Twofish's Blog

February 28, 2009

We are all losers now……

Filed under: academia, finance — twofish @ 11:47 am

Emerson: Someone said somewhere that the schools with big endowments were going to start spending part of their endowment on education, but that unlikely rumor turned out to be false.

What endowments? University endowments are getting crushed by the market collapse, and that’s the lucky universities. The unlucky ones have found that they they were investing with the likes of Madoff, and a few universities have found that they have no money at all.

There is a deeper problem in that the financial structure of academia forces universities to create a Ponzi scheme. In order to support the salaries of the tenured faculty you have to have lots of money coming in through tuitions and grants which require large numbers of teaching assistants and research assistants. However the only way you can get large numbers of TA’s and RA’s is by promising them tenured faculty jobs, and in most cases these promises are lies. They are lies because the economics of the situation forces them to be lies.

This creates very perverse incentives for academia, because they only way any decent human being can deal with this is not to think about the problem, which is particularly a problem for academia whose job it is to think about these problems.

This is part of an even deeper problem which is that we’ve created a society of winners and losers. Winners get money and power by taking it from losers, but this causes problems because eventually the losers realize that they are getting shafted, and then overthrow the winners.

So the solution is to create a large middle class of people that *think* that they will be winners someday, and tell the “almost winners” that the losers deserve what they get. You see this in academia, if you don’t get the job, you didn’t work hard enough, and you are a *loser* you don’t *deserve* to be a winner. The fact that your work and efforts allow the system to exist as it does is irrelevant.

You don’t deserve tenure, go work at a community college as an adjunct with all of the other academic losers, where you get to teach all of society’s other losers, and not any of the winners that get to go to elite universities. The only people that deserve money, power, or respect are winners, and you aren’t one of them.

The trouble with this system is that it requires people identify with winners more than losers. One good thing that is coming out of this is that people are realizing that the system isn’t rational, and that you have a much higher chance of ending up a loser than a winner.

With the result economic collapse, it turns out that we are all losers now…..

February 21, 2009

General Motors as an SOE

Filed under: china, finance — twofish @ 11:50 am

It’s pretty clear that the US government is going to be heavily involved in General Motors and the banks, and it looks to me that the US government is making a lot of the classic mistakes in running state-owned enterprises.

A few thoughts as to what I think the US is doing wrong….

1) Not adjusting to the “new normal”.  As long is the US thinks of owning the banks and General Motors as a “temporary aberation” you are going to have problems.  Maybe the long term goal should be to sell off GM and the banks to private investors, but this can and will only happen after years of restructuring.  The problem with thinking of things as a short term fix is that it forces everyone to think in terms of quick fixes which don’t work and end up costing more in the long run.

2) The government must act as owner.  To me it seems incomprehensible that the Federal government is taking such large ownership stakes without having at least a seat on the board of directors.  You can argue that governments don’t know how to run car companies, and they don’t.  But neither do private investors, which is why people hire and fire managers.  As owner, the job of the private investor and the government should be the same which is to maximize returns.  The state has other interests, but these have to be exercised by other agencies.

The job of the Board directors is *not* to manage the company, that’s the job of the professional managers.  The job of the director is to represent the interests of shareholders and oversee the managers, and right now there is no effective mechanism that I see for doing that, and the fact that American companies often are very skewed toward managers at the expense of owners is part of what got us into this mess.

3) The government has to separate out commercial interests from regulatory and social interests.  There is a legitimate state interest in protecting employment, in preventing pollution, and in having companies may a profit, but these roles conflict and you simply cannot have the same person in charge of all of these roles.  It’s like a trial in which the judge, prosecutor, and public defender can all be state officials, but they have different roles to play.  Something that is going to hurt a lot is that you don’t have the “state as owner” functions separated from the “state as regulator” and this is going to cause huge problems.

4) Health care and pensions – The biggest problem that the Chinese SOE’s faced was that they were being forced to pay for health care and pensions.  This is a problem for GM since GM managers are being forced to be both auto manufacturers and health and pension supervisors.  What China did was to have the state assume the health and pension liabilities of the SOE’s.  Once the SOE’s no longer had to pay these, they could focus on growth, at which point they generated profits, which the state could take and then pay for it’s liabilities.

