The Constitution fails us when no one is certain what to do about an important issue.
(1557)
The Global Interdependence Council (GIC) visited the Banque de France in May 2008.
The European Union follows the American example. ...
With a dozen small variations, repurchase agreements are a new and streamlined way to make short loans in big volume. Bear Stearns dominated the repo market for hedge funds but the volume got too big to manage when interest rates shifted.
The author finds himself on television, and wonders whether c-span is a variant of blogging. From that, we go on to question whether Franklin really liked the French.
Most people find taxes are their biggest expense. Why not reduce them?
(2129)Whither, Federal Reserve? (2)
Whither, Federal Reserve? (2)
Constitutionality of the Monetary System
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| The Constitution |
In noting that our Constitution has lasted for over two centuries, we assert that this simple short document has largely anticipated everything important to anticipate, including the Industrial Revolution, atomic warfare, and the Information Age, to name a few. When an occasional issue arises that is not only unmentioned in the Constitution but where no one is certain what to do, our system leaves us spiritually adrift. Such an issue is found in o0ur monetary system, where we have been wandering for two hundred years.
The founding fathers worried a great deal that popular majorities would abuse minorities, particularly in the case of the majority poor people voting themselves the property of minority rich ones, or that debtors in the majority might dishonor the rights of creditors. Although we have developed a welter of laws about debt and creditors, bankruptcy and taxation, they are if anything too specific. What is lacking is a few general words in the Constitution about the principles of credit and money. The problem now is the same as it was in 1787; we don't know what to say.
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| Albert Gallatin |
For a very long time, some very well educated people were strongly opposed to the creation of a bank, later to mean a banking system. Alexander Hamilton's proposition that a "national debt is a national treasure" was greeted with horror by several Presidents, as well as by Albert Gallatin, one of the most sophisticated financial thinkers of the time. Underlying this perplexing reaction to the simple proposal to create a bank was surely the perception that making the Federal Government into a substantial debtor creates a powerful ally to all debtors in their eternal struggle with all creditors; the outcome of such an unequal struggle would inevitably be to the disadvantage of creditors. In common parlance the word capitalist seems to imply a creditor. It took a very long time for it to become understandable that debtors, too, were essential beneficiaries of a capitalist system, but that idea still often meets with dissent. However, when millions of the world population belong to religions which prohibit the payment of interest, it should not be surprising to find many Americans who cannot get their heads around the idea that debtors and creditors need each other to an equal degree.
In the case of inflation, governments have always been somewhat favorable to debauching the currency. Naturally, a major debtor hopes to repay its debt with cheaper money. Since it has more or less always been necessary to use police powers to maintain a common currency, Kings and governments have long been in control of money, whether that means gold bars or beaded wampum. And for the same length of time, governments have been discovered bending the rules in favor of themselves. Bronze has been substituted for gold, the edges of coins have been shaved, the printing presses print paper money unrestrainedly, and the consumer price index has been manipulated to encourage inflation. Political parties have sought votes from debtors by promising to regulate banks, promote silver as a substitute for gold, disadvantage foreign competitors, inhibit or manipulate the value of currency on foreign exchanges.
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| Alan Greenspan |
For forty years we have operated without any fixed standard for money. Money for all that time has lacked any physical representation, or discipline. Money has become a computer notation. At first it was based on calculations of monetary aggregates, a bewildering concept promoted by Milton Friedman. More recently, it is entirely based on inflation targeting as promoted by Alan Greenspan. With a target of maintaining steady prices, an inflation rate of 2% is set as a specific target for the Federal Reserve. If inflation falls below that target, more money is created; if it rises above that level, less money is created. How much there is of it does not matter; it's beyond calculation. Although this simplified description fills almost any listener with doubts, it seemed vindicated by seventeen years without a notable recession. Even though events beginning in 2007 raise pretty serious doubts, it may still prove to be the best possible monetary system.
Even though this most fundamental of all commercial issues cries out for a simple principle to be stated in the Constitution so that neither populist congressmen not rapacious financiers can ruin us, it is not presently possible even to imagine what a new Constitutional amendment would, should or even could say. Meanwhile, some immense power rests in the hands of shadowy figures whom we blindly trust, for lack of a better idea about how we should select them or what we should instruct them to do.
http://www.philadelphia-reflections.com/blog/1557.htm
Macroeconomics of The 2007 Collapse
Sudden wealth creation, whether from the discovery of gold or oil, the conversion of poverty into useful cheap labor, or the sudden abundance of cheap credit, is of course a good thing. Sudden wealth creation can be compared with a stone thrown into a pond, causing a splash, and ripples, but leaving a somewhat higher water level after things calm down. The globalization of trade and finance in the past fifty years has caused 150 such disturbances, mostly confined to a primative developing country and its neighbors. Only the 2007 disruption has been large enough to upset the biggest economies. It remains to be seen whether disorder to the whole world will result in revised world monetary arrangement. One hopes so, but national currencies, tightly controlled by local governments, have been successful in the past in confining the damage. This time, the challenge is to breach the dykes somewhat, without letting destructive tidal waves sweep past them. Many will resist this idea, claiming instead it would be better to have higher dykes.
It is the suddenness of new wealth creation in a particular region which upsets existing currency arrangements. Large economies "float" their currencies in response to the fluxes of trade, smaller economies can be permitted to "peg" their currencies to larger ones, with only infrequent readjustments. Even the floating nations "cheat" a little, in response to the political needs of the governing party, or to stimulate or depress their economies as locally thought best. All politicians in all countries therefore fear a strictly honest floating system, and their negotiations about revising the present system will surely be guilty of finding loopholes for each other; the search for flexible floating will therefore claim to seek an arrangement which is "workable".
In thousands of years of governments, they have invariably sought ways to substitute inflated currency for unpopular taxes. The heart of any international payment system is to find ways to resist local inflation strategems. Aside from using gunboats, only two methods have proven successful. The most time-honored is to link currencies to gold or other precious substances, which has the main handicap of inflexibility in response to economic fluctuations. After breaking the link to gold in 1971, central banks regulated the supply of national currency in response to national inflation, so-called "inflation targeting". It worked far better than many feared, apparently allowing twenty years without a recession. It remains to be investigated whether the substitution of foreign currency defeated the system, and therefore whether the system can be repaired by improving the precision of universal floating, or tightening the obedience to targets, or both. These mildest of measures involve a certain surrender of national sovereignty; stronger methods would require even more draconian external force. The worse it gets, the more likely it could be enforced only by military threat. Even the Roman Empire required gold and precious metals to enforce a world currency. The use of the International Monetary Fund (IMF) implies attempts to dominate the politics of the IMF. So it comes to the same thing: this crisis will have to get a lot worse, maybe with some rioting and revolutions, before we can expect anything more satisfactory than a rickety negotiated international arrangement, riddled with embarassing "earmarks". Economic recovery will be slow and gradual, unless this arrangement is better, or social upheavals worse, than would presently appear likely.
http://www.philadelphia-reflections.com/blog/1596.htm
Second Mortgages Want to Be First
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| Chrysler Logo |
In a bankruptcy proceeding, there has long been a traditional conflict between the holders of first mortgages and the holders of second mortgages. It goes like this: since the holder of a first mortgage gets paid first, his incentive is to hurry up the process and get the money. The holder of a second mortgage, however, only gets paid what is left, so this party will normally wish to stall proceedings in the hope the market will improve and give the second mortgage a better payout. Normally, this sort of predictable dispute is covered by contracts, and in any event most banks hold both kinds of mortgages and are neutral about what is just and fair. In the current banking crisis, however, the major banks have developed an incentive to favor the second mortgage, so they have a new view of what is just and fair. Four of the largest banks hold a total of $440 billion of second mortgages, but have very few first mortgages because they were sold off in the securitization process. The banks mostly retained the function of servicing first mortgages, however, so they now have quite a conflict of interest.
Something like this seems to be going on with the resolution of the Detroit auto makers, with the difference that politicians tend to favor the interest of the auto workers in the bankruptcies because there are more voters to be influenced. And in the case of the auto companies, there are stockholders who will be wiped out by a bankruptcy unless the liquidation of the company assets produces enough cash to satisfy the creditors, secured and unsecured. After all, stockholders aren't creditors at all; they are owners of the company. No matter how things turn out, however, the secured creditors would normally have first call on whatever is salvaged. So, it's one class of secured creditor against another, or else it is the secured creditors against the "stakeholders", employees or any other unsecured creditor. If the government intervenes, there is the additional issue of the Fifth Amendment of the Constitution, which prohibits government from the "taking" of private property without just compensation. Representative Conyers of Michigan, whose political allegiance is not in doubt, has introduced legislation to prohibit lawsuits in these matters. So now, the prospect grows of a constitutional clash between Congress and the Supreme Court, over the Constitutionality of such a law which denies due process. So that gets us into the fourteenth amendment, too. If we look beyond the technicalities, the looming clash is between President Obama and Chief Justice Roberts. One of them wants to take money from secured creditors and make it available to someone with more political clout; and the other surely wants to preserve the sanctity of contracts, the rights of property holders, due process, and the right of the Supreme Court to declare contrary laws to be unconstitutional.
Unless someone backs off, the situation would seem to be as monumental as Franklin Roosevelt's Supreme Court-packing proposal. Because -- there is every reason to anticipate a 5-4 vote by the Supreme Court, a 5-3 vote if Justice Souter is not replaced by that time, and strenuous efforts to alter the balance.
http://www.philadelphia-reflections.com/blog/1631.htm
Steep Yield Curve: A Useful Subsidy?
The steepness of the federal interest rate curve -- ten-year treasury bonds pay more interest than three-month treasury bills, and the rate for intermediate time intervals slopes gradually from one to the other -- is a function of the Federal Reserve; the slope of this curve concisely describes current Fed policy. The Federal Reserve controls the money supply by raising or lowering short-term rates, which "affects the slope at the short end", and mainly in this way restrains or encourages inflation, or alters the exchange value of American currency. For the most part, long term rates are set by the public bond market. Once in a while, the Federal Reserve does buy or sell long-term treasury bonds to modify long-term rates in the economy. By affecting rates at either end, the result is some kind of change in the slope of the curve.
Because banks make interest payments to depositors near the short-term federal rate, while the same banks charge borrowers at near the public long-term rate, the current slope is a main determinant of bank profits. Banks borrow short, and lend long. If Federal Reserve tinkering steepens the curve more than it would be without interference, then bank profits are subsidized. Of course, it works the other way as well; in a banking crisis, yield curves can be steepened to rescue banks from failure, thus potentially sacrificing ideal monetary levels temporarily. For the most part, what is good for the banks is good for the economy; but it remains that bank profits are subsidized much of the time. Artificially widened yield curves either punish savers by lowering interest rates on their savings accounts, or else punish borrowers by increasing interest rates on mortgages and other credit. For political reasons, the pain is usually shared among voting blocs. It can be argued this invisible subsidy of banks by the public creates a compensating benefit of economic stability despite occasional bubbles and recessions like the present one. However, the Federal Reserve system has been in operation for almost a century, revealing a long-term bias in favor of inflation, which is a subsidy of debtors by creditors. Present policy deliberately targets a steady rate of 2-3% inflation; the gold market responded to a century of this by raising the price of gold from $17 to $900 an ounce. A 1913 penny has become a dollar (before taxes) you might say. You might also say it took the Federal Reserve less than a century to make the present dollar worth a penny.
If gradual inflation is a consequence, a fair question must arise whether the Federal Reserve is worth its cost. Compared with an inflexible, relentlessly deflationary Gold Standard, yes, it is. Even accepting the monetary crisis as partly created by central banking, the international dominance of the American economy and recent smoothing of banking instability testify to the durable usefulness of the Fed. But another criticism must be faced: In subsidizing depository banks with an artificial yield curve, is the Fed backing the wrong horse for the future? To answer that question, examine two components: With computer technology rapidly advancing, can the Federal Reserve accommodate non-banking competitors to banks? And secondly, can international central banking appropriately accommodate globalization? There are, after all, aspects within the 2007-20?? crisis which suggest -- maybe it can't.
