Lessons from Greece

The Star has a round-up of photos from the Greek riots:

A riot policeman falls after being hit with a molotov cocktail in Athens during a nationwide strike by civil servants protesting the announcement of draconian austeristy measures. May 5, 2010  (REUTERS/John Kolesidis)

A medic prepares to remove the body of a person who perished in a bank that was set on fire during demonstrations in Athens. Three people died in the fire. Greece faced a day of demonstrations during a nationwide strike by civil servants protesting the announcement of draconian austeristy measures. May 5, 2010.   (REUTERS/Pascal Rossignol) 

A riot policeman runs from angry protesters in the northern Greek port city of Thessaloniki. May 5, 2010. (AP Photo/Giorgos Nissiotis)

As credit default swaps on European banks bonds reached record levels today, surpassing the level triggered by the collapse of Leman Brothers, Nouriel Roubini, professor of economics at NYU who predicted the recent financial crisis, writes this warning in the Christian Science Monitor titled "Greece Debt Crisis is Only the Tip of the Iceberg":

Historically, we have seen a series of defaults and sovereign debt crises in both advanced and emerging market economies. If you are a country like the US, the UK, or Japan that can monetize its fiscal deficits, then you won’t have a sovereign debt event but high inflation that erodes the value of public debt. Inflation is therefore basically a capital transfer from creditors and savers to borrowers and dissavers, essentially from the private sector to the government.

While the markets these days are worrying about Greece, it is only the tip of the iceberg, or the canary in the coal mine of a much broader range of fiscal crises. Today it is Greece. Tomorrow it will be Spain, Portugal,Ireland, and Iceland. Sooner or later Japan and the US will be at the core of the problem, shaking the global economy.

We need to recognize that we are in the next stage of financial crisis. The coming issue is not private-sector liabilities, but pubic-sector liabilities.

Revived economic growth alone will not generate enough tax revenue to relieve this sovereign debt crisis. Fiscal deficits are huge and structural. They are not due solely to a cyclical downturn in growth but to long-term commitments such as pensions, Social Security and health care. To avoid default or high inflation, the advanced economies will require some combination of raising revenues through taxes and cutting government spending.

In Europe, where tax rates are already very high, the right adjustment is cutting spending instead of raising taxes further. In the US, the average tax burden as a share of GDP is much lower than in other advanced economies. The right adjustment for the US would be to phase in revenue increases gradually over time so that you don’t kill the recovery while controlling the growth of government spending.

 What worries me most is the political gridlock in Washington. While everyone agrees that $10 trillion deficits (by the Obama administration’s own estimates) for the next decade are not sustainable, there is no political will to act. The two parties are completely divided. Effectively, the Republicans are against any form of revenue increases. The Democrats are against spending cuts, especially of entitlements. [emphasis mine]

USA's oped puts the current crisis in perspective:

To be sure, there are huge differences between Greece and the United States. Here, the federal government represents about 20% of the U.S. economy, whereas the Greek government is about 40% of its economy. Washington's big spending is on benefit programs such as Medicare and Social Security, rather than on compensation for a massive and militant cadre of public employees. And, perhaps most important, the USA doesn't share a currency with other countries, giving the nation more flexibility to print money if needed.

Before Americans get too smug, however, they should note the obvious: Debt is debt. If too much Greek borrowing can send world financial markets into turmoil like that of the past couple of days, imagine the damage a U.S. debt crisis would inflict.

Washington's public debt is nearly $8.5 trillion, which comes to about 58% of the U.S. economy, compared with ratios exceeding 100% in places like Greece. But the U.S. debt is rising fast, and its true size is masked by the surplus run by the Social Security trust fund. Factoring that in, the total national debt is about $13 trillion, or 90% of the economy. Including unfunded liabilities for such programs as Social Security, Medicare and Medicaid, the federal government is looking at a long-term shortfall of about $62 trillion, or about $200,000 for every American, according to thePeter G. Peterson Foundation, a group devoted to promoting awareness about public borrowing.

These numbers should come as a shock. But in Washington, there appear to be two acceptable responses — denial and finger-pointing.

