Tuesday, September 30, 2008

Swedbank's Role In Baltic Boom & Bust

When Austrians discuss the issue of financial crises, it is often assumed implicitly that the central bank is always the culprit behind it.

That is true in one sense, namely that the central bank by providing cheap credit to private bankers and in various ways bailing out private bankers who run into trouble, should be considered ultimately responsible for whatever problems caused by these private bankers.

However, while basically true, it doesn't tell the whole story. The ultimate responsibility of central banks doesn't mean that these private bankers shouldn't receive some blame as well. As they take advantage of this set up from the central bank, they act as collaborators in their schemes. That is why one shouldn't feel sorry for them when they run into trouble as a result of that, much less bail them out.

Applying this to the popular subject of Swedbank and its troubles, it is worth noting that in this article in Swedish news paper Svenska Dagbladet, several economists which argue the case that irresponsible loose lending standards from Swedbank and other Swedish banks contributed to the unsustainable boom in these countries which have now turned into a bust. And while the Swedbank representative, Baltic division chief Erkii Raasuke, interviewed in the article is not surprisingly more reluctant than the independent economists interviewed to admit wrongdoing by his bank, he still admits that with hindsight, Swedbank did lend too much during the boom.

While the Baltic peg to the euro may have been a mistake as it forced them to adopt the too loose monetary policies pursued by the ECB at the time, irresponsible lending practices by Swedbank and other Swedish banks was clearly a very important factor as well.

Jay Leno On Bank Bailout

I saw Jay Leno this morning on Swedish television, although the show was likely originally broadcast a week earlier in America, as it discussed the original $700 billion bailout package as the big news. Anyway, I really liked one of the jokes he had on the bailout:

"Let's see: a failed president and a failed congress will put $700 billion into failed companies. What could possibly go wrong there?"

Why Q3 U.S. GDP Declined

The third quarter is almost over now, but it seems increasingly clear that the GDP figures will be the worst yet for this recession, at least with regard to the headline volume measure but probably also with regard to the more proper terms of trade adjusted figure. As I've discussed before, the headline measure may in fact for the first time since Q1 2007 be weaker than the proper measure.

If we look at the different components, it seems increasingly clear after yesterday's weak report that personal consumption fell in the third quarter for the first time since the 1990-91 recession. Average real (2000 dollars) consumer spending for July and August was $8293.2 billion, down from the Q2 number of $8341.3 billion. What this means that unless real consumer spending soared more than 1.74% in September (which is extremely unlikely), then Q3 consumer spending will be lower than in the second quarter. Assuming the number is unchanged instead (which might be over optimistic), then we're talking about a decline of 2.3%, something which will subtract roughly 1.6%:points from GDP.

Residential investments will also likely to continue to subtract from GDP. Exactly how much is very uncertain due to insufficient data data, but we're talking about at least 0.5%:points. After last week's weak durable goods report, it seems clear that equipment and software investments will likely decline too. As only July data is available for non-residential construction, it is more uncertain whether that will be positive or not, but it is unlikely that it will rise enough to push business investments as a whole on the plus side.

Trade also suffer from the same uncertainty factor (only July data available yet), but it seems likely that the trade deficit will fall in August and September due to cheaper oil. However, because the July deficit was so big, the Q3 deficit might still not fall. And given that the decline is driven by falling oil prices, this means that trade will more likely contribute negatively in the volume number (and perhaps even in the proper number).

The two factors which will likely add to GDP are inventories and government spending. Inventories will probably continue to fall during the third quarter, but as it will fall less than in the second quarter, it will still add to GDP. Just how much these two factors will contribute is uncertain, but is unlikely to come even close to compensating for the other factors.

So, while I will not at this point give a more precise Q3 forecast due to the insufficient data data available, I can already say that GDP (both the headline and the proper measure) will be below zero.

Monday, September 29, 2008

Now Who's Laughing?

Via the LRC blog I found this great clip from December 2006, when former (future at the time of the broadcast) Ron Paul economic advisor Peter Schiff debated a bunch of clowns bullish on the U.S. housing market. The arrogance of the bulls is unbelievable as they literally laugh at Schiff when he predicted that there would be a downturn in the U.S. housing sector. They should really invite them back to the show now, and ask them just how laughable they now think Peter Schiff's prediction in December 2006 of a downturn in the U.S. housing market really is. Somehow, I think they will not want to attend.....

Bailout Agreement Defeated (For Now)!!!

Great news! The bailout bill was actually defeated in the House of representatives by a coalition of limited government Republicans such as Ron Paul and anti-corporativist Democrats such as Dennis Kucinich.

