No Love for Ben

It was not too long ago that our economy seemed to be at the brink of collapse. Just about a year ago, last March, Bear Stearns was the first to fall. A few short months later, in September, another Wall Street financial titan, Leahman Brothers, crumbled under its own weight. We were at war and we had two Generals, Ben Bernanke and Henry Paulson, and neither disappointed. The U.S. was lucky: with a academic who has an affinity for Depression-era economics (Bernake) and a brilliant Wall Street mind (Paulson), we had a fighting chance. But to my surprise, as soon as things start to calm down, our lawmakers are beginning to seem a bit unappreciative.

Right next to Michael Jackson's picture in the Wall Street Journal this morning was this article (abridged online) detailing Ben Bernanke's contentious hearing in front of Congress Yesterday. The purpose of the hearing was to examine the decisions made during our time of war, with particular attention to the BofA takeover of Merrill. These hearings are missing the big picture, not looking at the cause for instability, but instead trying to answer the thousands of what ifs.

Our economy, at its core, is based on a single concept...confidence. Everything revolves around trust. Trust the dollar I put into a bank today will be there tomorrow, trust that I have the ability to purchase things today because I will have a job tomorrow, trust that if I make a loan to the government they will honor it tomorrow. Even our use of dollars is an inherent trust that our government is supporting our currency as legal tender. Breaking this trust has more dire consequences than any Bernie Madoff, Enron, or a dot-com bubble. Without trust nothing works. As the pillars of the economy started to wobble, and doubt filled the minds of every person around the world, Ben stepped up and reestablished our trust.

It is popular opinion (if not fact) that the major error of fiscal policy during the Great Depression was to allow banks to fail. Possibly the only thing worse than the failure of a financial system is the nationalization of one. The ripple effect that follows the loss of confidence in an economy is an irreversible fear that can bring any country to its knees. One only needs a refresher on any monetary crisis (don't have to go too far into history, just look at Iceland) to see how this break down of trust can destroy an economy. Merrill, and many other banks, were going to fail; the foundation was cracking. Our generals used everything at their disposal to hold it all together. From where I sit today, it looks like the worst is behind us and we should thank Ben for his help.

Instead Democrats feel he was too secretive (must have forgotten to write up enough memos as he was saving the world), Republicans think he has too much power (maybe we should have waited for them to vote on it, that worked really well when the house rejected TARP... 777 drop?). At the end of the day the world was in panic mode, faith in the economy was at one of its lowest levels, and I do not think we made it through by accident.

Ben used his brilliance, and all the leverage he had. He may have used brute force to hold things together, but during a time of war there is a need for action. There were definitely some casualties, but the flag still stands and now the general deserves a medal, or at least a full night's sleep!

The Justice Department and Gay Marriage

If you know me, you would probably never expect me to speak out defending the federal government when it defends itself for discriminating against gays and lesbians, but that's what I'm about to do.

A recent article in the Advocate, a GLBT news magazine criticizes the Justice Department for defending the "Defense of Marriage Act" (DOMA), which defines marriage on the federal level as between a man and a woman. Gay rights activists see this as betrayal. This is overly dramatic, but may just be a good rhetorical tool for calling attention to inequality. Although I would consider myself to be a gay rights activist, too, and I also vehemently oppose the DOMA for some very personal reasons (it's blocking my boyfriend and myself from being able to move to the States, as he can't get a green card for the States yet), this is not really a betrayal.

Activists point out that Obama claimed to be against the DOMA. But this position is reiterated in the brief from the Justice Department. However, whatever Obama would like, it is up to Congress to change the law by passing a bill, which he would then presumably sign into law, overturning the DOMA. In the meantime, it is only natural that the Justice Department would defend the DOMA: that's its job. It's part of the executive, which means it is charged with enforcing laws, not interpreting them or deciding if they are fair or constitutional (that would be the courts' job) or deciding if they should be replaced by other laws or changed in some way (that's the job of the legislature, in this case Congress). Furthermore, it is right that there is currently no federal legal precedent that would in any way suggest that the DOMA is unconstitutional (unfortunately). It is possible that the Supreme Court would simply decide otherwise, but it is unlikely to even hear the case, choosing to leave the can of worms closed. Again, this is a legislative issue, not an executive or even judicial one.

That said, if this is a rhetorical weapon, it may just work. I think Obama will now know we're watching. More importantly: Congress will know this, too. They are the ones that must make the first move. The move would be very controversial, and tantamount to allowing gay marriage throughout the 50 states. Though they would not all have to allow same-sex marriages to be performed in their own states, federal recognition would mean they would all have to recognize marriages performed elsewhere. There are many constituents in conservative states, even ones who vote democratic, who would not be happy about this. It would be a risky move. It is therefore unsurprising that Congress is taking its time.

In the end, of course, I hope they find the courage to do the right thing and get rid of the DOMA, but it's going to be a BIG deal if they do. In the meantime, neither the Department of Justice nor Obama himself have proved themselves to be traitors. If you want to bark up the right tree, call your state senators and representatives and tell them to get on it!

Obama and Iran: The (U.S.) President Has the Right Idea

Street protests have broken out in Iran, at times becoming violent. They will probably get more so, especially if the government decides to crack down on protesters, which it probably will. This has all happened due to the Iranian presidential election, which is believed to have been rigged so that the incumbent, Mahmoud Ahmadinejad, was declared the winner a suspiciously short time after the polls closed.

Ah, a new Iranian revolution? The moment we've been waiting for? Time for America to rush in? Some seem to think so. That would be asinine.

President Obama's current course (he expressed doubts about the election and that he would support free elections in Iran, but stated that it was up to Iranians to decide who would lead Iran) is the right one. What would those who disagree have him do? Speaking out in favor of the opposition would endanger that very opposition by making it look like it was backed by America, something that would not go over well in a country with a fairly high degree of anti-American sentiment (sentiment left over from when the CIA toppled their democratically elected leader and installed a more West-friendly monarch who ruled over the country for decades and bashed any oppositional voices, though his abuses arguably pale in comparison to the current regime's). What's more, it is unlikely the opposition candidate will come to power, and Barack Obama will have to deal with whomever is in power, probably Ahmadinejad. Acting to back the opposition in any way would make relations with him even more difficult.

Buit even leaving all that aside for a moment: what practical choice does he have? Since no words, whether harsh or soothing, will change the course of events in Iran, the only option would be some sort of intervention. Does anyone really think the U.S. is in a position to intervene in a country several times the size of Iraq that cannot in any way be conceived to wish for this intervention when it is already fighting wars on two fronts and running up a massive bill trying to rescue its own economy from collapse? Not to mention the long-term negative effects yet another Middle East intervention would have on the U.S.'s ability to cooperate with and influence other nations. It would increase anti-Americanism, making any progress in problem areas impossible, and further alienate our allies.

