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Saturday, October 30, 2010

Vintage Norman

At this point in the cycle, as we head into the elections next week and the uncertain outcome it portends, it may be a good idea to re-visit some thoughts Mike had a bit over two years ago at another critical time before an election. For new readers here and old friends....here you go from Mike's blog of September 17, 2008:

"A Dangerous New Policy"

The market turmoil today is easy to explain and easy to correct, but sadly, we will neither get a good explanation nor will we get the proper remedies. You will hear that it is because of the never-ending stream of bailouts that we are suffering through this, however that is not true. Up until last Sunday’s balk by Treasury Secretary Hank Paulson regarding a rescue of Lehman, things had been going fairly well: banks were recapitalizing, shares in some of the most beleaguered sectors like housing and banks were starting to recover, commercial credit issuance was rising, mortgage lending was picking up and most important, the U.S. was outperforming other countries around the world both in terms of its stock markets and its economy. That’s how it looked right up until Paulson uttered those famous last words: “I never once considered using taxpayer money to help Lehman.” What followed was the largest stock market decline since 9/11 and a virtual Who’s Who of financial firms who are now queuing up to witness their own demise. At this very moment, we are in a virtual freefall with no endgame in sight.

Perhaps it was not necessary to save an investment bank like Lehman. After all, in a $14 trillion economy the failure of what was essentially a financial intermediary should have been taken in stride. The problem, as I see it, was that by essentially throwing up his hands and saying that the government was prepared to leave the resolution of this crisis to “the free markets,” he changed the game in one fell swoop.

First and foremost let us understand that the idea of the “free markets” is a fallacy. Markets exist within the framework of a national and indeed, sometimes global, political system; they operate and are governed by laws, regulations and tax codes. In some cases they are even accorded special protections and rights, like in the case of patents and trademarks, etc. The word “free” in free markets is a misnomer. We have competitive markets, not “free” ones.

Yet the fallacy persists and many feel that all problems are better solved by the omniscient free market. Markets do react to problems and eventually “resolve” them, in their own way and sometimes that can be brutal. I’ll invoke the words of the philosopher Thomas Hobbes, who said, when talking about the natural state of nature and man, that life in that state can be “nasty, brutal and short.” As humans we give up some personal freedom to form societies in which there are rules and authorities. This keeps us from devolving into what Hobbes observed as man’s natural state of war and chaos. The markets are no different: they can be reigned over and controlled and corralled to some degree, or they can exist in a wild state.

I believe that our naïve appeals to “the hand of the free market” are being heeded and that is what makes this so very scary. Many of those who have longed for this day will be surprised, and not in a good way mind you. I said on Fox Business the other day that those who were against bailouts are seeing their dreams come true, however, their dreams will soon turn to nightmares. The current situation has devolved into that natural state that Hobbes described. Moreover, no one will be spared; not even those misguided folks who railed against the bailouts thinking that their good behavior (they paid their mortgages on time, never over-leveraged and wisely saved) somehow insulated them from any possible misfortune. They’ll be sadly mistaken.

Even policy makers have gotten influenced by this perception. Misinformed and misguided cries of “taxpayer on the hook” is leading to dangerous new policy, where the government is no longer acting as a backstop or countervailing force (because that is viewed as putting taxpayers in jeopardy) but rather, acting unilaterally to seize private property with some warped idea that the government needs to make profits. This is highly dangerous in my opinion.

Thirty-six hours after Paulson said that he would not help Lehman, he and the folks at the Fed appeared to go back on their pledge, saying that they would rescue AIG, the insurance giant that was taking its last few steps up the gallows. The Lone Ranger came riding in at the last moment. Or did he? For this help (which was not asked for at least in the way it came), AIG would have to pay loan-shark interest rates and the company’s owners—the shareholders—who had already lost pretty much everything (AIG’s largest shareholder, Hank Greenberg, is said to have seen his net worth decline by as much as $7 billion in a matter of days), would have just about zero, as the government takes a majority ownership position.