Steady inflation of 1000% per century may well be preferable to 19th Century volatility of 1000% every ten or so years. But a gradual rise of, say, 500% or less each century might be even better. Relentless political pressure on the Federal Reserve has typically been used to explain its slow retreat from truly stable prices, and this defense takes the form of mentioning its dual mission of minimizing unemployment while holding prices as steady as possible. In recent years, European political rhetoric goes further, aspiring to add the right to employment to their fifty-page Bill of Rights; similar utopianism has crept into our own newsmedia. Governments for thousands of years have cheapened their currencies. But while the drift is clear, our own pace is set by the amount of subsidy required to maintain a steep yield curve. As retail banks have struggled to compete with the wholesale investment banks, their increasingly uncompetitive costs require greater subsidy from the yield curve. It is always going to be more expensive to aggregate deposits for lending purposes than to raise large sums by floating a bond issue. Securitization is here to stay, because retail banks have consolidated and savings banks have gone out of business by the thousands; the mortgage industry can no longer survive without substantial amounts of mortgage-backed securities. Nor should it; securitization is a sensible route for importing capital from nations with a trade surplus. Depository banks long ago lost the borrowing business of corporations large enough to float their own bonds; securitization provides a means for smaller borrowers to share the same efficiency. After it has tried everything else, Congress will eventually devise a reasonable regulatory system for derivatives. Except for smoothing the transition to whatever proportion of market share the investment banks can justify, perhaps all of it, the subsidized yield curve impairs efficiency. It would be a mistake to allow some foreign nation to exploit such an opening before we do. The technical problem for all central banks is to devise a suitable alternative method of controlling the currency, other than by targeting inflation with adjustments in interbank lending rates.
Observers led by Martin Wolfe the economist for the Financial Times feel the 2007-20?? financial crisis can be adequately explained by Chinese pegging their currency too low, and could be rectified by persuading the Chinese to float their currency. Regardless of this extreme view, globalization is clearly both a good thing and an inevitable one. Thus some form of discipline must be devised to prevent central banks from destabilizing it for their own advantage. Wolfe proposes the use of a strengthened International Monetary Fund, which is unfortunately apt to project international politics into a process which could be harmed by it. An alternative to be examined might be to pool sovereign wealth funds as a pooled currency reserve, although this system probably could not withstand present extremes between surplus and debtor nations, so getting world acceptance could be protracted. Ultimately, everyone realizes that the real backing for an international finance system is the net worth of the whole world. But the example of Lloyd's of London is a haunting one; no one relishes putting absolutely everything at risk, down to the last shoe button. In the event of disaster, everyone wishes to hold back some nest egg to use for a recovery. Because of the same line of thinking, almost no one would trust foreigners to control more than a limited share of their future.
The future of international monetary relations is thus quite murky, but current pressures would seem to be driving something fundamental to change. When it does, regulating artificially manipulated yield curves had better be kept in mind.
http://www.philadelphia-reflections.com/blog/1638.htm
High Oil Prices and The Federal Reserve: Chicken or Egg?
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| Chicken or Egg? |
Although there is little public gloating from the green environmentalists, the price of oil has finally and decisively soared, with Americans actually taking public transportation to work. Although it would seem that more conservation would result from paying attention to household heating than to automobile mileage, it is summer and vacation driving is more on the public mind than buying sweaters for a lower thermostat setting. The rise of oil prices by 40% in a year has started conspiracy theories, and drags the Iraq war into the presidential election chatter. It's quite true oil consumption could not have risen 40% in the developing world of China and India, and nothing drastic has happened to world oil reserves or extraction. A glance at the accompanying charts shows that oil prices have risen much like commodities in general; it
http://www.philadelphia-reflections.com/blog/1467.htm
GIC in Paris
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| GIC logo |
Delegation Agenda
Sunday, May 11th:
6:30pm -7:00pm: Arrival and cocktails
Location: Aux Anysetiers du Roy, 61, rue St. Louis en L'Isle Metro: Sully Morland or Pont Marie
7:00pm: Dinner will be served; Registration and pre-payment was required for this event.
Monday, May 12th:
9:00am - 9:15am: Arrival and registration. A light breakfast will be provided.
Location: Bistro de la Muette, 10, Chaussee de la Muette 75016 Paris Metro: Muette
9:15am - 10:00am: Presentation by Michael Kennedy, Head of the General Economic Assessment Division, Department of Economics, OECD, on Outlook by the OECD.
10:15am - 11:30am: Round-table discussion directed by John Silvia, Chief Economist, Wachovia Bank, including Paul Thomas, Chief Economist, Intel, Tom O'Connell, Assistant Director General of Central Bank of Ireland, Sandra Pianalto, President of Cleveland Federal Reserve Bank, Mario Baldassarri, Senator, The Republic of Italy, and David Kotok, CIO, Cumberland Advisors. Each participant will introduce a topic of concern to the group with GIC delegates acting as discussants. Chatham House Rule will apply.
12:15pm - 1:30pm: Lunch at Bistro de la Muette, sponsored by Cumberland Advisors and Wachovia.
1:30pm-7:00pm Free Time
7:00pm - 7:30pm: Cocktails and Hors d'oeuvres.
Location: Cercle de L'Union Interalliee, No. 33 Rue du Faubourg Saint-Honor� 75008 Paris Metro: Concorde or Madeleine, 5-10 minute walks
7:30pm: Private dinner with Paolo Garonna, Deputy Executive Secretary United Nations
Economic Commission for Europe and sponsored by Cohen and Company. Dress code for the club requires a jacket and tie, no blue jeans or tennis shoes please.
Tuesday, May 13th:
8:45am-1:10pm: GIC & CEPII Conference "Monetary Policy and the Exchange Rate: The Euro and the Dollar"
Location: Maison des Arts et M�tiers, 9 bis Avenue d'I�na, 75116 Paris, Metro: Iena
Full Program will be distributed at the event. Speakers and moderators include:
William Dunkelberg, Chairman, Global Interdependence Center
Agn�s B�nassy-Qu�r�, Director, CEPII
Lionel Fontagn�, CEPII
David Kotok, Chief Investment Officer, Cumberland Advisors
David Woo, Head of Foreign Exchange Strategy, Barclays Capital
Manuel Balmaseda, Chief Economist, CEMEX
Denis Verret, Senior Vice Preside of Operations and Sales, EADS
William Clark, Director, New Jersey Division of Investments
Laurence Boone, Chief French Economist, Barclays Capital
Sandra Pianalto, President, Federal Reserve Bank of Cleveland
Christian Noyer, Governor, Banque de France
1:10 pm � 2:30 pm: Luncheon for conference attendees at the Maison des Arts et M�tiers sponsored by Barclay's Capital
7:00 pm: Dinner hosted by Christian Noyer, Governor of the Banque de France.
Location: Banque de France, Gold Library, 39, rue Croix des Petits Champs � 75001.
Please enter via 2 rue Radziwill, at the north end of the Bank. Recommended metro stops for the Banque de France are Bourse, Palais Royal-Louvre, Louvre-Rivoli or Pyramides, all a ten minute walk to the Banque de France. Dress code for the evening requires a jacket and tie. For security purposes, please bring invitation and photo ID and allow an extra ten minutes for security processes.
Wednesday, May 14th:
9:30am: Arrive at the French National Archives, for security process. Please bring your passport for security purposes.
Location: French National Archives, 1 rue Roberty Esnault Peltierie, corner of 37 Quai d'Orsay, 75 007 Paris Metro: Invalides
10:00 am: Private tour of French National Archives where GIC delegation will have a viewing of French historical treasures such as the Louisiana Purchase signed by Thomas Jefferson, Original Treaty of Alliance signed by Benjamin Franklin, Original Treaty of Versailles as well as other historical documents.
1:00 pm: Luncheon hosted by Mr. Arnaud de Bresson, Managing Director, Paris EUROPLACE.
Location: Place de la Bourse, Palais Brongniart, 75 002 Paris Metro: Bourse (line #3)
Lunch will be followed by presentation of the Paris financial market place.
4:00 pm � 5:00 pm: Travel to meeting with Christine Lagarde, Minister of Finance. Please arrive by 4:30 to pass through security.
Location: Ministry of Finance Building,139 Rue de Bercy, Paris 12 Metro: Bercy.
5:00 pm � 6:00 pm: Private meeting with Christine Lagarde, Finance Minister of France. Please bring a passport for security purposes.
http://www.philadelphia-reflections.com/blog/1451.htm
Milton Friedman on Capitalism
http://www.philadelphia-reflections.com/blog/1673.htm
Fixing the Financial Mess
Two years after August 2007, it remains uncertain whether we know enough about how the great financial disaster came about. There may be other shoes to fall on the floor, announcing unexpected dimensions of our problem. In particular, the recovery may be brief, followed by a resumption of downward trends we had hoped were finally behind us. That seems to have happened in 1937. If it happens again in 2010, what seemed like a three-year recession may prove to have been a twelve-year one, with early successes exposed as mere flashes in the pan.
Nevertheless, politicians are searching for answers to give the public; no one wants to delay solutions if they exist. Analyses can be revised if new information appears. Presently attractive approaches can be divided into three categories: International, Regulatory, and Goal-focused.
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| Martin Wolfe |
International monetary diplomacy. There is fairly uniform agreement that a major source of instability came from the unprecedented transformation of third-world countries into economic powerhouses. As many as a hundred million people were raised up from poverty in less than a generation; there was inevitable commotion in the world's economy as a result of a fundamentally very good thing. The British economist Martin Wolfe is the chief spokesman for the view that there was almost nothing the Americans could do about the upheaval, although the Chinese government made it much worse by pegging its currency too low. This line of analysis leads to the proposal of world monetary diplomacy, offering the Chinese greater influence in the International Monetary Fund in return for floating their currency, and negotiating a greater role for the IMF in world finance.
Regulatory restructuring. With or without the creation of a new international monetary order, others feel that individual nations must create internal regulatory barriers to prevent the ebbs and flows of international currency from circumventing local laws, upsetting local stability. The problems daunting this approach are two: many nations will fail to respond adequately, with consequences which could overwhelm those nations who institute responsible reforms. And second, the recent pace of financial innovation has been so rapid that regulation is easily circumvented. Draconian controls would surely lead to a loss of local competitiveness, and disadvantaged local captives would soon rebel. Urgently needed regulation and effective regulation often prove to be two different things.
Goal-focused adjustment. In recent decades, considerable success resulted from forcing the system to produce a certain desired outcome, essentially ignoring the myriad intermediate adjustments. Inflation targeting has come to be a description of stable prices forcibly maintained by one technical method (also called inflation targeting in a narrow sense). It lets the economy produce its own responses, and if necessary lets academics produce their own explanations. Unfortunately, this approach in time translates into Congress announcing there shall be no inflation, and the Federal Reserve responds, lo, there is no inflation. Since Congress has very little idea what is involved in this process of waving Merlin's wand, transparency, financial innovation and reduced transaction costs can suffer unduly before the underlying dynamics reach the surface of public awareness. In short, there are too many hidden steps between public awareness and the feed-backs which modulate the policy. One of those steps is apt to be blatant denial that policy had a given adverse effect.
http://www.philadelphia-reflections.com/blog/1674.htm
Federal Reserve Rolls the Dice
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| Lehman Brothers |
For the year preceding, it was general opinion that the financial crisis was caused by $100 billion or so of mortgage-backed securities, mostly California and Florida home mortgages. But around Labor Day 2008 Lehman Brothers collapsed, and the problem became twenty times as large. What that was about is unclear, but seemingly had to do with money market funds being treated as "funds in transit" in consequence of the international monetary agreement known as Basel I, and thus not requiring bank reserves to be maintained for them. It will take time to unravel the intricacies of, and assign the blame for, this mess. However, the markets responded by refusing to trade at now uncertain prices, thus "freezing up". The response of the Federal Reserve was to double the money supply through international markets, mostly using "Central Bank liquidity swaps". The participation of various countries in this action has not been made public.
The doubling of the money supply required borrowing between one and two trillion dollars. After five months, or just after the inauguration of the new Presidential Administration, the markets had seemingly started to function more normally, and the stock market had rallied somewhat. The obviously bewildered leadership of both political parties agreed to the proposal to purchase $1.75 trillion of the troublesome assets, taking them off the market and presumably hoping the markets would function as if they did not exist. By July 2009 this operation was only about half completed. Not only was there disagreement about what these securities were really worth, but the banks which held them were reluctant to allow prices of what they continued to hold to be driven down by comparison with these forced transactions.
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| Federal Reserve Bank of Philadelphia |
In any event, the second stage of this huge government bailout of the banking system is projected as follows: The portfolio of assets would be worn down, either by allowing debts to mature, or by selling them at what is hoped will be advantageous prices. Who will buy them is to some extent dependent on the state of the economy, and to some extent on the perception of the fairness of the pricing. The Federal Reserve Bank of St. Louis has been assigned the task of designing a public formula for how much to buy or sell, depending on selected indicators of the economy. A public formula is felt to be necessary in order to reassure the markets that purchases and sales are not being made in response to secret information or unsuspected problems.
