Gold Standard

Bill Bonner writes well in the Daily Reckoning Australia about the difference between the humanistic viewpoints of classical economists and the technical viewpoints of modern day economists.

The first economists - the two Adams, Adam Smith and Adam Ferguson - called themselves "moral philosophers." They were studying the human economy as though it were an anthill -- to see how it worked. They figured it must follow rules - just like all other things under Heaven - and tended to see mistakes people made, such as spending too much money, as moral failings.

Modern economists are more like auto mechanics. They think they can control the economy with a screwdriver. And to some extent they're right. Which is why the world economy is in such a mess; they turned the wrong screws. But it's why we moral philosophers are having such a good time; finally, we get to laugh and say "I told you so."

Economic activity is inherently a human process, and economists would need a lot more understanding of psychology (especially mass psychology) and philosophy. Instead, they tend to treat economics like it was a branch of engineering. This is most strongly evident in the modern field of "financial engineering".

But Bill Bonner has a strange fixation on the gold standard, which is actually not so relevant in this issue. He writes:

Since then, the U.S. government could print almost as many dollars as it wanted. Arguably, it printed too many. For something - perhaps it was too much cash and credit in circulation - led American homeowners to think house prices would rise forever.

In this case it is mostly too much credit. Growth of cash has been relatively sluggish (except in the far east and the Euro zone). The reality is that the credit decisions of commercial banks are not tied to the amount of cash anymore. Reserve requirements have been taken to practically zero. And this has happened in a regulatory environment that has the near equivalence of cash and credit as a base assumption.

In earlier times, before the deregulatory wave of the last 30 years, banks were forced to acquire a certain amount of cash for each accepted promissory note. But this is not so anymore. The last major relaxation in the US was in 1995 when retail sweeps were taken into use. There is almost nothing in these regulations to relax anymore. Banks have been able to magic deposits from thin air by accepting huge amounts of promissory notes at a negligible opportunity cost.

This relaxation has been a main cause in the growth of speculative flows as well. When banks can accept a promissory note at zero cost to cash reserves, it is very easy for them to lend huge amounts to speculators that make leveraged short term bets on price fluctuations.

In earlier times banks had to find actual depositors for a fraction of each dollar that they lent out. But now they have almost no opportunity cost at all.

Without cash reserve requirements, the only thing that is left to limit the growth of credit is solvency, either regulatory solvency in the form of capital requirements, or actual solvency. It is only natural that any lower limits of a self-enforcing process will eventually be reached, so here we are, exactly where the deregulators put us, either willfully or unwittingly.

More importantly, the lack of reserve requirements has essentially decoupled the financial economy from any actual monetary policy. When no cash reserves are needed for the growth of credit, a gold standard would not have necessarily saved the banks from this kind of a "race to the bottom".

In a certain sense, a gold standard would have been a fear factor for the bank owners. It would have made many of the ongoing bailout efforts much more difficult, thus raising the impact of the current crisis. This would have encouraged more strident risk controls from bank equity investors, but not in any binding way.

Bill Bonner's orthodox take on the gold standard creates a strange contrast with the philosophical and practical outlook of the classical economists that he so admires. A strict attachment to a crude and inflexible tool like the gold standard is more like a mechanistic view of the economy.

After all, gold has no practical inherent value at all. It is durable and its quantity is hard to manipulate. But it has been responsible for some of the most useless undertakings in human history, like gold rushes, military adventures, occupations and wars.

Money can also retain its value too well in some situations. In a deflationary spiral, money is seen to have a rising value. But cash should only have value as a medium of exchange. It should not be infinitely storeable. Value is only in what goods or services people can provide to each other, not in some heavy and soft (if quite pretty) metal in a safe.

The purpose of monetary policy should be aimed at keeping people from excessive hoarding or excessive consumption, either of actual goods or of the medium of exchange. The only way to create actual savings is to invest in capital goods (no, commodities are not capital goods) that have a value in being able to produce goods and (increasingly) services.

Dictatorial Powers for the US President

Andy Worthington (author of "The Guantánamo Files"), has written a good review of the recent US 4th Circuit Court decision against Ali Al-Marri, a Qatari national and legal resident in the US.

This decision has upheld an indefinite military detention, as an "enemy combatant", of a person that has never raised arms against the US. It gives the US president the authority to designate just about anybody as an "enemy combatant" on the basis of hearsay "evidence" of assumed intentions.

Mr. Worthington finishes with a strong quote from the verdict's minority opinion:

I leave the final words to Judge Motz, and her clear-eyed awareness of the injustice of the al-Marri verdict. “To sanction such presidential authority to order the military to seize and indefinitely detain civilians, even if the President call them ‘enemy combatants,’ would have disastrous consequences for the Constitution –- and the country,” Judge Motz wrote. “For a court to uphold a claim to such extraordinary power would do more than render lifeless the Suspension Clause, the Due Process Clause, and the rights to criminal process in the Fourth, Fifth, Sixth and Eighth Amendments; it would effectively undermine all of the freedoms guaranteed by the Constitution. It is that power — were a court to recognize it — that could lead all our laws ‘to go unexecuted, and the government itself to go to pieces.’ We refuse to recognize a claim to power that would so alter the constitutional foundations of our Republic.”

Unless Ali al-Marri is allowed a meaningful review of his status as an “enemy combatant,” Judge Motz’s fears have already come true.