That's one good thing about the American system where members of Congress can vote freely, in contrast to for example the Swedish system where members of Parliament are more or less forces to do what the leaders of their Party tells them. Here we saw many Republicans defy George W. Bush (and John McCain) and many Democrats defy Nancy Pelosi and Harry Reid (and Barack Obama).

We shouldn't celebrate too much, though. There is a very high risk that enough Congressmen can be persuaded to switch sides in a later vote to pass it, especially if the market sell-off intensifies. But even if it ultimately passes (perhaps in a slightly altered form), it is still nice to see this snub to the Republican and Democratic establishment.

Bank Problems In Europe Too

There has been great interest in my posts about Swedbank ( see here and here) as rumors have been spread that it is facing deep problems. So far these deep problems have yet to show up in Swedbank's financial reports and the chairman of the bank, Carl-Eric Stålberg, has angrily denied and denounced the rumors as lies spread by short sellers wishing to gain from a falling price of Swedbank stocks. However, since it has been the case in other failed banks that the banks themselves have denied problems until they were publicly revealed, it can't be ruled out that the rumors might be true.

There have however been other confirmed cases of banks with serious problems. Last year, Northern Rock started to experience serious difficulties, and today there were three highly publicized cases of financial institutions with problems. U.K. Real estate lender Bradford & Bingley were part nationalized and in part sold off to Spanish bank Banco Santander after it experienced serious liquidity problems. Meanwhile, the governments of Holland, Belgium and Luxembourg bought a stake in Fortis to help it avoid insolvency and German commercial property lender Hypo Real Estate was similarly bailed out by the German government.

Less talked about was how the government of Iceland nationalized the Icelandic bank Glitnir and how the Danish banks Bonusbanken and Ritzau are experiencing serious problems, with Bonusbanken being overtaken by another bank, Vestjysk bank, and Ritzau approaching insolvency.

These are undoubtedly interesting times and there will no doubt be reason to return to this subject in new posts. Because so many European financial institutions have been focused on "spreading the risks" and because this has meant in practice exposing themselves to the U.S. financial system, the U.S. financial crisis is having ripple effects. What this illustrates is that while "spreading the risks" may usually be a good idea, it shouldn't be done without judgment and analysis of the asset acquisition this requires, and that junk securities shouldn't be bought even if it according to mathematical models reduces "formal risk".

Sunday, September 28, 2008

About The Recent Surge In The U.S. Monetary Base

While this development has gone unnoticed in the "mainstream" financial media, some Austrian-leaning commentators have recently made a big deal of the recent massive surge in U.S. bank reserves and therefore also by extension the Fed balance sheet and the monetary base.

Between the two weeks ending September 10 and the two weeks ending September 24, the monetary base rose from $843.8 billion to $911.4 billion. Although a small part of that increase reflected an increase in currency in circulation, the overwhelming majority of it reflected higher bank reserves.

Looking at the more frequently update data on the Fed balance sheet, it appears that even these numbers underestimate the surge because they are two week averages. If we look at week averages and end of week levels, then the increase is even more dramatic than that.

As is apparent by the explanatory text inserted in the top of both the Monetary base and the Fed balance sheet statistics pages, the reason for this surge is the various schemes the Fed now uses to try to aid banks.

How much does this matter then? Not necessarily as much as some people think. As I've explained before, the monetary base is in itself unimportant for the economy. What matters is instead money supply, so unless the higher monetary base causes money supply to rise, it will have no impact on the economy.

However, to the extent this in fact causes money supply to rise, it will have an impact on the economy. And given the fact that banks usually don't like holding excess reserves, there is every reason to believe that at least some of the increase in reserves will be used to expand bank balance sheets, which in turn will likely cause money supply to rise. The general distress these days will however likely mean that banks will in fact hold some excess reserves, limiting the short-term effect on money supply. The general distress itself will also make banks more reluctant to lend, and the general public also more reluctant to borrow, which will also have a deflationary effect.

Just what the net effect of these two counteracting forces, the inflationary effect of the Fed schemes and the deflationary effect of the general financial distress, will be remains to be seen. I will keep a close look on coming money supply and bank credit releases. The latest bank credit release BTW featured a massive surge in bank credit. Bank credit contracted between March and June this year, but started to slowly recover after June, and in the week to September 17 it then suddenly surged by $134 billion, or nearly 1.5% in just a week. That could be just a temporary spike, but it may also be an effect of the inflationary Fed schemes. Again, we should watch coming releases to see whether this was just an erratic spike or whether it indicates that the Fed is successful in their attempt to create inflation.

