Business As Usual – One hopes

http://delong.typepad.com/sdj/2009/09/in-which-we-nominate-kenneth-almquist-to-the-order-of-heroes-of-intellectual-labor-third-class.html

One more thing about incentives. There has been no massive public outcry for really deep, radical changes in Wall Street. There will be changes, but they won’t be huge ones. The reason for this is simple. The Dow is at 9700, and unemployment seems to be stabilizing.

If the Dow were at 6000 and unemployment at 15%, there would be huge, angry, lynch mobs looking for bankers to string up, and there would be the political will and incentive for vast, deep, and radical changes in Wall Street.

As it is, things seem to be getting back to normal, and people aren’t quite as angry as they were a few months ago. With people not angry, people just don’t care that much about radical changes to the financial system, and that means “business as usual” when it comes to hammering out the details.

If we get back to Dow at 12000 and unemployment at 6%, then all will be forgiven. If we have a double dip, and things start going into free fall again, the public will be back to “shoot the bankers” and they’ll probably be even angrier than they are now.

Now what I’m thinking about is what are the minimum set of changes that we absolutely have to make to the financial system to make sure that I don’t have to go through this hell again.

There is no Asian Development Model

There is no Asian development model and talking about one obscures confuses things greatly.  The Japanese economy is as different from the economy of Hong Kong as one can possibly get.  The one thing that Japan has in common with Hong Kong is that both ran massive trade surpluses with the United States, but then again everyone runs massive trade surpluses with the United States, and so relations with the United States has more to do with the United States than with Hong Kong or Japan.

Also Germany and Saudi Arabia ran trade surpluses with the United States, but no one calls them Asian.  It is true also that most countries in East Asia feel more comfortable with government intervention with the economy than the United States, but again that’s a peculiarity of the United States than with East Asia.

The problem with talking about an Asian development model is that people see something that Japan does and assumes that China does the same thing and vice versa which is not true.  For example, because Japanese companies have captive banks in a corporate group structure people assume that Chinese companies do the same thing, when this is not the case.  In  fact that Chinese banking system has many more similarities with the United States than it does with Japan, largely because the critical era in which major decisions where being made happened between the Japanese property crash and Enron.

The problem with talking in terms of development models is that you end up with two or maybe three models, and that ignores the fact that there are many ways of getting it right and many ways of getting it wrong.

Overproduction is a problem ????

http://mpettis.com/2009/08/what-should-have-been-discussed-during-the-sed-meetings-part-2/

It’s always seems to be bizarre to me when people say that the Chinese economy has a problem with overproduction that must be resolved or else China is doomed.  It sounds like a parody of Stalinist propaganda.  Our factories are too efficient and productive, please save of.  The fact that the big problem that people see right now is that people save too much and factories are too efficient should tell you that China is *not* a Soviet style centrally planned economy.  Soviet propaganda lived in a world of overproduction, but Soviet reality was one of chronic shortages.

Anyway there is one solution to overproduction which is trivial economically but hard to do politically:

• Pay people to do nothing.

That’s actually quite hard to do politically.  The political problem is that people get quite upset if they see their neighbor getting paid to do nothing while they aren’t getting the money.  Figuring out who gets paid to do nothing is quite tricky, but there are ways around it.  One way of doing this is to make people think they are doing something useful, when they aren’t.

The other problem is that paying people to do nothing, or worse yet getting people to think that they are getting paid to do something when they are doing nothing tends to become a habit, and if you have to change so that you are no longer in a situation of overproduction, you have a problem.

One alternative way of saying “pay people to do nothing’ is to say “be less efficient” which is why I think it is weird when a lot of the people who say that the problem with the Chinese economy is that it overproduces also come up with ideas to make the economy more efficient.  If the real problem is overproduction, you really want to make the economy *less* efficient.  Sometime less efficiency is a good thing.  A power saw is more efficient than a hand saw, but it leaves a bigger mess if something goes wrong.