The reasoning would be that if these assets are sold to speculators at fire-sale prices, the money supply will shrink inappropriately, and the recession will be prolonged by the need to borrow replacement reserves for the monetary system. Unduly profitable sales would probably lead to inflation, since the present level of monetary reserves is twice as large as was thought appropriate, as recently as a year or two ago. But this maneuver by a central bank has never been tried before, and the results may well differ from present predictions. The Federal Reserve is prepared to take as long as ten years to accomplish the complete maneuver, but that plan presumes ten years of recession, and five congressional elections. It also implies that the economy could swing between 7% annual inflation, and 7% annual deflation, in the two worst cases, and assuming nothing extraneous happens to the economy.
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| President Barack Obama |
In the meantime, two other ominous notes. Although the nationalities of the lenders have not been made public, one can safely assume the Chinese are a major component. Since they are refusing to lend us money beyond two, and at the most five, years, we would be indefinitely in the position of borrowing short and lending long. In other situations, that imposes a risk of depositors starting a run on the bank. And secondly, it is hard to imagine that Mr. Obama's presently ambitious programs in healthcare, environmental protection, two wars and several election cycles, will be allowed to proceed without enormous public resistance to even further fiscal deficits.
http://www.philadelphia-reflections.com/blog/1688.htm
U.S. and E.U. Exchange Experiences (1)
The Global Interdependence Center (GIC), founded by Nobelist Lawrence Klein in 1976, brings noted foreign financiers to address Philadelphians interested in finance, and takes those Philadelphians abroad to return the visits. It's a gracious, entertaining, and highly stimulating travel club of very nice folks. Its 25th Annual Monetary and Trade Conference was especially exhilarating. Christian Noyer, President of the Banque de France, gave a description of the rationale and direction of the European common currency. Since he was the Euro's driving force right from the beginning, the experience of hearing him was pretty much like hearing Alexander Hamilton tell the story of the founding of the American banking system. Such a notable event needs to be reported.
Christian Noyer urges that the central concept of the European Union is deliberate, voluntary surrender of national sovereignty -- for a mutually beneficial purpose. The declared purpose of limited surrender of national control of the currency is economic; price stability, lower interest rates, the stimulation of international trade by lowering transaction costs. But the unstated, grander, purpose is the elimination of war. Because the limited technical purpose has been achieved in almost all areas, the grander purpose of eliminating war has not been an accident. With this simple, even humble, declaration it immediately becomes possible for a mildly irritated American audience to understand that European reluctance to become our active military ally grows out of a highly commendable set of motives, and widely differing historical experiences.
As things worked out, the new nations who have recently joined the Union ("The U") are anxious to modernize, because the people of those nations demand modernization and their leaders must agree to achieve it. Inflation, that hitherto inevitable fund-raiser for national goverments, must be eliminated in order to join, and stays eliminated because the other members of The U will not tolerate it in a partner. In his curious way, "price stability" has placed the Union on the side of the people against the locally powerful, although it would be untactful to emphasize it. From the elimination of inflation comes lower interest rates, and from that, a stable currency. From that comes economic growth, for which the political lingo seems to be "modernity". As a consequence of this undeniable success, all nations in the area want to join the Union, and none wants to leave it. If that prevailing attitude doesn't lead to the elimination of what might then be a civil war, it's hard to know what will eliminate it. The marvel of all this skillful analysis is how natural, soft and modest it sounds, feeling like an old soft shoe. Eventual political unification is clearly an old dream in Noyer's head, but for now he seems content with the vindication that it is possible to have a currency without having a country control it. It seems to be a steamroller of economic logic, flattening out the pretenses of merely political power.
No less an economist than Martin Feldstein has written that stable unified currency is doomed in the European context of widely diverse labor markets; Noyer seems pleasantly serene in the face of this argument. He wouldn't say so, of course, but some in the audience got the idea that Noyer probably believes the power of this cooperative idea will eventually discipline the unions the way it disciplined the politicians. One certainly hopes so, for the sake of this smooth, cuddly French aristocrat.
http://www.philadelphia-reflections.com/blog/1229.htm
U.S. and E.U. Exchange Experiences (2)
 America can learn about itself from the E.U. 
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To see the economic power of unifying the currencies of Europe, and the political attractiveness of its results among the people of those countries, makes it suddenly more clear why our own Civil War is so often said to be about the Union and not about slavery. Unlike our grandfathers in the Civil War, we take the benefits of free interstate commerce for granted, while for them it was still a demonstrated achievement. Lincoln for example, was an ardent Whig, which in those days meant an advocate of helping commerce by the intervention of government. There is even a shadow of present concern that Americans will have so forgotten the lessons of free interstate commerce that they might somehow surrender it for some other blandishment. Certainly, free international trade has its enemies. The abolition of slavery was of course an overdue achievement, too, but perhaps our long slog toward equal rights has allowed this second crusade to overshadow the history of what really was the main one. In case anyone feels impelled to start a quarrel about this viewpoint, let me remind him that Quakers started the abolition movement, right here in Philadelphia, and have nothing to apologize about.
Going further back, we got our Constitution more or less right before we convinced the public of the economic benefits of unification; eventually we got a bad Civil War. The Europeans learned that complicated words in a Constitution have consequences, suspiciously loaded the proposed document with interminable conditions, and eventually rejected it. It's an old political trap that a proposal so loaded with attractions will often gather more opposition from objectors to multiple small points than proponents for the big points. Keep it simple, senor. If you expect men to die for that document, they have to be able to recite it. If you must make it complicated, just appoint a Supreme Court and wait a little.
http://www.philadelphia-reflections.com/blog/1230.htm
What's a Repo?
On St. Patrick's Day, 2008, Bear Stearns became insolvent and was given to J P Morgan. The Federal Reserve assumed all risks. Effectively, the fifth largest investment bank in America was nationalized for $2 a share, because no private bank would buy it at any price. A year earlier it was worth $170 a share, even one trading day earlier it sold for $26.
At the heart of this catastrophe were "repo's", or repurchase agreements. (They should not be confused with repossessions of cars and other hard goods bought on time, which are also called repo's.) Although most people had never heard of the high-finance version of repo's, the volume of these instruments had grown to $5 trillion by January 2005, presumably even several times larger than that when they caused the nationalization of Bear Stearns. Newsmedia accounts offered the guess that 16% of the resources of the whole financial sector were caught in open repo's when the music stopped. Repo's must be awfully good, or awfully bad.
They were both of these things at once. Like so many innovations in the post-computer era, they offered a major cost saving to an inefficient transaction system, but were so successful they overwhelmed the institutions which flocked to their reduced cost. The unanticipated difficulties might have been imagined, but they were not adequately guarded against. Essentially, these loans limited exposure to a few days, a feature that made them appear quite safe. Unfortunately, tons of these loans could expire simultaneously if a rumor got started and everyone held off using them for a week. With a run on a bank, at least people have to take action to withdraw their money; but with these things, simple inaction quickly led to massive cash shortages at the bank. Speeding up the loan process had made it cheaper, but made it vulnerable.
Consider the inefficient complexities of a bank loan. The bank wants collateral, perhaps 80% of the value of the loan. The ability of the borrower must be investigated, a clear title assured, and papers arranged for transfer in case of defaulted collateral. Lawyers must organize the agreements, and it all takes time, costs money. To go through all this for a one-week loan for anything less than huge transactions is simply not practical. So the idea was devised to sell the collateral to the lender at a discount, together with a repurchase agreement to buy it back at full price. For safety sake, the discount could be greater than the interest cost, and part of it returned if all went well. The collateral could be held by a third party, who essentially guaranteed the details while the collateral itself never moved. Bear Stearns had perfected these variations at such favorable prices they dominated the market for them with hedge funds; the margin for error narrowed when interest rates dropped, cash got scarce when investors got uncomfortable, the whole hedge fund industry was suddenly paralyzed, and everything connected to hedge funds was frozen secondarily. Much of this was handled automatically by computers, so huge volume made it impossible for anyone to know who might be insolvent. It seemed comparatively harmless to decline to play this game for a few days, but it was not harmless if most people decided to do so at the same time. The daily variations of interest rates and/or duration generate a ("Gaussian") normal distribution curve for the risk, predicting serious deviations will occur once every two centuries. But when events --even false rumors -- suddenly get everyone's attention at once, small daily fluctuations no longer bear much relationship to the frequency of violent fluctuations. Once-in-a century events start to happen every few years. At those times, the public stops speaking with a million voices and shouts in unison. Quite often, there is no cataclysmic event to trigger it. Like the conversational babel of a dinner party, it can all stop at once for no particular reason.
The mathematics of this matter could be taught to a tenth-grade math class. It starts to get beyond everybody's anticipation however when two such Black Swan events happen at the same time. In this case, an unanticipated pause for a few days bumped into the rule that non-bank institutions must mark their portfolios to the market every day. But for days at a time in this crisis, there could be no trading in certain issues; there was no market to mark to. How then can you demonstrate your solvency -- what might your competitors be hiding during these unannounced market holidays? And, since banks are in the same pickle but aren't required to mark to market, how can you trust them to pay bills? When you see European banks, who must obey new rules called Basel II, go bankrupt and get nationalized, how can you be sure American banks, who needn't obey Basel II until 2009, are any safer bet?
Progress is progress, but how much of it can we cope with?
The 'repo' market from Marketplace on Vimeo.
http://www.philadelphia-reflections.com/blog/1420.htm
HowTo Create A Subprime Derivative
http://www.philadelphia-reflections.com/blog/1439.htm
Novation
Novation is a term that perhaps nobody but a specialist expert can now define, but is nevertheless destined to be politicised in the coming election campaign to the point where almost everybody could be shouting it like a war cry. That is, unless the hired political consultants decide some other feature of credit derivatives serves warcry purposes better. We're talking sixty trillion dollars here, about five times the size of the domestic American stock market.
Someone owned or thought he owned pieces of paper worth this staggering sum, which can be regarded as side bets on the bond market. Just as in a horse race, where you don't usually own the horse when you bet on the winner, you needn't own the bonds to bet on whether they will default. The side bet is often between two outsiders who acquired their bets through, well, novation. The process begins as a credit derivative, in which someone gets paid an annual sum in return for agreeing to pay off -- if the bond defaults. That could be regarded as a useful insurance policy, making more credit available by making it safer to buy bonds. The bondholder gives up a little interest in return for assurance the bond is now completely safe. Sucker.
Like the Sun Belt mortgage originator, the originators of these derivatives often wasted little time clipping off a fee and passing the carcass to someone else. And that process got repeated until the accumulating fees in the chain slowed the process to a point where the weakest or most reckless holder got into danger. The game might have slowed to the point where it became self-correcting, but what actually seems to have happened is that much of the long-term debt involved was financed by short-term borrowing, and the start of some rumors triggered a run on the bank. Not exactly, of course, but when institutions which had made one-week or one-month loans stopped lending, it only took a few days for the money to run out and Bear Stearns was quickly unable to pay its bills even though it started the week with $18 billion in reserves.
That short description is about the best that can be made out of an opaque situation, based on what the Securities and Exchange Commission is willing to tell reporters about its investigation. More will be forthcoming, and no doubt some villains and fools will emerge with a lot of blame. For example, the price of credit derivatives concerning Bear Stearns debt had been creeping up steadily during the month before the explosion; whether somebody knew something bad, or whether there really was something bad is presently unclear. It's disconcerting to learn that Goldman Sachs was dumping this paper, and JP Morgan Chase was mostly buying it, but it's early days for unfounded suspicions. More will come.
Now to return to novation. We legal novices learn that novation transfer is the same as assignment transfer, except all parties have to agree to novation before it can take place. That's going to make it harder for a lot of people to deny they knew what was happening. The astonishingly large sums involved are apparently not entirely real, because in some way the old debt is not extinguished, and the new debt is merely added to the sum total outstanding. That surely means the same debt is counted several times, and the apparent sum is to some unknowable extent much larger than the underlying reality. This also accounts for the amazing speed of growth. In January 2007 the total was said to be about $25 trillion, in January 2008 it was reported to be $42 trillion, and in May 2008 it was said to be $60 trillion. Things which move that fast can quickly spin out of control, especially when short term creditors need do nothing much for a couple of weeks as their money emerges from the pool. Some people did sell short, of course, but whether that was panic or malicious must probably be left to politicians to declaim.
