Twofish's Blog

January 21, 2009

Homework for Austrians and Chicago Schoolers

Filed under: austrian economics, china, finance — twofish @ 10:41 am

There is some good news. I’ve seen figures that say that the property market in China is stabilizing. Prices are still going down, but lots of people are snapping up cheap deals in real estate, and so the volume of real estate sales is actually going up.

I think the huge savings is going to be very helpful for China to recover, since if you have lots of money in the sidelines, the markets don’t collapse when there is a massive price drop. You see a super-cheap house or super-cheap stock. The buyer has cash. The seller has cash. The buyer and seller both shake hands. The buyer gets a really good deal. The seller takes a loss but has cash. This is the way that markets are *supposed* to work.

The problem right now in the United States, is that this won’t happen if the buyer and seller both have large debts. You don’t have buyers with ready cash, and what cash they have, they want to keep. The sellers are also broke so they can’t sell and realize a loss.

An exercise for Austrian economists is to look at market microstructure. Austrians have developed a rather rigorous framework for going from the individual actions of buyers and sellers into social good. The basic idea is simple which is that the buyer and seller will only undertake exchanges that improve each others well-being, and therefore a system based on market exchanges will naturally deal to an improvement in social well-being.

What I think Austrians should do is to look at situations where this breaks down.  If you have a situation in which “bad things are happening” then it must mean that this rigourous logic has broken down somewhere, and the nice thing about rigourous logic is that when it breaks, you can list the places where it is broken.

So you have situations in which:

1) invididual exchanges benefit the people making them but don’t result in social benefit, perhaps because there is a third party that is not part of the transaction that is being harmed.  A very good example of this is the whole subprime mortgage issuance system.  You have a mortgage broker that makes money from commission when a deal is signed, and a borrower that gets a lot of immediate cash.

2) individual exchanges which *would* benefit the people making them don’t happen.  This can be because neither has the cash.

One thing that comes out of this is that corporate structures are very important.  Many economic transactions include merely a buyer and a seller, but most economic transactions involve agents and the buyer and seller may be abstract entities.  Also, it’s important to look at this carefully because I think it is obvious now that some of the things that were suggested to align the interests of the “principal” and the “agent” did no such thing.  Stock options and bonus system for example.  The problem with stock options and the bonus system is that you make a ton of money when the company makes a ton of money, but you lose the same amount if the company loses a small amount of money or $1 trillion dollars.  So the logical thing to do is to assume huge amounts of borrowing and risk so that when the company makes money, it gets magnified, but if the company loses a ton of money and threatens to destroy the world financial system, you just get fired.

In any case, I think thinking in terms of market failure at the level of individuals is another way of looking at the problem, and it’s something that I think Austrians and Chicago Schoolers can do usefully if they want to keep the evil socialist, big government, serfdom promoting Keynesians from totally dominating the economic conversation.

Thinking bad thoughts

Filed under: china, finance — twofish @ 10:26 am

I think that much of the capital flows are due to “pull” rather than “push.” It’s not that people in China are trying to convert RMB to dollars (i.e. capital flight), but rather Western banks are trying to gather every penny that they can find, and if they can find a way of pulling dollars out of China, they are.

The other thing is that any sort of sustained economic slowdown in China could lead to a political crisis, and I haven’t seen anyone publicly think through how a political crisis in China would affect the world economy (most likely because thinking about this is too depressing and scary). The last major political crisis in China was in 1989 when it had nowhere the world impact that it does now. I can think of situations in which political crisis -> Chinese government crackdown -> US human rights reaction -> China dumps Treasuries to sink US economy. There are a lot of outcomes for a political crisis, but I can’t think of any scenarios in which a political or economic crisis in China would cause China to buy more Treasuries or be good for the world economy.

Some other things that can be done:

1) I think that the situation is much too fluid to say whether Chinese purchases of Treasuries will go up or down. It may be more productive to just list the factors that influence that decision so that you have a framework for seeing what happens as things evolve.