Anyone some other things that I disagree with Michael Pettis about:

a) In general, I don’t think that the government is pumping money into the economy to create “excessive investment.”  In fact I would argue that with banking policy, it’s doing the reverse.  Lending interest rates are high, which discourages borrowing while borrowing interest rates are low, which discourages savings.  The reason people save is that they are looking forward to retirement, and the reasons that companies are saving is because they are making profits, and make investments out of retained earnings because it cost them a great deal of money to borrow from banks.  The one area that the government could change policy to reduce investment is by taking some money in the form of dividends, but as I point out later there are good reasons not to do that.

b) Also it’s interesting that the examples, that Pettis gives to argue that the government is biased toward investment really show no such thing, and the policies that he proposes to remove this bias also do not fix the problem.  It’s true that China make be keeping it’s exchange rate low, but keeping it’s exchange rate low doesn’t change the consumption/investment ratio.  Also it is also true that banks are biased toward large enterprises, but again if the Chinese government removed this bias it wouldn’t change the consumption/investment ratio, and if this bias changes so that small and medium enterprises such that interest rates go down, this will actually increase investment.

The big problem here is that people when they talk about China, they aren’t talking about China, but rather Japan and Korea which had very radically different economies.

c)  Finally, I do not think that China is overinvesting.  The danger in thinking that you are more efficient than you really are is that it leads to Great Leap Forward type situations, in which you cut back on production, and later found that this was a bad idea.  What worries me about statements that China should consume more is that they fail to take into account China’s very rapidly aging population.  Once the baby boom generation ages, then all of that previous investment is suddenly going to prove useful.

One final thing.  Michael Pettis likes to use the phrase “it has never happened before.”  That doesn’t prove anything with regard to China.  In the case of China, there are so many things that have never happened before in human history, that “it’s never happened before” is just not an argument.

There are worse things in the world than NPL’s

OK, you’ve been pushed out of an airplane and are plummeting to the ground.  You want to pull on the parachute ripcord, but there is this economist that says that you shouldn’t because you might break your arm, and in any case you can’t keep pulling ripcords and expect a parachute to come out.

But you tell the economist to go stuff it, you pull the rip cord, it turns out that you did break your arm, and then the economist tells you ‘ha ha I told you so.”

That’s basically the story of the Chinese economy over the last few months.  The government pulled the parachute, it came up, and now people are worried about non-performing loans.  It’s not clear whether you have a broken wrist, a broken arm, or are just sore.

If the government keeps pumping the accelerator, yes it will have an NPL problem, but I don’t see one happening if it takes its foot off the accelerator and starts gently tapping on the brakes.  Even if you do have an NPL problem its better than the alternative.

Two comments:

People keep on talking about the massive NPL’s that the government ran up in the “last loan expansion”  Actually it didn’t.  Since the 1998 reforms, there have been two periods of massive lending.  One in 2001 and one in 2005.  Neither of them seem to have resulted in massive amounts of NPL’s.  This time you can argue that because of the massive expansion of the Chinese economy, you have more NPL’s, maybe but…….

I’m going to say something shocking…

*Running up massive NPL’s in the early 1990’s was the right policy*

In economics, there are no good or bad policies, only better and worse ones.  The massive bank loans of the early 1990’s lend to a problem that took China about a decade to solve, but it was better than what happened to Russia.  Because Russian banks didn’t issue massive NPL’s, you ended up with hyperinflation combined with huge unemployment.  In the case of China, the NPL’s kept the system going long enough so that it could be dismantled in an orderly way.

Right now we don’t how bad China’s new NPL problem is or whether it has one at all.  Personally, I think it’s important to worry about it, and now that you aren’t going to fall to your death, you can start worrying about your arm.  I don’t think it’s going to be that bad, but however bad it is, it is better than the alternatives.

More notes on Gillam Tett’s book

I’m rather surprised that people haven’t asked her more about her fieldwork in Tajikistan.  Googling around, I found a lot of interesting and relevant things about Tajikstan that is very relevant to world affairs. You have the interaction between Soviet/post-Soviet ideology and Islam.  You have some very interesting gender issues.  Men in Tajik society were suppose to be “modern” since they had to go out and work in a Soviet system, and women “traditional” and this caused a interesting interactions when the Soviet Union fell.  You had a major and very tragic Civil War, which has some relevance to my life.