Greg Mankiw links to the CBO's projected US spending by 2020:

 

We certainly are not Greece as USA's oped points out--not just from a debt perspective, but cultural perspective as well.  However, it remains to be seen whether politicians from either party will be able to talk to American voters like they're adults or continue to infantilize them, telling them that yes, we can cut taxes (except for those greedy rich), and continue to keep our entitlements.  This recent poll indicates Americans aren't too keen on entitlement spending: 83% blame the government for increasing the deficit through spending, while only 18% of them are willing to raise taxes to lower the deficit. 58% believe the health care bill will raise the deficit and therefore, support its repeal.  Some other polls put the favor for repeal lower, and instead call for an "amend and modify" approach.  


Despite the opposition to increased spending, it's unlikely many Americans, particularly seniors, will want major changes or cuts to their entitlement programs. Talk about cognitive dissonance.  I don't think we're at the point of California yet--the state is practically ungovernable. But as boomers retire, the window of action for real reform of federal spending is narrowing.

Brace Yourselves: More Bailout $$$ for Fannie and Freddie

From the AP (H/T from Hotair):

WASHINGTON – Freddie Mac is asking for $10.6 billion in additional federal aid after posting a big loss in the first three months of the year. It's another sign that the taxpayer bill for stabilizing the housing market will keep mounting.

The McLean, Va.-based mortgage finance company has been effectively owned by the government after nearly collapsing in September 2008. The new request will bring the total tab for rescuing Freddie Mac to $61.3 billion.

Erza Klein posits:

The problem is that Fannie and Freddie are not a direct and simple subsidy for the banks. They are private companies with a government charter. Rather than using taxpayer dollars to subsidize mortgages, they were borrowing money very cheaply because their quasi-governmental status assured the market that there'd be a taxpayer bailout in the case of any sort of collapse. That is to say, their business model relied on markets ignoring the risk of their activities. And then, because they were private companies with shareholders to please, they also got into slicing and dicing mortgage packages to make money like an investment bank rather than a housing policy. In theory this should've worried the markets where they borrowed their money, but again, the government backstop saved them. Forget too-big-to-fail. This was not-allowed-to-fail.

So, of course, they failed. As Raj Date of the Cambridge Winter Center put it to me, "anytime the debt markets aren't paying attention to your risk profile, you're doomed."

Their failure was not, as some would have it, the cause of the mortgage crisis, or even close. For one thing, only about 2 percent of their portfolio was subprime. For another, they didn't start backstopping the subprime market till long after it had taken off. And for a third, their greatest losses actually were in non-subprime loans.

But they were part of the problem. And the fundamental mismatch between their risk and activities will continue to cause problems. But solving the Fannie and Freddie problem is more complicated than it might appear. What you're talking about, essentially, is a massive subsidy for home ownership. That is to say, a massive subsidy for the middle class. So easy as it is to talk about the failure of Fannie and Freddie, it's a lot harder to talk about their elimination, as that's talking about the removal of a popular subsidy in a fragile market.

The WSJ doesn't take the role of Fannie and Freddie as lightly in the meltdown, and has a much higher number than the AP for total loss to the taxpayer.  Sens McCain, Shelby, and Gregg have introduced an amendment to deal with the 2 GSEs:

The Financial Crisis Inquiry Commission spent yesterday focusing on financial "leverage," using Bear Stearns as an example. But Fannie and Freddie were twice as leveraged as Bear, and much larger as a share of the mortgage market. Fan and Fred owned or guaranteed $5 trillion in mortgages and mortgage-backed securities when they collapsed in September 2008. Reforming the financial system without fixing Fannie and Freddie is like declaring a war on terror and ignoring al Qaeda.

Unreformed, they are sure to kill taxpayers again. Only yesterday, Freddie said it lost $8 billion in the first quarter, requested another $10.6 billion from Uncle Sam, and warned that it would need more in the future. This comes on top of the $126.9 billion that Fan and Fred had already lost through the end of 2009. The duo are by far the biggest losers of the entire financial panic—bigger than AIG, Citigroup and the rest.

