Not So Dismal

Making Economics a Little Easier to Understand

Posts Tagged ‘Economics

A Gloomy but Great Day for America

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Today is a great, if gloomy, day for America. Congress continues to do what it has always done best: stall and tend towards inaction and gridlock. The American people should be very approving, in this case.

A bailout is unnecessary. The issue here lies in low interest rates and accounting rules, not how quickly the Treasury can print new money. Since the Greenspan era, the Fed “target rate”, or the charge at which the Fed would like to see banks loan money to each other overnight, has almost constantly been negative once inflation is taken into account. This rate directly affects the interest rates offered by banks to consumers, the rates that all manner of corporate paper garners, etc. When interest rates are kept so low, subprime investments emerge; with money still left to loan at cheap rates after all of the normally-acceptable loanees have been placated, “malinvestment” occurs.

This malinvestment must be allowed to diffuse itself. Yes, this means a period of slower economic growth, and possibly even a short period of recession. But another word for recession is reorganization: various resources are simply shifting from one failed business or policy into a new and more promising one. Just as a child might build a better toy spaceship out of Lego pieces only by first taking apart his old design, so an economy must liquidate the bad before creating newer and better opportunities.

We see it almost hourly now: various banks failing or being purchased at low prices relative to their assets. This is a good thing because those that made mistakes are being made to pay for them, swiftly and surely. However, the originator of all this trouble has yet to be taken fully to task: the Congress, forcing bad loan policies on banks, the Fed with its artificially low rates and the GSEs with their wreckless decisions all hold equal blame with those that actually made loans at the end of the day for creating a scenario almost impossible to resist.

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Written by caseyayers

29 September, 2008 at 7:50 pm

Let the Market Liquidate

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It’s incredible the lengths to which politicians on K Street and traders on Wall Street will go to in order to forget history. It must be truly difficult, especially for those old enough to have lived through similar scenarios in the past. There’s a wealth of knowledge that can be referenced in regards to this most recent “crisis” in the financial sector. The problem is that events never look quite the same twice, so all too many people either cannot or refuse to see the swinging pattern that we have been in for a long time now. Just as there seems to be a political pendulum that often swings from left to right- and back- a similar pendulum affects the American financial markets.

The two forces at battle here are interest rates and regulation. We are currently in a time of low interest rates and little regulation. This appears to be on the verge of changing, with Republicans and Democrats alike taking a populist stance against the “fat cats” on Wall Street, all while trying to figure out where to endorse a check that will increase the national debt by almost ten percent.

Look for regulation to make a strong comeback; following closely behind will be inflation. Regulatory measures serve only to squash free market efficiencies and add barriers and costs that make otherwise favorable investments no longer feasible. Regulation, in finance and elsewhere, serves to stunt growth. This is not exactly what the American and global economy needs at the moment, but don’t tell that to those dwelling within the Beltway, or executives looking for a way to personally escape their troubles at any cost to their shareholders and the American people.

The real problem is, and has been, and overabundance of money in the US financial system caused by incongruously low interest rates. Indeed, the current real interest rates offered by the Federal Reserve to banks is negative, once even very conservative inflation figures are taken into account! These low interest rates flooded the economy in the past few years with more new funds than were required to sustain normal growth. The excess money was left only to chase sub-standard investments. After all, money does not sit still for long. Indeed, it is this pattern of low interest rates that created the dot-com bubble in the late-90s, too. Fed Chairman Greenspan lowered rates dramatically to combat perceived weakness at that point, as well as to jump-start the economy following 9/11, after having taken them higher only for a very short amount of time. The housing bubble was given birth by these new low interest rates. After rates had increased slowly for a time, new Chairman of the Fed Ben Bernanke led the Reserve Board in lowering rates again to fight the outer bands of the current mortgage storm over the past two years. This series of rate-cuts undermined the US Dollar and resulted in the insane growth in commodity prices, including oil and gas, over the past year. The truth is that fiddling with interest rates almost never results in long-term good.

More concerning still, low interest rates combined with the Treasury’s plan to print C-notes continuously for months to come to bail out Wall Street will flood the market with ever more dollars. New regulations and the wounded nature of finance’s old titans will leave these dollars with no new direction in which to go. Given our current course, we face a short-term future where zero growth leaves new dollars only to chase existing goods, resulting in high levels of inflation. It’s the 1970s all over again.