Also the fact that she was a goat herder was treated as a point of humor, but I found it interesting that no one seemed to take that seriously.  Being in banking, my first reaction was “how do people in Tajikistan make money herding goats” since that hits the second question which is “how can I make money off the people in Tajikistan herding goats.”  The only google reference that I can find is that goats are being used for cashmere, which makes me interested in the economics and social structure of goat herding.  It seemed from some of the pages that Tajiks are considered to have some special ethnic affinity to goat herding.

The other reason I was pleasant surprised by Tett’s book is that she didn’t do the standard reporter thing.  I’m afraid to talk to reporters since I often get the impression that reporters feel that their job is to make you look bad.  Reporters seem to assume that life is a battle between good and evil, and heaven help you if a reporter thinks that you are evil.

However besides some nit-picking, I think that it is useful because it addresses a big problem in that most of the public really has no idea what bankers do and how banks work.  It’s because no one really has the incentive to explain it to them.  It’s not that bankers are intrinstically evil or are hiding something out of shame or fear.  The problem is that the risks of being a public figure outweigh the benefits of public knowledge.  If there is a one in a million chance that I will be fired or publicly humiliated by something I say, then why should I take the risk, since I personally don’t get any benefit out of greater public knowledge.  And the fact that there is no shortage of people that are “out to get you” just increases those risks.

So here is some nitpicking…..

* one thing that I think Tett seems to imply from the interview is that people don’t talk about the “shadow banking system” because they are ashamed or fearful about it.  Actually bankers don’t talk about the “shadow banking system” for the same reason that people don’t talk about the clouds or the air they breath.  It’s such a nature part of the system, that people don’t think about it.  The other thing is that it’s not a matter of the banks hiding things from the regulators.  Most of the regulators in 1990-2008, where actively encouraging the development of the new banking system.  It’s also not that the regulators were hiding anything from the public, after all it was the public that voted in a series of administrations that believed in loose regulation.  It’s not also that bankers had this nasty conspiracy to defraud the public.  Most people in banking believed what they were doing was a good thing, and personally I still believe that if you properly regulate derivatives trading that you will end up with a better financial system.

* Something else that Tett also doesn’t make clear is that when she says the banks were able to use CDS to reduce their capital levels.  She is referring specifically to European (particularly German) banks.  American commercial banks aren’t allowed to do this.  This does bring up a problem in that in a global economy, you just can’t fix one countries regulations, since you can side step them.  Also, you have to view regulation as a system.  In England they drive on the left side of the road.  In the US, they drive on the right side.  What happens at the intersection.  A lot of English regulation is based on what are basically informal “gentleman agreements,” but Americans are suspicious of that sort of system and prefer impersonal rule based systems. These systems work in isolation, but you end up with Frankensteins like AIG-FP when you aren’t careful.  One thing that caused problem is that insurance in the US is primarily a state regulated system, and US states normally don’t talk directly with people in other countries, so no one ever thought of getting the New York insurance regulators and the UK FSA in the same room.

And if you have this much trouble making the US and UK financial systems compatible, just wait until you try to bring in China and Saudi Arabia.  In the case of China, this turns out to be a lot easier because of Hong Kong.

* Not that it would have helped much.  The way that derivatives were used help cause the problem, but the underlying problem was bad loans, and in that area derivatives didn’t play a huge role.  For example, Washington Mutual didn’t have much in the way of derivatives, and if you look at the dozens of banks that are failing on the FDIC website, derivatives didn’t play much of a role in their failure.

Notes on Gillian Tett’s book Fools Gold

Got it on back order.  From the interview it looks like one of the best books out there…..

http://www.npr.org/templates/story/story.php?storyId=104130944

Something that Gillian Tett makes more clear is that most people outside of banking think that the “shadow banking system” is some secretive thing that is a small part of the system, whereas in fact that “shadow banking system” is bigger than the “non-shadow banking system.” If you get a mortgage, a credit card, auto loan, commercial business loan, or any credit at all, the money that you got came from the “shadow banking system” rather than the “non-shadow banking system.”