From the 2008 meltdown through 2020, the toxic twins will cost taxpayers close to $380 billion, according to the Congressional Budget Office's cautious estimate. The Obama Administration won't even put the companies on budget for fear of the deficit impact, but it realizes the problem because last Christmas Eve it raised the $400 billion cap on their potential taxpayer losses to . . . infinity.

Moreover, these taxpayer losses understate the financial destruction wrought by Fan and Fred. By concealing how much they were gambling on risky subprime and Alt-A mortgages, the companies sent bogus signals on the size of these markets and distorted decision-making throughout the system. Their implicit government guarantee also let them sell mortgage-backed securities around the world, attracting capital to U.S. housing and thus turbocharging the mania.

The virtue of Mr. McCain's amendment is that it will give Senators a chance to vote on the kind of reform that Congress blocked for so long, notably with Senator Barack Obama helping the blockade. The amendment mandates that the current government conservatorship of Fan and Fred will end within 30 months. In the meantime, the companies will have to reduce their mortgage portfolios by 10% each year. If the terrible twosome can't stand on their own after conservatorship, they would then go into receivership and be liquidated.

If they can survive on their own, they would have three years before the expiration of their federal charters, during which time they would have new operating restrictions. Messrs. McCain, Shelby and Gregg would repeal the affordable housing goals previously legislated for Fan and Fred and which contributed to their terrible mortgage bets, and the companies would have to reduce the mortgage assets held on their books by nearly 50% within two years and raise their capital standards.

Fannie and Freddie would also have to start paying state and local sales taxes, lose their exemption from full registration at the Securities and Exchange Commission when they issue securities, and start paying fees to repay the taxpayer for the value of federal guarantees. The $400 billion limit on taxpayer assistance would be reinstated, and for as long as they are in federal conservatorship or receivership, they would have to be included in the federal budget.

In short, the McCain amendment precisely targets the problems that caused the mortgage crisis: If the housing giants are no longer subsidized, they will become small enough to fail. That means they will stop lending money to people who cannot afford to pay them back, and in turn they will stop endangering taxpayers.

[emphasis mine]

It's time to get the government out of the housing business. Erza wants to tackle it in a separate housing bill, arguing those reforms won't be felt in the financial market as much as the housing market.  However, an astute reader points out a graph from Calculated Risk that shows just how much the GSEs subsidized the mortgage market as percentage of market share:

While I can follow Erza's logic that housing may be better dealt with via a separate bill, I have little confidence the Dems will actually break up their sacred cows. They will likely retain some type of government intervention in the housing market. Rep Barney Frank who once admitted that maybe Fannie and Freddie should be ended, sent a memo to the WH to defend the financial reform package and fight the GOP on the Fannie and Freddie narrative:

...Frank argues that Democrats have the facts on their side, and then need to do a better job of communicating them. 

Freddie and Fannie have already been reformed, to some extent, by virtue of being placed into conservatorship. 

“So the argument that we have ignored the need to change the operation of Fannie and Freddie in our rush to do financial reform is of course exactly backwards,” Frank wrote. “We did Fannie and Freddie first.” 

Frank also wrote that the Republican proposal to abolish Freddie and Fannie would remove an important government prop to the housing market. “It is the unanimous view of every profit and nonprofit entity concerned with the housing market in the United States that simply to abolish Fannie and Freddie, as the Republicans are proposing in the House bill, and not do anything to replace the functions they are now performing with a conservatorship, would be a disaster for housing, and therefore for the economy as a whole,” Frank said. 

Finally, Frank said that Freddie and Fannie are not losing money as they are currently operated – which means they aren’t making the deficit any worse. 

“This is an important point that has to be repeated – as Fannie and Freddie operate today, going forward, there is no loss,” Frank wrote. “The losses are the losses that occurred before we took the first step towards reforming them – we the Democrats – and nothing we could do today will diminish those losses.” 

In Wednesday’s earnings report, however, Freddie Mac said is lost $6.7 billion and was obliged to pay $1.3 billion in dividends on senior preferred stock held by the US Treasury. 

“Our first quarter 2010 financial results were driven significantly by the required adoption of new accounting standards, along with continued weakness in the housing market,” said Ross J. Kari, Freddie Mac’s chief financial officer.