Herein lies the problem as I see it. The government is not a profit seeking enterprise. Rather, it exists for the public purpose. Yet mandating the government to “make profits” on the false notion that this someone behooves taxpayers, will not only destroy taxpayers but destroy the economy as we know it.

At the end of the day no private business can compete for profits with government in an economy where taxes must be paid in a currency that the government has the monopoly power to issue. Think about it. A company is set up to sell widgets. It has to raise capital (remember, the government’s cost of capital is zero ‘cause it issues the stuff), it makes a profit of $100 and gives 10% to the government as tax, leaving it with $90. It also has to pay back investors or the bank that lent it money to start up. So, it’s really left with less than $90.

In contrast, the profit seeking government uses its own money, which it can issue without constraint, then sells widgets for $100 and pays no taxes to itself. It should be clear that pretty quickly the government ends up owning the means of all production. That’s not called Socialism; that’s called Communism. The markets are not afraid of Democratic Socialism, however, the markets ARE afraid of Communism. Really afraid!

By operating under the false notion that the government must “make a profit” and that private owners and risk takers must be destroyed each and every time a firm needs something as simple as a loan or loan guarantee, private sector risk taking understandably collapses. Who will take risk when the government stands ready to take your property, unilaterally, without invitation or even a discussion of whether or not you are getting some fair compensation for it? The answer is nobody! That is why you are seeing stocks collapse today.

In all of the recent examples: Fannie Mae, Freddie Mac and AIG, the Fed or the Treasury could have extended loans or loan guarantees backed by these companies’ assets, charged an interest rate of whatever it chose, but preferably just above the yield on a 10-year Treasury, say. (Even though it could have chosen 0.0001% or any increment above 0% because the government’s cost of funds in zero) and that would have been sufficient “payback.”



In closing I will leave you with this example: Imagine if you went to buy a house and asked a bank for a loan, which the bank granted at some interest rate above the bank’s own cost of funds. That would be the bank’s “profit.” The bank will also secure the loan with the house. In other words, the bank can take the house if you default on the loan. I’m sure everyone understands this. Now imagine a scenario where the bank lends you the money at a specified interest rate, secures the loan with the property and owns whatever equity you build up in your home as well!! What kind of deal is that??? In the meantime, you are still stuck having to pay taxes and forking out money for the upkeep of the property. Who would buy a house??? The answer is nobody. But that is exactly the system we have set up here with the “bailouts" and this idea that the government should make profits. Herbet Hoover once said, "The business of government IS business." We had the Great Depression afterward.It should be no wonder, then, why investors are dumping stocks.

27 comments:

  1. "Vintage Mike Norman?" Isn't that akin to vintage malt liquor?

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  2. Smells like vinegar just like all the others. How about this "vintage" from June 2009:

    "Dollar bears don't understand...

    Dollar bears don't understand ouble entry accounting.
    Dollar bears don't understand for every debit there is a credit.
    Dollar bears don't understand for every liability there is an asset.
    Dollar bears don't understand for every borrrower there is a saver.
    Dollar bears don't understand for every dollar of the trade deficit there is a dollar of capital account surplus.

    This is the beginning of what could be a secular advance in the dollar. If I am right, gold is going down significantly.

    Gold at $400, anyone?"

    I would love to see some "vintage" 2007 blogs where you said housing and the stock market would be up. I'm sure those were long ago in your recycle bin. But you can still try to cherry pick your way to respectability - and fail miserably, of course. Its fun to watch though!