The “shadow banking system” needs to be regulated because it *is* the banking system, and it really can’t be shut down, because there really is no “non-shadow banking system” any more. People in banking don’t talk much about the non-shadow system not because it is some deep dark secret, but rather because it’s like the air or the clouds. You see it every day that you don’t think about it.

Part of the reason the shadow system is rather poorly regulated is that throughout the 2000’s, there was this idea that government was the problem rather than the solution, and any sort of government intervention with business was bad, so routing everything through this other banking system was a good thing. Over time, the shadow banking system would prove to be so much better than the traditional one, that the traditional system would fade away.

The fact that this just didn’t work probably became obvious the day after Lehman died. I’m willing to bet that no one at the US Treasury had the slightest idea that if Lehman died, that AIG would go under, because there was just no one keeping track of who had what risk.

Discussion on the US financial system

http://blogs.cfr.org/setser/2009/05/27/the-treasury-market-in-a-world-no-longer-dominated-by-central-bank-reserve-managers

Notes on China, Keynes and employment

http://mpettis.com/2009/05/exports-versus-domestic-demand-–-the-argument-rages/

I really don’t think that there is very much of a “debate.” I don’t know of *any* Chinese political or economic leader that thinks that China shouldn’t move from export driven growth to internal growth or that China has much choice in the matter. I also have yet to meet anyone that doesn’t think that the Chinese economy needs structural changes. As far what people are argument about, much of it is about fine tuning the details, and I don’t see much of a division into two camps.

The main debates is a replay of the Keynes-Hayek debate.

MPettis: It is that China should stop misallocating capital in order to achieve short-term employment growth.

I simply do not understand how if the goal is to increase domestic demand and reduce precautionary savings, how increasing unemployment will make the problem better not worse. It seems to me that you want to get cash into the hands of consumers however possible, so that consumers start spending and developing domestic industries. If you create mass unemployment then you’ll never have the demand to create internal growth, and it’s also a false economy when it comes to government deficits because when your tax receipts plummet your debt is going to be worse off than before.

I just doesn’t make sense to increase unemployment. Even if people are being employed in things that are immediately non-productive, you maintain consumer spending which create productive industries. If you contract the economy, you’ll never have the mass consumer demand necessary to create productive industries and *that* is what causes lost decades.

This is the Keynes-Hayek debate all over again, and Keynes won that one. Keynes’s argument is that in an economic bust, you do anything to get people spending. He suggested paying people to bury money and dig it up again. So using Keynes’s theories, the most important thing is to spend money, what you spend the money on is less important.

Even there, it doesn’t look bad. Barry Naughton has written up a paper on the details of the stimulus package, and it seems to be to be spent on rather sensible things.

http://www.hoover.org/publications/clm/issues/44613157.html

———

Jack P: The debate is whether the crisis should be an opportunity to force the change quickly or whether the transition should be postponed in order to limit the short-term impact of the crisis.

I don’t think that is the debate, and if that is the debate, it is a very silly one since the degree to which China can rely on exports is something that totally out of China’s control. Everyone I’ve seen wants change. The question is “change to what?” A lot of discussions end up with you have one group that portrays themselves as “progressive reformers” and the other group as “evil regression people that want to turn the clock back to the past.” It usually doesn’t describe what people are actually arguing about. Everyone wants to move things forward, the trouble is that people disagree as to the direction.

Jack P: Japan in the early 1990s showed just how misguided and risky policies aimed at misallocating capital in order to maintain employment can be.

And I think people draw the wrong lessons from Japan. Japan (and for that matter the Soviet Union) “stagnated” at standards of living far, far beyond those of anything China is likely to see in the next three decades. Japanese stagnation existed largely because of lack of productivity growth because in an industrialized economy, the only way of generating growth is through productivity increases. If you have a non-industrialized economy, there are other, easier ways of generating economic growth, and the cost of “capital misallocation” are far smaller.

