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.

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.

Tax Breaks or Government Direct Spending, Is There a Right Answer?

The Times and the WSJ (as well as almost everyone else) covered many of the details of Obama's new tax cut proposal which is part of his overall economic stimulus package. Although this is a common tool used by many presidents during a recession (it was practically George W. Bush's mantra) I think we are facing very different circumstances in the 2008 recession. The articles (NY Times, WSJ) discuss the tax break as a foregone decision, entirely dedicating the focus on the size of the break. The plan is a $300 billion tax cut for those who are currently working, no income cap (the $250,000 that we heard so much about during the debates) has been determined yet. I will ignore my fear of labeling myself an extreme liberal and explain why a tax break may not work, but will also briefly look at why it really doesn't need to work to be effective. 

 

Regardless of actual effectiveness a tax break is a common political response to any recession. The hope is to energize spending with a wealth effect, which jump starts personal consumption. But, in contrast to recessions of our recent past, I do not believe the wealth effect will occur in our current crisis. The difference in 2008/2009 is primarily a change in consumption, stemming from job market instability. I predict this fundamental shift in consumer behavior will prevent a tax break mechanism from making any improvements in the recovery process.  

 

First examine the graph below from the WSJ, (source: "Hard Hit Families Finally Start Saving, Aggrivating Nation's Economic Woes").   The take away is that Americans are not spending... anything. For the first time in a very long time Americans are actually saving money! 

   

For a tax cut to be effective in our economy one simple mechanism needs to occur: citizens get a check in the mail from the Government then go out and spend it. The stimulus is generated by the heightened consumer activity which raises demand for goods. This stimulates businesses to produce more goods, hire more people to meet the demand etc. So turns the wheels of the economy. This, of course, is a perfect world, where this mechanism works and every $1 of tax cut is spent within the U.S. economy. In stark contrast, I believe, is the reality; U.S. citizens get a check in the mail and will use it for: (1) credit card bills with now exorbitant interest rates, (2) towards a mortgage they can't afford anyway (the real problem here is explained in my article "Truly Understanding The Credit Crisis...") or (3) Hoard it for a rainy day. Each of these three uses, I think, is very rational behavior for the common citizen in today's world. If nothing else, the gloom of an impending deepening recession, and the possibility of massive layoffs would lead someone to hoard their dollars to float them through possible unemployment. None of these three realistic outcomes will lead to the kind of economic stimulus the President-Elect is hoping for, it will just increase the debt burden of the Federal Government. 

 

As I discussed in previous articles, the Federal Government has a very advantageous cost to capital. With historically low rates on treasuries the government is in a great position to spend, but there should still be some thought to spending wisely. Cutting taxes is not going to give the economy the jolt it needs but I do have two suggestions which I believe might make a wider impact. First direct government spending, and secondly the support for weak state and local governments.

 

Obama is a champion of direct infrastructure improvements, I can only hope he does not lose his focus on this productive stimulus option. Direct government spending may remind us of the Great Depression but it may not be a bad idea. I had realization that the tone of financial markets were really dire when the short term treasury rate dipped below 0% in December at the same time the Federal Funds Rate was at 0% (see related article "Money Does Grow On Trees..."). Investors just do not trust private investment right now. The solution to restore confidence is to stabilize consumption, which can only be done with a stable job market. When people know their next paycheck will definitely be there, they will spend today. It is scary to say it, but with private business contracting, and private cost to capital extremely high, the logical solution is for government to employ its citizens directly. It stabilizes the job market and will give a lot of attention to some much needed infrastructure improvements. Sounds like socialism? Call it what you want, it will be effective. People will be employed, consumer confidence will return, Americans will soon start consuming in massive quantities, the consumption will spur private activity, the activity will stem the risk of lending to private companies, and the lending will get the whole economy back on track. 

