It's the accumulating wealth at the top of the pyramid, stupid!

Photo by: Exothermic on Flickr

The accumulation of wealth in the hands of the few can explain many of the rich world's current economic ills. The solution is redistribution, but not in the old, socialist style. It's time for a tax on non-productive assets, a removal of inefficient tax breaks, and the liberalization of laws on who can build what when, where, and how high.

Scholars from Marx, to Hobson and Lenin, to Keynes, to Thomas Piketty have recognized that wealth tends to accumulate among those who already have it. The reasons are simple: wealthy people have money left over that they do not need to spend. They can therefore invest this cash and get returns on it. What's more, their financial security allows them to take greater risks, with higher average returns, than those who are not as secure. For example, imagine you offer an average 40-year-old homeowner on an average American income the following: If she pays you $100,000 by mortgaging the house or borrowing from savings or friends, you will pay her $150,000 at the end of the year (and let's imagine she believes you), OR, she can give you $100,000 for a 50% chance of getting $300,000 at the end of the year, but with a 50% chance of losing all of it. Most people in her situation would choose the safe $150,000. It's a 50% annual return, so why not? A wealthy person, though, would almost certainly jump on the riskier option, especially if there was a possibility of "playing" more than once. After all, the average win is $200,000, a profit of $100,000 (or 100%) in a year (on AVERAGE!)! People who would not lose everything if they lost $100,000 can afford to take such risks when there is a high probability of great reward overall. So wealth accumulates at the top.

Is that bad? Beyond envy, it also seems unfair that some people can afford to take greater risks and get greater rewards than others, though it should be pointed out that, in the above (unrealistic) example, there'd be nothing preventing someone from "climbing the ladder" by starting at lower risk. Nevertheless, those who start life with more have greater opportunities. Some of them are lazy or incompetent and squander them, drifting down the wealth pyramid, and some at the bottom rise up, but study after study has shown that this is rare. There is thus already a moral case for increasing equality of opportunity. There is also a macroeconomic one, however, and it also claims to lay the blame for stagnant wages, rising debts, and financial crises at the door of wealth accumulation with the rich.

The macroeconomic case is as follows: The rich are the ones who invest in the capacity for the economy to produce things because they have the extra capital to do so. The workers and the poor, who need to spend most of what they earn to survive and have less money left over to risk on investments, etc., are thus the main consumers. They represent the demand in the economy, and the rich represent supply. When consumers buy things from firms, those firms become more successful, expand, hire more workers, and pay higher wages, increasing those workers' consumption, boosting other firms, etc. etc. The problem, as per Hobson and Lenin, is that, as wealth accumulates with the rich, and the rich consume less than they earn, investing the rest, production will grow faster than demand. Consumers won't be able to buy all the goods on offer at a price that would turn a profit for producers. The result is falling profits, collapsing wages, and crisis. The solution, as proposed by Hobson and Keynes, was to redistribute some of that extra wealth at the top to those at the bottom in order to boost demand and slow supply, keeping them in line with each other. The high inflation and stagnation of the '70s suggests countries may have done too much of this by the late '60s and '70s, and some countries never passed through the reforms of Britain and the US of the '80s, '90s, and 2000s and might still need more of them. For many parts of the rich world, especially Britain and the US, however, this explanation for crisis and stagnation is compelling.

Following this explanation, the financial crisis of 2008-9 was caused because of how the economy reacted to oversupply and lack of demand. With redistribution cut and other costs for working people rising, like healthcare and college tuition, leaving less money for consumption, the wealthy saw declining returns from boosting production. They sought other places to put their money, like subprime mortgage debt, real estate, gold, wine, and art (record prices being hit again right now for works of art). As mentioned, working class people tend to spend all that they earn. Redistribution in effect gives them extra earnings. In the 2000s, working class, poor, and middle-income people instead simply spent more than they earned and borrowed the difference. Those who had more savings than debt thus plowed money into loans, making them cheap. Interest rates were low. This allowed demand to continue to match supply for a time and gave investors two ways to make money: increasing supply and investing in debt. It was not sustainable, however, because debt levels obviously cannot rise forever. When they stopped rising, consumption no longer kept up with supply and a long period of crisis and weak demand followed. Today, wages and productivity are not rising as quickly as expected, whereas asset prices, like the prices for houses, penthouse apartments, works of art, and the like are all back to their rapid rises of the pre-crisis years. This is once again fueled by debt in the form of ultra-low interest rates and quantitative easing by central banks. In essence, we are trying to prop up demand by making borrowing artificially cheap again. This can work in the short term, but only if overall productivity and wages rise and consumption becomes sustainable. The Marx-Hobson-Keynes explanation of the crisis suggests this will not happen.