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  3. mike pointed out the facts that interest rates are where the fed wants them to be as a function of decision not any formula or market dictation.

    he also points out the hypocrisy of the currency market bias towards the dollar which is to magnify the debts of the USA without any respect to the assets created by those debts by the means of a sovereign currency ( which bernanke always says he can mop up to stoke inflation ).

    the hypocrisy of the currency market does not do the same to the german euro which is riddled with a much more complicated series of debts in the zone while not having any consequence on the euro to usd trade, if not making the euro hypocritially stronger.

    therefore, we know the us government is playing the situation to make the dollar weaker for the purpose of propping exports.

    we are supposed to be off the gold mark since 1970's. however, this trade is an indicator of what ? it is a bubble factor just like everything else.

    during carter austerity ballooned the price of gold. during reagan spending ( debts ) the price of gold dropped.

    obama austerity due to the republican of tea mindlessness is ballooning the price of gold.

    whoever is reading this blog for trade picks especially on subsidized commodities like gold should look else where.

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  4. John,

    I read your post up until you wrote, "Obama's austerity and..."

    Then I nearly wet my pants. Government spending has skyrocketed under this Administration. I just got though readin Orwell's '1984' for the first time in years. As I read through your post I realized that the Ministry of Truth will have to add one more principle of IngSoc (English Socialism): Spending is Thrift.


    You also remarked that interest rates are where the Fed wants them to be. Yes, that is a factual statement, but that is part of the problem. The interest rate is the most important price in an economy. Prices send signals to producers, consumers, sellers, speculators, etc., so it is crucial that the interest rate be telling the truth so to speak. What are th chances that the central planners by sheer luck guesssed the correct interest rate? I'm sure you will explain to me that central banking is an inexact science and so on.

    Isn't the Fed trying to centrally plan the economy to a degree? And here I am told ad nauseum all my life that we are supposedly a free market economy with free market prices. The dollar is one half of every transaction made. How can we have a free market when the money itself isn't free market money, i.e commmodity money? How can we have a free market when the most important price in the economy is planned by a group of men at the Fed? How can these men possibly have enough information to know what the price of anything should be, especially the interest rate?

    Aren't we kind of like those Soviet peasants who toiled endlessly under those interminable 5 year plans issued by the Politburo?

    You also indicated that Bernanke will "soak up" all the excess liquidity when the time comes. We shall see! QE2 will be followed by QE3, QE4, QE5 and so and so on until the day comes when the dollar cries no more.

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  5. Welfare state:

    Gov't spending is running at 25% of GDP, pretty much where it was under Reagan. It's not skyrocketing.

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  6. Welfare,

    "Isn't the Fed trying to centrally plan the economy to a degree?"

    Only for about the last 100 years or so???

    Check this excerpt from Mikes post above: "First and foremost let us understand that the idea of the “free markets” is a fallacy. Markets exist within the framework of a national and indeed, sometimes global, political system; they operate and are governed by laws, regulations and tax codes."

    This is the reality of how things work....IRT Johns comment above about the USD/EURO this past spring: The ECB has been buying both govt and bank securities since this time, and guess what? The Euro has turned back up...no kidding!

    This post from 2 years ago demonstates how to identify and break down the real issues that can effect markets/prices.

    After tomorrows election, it will be necessary to take a hard look at the projected path of govt policy again, and I look forward to Mike's take.

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  7. I just heard Bloomberg's Eisen interview Dr Reinhart from the American Enterprise Institute on Bloomberg.

    He almost is guilty of plagarism of Mike Norman :
    a. double accounting entries
    b. revenues & assets
    c. QE2
    d. soft dollar, easy credit
    e. etc etc

    John and WelfareDingDong State are way out to pick a few small items out of context and blow them up into generalizations - but that's what tea party libertarian republican'ts doo doo on themselves.

    http://www.aei.org/scholar/129

    Dr Vincent Reinhart - a former director of the Federal Reserve Board's Division of Monetary Affairs.

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  8. WS. Isn't it painfully obvious to you that the Fed is a weak institution. That monetary policy itself is useless. The modifying the price of money ( interest rates) does little if anything to stimulate the economy?

    IMHO, the fed creates artificial events like policy meetings and speeches in order to give markets something to bet on?