5) The role of local governments – One other thing that helped Chinese SOE’s was that the SOE’s were often owned by different and conflicting local governments which allowed functions to be separated.  One thing that the Federal government could do is to contract with state governments to manage their interests as owners.  This could be useful because different states have different interests that could be used to diversify the board.  If the state of Michigan has a seat on the board, they are going to care about unions and lost jobs.  The state of Mississipi just isn’t, and is going to do whatever it can to squeeze the unions and cut jobs in Michigan.  If you have both on the board, you end up with a diverse and probably more effective board of directors.

One other thing is that the Federal government has no effective institutions for exercising ownership powers over companies, because it’s something that the Federal government has never had to do.  State governments do.

6) The government as shareholder has to have interests aligned with other shareholders.  The part of the government that acts as shareholder has to have interests aligned with other private shareholders.  The Chinese government has set things up so that when the government makes a profit, it is shared on a equal basis with other shareholders.  The fear of a private shareholder is that the government can come in and take everything, and the government indeed can….. One time and only one time….

The trouble with the government investments in GM and the banks is that the government now has priority over other investors.  This is not a good thing because it means that no private shareholders are going to be willing to invest in GM or the banks, and  ultimately this makes things more expensive for the government.  If you have the government actually owning common stock, this forces the government as owner to try to make the company profitable, and this in turn means that the government as owner will fire the managers if that isn’t happening, and get new ones.

Right now the relationship between GM and the government seems to be very dysfunctional.  Basically GM is saying that if the government doesn’t put in money, that they will declare themselves bankrupt and make things very expensive for the government.  They are basically holding themselves hostage.  The problem with this is that at this point the government either hands GM a blank check and has GM blow up the economy.  The problem with this is that the government doesn’t have ownership interest.  If the government acted as owner, they  could write the check and fire the managers that forced them to write the checks.

General Motors and the lessons of SOE’s

Filed under: china, finance — twofish @ 11:10 am

rziemba: However, they have also frequently received payments from the government to compensate for the gap between the cost of oil on the global market and the fixed price of products on the domestic market (eg for much of 2007 and 2008). these payments were often ad hoc. In general though this gap contributed to the incentives to find and sell resources abroad on the global market.

Precisely which illustrates how the oil companies are profit oriented. In the middle of 2007, there were fuel shortages all over China while Chinese oil companies were selling oil oversees. If the purpose of Chinese oil companies was to acquire resources, then the Chinese government could have just ordered the oil companies to sell their oil in China at a loss. They didn’t.

*Why* they didn’t is interesting. They didn’t force companies to sell oil in China at a loss because that would have killed profits and would have hurt the state’s role as shareholder.

This points out another thing that the US is getting wrong with GM and the banks. People are willing to buy stock in PetroChina and Sinopec because the rules are set up so that what helps the Chinese government helps shareholders and what hurts shareholders also hurts the Chinese government.

In the case of GM and the big banks, the fact that the US government has pumped money in as preferred stock rather than common stock makes private shareholders wary of putting money into those companies, because they are afraid that the government will come in and just take it.

The other thing that the US could do with GM is come up with a consortium of state governments to serve as shareholders. The way that this would work is to have the Fed lend money on a non-recourse basis to state pension funds which would then buy common stock in GM and the banks and then exercise supervision over management.

What’s interesting about CDB is that they have an ownership stake in Barclay’s and a seat on the Board of Directors which means that CDB indirectly owns Lehman’s American operations.

It’s not that the Chinese leadership is brilliant about SOE management. It’s just that the government has made all sorts of mistake until it came up with something that seems to work. What I worry about the banks and GM is that the US government is going to go through the same learning process and make very similar mistakes.

Has the Chinese economy hit bottom?

Filed under: china, finance — twofish @ 11:08 am

I’m seeing all sorts of numbers that suggest that China has hit bottom. Retail sales never stopped growing. Electrical and coal usage has stopped shrinking. The price of oil and Baltic dry goods are going up. Stock and real estate prices are stable, and sales volumes are going up. One other thing is that Walmart is still profitable and sales are up.

You might be able to argue that the numbers are just government cook statistics and propaganda. Maybe. But even having things in a situation that you can get people to believe that things have hit bottom through cooked statistics and propaganda says something.

What may have happened was that when exports stopped you had a shock to the system that resulted immediately in the loss of tens of millions of jobs. However because you had large amounts of savings, it appears that the Chinese economy could absorb the shock of these job losses and react in a way that keeps things from getting worse, so China has hit bottom pretty quickly, and can think about long term strategic goals.