So what can be done? Higher income taxes blunt incentives to earn more and therefore hurt productivity and consumption. They therefore are not the best way forward. There are loads of tax exemptions for income however, and these ought to be removed. The most glaring of all is the capital gains tax (CGT). CGT is a tax on money earned from investments. Some argue it's unfair because it taxes money you've already earned. Nonsense. That's true of everything other than income tax and CGT. It taxes only money earned above what you invested. Wealthy people make loads of money through investments, yet these are taxed as if they were earning the wage of a secretary (as Warren Buffet pointed out). This is wrong.

In general, however, it makes the most sense to tax investments that are not contributing to the economy. Income (corporate or personal) is a good thing. If income is spent or invested in ways that boost productivity and the economy, this is a good thing. Taxes on all these should be relatively low. If income is spent on things that do not do this, however, this benefits only the asset holders (the rich). Since this reflects excess earning generated from the economy, there is a case for clawing back some of the value and investing it in things that improve equality of opportunity (like free child care for working parents, free preschool, and cheaper, better education). Mansions, penthouses and the like contribute nothing to the economy. A tax on the value of non-productive assets (like the proportion of the value of a home over the median value for homes in a state or city and a tax on the entire value of second and third homes, as well as ones on yachts, private jets, cars above the median value of cars, etc.) could be used to pay for these amenities, all of which should properly seen as investments in greater growth and prosperity for the future (notice they are NOT "wealthfare" or healthcare spending, both of which only boost consumption and are not investments in greater future growth).

Another thing that would help those in the bottom half of the pyramid would be relaxing restrictions on building and on building heights. Artificial restraints on these, particularly in prosperous cities, have crimped the supply of housing and caused house prices to skyrocket. Increasing the supply of housing, and therefore reducing its price, would reduce the cost of living for younger and poorer people, raising their standard of living and boosting consumption without the need even to raise wages. The problem is that the majority of Americans and Brits already own their homes and have no desire to see house prices fall (I wrote a post on the "new landed class" about this). In fact, due to all the mortgage debt, a fall in house prices could even be dangerous for the economy. A slowing in house price inflation, followed by a long stagnation, however, would be of immense help to future generations.

Wealth does accumulate at the top and this is a problem for everyone. The solutions needn't discourage work or "punish" the successful, but should instead steer cash from non-productive uses like property buying and luxury goods towards productive uses that help level the playing field a bit, above all to those that help working people get working more easily and help their kids climb the education ladder at low cost. It's time for a change.

Rating Agencies: Why the Fuss Is Overdone

Ever since the financial crisis hit in 2008, the issue of the rating agencies has come up again and again. And yet: there has been little in the way of reform. This is for two reasons: one, there has been a lack of promising suggestions for replacing the current setup; and two, much of the hullabaloo has been overdone. The reason: the structure of the rating market itself is its most attractive attribute.

It's true: rating agencies are paid by the very people they rate. If this seems like an area for a potential conflict of interest, it's because it most certainly is. Producers and providers in competitive markets have to compete for customers by giving the customers what they want. There's just one catch here: the rating market is uncompetitive. It is, in fact, an oligopoly.


Oligopolies represent one of the three market failures (cure: anti-cartel authorities). The other two are one-sided information (cure: laws requiring transparency and information sharing) and externalities, which are goods or services that are either enjoyed by many but paid for by few or vice versa (cure: usage restrictions/regulations and externality charges). The rating market is oligopolistic, which is bad for consumers of its products. The good news: the direct consumers of its products are banks and its products are ratings, used by everyone and paid for only by the banks (a positive externality it makes sense to maintain).

Standard and Poors (S&P), Moodys, and Fitch, the big three ratings oligarchs, do not really have to compete very much for customers. Securities almost have to be rated by at least one of them in order for them to even have a chance of being traded, and many or most are rated by two or more, especially by S&P and Moodys. This puts the Big Three in a position of power. They do not have to offer better ratings for higher prices. In fact, doing so would be pretty much the only thing that could damage them because it would damage their credibility.

So why is their credibility already so damaged? Their ratings were horrendously inadequate and had not been adjusted to the new instruments that have been coming to the market over the last 15-20 years. They failed because of poor modeling and a system in need of updating (ratings are based mostly on past credit performance), not (or at least, not usually) because of collusion with the banks they were supposed to rate. The agencies now have every incentive to reform because their most valuable asset, their credibility, is at risk.