Intervention would be madness, and choosing sides would clearly do more harm than good. Plus, implying support (physically) for a revolution and not being able to back up the promises with actions would endanger the lives of thousands of Iranians if they started a civil war expecting the U.S. to intervene (which is albeit unlikely, since they do not wish to see any U.S. intervention anyway, regardless of what happens).

Given the utter lack of viable alternatives, Obama seems to have chosen the best (or least bad) policy. The greatest thing that Obama has shown since becoming president is not whether he is left or center, but that he is a pragmatist and understands the complexity of the situations that he could so direly influence. For me, at least, this is a relief.

The protests in Iran are heartening because they prove what many have said: Iran is not monolithic, and many of its citizens would like to see bigger reforms and more freedoms. That's a critical first step, but these things have to go inside-out. For now, our focus needs to be on getting Iran to become a better global citizen externally. Easing tensions between Iran, (would-be) Palestine, Israel, and the United States is where we need to focus our attention now. A patient who has no pulse and has broken a leg is best helped by addressing the stopped heart first, we can handle the broken leg later if the patient can be resucitated.

The IMF: learning from its mistakes, or too soft?

The International Monetary Fund has always been subject to criticism for its hard line on desperate countries. It is a fund that was set up at the end of WWII in order to insure monetary stability in North America and Western Europe. It soon took on that role for the rest of the world as well. At first, it was designed to help countries maintain fixed exchange rates by assisting them in handling balance of payments problems. These occur when a country's current (mostly trade, but also things like aid and interest payments on loans and investments) and capital accounts (mostly loans in or out) do not balance. With floating exchange rates, such a "problem" would simply cause the currency to rise or fall to adjust. In the world of fixed exchange rates from the end of WWII to around 1973, this was not possible. The IMF was meant to lend between countries to help them adjust. It's success was limited.

The IMF has arguably been much more successful in its later role as a lender of last, last resort (the lender of last resort is a country's central bank, the IMF then comes when the country itself needs help). When a country gets into a nasty crisis, generally because of too much debt, so that the country is be unable to pay the interest on debt from foreign creditors, the IMF loans the country money at a discounted rate to help it out of the crisis.

This aid is not without cost, however. There are strings attached: the countries must balance their budgets and pay down debt by cutting spending and raising taxes. They must also fix the imbalances (usually current account deficits, mostly made up of trade deficits) that led to the crisis by lowering wages and prices to make their goods more competitive and to curb demand. The name for this is retrenchment, and it means a lot of suffering for everyone in the economy, but is a necessary move to make the country run better and make it sustainable. It is the only way the IMF could be (fairly) certain it gets its money back.

The other good reason to be tough: it discourages lax behavior in the first place by making sure no one turns to the IMF unless absolutely necessary. Governments do everything else in their power first. Otherwise, governments might run bad policies and then just wait to be bailed out.

Or so the theory.

The Asian debt crisis of 1997-98 changed the perspective for many. The Asian governments generally did not have terribly high debt. Their countries were suffering from a different kind of crisis, much like the one the rich world (and now everyone else) is suffering from now. The answer should have been more government spending to boost flagging demand, not less. The argument is that the austerity measures forced by the IMF actually made the recessions in Asia much more severe than they had to be.

The IMF learned from this. It is now lending almost no-strings-attached to a number of weaker countries hit by the current economic crisis. Is this a rational response to a crisis where boosting demand could help bridge the recession? Or is this niceness coming at the risk of being too soft, causing countries to become too reliant on the IMF in the future?

The new, friendly IMF is probably only a temporary response to the current crisis. But even if it isn't, the old criticisms of the IMF were valid. The prescription of currency devaluation, tax hikes, spending cuts, privatization, and deregulation is not always the best answer. For governments who get themselves into a mess via their own profligacy, though, it really is. I would hope the IMF remains tough on them in the future. Most of the Asian countries, however, were not profligate, but rather suffered from currency speculation and a rather heavy indebtedness of the private sector, not the government (largely due to financial market deregulation at the behest of Washington-based organizations like the IMF!). Had their currencies been free-floating (as they are now), this likely would not have happened (the currency speculation would not have occurred and there probably would have been less borrowing in foreign currencies with the expectation that the fixed exchange rate would hold).

Hopefully, the new IMF is one that differentiates, rather than having a standard set of one-size-fits-all prescriptions that obviously don't fit all. One thing this crisis has shown: the world still needs the IMF, and it still has a critical role to play in world financial stability. Previously, the IMF's nastiness almost did it in, as countries wouldn't turn to the IMF no matter what, and countries like China contemplated making their own pooled funds as an alternative to the IMF's (western/U.S. dominated) meanness. Let's hope it contributes to stability and doesn't encourage profligacy, and that it remains the only lender of last-last resort. A competition among lenders could lead to destabilization as they all get friendlier. It would also be a waste of money, hording cash with IMF-like funds around the world rather than using that cash for something else. As is so often the case, it's all about balance.

The Green Economic Revolution: Will it Destroy Our Economy?

By Charles Kirchofer, April 4th, 2009

Barack Obama and other world leaders have been talking a lot about a sort of green industrial revolution. The hope is that this will create new, high tech jobs, reduce the US and other western countries' dependence on foreign oil and energy supplies, and, of course, help the environment by curbing greenhouse gas emissions, along with other environmental benefits. These benefits, it is hoped, will outweigh the costs. Sure, some jobs will be destroyed by higher energy prices and/or taxes, but these will be replaced by a plethora of jobs in green energy and in other areas that benefit from the technology developed in the green energy sector. The reductions in greenhouse gas emissions will benefit the world by saving it money on things like building dikes and levees and transporting water to newly dried out regions, not to mention the benefits received by the world's poorest, who will all too often be unlikely to implement such measures to protect themselves from climate change. The benefits to security and political stability are clear: the US will enjoy greater security and independence, fights over oil will be less likely and will open the door to fair negotiations on peace in the Middle East, or so it is hoped.

But will all that is hoped for really happen? I think this depends more on the way the plans are enacted than on whether they are enacted. There are good ways and bad ways to do just about everything. Unfortunately, from what I've heard so far, Congress is looking to do it the bad way, although there is hope that a more pragmatic Obama may lead them to better decisions.

Cap and trade: Why it's a good idea
An externality is something a company produces that it cannot charge for (or is not charged for). They can be positive or negative. For example, an externality of Coca-Cola advertising for its products is that some people might to be enticed to buy cola in general, but not necessarily Coke. In this way, Coke's advertising provides a service for all cola producers that they don't have to pay for - a positive externality. Pollution is a perfect example of a negative externality. Companies (and people) produce it, and the cost is spread around to everyone. Negative externalities are examples of market failures, areas where the market does not provide the best result for everyone. In these situations, government must step in. No one would argue that the government should let companies dump toxic chemicals into our water supplies, etc. All right, but the way government steps in is perhaps more important than whether it does.

