Not So Dismal

Making Economics a Little Easier to Understand

Posts Tagged ‘Money

Bailout 2.0

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From today’s Politico Arena question, which is “Bailout II: Does the New Plan Sound Better Than the Old? What else must happen?”

It’s “better”, but only insofar as it’s shoving open the credit markets.

One of the weapons that has helped most in the past few days is one that is hardly being mentioned: FASB, an accounting standards organization, released changes regarding mark-to-market accounting for illiquid assets, suggesting that it might be okay to value mortgage packages and other securities that simply aren’t being traded at their cash value, rather than at the bidding price. This is important because the bidding price is far below both the actual hold-to-maturity value of these securities and even discounted prices many companies might accept to simply get rid of them. If the change is enough to allow auditors the latitude to sign off on less paranoid financial statements, then we may see that many companies on the cusp of problems are, in fact, doing okay from a cash flow perspective.

But the crush of new money bursting through the gates remains a big part of this, to be sure. And that’s what should be most concerning: this money may be useful to break open the clogged pipes, but now the fear should be focused on when they burst. In other words, having hundreds of billions of new dollars in the market that aren’t really needed will lead to massive inflation, and sooner than many people think.

Written by caseyayers

14 October, 2008 at 8:34 am

Government’s Role in Stability

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My answer to today’s Politico Arena question, “What can government do right now to stabilize markets or reassure the public? Bonus question: How low will the Dow go?”

The best thing government can do to stabilize the market is to declare fully, and with the greatest finality possible for such a tenuous situation, the level to which they intend to continue meddling in the markets. The reason we keep seeing day after day of multi-hundred swings this way and that is that noone can price the market. There are too many shadowy variables for traders to really get their hands around this thing.

Protect all deposits to an unlimited value. This should help to stop any runs on banks in their tracks. Provide short-term liquidity to businesses that prove both creditworthy under normal circumstances and unable to obtain credit in these troubled times. Don’t buy stakes in banks, don’t keep throwing money blindly at the sector. Doing this does very little to truly help break the credit logjam; rather, the money is simply being brought in by the truckload to any destination that might have given the slightest hint of illiquidity. This will lead to massive inflation later when we finally figure out that smaller, far more targeted sets of money, such as those the Fed auctions using its term lending facilities, were the smarter solution.

The Dow will go as low as fear can take it. But salvation here lies in greed: already valuations on some companies are absurdly low. Many companies with no exposure whatsoever to housing and with more than enough cash on hand to survive any credit freeze have been trashed. Somewhere between 7000 and 7500, the bargains will become too great to ignore for the savvy investors.

Written by caseyayers

10 October, 2008 at 8:48 am

Convenience of Money

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An interesting piece by Tim Harford, the author of The Underground Economist, appeared in Slate Magazine last year that discussed price rigidity, using a classic example. The price of a bottle of Coca-Cola remained at a nickel for over Glass Bottles Always Taste Betterseventy years, an incredible fact given the long-term inflation of so many other prices, including those of its main ingredients. Yet Coke was hard-pressed to raise the price in order to stabilize their margins because of the vast leap between a nickel and a dime. Indeed, the next-highest denomination resulted in a full doubling of the price of a bottle of the world’s favorite soft drink. In the 1950s, when a price change was absolutely necessitated, Harford tells us that the, “…boss of Coca-Cola wrote to his friend President Eisenhower in 1953 to suggest, in all seriousness, a 7-and-a-half cent coin.”

This may seem like a bit of a comical notion, but the lack of flexibility in US denominations did adversely hurt Coke, allowing its time-honored competitor Pepsi the chance to use their famous slogan, “Costs a nickel, worth a dime.” A similar situation faces soft drink bottlers and various other vendors today. Across the country, it appears that prices are being pushed past $1.00 for a 20 Oz. bottle and $0.50 for a can en masse. While prices obviously differ from place to place, the new ceiling for cans tends to be around a dollar, indeed a doubling in price.