Bin Laden Calls For Action On Al-Qaeda

Wall Street Journal says: "Greenspan calls for action on financial crisis".

Now we only wait for them to report "Bin Laden calls for action on Al-Qaeda" or "Mob bosses calls for action on organized crime" or "Castro calls for action om communist oppression in Cuba".......

Saturday, September 27, 2008

More On Credit Rating Institutes

I recently told you how credit rating institutes Standard & Poors and Moody's gave Lehman brothers a very high credit rating and actually had that rating still in place by the time Lehman went bankrupt! Only after the bankruptcy was already a fact did they lower Lehman's rating to junk status. Good work, guys.....

As a follow-up to this, I would like to recommend this Bloomberg news story about how the reason credit rating institutes have done such a terrible job may be that companies are pressuring them into giving high credit ratings, and that they fear losing business if they are too honest about the sorry financial state of some companies.

But this lack of integrity will hopefully now backfire as few can take them seriously now that it is made clear that they will provide high ratings regardless of whether companies deserve it or not.

UPDATE: A reader tips in the comment section about this Wall Street Journal article that show how the strong standing of the useless credit rating institutes is the result of government intervention.

The Bailout Reader

The Ludwig von Mises Institute has published a "bailout reader", a collection of articles related to the financial crisis and the proposed bailout of Wall Street. One of the articles in the section "Who predicted the crisis" was my classical "America's unsustainable boom" from November 2004, where I identified the housing bubble and the generally unsound elements of the U.S. boom, and predicted that this would eventually turn into a bust.

Friday, September 26, 2008

Public Opinion 50-50 On Wall Street Bailout

I really liked this statement from Democratic congressman Paul Kanjorski about the feelings of the people who contact him about the planned Wall Street bailout, which he says is evenly divided:

"Calls to congressional offices are ``running 50 percent `no,' and 50 percent `hell, no. Out of 100 calls, you are lucky if one of them is positive."

The question is then why is it that only Ron Paul and perhaps a few others are taking an unequivocal stand against bailing out Wall Street? That seems like a sure vote winner in a election year.

Baltic Economies Start Adjustment Process

As I noticed in the previous post, the Swedish banks which dominate banking in the Baltic economies have started to tighten lending standards, which will slow down credit expansion and therefore also monetary expansion. The monetary statistics from the Bank of Latvia confirm that this have already happened. In the year to July 2007, M2 rose by more than 30%. By contrast, M2 growth in the year to July 2008 was less than 6%. The story is similar in Estonia, where M2 growth fell from 23% in the year to August 2007 to 8% in the year to August 2008.In Lithuania, the deceleration in M2 growth was a lot less dramatic, from 22% in the year to August 2007 to 14% in the year to August 2008.

Note that in both Latvia and Estonia, real money supply growth have turned negative. With the heightened anxiety about the Baltic economies and the tougher lending standards this apply, monetary growth will probably decelerate even more dramatically later.

This is actually good news as the previous levels of money supply growth were clearly unsustainable and unsound. Largely as a result of this, consumer price inflation has started to fall from the peaks reached earlier in the year, particularly in Latvia. Between May and August 2008, when as a comparison euro area price inflation rose from 3.7% to 3.8%, it fell from 17.7% to 15.6% in Latvia, from 11.4% to 11.1% in Estonia and from 12.3% to 12.2% in Lithuania.

These levels are still of course far too high, but at least in Latvia and Estonia, they reflect mostly previous monetary inflation, and if you had looked at seasonally adjusted monthly numbers, it would have likely showed significantly lower numbers, particularly in Latvia.

Also as a result of this, the previously very high current account deficits are starting to fall back in Latvia and Estonia. In Latvia, the current account deficit fell from 24.9% of GDP in Q2 2007 to 15.6% in Q2 2008. In Estonia, the current account deficit in Q1 2008 (latest available) fell to EEK 7.9 billion from 13.0 billion in Q1 2007.

Lithuania by contrast is a different story, as its deficit rose from LTL 4.3 billion in Q2 2007 to LTL 4.8 billion in Q2 2008. That Lithuania had a different trend from Latvia and Estonia clearly reflect that they had a much more modest deceleration in monetary inflation (that is also the reason why their deceleration in price inflation were more modest).

That Lithuania has had a more modest deceleration in monetary inflation is also reflected by GDP growth numbers. In Lithuania, quarterly growth numbers are in fact still positive, although much lower than before. The yearly growth rate is a still good 5.5%, compared to 0.2% in Latvia and -1.4%.