CO₂ production is a perfect example. It costs everyone, but the costs are not immediate and are not felt by its producers. There are two ways to make the costs more immediate: a carbon tax and a cap-and-trade system. Though it is more complicated, I prefer a cap-and-trade system because it encourages carbon emitters to either reduce or balance their emissions, both of which can be beneficial. With a carbon tax, this flexibility does not exist. The great thing about the balancing is that companies would then have an incentive, for instance, to buy up plots of rainforest and protect them. This is a double-edged sword of adding value to rainforests and natural lands (which are valuable, but their monetary value is generally underpriced) and increasing the immediate costs of releasing carbon. The flexibility would also allow companies to decide themselves the best way to invest money: buy more carbon credits, reduce carbon emission by increasing efficiency or changing energy supplies, or acquiring more credits through the purchase and maintenance of natural areas, which would allow them to "grow" their own carbon credits. In the future, some companies might exist only on the basis of "producing" carbon credits through conservation. The number of credits in the system would be reduced each year in such a way that the price of carbon rises at a somewhat faster rate than inflation, but not so fast that it kills industry.

Cap and trade: Difficulties
Cap and trade is not without its political difficulties. Aside from cost concerns (which can be continually adjusted, by the way), senators from states that rely heavily on coal and other carbon-intensive industries don't like the idea. Cap and trade would hurt their states more than others. This is where the inefficient politics of earmarks comes in. It might be necessary to divert some of the proceeds from the cap-and-trade system back to the very states that pay most in the form of subsidies. This is perhaps not such a bad idea as long as the subsidies aren't flowing back into the very industries that are paying most. That would obviously be pointless. Instead, the money should be used to help states adapt. Besides, it is still unlikely that the demand for coal is just going to disappear - the carbon credits should not be so extreme. They should encourage a sustainable shift to greener methods. After all, we can't move away from coal if we have nowhere to move to. Coal will be made more expensive, but consumers will still pay for it until other possibilities arise. But those subsidies might help to make the shift for workers in those states affected easier.

This would still be OK. It is my feeling, however, that that should be the end of the subsidies. Once the market failure of negative carbon emission externalities is removed by the cap-and-trade plan, private investment will be able to provide the green solutions we need (after all, "necessity is the mother of invention"). I simply do not believe the government is good at picking the winning technologies. I also think private funds, not public ones, should be risked on the project. Big investments in infrastructure (like direct current transmission wires), due to their massive scope and scale, are an exception, as such a project can only succeed with government assistance. This doesn't mean that the government shouldn't help green technologies in other ways, for example by creating legislation conducive to the types of development needed (making it easier to get permits for windfarms and to use government land for them, for example). This way, the private sector can be steered to produce the technologies we desire, but will be encouraged to find the most efficient and cost effective technologies. This is something that happens less often when politicians, wedded to specific ideas and special interests, get involved. When a politician hears about something and turns it into a pet project, he or she is much less likely to abandon that project when it becomes apparent that it is destined to fail. CEOs are less sentimental.

Although Barack Obama might agree with the above plan (although he also plans to spend a lot more on subsidies than I would like), Congress looks set to mire the entire project in earmarks and subsidies that would drive up the cost of curbing emissions dramatically. In the end, such acts could end up getting repealed as their costs are seen. That would give green ideas in general a bad name, and that would be a real shame.

Oh yeah, and it's also time to divert agricultural subsidies into this project. They are not needed and they are hurting the poorest in developing countries. Agricultural subsidies currently cost more than a solar "Grand Plan" would cost. They are politically popular, but hurt many and are a total waste of money and a misallocation of resources. Get rid of them!

Detecting and Controlling Housing Bubbles

By Charles Kirchofer, Feb. 20^th, 2009

I had originally intended to devote this post to an idea of how to control housing booms and target specifically asset prices that are rising in an economy as an alternative to the blunt (and at times ineffective) tool of interest rate increases. However, upon researching the matter further, I discovered the mere detection of a housing bubble is more difficult than I'd originally thought. Everyone knows that bubbles very often remain unidentified until after they burst. There are always some people shouting warnings, but they are often the ones who had said it would happen every year - when it didn't. All too often, the investment and regulatory communities stop listening to the investor who cried "bubble!"

But then I thought, "geez, I knew it was a bubble... I think." Indeed, Alan Greenspan had even suggested that we might be looking at a bubble. The amount this concerned him was, we know now, not enough to mobilize him to avert a crisis. It's clear that he did not see the true nature of what was coming. Of course, the housing bubble was not the only cause of our current woes, but it was a main contributor to the intermediate causes, or so it would seem (to read more about other intermediate causes, as well as the deep cause, check out our other posts (some of them coming later as Mr. Mohr joins and moves his posts to this blog from my old geocities website). So why didn't regulators step in? Surely a bubble bursting with kind of pow must have been foreseeable?

So I started doing some research. This is what I found:

Sale Price of New US Homes		House price	Boom gain/			Ratio Houses
Year (Dec)	Median Price	inflation	Bust loss	CPI inflation	Boom CPI	to CPI boom
1980	$67,000.00	8.9%		13.52%
1981	$68,400.00	2.1%		10.38%
1982	$71,700.00	4.8%		6.13%
1983	$75,900.00	5.9%		3.21%
1984	$78,300.00	3.2%		4.32%
1985	$87,900.00	12.3%		3.56%
1986	$95,000.00	8.1%		1.86%
1987	$111,800.00	17.7%		3.65%
1988	$121,000.00	8.2%		4.14%
1989	$125,200.00	3.5%		4.82%
1990	$127,000.00	1.4%	189.6%	5.40%	4.72%	4 to 1
1991	$122,000.00	-3.9%		4.21%
1992	$126,000.00	3.3%		3.01%
1993	$125,000.00	-0.8%		2.99%
1994	$135,000.00	8.0%		2.56%
1995	$138,600.00	2.7%		2.83%
1996	$144,900.00	4.5%		2.95%
1997	$145,900.00	0.7%		2.29%
1998	$152,500.00	4.5%		1.56%
1999	$164,800.00	8.1%		2.21%
2000	$162,000.00	-1.7%		3.36%
2001	$180,200.00	11.2%		2.85%
2002	$197,600.00	9.7%	58.1%	1.58%	2.46%	2.6 to 1
2003	$196,000.00	-0.8%		2.28%
2004	$229,600.00	17.1%		2.66%
2005	$238,600.00	3.9%		3.39%
2006	$244,700.00	2.6%	24.8%	3.23%	3.09%	2.7 to 1
2007	$227,700.00	-6.9%		2.85%
2008	$206,500.00	-9.3%	-15.6%	3.84%
Sources:	http://www.census.gov/const/uspricemon.pdf
	http://www.measuringworth.com/calculators/inflation