Surely the most terrifying part of this simple story is that so much money could be moved around without public awareness. When the $25 trillion figure emerged, a number of people asked what in the world was going on, and kept asking that question for eighteen months. Nobody knew nothing.
http://www.philadelphia-reflections.com/blog/1460.htm
Franklin's Admirers on TV
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| Brian Lamb |
There are now three channels of C-span, continuous cable television programs about the influence of history on current problems. Sessions of Congress and its committees, the speeches of the President, political campaigns, are shown as they happen. But interviews and book reviews are shown in parallel, with an opportunity to go into the archives and organize originally unrelated programs into seminars on a current topic. The editor, Brian Lamb, has a light hand and considerable impartiality. But he's there, all right, organizing blogs into topics just as Philadelphia Reflections tries to do.
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| Friends Select School |
This similarity of design had been floating around for some time, but it suddenly came into focus when I recognized myself in the front row of an audience on C-span, listening to Edmond S. Morgan talking at the Friends Select School about his new book on Benjamin Franklin, a few months earlier. Thank goodness I bought a book and had it autographed, because the filming had been so unobtrusive I hadn't noticed it at the time. I clearly need to have haircuts more frequently. Professor Morgan's parting words that evening had stayed with me, "Franklin doesn't tell you everything about himself, but what he tells you -- is straight." That's quite a compliment from the editor of 47 volumes of Franklin's work.
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| Walter Isaacson |
Grouped with this tv portrayal of me as a groupie were interviews with Walter Isaacson and some other Franklin biographers, taken at other times and placing focus on other aspects. Here again, more insights emerged from quickly considered replies to audience questions than from the prepared speeches. Replies to questions from the audience are more in a class with blogs, anyway. Whenever you get all of the adjectives and qualifications polished, you sometimes don't say what you mean. Perhaps that last comment can be rearranged to say that answering audience questions occasionally leads to blurting out precisely what you mean.
And so, two unrelated audience answers need to be linked. A question about Franklin's love life caused Isaacson to refer to Franklin as a lifelong seducer. From the unknown mother of his illegitimate son William, to the simultaneous flirtations with two famous French ladies that took place when he was an octogenarian, and not overlooking several other affairs with Cathy Green and Polly Stevenson and allusions to others, Franklin was obviously an accomplished seducer in the full meaning of the term. It is thus legitimate to suspect the techniques of seduction at work in many of his public projects, from starting the Library Company to persuading the French to help the Revolution. He discovered late in life what many have discovered about the life of a diplomat, and quickly recognized that he was already pretty good at what that seemed to entail. Let's slide to a slightly different application of that idea.
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| Benjamin Franklin and French Women |
By the accident of hostess seating arrangement, I found myself seated next to two historians from Harvard, and somehow it came out that one of them felt that Franklin loved the French. Simply loved them. Somehow that didn't sound quite right when compared with Franklin's early years of mobilizing Pennsylvania to fight the French, starting the first National Guard militia unit to defend Philadelphia against French raiders, supporting General Braddock's expedition with his own money, urging the British government to sweep the French from Canada, and working most of his life to assemble the colonies and Great Britain into one world-dominating entity. It's true that 18th Century France was at the peak of scientific achievement, and Franklin the inventor of electricity was quickly taken in by the European scientific community; but that's scarcely the same thing as loving France. Louis XVI was in fact quite annoyed by all the attention Franklin was receiving. And so the scholar on TV went on to say that correspondence had been discovered in which Franklin quite casually remarked that during the Continental Congress he had strongly argued that America should stand alone and have no European allies. Congress it seems overruled him, so he dutifully set sail for France to seduce them.
We come to another chance social encounter. On a recent trip to Paris, the GIC had taken along as a speaker, no less than a member of the Open Market Committee of the Federal Reserve, a Governor of a Federal Reserve District, to speak about the threat of inflation and currency crisis. In time, our French hosts invited us to look at some documents of interest, like the Louisiana Purchase. Lying on the table was the original treaty between America and France, signed by B. Franklin. The Federal Reserve governor, making small talk, observed that Franklin sweet-talked the French into loaning America too much money, eventually leading to their bankrupcy. As I recall, my rejoinder was, "Well, just print some more paper money, right?" It was intended to be a jocular remark, but it somehow didn't seem to be taken as such.
http://www.philadelphia-reflections.com/blog/1471.htm
Commercial Credit Sinks Globalization
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| Lehman Brothers |
In August, 2007, the world sort of woke up to the housing bubble in California and Florida, along with the ingenuity of securitized mortgages. About $100 billion was involved, and credit markets froze up as the risk premium of low quality loans (relative to U.S. Treasury bonds) gyrated furiously, almost always in the direction of down. There was a staggering amount of credit default swapping, some $60 trillion, but it did not seem to be unraveling. Why in the world did a problem of that magnitude, while admittedly large, lead to continuing panic which was widely believed to require $4 trillion in rescue funds eighteen months later? There were obviously some big missing pieces of this puzzle. Worse than a money panic itself, was the realization that we only understood about 5% of the problem after a year of investigation.
The case in point is that in the fall of 2008, world trade almost came to a total stop. How does $100 billion of dud mortgages in California, discovered a year earlier, do that? It would appear that Lehman Brothers was one of four or five large banks who were so overstretched in securitized mortgage debt that it looked as though they would collapse without huge infusions of government money. The government rescue team knew they could not rescue every bank that looked shaky, and they knew that rescuing anybody carried the risk that this kind of episode would be repeated in the future, as a result of knowing that any sort of risky behavior would be protected by the government treating big banks as "too big to fail". To bring the collapsing markets to their senses, some relatively big bank had to be allowed to fail, and it turned out to be Lehman. The CEO of Lehman afterwards expressed public bitterness that Lehman suffered while others were saved, but it was clear that there were too many people in the lifeboat, so someone had to go overboard or they would all sink. Lehman went bankrupt.
What had not been considered in the choice of Lehman, was its heavy involvement in commercial credit, short-term loans, sometimes only overnight, with inventories as collateral. Because of the huge volume of commercial credit, with extremely fast turnover, the conventional payment mechanism was a repurchase agreement. In a repo, the loan takes the form of a sale with a guaranteed agreement to repurchase in a short time. The mechanics of lending are greatly simplified by actually selling the inventory of, say computer chips, for enough more to pay the interest cost, associated with an agreement that the lender owns the security outright if there is a default by a date certain. The arrangement is very clever and efficient, but it has one flaw: the bank really has no use for a boatload of computer chips. Commercial credit repos had grown to immense size. When the banks encountered a credit freeze, the collateral simply could not be transformed into anything useful to the banks, even though industries throughout the world were on the edge of collapse for lack of components to assemble. It was a dangerous mess, all right.
Underlying all of these moving parts was globalization of the industrial process. It was not very long ago when automobile manufacturers like Ford would own the majority of the steps in the process, down to growing trees to provide wood for the floor-boards. Or IBM would make substantially all of the parts of a computer and assemble them as a a final product. But, in order to take advantage of cheap labor or available resources of other types, pieces of components of cars and computers started being fashioned together in several foreign countries and shipped to another foreign country for assembly. In the most extreme case, only the design and marketing of a product might take place in America, while everything else was assembled in many places. Almost every step of a complex manufacture involved paying the subcontractor for his piece, using the pieces as collateral for a loan to pay for itself. Because a tangible price was being charged for delays in the process, "Just in time" assembly was absolutely essential.Everything had to work like gigantic clockwork, but if it did, it considerably reduced the price and increased the sales of the final product.
The collapse of Lehman Brothers (ultimately triggered by real estate mortgage securities), caused the whole world's manufacturing to come to a halt in just a few days. When the nature of the problem became apparent, it was comparatively easy to patch up, at least by a government savior who had unlimited amounts of money available, and was willing to spend "whatever it takes".
What's left to do, now, is to figure out a system that will prevent international trade paralysis without slowing down or eating up the profitability of globalization. A great deal is at stake in repairing a problem we didn't even recognize as a possibility. And probably similar things remain to be discovered.
http://www.philadelphia-reflections.com/blog/1732.htm
Thieves of Baghdad
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| Col. Matthew Bogdanos |
Col. Matthew Bogdanos, of the U.S. Marines, gave an interesting insight into what the Baghdad Museum really was, how it was captured, and how the treasures were recovered, at the University of Pennsylvania Museum the other night. Our own museum is said to be the second largest archeology museum in the world, after the British Museum. After discovering what was really in the Baghdad museum, that ranking may have to be revised; but the chief Philadelphia interest traces back to the discovery of the ancient city of Ur by Philadelphia archeologists during the last century, an event which essentially created the University Museum. This was where civilization began, and we discovered it.
The reserve Colonel happens to be a prosecutor for the New York District Attorney, was trained extensively in classical antiquities; and so was the perfect point man to lead the capture of the Museum during the Iraq war, very well suited to follow the looted treasures into the international antiques market -- and recover substantially all of it. Something like 62,000 pieces were recovered, and all of Nimrud's Treasure, the prize possession of the museum.
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| The Baghdad Museum |
There has been criticism of our troops -- some of it right out of this evening's Philadelphia audience -- for allowing the place to be looted in the first place. But that sort of assumes the place was lying vacant and undefended while our troops were out shooting innocent civilians. That's a misapprehension quickly dispelled by videotaped scenes of real live shooting and rocketing coming out of the place at the time, which the Colonel was happy to display. Questioners were invited to claim they would have been willing to go into that hornet's nest in order to save alabaster statues, but others in the audience inclined to giving the Marines some benefit of doubt.
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| Hussein Millions |
That place was vandalized when the troops got into it; to say it was thoroughly vandalized is only true in a sense. There was indeed a lot of looting, but the bigger surprise was to find there were hidden storage rooms behind steel bank doors, filled with the really best antiques, as well as vast boxes of American hundred-dollar bills. By weighing the hundred dollar bills (22 pounds for each million dollars) it was estimated that Saddam Hussein had about $800 million in U.S. currency stored in that one place. Gold as a raw commodity has since gone up considerably in value, but many of the best antique gold pieces on display in the museum were only copies, the originals were kept in the secret vaults. The international market appraises quite a few of these pieces at over $10 million apiece. Apparently the thieves knew exactly which pieces were valuable, and went straight to them without even pausing to notice other rooms full of objects of lesser value. The museum had been closed to the public for the previous twenty years; it seems rather obvious that Saddam was storing these objects in order to buy weapons for continuing guerilla activities underground, or in exile. The museum itself consisted of nearly twenty separate buildings in the center of Baghdad, and the custodians obviously must have known where things of serious value were kept, in order to get to them so precisely.
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| Nimrud's Treasure |
Offering an amnesty, no questions asked, brought in thousands of recoveries from the local public. Getting other pieces back from art galleries in London, Geneva and Berlin required methods that were not described in detail. Some of us who remember the German and Japanese mementos which were "liberated" during World War II, have an immediate appreciation of the improved American troop discipline which must have been imposed in the Iraq War. That's something to think about, too. Our troops had been given extensive training to respect the cultural heritage of the enemy, and they evidently did so to a remarkable degree. One certainly has to doubt that Saddam was locking that material in vaults for twenty years in order to preserve culture of any sort. If it had any other purpose than to serve as a way of transforming oil wealth into munitions, it's a little hard to imagine what it was.
http://www.philadelphia-reflections.com/blog/1795.htm
Restoring the Gold Standard by Levering Judges' Salaries
Generally speaking, creditors hate inflation and favor a gold standard because they fear debtors -- who outnumber them at the polls -- will dishonor their debts by inflating the currency. And debtors generally are rather serene about the risk of inflation, for the same reason in reverse. Since governments are almost invariably debtors, the combination of government and debtors on the side of promoting inflation represents a dishearteningly strong force for creditors to combat. It is plain for everyone to see that inflation has been steadily moving ahead. But it is something for everyone to ponder that leaving creditors with only one recourse is almost certain to translate that particular recourse into action. Creditors will raise interest rates in anticipation of inflation, and the economy will suffer for debtors as well as everyone else.
So, hard-money advocates like the Paul family of Texas have been rather nonplussed to discover that Federal Judges have handed them in 2010 a very effective weapon they had long overlooked. It should be no surprise that it came from that direction; judges are long accustomed to looking backward to the historical origins of the laws they are charged with interpreting. In this case, the defining statement is found in the Declaration of Independence.
Parenthetically, conservatives are reluctant to include the Declaration in an explanation of the Constitution, since it is plainly true the Constitution was written to correct the weaknesses of the Articles of Confederation, which was much more closely defined by the circumstances of the Declaration. The almost immediate response to any such logical jump over the Constitution, particularly those of Abraham Lincoln, is to thump the maxim that The Declaration of Independence is not Law. And it isn't; it's just in this case it makes a concise statement of a major reason we were offended by the King of England:
"He has made judges dependent on his will alone, for the tenure of their offices, and the amount and payment of their salaries."