    Can we at least start by agreeing on that?

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  9. Mike,

    You remarked that government consumption spending is 25% of where it was under Reagan. Leaving aside that the government was spening far too much during the Reagan years too, the GDP is now mostly fluff. Over 70% of it is consumption spending. Subjective concepts like hedonics have been introduced that further distort the GDP and inflation numbers. As a point of reference, if we used the federal government's price inflation measuremtns from the 70's the CPI numbers from the last 10 years would have been between 6 and 8 percent according to non-governmental sources. With the new price inflation measures the government claimed that the price inflation rate for the last 10 years was between 2 and 3 percent.

    Very little of the GDP is actual production. One of the biggest problems with the GDP statistic is that it is calculated using the government's phony CPI statistic. The statistical measures that are supplied don't serve to elucidate anything but, rather, to further confuse. Given that the GDP is fluff and based on flawed measures, how do we realy know how much the government consumes relative to the total amount of wealth produced.

    Latly, where is it written that the central government should decide value on 25% of the wealth produced? For that matter, why should the central government even get to decide value on 10 percent of the wealth produced?

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  10. Bubblerefuge,

    I think the Fed chairman is more powerful than the president, at least internationally, because the dollar is the reserve currency of the world....for now. Not only is the dollar one half of every transaction domestically, it is the primary currency used for transactions in commodities traded on the world market. The Fed creates price inflation and asset bubbles. The Fed also distorts the economic decisions of market actors. So, no, I don't think the Fed is impotent at all. The adjectives I would used to describe the Fed are arrogant, incompetent, destructive, and dangerous.

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  11. WS,
    Its impossible to have a fruitful discussion if you are going to invent your own measures of inflation
    from some un-named source who is probably spewing austrian school economics and getting paid butt-loads of dollars for pimping gold for call-centers and direct marketing organizations which mark up gold 2-3X when they sell it to grandma and grandpa over the phone.

    Anyway you said:
    The Fed creates price inflation and asset bubbles.
    Explain to me the mechanism? The fed controls the price of money(interest rates). But how does that cause inflation in your view?

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  12. Bubblerefuge,

    Off of the top of my head, Shadowstats.com or safehaven.com are good sites that report on inflation among other things. There are many more quality sites. If you just look around and stop swallowing whole verything the government reports, you might come toa differnet understanding. The above sites aren't filled with Austrian economists though that certainly wouldn't distract from them if they did. In your mind, anything that is held by the Austrian school is ipso facto wrong. What an open-mind you have?

    Why would you trust the government when they have every incentive to debase the currency (i.e., create price inflation) while simultaneously underreporting it? You are like the fish who upon being informed that he is surrounded by water replies, "What water?"

    Since you brought up gold, I'll bring up silver. When did the Normanites stop buying gold and silver? When they were at $400 and $14 an ounce? I'm laughing all the way to the bank big boy. You?

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  13. The above post should read "subtract from them" and not "distract..."

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  14. WS,
    I don't think everything the austrians say is completely wrong.
    Creative destruction and all that I agree with to some extend. Just don't like the banking model and I think a fixed currency regimes have blown up time after time and cause too much pain and suffering.

    I don't distrust the government. They maybe very incompetent and inefficient in some areas. But stop distracting.

    What incentive does the government have to debase the currency?
    How does the fed debase the currency? This is a key point.

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  15. The "creative destruction" concept actually came out of the classical school which built upon the findings of the medieval Schoolmen-- the Spanish Schoolmen especially. Austrian economics is an extenuation of classical economics. Much of the economics profession took a left turn at the turn of the 20th century in return for a seat at the power table. Many economists are now just apologists for state power and are heavily subsidized for their efforts. The term "creative destruction" was actually coined by Joseph Schumpeter who, while schooled in Austrian economics, went down a slightly different path.