No Coke, PepsiBut the fact that it costs twice as much isn’t the issue anymore. Indeed, even the poorest among us would rarely be found complaining about the average price of a can of pop/soda/insert-your-regional-slang-here. The problem now is what I call “convenience of money”. While $1.00 is a nice, round figure, bottles are left in an odd predicament. In most cases, $2.00 would be seen as too high of a price, and on an ounces-per-dollar basis would be less of a value than a dollar can. Prices for bottles have fidgeted often around the $1.25 point. Even though this is much more reasonable than $2, I would surmise that Pepsi and Coke’s sales don’t show as large of a difference between $2 and $1 as they show between $1 and $1.25 due to a demand curve bent as if by gravity to the easiest combinations of monetary denominations.

The problem is that blasted quarter. People just don’t carry change like they used to, and while there may be a few $1 bills in their wallets, the likelihood of being able to finish the transaction with a quarter is much smaller. Indeed, in this day and age, it is a $1.25 bill that Coke and Pepsi should request from the US Mint, rather than the 7 1/2 cent piece of old.

Broadly speaking, it might be even better for the soda companies if dollar bills were to simply be taken out of circulation, replaced with dollar coins entirely. The Mint has tried again and again to get people to switch over voluntarily to a higher-denomination coin. Yet the embattled green portrait of George Washington survives with nary a scratch.

Dollar-scanning machines tend to break down more often than their coin-only counterparts and can become an issue when dispensing return funds when more than one dollar bill has been submitted. Vending machines have already mostly been converted to accept dollar coins, whether they are of the Susan B. Anthony, Sacagawea or Presidential variants (all share the same size and weight). Coinage loves company, as well; having dollar coins on hand makes it more likely that smaller coins will again find their way to people’s pockets, making $1.25 not so awkward a price, after all.

Another tactic has been to switch to plastic: more and more machines include credit card swipers on the front, which allow consumers to either swipe their RFID-enabled card or their old-fashioned magnetic strip to purchase some edible goodies. Overseas, cell phones are often used for transactions, with the final tab simply added on to a phone subscriber’s bill at the end of the month. Both methods take the actual money out of the equation, leaving only the true price for customers to consider; having a quarter on hand isn’t a part of this purchasing decision. While these alternatives do carry transaction costs, a price point of, say, $1.35 for credit card purchases vs. $1.25 for cold, hard cash would not scare away many customers looking for a caffeine fix. Or, perhaps, not having to be as concerned about machine break-ins, drivers having to carry around so much coinage and cash and technicians having to fix the mechanical pieces required to process the money would present a large enough savings to vending companies to make the transaction costs a wash.

One caveat is that higher prices still carry a psychological barrier to customers. Especially in these smaller denominations, people have been taught to think in coins. Perhaps $1.35, then, is a larger leap for some people than it honestly should be. Certainly $1 seems like a much better value than $1.15 would be, for example. But alternative payment systems strip away the physical tie to this price psychology and affords companies more flexibility in adding more balance-sheet “bounce to the ounce”.

Written by caseyayers

8 October, 2008 at 4:00 pm

The Pie is Bigger Than it Looks

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So how do runs on the bank work, anyway? To understand how bank runs create a self-fulfilling prophecy, it’s important to understand how banks keep and loan money.

Banks don’t keep all of their deposits on tap. Rather, only a portion of these are kept around at any time. Under normal circumstances, this is fine, because it’s very unlikely that everyone will suddenly ask for their money at the same time. Therefore, just keeping a small percentage on hand is enough for the daily traffic at any branch. Why don’t they keep all of the money on tap at any particular moment? That question strikes to the heart of how banks stay in business at all.