Note the operative phrase dependent on his will alone , which takes us back to the Magna Carta, where even the King must obey the Law. If judges are the umpires, it isn't in accord with deeply felt British culture that the King could force the umpires to favor his wishes in their official decisions, by threatening punishment on their persons. No, a thousand times no. Anyone can see that.
Furthermore, the determination of underlying intent is so difficult to prove, and so easy to deny, that it is scarcely mentioned in debate. If two motives seem possible, the other party will assert the high-sounding one and deny the ulterior one. The offended party will instinctively suspect the reverse, and will brush aside any protestations to the contrary. Since that is bound to happen, please skip the preliminaries and get on with the evidence. So it is in this case; any reduction in judge's salary is treated like an attempt to influence official decisions. The Administration maintains a reduction of Federal judge salaries is necessary for budgetary reasons. Please don't insult my intelligence that way. You aren't allowed to reduce the salaries of judges for any reason.
From this rather easy position to take, it is only a short step to say that refusing to raise judge salaries during an inflation is a reduction of salary in real terms, after adjusting for inflation. Your paper money is phoney; I want to preserve my purchasing power. Your refusal to adjust for inflation is even more clearly a salary reduction, since the link to gold was severed during the Nixon and Johnson administrations. We are not on anything remotely resembling a gold standard; we are on a monetary standard which is by law adjusted to inflation, and just about nothing else. Hubert Humphrey may have thought he was creating a loophole by mandating concern with unemployment, but just try to convince the judges of the Supreme Court of that one.
And so, it seems predictable that Judge Beer of the Eastern District of Louisiana, and his fellow judges, will achieve an effective gold standard for Federal Judges if they have the fortitude to tough it out. After that it gets harder, Congressman Paul. You have to push the concept that what is fair for Federal Judges is fair for everyone else. You should assume that judges will vote in their own favor, and therefore reasonably assume that the public will vote in its own favor, too. If that be treason, said Patrick Henry, make the most of it.
http://www.philadelphia-reflections.com/blog/1838.htm
Causes of the 2007 Crash: Political and Technological
Dealing with a topic as complicated as the causes of the 2007 financial crisis, it's quite possible for two viewpoints to be entirely in agreement, until abruptly coming to different conclusions. In this paper, we consider the relative merits of blaming government housing subsidies in various forms, relative to blaming the unanticipated effects of the computer revolution. The subsidy argument has just been succinctly and effectively argued by a lawyer, Peter J. Wallison. Agreeing with every word he writes, I nevertheless hold the perspective that disruptive effects of the computer revolution were equally responsible, if not more so. Politics versus technology, choose your poison.
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| Federal Reserve |
Mr. Wallison served as a lawyer in the financial loins of Washington, and thus has the perspective of a Reaganite who sees government as the main problem; with the significant distinction that his proposals for solution also lie in government corrective action, particularly "covered bonds" and step-wise privatization of the Federal Housing Authority (FHA). While agreeing with both reform proposals, my concern here is about too little general recognition in the analysis of how vulnerable the banking system has become, to revolutions made possible by even primitive computers of the 1960s. Such revolutions soon grew many times magnified by the inexpensive high-speed internet. If that analysis is correct, it predicts mere legislative action for the housing industry will prove inadequate; banking has taken a radical new direction.
Mr. Wallison's argument in the January 3, 2011 edition of the Wall Street Journal is admirably succinct. He points out the New Deal Federal Reserve deliberately suppressed interest rates to the benefit of the housing industry, but made a significant exception for the Savings and Loans. (It was forced to abandon that approach by the innovation of money market funds, in turn made feasible by widespread adoption of the IBM 360 computer.) When the S&Ls collapsed, that segment of the market was awarded to the GSEs (Fannie and Freddy Mac, insured by FHA). In 1992, Congress imposed the goal of promoting "affordable housing" on the GSEs, which is to say the subsidization of "subprime" (i.e. high risk) mortgages. By 2007, half of all mortgages were subprime, and by September 7, 2008 Fan and Fred were insolvent, effectively replaced by the Federal Reserve (i.e. the taxpayers) as the final guarantor against national insolvency. It will take a decade to restore the economy from its present setback, but Mr. Wallison's proposals do indeed have some chance of eventually leading to a viable economy. He proposes the threshold for "jumbo" mortgages be reduced by $50,000 every six months until mortgages are effectively privatized. And he also suggests we create a pool of mortgage assets as security for a bond issue, thus privatizing existing mortgages in the way Europeans describe as a "covered bond" system. Go ahead, do it; it might work, and nothing else is on offer.
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| IBM 360 Computer |
Meanwhile take a look at banks; we seemingly can't get along without them. But other institutions are undermining them, with cheaper products made possible by computers. For two centuries, banks transformed short-term borrowing into long-term loans; no one else could do it. It's a simple idea, and it works, that a constant or even rising pool level can be maintained by a steady inflow of short-term deposits. But it is risky; the risk is that some event will precipitate a sudden rush of withdrawals, a run on the bank. Sooner or later, the law of averages catches up. The risk is real, it happens every few years. A price in the form of interest must be imposed to maintain reserves against occasional bank runs, and collectively the whole nation must maintain a central "bank", charging interest to maintain reserves against simultaneous runs on multiple banks. No device has ever been created for a nation to protect against a universal bank panic, which is as effective as placing the risk in the hands of private bankers who can expect to be stripped and shorn if things get out of control. Robert Morris demonstrated this point in 1779, and the nation seemingly must re-learn it every few decades.The IBM 360 computer made it possible to transform short-term into long-term in greater volume and lower cost by allowing banks to get bigger; but it could also perform the short-long transformation in cheaper ways than depository banks do, and from there the bank-competitive process we know as securitization has gone on to commercial credits, auto loans, credit cards, high-velocity stock trading, and mortgage-backed securities. These approaches are often cheaper and more convenient that the trusty old banking system, and Credit Default Swaps show its power isn't exhausted; any legislation to prohibit CDS is sure to to be circumvented. Insurance is also on the edge of being threatened. An industrial revolution of this magnitude takes decades of tweaks to become stabilized, but it will suffice for now, if we can establish reasonable protections against the risk shifted into the securitization or investment banking arena. As risk shifts, remuneration for accepting risk must shift as well. This new system for generating capital must not be starved because depository bankers resist the loss of their share of profitability; politics will have much to answer for if that happens.
Most likely, the main obstacles to getting this system fixed will come from overseas. Fifty years of disillusionment with the United Nations will make nations, the United States chief among them, resist loss of sovereignty in something so vital as finance. But that's for the future. For nearly a century, the past has been disrupted by idle notions of the fairness of coerced redistribution, in ways Mr. Wallison has succinctly described. But meanwhile we almost willfully ignore technological upheavals which everyone welcomed but no one fully anticipated.
http://www.philadelphia-reflections.com/blog/2049.htm
Lowering the Taxes on Corporations
In the early years of the 21st Century, Ireland lowered taxes on corporate profits to a 12.5% rate, far lower than neighboring countries. Whatever else it did, it promptly encouraged corporations in Germany, Denmark, the United Kingdom and other neighbors -- to move headquarters to Ireland where taxes were so low. Ireland is primarily rural, and a housing shortage developed in the cities as workers migrated to take advantage of the new jobs. Home prices went through the roof, mortgage applications overwhelmed local banks, who promptly re-sold mortgages to foreign banks. Sound familiar? It caused a housing bubble and then a horrendous international financial crisis. The European Union is financially and politically strained by the consequences, and threatened to break apart over it.
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| Irish Jig |
That sounds pretty bad, and should be a lesson to others. What Canada and a number of the individual United States got out of it was mainly this: if you lower corporation taxes, it causes prosperity. And so it might, if politicians would do it gradually and moderately. Gradually and moderately are unfamiliar words in politics. Furthermore, there has long been a fundamental unfairness in taxing corporate profits twice -- once when the profits are made, and a second time when dividends are paid to shareholders. But it is obviously dangerous business, particularly when the governments involved are inexperienced. Canadians started talking about lowering their taxes to 16.5%, and no one could say whether that is a safe level or not. Within weeks, twenty-nine states with Republican governors were sending up trial balloons about joining this movement, and Governor Mitch Daniels of Indiana was much in demand as a consultant, and maybe a Presidential candidate, because Indiana had lowered corporate taxation some time ago, with favorable results.
This was exactly the sort of behavior James Madison had in mind when he designed the United States Constitution; it gave the people a way of disciplining overbearing state governments. Raise our taxes, and we will move. So there are strong arguments that these governors are approaching the right thing, and equally strong indications that everybody had better be plenty careful how this is approached.
The basic idea is good; double taxation should stop, and there is nothing in Madison's Constitution to prevent the Governors from doing what they say they would like to do. So how's this for a suggestion: if this movement gets started, let's take the opportunity to reduce all corporate income taxation to zero. If everybody has the same zero rate, the incentive to migrate will disappear, and that's a good thing.
But if a major revenue source for the states disappears, what will take its place? At that moment of what would look like crisis, it would be time for a national reconsideration and revision of the tax codes. And that would be an even more desirable outcome, provided it is done in an orderly and sensible way.
http://www.philadelphia-reflections.com/blog/2064.htm
Foreground: Parliament Irks the Colonial Merchants
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| Charles Townshend |
Charles Townshend, Chancellor of the Exchequer under King George III in 1766-67, had a reputation for abrasively witty behavior, in addition to which he did carry a grudge against American colonial legislatures for circumventing his directives when earlier he had been in charge of Colonial Affairs. His most despised action against the Colonies, the Stamp Act, seems to have been only a small part of a political maneuver to frustrate an opposition vote of no confidence. The vote had taken the form of lowering the homeland land tax from four to three shillings (an action understood to be a vote of no confidence because it unbalanced the budget, which he then re-balanced by raising the money in the colonies.) The novelist Tobias Smollett, subsequently produced a scathing depiction of Townshend's heedless arrogance in Humphry Clinker, but at least in the case of the Stamp Act, its sting was more in its heedlessness of the colonies than vengeance against them. One can easily imagine the loathing this rich dandy would inspire in sobersides like George Washington and John Adams. After Townshend was elevated in the British cabinet, almost anything became a possibility, but it was a fair guess he might continue to satisfy old scores with the colonies. When King George's mother began urging the young monarch to act like a real king, Townshend was available to help. On the other hand the Whig party in Parliament had significant sympathy with the colonial position, as a spill-over from their main uproar about John Wilkes which need not concern us here. Vengefulness against the colonies was not widespread in the British government at the time, but colonists could easily believe any Ministry which appointed the likes of Townshend might well abuse power in other ways, before such time as the King or a more civilized Ministry could arrive on the scene to set things right. It was vexing that a man so heedless as Townshend could also carry so many grudges. Things did ease when Townshend suddenly died of an "untended fever", in 1767.
Whatever the intent of those Townshend Acts, one clear message did stand out: paper money was forbidden in the colonies. Virginia cavaliers might be more upset by the 1763 restraints on moving into the Ohio territories, and New England shippers might be most irritated by limits on manufactures in the colonies. But prohibiting paper money seriously damaged all colonial trade. Some merchants protested vigorously, some resorted to smuggling, and others, chiefly Robert Morris, devised clever work-arounds for the problems which had been created. Paper currency might be vexingly easy to counterfeit, but it was safer to ship than gold coins. In dangerous ocean voyages the underlying gold (which the paper money represents) remains in the vaults of the issuer even if the paper representing it is lost at sea. Theft becomes more complicated when money is transported by remittances or promissory notes, so a merchant like Morris would quickly recognize debt paper (essentially, remittance contracts acknowledging the existence of debt) as a way to circumvent such inconveniences. In a few months we would be at war with England, where adversaries blocking each other's currency would be routine. By that time, Morris had perfected other systems of coping with the money problem. In simplified form, a shipload of flour would be sent abroad and sold, the proceeds of which were then used to buy gunpowder for a return voyage; as long as the two transactions were combined, actual paper money was not needed. Another feature is more sophisticated; by keeping this trade going, short-term loans for one leg of the trip could be transformed into long-term loans for many voyages. Long-term loans pay higher rates of interest than short-term loans; it would nowadays be referred to as "riding the yield curve." This system is currently in wide use for globalized trade, and Lehman Brothers was the main banker for it in 2008. And as a final strategy, having half the round-trip voyage transport innocent cargoes, the merchant could increase personal profits legitimately, while cloaking the existence of the underlying gun running on the opposite leg of the voyage. If the ship is sunk, it can then be difficult to say whether the loss of such a ship was military or commercial, insurable or uninsurable. In the case of a tobacco cargo, the value at the time of departure might well be different from the value later. Robert Morris became known as a genius in this sort of trade manipulation, and later his enemies were never able to prove it was illegal. Ultimately, a ship captain always has the option of moving his cargo to a different port.