And that’s my point. This is a cycle that the US is repeating for the umpteenth time. The economy boomed post-World War II largely because there was such a pent-up supply of money that simply couldn’t be spent during years of rationing. This newly-unleashed wealth resulted in explosive growth. The heavy, near-socialistic regulations on industry that existed during the war were torn down, and a relatively free-market emerged. Yet in the next two decades, regulation would creep back into American policy, again stunting the economy. Then, too, interest rates were kept at levels that put money into the marketplace at a faster rate than America’s GDP could digest. Cue the staggering inflationary period in the 1970s. Reagan broke the back of this inflation by taking dollars out of the market; Fed Chair Paul Volcker took the unpopular, yet necessary, steps to bring the monetary supply back in line with the true economy.

Inflation kills growth. If one expects a five percent yearly return for undertaking some sort of investment risk, yet sees that his money will be worth less the next year than now, he will instead require a return of five percent plus the anticipated rate of inflation. Only the very best projects are fully funded, and those nearer to the margin are either underfunded and forced to fail or never even are endeavoured upon. By breaking the back of inflation, Reagan and Volcker reset the economic environment and created the most important condition for growth to occur. Reagan then successfully sparked one of the most incredible periods of growth in the history of the world by lowering interest rates back to nominal- but not low- levels, decreasing the regulatory bondage faced by American enterprise and lowered taxes across the board. Lowering taxes simultaneously lowers the required rate of return for an investment and decreases regulatory (aka avoidance) costs that increase when taxes are high.

As Reagan proved, the recipe that sets the American economy on fire, rather than on firesale, is a nominal interest rate environment combined with low levels of regulation. Problems arise when politicians get greedy and try to meddle with the normal ebb and flow of capital in the free market. Meddling with interest rates corrupts the economic environment and results in mal-investment, such as the sub-prime housing debt now out in the market. Worse still, several Congressional measures have been passed in the past few decades that require banks to make a certain portion of their loans available to uncredible clients. Creating legal momentum and combining with it interest rates that spawn more money than the economy can normally absorb leaves nowhere for the money to go but to sub-prime debt. Indeed, although banks should have resisted the urge to make loans oftentimes bordering on crazy, blame for this should be shared by the monetary and fiscal policymakers in Washington.

Unfortunately, what comes up must come down. There are those out there that argue that the lack of a bailout will result in catastrophe. Yet we’ve already seen breathtaking changes in the composition of the financial sector in the last few weeks. The market will adapt on its own, as it should. Bad investments must fail, otherwise no true risk was taken. This creates a moral hazard equation where, in the future, people are ever more likely to make erratic investment decisions because they are confident that they will be able to keep the gain for themselves and share in any losses with the taxpayer.

The bailout must not occur. Instead, as is so often the case, economist Brian Wesburyoffers a better solution. The fact is that bad investments did occur, but the illiquid nature of the mortgage market means that just a few failures, or an immediate need for cash by just one or two small firms, creates a catostrophic accounting loss for all of the players in the market. As he says, the current accounting rules create a nonsensical mark-to-market necessity that is bringing even relatively well-capitalized firms to their knees:

Imagine if you had a $200,000 mortgage on a $300,000 house that you planned on living in for 20 years. But a neighbor, because of very special circumstances had to sell his house for $150,000. Then, imagine if your banker said you had to mark to this “new market” and give the bank $80,000 in cash immediately 9so that you would have 20% down), or lose your home. Would this reflect reality? Not at all. Would this create chaos? Absolutely.

Indeed, many mortgages may fail and not pay out. But the financial instruments these are wrapped up in were created with this largely in mind: by wrapping many mortgages together into some other type of product, risk is diversified and lessened.

The Congress needs to act to end this crisis, but a Publisher’s Clearinghouse check won’t do the trick. Instead, as Wesbury suggests, a suspension of mark-to-market requirements for certain instruments would allow banks to isolate these products until the real value of each can be more properly divined. In the meantime, the Federal Reserve needs to begin slowly cranking rates back up to a reasonable level (reasonable being defined as 2-3% after taking out inflation’s dithering effect). Investors that made particularly bad decisions will fail. But this is the risk that they took when they were tempted by astronomical gain. The stock market should not be in the same business as Little League baseball, handing out trophies to all participants.

It is not necessarily our fate to once again re-enter the stagflationary period of the 1970s, but that is the trajectory we currently follow. We must work together to slow down policymakers and to bring an end to the ready-fire-aim mentality that sweeps evermore heavily upon Washington in an election year of this magnitude.

Let the market liquidate. Rewrite the rules, though, so that the liquidation is fair and not frenzied. It won’t be pretty, but it won’t be another depression. $700 billion sounds like a lot of money, but it’s only five percent of annual GDP. If we took that whole hit this year alone, it would be the first thing large enough to actually cause a minor recession to an economy still silently growing at more than three percent. Next, set fair rates and resist the urges to let Washington arm-wrestle the invisible hand of the market with new regulations. Indeed, the answer here is less government meddling, not more.