2) The other thing to do is start at the end. What is the “very bad thing” that you are afraid of happening, and then work backwards to see how you get to that very bad thing.

Looking at how the past sees the future

Filed under: Uncategorized — twofish @ 10:25 am

What you need to do when you study history is to look at what people *at the time* thought they were doing and why, and one thing that you quickly learn is that people are horribly bad at predicting the consequences of their actions, and history also causes actions to have unexpected consequences. Sometimes unexpected good. Sometimes unexpected bad.

The problem with reading history is we know what happened, and one thing that is interesting is to look at history with “blinders.” Read what people were doing in 1929 *knowing nothing about what happened after 1929*, and you quickly find that people seem to be doing reasonable things that had extremely unexpected consequences. The actions of the Federal Reserve and Treasury in 1929 were perfectly reasonable *given they knew what they knew*, it’s just that we have the benefit of knowing what happened. You don’t even have to go back to 1929. Go back in time to 1998, 2000, 2003, 2007 and try to remember what the world looked like at these dates. (It helps if you are older.)

This is extremely important in trying to figure out what to do, because *we do not know the future*. It’s certain that we will be doing things that will seem bizarre and stupid to people that do know how history turned out, and it’s also certain that there will be a lot of unexpected happenings. It’s also a constant of history is that the solutions of one era become the problems of the next.

Once you realize how important chance, fate, and the unexpected are to historical events, then the notion that the entire world is run by a few people that control everything becomes impossible to justify. There is a power elite in the world, a relatively small set of people that have the ability to make key decisions, but they are human and they cannot see the future or even totally understand the full consequences of their decisions.

It is good for a ship to sink inefficiently

Filed under: austrian economics, china, finance — twofish @ 10:23 am

Observer: Inefficient DOES NOT mean less systemic risk, says Chinese banks of the 90s.

It does, and the experience of Chinese banks in the 1990’s illustrates nicely my point.

Lehman Brothers was only about to be insolvent for about a week before it stopped operating. Chinese state banks were able to continue to operate for about a decade even though they were insolvent, and that was because they were highly “inefficient.”

The reason for this is that Lehman had about 3% of their assets in cash or near-cash equivalent. Chinese banks in the mid-1990’s had about 50% of their assets in cash or near-cash equivalents. What this meant was that the second Lehman went insolvent, it was game over, whereas Chinese banks in the 1990’s could continue to operate even though they had huge amounts of debt, because they had large holdings of cash.

The same is illustrated by the commercial banks in the US. Investment banks were leveraged 30:1. Commercial banks are leveraged 10:1 and have a cash line from the government. What this means is that investment banks had days to deal with insolvency, US commercial banks have months, and Chinese banks in the 1990’s had years.

Where the US ran into trouble is having cash reserves and not using leverage is seen as inefficiency, which it is. If you have cash reserves and you don’t use leverage, you are big and slow. But if you hit an iceberg, then you *want* to be big and slow, because the bigger and slower you are, the more time it takes for the ship to sink and the more time you have to do something. If you have five years to fix a problem, you can do all sorts of things that you can’t do if you have five days or even five hours.

January 18, 2009

The 80’s are dead

Filed under: academia, china, finance — twofish @ 9:45 pm
DB: As for the question whether or not China was in need of foreign capital to accelerate its economic growth, Huang Yasheng, Associate Professor at the MIT Sloan School of Management, argues that the main driver of China’s economic miracle up to the end of the 1980s were domestic private village and township enterprises.

Somewhat correct but completely irrelevant…..

What he doesn’t mention is that in order to drive this economic growth, these TVE’s had to borrow extremely heavily to the point where you had rural credit instititutions that were (and still are) insolvent. The TVE’s growth phase ended around 1990 when the countryside basically ran out of cash.