Frank is referring to the Rep Jeb Hensarling's bill that was introduced a few weeks ago, which the Senate amendment is modeled on.  I predict Sen Reid will block the amendment from coming to the floor, and the GOP will have their ads to run in November.

Life Lesson of the Day: Delayed Gratification

Maggie's Farm has a short, entertaining video that shows how researchers figure out which kids grow up to be successful.

Media Starting to Notice Flaws in the Senate's Financial Reform Bill

If you need a primer on current financial reform legislation, the Washington Independent has a good summary; both Republican and Democratic proposals are fairly similar. Daniel Indiviglio at the Atlantic sums up a NYT article that quotes experts questioning whether Sen Dodd's bill really gets to the causes of the economic meltdown, boiling it down to 3 glaring deficiencies:

• The bill does not deal with Fannie or Freddie, the GSEs that played a major role in the crisis (the Republican proposal begins to deal with the GSEs; Democrats say this needs to be addressed in a separate bill)
• The bill does not address the credit crunch that led to investor panic; banks were not able to turn over their short term debt
• The bill leaves it up to regulators to determine capital reserves and leverage requirements at a later date. There are concerns that regulators will be less aggressive as the economy recovers.

Erza Klein links to another proposal at the Econlog:

Here I'd direct you to Arnold Kling's 8-point FinReg fantasy. Kling is an adjunct scholar at Cato and a former economist at the Federal Reserve, but his plan -- which includes getting Fannie and Freddie out of the mortgage market, breaking up big banks, and making derivatives less attractive by deprioritizing them in bankruptcy hearings -- doesn't read like the Republican plan and it doesn't read like the Democratic plan.

The argument over the policy of financial reform -- which is distinct from its politics -- is not between Republicans and Democrats, or even liberals and conservatives. It's between people who think the financial sector needs to be changed and people who think we just need to give the regulators more information, power, and instructions so they can look after it better. Kling is a libertarian and I'm not, but we're probably closer on this than I am to either the Democratic or Republican proposal. 

Kling's proposal gets the government completely out of the mortgage market, except for some tax vouchers to the poor. He also ensures creditors hold debtors responsible for their behavior, which is what should happen in a functioning market economy: 

5. Replace capital requirements with systems that put senior creditors in line to lose money in a default. Let them discipline the risk-taking of financial institutions.

6. Define priorities for creditors in a bank bankruptcy. I think that the solution to the social value--or lack thereof--of derivatives and other exotic instruments can be handled by the priority assigned to them. I would assign them a low priority. That is, first ordinary depositors get paid off. Then holders of ordinary debt. Other contracts, such as swaps or derivatives, come after that. I think that this would provide all the incentives needed either to curb derivatives or lead them to be traded on an organized exchange. I don't think that getting them onto an organized exchange should be sought after as an end in itself.

Another alternative worth considering is in John Taylor's op-ed via the WSJ, "How to Avoid a Bailout Bill", which outlines changes in bankruptcy law to be able to deal with systematic risk type institutions quickly.  


I'm not really optimistic a "Council of Federal Regulators" will be able to stop systematic threats, or that current draft legislation will really end bailouts. Congress, current regulators and the Fed did not see the need to fundamentally change the rules in an attempt to avoid the crisis. Erza Klein points this out today when he posts to a transcript of Alan Greenspan and other Fed members in 2004, dismissing their own data on the housing bubble, believing economic fundamentals were sound.  Klein writes:

But this is why you need to be very careful with the idea that regulation plus information is sufficient. We had regulators and they had information. And it proved totally insufficient. When I asked Sen. Mark Warner how the bill would have stopped the crisis, the first thing he brought up was the Office of Financial Research, which is there to distribute real-time information. Maybe the OFR would put the dots together and maybe it wouldn't, but there's a serious chance that even if it did, the top-line regulators would find reasons to ignore the conclusions of these nameless quants who don't understand the sophistication of the risk analysis being performed on Wall Street, or the anger that the president and the Congress and the Wall Street Journal editorial page will turn on any regulator dumb enough to try and interrupt the good times based on a graph and a theory.