Japan’s experience may be relevant to China in 2030, but applying it to China in 2010 leads to totally incorrect policies, since Japanese stagnation is a much higher standard of living than Chinese growth. If someone comes up with an economic policy that leads to ten years of stagnation at Japanese standards of living, that a wonderful policy that we need to adopt, because it puts China at a higher standard of living than anything that anyone has proposed.

In any case, if it is choice between Japan-1990 and US-1930, I go with Japan-1990.

Pettis: I suspect you may be wedded to a version of Say’s Law.

I’m a Keynesian. Say believed that production naturally creates its own demand, and I certainly don’t believe that. Suppose you have aluminum workers that are producing too much aluminum. They should really stop producing aluminum. That’s fine. The trouble is that if you have them stop producing aluminum and then leave the factory with income, they stop consuming anything, at which point you have this

unemployment -> reduced demand -> unemployment -> reduced demand -> unemployment

spiral that led to the Great Depression, and it’s not a matter of hitting bottom and bouncing back, you don’t bounce back.

So here are the policy options in order of preference.

1) Your best situation is if you get them to stop producing aluminum and pay them to start producing something useful.

2) Your second best situation is to get them to stop producing aluminum and pay them to do nothing.

3) Your third best situation is to pay them and keep producing aluminum.

4) The worst thing you can do is to shut the factory down and put them out of work, because at that point you end up with a domino effect, that you are not going to get out of.

Pettis: Getting people to spend is certainly an important part of any solution, but only if it creates net demand.

How is putting people out of work going to create net demand? If you put the aluminum workers out of work, yes you stop producing aluminum, but you have this domino effect as the workers no longer purchase goods and services which puts more people out of work.

You can see this in the trade data. Chinese net exports has *increased* over the last few months, but growth is going down. Why? Because when you put a migrant worker out of work, you end up putting five other people out of work. Now that migrant worker is just no going back to the export factory. So have them build a school or hospital.

Pettis: If the only way to keep people employed is by creating additional capacity greater than the ability of the newly-employed to absorb it, in a world of excess capacity there are likely to be one of two consequences.

If that is the problem then employ people generating things that don’t produce new capacity. If we have too many steel mills then employ people to demolish them and replace them with parks and hospitals. Employ people to build lots of tanks and aircraft, and the put them in the middle of the desert and blow them up. That’s what got us out of the Great Depression.

Pettis: In April for example there were indications that aluminum production in China rose by around 10%, even though the world is seeing a glut of aluminum production. This certainly helps employ aluminum workers, but it cannot magically resolve the unemployment problem except by pushing it abroad.

If you can’t think of anything better to do, then take all of of that aluminum, put it in the middle of the south China sea and then sink that ship. That is what happened in World War II except that no one has to die.

That’s assuming that you can’t think of anything better to do, and I can think of a dozen things.

If you have lots of cheap aluminum, then give people coupons to buy refrigerators that use that cheap aluminum.

What I find very odd is that the problem of idle hands and overcapacity is not a new one. It existed throughout the 19th century, and some of the best economic minds of the late 19th and early 20th century thought deeply about what to do. Some of the answers they came up with were wrong (say hi to Karl Marx), but it seems very strange that after dealing with the problem of overproduction and unemployment for a century and a half we are having this debate as if this is a new and original problem, and I’d appreciate it if someone would explain what the big problem is with the solution that Keynes suggested 70 years ago.

—-

Pain and Gain

http://blogs.cfr.org/setser/2009/05/13/not-putting-your-money-where-your-mouth-is/

WStroupe: Far too many people here and most everywhere evidently fail to see this crisis in its correct fundamental perspective, namely, the crash of the asset-based model itself.

I’m not seeing it because I don’t think it is true.  You’ve had asset booms and busts happening for the last 200 years, and I’m not seeing anything in this bust that is fundamentally different from what happened in the 1920’s.

In fact, I would argue that the big mistake that people made was the notion that the economy fundamentally had changed, when in fact it had not.