 

Some attention also needs to be made to state/city government budget deficits, which I have not heard addressed on the national level. Many states are in some serious trouble, with California and New York at the top of the list.  Since states and local governments are responsible for all the services that stabilize communities like fire, police, and health, allowing these governments to become delinquent on their debts will further destabilize economic recovery. States do not have the same spending luxury as the Federal Government. With dropping income taxes from rising unemployment states are looking at some serious deficits. Compounding the problem is the municipal bond market which is the way many state and local governments take on debt (the state version of treasuries). This market has slowed rapidly in recent months, loosing a large number of buyers because of the wall street fallout. Less demand puts upward pressure on price (the interest rate) and will begin to stall a State's access to capital. This should be on the radar for the Federal Government, a bailout for some states will probably be inevitable, and should be funded to keep basic services running. 

 

Shifting the gears of pessimism, I want to briefly look at why a tax break does not necessarily need to  work1 to be  effective2, maybe there is a much bigger plan. This tax break may be a move by Obama to start restoring the spirit of Americans. Consumer confidence is simply all about confidence in ones government and the stability of their lives. The policy, at least in the short term, for this administration is to use everything at their disposal. Money is cheap, treasuries remain low, and moving the Fed Funds rate hasn't given the effect the Federal Reserve was hoping for. As a result Obama is pulling out all the stops. He is vying for the American spirit, comforting citizens by having them believe he is doing everything possible and thereby restoring their confidence in the free market. I personally think $300 billion is a high price to pay for the spirit of Americans but I suppose it may not be the worst idea as long as the Government doesn't run out of money (or have to start paying a significant interest rate). I have outlined more worthy 3(from an investment perspective) uses for the funds, but can accept that there are less tangible victories than the return on investment. I just hope Obama is not expecting some traction from this plan, because it is unlikely to come. 

 

1.   Work meaning actually cause economic stimulus. 

2.   Effective meaning making some kind of impact or change. 

3.   I determine them to be more worthy because i think they will have a wider impact on the overall economy. 

The Bubble Asks for a Bail Out

Last Monday the front page of the Wall Street Journal headlined a story  which outlined why the most powerful real estate developers in the U.S. have formally asked for a bailout loan from the Federal Government. A drop in asset values from to the real estate bubble, rising vacancies and dropping rents in the commercial markets have depressed cash flows so much that many of these large developers cannot meet their debt obligations.  These developers cannot look to banks for additional credit because they are already over leveraged; they are left to turn to the government for help. 

The depressed rents and a sudden depreciation in assets that the developers are describing should not be a surprise to anyone. When Bernanke and Paulson said the real estate market would be entering an adjustment period, this is exactly what they were talking about! 

To understand how dangerous it would be to extend government credit to real estate developers, it is important to first take a step back and restate the causes of the "real estate bubble" which is considered the impetus of the 2008 recession. The real estate market is like any other free market, driven by supply and demand forces. In its most simplistic and fundamental form, the real estate bubble was created by artificial demand side changes. An extremely lax credit environment created artificially¹ high demand for real estate, (more borrowers qualified for loans = more demand) which in turn led to an artificially high valuation for real estate. Credit was then extended based on this artificially high valuation of real estate assets.² The bubble "popping" was the realization that all the underlying assets were, in fact, overvalued, which meant many of the properties purchased within the bubble had mortgages based on a value higher than asset’s actual worth. The bubble was simply a difference between an artificial inflation and reality. This recession is an adjustment period for the credit markets, where all of the mortgages will somehow adjust or unwind to meet pre-bubble prices.

Offering government issued loans to developers would slow or reverse this market adjustment, which must happen for the real estate market to find a firm footing and for credit to start flowing again. If the government extends loans to real estate developers they could only do so by ignoring the deflated value of the underlining assets. (This is inherently true in the request to the Government. The market has deemed these assets unfit to extend additional credit, forcing developers to ask the Government for a loan.) To issue a new loan on these deflated assets the Government would have to repeat the mistakes of the past and secure a loan based on an inflated asset value. The Government would essentially be reinflating the bubble by allowing Real Estate Developers to continue to over leverage their depreciated assets. This will continue to fuel the artificial demand that caused this recession and prevent the market from finding a bottom from which to rebuild. 

The recovery of the credit markets is hinged on a return to a realistic (pre-bubble) valuation for real estate. Proper underwriting depends heavily on being able to comfortably assign an applicable risk premium within the interest rate, and this can only be done if the lender is comfortable with the stability of the securtized asset. If the Developers received a bail out their assets will not undergo the market adjustment, it would artificially keep real estate prices high, and prevent the market from finding a bottom.   