OK, I know it's a lot of information, so I'll break it down now. Notice the column boom gain/bust loss. The inflation of house prices is staggering, especially when compared to consumer price inflation in the next column. What's even more noticeable is the growth during the boom of the 80s. During the 80s house prices rose by over 189% compared to a rise of just 47.2% in consumer prices in the same period. That's a ratio of more than 4 to 1! This of course ended in the Saving and Loan Crisis of the late 80s and early 90s. As a result, house prices remained stagnant in the early 90s, during which the U.S. also found itself in a recession. By 1993, however, things had recovered. Soon the recession was forgotten. There were small dips in house prices due to the 2000 dotcom crash and the 2002 recession in the wake of the September 11th attacks on the World Trade Center in New York. Otherwise, things were all up hill. Please note that I count the overall rise in house prices only during the boom years. The early 90s, therefore, have been left out. During the 2000 boom years, house prices grew, on average, around 2.6 times as fast as consumer prices. That's quick, but nothing like the rates seen in the '80s. After the brief dip in house prices after the 2002 recession, house prices began to rise yet again. We can see from the ratio, however, that they rose little faster than they did in the 1990s.

Looking at it this way, it is not surprising that many did not realize there was a housing bubble. What you may also notice, however, is that there are very few real "busts." I would hardly call one year where house prices fell only mildly a bust. You'll notice that from 1980 to 2006, house prices never fell for more than one year, and their largest fall in one year (December to December anyway) was 3.9%. It may therefore be more accurate to look at the whole situation from the late 1970s until 2006 as one long, nearly continuous housing boom interrupted by a few short breathers, most notably in the early '90s.

Also of note is the steady fall in household saving rates (not in the table). These peaked in 1981 at somewhere around 12% and fell steadily through 2005, when they even became negative. For comparison, the rate in the 50s and 60s was around 7.5%.

So what's to make of all this? I have already alluded to my opinion (which isn't really anything new): We've witnessed one long, credit-fueled housing boom from the late 1970s until 2006. So what does this mean for regulatory policy?

It means the Federal Reserve and other regulators may have to start reacting to things other than inflation. Looking at the data, however, it's easy to see why they didn't realize this. The "end" of the 80s housing boom resulted in a couple years of housing market stagnation and relatively mild recession. The U.S. economy got through it with little difficulty. The same is even more true of the dotcom crash and the 2002 recession. After all, if the U.S. economy could snap right back into growth again after terrorist attacks on one of its largest financial centers and keep growing right through a war with rising oil prices, they must be doing something right.

So what should regulators react to and how? They should react to a whole myriad of things the Fed has been tracking all along (but not necessarily regulating) in addition to consumer price inflation; like house price inflation, household saving rates, and mortgage down payment requirements. I think the Fed might want to use interest rates to influence saving rates in the future. Saving rates as high as those in the early 80s, when combined with low inflation (unlike the early 80s), may be too high. Conversely, saving rates below 5%, even when inflation is low, might signal problems on the horizon. Much was said in this direction during the '90s and 2000s, but no one reacted because of uncertainty about just what the figures meant. I think now it would be reasonable for the Fed to raise interest rates during times of low inflation (and even fairly slow economic growth) to increase household saving rates if necessary to stop a credit-fueled rise in house prices or even stocks or other investments not counted in the consumer price index (a common measure of inflation). This goes along with my article on global imbalances in saving and borrowing, half of which begins at home (the borrowing part).

The other thing the regulators ought to look at is house price inflation. We've seen that house prices can inflate for decades without causing problems (at least right away). I postulate that house price inflation, despite relatively low consumer price inflation, coupled with declining household savings (certainly becoming critical when they drop below 3 to 5%) is a toxic mix to be steered against. For this (and for other types pf asset price inflation), I would recommend a more precise attack, possibly in addition to higher interest rates, to spur household saving. One possibility would be increased down payment requirements. Down payments averaged over 31% of the price of a home in 1982. From there they dropped steadily until reaching a low of 19.2% in 1994, a level that was again approached in 2007.

But it is perhaps not the average rate that is of greatest concern. So far house prices have not fallen so far that they've caused negative equity on the average. In spite of that, negative equity is occurring with alarming frequency, even if not to the "average" mortgage. Mortgages with no money down are a bad idea, particularly when the toxic mixture I mention above is present. In times when the conditions above are present, I would recommend setting down payment requirements up to as much as 20-30% for all mortgages, not just the average mortgage (and no exceptions or loopholes, which was the main problem recently, not that banks suddenly thought mortgages with no money down were necessarily good). This would serve to slow the inflation of the bubble, as houses become somewhat more difficult to buy. This reduces the incentive for speculation with real estate as well, another cause of many of the headaches. Finally, it would cushion the bursting of any bubble that managed to form by ensuring that any mortgages made are placed on a sound footing and that negative equity is avoided, thereby not providing an incentive for homeowners to just walk away. Of course, as I've mentioned in previous articles, teaser rates and the like should be outlawed (see Mr. Mohr's article on teaser rates for more information (move from old site pending)).

This outline is vague. I also am well aware that over-regulating the market could strangle it, preventing American families that otherwise might be able to buy a home from having one. That would certainly be unfortunate. As I'm not an expert on public economic policy details, I leave this to the experts to hopefully find the right balance. One thing is clear, however, the current balance isn't right.

How same-sex marriage destroys opposite-sex marriage, and what we can do about it.

By Charles P. Kirchofer, Oct. 29^th, 2008

The religious right is always telling us that same-sex marriage destroys marriage for everyone else. I just couldn't wrap my head around that, but today I figured it out. The religious right has simply had problems with the word "destroy." The following are a series of questions and answers that lead me to the correct definition of destroy that the religious right must be using. I then offer a solution as a sort of compromise.

Does the marriage of a same-sex couple cause your marriage no longer to be recognized by the state? No.
Does the marriage of a same-sex couple cause your marriage no longer to be recognized by god? No.
Hmm, still seems fairly undestroyed. Maybe it's the "fabric of the American family" itself that is somehow damaged.

Does same-sex marriage make you more likely to divorce your husband or wife? No, unless you're gay too, I would imagine, but then we need to be having a different conversation.
Does same-sex marriage make you beat your kids? No, I don't see a connection there. If same-sex marriage has led you to beat your children, please feel free to describe the incidents in the comments section and explain what led you to the beatings. Please don't forget to include your real name and home address (note, comment postings are not made in confidence).
Does same sex marriage make you love your own family less? I assume not.

Hmm, that must not be what they're talking about either. If you went to court and told the judge your neighbor destroyed something of yours, you'd have to show that it was indeed destroyed and if and how your neighbor did it. Let's try an example that will get us closer.