DB: Then at the beginning of the 1990s, the central government decided to shift the economic development scheme towards urbanization driven and controlled by the public and governmental sector

Because they had no choice in the matter. The boom in the countryside was not because private enterprise was particularly good but because Maoist communal agriculture was a total disaster. By 1990, the rural countryside had recovered from the Maoist disaster. At that point, there were no productivity gains to be made anymore, and the rural credit institutions that were designed to take advantage of these gains started going bust.

Also “privatization” is not a good way of describing rural land ownership. The “contract responsibility” system is something that is not quite private and not quite socialist. You can see it when people like Huang are saying good things about it that it becomes private, but when they say bad things about it, it becomes non-private.

DB: Now the point is: Huang argues in his studies that economic activity driven by the private sector in townships and villages in the 1980s have led to greater benefits for the Chinese people then the subsequent government- and public sector-led urbanization. What do you think of his view?

Maybe it is true, but it is completely irrelevant. The basic problem is that what worked in the 1980’s wouldn’t necessarily work in the 1990’s and the 2000’s and the 2010’s. The reforms of the 1980’s were designed to fix the problem of the 1970’s, and once those problems are fixed, you have to do something different. Times change, and policies that create a miracle in one place and time can be totally disastrous in another. Much of the “China miracle” wasn’t that privatization was very good, but because Maoist communal agricultural was particularly bad, and switch to another system (any other system) would have improved things.

This is the problem that I have with ideological people whether they are socialist or capitalist. They fail to adapt when the situation changes. People loved the Soviet model in the 1960’s not because they were total idiots but because the Soviet Union generated extremely large amounts of economic growth in the 1950’s. When talking about the failures of state planning in the 1990’s, we also have to consider the successes in the 1950’s. We can certainly learn things from the 1980’s, but we can’t repeat them because the world is different.

This applies to current issues. I personally think that Chinese industrial and banking reform in the 2000’s was a huge success. Does that mean that I think that we can relax and just follow exactly the same policies? Hardly. *Because* it has been a success, a lot of the problems that the policies had to fix have been fixed, which means that there is nothing more to do. China’s economic model in the 2000’s is highly capital intensive and highly export intensive. It worked well in the 2000’s because China is where the Soviet Union was in the 1950’s or where East Asia was in the 1980’s.

It’s going to stop working in the 2010’s Much of the export intensive part will never come back. Building one expressway is going to be very useful, but building two isn’t. Right now building stuff works because there are a lot of things that need to be built. As time passes there are going to be fewer and fewer things that can be usefully built.

So right now the big thing in China is trying to move the economy from an capital driven, export driven economy to an technology based, innovation based economy. This means basically tearing lots of things up and starting over again, and looking at how other countries (particularly the United States) promote innovation. It’s going to be wrenching and painful, change always is, and people will do a lot of stupid things and make lots of mistakes, just like they did in the 1990’s and in the 2000’s. Expect to make mistakes and set things up so they aren’t fatal ones.

I’m optimistic because managing an economy requires constant change and constant renewal, and my feeling is that the people in the Chinese government aren’t trapped replaying the glories of the past like the Soviet leaders of the 1970’s or frankly like Ya-Sheng Huang is.

Missing the problem

Filed under: finance — twofish @ 9:11 pm

I think that Friedman misses the problem.  It’s not just banks with bad balance sheets that aren’t lending.  It’s banks with *good* balance sheets that are reluctant to lend.  The problem is that people are scared and uncertain about the future, and when that happens, people hoard cash.  If you are an debt, you hoard cash.  If you aren’t in debt, you hoard cash.  If you have lots of cash, you want more cash.

One problem is “who do you lend to?”  Obviously, you lend to people with good credit risks.  The trouble right now is that *NO ONE* (except maybe the US government) is a good credit risk.  Raise your hand if you are sure you are going to have your job next year? Point to any company large or small that you know is not going to be bailed out by the government, and raise your hand if you are sure they are going to be in business next year.  There aren’t any.