In the case of the United States, there was a shock, but no reserves so that the system was less able to absorb the shock to the system, which means that things are still getting worse. The basic difference between the United States and China right now is that in the United States the firehouses are on fire, which makes things much more complicated to fix.

I would argue that part of the reason that the Chinese economy is in good shape is that over the last decade, you’ve had lots of lectures from Wall Street bankers to Chinese banks about the importance of risk management and of capital reserves. It’s very much a case of “do what I say” and not “do what I do” and part of the reason that you had so many Western academics and business people end up in China is that no one in the West would listen to them.

But the solutions of today become the problems of tomorrow. At some point China will become arrogant, the West will be humble, and then the Chinese economic system will collapse and the Western one will remain standing, at which point things will reverse once again. The only thing that you can really change is when it will happen.

It’s the same sort of dynastic cycle that has existed in China for thousands of years. You are poor, you behave well, you get rich, you start behaving badly, you end up poor again. If you understand the dynamics of the cycle, you can moderate it somewhat, but you can’t stop it, because wealth and success breeds arrogance and arrogance breeds poverty and failure.

You can see why I end up arguing with DJC. It’s because I don’t think he understands the basic lesson of Chinese history, and demonstrates what I think is a destructive arrogance. He believes that China is destined to succeed. This is false, no one is destined to succeed, and the second you think that you are destined to succeed, you are doomed. Even pointing out how successful you were in the past is pointless. Past is past. The fact that you were successful in the past can make it *harder* for you to succeed in the future.

Even if you do understand the fundamental lesson of Chinese history, there are limits to how much you can change things. Rich and successful people end up arrogant over time. But if you don’t understand this lesson, then things get very bad very quickly as southeast Asia and Japan illustrated in the 1990’s when they became very arrogant, very quickly.

February 16, 2009

Death of old economic theories and birth of new ones

Filed under: china, finance — twofish @ 9:31 am

> If it increases production relative to
> consumption, then China is actually reducing
> net demand, even while it is increasing total
> demand.

No. If the production is fed back into investment and government spending, then net demand doesn’t change. China can increase demand by increasing investment. This will lead to increases in future production, which leads to future increases in standard of living.

There are several variables here, and I don’t think that increasing the consumption variable is a good thing. The variables that can be increased are investment (although this requires effort to make sure that it ends up in efficient investment) or government spending on public goods.

One of my suspicions is that the reason that we are in this mess is that the prevailing economic theories, remove variables from the demand equation so you end up with something that doesn’t balance.

If you end up being a market fundamentalist then you can’t adjust the government spending part of the equation. If you think that the market allocates investment optimally, then you remove the investment term of the equation. If you then believe that trade should balance then net imports disappears. That gives you consumption as the only variable that you can change.

But then you run into a situation in which a demand shock causes market psychology to push consumption down, at which point you have nothing to suggest except let the economy fall apart.

You run into the same problem with the controls you use. The only two “valid” controls in Greenspanism are the interest rates and by implication exchange rates. If you argue that government spending should be minimial and trade should be balanced, that gives you only interest rates, at which point you run into problems because you have conflicting requirements (full unemployment versus efficient credit allocation) which you can’t match by fixing one number.

In a lot of ways, the prevailing economic theories have painted themselves into a corner by systematically throwing away any controls and variables that can prevent or get us out of a mess. But it’s important here to point out that this is a prison of one’s own design.

The other issue is that a lot of this is the result of trying to create a universal economic theory. If you start looking for economic controls, you will find that a lot of them are specific to one economy. For example, increasing or decreasing SOE dividends is a control that is available in China rather than the US, whereas changing the overnight interest rates on commercial paper is available to the US, but not China. None of this is available if you try to make things too abstract.

I think that the events in the world have illustrated the failure of monetarist economic theory. Yes you could argue that things would be perfect if people acted according to the theories and you didn’t have to deal with annoying things like political reality, but any economic theory that only works when people stop behaving like people can’t be that useful, can it?

Personally I think that China should go to the position that it took during the Asian Crisis and commit to peg the RMB against the dollar. I really don’t see how devaluing is going to help China, because it will lead to a round of competitive devaluations. Given China’s huge foreign exchange reserves, there is no requirement to devalue.

Also, discussions of net and total demand have to include the fact that Chinese imports tend to be raw materials, and exports tend to be finished goods. Which means that US/China trade balance may behave in ways that are radically different from those between China and the rest of the world.