Plaintiff: Your honor, my neighbor destroyed my car.
Judge: The evidence I have here shows your car looks to be in mint condition. Is it in some way damaged?
Plaintiff: Yes!
Judge: ...how? Does it no longer run?
Plaintiff: No, it still runs.
Judge: Then what is the nature of the damage?
Plaintiff: Yeah, it's destroyed, the car is worthless!
Judge: Why is the car worthless? It looks fine and still drives. I fail to see the problem. How did the defendant destroy or damage your car? What exactly is it that the defendant has done?
Plaintiff: He bought one just like it, your honor.

Sound familiar?

I remember that when Cabbage Patch dolls were first introduced, they were extremely valuable, because they were rare. The destruction unleashed upon heterosexual marriage must therefore be a reduction in its exclusivity! That means the rarer marriage is, the more it's worth! Marriage is a commodity for the religious right, and the religious right is a cartel! Now I understand.

So what can we do to solve this? I propose we make an exchange as a compromise. We allow gays to marry, but provide divorce lawyers free of charge. That way the number of divorces will rise, ensuring that marriages remain as valuable a commodity as the religious right would like them to be. Then they can continue life with the knowledge that they belong to an exclusive club of owners of a rare good: marriage. That must be why divorce rates are so much higher in red states:

Red States			Blue States
State	Divorce Rate		State	Divorce Rate
IA	3,9		MA	2,4
NM	6,0		RI	3,2
OH*	4,5		VT	4,0
NV	9,0		NY	3,3
FL*	5,9		MD	3,5
CO	5,1		HI	4,2
MO	4,9		IL	3,7
VA	4,6		CT	2,8
WV	5,0		CA	4,3
AR	7,1		ME	4,4
AZ	5,8		DE	4,8
NC	5,1		NJ	3,0
TN	6,6		WA	5,6
LA	3,6		OR	5,3
SC	4,2		MN	3,6
GA	5,2		MI	4,1
KY	5,8		PA	3,3
MS	5,7		NH	4,4
MT	4,9		WI	3,4
IN	6,4		Mean	3,86
SD	4,2
TX	5,4		w/o OH, FL, PA, NV
AL	6,2		Red mean	5,3
KS	4,7		Blue mean	3,89
ND	3,4
AK	5,5
OK	6,7
NE	4,0
ID	6,2
WY	6,5
UT	4,7
Mean	5,4

Sources: http://www.divorcereform.org/94staterates.html
and http://electoral-vote.com/evp2006/Info/red-blue.html

Notice also the results when I removed the swing states (Ohio, Florida, and Pennsylvania) and Nevada (with the volume of weddings in Las Vegas, it would be unfair to include Nevada (divorce rate 9.0) in the mean). The result: the red states still have a significantly higher rate of divorces. I guess the religious right's plan for marriage exclusivity is well under way!

George Bush, India, and Crumbling Nuclear Non-Proliferation: What China's Deal with Pakistan Teaches Us

By Charles Kirchofer, Nov. 3^rd, 2008

China has recently planned a deal with Pakistan to sell it two nuclear reactors (article). This was in some ways a predictable outcome because of George Bush's previous deal with India, allowing India to benefit from sharing nuclear technology without the restrictions of the nuclear Non-Proliferation Treaty (NPT). This foolish move has completely destabilized the treaty and reduced the hopes the world has of maintaining a nuclear peace.

China technically is not allowed to sell reactors or any other nuclear technology to Pakistan as a signatory of the NPT. Parties to the treaty agree not to spread atomic weapons to any other countries or even share any technology related to atomic weapons. They are also forbidden from selling or sharing any information about any nuclear technology to any country outside of the treaty (e.g. Pakistan). At the moment, there are five powers officially permitted to possess nuclear weapons: The United States, Great Britain, France, Russia, and the People's Republic of China (the five permanent members of the UN Security Council). There are also four countries that are not part of the treaty: Israel, Pakistan, India, and North Korea. North Korea was originally part of the treaty, violated it, and has now withdrawn. Israel, Pakistan, and India have each developed nuclear programs and have remained unpunished (and unencouraged, theoretically at least) as they did not sign the treaty and were therefore not obliged to abide by it. Recent moves by the Bush administration and the Chinese government are cracking the already weak foundation of the treaty and making the world a considerably more dangerous place.

The first blow from the sledgehammer
In 2005, U.S. President George W. Bush made a deal with the Indian government to exempt India from the restrictions of the non-proliferation treaty. But why? Bush had a few reasons, the most important probably that India is the world's largest democracy, and could perhaps in the long run provide a counterweight to a rising, fairly cooperative, but authoritarian, China. The fact that no liberal democracy has yet waged war against another liberal democracy probably factored into the logic: if nuclear power is going to be in someone's hands, why not in India's? The idea was also that the NPT was bound to fail eventually anyway, especially as nuclear power becomes more popular in light of increased energy needs and scarcer energy resources. The argument that this was just another capitalist deal in the interests of big business doesn't hold water: a U.S. company hasn't built a nuclear reactor in several decades. The nuclear experts these days are the French, among others. No, Bush did this for balance-of-power reasons and out of the belief in the inherent peacefulness of democracies.

These reasons do have their merits. India generally seems to be a country that is responsible with its nuclear weapons. It does, however, have conflicts with Pakistan. These have come to a nuclear stalemate, much in the way the U.S. and Russia both restrained themselves during the Cold War. But there are other reasons, whether India is good-natured or not, to be concerned. The NPT, like all of international law, requires a consensus to maintain it. Bush's actions have undermined the treaty by showing the United States (probably the most important member as a role model) is not completely serious about non-proliferation, and that it is willing to play favorites when it sees that as in its best interests. This gives other states a reason to make exceptions for deals they see in their own interests as well. The first state was China; more may follow. Once deals are made, they're hard to turn back. Unfortunately for the world, treaties are easily destroyed by exceptions. I plead to the next President to think carefully about non-proliferation and act quickly. The treaty may be far from perfect, but it's the best thing we have to prevent a nuclear war. China's deal with Pakistan has shown that Bush has indeed set the ball rolling. It is up to the next president to stop it.

How Structural Realism Shows America Needs a More Liberal, Multilateral Approach to Foreign Policy

By Charles Kirchofer, Dec. 17^th, 2008

I actually should be finishing work on part two of my series (if you can call something that when it only has one part) on the big issues for Barack Obama in foreign policy. Or I could work on my planned article on why the stock market is not a casino, even now. Instead, I want to take a few moments to do something unorthodox. If you were thrown off by the title of this article (thinking "what the f$!k is 'structural realism'?!"), have no fear: I'm not about to get all theoretical on you. What I will say, however, is this: there are two major schools of thought on international politics (and maybe a third or possibly fourth, depending whom you ask). These are realism and liberalism. Realists believe nation states are the central players on the international scene and that these states live in a competitive environment. Liberals believe the world is becoming ever more integrated, that NGOs, international organizations, and transnational corporations have seriously reduced the influence of nation states on world affairs, and that there is something called the "international community," whose desires may be universal and are to be put above national interests. OK, that's it for the theory. Here's the unorthodox part: rubbish, I say. I'm about to argue for a more liberal American approach to foreign policy for realist reasons. That's right: the two terms are a false dichotomy, which is why I say they're both right and therefore both wrong, which means we are free to combine reasoning from both "schools" as they fit.