Unfortunately, I don't think we're going to get anything as sensible as Kling's proposal due the politics of upcoming midterm elections.

Sunday Reflections

I took my son to see "Oceans" this week. It's a visual feast.

This photo of a Hawaiian sea turtle won the Wiki Commons Picture of the Year (2007). 

Crony Capitalism and the Current Economic Crisis

Marginal Revolution sums up Russ Roberts's new paper, "Gambling with Other People's Money," on what caused the current crisis in six points.  The first and last point of their blog illuminate key points in his paper:

1. It isn't "too big to fail" that's the problem, it's the rescue of creditors going back to 1984, encouraged imprudent lending and allowed large financial institutions to become highly leveraged.

6. The increased demand for housing resulting from Fanne and Freddie's expansion pushed up the price of housing and helped make subprime attractive to banks. But the ultimate driver of destruction was leverage. Either lenders were irrationally exuberant or were lulled into that exuberance by the persistent rescues of the previous three decades.

But what they seem to primarily miss is Roberts' main point on why the bailouts and favorable regulation (or deregulation, depending on your view) occurred:  Crony capitalism. Roberts writes:

The most culpable policy has been the systematic encouragement of imprudent borrowing and lending. That encouragement came not from capitalism or markets, but from crony capitalism, the mutual aid society where Washington takes care of Wall Street and Wall Street returns the favor.9 Over the last three decades, public policy has systematically reduced the risk of making bad loans to risky investors. Over the last three decades, when large financial institutions have gotten into trouble, the government has almost always rescued their bondholders and creditors. These policies have created incentives both to borrow and to lend recklessly.

When large financial institutions get in trouble, equity holders are typically wiped out or made to suffer significant losses when share values plummet. The punishment of equity holders is usually thought to reduce the moral hazard created by the rescue of creditors. But it does not. It merely masks the role of creditor rescues in creating perverse incentives for risk taking.

The expectation by creditors that they might be rescued allows financial institutions to substitute borrowed money for their own capital even as they make riskier and riskier investments. Because of the large amounts of leverage—the use of debt rather than equity—executives can more easily generate short-term profits that justify large compensation. While executives endure some of the pain if short-term gains become losses in the long run, the downside risk to the decision-makers turns out to be surprisingly small, while the upside gains can be enormous. Taxpayers ultimately bear much of the downside risk. Until we recognize the pernicious incentives created by the persistent rescue of creditors, no regulatory reform is likely to succeed.

He explains the creditors' role in a simple analogy of a poker game that I summarize here: You, the creditor, is asked to lend $ to your friend, a poker player. He asks you to lend $100 for every $3 of his own money, and will pay you back a favorable rate of interest. While that may seem like a high risk, you go along with it for  awhile since your friend is a very skilled poker player. But you will keep an eye on him because you want him to stay solvent so he can pay back his debt. However the gambler will take a big risk if he thinks he can score a major win.  After all, he has only put up $3. As long as he's winning, everyone's happy. But at some point if he becomes increasingly reckless, asking to borrow more and becoming highly overleveraged, you will start reining him in by charging a higher rate of interest, or asking for collateral. That's what normally happens...until Uncle Sam enters the room. Everyone in the room knows Uncle Sam is very rich, and helps write the rules of the game, at times, intervening. They've also seen him cover the debts when everyone goes broke.  Uncle Sam's mere presence in that room changes the incentives for everybody. If you think there's a good chance Uncle Sam will bail out your player, you will keep less of an eye on him and just keep lending $. Why shouldn't your friend take more risk? Why shouldn't you if you know rich Uncle Sam is going to bail you all out of if things go sour? Now enter the moral hazard of Fannie and Freddie, and their implicit government backing.    

I don't believe regulation or deregulation as an end to itself; that confuses process with purpose.  There clearly needs to be some regulation of capitalism; it's a matter of striking the right balance between maximizing capitalism's benefits for society at large and attempting to prevent it from bringing the economy to a halt, or systematically fleecing little guy.  As such, I tend to believe the crisis was caused by a confluence of several factors: what Roberts' describe as both Republican and Democratic presidential administrations' desires to make everyone in America a homeowner, a global savings glut that decreased the Fed's ability to use monetary policy to cool off the housing sector, exotic financial instruments created by Wall Street that were traded opaquely, and the lack of will of the government to regulate or bring transparency to such instruments (except of course, for Brooksley Born at the CFTC). Crony capitalism is a recurring theme in all this.  I also think that as unfortunate as TARP was, it had to be done because Wall Street's implosion would have badly hurt Main Street (how it was executed though, as well as the bailout of automakers, is another story).