The rating agencies are likely to last, however, because there is no real alternative! Out of disgust over "speculative attacks" on Greece and Portugal after rating agencies downgraded both countries' debt (due to very real fears the countries may not be able to pay lenders back), European leaders recently stated their intention to create a European rating agency. As Austrian commentator Eric Frey put it, "That a European rating agency is called for in this particular situation illustrates that such an agency would be stillborn. If a rating agency has to first ask (French President) Sarkozy and (German Chancellor) Merkel before lowering a rating, no one will ever take it seriously."¹ It's not like government agencies did such a bang-up job protecting the economy from the crisis, nor did most experts anticipate the full extent of the crisis. Why should we expect some new goverment-run agency to do better, especially one that is politically compromised?

Is there scope for reform? Probably, on the micro scale. Perhaps agencies responsible for giving ratings could steadily rotate and other things could be done to prevent cronyism, etc. (author's note: I just saw that a proposal for rotation has actually been made that would include a provision for using the accuracy of agencies' ratings to decide how many future ratings they give. Has someone in Washington been reading my blog?). Still, even this is no guarantee - ratings work well until they don't, as this crisis has shown all too well. Our greatest comfort is still that the ratings market is so uncompetitive. Perhaps we could do with a less competitive baking sector as well? Or at least one that values debt and risk less highly for systemic, not personal, reasons?

1. Eric Frey, "Zynischer Kampf gegen Windmühlen," Krisenfrey (blog), 8 May 2010, http://derstandard.at/1271376262183/Blog-KrisenFrey-Zynischer-Kampf-gegen-Windmuehlen.

The Next Financial Crisis: the European Chapter?

European leaders have had it relatively easy in the recent crisis. The events that sparked the crisis occurred in America, and many of the effects of the crisis have been more severe there (big exceptions in smaller countries like Ireland, Latvia, and Greece, but also Spain). That the housing bubble triggered the crisis has made it easy to blame the entire crisis on America. Increasingly, though, Europe is beginning to look very weak. These problems, though, are homegrown.

Everyone is aware of Greece's current liquidity issues. It now appears that European leaders will head off a crisis in Greece by bailing the country out. Although many political and legal problems remain unresolved in doing this, it does look like it will be done. As The Economist argues, Greece will then have about three years to resolve its budget issues.

It also points out, however, that even with help from the EU and severe budget tightening (of which the actual application is questionable), Greece's debt will stabilize at around 150% of GDP, a huge amount by any standards (except Japan's, which is a different case, however, with lots of domestic savings, domestic financial repression, and assets abroad). Even assuming Greece manages to cut its deficit from something around 12% of GDP to under 3% in the next three years (a highly questionable assumption given the country's economic and political prospects), there is still every possibility the country could decide not paying back its debts was a better option. Indeed, that might even be true for Greece. Such a massive debt burden would hinder growth and spread economic and social malaise for years to come. In a country where social unrest bubbles beneath the surface, such austerity measures might simply be too unpalatable.

So why not let Greece default now and save ourselves the trouble (and extra money) of bailing it out? EU law stipulates that bailouts are illegal, and Germany has been opposed to them until recently. Why the change of heart? Cold calculation. Germany's Chancellor, Angela Merkel, has realized that a Greek default could sweep other countries with it, most notably Portugal, but possibly Ireland, Spain, or even Italy. Assuming that did not happen, though, the damages would be bad enough. European banks hold a lot of Greek bonds, and German banks are among the largest holders. If Greece goes down, bank bailouts may be necessary instead of a country bailout.

So a homegrown banking crisis could hit Europe. Apparently, Europe's banks are even more leveraged than American ones and even more thinly capitalized. Several banks would be unlikely to withstand a large-scale Greek default, never mind one involving several Euro-area countries. It seems the Europeans are not invulnerable to bad investment decisions, either.

Of course, this is no time for schadenfreude; such a disaster would ripple throughout the globe, nailing already weak economies and overly stretched government budgets. It was a couple of years after the 1929 crash before the Great Depression hit its deepest point. Let us hope that we are not about to repeat the false optimism that prevailed into 1930 again...

Epidemiologists, Hyman Minsky, and Forest Fires in Yellowstone

Why do crises happen, and how can we stop them? This is the question asked in many a field, from economics, to epidemiology, to research on forest fires. The problem is, as Minsky has explained, epidemiologists fear, and forest fires in Yellowstone Park have illustrated: the safer we make things, the worse potential they have for damage.