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| Thomas Willing |
Other colonists surely responded to a shortage of currency in similar resourceful ways, including barter and the Quaker system of maintaining individual account books on both sides of the transaction, and "squaring up" the balances later but eliminating many transaction steps. Wooden chairs were also a common substitute as a medium of exchange. But "Old Square-toes," Thomas Willing, experienced in currency difficulties, and his bold, reckless younger partner Morris displayed the greatest readiness to respond to opportunity. Credit and short-term paper were fundamentally promises to repay at a certain time, commonly with a front-end discount taking the place of interest payment. The amount of discount varied with the risk, both of disruption by the authorities, and the risk of default by the debtor. This discount system was rough and approximate, but it served. Quite accustomed to borrowing through an intermediary, who would then be directed to repay some foreign creditor, Morris and Willing added the innovation of issuing promissory notes and selling the contract itself to the public at a profit. Thus, written contracts would effectively serve as money. A cargo of flour or tobacco represented value, but that value need only be transformed into cash when it was safe and convenient to do so.
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| Robert Morris |
The Morris-Willing team had already displayed its inventiveness by starting a maritime insurance company, thereby adding to their reputation for meeting extensive obligations; they established an outstanding credit rating. Although primarily in the shipping trade, the firm was also involved in trade with the Indians. There, they invented the entirely novel idea of selling their notes to the public, essentially becoming underwriters for the risk of the notes, quite like the way insurance underwriters assumed the risk of a ship sinking. Their reputation for ingenuity in working around obstacles was growing, as well as their credibility for prompt and reliable repayment. In modern parlance, they established an enviable "track record." A creditor is only interested in whether he will be repaid; satisfied of that, he doesn't care how rich or how poor you are. The profits from complex trading were regularly plowed back into the business; one observer estimated Robert Morris's cash assets at the start of the Revolution were no greater than those of a prosperous blacksmith. It didn't matter; he had credit.
In the event, this prohibition of colonial paper money did not last very long, so profits from it were not immense. But ideas had been tested which seemed to work. Today, transactions devised at Willing and Morris are variously known as commercial credit, financial underwriting, and casualty insurance. In 1776, Robert Morris would be 42 years old.
http://www.philadelphia-reflections.com/blog/2111.htm
Black Swans (Financial Variety)
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| Nicolas Baudin |
The mouth of the Delaware River once teemed with white swans, but black swans were unknown until the French explorer Nicolas Baudin brought home a few from Australia, where they are now celebrated as the state animal of Western Australia. The Empress Josephine Bonaparte was delighted with them, made them known as her birds, and thus made the term "Black Swan" more or less synonymous with rare chance occurrences. The implied inference that every white swan contains a remote potential for breeding a black one is doubtful biology, however. More likely, black swans are a distinct species -- Cygnus atratus-- confined to Australia and New Zealand, and just about extinct in New Zealand. In that view of things, the rarity of black swans is equivalent to the prevalence of black ones, mixed within the population of generally white ones. Nevertheless, for this article it is convenient to continue the unlikely conjecture that most, or perhaps every, white swan contains a small potential to hatch a black one.
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| Credit Default Swaps |
Many theories exist for the discovery that financial crises are commoner than chance alone would seem to predict; if they follow a Gaussian normal distribution curve, it must be somehow different from the distribution curve of smaller fluctuations. Observing this discordance is more or less how the phenomenon was discovered. The normal volatility of economic activity is calculated from the fluctuations observed in, say, twenty years. When that derived curve is extrapolated to include cataclysmic events which by theory of the unmeasured "long tail" occur every hundred years, speculators have later discovered by actual measurement that, alas, such disasters actually occur much more frequently. Calculated risks derived from such extrapolations have upended many insurance companies and insurance-like vehicles like Credit Default Swaps, who set their premium charges to match the mathematics. Since CDS approached a hundred trillion dollars in the last crisis, it is important to understand the mechanics of this kind of Black Swan if we possibly can.
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| Black Swan |
One way to do that is to question the conventional equivalence of risk and volatility; that is, that the more markets bounce around, the riskier they become. Why should that be true, we might ask. And if it is somewhat true, why does that make its converse true, that calm seas are safe ones? Those of us who sit and watch the ocean shore soon adopt the habit of speech that high waves at the shore mean a storm is approaching, not that it will ever arrive. After all, the center of the storm may be traveling parallel to the coastline, not directly toward it. And calm seas are particularly undependable predictors; no matter how calm it may be, the next storm might arrive in a few hours, or it may not come for months. Many other analogies spring up, once one puts aside the basic assumption that world economics can be depicted as a linear electrocardiogram. At the very least, they are two-dimensional, possibly three. Possibly four, if you regard time as a dimension.
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| Dow Jones |
It must be noticed that market volatility is universally viewed as linked to bad things, and many efforts have been made by central banks to reduce risk by constraining volatility. Alan Greenspan is famous for having controlled the economy for seventeen years without a major depression. Is that necessarily a good thing? Is it equally possible that kinetic energy was constrained within the inflating balloon until the bursting of it was a far more damaging explosion than small planned deflations would have been?
Experimental testing of these ideas has itself been constrained by an inability to predict the explosion point of expanding financial balloons. Planned deflations have been particularly feared, because of lack of assured ways to get them to stop deflating. But practical warnings such as these are not the same as claiming that lack of volatility is always the ideal state.
http://www.philadelphia-reflections.com/blog/2143.htm
After Six months
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| Snapshot of A Depression |
Phase One: An early recession, with ominous signs of inflation. (Six months of blind man's buff. Stocks down 8-10%, signs of inflation, moderate foreclosures, house prices decline around 10%, increased unemployment, consumer confidence down, oil and gold up, dollar down.)
Phase Two: Government attempts to put out fires. Priorities are set by emergencies as they arise. So far, lowered interest rates, $600 per person stimulus package, offers to substitute government bonds for securitized debt, expand Fannie Mae. The critical need is to abandon these approaches quickly, unless they somehow correct the underlying problem and assist in long-term reforms.
Phase three: Long term reform. Task forces, gathering ideas from all sources, seek to identify the critical issues that caused this problem and keep it from happening again. Dangers: politics (D v R), conflict between East (mainly concerned with fuel prices) and West (mainly concerned with housing surplus), foreign meddling or hostility, collapse of China or other developing economies. We may assign too high a priority to those who are suffering, and neglect to do what will work. Some short-term emergency may get out of hand and disrupt more basic solutions. All problems begin as solutions.
==============================================================================
What are the possible underlying problems?
1. We have too much debt and leverage, and far too much is concentrated in home real estate mortgages. Did the slanted tax exemptions do this? Did the innovative mortgage methods do it? Did we develop excess inventory of houses just by too rapid a pace of good things?
2. The cost of buying a house is greatly in excess of the cost of renting a comparable house, overturning a century of previous history. Meanwhile, owner equity is less than half of national home prices. If prices decline, owner equity will be even less.
3. Banks and insurance companies are becoming obsolete. Should we rescue them, or put them out of their misery?
4. Wall Street got rich by doing obscure things. Should we punish them, or are they the only people able to save the situation?
5. What will we do if China collapses, the cheap dollar ruins Europe, or international trade is paralyzed by protectionism?
6. Should we revise the entire world monetary system, either by going back to a commodity-based currency, or switching to an equity-based currency? If that is too radical, how do we control a completely debt-based currency now that its flaws are appearing?
http://www.philadelphia-reflections.com/blog/1418.htm
Taxes as a Form of Consumption
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| Refund-Check |
About half of the American public pays federal income taxes, and among the half who don't, a great many receive a green government payment check, meaning they have negative income taxes. The tax assistance companies, H. and R. Block and the like, had little for their offices and staff to do in January, February and March until someone hit on the idea of processing "fundable tax credits" for a fee. That is, the lower-income segments of the population get the promise of an April tax "rebate" as the consequence of tax-form preparation, so H. and R. Block just loans them the money, discounted for fees and interest. It keeps staff busy, generates revenue. Hardly anyone in the upper income half of the population is aware of all this, so there is little political friction. This whole system of income redistribution quite effectively keeps the two halves of the population sitting in the same chairs at the tax-preparation offices, but in different months of the year; one half getting paid, the other half coughing up the payments.
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| Tea Tax |
It thus becomes possible for two inflammatory slogans to bandy about, without starting fistfights or revolutions. The first was overheard at a local bank, one stranger remarking to another, "Has it ever occurred to you that taxes are a form of consumption?" To which the other person replies, "Yes, and taxes are the largest expenditure I make." A nation which once went to war over a two-cent tax on tea is remarkably passive about the ways things have evolved, but this essay is not devoted to unfairness. Prepare to hear how the upper income brackets might reduce their taxes, whether that counts as decreased consumption or not. Whenever you tax something, you get less of it; if you tax public income more, the public will earn less. So, this little essay is serious when it proposes that we all earn less, so we can get taxed less. And being taxed less, we need save less for our retirements.
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| Taxation |
The general principle is this: income is usually taxed in the year it is earned, with some exceptions, rebates and deferrals. The exceptional situations are often referred to as "loopholes" and therefore live in political jeopardy. However, if a person spends the money or dies while these deferrals continue to exist, the income may escape taxation entirely. In a sense, the largest loophole of all lies in the present fact that nearly half the population pays no income taxes at all, so saving income earned under those circumstances may lead to investment capital, which is later spent during highly taxed periods of that same person's life. Money earned by a child, usually on investments donated by a relative, is an example. Since at present, a child may receive annual gifts of $13,000 tax-free, as much as a half-million dollars can be accumulated in this way, always at the risk that laws may be changed and, further, at risk of spendthrift abuse by a psychopathic child. Whether these are wise risks for a parent to take, depends in large part on what sacrifices are made for the purpose, especially loss of parental restraint of unwise spending. A much more serious argument grows out of the possibility that money in the hands of children who lack experience in deferred gratification may actually provoke recreational drug use, or other sociopathic behavior.
Finally, lack of planning may create opportunities as much as planning does. A person who has paid little attention to financial planning may arrive at an advanced stage where life expectancy is considerably shorter. Savings at that point may be divided into money on which deferred taxes must be paid when you spend it, and money on which taxes have already been paid. More savings will be consumed if the individual triggers deferred tax liabilities, than if he just uses up money on which taxes have already been paid. Therefore, if he ignores lifetime habits and spends after-tax capital first -- the whole nest egg will last longer. But none of this deferred-income tax issue can compare with the problem of income on which taxation has been completely forgiven at the time it was spent, the so-called tax expenditures. The largest such tax expenditures are on the interest of home mortgages, on employer-paid (but not self-paid) health insurance, and employer-paid retirement income. Of these, the least consequential are the retirement income, because the tax is merely deferred, not completely forgiven. The two biggest items are home mortgages, which lie at the root of the 2007 financial crash, and employer-paid health insurance premiums, which triggered the Obama health proposal of 2009. The Obama plan purports to rein in health costs, but is estimated by the Congressional Budget Office to cost the Treasury $100 billion a year.