There is no solution that will help troubled Real Estate Developers, they are probably extremely over leveraged now that their assets have lost so much value. As the economy contracts real estate rents will need to come down to meet demand changes. It may also pose the scenario where an asset manager may need to offer space at a loss to cover at least a portion of fixed costs. The riskiest of the real estate developers, those who took on the most debt based on inflated values, will probably not survive the adjustment, but this is a necessary process. 

If left uninhibited, the market forces that are driving real estate values downward are the path to economic recovery. Inexpensive space decreases the barrier to entry for emerging businesses. New and more conservative Real Estate Developers will now have a greater opportunity to expand by capitalizing on the bad bets made by riskier developers. The worst over valued properties will be defaulted, and then resold at more realistic values at auction and lenders will be insulated by auction losses by Government backing already guaranteed through TARP. This process will eventually lead to the bottom of the market, where prices become stable. This stability will allow credit to start flowing again by solidifying confidence in the value of real estate, which will once again be used to leverage new loans.  

This new request will prove to be a real test for the Federal Government. The Developers' problems are a description of the natural market forces adjusting in the wake of a real estate bubble. Depressed rents, and depreciated assets are a necessary evil as our economy searches for a firm footing. I can only hope that congress has the sense not to hand out money to everyone that asks, and instead analyzes the impacts of their stimulus. This will be an opportunity to either show a true understanding of the causes of this recession by denying the developer loans, or show true ignorance by granting them. 

 

1.   Demand was "artificial" because borrowers received loans they should not have qualified for in a normal credit environment. This is a widely accepted cause of the real estate bubble. 

2.   To understand the crisis in more detail please see two articles I wrote in October, "Truly Understanding the Credit Crisis..." and "You Would Have Been an Idiot Not to Take a Teaser Rate..."

Money Does Grow on Trees! The Fed Goes to 0%.

In the past two weeks the Fed made a remarkable policy decision by moving the federal funds rate to zero, and the market made a remarkable move to push the U.S. treasury yield on a 4 week note below 0%. These stories are an important fear indicator. The Fed has taken the position that they are willing to flood the market with dollars. With not even a whisper of inflation the policy is to literally give money away for free. But instead of throwing money out the backs of armored cars, banks and a broad range of investors are giving it back by buying short term treasuries at a loss, saying thanks, but no thanks, the market risk just isn't worth it. 

The treasury yield story is history in the making. Both the Times and the Wall Street Journal have various economists weighing in, both suggesting that this has not happened since the Great Depression. The interesting nuance now is we supposedly have safety measures in place that would curb the kind of risk one assumed when keeping cash in a simple bank account during the Great Depression. This treasury yield signals that a bank/investor/hedge fund would rather give
their money to the federal government for safe keeping rather than holding it in cash. There is so little faith in the U.S. Banking system in the year 2008 that there are people making rational choices to have the Federal Government hold onto their money, at a loss, for the protection from a financial collapse over the next 4 weeks. If this all sounds very grim, it is because there is no
other rational explanation. Many of the articles site the fear of other riskier options like the broader stock market that have driven higher demand for these safe treasuries, but such a mounting demand that it actually pushed the yield negative is shocking.

The story on the federal funds rate seems to be a last stand, it is the Fed’s Alamo. What more can the Fed do to try to spur lending again? They have literally left the vault open and no one has shown up to take the money. There have been some early reports that this, along with moves by other major central banks to cut their benchmark rates, have helped curb some investor fears, but these are unchartered waters and no one really knows how long it will take for credit to flow again.

This all circles back to the uncertainty in the real estate market. I see the majority of lending in the U.S. as a house of cards with real estate as the base. Most loans are secured on a real estate asset. Small - medium businesses rely on the real estate market to leverage capital improvements and individuals rely on their real estate stability to access credit and build wealth. We are in a time where no one is really sure when the real estate trough will be. As a result, the base of the house of cards has collapsed. No one wants to take on additional risk lending or borrowing when the value of the securitizing is completely unknown. It creates the circumstance we see today, the Fed can offer money for free but with lenders and borrowers sitting on the sidelines there seems to be little interest to be the first one back into the pool. 