    Austrians are critical of "fixed currencies." Part of the problem with money in the nineteenth century was the fixed exchange rate of gold and silver which is a kind of price fixing. We advocate a free market in money. I advocate a complete separation of money and state. The concept of money and money itself came out the spontaneous order of the market, not from government central planners or academics. If you are going to criticize Austrian thought, you should at least understand it first. Buzz me when you have read just one book cover to cover from an Austrian.

    You wrote, "I don't distrust the government." Yep, that about sums it up. It's not a distraction to point out that governments have every incentive to massage the numbers to deceive the public. On the contrary, it's crucial to understand that simple truth.

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  16. as for norman's points, they all point to how the system is rigged as for the fixed currencies.

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  17. if gold prices were once rigged to be fixed, they could also be fixed in bubble rising. bubbles are fixes just as much as price fixes are fixes.

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  18. finally, this is all worthless as for USA manufacturing.

    Republicans are for exporting factories to China and blaming lawyers & workers who don't want work for nothing.

    Republicans are for finaning $1 trillion in tax cuts for the rich by allowing a communist state like China to open treasury accounts and create savings gluts as well as liquidity traps against the USA.

    Republicans are for allowing the said exported job centers' corporate bodies to keep taxes offshore for years which create liquidity traps against favor for the USA.

    Who cares about these Austrian mumbo jumbo con artists ? They don't want Austrian and German precision tax collection so they aren't Austrian Economicists at all.

    They are tax dodgers and job exporters.

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  19. WS,
    point out that governments have every incentive to massage the numbers to deceive the public
    I don't see what incentive they
    have to deceive the public on inflation. Not to mention the fact that it is hard to do when it comes to inflation because people see it every day.

    As far as the Austrian school, I haven't read a book on it as nothing about it has caught my eye. OTOH, I think that fiat money and the modern monetary system and capitalism is a big part of the progress and real wealth that has been created over the past 50-100 years. The problem is it could be so much better because policy makers don't seem to understand it.

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  20. This comment has been removed by the author.

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  21. welfarewarfare state: "The concept of money and money itself came out the spontaneous order of the market, not from government central planners or academics."

    What about fiat money, WS? Can you explain the concept of fiat money -today's US$ for instance - without linking it to the government. What is your opinion, which money is better for the economy - fiat or commodity money?

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  22. RVM,

    Every fiat curency, however distant in the past, has a link to a commodity-based money. How else would we know how much the worthless paper should command in goods and services without some link to a real money like gold or silver?

    As a thought experiment, imagine yourself stranded on an island with natives who hadn't discovered the concept of money. They simply bartered. Besides the obstacle of getting them to accept a piece of paper as real value, how are prices going to be discovered? A real commodity with intrinsic value would have to be the first money. It is only then that you could slowly convert to a fiat paper system after exchange rates (prices) had already been discovered.

    The process always beings with a commodity-based money then paper is introduced as a claim check for the commodity asa convenience then government eventually seeks to end convertibility of the worthless paper into the commodity money.

    It goes something like this: commodity money>>> receipt money used as substitute for real money as a convenience>>>fractional money whereby only a portion of the receipt money (paper money in other words) is backed by commodity money>>>pure fiat currency>>>destruction of fiat currency.

    Cheers!

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  23. welfarewarfare state: "Every fiat currency, however distant in the past, has a link to a commodity-based money. How else would we know how much the worthless paper should command in goods and services without some link to a real money like gold or silver?"

    Is that how you explain the concept of fiat money, WS - the worthless paper has some link to a real money like gold or silver? It is a nonsense - you can't call fiat money gold.

    Fiat money is just worthless paper - not gold or silver - still it commands all goods and services.

    You also didn't say which money works better for the economy - fiat or commodity money.