The best way to illustrate this is with a very visual (and uncontroversial) example: forest fires in Yellowstone. In the early part of the 20th century, officials in national parks began to suppress any and all forest fires that developed. This seemed to make sense, since forest fires could be very destructive to the forest and dangerous for people visiting it or living nearby, as well as for some endangered species living in the park. For years, every small fire was extinguished. The problem, we now know, is that this led to a buildup of dry, dead wood in the forest -- an enormous pile of fuel waiting to be ignited. The fires soon became harder and harder to control until a fire in 1988 destroyed 36% of the park's forested land. With that much fuel, it was just a matter of time before a drought (like the one in 1988) and other environmental conditions set the stage for a nearly unstoppable fire. Eradicating small fires over years made a really big one not only possible, but essentially inevitable.

Epidemiologists have the same fears. They know that the first time a disease strikes a "virgin population" (i.e. one that has never been exposed to the disease before), the effects are devastating. This effect contributed in no small part to Europeans' success in conquering the Americas: diseases like smallpox, brought by Europeans who were resistant to it, killed and weakened vast proportions of the native populations there.

Throughout human history, infectious diseases have been among the leading causes of death. Cities, in fact, were unsustainable because so many people died of diseases there; they required a steady stream of immigrants from the countryside to persist. By the middle of the 20th century, scientists in America and Europe began to declare that infectious diseases would soon be a thing of the past. They were wrong. Just as humans can build up a resistance to disease (actually largely via natural selection: those who have no resistance die), diseases can adapt to various treatments such as antibiotics, insecticides (for Malaria), etc. Last year, for the first time, a larger proportion of the world's population lived in cities than in rural areas. As mentioned above, cities are a great place for pathogens to live. On top of this, the lack of infectious diseases over the past 60 years means that our bodies may be "out of shape" when it comes to combating disease. The question, then, is if we will be able to stay ahead of diseases with vaccines and other measures. We must constantly adapt and must not allow a virgin, non-resistant population to build up.

This brings us to Minsky. He posited that free markets would always be prone to financial crises because long periods of stability would lead investors to take on higher risks (as their memories of past crises fade or as new generations with no memories come onto the scene). Eventually, debts would pile up to an unsustainable level, requiring only a trigger to set off something akin to a financial forest fire. He believed government regulation was the key.

I will take this one step further, combining with theories of evolution and epidemiology, and say that regulation will probably be unsuccessful in the end as well. For example, one reason the recent crisis has been so bad is that central banks have done such a good job at smoothing the business cycle. Securitization seemed to be doing a good job at spreading, assessing, and pricing risk, and government guarantees, whether explicit (FDIC) or implicit (Fannie Mae and Freddie Mac) seemed to take care of the rest. This lowered people's perception of risk and raised their appetites for it. It can therefore be argued that by hauling out the fire hose and stopping all the previous fires (like the dot-com crash of 2000-2001), the Federal Reserve allowed a pile of "dead wood" to accumulate that needed only a trigger (declining house prices coupled with rising commodity prices) to ignite it. Voilà! Financial meltdown!

But don't stop here, these lessons can be applied to many other areas as well. This is just a hypothesis, but I bet Americans do more foolhardy things abroad than some other people because they are so used to everything being safe back home (e.g. "do not place house pets in your microwave"). The drive, often via lawsuits, to make everything safe in America could very well lead Americans to walk brain dead into dangers they no longer see. Here in Austria, I have another example. Austrians are so used to waiting for the light to turn green before walking across the street, and to cars stopping when the light is red (something I also expect in America), that they also no longer bother to look before crossing the street as long as the light is green. The typical response is "well, they have to stop. If they don't they'll go to prison." My response? A nice thought for you in the afterlife, I imagine.

The challenge now seems to be to control risks that are harder for individuals to see coming, while returning personal responsibility to those slammed by risks they really ought to have seen coming. What does this mean for the Viennese? Nothing, really, I'm certainly not advocating letting people who drive through red lights and kill people off easy. What does it mean for Americans? If you injure yourself by sitting on your folding chair after opening it incorrectly, it's your problem. What does this mean for the financial system? Look to Yellowstone. We need more small forest fires (recessions) and fewer explicit and implicit guarantees that give false security. Where guarantees are given, conservatism (as in low risk and low returns) needs to be enforced.