Finally, there are two US-China committees. One is the CECC which I have a lot of respect for, and the other is the US-China Security Review Commission which I don’t. The problem with the CSRC is that I get the since that they’ve already decided what they are going to say, and so talking to them isn’t that useful.

February 13, 2009

Broken markets

Filed under: china, finance — twofish @ 10:30 am

This also is why the standard argument against the stimulus package is wrong. The idea is that there is a fixed amount of lending and that if the government increasing borrowing then there will be less private borrowing, so the stimulus does nothing except increase public debt.

The argument would be correct if we had functioning financial markets that were already allocating capital to maximize efficiency, but we don’t. The markets (particularly the securitization markets) are broken and are simply not responding to interest rate signals. From an interest rate point of view it makes no sense for people to be buying massive amounts of T-bills, but they still are.

February 9, 2009

Notes on Chinese money

Filed under: china, finance — twofish @ 3:21 am

bsetser: But it doesn’t mean that the US shouldn’t be talking to China about whether China’s peg to the dollar creates the basis for a stable global monetary architecture

In the near term (for the next one to three months), I think it’s pretty clear that China pegging to the US is a good thing. The dollar is appreciating, and a peg prevents the world from getting into a system of competitive devaluations. Right now, both the US and China have their hands full with crises, and currency isn’t high on the list of fires burning.

What happens in the longer term (and by longer term I mean 3+ months) depends on how the US and Chinese economies react to their respective stimulus packages. If the Chinese economy starts booming while the US economy stays stagnant, there will be huge calls for currency revaluation, whereas if the US economy starts booming while the Chinese economy stays stagnant, people will be asking China to keep the peg as an alternative to devaluation. Alternatively it could be that the US and China end up with lock step recoveries, although I think this is rather unlikely.

bsetser: No country really has a comparative advantage “as consumers.”

I disagree with this. Rich countries with large amounts of immigration that keeps the workforce young do have comparative advantages as consumers.

bsetser: But the combination of a rising dollar-RMB and China’s own slowdown has led to a dramatic increase in capital outflows from China.

It’s hard to figure out cause and effect from this. I’d argue that it was the reverse. That the near-collapse of the US financial system caused people to pull money out of China and this led to devaluation pressures. We can look at the timelines, but I strongly suspect that you’ll see that the capital outflows started before the the devaluation pressures, and probably started the day after Lehman went under.

One of my strong suspicions is that money from Western investment banks was actually at the core of the informal financing system in southern China. People would borrow money from Western banks and then lend RMB. When Lehman collapsed, the Western banks called in their loans, which led to a massive capital outflow and also caused factories in Southern China to close their doors as their financing was cut. So what you ended up with was a credit crisis rather than a demand shock.

Something that is still something of a mystery is who are what was responsible for the “hot money” and I think it was Western investment banks financing Chinese export industries through Hong Kong.

bsetser: But it doesn’t mean that the US shouldn’t be talking to China about whether China’s peg to the dollar creates the basis for a stable global monetary architecture …

The US and China need to be talking on a dozen topics. Currency being one of them. Personally, I’d put banking regulation and capital mobility as a higher agenda item than currency.

February 8, 2009

The big mistake

Filed under: china, finance — twofish @ 4:30 pm

A lot of my thinking revolves around what I think is the fundamental economic mistake that has been made over the last few years, which is the adoption of what I would call “monetarism” or “Greenspanism.” This belief is the idea that governments should be responsible for only managing high level abstract quantities such as interest rates and government spending, and should not and in fact cannot “micromanage” the economy. The monetarist philosophy is basically that governments should just sit interest rates and let the rest of the economy do its own thing.

The big problem with this is that if you view things like interest rates and government spending as the *only* variables that a government can control, you find that you don’t have enough flexibility to avoid big problems.

For example in China right now, if you argue that the only thing the government can control is the supply of money, you’d be forced to make a decision between understimulating the economy or having large numbers of NPL’s in the future. But I’d argue that you have this dilemma because you’ve intentionally reduced the controls that you have to just changing the money supply. Once you realize that you have other controls, then the dilemma is smaller.

Take what happened to the United States in 2001-2002. Yes it was necessary to cut interest rates, but I think that the mortgage bubble and NPL problems could have been avoided with tighter regulation. The reason that there wasn’t tighter regulation, was the belief that the “market knows best.” However, this belief ignores the fact that the dynamics of the market is heavily influenced by the state anyway. The US financial system was designed to put lots of credit into residential housing so any new credit would have gone there unless you took some active regulatory steps to avoid this.