Written by caseyayers

23 September, 2008 at 6:59 pm

On the Subject of Texas Tea

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Originally posted in April of 2006, this piece hopefully still provides some useful information today.

Let’s do a little rundown on gas prices and the like. Not only might it be educational for everyone involved, but it’s indirectly helping me feel prepared for my Economics exam later today.

So Why are Gas Prices so High?

There are several reasons for this.

  • Worldwide Demand is Increasing
    For a while, the United States has been far and away the largest consumer of oil. That- perhaps odious- record is on its way out the door. India and China, the world’s two fastest growing economies (ours being the bronze medal winner by any fair standard) have spurred a massive demand for oil in that part of the world that was not once there. Think of China for a minute. When you picture the Chinese people in the city, how do you see them getting around? In the past, the answer has always been bicycles, right? No longer. Regardless of the social oppression weighed on its people by the Chinese government, China’s people have gotten financially more wealthy in the past decade, to the point where luxuries like automobiles are becoming an imminent reality for millions. The same goes for India. That’s just a minor example, though. Think of all the factories in India and China, and imagine what they run on: oil. And oil isn’t just for energy. It is refined or used in producing lubricants of all sorts- from the things that make machines work all the way down to Vaseline- as well as CDs, carpeting, and a million other things. Simply put, as the whole world wants more stuff- China and India in particular- the price of oil will continue to rise.

  • Refinery Capacity is too Low
    Another contributing factor is the fact that we have a very limited number of ways to turn that black stuff out of the ground into car-friendly gasoline. To do so requires heavy refining, as well as mixing the oil with any number of chemicals for efficiency or environmental reasons. Here’s the problem: we haven’t built a new refinery capable of making gasoline since the 1970s. It’s pretty absurd to think that demand for oil hasn’t risen in the last forty years. It’s even more absurd that supply has been bottlenecked by these old refineries.

    So why haven’t we built any new refineries?

    The environmental types would have you believe that the Earth’s imminent demise is only one more oil refinery away from happening. Of course that notion in itself is absurd, but let’s take a more common sense approach to the situation: if we haven’t built any of these refineries since the 1970s, they must be pretty broken-down and dirty places, right? Of course. The pollution levels are very high from these facilities. Common sense tells me that decades of research would allow us to make a far cleaner-burning refinery today, one that would actually help the environment in comparison with what is running now. So let’s say, just for simple math, that a refinery built this very moment would only release half as much pollution to make the same amount of gas as one of the old refineries does. Great! Let’s build twenty of them. As we turn the new refineries online, we simply turn the old ones off. Same amount of pollution, double the capacity. Using the same reasoning, we could build, say, fifteen of the new refineries. That would actually lower the pollution levels from refineries by 25%, while still raising capacity by 50%.

    You said other things make the gas expensive as well. These chemicals?

    Yep. Ethanol’s a prime candidate for discussion. A lot of people look at Ethanol and see the great “ANSWER” to oil. Ethanol is made from corn, switchgrass, agricultural waste and many other types of plants. The process to create ethanol is very similar to making beer. In fact, Coors has an ethanol plant in Colorado, believe it or not. Ethanol burns cleaner than gasoline (though not much) and is theoretically unlimited. After all, if it comes from corn, we can simply grow more corn when we need more gas, right?

    Not so fast.

    First of all, ethanol is very expensive to make. The only reason it is surviving on the market at all right now is because the federal government has given billions of dollars in subsidies to farmers and ethanol producers to lower the price to the point that it can begin to compete with gasoline in some areas. Secondly, we can’t make enough. The idea of simply growing more corn sounds great at first, but the problem is scarcity. Just like there’s a limited amount of oil in the ground, there’s a limited amount of ground. It would take somewhere around three times ALL the arable land in the United States to grow the corn required to keep up with demand for ethanol if it replaced oil entirely. Lastly- and here’s the kicker- a large amount of oil is used to make ethanol. Think of the tractor that the farmer uses when tending to the corn, the machine that husks it, the truck that drives it to the refinery, the power plant that keeps the refinery going, the truck that takes the ethanol to the distribution center, et cetera. The sad fact of the matter is it takes almost a gallon of oil to make a gallon of ethanol, and ethanol is no more efficient when used later on. All that is happening is we’re paying for the oil twice over with ethanol- once for the oil needed to make it and again for the ethanol itself.

    But aren’t the oil companies taking massive profits on gas sales?