Extra! In the Fall of 2011, this boring matter suddenly came to the surface, in the form of huge American deficits threatening to bankrupt the country, as they were apparently actually going to do in Greece. As politicians do, many attempts were first made to rename the over-spending issue for partisan advantage. It was, for instance, tax expenditure. It was, possibly, a sovereign debt crisis. In any event, the Congressional Budget Office included such wealth redistribution under the heading of tax expenditure, which totalled a trillion dollars. Since everyone was searching for a painless category to eliminate in order to balance the budget, this term was hard to avoid. As far as Congress is concerned, the national deficit is whatever the CBO says it is, and in this case it lumped a lot of things together which politicians would like to split apart. When you take things in small pieces, it becomes possible to boil the frog by slowly heating it up before it realizes it is cooked. Lumping things together induces the frog to jump out of the pot, but however that may be, it has got lumped together by the referee of such matters, and there is a strong possibility it will stay lumped.The essential point for accountants to focus on, is that tax expenditures are all counted as revenue when any non-accountant can see they are expenses. For political speech-making purposes, this distinction is vital and no opponent will let another politician wiggle out of it. And the beauty part of it is that it also spotlights three of the most besetting evils of modern politics: the tax exclusion of employer-based health insurance, the home mortgage interest tax exclusion, and the "earned" income tax credit. The first of these is responsible for our health insurance mess, and the other is responsible for our home mortgage crisis; the two main political problems of the day are suddenly plopped into the limelight, just when a lot of people are looking for ways to hide them. Furthermore, this bombshell was fired by a panel of the four outstanding tax economists of the nation, each of them roundly denouncing them as unthinkable ideas that never should have been born in the first place. Alan Greenspan, famous for unintelligible speech, simply said all of these tax expenditures, every one of them, should be eliminated immediately. One would hope that is clear enough. Martin Goldstein, formerly chairman of President Reagan's Council of Economic Advisors, agreed. As did former Governor Engler of Michigan, widely acknowledged to have rescued his state from impending bankruptcy. Senator Nelson, a Democrat from Florida and chairman of the committee, positively beamed with pleasure. It was hard to think this was anything but a turning point in history; let some political candidate disagree, and he can expect to have his audience shown a videotape of this succinct epic in the history of Senatorial hearings. These greybeards said, in what was obviously an unrehearsed moment, just eliminate these three terrible ideas in one stroke, and the national deficit will be reduced by a trillion. That's what they said, and it's easily proved that they had said it.
http://www.philadelphia-reflections.com/blog/2129.htm
Morris Quits His Business
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| Charles Dickens |
There are a dozen episodes from American revolutionary times which might be called pivotal, but a single debate in the Pennsylvania Legislature seems to have started our political parties in their present form. The two debaters, their topic, and its consequences all rise to dramatic, even operatic, heights. In another place, we intend to explore the clashing philosophies of the Eighteenth century, with Hegel and Hume at the apex, but two quotations from Adam Smith are more intelligible to ordinary readers. Charles Dickens nearly ran away with the topic in his novel A Tale of Two Cities, but Charles Brockton Brown and Hugh Henry Brackenridge were good enough and they were Pennsylvanians, present at the scene. John Adams and Thomas Jefferson debated for decades about which of them was the main protagonist. But all of that is background material for that operatic scene at Independence Hall, where the real David and Goliath were William Findlay and Robert Morris.
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| Robert Morris |
Robert Morris, it must be remembered, was probably the richest man in America, a signer of the Articles of Confederation, the Declaration of Independence, and the Constitution. He was one of three men, including Ben Franklin and George Washington, about whom it could be said that the Revolution could not have been won without them. He essentially invented American banking, had founded the first bank, the Pennsylvania Bank, invented investment banking, corporate conglomerates, American maritime insurance, and dozens of financial innovations. His merchant house probably had 150 ships sunk by the enemy. George Washington lived in his house for years.
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| William Findlay |
William Findlay, on the other hand, was a Scotch-Irish frontiersman with a flamboyant white hat, elected by others like him from the Pittsburgh area to promote inflation through state-issued debt paper, so as to finance land speculation in the West. He had no education to speak of, and no accomplishments to mention. He made no secret of his self-interest in land speculation, and therefore no secret of his opposition to rechartering the Bank of North America, which Morris had founded for the purpose of restraining inflation and speculation. Findlay wanted the bank to disappear, get out of his way, and he boldly denounced Morris for his self-interest in promoting a bank he owned stock in. He utterly denied that Morris had any motive other than the profit he would make for the bank, so they were equal in self-interest. Let's vote.
Prior to that time, Findlay had politically defeated Hugh Brackenridge, using the two strong arguments that Brackenridge had gone to Princeton, and written poetry; how could he possibly represent the hard-boiled self-interest of his frontier constituents?
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| Hugh Brackenridge |
Morris was positively apoplectic at this sneering at everything he stood for. As for the country's lack of trust in a man who had risked everything to save it, well, what have you done for us, lately? America had lately thrown off the King, but what it had really discarded was aristocracy. Every man was as good as every other man, and each had one vote. Under aristocratic ideals, a man was born, married and educated in a leadership class, expected to be utterly disinterested in his votes and actions, scrupulous to avoid any involvement in trade and commerce, where temptations of self-interest were abundant. Washington never accepted a salary for his years of service and even agonized for months when he was awarded stock in a canal company, wanting neither to seem ungrateful nor to make private profit. John Hancock, who came pretty close to having as much wealth as Morris, gave up his business when he was made Governor of Massachusetts. Benjamin Franklin was only accepted into public life when he retired from the printing business, to live the life of a gentleman. That's how it was, everywhere; every nation had a king, and depended on rich aristocrats to supply the leadership for war and public life. But, now, America had a republic where every man was equal. Morris, and the Federalists he represented, wanted to turn the clock back to an era that would never return.
Goaded too far, Morris impulsively resigned his business interests, to prove he had the nation's interest at heart in opposing inflation. It didn't help. Findlay won the vote, and the Bank of North America was closed.
http://www.philadelphia-reflections.com/blog/2178.htm
Morris Defends Banks From the Bank-Haters
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| Robert Morris |
In 1783 the Revolution was over, but the new nation would not launch its new system of government until 1790. It was a fragile time, and a chaotic one. Just after the British abandoned their occupation of Philadelphia in 1778, Robert Morris had been given emergency economic powers in the national government, but the state legislatures were struggling in parallel to create their own models of governance, often in overlapping areas. Thus it came about that the Pennsylvania Legislature was still occupying the Pennsylvania State House now called Independence Hall, when it issued the charter for America's first true bank the Bank of North America in 1778, as it also was in 1784 when the charter came up for renewal. Morris was a member of the Assembly both times. Although he was not a notable orator, it was said of him that he seldom lost an argument he seriously wanted to win. Keeping that up for several years in a small closed room, will itself make you many enemies.
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| Tavern and Bank |
Morris was deeply invested in the bank, in many senses. He had watched with dismay as the Legislature squandered and mismanaged the meagre funds of the rebellion, issuing promissory notes with abandon and no clear sense of how to repay them, or how to match revenues with expenditures. There was rioting in the streets of Philadelphia, very nearly extinguishing the lives of Morris and other leaders, just a block from City Tavern. Inflation immediately followed, resulting in high prices and shortages as the farmers refused to accept the flimsy currency under terms of price controls. Every possible rule of careful management was ignored, and promptly matched with a vivid example of what results to expect. Acting only on his gut instincts, Robert Morris stepped forward and offered to create a private currency, backed by his personal guarantee that the Morris notes would be paid. The crisis abated somewhat, giving Morris time to devise The Pennsylvania Bank, and then after some revision the first modern bank, the Bank of North America. The BNA sold stock to some wealthy backers of which Marris himself was the largest investor, to act as last-resort capital. It then started taking deposits, making loans, and acting like a modern bank. Without making much of a point of it at the time, the Bank interjected a vital change in the rules. Instead of Congress issuing the loans and setting the interest rates as it pleased, a commercial bank of this sort limits its loans to a fraction or multiple of its deposits, and its interest rates are set by the public through the operation of supply and demand. The difference between what the Legislatures had been doing and what a commercial bank does, lies in who sets the interest rates and who limits the loans. The Legislature had been acting as if it had the divine right of Kings; the new system treated the government like any other borrower. As it turned out, the government didn't like the new system, and has never liked it since then. Today, the present system has evolved a complicated apparatus at its top called the Open Market Committee of the Federal Reserve, most of whose members are politically appointed. Several members of the House Banking Committee are even now quite vocal in their C-span denunciation of the seven members of the Open Market Committee who in rotation are elected by the commercial banks of their regions. Close your eyes and the scene becomes the same; agents of the government feel they have a right to control the rules for government borrowing, while agents of the marketplace remain certain governments will always cheat if you allow them to.
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| Seigniorage |
That's the real essence of Morris's new idea of a bank; other advantages appeared as it operated. The law of large numbers smooths out the volatility of deposits, and permits long-term loans based on short term deposits. Long-term deposits command higher loan prices than short-term ones can; higher profits result for the bank. And a highly counter-intuitive fact emerges, that making a loan effectively creates money; both the depositor and the borrower consider they own it at the same time. And finally there is what is called seigniorage. Paper money (gold and silver "certificates") deteriorates and gets lost; the gold or silver backing it remains safe in the bank's vault, where it can be used a second time, or even many times.
For four days, Morris stood as a witness, hammering these truisms on the witless Western Pennsylvania legislators. At the end of it, scarcely one of them changed his vote, and the bank's charter was lost. But at the next election the Federalists were swept back into majority, defeating the opponents of the bank. Although, as we learn democracy works, still not convincing them.
http://www.philadelphia-reflections.com/blog/2188.htm
Tammany: Philadelphia's Gift to New York
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| Tammany Hall |
Edward Hicks painted a scene over and over, depicting William Penn signing a treaty of peace with the Lenape Indians at Shackamaxon ( a little Delaware waterfront park at Beach Street and E. Columbia Ave.). This scene was apparently a reference to a larger and more finished depiction by Benjamin West. The Indian chief in the painting is Tammarend, chief of the Delaware tribe. Long before Hicks got the idea for the picture from Benjamin West, Tammarend was locally famous for having the annual celebrations of the Sons of St. Tammany named after him. These outings centered on the joys of local firewater, and thus may have had something to do with the evolutions of the Mummers Parade. George Washington presided over a lively Tammany party at Valley Forge, and local Tammany Hall clubs sprang up all over the country. The most famous offshoot had its headquarters on 14th Street in New York, as a club within the local Democrat party asserting Irish dominance over New York politics, allegedly using Catholic Church connections to control other immigrant groups. The identity of Tannerend seems to have got thoroughly mixed up along the way; the famous statue of "Tecumseh" at the Naval Academy in Annapolis, much revered by the cadets, is actually a depiction of Tammany.
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| Penn's Treaty With the Indians By Benjamin West |
At earlier times, Tammany was the vehicle Aaron Burr used to assert control of the now-Democrat Party, particularly in the contested Presidential election of 1804. Shooting Alexander Hamilton in a duel, along with disgrace and impeachment as Vice President necessitated Burr's rapid conversion into a non-person, both in New York and in Philadelphia. In Philadelphia, the uproar led to the dispersion of Tammany influence, while in New York other bosses, particularly Boss Tweed, took over the organization and consolidated its role as a small club which dominated a larger political party, which in turn pretty well took over the government of New York City, which in turn dominated the governance of New York State, and even occasionally leveraged itself into national politics. Eventually, Tammany fragmented sufficiently that Mayor Fiorello La Guardia was able to dislodge it from control, which in time led to its dissolution. In a larger sense however, the decline of New York's Tammany Hall began when in the late 19th Century it adopted the Philadelphia system of consolidating graft from local leaders into unified "donations" from local utilities. That greatly improved the efficiency of collections and disbursements, but undermined the need for an effective local organization of ward leaders.
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| Aaron Burr |
So, although Tammany was originally a Philadelphia creation perfected by New York, it continued to have connections to Aaron Burr in early days, and Philadelphia machine politics later on. But of course for seventy five years, around here it was Republican.
http://www.philadelphia-reflections.com/blog/2187.htm
Funding the National Debt
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| Alexander Hamilton |
Although Alexander Hamilton's arresting slogan that "A national debt is a national treasure" has diverted attention to the underlying idea toward him, Robert Morris had introduced and argued for the same insight in the preamble to his 1785 "Statement of Accounts". The key sentence was,"The payment of debts may indeed be expensive, but it is infinitely more expensive to withhold payment." This fatherly-sounding advice was surely a distillation of a long life as a merchant, and the gist of it may have been passed down to him as an apprentice. Failure to pay your debts promptly and cheerfully results in the world assigning a higher interest rate to your future credit; it is not long before compounded interest begins to drag you down. It doesn't exactly say that, but that's what it means.
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| Liberty Bond |
Another way of looking at this folk wisdom is that it leads to a simplified method of organizing the finances of an organization. Because higher rates of interest are demanded of long-term borrowing than short-term, it becomes efficient to segregate them. That is, to establish a cash account for every-day transactions, and a separate bond account for long term, or capital, debt. As bills arrive, they need only be verified for accuracy and sent for payment from either a cash account or a capital account. The original wisdom of agreeing to such debts lies with management, not the treasurer. The job of the treasurer's office is to pay legitimate bills as quickly and cheerfully as possible, ignoring any imprudence of earlier agreeing to pay them; rewards will come from lower interest charges and improved credit rating. An unexpected benefit of thus organizing institutions and governments is to make the accounting profession possible. Accountants perform the same function in every business, whether the business is selling battleships, or parsnips. The accounting profession made itself computer-ready, two hundred years before the computer was invented.