Keeping just a portion of the money on hand, a practice known as having a fractional reserve system, means that the bank can use most of their funds to make loans to other people, to businesses, and to other banks. This also leads to an expansion of money behind the scenes. The Federal Reserve sets the reserve requirement; we’ll say it’s 10% for this example:

You deposit $1,000 at your bank. The bank is required to keep $100 of that on hand as its reserve, but is free to loan out the other $900. So they do: your bank also issues credit cards, and I walk into Home Depot with their card to purchase a washer and drier that cost $1,400 together. I put $900 on my card, which means that Home Depot will receive this money. However, the store offers a special no-interest deal for the remaining $500. They can afford to lend this credit, ironically, in part because of the other $900 that I just gave them. Home Depot only uses part of that money, though, and also takes out a loan at a favorable rate to help cover the financing. They do this by drawing on someone else’s savings.

Confused yet? That’s what makes the current situation difficult to understand: everybody owes everybody else somehow, and it all started with just a few green pictures of Ben Franklin.

An economist would tell you that a 10% reserve requirement on $1,000 means there’s actually $10,000 out there. The math is simple: either divide $1,000 by 10%, or carry it out all the way. Everyone has to hold onto 10%, meaning $1,000 creates a new loan of $900, and then another of $810, and then another of $729, and so on until the difference is negligible. But this isn’t really how it works. As in the example, sometimes money “sticks” before it has reached its terminal point. Home Depot pockets the majority of the cash from that $900 I put on my credit card. When that happened, the possibility of that money being loaned out again quickly to somebody else decreases significantly.

So that’s the first cause of the current “liquidity” crunch: money gets stuck along the way. In a period of uncertainty like today, this money leaves the economy and goes underneath a mattress somewhere. But this money has been taken out of the system somewhere halfway through. The real trouble starts when the money is taken out from the origin point: your checking or savings account.

Bank runs happen because people are afraid that they won’t be able to get their money back. This could be due to fears over national security, the global economy, or just poor management of a local bank. In any case, a mad rush of withdrawals can quickly wipe out a bank’s “current liquidity”, otherwise known as the 10% they kept on hand from your savings and those of everyone else. And when this happens, the bank quickly becomes broke. They have to tap into money they’d otherwise use to make loans in order to meet withdrawal requests and, piece by piece, have to take apart all of the different, longer-term instruments like bonds or mortgages that they owned as they keep running out of cash.

Welcome to the current situation. The reason why so many mortgages, and we’ll talk about how they’re wrapped up in packages some other time, appear to be worthless now is because a couple banks that were particularly reckless had to dump out of them for pennies on the dollar just so that they could have a little more cash on hand. The mark-to-market rules I keep harping on means that other banks have to pretend like their securities are just as worthless as those sold at firesale, making it appear like they took huge losses when in fact they have plenty of cash left.

The prophecy is fulfilled when people become worried about these banks’ health and withdraw all of their money. Since our economy is based on a monetary system that boils down to little more than keeping tabs on a scoreboard, when the lifeblood of the system is taken out the whole thing breaks quickly. That’s what we’re seeing now.

Written by caseyayers

2 October, 2008 at 7:47 pm

The New Sound Money

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There’s a great article on the Wall Street Journal’s opinion page today that can be found here.  Excerpt below, but I highly recommend you read the whole thing if you’re willing to swim in some moderately-deep economic waters.  Maybe I’ll cover the subject at a more elementary level in a few days.

The whimpering is real, and justified, because it hurts to have your world come crashing down. And global financial markets are definitely crashing, even when the impact is momentarily softened through massive injections of artificial money — “artificial” because the fiat money does not represent a store of genuine value but rather an airy government claim to future wealth yet to be created.

In the aftermath of this financial catastrophe, as we sort out causes and assign blame, with experts offering various solutions — More regulation! Less complex financial instruments! — let’s not lose sight of the most fundamental component of finance. No credit-default swap, no exotic derivative, can be structured without stipulating the monetary unit of account in which its value is calculated. Money is the medium of exchange — the measure, the standard, the store of value — which defines the very substance of the economic contract between buyer and seller. It is the basic element, the atom of financial matter.

It is the money that is broken.

Written by caseyayers

30 September, 2008 at 1:02 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