These two stories indicate that the recession still has a way to go to find its bottom. Even with the fund rate at 0% and the Fed pumping dollars into banks to sure up their balance sheets (See "Throw in the Kitchen Sink" for a description of all government infusion programs) lending continues to be sluggish and the market seems extremely risk adverse overall.

Because every story has a silver lining, these two represent a unique advantage to the President elect. The government now essentially has zero cost to capital. Even the 10 year treasury is at an all time low, settling just over 2% today. With such inexpensive borrowing this is an excellent time to make the kind of infrastructure investments Barack Obama has suggested. This approach will indirectly stabilize the housing market by putting dollars directly into the hands of consumers and our nations infrastructure will get a much needed face lift at the lowest possible cost. Maybe a massive government driven stimulus is exactly what this free market needs to get back on track.  

Homeowners Re-defaulting. I Told You So?

I read a report in Reuters today that was titled "Homeowners Redefaulting After Getting Aid" and I now have the unfortunate right to say to the FDIC, "I told you so." 

The FDIC plan to restructure mortgages seemed dangerously underdeveloped when I first analyzed it in my article "When a Government Becomes a Bank, Anyone Else Concerned with Moral Hazard (part 1 of 3)."  In this 3 part series I analyzed 2 proposals for readjusting troubled mortgages, the worst of the two being the FDIC's loan guarantee program. The basic argument I tried to convey is the loan guarantee does not address the essential problem troubled borrowers are facing: Troubled homeowners are over leveraged, at best they can afford their loan principle at a "teaser rate" which the current market cannot provide, even with a government guarantee. Without addressing this core issue the FDIC program is going to fail, miserably. This Reuters article reports that over half of all restructured mortgages have failed within the first 6 months; it is just proving my point. 

I am disappointed the FDIC program did not take into account some nice aspects of the second program I profiled in "When a Government Becomes a Bank," which extended the term of the loan. The term focused plan was part of the depression era Home Owners Loan Corporation program. It allowed principles to be extended over a longer period of time, thereby reducing the monthly debt service to a manageable level. This is still a viable solution if the market is willing to look at a much longer time horizon. If not, this may be the best government driven solution I have heard so far, and presumably would have significantly less risk to the taxpayer.

I see this recent statistic as the start of a colossal blunder by the FDIC and I am worried that it may shake congress' confidence in Henry Paulson and Ben Bernanke's (who were weary of the FDIC plan as I pointed out in "Nice to Know Henry Paulson Agrees a Loan Guarantee Will Not Work") economic recovery vision. The Reuters article is already showing signs of grandstanding by politicians, citing Rep. Barney Frank (D) who chairs the House Financial Services Committee as saying that he would agree to release the remaining $350 billion only if "they (the Bush administration) made it clear they were wrong in refusing (to use) it for foreclosure relief...Foreclosures are getting worse." The problem is not a resistance to help foreclosures, the problem is the FDIC plan is fundamentally flawed, and does not address the central over leveraged issue. Someone needs to either guide the private market to provide term extending debt packages, or seriously explore a government driven alternative in order to make any real change in foreclosure rates. 

In light of these new statistics I tried to find any FDIC projections for default rate, which were unavailable, but I did uncover a new shocking detail about the plan. From a press release from Nov. 20, 2008 which highlights a speech given by FDIC chairman Bair to the Johns Hopkins Cary Business School:  

"We'll accomplish this (the loan guarantee program) at no cost to the taxpayer or the deposit insurance fund. The TLPG is being offered under the systemic risk exception in our statute. Fees for the guarantee have been structured to cover our expected costs. However, in the unlikely event of a shortfall, the difference will be made up through a special assessment on all insured institutions, consistent with the procedure contained in our statute." 

A very relevant, yet not widely publicized detail. In this case the taxpayer is saved, new burden for default is put on the already distressed financial sector. So if I understand the reasoning:

1.    The banking sector cannot afford the losses they are taking on defaulting mortgages. Therefore: 

2.   The FDIC will "guarantee" the mortgages. But 

3.   The guarantee will be paid for by the banks that are FDIC members. Therefore:

4.   Banks are again guaranteeing themselves. 

Is this madness?! This is not a government guarantee at all, this is spreading the losses out among all banking institutions through a government created utility. I won't even begin to address the free market problems and backward incentive structure this creates, it will have to be put into its own installment. How did this plan get approved? 