I'm sure there are more lessons. If you think of some, please comment.

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 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.

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.

The Financial Crisis: Causes, Solutions, and Future Adjustment

By Charles Kirchofer, October 18th, 2008

It's impossible to turn on the TV these days without hearing more about how the financial world as we know it is coming to an end. What is going on, how did it happen, how can we fix it, and what can we do to prevent another one?

What's going on
The answer to what's going on is easily said and harder described. Banks currently either do not have enough money to loan to each other and to private customers (businesses and consumers) or are too nervous to do so because so many banks, business, and consumers have been defaulting (not paying back) on their loans in the past 12 to 18 months. If you've read my economics posts, including the one on central banks and interest rates (forthcoming), you know that not being able to borrow money slows an economy down. Business cannot expand. In addition, fear tends to make people save money. This is also bad news during an economic downturn. Less money changing hands as fewer goods are purchased means slower (or negative) economic growth. So how can we get money flowing again?

How we can fix it
The Federal Reserve, led by Ben Bernanke, and the federal government (led by Treasury Secretary Henry Paulson), along with the central banks and governments of Europe, Japan, and other parts of the world, are attempting to fix the crisis by solving the illiquidity problem. If markets are illiquid, money is not flowing around, which is essential if businesses are to get the money they need to expand. Governments are propping up banks (by injecting them with capital or nationalizing them if necessary) and central banks are lowering interest rates and providing nearly no-strings-attached loans to banks. What will this do? It ensures the banks can pay their bills, and hopefully will loan to one another, carrying on business as usual. One other big point is to keep people and investors from panicking. Panic means everyone holds on to their money and the economy comes to a grinding halt - leading to a recession or, worse, a full-scale depression.

But why is the government bailing out banks and not the little guy? This is the question we hear most often these days, and it is based upon a false idea. The underlying idea is that the government could choose to bail out homeowners instead of banks. This is false. Even though the credit crisis started with some people unable to pay their mortgages, it has gone far beyond that now. Even if they had the money, there's no guarantee that many of the people would stay in undervalued homes with overvalued mortgages. Even if they did, this would not solve the problem of illiquidity. It must be understood that if the banks were allowed to fail, the result could be another Great Depression. This was the mistake governments made back then (along with a gold standard that didn't allow the Fed to drop interest rates when it needed to) that largely led to the Great Depression being as bad as it was. The government is not choosing banks over the little people, the government is doing what is absolutely necessary to save everyone from economic doom! Help for the little people will never be enough if they all lose their jobs and the economy dives. However, the government is discussing plans to push banks to refinance mortgages and work to prevent further foreclosures. The banks may also have to use some of the bailout money to accept mortgage losses, meaning the homeowners would have to pay back a smaller amount on their mortgages. So the government is working to try to help homeowners, but it is first working to save essentially the entire world, and that has priority.

How it happened
Experts are likely to argue about the precise causes of, and their respective influences on, the financial crisis for years to come. There is already some agreement, however. For me, it comes down to six factors:

1. Innovation ahead of regulation. Financial markets have done some innovative things in the past few years, some of them designed to get around regulations in place. Even if regulators had recognized what was going and improved regulation, it is likely investors, who are better paid (i.e. have better incentives), often more talented, and certainly more numerous than regulators, would probably have found new ways to cut corners and outfox the regulators.
2. Bad government policies. The government's implicit support of Fannie Mae and Freddie Mac, as well as its directives to boost home ownership with tax exemption schemes and government funding, caused some of the problem on the housing market. Since everyone believed Fannie Mae and Freddie Mac could never fail because the government wouldn't let them, many invested in the companies (and companies they guaranteed) as a safe bet. This meant the twins had a steady flow of cheap cash that they then invested in housing. At the same time, the government did not exercise direct control over the two. In this way, the two are private when they're turning profits, and become public when there're problems. This led to a lower perception of risk (moral hazard) and big imbalances.
3. Money was too cheap. It is now generally accepted that money was too cheap. This has two causes. One: The Fed kept interest rates too low for too long and did not raise them quickly and high enough. Two: other countries (like Japan, China, Germany, Saudi Arabia, Norway, and others) saved too much money and invested it in dollar assets. This made money cheap in the US, regardless of Fed policies, meaning the Fed did not have complete control over the price of money (especially in the form of long-term bond rates, which Alan Greenspan tried unsuccessfully to raise in 2004). Also, cheap imports from China, partially held cheap by the purchasing of dollar assets, led to disinflationary pressures. Since the rate of inflation (exluding housing, in hindsight a rather foolish exclusion) remained low up until the crisis, the Fed saw little reason to dramatically raise interest rates. Another disinflationary effect was the steady stream of low-wage workers from Mexico, which may have helped prevent a wage-price spiral in food and low-end goods.
4. There was an underestimation of the effect of financial innovation on house prices and of the odds of a national house price decline. Previously, people bought their houses to live in them. That meant house prices generally remained stable (generally only rising in the last 2-3 decades), at least on the national average. If a person's house lost value, it didn't mean they'd turn around and try to sell it. This time around though, there was an increase in the number of investors buying houses, holding on to them and/or fixing them up, and then selling them at a higher price. Historically, the number of housing being bought by investors was rarely higher than 10% (mostly with the intention of renting the properties, not flipping them). By 2005, however, this number had risen to 28% (Greenspan 231). This meant there were more people who would be unable to pay mortgages over the long term and who were relying on rising house prices. These people also were less wedded to the homes, since they weren't living in them. The phenomenon was common enough to have TV shows about "flipping" houses. This was a sign the game had changed. As investors looked for the next place they could get high returns after the dotcom crash, needing to stay away from low interest rate bonds and bank accounts, they began investing in housing, housing securities, etc.
5. The Anglo-Saxon investment banking system is more pro-cyclical. Since assets (like stocks or homes) are used to back borrowing, higher asset prices mean more borrowing power. More borrowed assets mean more assets and more borrowing power again if assets rise. The opposite is true, however, when things fall. The system means Anglo-Saxon countries recover from crises and expand very quickly, but they can also fall into crises quicker, harder, and farther than countries that rely on more traditional banking systems. It is important to point out that in sum, since central banks and regulators had previously been able to maintain stability with this system, that the Anglo financial sectors have expanded much more quickly than their traditional counterparts.
6. Governments often subsidize debt and punish savings with their tax structures. Consumers get tax breaks on mortgage debt, for example. This effectively encourages people to go into debt, as that might be cheaper for them in the long run. This means the government is essentially paying part of the bill for houses. No wonder the government is then also on the line when prices fall! This is also related to the implicit Fannie and Freddie guarantees, as the twins were given the explicit mission of increasing home ownership.

How we can prevent the next one
This is the most difficult and crucial question of all. There are a few things we can do. For one, the lending practices must be looked at, and tighter financial requirements for people taking out mortgages are in order. New capital reserve requirements for investment banks and other investment organizations should probably be looked at, too. Central banks, the Fed in particular, that have previously essentially ignored asset price inflation (like house prices and stocks) are going to need to pay better attention to it in the future. In their defense, they seemed to be right to ignore it for a long time. After all, the stock market and asset crashes of 1987, 2000 (the dotcom crash) and 2001 (9/11) all resulted in very little negative impact for the real economy at large. In my view, this was only because the size and depth of the debt hadn't yet reached critical levels and because there was always a new bubble to invest in, brought about by low interest rates and cheap money from Asia. The pro-cyclical nature of the Anglo banking system needs to be steered against more aggressively in the future, which means more attention paid to asset prices, particularly in Anglo-Saxon economies like the US and Britain.

In addition to better (not necessarily more) regulation and closer attention to asset price inflation, Fannie Mae and Freddie Mac need to be completely privatized with no implicit government support (though how to do that exactly is a question in and of itself). Even so, tighter regulation will be needed everywhere due to the moral hazard caused by the knowledge that the government would be forced to bail the banks out if it ever happened again. One proposal is to penalize banks fiscally (through taxation) for becoming "too big to fail." Whether this would be feasible economically or politically (as it would require worldwide cooperation if the US were not to be unduly disadvantaged as a result) is another (difficult) question entirely. If the next time were to come in the too-near future, governments might already be too indebted to do so. The result would be an unavoidable depression. There is no question then, that regulations need to be modified to keep up, and possible risks must be foreseen earlier.

One problem could come from over-regulation, though. A return to the over-regulated old days could lead us back to times of stagflation. For this reason, regulators need to be sure to control things effectively, create the right types of incentives (possibly by not incentivizing debt), and not get involved in areas where it makes no sense. Protectionism and stops on trade and finance would hurt everyone and would do nothing to prevent a future crisis. Such measures would therefore be highly counterproductive.

Work Cited
Greenspan, Alan. The Age of Turbulence: Adventures in a New World. London, 2007.