    Nope. You know that “obscene” profit of thirty-something billion dollars ExxonMobil made last year? Congressmen and Senators are calling that a travesty, unpatriotic, blah, blah, blah. Sure, I’d love to have $30+ billion dollars laying around, but the fact is that ExxonMobil and other such oil companies aren’t simply sitting on that money or filling swimming pools with $100 bills. In the last five years, Exxon has invested over $74 billion dollars in new oil finds. The fact is it is really expensive to start up a new oil pipeline or off-shore drilling platform, much less to find the stuff in the first place or turn it into usable gas. The fact of the matter is that every time Exxon simply GUESSES where oil might be, it takes over ten million dollars just to poke the hole in the ground to check. Even worse is the fact that we aren’t letting them actually go to where we know the oil is, like off of the west coast of Florida or that small patch of hell in Alaska.

    Here’s another point- the typical margin for gasoline sales is maybe 10% for oil companies. That means when you pull up to the BP or Shell down the street, even at three bucks a gallon, they’re only pocketing maybe 30ยข per gallon. Here’s the dirty little secret- the government, between federal, state and local, collects over fifty cents per gallon. That means that the government- remember, the ones calling the oil company profits obscene- are actually pocketing almost 70% more than they are. The government would claim that that money is needed to build roads. Without getting into a usage argument, I’ll agree with that, but say that the oil companies need their profits just the same to be able to invest in finding other oil supplies around the globe to make sure we don’t run out.

    But isn’t oil bad for the environment?

    Sure. I won’t argue that point. I get angry every time I see one of those dump trucks outside of UNF spew a tower of black smoke out of the top. However, what is the answer, exactly?

    Well, for those of you environmentally inclined, you should welcome the rise in prices wholeheartedly. The fact of the matter is that $3 a gallon is just about where hybrid cars begin to pay for themselves in gas savings. Hybrids obviously use less oil and are all much less polluting than standard vehicles. But are they the answer? No. Remember when I said that China and India are starting to drive? The fact is the number of cars on the roads of the world is increasing at such a rate that even if the entire country switched to hybrids this very moment, within ten years our oil consumption would be right back to where we are today.

    So what do we do to fix this once and for all? First of all, we need to start getting rid of our power plants that run on oil and coal. We replace them with nuclear power, as well as photovoltaic solar plants when the technology is ripe enough in ten to twenty years.

    Wait, isn’t nuclear power a scary thing that will end us all?

    I dunno. How about we ask Peter Moore, the founder of GreenPeace? The fact is that nuclear power is incredibly safe now, especially with advances in the technology made in the last twenty years. You know, the twenty years in which we haven’t built any nuclear power plants. Do you think the French, perhaps, are environmentally attuned? I do too; they produce almost all of their power through nuclear technology.

    So you were saying about how to stop using so much oil?

    Yes. Don’t interrupt me.

    Sorry.

    Right then. So the first step, as I said, is to get rid of those power plants. They take up a huge amount of oil and coal and release a lot of pollutants. Now what about our automobiles? I’ve already explained why ethanol is not an answer in any way, shape or form. So what’s the golden goose? Hydrogen. By 2009, the first hydrogen-based cars will begin rolling off of the lines from makers like GM. Running on a relatively simple chemical reaction, the only emission from the system is water. Cool, huh? Well, the only problem is they currently have the tendency to explode. Once GM and the others get the technology down, though, it has the power to truly make gasoline obsolete.

    So where can I fill up with hydrogen? I only remember seeing 87, 89, and 93 octane at the pumps last week…

    Good point. It’s a chicken-and-egg scenario, isn’t it? There’s no cars that use hydrogen, so why build the (very expensive) pumps? At the same time, why build cars that people can’t use?

    You’ll love the answer to this one.

    You know those record profits the “oil” companies are making? Companies like Shell are reinvesting a piece of those in promoting hydrogen technologies as well. Think about it from their perspective- they know oil’s days are numbered, so to remain a viable company, they have to lead the way to the future. So for each obscene billion dollars of extra profit, the “oil”- perhaps “energy” is a better term- companies are reinvesting that not only in finding new oil, but also in developing oil’s replacement. It’s all rather elegant, hm?

    That’s all very nice, but I’m tired of paying so much right now. What’s the deal?

    Well, I’m sorry. The fact is that if you’re not willing to pay the price, the Chinese and others are. Oil demand has risen with no subsequent rise in supply. The solution? Get mad. Start making people aware of the fact that we can’t even make any more gas than we are right now. Understand the fact that the government is taking a far larger piece of profit out of every gallon than the oil companies are. Thwart any legislation against “windfall profits” that are being used to develop cheaper and safer energy sources. And, sorry folks, just drive a little less.

  • Written by caseyayers

    25 April, 2006 at 11:34 pm