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| Robert Morris |
In the same document, the retiring national Financier was advising the wisdom of "funding" the war debts, which were largely owed to France, with whom relations were rapidly souring. Lump them all together into a fund, issue bonds and sell them as representations of the nation's capital at the time of issue. Disregard what the money was used for, by either the debtor or the creditor. In spite of appearances, money sequestered in a fund for later payment, belongs to the creditor the moment it is promised, not the moment it is transferred. Morris and Hamilton discovered that the fund itself had the property of a bank, in creating money. As long as the creditor did not cash your bonds, he could use them as money, in effect doubling the amount of money you yourself can spend. It was this discovery which so exhilarated Alexander Hamilton, causing him to over-praise the methodology to an already suspicious Congress. Tending toward the teachings of Shakespeare's Polonius, Hamilton's excitable manner caused them to remember, neither a borrower nor a lender be. But Congress was eventually persuaded. The federal government lumped the states' debts together in an "assumption of debts" , consolidated all these various little debts into a single "funded debt", and made the deal work with changing the "residency" of the nation's capital from Philadelphia to the banks of the Potomac. It was called the Great Compromise of 1790.
Morris well understood that a funded system requires some final payor of last resort. Such a payor need set aside only a small portion of the debt for dire contingencies, but his name gets first attention on the list presented to prospective creditors. In 1778 Morris had offered his own personal wealth as that last resort, which the public at the time trusted far more than the Treasury of the United States. Over the next twenty years he came to realize that the last resort of established nations, no matter what the paper said, was the aggregate underlying wealth of the whole nation. With a vast continent stretching to the West, and countless immigrants clamoring to join from the East, the wealth supporting the debt of the United States in 1790 seemed endless. After two hundred years we have finally begun to accumulate a national debt which equals our Gross Domestic Product, and have only begun to pull back as we observe what happens to other nations who got to that point sooner. Let's hope devising an automatic check and balance does not require a second Robert Morris. Men like him can be hard to find.
http://www.philadelphia-reflections.com/blog/2189.htm
Morris at the Constitutional Convention
True, George Washington was the presiding officer of the Constitutional Convention. But Pennsylvania was the host delegation, so the role of presiding host should have fallen to Benjamin Franklin, the President of Pennsylvania. However, Franklin was getting elderly and turned the job over to Robert Morris, who among other things was rich enough to host some necessary parties. The rules of decorum at that time thus kept Washington and Morris out of the floor debates. The proceedings were in any event kept secret, so even an occasional frown or encouraging smile is not recorded for history.
But Morris had been an active debater in the Assembly and other meetings, so he knew enough to line up a consensus in advance for the matters he thought were essential. Obviously, Morris was strongly in favor of giving the national government power to levy taxes, and Washington whose troops had suffered severely from the inability of the Continental Congress to pay them, also regarded this taxing power as the central reason for changing the rules. By making it the central argument for holding the convention at all, Washington, Franklin and Morris had made taxation power a foregone conclusion. And by giving them what they wanted from the outset, the rest of the convention was in a position to do almost anything else it wanted without open comment from the Titans. This situation had the effect of empowering James Madison, the only participant who had studied the inside details intensively, and cared about every comma.
Most of the convention delegates had considerable experience with state legislatures, and Franklin and Morris had spent decades struggling with the weaknesses of legislators. A wink or a quip in a tavern was as good as an hour's speech for reminding the delegates what they already knew about human nature. What was designed was a dual system of powers of taxation, with federal oversight of balanced state budgets combined with a federal power to tax on its own in emergencies or unforeseen situations. Since the members of the first few congresses after 1789 were largely the same people as the members of the constitutional convention, many of the details of this balance were worked out in a few years. State powers to tax and borrow were tightly constrained, only the federal government could tax and borrow without limit. Since government borrowing is merely the power to defer taxes until later, the borrower of last resort was the U.S. Congress, alone empowered to encumber the wealth of the whole nation in a federal pawn shop window called the funded National Debt. For almost two centuries, this pawn shop window seemed able to support any imaginable expense. Today, we monitor this as the ratio of national debt to Gross Domestic Product (GDP), and we have a clearer idea what ratio flirts with hopeless inability to pay it back. The system continues to lack a permanent definition of its limit, but the system is nevertheless still Morris's system, wrapped in a mountain of descriptive detail.
http://www.philadelphia-reflections.com/blog/2190.htm
Bonds--Do They Have A Future?
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| Relic of the Past? |
Ever since we finally went off the gold standard completely during the Nixon Administration, the Federal Reserve has adjusted our money supply to create a fairly steady 2% inflation. If inflation is ever less than 2%, the Fed puts more money into circulation. Since many bonds are paying less than a 2% dividend, everybody who buys and holds them at par will lose money in "real" terms. That is, everyone who buys bonds when they are issued and sells them when they mature, will lose spending power. Since they fluctuate in the meantime, it is possible for a trader to buy them when they are undervalued by the market. That trader will possibly make money, but only because someone else lost money. Something like that occurred during the recent financial crash bailout, when interest rates declined from 3% to 2%, but were repurchased by the Fed as "Quantitative Easing", effectively giving speculators a 33% profit at government expense. But that doesn't happen often, and just guess who lost the money the speculators made. There is also that daunting question: when the time comes for the Federal Reserve to disgorge them, just who is going to buy all these cheapened bonds? In Japan, bonds paid a dividend of less than the current inflation rate for more than a decade; it's hard to think of a reason why the same thing could not happen in America, so it's also hard to imagine a reason why buy-and-hold investors should not abandon bonds, perhaps suddenly all at once, at some unknown time in the future. At that point, many of them will resolve never to try that, again. The whole idea is troubling.
It's particularly troubling in view of the lack of success, so far, of TIPS. These vehicles are new; perhaps the algorithm is set to ignore minor inflation and will over-respond to more major inflation, ultimately rewarding those who buy them. But at least so far, they are a disappointment. Furthermore, TIPS are quite cleverly designed to be inflation-protected, while unfortunately inflation usually does not follow a straight line but is volatile, or saw-toothed; the jury is still out. But the jury better hurry up, because investors are looking for net income after expenses, which include brokerage costs, taxes, and inflation. A long-term bond might have to pay a dividend approaching 4%, just to emerge with the same net value it started with; after five years of 4%, you could be 20% behind. And yet, the bond market with or without inflation protection is far larger than the stock market, and compares in size with any other kind of market. Who buys them, especially in these huge quantities?
Somebody must maintain statistics which answer this question, but as a guess, the main buyers are insurance companies, endowments, annuities, hedge funds, banks. The great argument for bonds is safety of principal, and although safety is in question anywhere there is inflation, whenever the topic is cash flow, safety is definitely an issue. Cash shortages are what cause bankruptcies, which are mainly useful in providing time to liquidate underlying wealth to pay restless creditors. The management of a non-profit organization must meet its payroll out of cash flow, so non-profits protect themselves from dissolution by having a regular flow of nominally secure bond dividends. Since most for-profit organizations also experience variable periods of time without profits, the situation is not greatly different from permanently nonprofit. That's particularly true if the for-profit organization has a vocal, activist stockholder group, who will protest fiercely if the management retains abundant cash. For such a predicament, holding bonds creates safety by some definition. The price of that safety is the long-term average loss on the bond portfolio; conversely, the net loss is the cost the company could afford to pay the activists to go away.
To restate the characteristics of the willing bond purchasers, they are governments and nonprofit entities, who have no common stock revenue alternatives, but regularly face a need to raise money. They also include borrowers and lenders at nominal interest rates like banks and insurance companies, who can afford to ignore inflation because their own liabilities are in nominal dollars, or come due at a date certain. And then, there are a host of beneficiaries of special-interest bond provisions, like "Flower bonds", state and municipal governments, foreign aid, student aid, etc. As an overall statement, natural bond buyers are those who either do not possess an equity (common stock) alternative to offer, or else are shielded in some way from inflation and tax costs of buying bonds. Speculators and traders are excluded from the discussion, because fixed-income trading is a zero-sum game, something you teach your children to avoid.
Things in the bond market were not always so bad; Robert Morris, Jr. was a genius for devising this market in 1784. But the equity market was then not so well developed, life expectancies were shorter, and inflation was not guaranteed by the Federal Reserve. The income tax had not been invented. It was possible to enjoy the promised benefits of lending in those days, for decades or even lifetimes. It was much harder to find investments of superior performance, without getting involved in business management. Meanwhile, the bond market just got huger and huger. Modifying or dismantling it in logical ways would have enormous disruptive effects. So enormous, we have just adopted the stance of kicking the can down the road.
Are we waiting for the bond market, the bond vigilantes, or speculators to find some vital vulnerable flaw, and topple it all into the ashcan of history? Or is there some better plan that no one has mentioned?
http://www.philadelphia-reflections.com/blog/2195.htm
Bank Accounting Off the Books
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| Banking |
Banks have long operated in a dual system of regulation, state and federal, which permits some shifting back and forth between regulators. Mergers sometimes confuse matters further, and a system of one-bank holding companies adds to the stew. Local banks, waving the red shirt of domination by Wall Street at their state legislatures, have resisted interstate banking in a wide variety of ways. Sometimes a customer finds that funds transfer between two branches of the same bank must be treated as out-of-state action, and so on. Inevitably there is a certain amount of dealing by subsidiaries which is not recorded on the books of the home bank of a bank conglomerate in ways prescribed by the subsidiary's regulator, or not recorded at all. Equally inevitable is the accusation of off-the-books illegality by competitors, politicians, or the merely captious. Fine points of these legal and accounting arguments must be left to experts, peer review, and courts. Muttering Enron at every opportunity, accusers may be right that some of these arrangements have stepped over the line; partisans in Congress and the legislatures on the other hand may be correct that existing law is bad law. This is not a good place to debate either point.
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| Credit Crunch |
It does seem appropriate to notice that banking has long been massively inefficient, and that much of this inefficiency has been imposed by regulators. Regulators represent the public, more or less, and the public is rightly nervous about stweardship of its assets. Dual regulation offers refuge from the ancient fear of confiscation by the sovereign, and is worth a certain amount of inefficiency if it works. But it does create loopholes, and it does impair transparency. In the case of the credit crunch of 2007, it sequestered bad debt in off-the-books ways, perhaps creating tax avoidance, but mainly creating distrust among counterparties. In those days of awful turmoil, no one knew what was going on, multi-billion dollar losses were being confessed by premier institutions, so transactions were delayed, avoided, or rejected. Transactions with anybody. When the time comes to reconsider regulations, it should be emphasized that by far the most damaging component of the whole mess was lack of transparency. Once more, a massive computer programming effort is entirely capable of restoring transparency to the existing regulatory structure, higglety pigglety though it may be. After we achieve transparency we might consider achieving efficient transparency, and after that perhaps ponder fairness in transparency. When a trader calls another, and asks to buy a zillion shares, the happy recipient of the call likes to glance up at his screen to see what the other fellow is worth, before he shouts, "You got it!"
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| Avoiding Iceberg |
What the Federal Reserve might well call the highest priority calls for respect, as well. Ever since we began the century-long transition from a gold standard for money, there has been concern that the Fed might not be able to determine how much money, or credit, or liguidity -- is actually in existence. We have reached a point in this process where the Fed has largely stopped trying to measure monetary aggregates, and merely adjusts its tools to keep the money supply sailing between the rocks of inflation and recession; if neither rock is in sight, the amount of money is about right. That system has served us for eighteen years, long enough to spark hope that it can be permanent. But when a rocky shore does make an appearance, the Captain of the ship must know how much slack he has, and how reliable his sonar. For huge sums to be obscured within bank subsidiaries or delayed marking to market, is to increase the chance we will run up on the rocks when it might have been avoided. He too needs transparency, but he also needs prompt obedience to his orders. The rest of us passengers are rightly concerned when he appears before Congress and admits he is not sure what the situation is. As long as that is the case, fairness -- and dogma -- be damned.
Taking a step backward, the whole credit crunch has brought to the world's attention that real estate transactions are both immense, and immensely inefficient; a great deal of money is to be made if any step in the chain can be streamlined. Therefore, real estate agents, real estate lawyers, title insurance, surveyors, advertisers, inspectors and everyone else who makes a living from real estate sales -- can expect to be drawn into an annoying process of inspecting the premises, promises, kick-backs, referral fees and marketing costs of a whole expensive process, first blasted open to inspection by implementation defects while computerizing the mortgage step. It appears to be high time for it.
http://www.philadelphia-reflections.com/blog/1391.htm