Concern about credit risk is a problem because right now no private entity is a good credit risk.  No one.  We are all subprime.

It’s not that bankers are evil people.  It’s not they they are trying to hide anything.  It’s just that the banks are reacting in exactly the same way that you or I would if someone asked us for a loan.  I’m sorry, I have a lot of cash, but I have to look out for myself, because I scared to death about what could happen in 2009.  Right now banks are not lending any of their own money.  The only reason that you can get a low interest mortgage is that the banks are acting as storefronts for the Federal Reserve are the only people buying mortgages right now.  This is true for pretty much everything.  The only things that people that are willing to lend right now are things that have an implicit or explicit government guarantee.  There’s no point it arguing whether or not we should have a state managed banking and financial system in the United States.  We are already there.

This is the problem that Friedman’s proposal doesn’t address.  You can fix up the banks balance sheets, and they still will not lend, because there is no one without credit risk to lend to.  The only people that are not a credit risk are people who already have cash, and they aren’t going to borrow, and it’s a self-fulfiling bad cycle.  A lot of the loans that would go out now will be non-performing precisely *because* loans are not going out.  The next set of non-performing loans will not be people that did “stupid stuff” but people with viable businesses and household accounts that are stuck because the economy has gone bad.

Everything you thought you knew about banking was wrong

Filed under: china, finance — twofish @ 11:48 am

Victor Shih was complaining that China is destroying a decade of progress by reverting to a system of state banks in a planned economy.  China is doing it because *everyone* is changing over to a system of state banks in a planned economy.  Even if they are formally privately owned, I am certain that after this year is out, that the big US banks are going to be under so much government regulation and restrictions that they will be state controlled entities in all but name.

The name of the game in China over the last decade was to make Chinese banks work like American banks.  This actually wasn’t a bad thing since what happened in some cases was that Chinese banks started acting like the *ideal* of how an American bank should work, which is quite different from how they actually worked.  The trouble is that the American banking model is dead.  It just is, and right now people are trying to figure out what the new models are.

My personal idea is that US banks may work something like a “regulated public utility.”  That big banks deliver cash in the same way that state regulated electric companies deliver power.  The need for cash and the need for power are quite similar, and for the large number of “geeks” that work in banking, this may not be a bad thing.  If US banks start being “regulated public utilities” then there may be a place for the 21st century equivalent of “Bell Labs.”  Less money, but cool geeky basic research.

Also, I don’t know if heavy state regulation is a good thing or not.  The disadvantages of state involvement in industry are well known, but right now people are talking about heavy state involvement for two reasons.  We have a crisis that needs ideas now.  People that tend to be anti-state involvement aren’t giving them.  Among free market ideologues, what just happened was impossible, and hence they have no politically feasible ideas right now on what to do.

The only real idea I’ve heard is let the world financial system fall apart so that a great new system will come into being, but right now that’s not something that people are going to support.  Social systems are complex things.  In 1978, when Deng Xiaoping introduced markets to China, it was originally intended as just a small experiment that was a sideline.  There was the idea of a birdcage model in which markets would exist just within a small birdcage of central planning.  But what happened was that the idea worked well enough so that the bird escaped, which was a good thing.  Right now, I’m seeing people applying the same birdcage idea to state involvement in banking and industry.  Maybe limited state involvement will work, but I think it’s likely to take on a dynamic of its own.

And if you don’t like the direction that things seem to be going.  Come up with a better idea…….

Postscript to letter to shareholders of Chinese banks

Filed under: china, finance — twofish @ 11:28 am

Victor Shih wrote a hypothetical letter to from Chinese banks to shareholders:

P.S.: If you don’t like what we are doing then you can kindly buy shares of a Western bank, who are in worse shape than we are, and are going to be forced over the next few months by their governments to be doing exactly what we are being forced to do right now.