But while this means that Lithuania is now experiencing less pain than Latvia and Estonia, this also means that Lithuania hasn't started the kind of adjustment process to more sustainable inflation rates and external deficits that Latvia and Estonia has started. As the current situation is unsustainable in the long run, this means that Latvia and Estonia will get over with the painful but inevitable adjustment process much quicker than Lithuania.

More On Swedbank

Swedbank continues to be the center of negative news in Swedish media (see for example here, here, here, here and here). Rumors circulate about how much money Swedbank can lose in its baltic division and its stake in Lehman brothers. Swedbank chairman Carl Eric Stålberg angrily denies the rumors and says that they are confident to get back the money Lehman owes them and says that their credit losses in the Baltic countries will be limited. However, many depositors and speculators don't believe him and which is why some are now withdrawing money from Swedbank accounts (Stålberg however claims that there are very few withdrawals and that more people are depositing new money).

Stålberg characterize these rumors as something made up by vile speculators, and has come out advocating a temporary ban on short selling, to prevent short sellers from pushing down Swedbank stocks.

At the same time however, media reports that Swedbank and other Swedish banks are increasingly starting to require some of their borrowers to repay the loans in advance. That presumably reflect a fear that they won't be able to pay back later, and likely also reflect a generally more restrictive lending standard. That implies that monetary conditions are rapidly becoming much tighter. This should finally solve the problem of too high inflation and current account deficits, but also deepen the short term downturn. I'll return later in the day with a separate post on the baltic economies.

Thursday, September 25, 2008

Just Remember, Economy's Fundamentals Are Strong

As I told you about before, professional clown Don Luskin has assured us that the underlying economy remains strong. And if he says it, then it must be true. Just make sure to ignore the actual numbers. Here are just today's numbers:

Initial jobless benefit claims rose 32,000 to 493,000, the highest since 2001. Meanwhile, continuing claims also rose to a new cycle high.

Durable goods orders plummeted 4.5% while shipments fell 3.5% in August. So-called "core" orders (excluding aircraft and defense orders) fell 2% and "core" shipments (the input in the GDP report for equipment and software investment) fell 1.7%,

Meanwhile, new home sales fell 11.5% in August from the previous month and by a full 34.5% from August 2008. Meaning that despite the plunge in construction activity, inventory levels rose.

And other reports in previous days have almost all given us the same grim picture. But again, since Don Luskin says the economy is strong, we shouldn't let such pesty things as fact make us think otherwise......

That Flip-Flop Didn't Take Long

September 16, 2008: Larry Kudlow praises Henry Paulson for his "courageous" opposition to bail-outs.

September 24, 2008: Larry Kudlow praises Henry Paulson for his bail-out plan.

Kudlow flip-flops almost as fast as Paulson himself on the bail-out issue, in other words. The only consistent idea that Kudlow holds appears to be that what Henry Paulson says is the right thing.

Meanwhile, Paul Krugman of all people has written a really good post on the bail-out issue.

Wednesday, September 24, 2008

Paulson's "Nigeria Letter"

Many, probably most of my readers have in their email inboxes received one or several so-called "Nigeria letters". These mails claim to come from a son or widow of a former African dictator, or someone else with some government connection, asking for some kind of business transaction, which while formulated in very many different ways often offer the promise of receiving money. For some reason, many of these mails contain only all capital letters. The purpose of this scam letter is of course to fool you into giving the con artist access to your bank account, from which he of course intends to withdraw and not deposit money. Since most of us have already received so many of these scam mails or have heard about them, we aren't fooled of course. But since they keep bother sending them out, presumably a small minority are actually fooled by this.

From the LRC Blog we can see this variant of the Paulson plan formulated in typical "Nigeria letter" way. As you can see (at least if you have read an actual Nigeria letter), it is eerily similar to the actual press statements from Henry Paulson:








Swedbank Troubles Continue

Swedish media reports of rumors that one of Sweden's largest banks, Swedbank, could face a takeover bi, either from Danish bank Danske bank or Norwegian bank DNB Nor. Also, credit spreads for their mortgage backed securities have widened.

Swedbank is perceived by the markets to have more trouble than other Swedish banks for two reasons. One is their high presence in the Baltic states, which have entered a recession and whose situation with high credit driven inflation combined with fixed exchange rates in many ways are similar to the Swedish economic problems of the late 1980s and early 1990s I told you about in the previous post. Other Swedish banks have significant activity in the Baltic states too, but Swedbank's exposure is higher than the others.