The realist foundation
OK, maybe there's going to be more theory than I promised, but stay with me. Structural realism holds that the number of great powers in the world (called "poles") decide the system's structure, which, in turn, influences outcomes. For example: the world before 1945 was multipolar, with most of the great powers right next to each other in Europe. Because the competitors were next to each other and relied on each other for resources because they were all relatively small, it was very unlikely that there would be any lasting European cooperation. Indeed, though they tried, this was the case. After 1945 the world became bipolar, with the U.S. and the U.S.S.R. as the great powers. Now, with none of the great powers in Western Europe, the countries there were no longer in a position where they had to compete with each other. Cooperation was then possible. The result? The European Community and later the EU, complete with a shared currency. Liberals would say the Europeans just finally learned their lesson and learned to cooperate, but everyone thought that in the late 19th century and after WWI, too. Do ideas and public opinion matter? Sure, but I think this structural explanation explains the timing better and is the more likely underlying enabler (combined with factors the liberals point out).


Nice history lesson, so what's this have to do with anything?
Good question. The world today is no longer bipolar, it's become unipolar, or possibly multipolar. Militarily, at least, the world is definitely unipolar, with America the military superpower (it's military spending is more than the spending of the next five top military spenders combined). Good for the U.S., right? Well, not really. Realists predict that states always move toward balancing power. This would mean essentially everyone else would align against, or at the very least refuse to cooperate with, the United States. European countries may not have agreed with the Vietnam war, either, and yet cooperation remained high because the system was bipolar. It was the U.S. or the U.S.S.R. Faced with that decision, they largely stuck with the U.S. Diplomats will tell you cooperation has become more difficult. Realists would argue this process was set in motion after the fall of the Soviet Union (meaning the tendency would be present even without the Iraq war).

That said, I think we can agree the Iraq war certainly helped to ally states against the U.S. This is bad news. The U.S. was used to playing the world police force during the Cold War. It was indirectly encouraged to do so by the presence of the other pole (the U.S.S.R.), and it was also constricted by the Soviet presence, which checked U.S. power. In the 90's, the U.S. suddenly saw itself changed from a superpower to what some called a "hyperpower." With all this power sitting around, some felt it was time to use it to change the world according to their own standards, just as realists would have predicted (because there was no longer any check on American power), which is not to say they all necessarily would have recommended it (indeed, many realists spoke out against the war as being unnecessary and too risky). Hence: the Iraq War.

What does this mean for us now? Regardless of whether the world is (still) unipolar or if it has become multipolar, cooperation is likely to become more difficult. My conclusion? Start thinking like liberals. Start welcoming cooperation, rely more on "soft power" ("winning over the hearts and minds" of the world, making them want to be more like us and want to cooperate with us), encourage reform in, and support the workings of, international organizations (particularly the UN and NATO). As I've mentioned before, it's time to dust off the old-time art of diplomacy, because coercion is simply going to meet with ever more resistance and become ever more counterproductive for global and U.S. aims.

In the end, the realists accurately describe how the world works, but the liberals accurately prescribe what we should do in the current environment. So we should speak softly and be more friendly, everyone already knows we're carrying a big stick (and the realist in me would advise keeping it).

Japan's Economy Is Cruising Downhill as Fast as Any Other Developed Economy, So Why Is the Yen Skyrocketing?

By Charles Kirchofer, Feb. 15^th, 2009

Some surprising things have happened as a result of the credit and economic crises. A steadily weakening dollar, which seemed set to keep on weakening as the world began to diversify away from it, suddenly became stronger. The euro held its own in the storm, proving it was indeed a safe haven for its member states, but at the same time it proved that it was not ready to take over the dollar's role as the reserve currency (investors preferred dollars to euros when in doubt). No surprise, on the other hand, was the pound: as the City's over-leveraged banks went south, so too did their over-valued currency. In Japan, a country whose banks were not heavily involved in shady investments, a rise in the yen seems unsurprising. The fact that the yen continues to rise rapidly even as Japan looks set to contract more quickly than any other developed country outside the UK tells us there may be more to the story.

The answer, though, is relatively simple when we look a bit deeper. As illustrated in The Economist, the big thing in the 2000s has been a yen carry trade. Investors borrowed money in yen at incredibly low interest rates and used this money to buy other currencies that would give them higher returns. This means yen were being sold more than bought, pushing the exchange rate down. Japanese households did similar things, buying into investments abroad (selling yen).

We're looking at yet another economic snowball effect. Investors could only make money on the carry trade deal as long as the yen stayed low. If it began to rise, the amount of debt they would have to pay back denominated in other currencies would increase, making their investment not worth it. For example: say you borrowed ¥10,000 and bought $100 with it at an exchange rate of ¥100 per $1. The interest on your loan in yen was 1.5%. You only had to beat that rate on an investment somewhere else to make a profit with easy money, easy to do in the bubbly 2000s. But now let's say the yen starts rising. The exchange rate climbs to around what it is now: ¥90 per $1. Your debt, without counting the interest charges, has gone from $100 to $111, an increase of around 11%! Add in the interest you'd have to pay and it becomes nearly impossible to pay back the loan with investment.

So what's the answer? At the first sign the yen might be revaluing, investors sold their investments in other currencies and bought yen to pay off their debts before they became unpayable (the smart ones and the ones that hadn't already lost too much to pay back, that is). In addition, no one borrowed yen to make a carry trade anymore. The result: more yen being bought than sold, resulting in a rise in the price of yen compared with other currencies.

So what's the solution? Unfortunately for Japan, there doesn't appear to be an easy one. Tim Geithner of the U.S. Treasury would be quite displeased if Japan were to try to intervene to weaken its currency, as the dollar is quite strong at the moment as well. Strong currencies mean uncompetitive exports and often larger current account and trade deficits. It is also likely that most of the other large economies, like China and the EU, would be unhappy to see Japan devaluing its currency to help its exporters when their exporters are suffering, too. It would also be difficult for the Japanese government to intervene on its own. It would likely need other governments to help sell yen to reduce its value enough to please Japanese exporters, and this would not be in other countries' best interest as it would hurt their own exporters. Looks like Japan's in a pretty pickle. Again.