 Everyone cross their fingers that Obama has someone a bit better for the FDIC, this plan is a fast sinking ship.

What if Housing Doesn't Come Back?!

I have been mulling around a simple concept over the past two weeks. Our housing market for many years has been driven primarily by easy access to credit. It allowed many home buyers to overextend, and even more suitable buyers access to extremely (relative to the 80s) inexpensive financing options. Much of this (putting aside much better Fed policies since the 80s) can be attributed to an extremely lucrative market for mortgage backed securities. It leads me to the simple question, what if the mortgage backed securities market doesn't come back...ever?  

 

Many economists, including Henry Paulson, are calling the real estate tumble a "market correction" which is an inherent acknowledgment that there was something wrong with the housing market that now needs correcting. There has been a lot of discussion about the need to make mortgage backed securities more transparent so investments carry the appropriate risk level to stem a future crisis from happening again (I have yet to hear of one viable option). But no one is really admitting that whatever new form these securities will take, it will never be the same. These new securities will have added cost due to new government oversight, and more importantly they will be sold in a market where investors now consider the security extremely risky, instead of extremely safe. 

 

Since most individuals purchase real estate with credit, cost of accessing credit is a strong contributing factor for the demand for real estate. Packaging mortgages and selling them in a bulk security greatly lowered the cost of borrowing. It opened the mortgage market up to a world (literally the entire world) of investors. A bank in Ohio no longer needed to hold the entire mortgage amount; they could sell these mortgages on the open market, possibly finding a buyer in an investment bank in India. The attraction for investors was a chance own what was considered a diversified (a wide range of underlying properties in a security), safe asset. The U.S. housing market was perceived as very strong through the 90s and could offer a lucrative return, thereby encouraging more investment. So what happens when the perception of mortgage backed securities moves from being the safest to the riskiest investments? There is the obvious response that credit immediately freezes, we have already seen that, but what happens 10 years from now?  

 

This may be the end of real estate based wealth building as we know it. For years housing prices were driven upward, I would argue primarily by easy credit. Securitizing mortgages brought borrowing costs down so low there was an influx of new demand into the market. Now, with more investors becoming extremely risk adverse to U.S. housing market investments, there will be an immediate capital drain from the market. Even as the credit markets begin to thaw it will take a significant amount of time before the fear towards the market subsides.  

 

Looking forward two years from now, after the global recession will begin to (hopefully) ease, and when consumer spending and Fed policy returns to normal; the mortgage market may look very different. With an additional fear factor, investors will be looking for a higher return to account for newly recognized (does not even need to be real, just perceived) risk in the U.S. market, this will translate into much higher interest rates for mortgages. Higher rates means a higher barrier to enter for new buyers, and demand will take a heavy hit. I would also predict this will effect all tiers of real estate in different ways. Those with good credit that remain in the market post-crisis will not be able to afford the principle they were able to pre-crisis because of higher debt service. This means even the luxury home market will take a significant hit. I also believe the overall skittish feeling toward the market will deter eager investors who purchase properties on spec for a short term reward. All of this translates into a long term national depression in demand for new housing. In the end I think this "correction" will adjust for more realistic risk, and once the adjustment is made home prices will appreciate again, but at a much slower pace then we may have become accustomed to over the past two decades. I would predict, after the adjustment is completed in about a year or two, the appreciation of most real estate will closely follow local income growth (which hasn't been too great on a nation scale the last 20 years) of the middle class or better, (those with good-to-great credit) rather than any other external factors. 

 

To end on a bright note. If you rent, this is great news! Wait out this adjustment period, build your credit now,  save up for a ridiculously high down payment to secure your loan, and hopefully the post-recession, post-crisis, interest rates won't be too far out of reach! Just don't count on your home being your nest egg unless you anticipate a sudden jump in U.S. income growth, similar to the growth we had post world war two, but have not seen since. Your home will just be your home, it will not generate income or make you a millionaire, but at least you get a tax credit on the mortgage and don't have to deal with a landlord!