We know that we have had our difficulties in the past, but your experience as a minority shareholder in a state-run nationalized bank will no doubt come in handy when Western governments start nationalizing their banks and turning them into state-run entities.

That is of course assuming that there is any shareholder equity left in any of their banks once all of the losses come out, or that when Western government nationalize their banks, they don’t end up massively diluting if not totally eliminating the value of the shares you bought before the nationalization.

Filed under: Uncategorized — twofish @ 10:56 am

Comment on Victor Shih’s blog

On the other hand, China is much more urban than before, and the experience of other countries is that rural needs are often ignored because they do not have mobilizing power.  The situation in 1989, was very interesting because the government was rather popular in rural areas and very unpopular in urban areas, and it was unable to mobilize its rural supporters in any useful way.

Also the fact that Chinese society is more highly stratified I think vastly *decreases* the likelihood of systemic challenges to the political system.  There is not much in the way of social connection between urban dwellers and rural migrants which means that coordinated action is very difficult as these two groups may have sharply different and conflicting interests.  If you do have a situation in which the PAP has to go in to a major city to put down a demonstration by rural migrants, then I suspect that the urban dwellers are much, much more likely to side with the police than with the migrants.  I also think that the migrants know this which means that they aren’t going to push things too far.

The other major difference is that unlike 1989, there is no obvious ideology that you can use to unite the various groups.  “Socialism” won’t work, and neither will “democracy.”  The one ideology that might work is “nationalism” but that works in favor of the government rather than against it.  This is a really big problem since in order to have a major challenge to the government, you need to find some alternative political and economic program, and so far at least, I haven’t heard any one suggest that the government do anything other than what it is already doing, or explain how overthrowing the government is going to create jobs rather than lose them.

We can also look through the list of possible triggers.  There aren’t any popular leaders like Hu Yaobang that I can think of to rally around.  Public cynicism around Chinese government officials actually works for the government.  If they all are crooks, then none of them are worth fighting for.

Natural disasters and infectous disease have in the last few years *increased* the government’s popularity, and during a national emergency it is very difficult to say anything bad about the government without turning popular opinion against you.

Students in China today are very different than the one’s in 1989.  For one thing, they are much more diverse and much more likely to be studying a field that requires social stability (like business or finance) than a field in which they can act as social conscience.  My sense of the younger generation in China is that they are much, much more individualistic and career oriented than previous generations, and this makes political action difficult.

Of course, none of this matters if there is a sustained economic problem.  If after a year or two it is obvious that the government is mishandling the situation, then everything changes, but at the very least, the government does have several months to deal with the problem.

Sleeper agents and real conspiracies

Filed under: academia, massachusetts institute of technology — twofish @ 9:50 am

Harvard has a huge bank account. Also, it’s possible to monetize the value of the MBA. We let you classes with large subsidies, and then in the process brainwash you so that when you make megabucks, you feel guilty and give us large amounts of cash. Every few months, I can this call from Cambridge, MA, in which some freshman starts a conversation about how my job is going. At this point I get out my credit card, since I know what they are going to ask next (i.e. you do know who gave you the skills for that job.)

This is the basic business model for Harvard and MIT undergraduate programs.

MIT has extra cash come in from technology industrial programs. They also heavily subsidize the classes, so that when you go out in the world, MIT has “sleeper agents” in the major banks, governments, and industries which MIT can then use for its own nefarious purposes. If someone from MIT career services calls me and wants the names and phone numbers of people in my firm that have jobs open and they want to know the secret code words to put on a resume to get them those jobs, my “preprogrammed brainwashing” kicks in, and I tell them.

This business model works, much, much better for the student than those that rely on tuition to fund operations. From the point of MIT, it also works because it requires vast sums of money, lots of branding, and pre-existing social networks, which keeps competitors out. There is no such thing as a “non-profit” university, you just have to understand the business model to make sure it makes sense for you.

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