The Conundrum of Global Saving/Spending Imbalances: Why It's so Hard to Stop the Flood

By Charles Kirchofer, Jan. 29^th, 2009

In the realm of international relations, analysts often look at events on three levels: deep causes, intermediate causes, and precipitating causes. The deep causes are often systemic effects, like the structure of the international system (i.e. anarchic, with x number of great powers... it doesn't matter though, just keep reading). The intermediate causes are often related to policies of countries and alliances they form. The precipitating cause is generally just one event. I'd like to spend a little time today talking about the deep causes of the current financial and economic crisis. First, let me just mention what some of the individual causes were.

The precipitating cause was, of course, the bursting of the housing bubble. The intermediate causes were many and varied. They mostly relate to policy and regulatory decisions. Mr. Mohr and I have spent most of our time talking about those, so if you'd like to know more, just check out nearly the all the articles we've written on the subject of the financial crisis on the economics page (www.therealissues.net). The cause I'm going to talk about today is the deep one. It is particularly problematic because it is global and very hard to control. I'm talking, as the title suggests, about global imbalances in spending and saving (i.e. global differences in current account surpluses and deficits, which can also roughly be related to global trade surpluses and deficits).

Everyone knows the United States is the world's largest debtor. This is partly because of its size, however. To put things into perspective, household debt in the U.K. is actually higher than in the U.S., and the U.S. is by far not the most indebted country in terms of debt in proportion to GDP. (It makes sense to look at debt as a proportion of GDP because $100,000 of debt a lot for a person earning $20,000 a year, but chicken feed for a millionaire. The United States, luckily, fits into the latter category). Nonetheless, the fact that American households' saving rate has been negative (the average household has been borrowing more than saving in the past couple years) is obviously problematic.

The usual solution to too little saving is to raise interest rates. Higher interest rates mean it costs more to borrow money and you get a higher return when you save, thus encouraging saving and discouraging borrowing. But household saving rates are not the primary interest of central banks. In the past, households spending more than they were earning translated into inflation. Central banks are charged with price stability (controlling inflation), and the U.S. Fed is also charged with promoting growth. This time around all that borrowing didn't result in inflation (at least of the kind the Fed was concerned about, namely asset inflation (like stocks and housing), it was probably a mistake not be concerned with these features). This left central bankers scratching their heads wondering what to do, and if they needed to do anything at all.

The answer, as we now know, was: yes, you probably needed to do something. But this wasn't completely clear.

Would raising interest rates have helped? It probably would have at least mitigated the effects of some of the intermediate causes. Higher interest rates earlier may have slowed the inflation of the housing bubble and made its bursting much less dramatic. In addition, higher interest rates mean a higher return on money saved in bank accounts or government bonds, and lower returns for investments in stocks, commodities, and real estate. There are certainly indications that this would have been a good thing. As I've explained in past articles, however, the Federal Reserve tended not to bother with asset price inflation, concentrating only on inflation of other consumer goods. As I've also said before, I think this was a mistake (as it also is to leave real estate prices out of the core inflation rate).

Of course it's not that simple. Low interest rates meant people were encouraged to spend money rather than save it. Most of the money that was coming in was coming from outside the United States, since people inside were saving less than borrowing. The problem with raising interest rates is that it could even make that particular problem worse. Getting a higher return on savings in the United States might have encouraged more capital inflows from abroad. In addition, it could have further strengthened the dollar, encouraging America to import even more, and hurting American exports further. This could actually exacerbate the current account problem, making the deficit larger. One way it might work in reverse is with energy. A stronger dollar means imported oil would get cheaper. Cheaper oil would make a smaller contribution to the trade deficit. Normally, however, a central bank might seek to weaken a currency if it wanted to reduce imports. But the way to weaken a currency is by cutting interest rates, which would potentially have been even more disastrous. Left with this conundrum, it was difficult to say what direction the rate setters should take.

In addition, there's evidence that suggests that the Fed no longer has complete control over interest rates in America. As the Fed raised rates in 2004, Alan Greenspan noticed that long term rates actually fell. This may be because investors from China continue to want to offload money into the United States and continue to offer cheap loans, regardless of what the Fed does (and how low the return on the investment becomes).

Why would China want to send so much money to the United States even though interest rates were so low? This held the Chinese currency, the yuan, lower and boosted Chinese exports. In addition, it made China stable. Investors are less afraid to give someone money if the person (or in this case, country) has a lot of money. The likelihood of the Chinese Yuan collapsing was extremely slim, making China much safer than other comparable developing countries.

For a while, however, it looked like rebalancing might be beginning. The dollar was sliding and the yuan revaluing. U.S. exports were booming and holding the U.S. economy above water. Then came the financial storm of October. After Lehman Brothers collapsed, capital from all over the world fled from the smaller currencies to the world's reserve currency, even though the crisis was most acute in America and America was the world's biggest debtor. The unexpected result: the dollar took off and nearly all other currencies lost value against the dollar. That was it for rebalancing and for the U.S. export boom (as an expensive dollar once again made American exports too expensive and imports cheaper). The yuan has also lost value against the dollar, even though it, too, has gained considerably against most other world currencies. The latter part is something congressional leaders should keep in mind when considering any trade tariffs or other protectionist measures.

As I've illustrated, the Fed is faced with an absolute conundrum. Raise interest rates, and the trade deficit and inflows of capital increase, likely increasing America's current account deficit. The incoming money then seeks investments, quite possibly creating bubbles. Lower them, and Americans save less and foreign investments from abroad must seek higher returns (not in bank accounts or bonds), possibly also leading to yet another bubble. What's a Fed Head to do? I hate to say it, but probably much as he has done, hopefully having learned from the mistakes of the past eight years. The Fed should continue to respond to domestic conditions. Right now that means keeping interest rates low and fighting deflation and recession. Soon thereafter, it could mean raising interest rates in response to inflationary fears, but possibly also in response to asset price inflation or too-low household saving rates. The Fed cannot control the U.S.'s current account balance, so it must concentrate on sound policies for the areas it can influence.

And what about the imbalances? Sorry, there's no easy solution. With higher interest rates the inflows might land in bank accounts and bonds, a less dangerous place than stocks and other markets. I suspect that as things right themselves in the financial markets, money will begin moving to smaller currencies again, meaning the dollar will begin to lose value again. A devaluing of the dollar while the Fed raises interest rates to fight all-around inflation would be the perfect scenario, but it is not alone within the Fed's power. Most of the time, such a development would be nearly impossible. It relies on net creditors around the world seeing diminishing returns in America and slowly investing their money somewhere else. Higher interest rates in China with a smaller foreign currency reserve would allow the yuan to revalue. This would make Chinese exports more expensive and increase Chinese imports. This would do a lot to fix global imbalances and increase global stability. China might have to accept lower growth rates, but in return it would gain a larger domestic market and a more balanced (and therefore more stable, in the long run) domestic economy.

It's important to note, of course, that this should all happen gradually. As I illustrated in my article on a dollar rout, a rapid shift of investments away from the U.S. would present a catastrophe of unbelievable proportions for the U.S. and the world.