WStroupe: It’s about switching back to a more traditional income-based model. That will be a gut-wrenching process entailing far more pain and suffering than the U.S. has experienced so far, and it only gets worse the longer U.S. leaders waste precious time and money trying to revive the asset-based corpse.

I really don’t think so.  What the US has to do is to boost savings and cut consumption.

Annoying yes, but not the end of the world.  What happens when you boost savings, is that you increase productivity so the amount that you save comes back to you in higher wages.  OK, people go from -2% savings to 5%.  Moderately annoying, but no one is going to starve, and that money is going to come back to you.  You save 5%, a factory gets built, you get a higher paying job.

Take your 401(k), people were assuming 10% growth, now assume 3-5%.  The numbers that come out are somewhat ugly, but they aren’t disastrous.  What will cause massive financial disasters to most people is if they lose their jobs for an extended period of time.  If you are typical and the return on your pension goes from 10% to 5%, it’s ugly, but not the end of the world.

For most people under 55, if you are out of work for a year, then it is the financial end of the world.  Imagine what happens to you if you lose your job for three years.  You are never going to bounce back, so this is why it’s vital to get people back to work, because most people under 55 people have personal financial situations in which even if you have a massive boom after three years of unemployment, it’s not going to be of any help to you.

And God help you if you get sick during those three years.  Without fundamental changes in the social system, if you get hit by a car while unemployed, you are going to be in poverty for the rest of your life.

I don’t see anyone trying to revive the corpse.  If you disagree, go to a bank and try to get a subprime mortgage today.  The money and effort being spent involves burying the corpse, which can be frightfully expensive.

There is this very popular notion that in order to get something you have to undergo a lot of pain.  What that ignores is that you can undergo a lot of pain, and still get nothing.  I’m extremely skeptical of the idea that just because an idea is painful, you end up getting some benefit out of it.  It has something to do with Stalin, Mao, and the Great Leap Forward.  In the 1950’s, Chinese were told that if they sacrificed for the common good, there would be a few years of pain and then this economic boom.  So there was a lot of pain and then nothing.

So when someone says “you have to go through this pain to get to the boom” I’m really skeptical because I’ve heard that before.  There is also the early-1990’s when you had large number of people saying that Russia would boom and China would stagnant because Russia was taking strong medicine whereas China was not.  Things didn’t work out that way.  The first thing I ask, is “is this pain *really* necessary and if it is then what are the ways that we can reduce the pain?”

Also if you talk about getting rid of the old system and going for this wonderful new system, I keep thinking “wasn’t that what Mao and Stalin promised?”  OK, you claim you are different.  That’s fine.  Explain to me how you’ll end up with a boom, and give me numbers.  How much needs to be sacrifices, for how long, and at what point do you throw up your hands and say, well maybe I was wrong about what the problem is, and we need to do something different.

If what you propose will have me accept a 5% return on my 401(k) and a 5-10% tax increase if I hit the jackpot and make more than $250K, that’s fine.  Annoying, yes, but survivable.

If what you propose has me out of work for two years, at which point I lose my house and savings, and have no insurance, then this will not work because I’m busted even if the economy comes roaring back, and if you multiply me by fifty million, I don’t see how the economy is *ever* going to recover.

Also, this plan has another big, big problem.  If I lose my job for two years, I’m wiped out.  The ex-CEO’s of Bear Stearns, Lehman Brothers, General Motors, AIG, Citigroup, and Enron all can survive two years without a job or health insurance.  If you blow up the economy for two years and then you have a massive boom, I’m going to be in poverty for the rest of my life.  They aren’t, because they have enough money in the bank so that two years without work or health insurance is a vacation, and so a bust then boom is going to benefit them, not me.

If the choice is between is between two years of hell followed by a boom, and Japanese style zero-growth economic stagnation then I vote for zero-growth stagnation, and so will most people.  If this doesn’t work for you (and it doesn’t work for me), then come up with another choice.

Notes on economic stimulus

http://mpettis.com/2009/04/new-trade-and-reserve-numbers-from-china/