Similarly, the Chinese financial system is currently biased toward providing capital toward SOE’s, and if you just increase credit and do nothing else, you are likely to end up an overabundance of heavy industry in SOE’s. If you are a supporter of “Greenspanism” then your only choice is to reduce credit and contract the economy, at which point people start to riot. However, I’d argue that this dilemma happens only because of limitations you’ve imposed on yourself, and that the solution is to increase credit and figure out ways to “micromanage” things so that this credit doesn’t result in heavy industrial factories. For example, increase credit while at the same time taking dividends from SOE’s and issuing capital budget restrictions.

February 5, 2009

Nature of Chinese stimulus

Filed under: china, finance — twofish @ 9:12 am

Yu: This is where the government needs to do more, as Wen has implied, rather than rely on the banks as quasi-fiscal organs of state.

One problem is that if you rely on direct funding from the government, what tends to get funded are large infrastructure projects which then take on a life of their own. The big problem with Keyesian stimulus is not so much starting big projects, but shutting them down once you have gotten out of trouble. Once you have a large political group that is making money from an infrastructure project, it becomes difficult to shut down. This is less of a problem with health and education, but it can be a big problem with things like roads.

Something that the government has to do is get credit to small and medium enterprises, and at that point the banks play a crucial role since only the banks have the staff to figure out who to lend to. The problem with lending to small and medium enterprises is that it’s something new for the big state banks, and they are likely to do it badly at the beginning. A small increase in NPL’s is not necessarily a bad thing, if it actually does encourage small and medium enterprise formation.

One important point is that when I say that the Chinese economy should be focused on investment and not consumption, I *don’t* support state subsidized capital to heavy industry. What I do support is investment in small and medium businesses. Getting credit to a dim-sum stand is in some ways much, much harder than getting credit to a steel factory.

Flora: have to say I share your concern on China’s longer-term growth outlook. the “expensive bet” on a quick recovery in global trade and economy trade will likely prove miscalculated,

I don’t think that the Chinese government is betting on a recovery in global trade and economy. It needs to create enough demand so that you have reasonable economic performance in China *regardless* of what happens in the rest of the world. It really doesn’t have a choice in the matter. If the government doesn’t get the Chinese economy growing in the next year or so, then the people on the streets will take matters into their own hands.

Flora: The Govt should focus more on helping the private sector in the rational way instead of blindly throwing money into public sector investment mainly initiated by local govts…

It’s not either/or. The problem is getting money into small and medium enterprises is very tough to do. One big problem is that large enterprises are too big to fail, so no one minds loaning them money. Small and medium enterprises can fail, so people are reluctant to lend to them in tough times. Another big problem is corruption. It’s much harder to make sure that money to small and medium enterprises gets to the right people than it is to monitor money to big enterprises.

Flora: a permanent derating of china’s GDP to below 5% beyond this cycle is not totally out of the question just like what happened to Japan after early 1970s.

I don’t think this is likely. Japan’s GDP started to hit limits after it had already reached levels of industrialization that China will not see for decades. Remember that by the 1920’s, Japan was already an industrialized nation with a far more productive economy than China has now.

Chinese GDP growth is not magical. It’s that the country is so underinvested that anything will help. The first freeway that you put in a county will generate huge amounts of economic growth as well the first factory. It doesn’t matter if the freeway or factory are incredibly inefficient. It is less inefficient than what was there before. If you have a poor enough country, then even industrialization through a broken inefficient system will create growth. Look at Russia from 1930 to 1960. Part of the problem with these discussions is that people are so fixiated about Japan and Russia in 1990, that the don’t look at the lessons of Japan and Russia in 1935.

CEO Pay Caps

Filed under: finance — twofish @ 6:28 am

A lot will depend on the details, but I think you can structure it so that it leads to good incentives.  The system that Obama seems to have in mind right now is if you take government money, you get punished for it.  If you are a CEO and you get your company in a situation where you have to take government money, then your salary gets cut to $500K.  I think this will work if there is a flip side which is that if you are a company in a situation were you *don’t* take government money, then you can pay yourself whatever you want.

If you have a situation in which a CEO that takes government money is limited to $500K, but one that pays back any loans can pay themselves $10M, you have a CEO that is very strongly incentivized to make a profit, pay back the government, and then two seconds later pay themselves $10M.

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