So it all comes down to the Chinese? Well, to them, the Americans, the Saudis, and all others with massive current account imbalances. As much as everyone else likes to blame the Americans (and let's face it, the intermediate and precipitating causes are to be found in America), the entire world helped make the mess, and the entire world must clean it up. I just hope that this will occur naturally and gradually over time, without political fights and big policy mistakes. The second part is definitely a big stretch, the first part is hopeable.

What Credit Default Swaps Are, and How They Contributed to the Housing Bubble and the Worst Recession Since the 1930s

By Charles Kirchofer, Jan. 5^th, 2009

You've probably heard them mentioned in the past year with regard to the housing crisis, the credit crunch, the financial crises, and perhaps even the recession. But what the heck are Credit Default Swaps, and why are they the devil? Well, the short answer is: they're not the devil. The long answer is coming.

Credit Default Swaps (henceforth CDSs) are a type of derivative. What are derivatives? Well, I hope to explain that more fully in a separate article soon, but I'll just say right now that they are financial tools that are designed to protect companies or investors from either market risk (risks that come from fluctuating prices, derivatives against these include forward contracts, futures, and options, which allow buyers and sellers to lock in a given price for something) or credit risk (the risk that someone will default on credit (not pay it back)). CDSs are of the latter type. An explanation with examples is coming, don't worry.

Invented by a group of bankers in 1994, CDSs were supposed to make credit risk easier and more efficient to manage, resulting in higher gains and more stability at the same time (we may laugh now, but for the first several years they did just that, and for more than a decade they seemed to be doing just that and more). How do they work? As always, I like to work with examples:

Company A loans company B $10 million in the form of a 5-year corporate bond (bonds are always essentially just loans directly to something, generally a company or government). Since company B could go under, meaning company A might not get its money back (credit risk), company A cannot rely for its survival totally on getting that money back. If it did, company A would go under if company B did. Obviously not a safe strategy. Before CDSs, the company was required to hold on to a good amount of cash to make sure it could make do if company B (or any other of it's debtors) failed to pay. A CDS allows company A to insure against default. Company A now pays an insurance company, or other CDS supplier, interest (calculated by the insurance company according to the likelihood of company B defaulting) on the principle (the $10 million). Let's say they pay 1.5% a year ($150,000). In the event that company B goes into bankruptcy, the insurance company agrees to buy the now worthless bond from company A for the full $10 million. Thus, the credit risk is transferred to the insurance company, and insurance companies are excellent at assessing risk.

Or are they? Insurance companies are generally exceptionally good at assessing risk in normal situations. The problem is, they were not used to financial risk. If you fall down the stairs, this doesn't usually increase the likelihood that tons of other people around you will suddenly start falling down the stairs, causing a chain reaction. In normal insurance situations, chain reactions are uncommon and limited in scope (your neighbor's house catching on fire could spread to yours or lead to a massive forest fire, but a forest fire in California doesn't make one in Connecticut any more likely). In the financial world, chain reactions are very common due to the interconnectedness of the parties involved. One very large company going bankrupt does increase the risk of others following suit, directly and considerably. The insurance companies' and swap initiators' models did not adequately account for the system-wide risks that could stem from a string of bankruptcies snowballing into an avalanche of bankruptcies. If you have read my earlier articles on the financial crisis you will see that, though I am now going into more detail on one of the causes, the conclusion is the same: risk was underpriced.

So what can be done about it? Well, there are a few things, but if investors and insurers think investments are safer than they are, crises will always happen, almost regardless of regulation. What are the few things that should be done? Well, regulation. Get rid of CDSs? No. At their core, they are a good idea, and believe me, no one is underpricing risk at the moment. But they do require regulation. Because they were direct deals between two parties (in the derivatives world, direct deals between parties are called over the counter derivatives, President Bush spoke out against those), they were not subject to any regulation whatsoever. This has proved to be a mistake. Certain reserve requirements for insurance companies may be in order, though I stress that they've probably learned that the hard way already (although the important thing is whether they'll remember that lesson in 10 or even 20 years). There is also a second thing that could be done, and this one's a biggie: taking out a CDS on someone else's debt should be outlawed.

One of the staggering things about CDSs is that they were used for speculation, not just for their original (well intentioned and legitimate) purpose of mitigating risk. Speculators would take out CDSs on debts between other companies, basically placing a bet that company A or B would file for bankruptcy. Anyone can see this is an invitation to shady practices when the following rule of insurance is considered: you cannot take out fire insurance on your neighbor's house. It's clear why: that would give you incentive to burn your neighbor's house down, or at least not to call the fire department if it started on fire. This is one area that clearly needs to be within regulation, and it is one purpose for which CDS should be absolutely banned. This fits into my and Mr. Mohr's constant harping about poor incentive structures, basically setting up the system so that people will act foolishly.

So how did this help cause the financial crisis and the recession? That part's easy to see. As real estate prices began to fall, companies that had invested heavily in the real estate markets (read Mr. Mohr's extensive articles on that topic) began defaulting on loans. Soon those CDSs started getting called in, and their issuers (like the insurance company AIG, one of the largest to nearly fall and still only on government life support), not expecting so many to be called at once, also defaulted. Suddenly there was a lot of debt with no one to pay it, and investments that had looked safer than they were because of debt insurance in the form of CDSs were seen as toxic. Loans stopped being made, money stopped flowing, and the whole thing came crashing down. Businesses, even very healthy ones, rely on loans to expand and to do their daily business. The credit crunch made this extremely difficult. The result? Layoffs. This, combined with people being forced from their homes and the loss of equity making everyone feel poorer, resulted in reduced consumer spending, resulting in harder times for companies, resulting in more layoffs and reduced consumer spending. Enter the gut-wrenching downward spiral called a recession we find ourselves in today.

The only hope? Loose monetary policy (which the Fed is on top of, with interest rates around 0%, a historic low), bail-outs to stop or slow the defaults (in progress), and increased government spending (pending). With these three combined and executed well, forecasters hope the recession will end in the seond half of 2009. I'm somewhat less optimistic, considering that even if the recession does end at such an early date (quite questionable considering the optimistic assumptions upon which most forecasters base their predictions), the growth that sets in afterward is likely to be sluggish at best for quite a while, giving the feeling of a continued recession, as real growth (above inflation) of at least 1% is probably necessary for job creation. However, the government endeavors to create jobs itself in the meantime, and with money growing on trees, the government will be able to borrow cheaply and spend through the recession. Even gloomy forecasters see us coming out of the recession by or in 2010, so the end is definitely in sight. By the way, the pessimistic prediction of unemployment possibly reaching 10%, though unprecedented in our time, is still only 2/5ths what it was during the Great Depression. So although it is true that this is the longest and possibly worst recession since the 1930s, is still hasn't (and almost certainly won't) by any means come anywhere near equaling or beating the Great Depression, and that's reason to relax right there.