In a somewhat similar vein, the Atlantic published an article a year ago called: "The Quiet Coup: How the Bankers Seized America" by former chief economist of IMF Chief, Simon Johnson, who describes the typical incestuous relationship between the financial oligarchy and the government in developing countries, and their striking similarities to our current situation. Johnson comes down on the side of deregulation and too big to fail but views these symptoms as stemming from crony capitalism.  He sums up the financial sector's historical importance to the economy:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.  

So the key thing to watch as the details of the Senate financial regulation bill gets debated is to ask what penalty do the creditors pay if a firm is deemed a systematic risk and on the edge of insolvency? Will they get a better deal through resolution than if the firm had to go through standard bankruptcy? Remember, Goldman Sachs as creditor to AIG got 100 cents on the dollar (why now Secretary Geitner may find himself under investigation since he arranged the deal as head of the NY Fed, and the NY Fed's actions are being closed looked at by the TARP Special Inspector General). Are there any preferred players in the bill?  This will tell us whether the government is serious about ending crony capitalism, or merely perpetuating it.

Obama and the American Dream

It seems Obama went temporarily off script at his town hall on financial reform in this short clip:

“We’re not trying to push financial reform because we begrudge success that is fairly earned. I do think at a certain point you’ve made enough money, but you know, part of the American way is, you know, you can just keep on making it if you’re providing a good product or you’re providing a good service.” [emphasis mine]

While he did qualify his remarks, I was still struck by that statement because it exposes a bit of his philosophy, and opens up a discussion on the American dream.  So what is the American dream? Let's turn to Eddie Izzard for an explanation, who compares the American dream to the European dream: 

America, you have the American Dream, you have the American Dream! We haven’t got the European Dream yet, that’s what we’ve got to get; we’ve got to get a dream to build on. You have the American Dream; the dream is to be born in the gutter, and raise, and grow up and get all the money in the world and stick it in your ears and go ( blows raspberry ) The American Dream! A fantastic dream of money in your ears and swimming through fivers. The American Dream!

In Europe… I don’t know, we haven’t got a dream yet. Well, the dream was… (mimics sleeping and dreaming ) “Oh… get off, you fuckin’…! Flag. No! ( wakes up with a gasp )

“Hilda, Hilda, wake up, Hilda!”

“What is it, Dr. Heimlich, you waking-up type person?”

“I’ve dreamed the European Dream. I dreamt that every country in Europe spoke a different language and they hated each other… Oh, that’s true, isn’t it? Yes.”

That was the dream, but now, maybe now, the dream is to be in the South of Europe – to be in Greece, in Italy, in Spain, and to be on a moped with no helmet on, riding along, going, “ciao!”

That’s a pretty cool dream; it’s not much of a dream, but it’s as good as we’vegot so far, and it’s pretty funky, ‘cause when you die… you look a mess, but I don’t know, I just like it. ( mimics riding on a Vespa ) ‘Cause you’re in a fucking hairdryer. There’s dogs walking faster than you! It’s just pretty damn cool for me. That’s the European Dream, thank you very much. 

On a personal note, it's not my American dream to make gobs of money.  But what Eddie is alluding to in his joke is that with America, the sky's the limit.  That optimism is part of our cultural fabric; we simply do not have the fatalism in our culture that plagues many other societies.  Most of us believe and smile knowingly when parents tell their kids to work and study hard, and you can be anything you want. Some American dreams are modest. They want a good college education, or to open up their own cozy neighborhood restaurant. For others it's to be the American Idol winner, or a CEO of a multi-national corporation where you can make an unspeakable amount of $ so your family will be insanely rich until the cows come home.  The point is, the American dream is precisely that, without limit.