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  24. RVM,

    You completely missed the point. The current dollar was at one time convertible into dollar and silver. The gold and silver were viewed as the actual money and the paper as simply a claim check or receipt money. The process from commodity-based money to fiat paper isn't one step. I will reiterate that every fiat paper currency in the world has a link, however distant, to a commodity money in its past. Otherwise, how would we know what the price of anything should be in paper. The paper had to at some point represent a real value like gold and silver in order to arrive at prices for goods and services.

    As an example, the Euro was priced based on various national paper currencies which were all convertible into gold and silver somewhere in their past.

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  25. WS, I have the strange feeling I have conversation with a radio.

    I've never said that before the fiat money system there was the gold standard monetary system. Both are totally different.

    Can you just express your opinion about two things:

    1. What makes the worthless paper money valuable today?
    2. Which money is better for the economy - fiat or commodity backed money?

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  26. RVM,

    You asked what makes the worthless money valuable today. If you look on a Federal Rserve note, you will read on the front that this note is legal tender for all debts, PUBLIC and private. The government doesn't accept taxes in anything but dollars. The individual must somehow accumulate dollars to pay his tax burden which creates a demand for the fiat currency.

    The only thing that allows a fiat currency to hold its value is the government's discipline in not creating too much of it. Good luck with that! It is a faith-based currency. All of the incentives are for the government to debase the currency to make its liabilities and debts cheaper to repay in devalued dollars. Politicians also like artificially low interest, especially before election time, which creates pressure on the central bank to create new credit money to lower the interest rate. This is just one more incentive for the government to debase the dollar.

    I don't call for a commodity-backed money. The commodity IS the money. I don't mind receipt money(paper money) circulating as a substitute for the actual money, but I don't want a fractional money whereby only a portion of the paper money is convertible into the commodity money.

    I also advocate competing currencies. Let the individual choose his favored money and create competition. This is exactly why gold and silver ended up as monies to begin with.

    Fiat money is political money. It creates price inflation, unemployment, artificial bubbles, and serves as a barrier to wealth creation when the fiat currency inevitably heads toward a galloping inflation. We should be experiencing a proce defaltion right now. It is just that the markets 800 pound deflationary gorilla is going to be crushed by the Fed's 2000 pound inflationary gorilla. If money printing created wealth then Zimbabwe (hyperinflation) and Argentina(25% price infaltion)should be paradises. Can you name just one fiat currency that has lasted for 100 years?

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  27. WS: "The government doesn't accept taxes in anything but dollars. The individual must somehow accumulate dollars to pay his tax burden which creates a demand for the fiat currency."

    Agree!

    WS: "The only thing that allows a fiat currency to hold its value is the government's discipline in not creating too much of it."

    Maybe. If the government is smart enough to net spend as much as the private sector desires to net save.

    WS: "All of the incentives are for the government to debase the currency to make its liabilities and debts cheaper to repay in devalued dollars."

    Disagree! US government doesn't need to issue any debts at all as it is the sovereign issuer of its currency and freely floats it on the forex market. The debt it voluntarily issues can be paid off with interest at any prize - no need to target inflation.

    WS: "I don't mind receipt money(paper money) circulating as a substitute for the actual money, but I don't want a fractional money whereby only a portion of the paper money is convertible into the commodity money."

    Disagree! Read this:

    http://heteconomist.com/?p=658

    WS: "I also advocate competing currencies. Let the individual choose his favored money and create competition."

    Agree - viva forex!

    WS: "..This is exactly why gold and silver ended up as monies to begin with."

    Disagree! This is why their money role became history:

    http://heteconomist.com/?p=658

    WS: "Fiat money ..... creates price inflation, unemployment, artificial bubbles, and serves as a barrier to wealth creation when the fiat currency inevitably heads toward a galloping inflation."

    Disagree! Read this:

    http://heteconomist.com/?p=658

    WS: "If money printing created wealth then Zimbabwe (hyperinflation) and Argentina(25% price infaltion)should be paradises.Can you name just one fiat currency that has lasted for 100 years?"

    Not applicable.

    Cheers

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