The other is that Swedbank had a larger stake in now bankrupt Lehman brothers, some of which will be lost.

In their latest earnings report no significant problems seemed to exist, as profits in fact increased from the previous year despite an increase in credit losses. However, that was before the hit from Lehman. And while that will only be a temporary hit, credit losses in the Baltic states will likely significantly increase.

It is primarily the uncertainty over the Baltic situation which has caused Swedbank stock to plummet more than 60% from year ago levels to only about 100 SEK per share. Based on the annualized earnings per share of 25 SEK per share from the first half of 2008, the stock would appear to be very cheap. However, given the general mistrust toward financial stocks and the likely sharp increase in credit losses in particularly the Baltic states but probably also Sweden and given the fact that the financial turmoil is likely to reduce the profits of their financial crisis, the stock looks risky in the short term.

Tuesday, September 23, 2008

Myths & Facts About Swedish Bank "Rescue"

Since I am from Sweden while most of my readers aren't, and since the bail-out of Swedish banks by the Swedish government in many American media reports have been said to be essentially the same as the bail-out propsed by Hank Paulson, and since this bail-out in these same media allegedly was a big success, I have recently received questions about it.

The truth is that first of all that the Swedish solution was much better than the plan proposed by Paulson or for that matter the Democrats. And secondly, while the plan was better than the ones proposed in Washington, it wasn't as big of a success as it is often asserted.

The background to the Swedish banking crisis was a ill-timed "deregulation" in 1985, where Swedish commercial banks were permitted to lend as much as they wanted in a time where the tax system and the high rate of inflation meant that after-tax real interest rates were significantly below zero. That of course meant a massive credit and monetary expansion during the latter half of the 1980s. As Sweden at the time also had a fixed exchange rate, this meant that the real exchange rate rose sharply and soon became highly overvalued. As the overvaluation and the recession in important trading partners such as the U.S. and the U.K. caused net exports to decline, the Swedish economy began to weaken considerably in 1990. Meanwhile, Swedish politicians instituted a tax reform which closed several loopholes and broadened the tax base, while at the same time significantly reducing marginal tax rates. That reform was a very sound one in a long term perspective, but as the reduced tax rates also meant that the ability to deduct interest expenses fell sharply, this caused real interest rates to sky rocket. The weaker economy meanwhile caused inflation to fall while nominal interest rates had to be raised to defend the fixed exchange rates, contributing even more to a real interest rate shock.

The end result of this was a deep economic downturn, which caused hugh losses for the banks in Sweden. Fearful that many banks would collapse and that this would cause a general run on the banking system, the Swedish government decided to declare that they would guarantee all depositors that they would get any money they deposited in a bank back. However, they made it very clear that they would not bail out those who owned shares in Swedish banks. Share holders in any bank which went bankrupt or turned to help from the government would see all of their equity wiped out and all operations overtaken by the government.

These harsh terms made the banks extremely reluctant to seek aid, so most banks did everything they could to avoid it. In the end, apart from a smaller regional savings bank, only Gota bank was taken over. Moreover Nordbanken (now known as Nordea), which was largely state-owned to begin with was fully nationalized. The other large banks, S-E-Banken (now known as simply SEB) and Handelsbanken, as well as the main savings bank called Sparbanken (what is now known as Swedbank) was not bailed out. S-E-Banken was close to collapsing, but the main owner, the Wallenberg family, chose to recapitalize the bank themselves rather than turning it over to the government.

The Swedish solution thus limited the bail-out to depositors while destroying the equity of any bank whose depositors had to be bailed out. By contrast, the Republican bail-out plan would fully bail out share holders as well, and the Democratic bail-out plan would partially bail them out.

Was this limited bail-out a success then? Well, it probably limited the severe downturn in the economy somewhat, but at the initial cost for taxpayers of 4% of GDP (which in today's America would be equivalent to more than $550 billion). Admittedly, some of those costs weren't really costs in a proper accounting sense, since the government was able to recoup some of the spending it made by later profits these state owned banks made. However, it is certainly not the case that nearly all of the spending has been recouped, as some of the calculations that have been made that seemingly conclude this overlook that much of Nordbanken was already state owned and also assume a too low opportunity cost for the money. On the minus side must also be added that the limited bail-out created a moral hazard that has contributed to current problems in the Swedish economy.

The economic recovery that followed could hardly be attributed to the bank bail-out as it first of all was exaggerated by the terms of trade factor, and secondly can be attributed to long term effects the free market economic reforms implemented in the late 1980s and early 1990s (including the aforementioned marginal tax rate cuts) as well as the end of the overvalued exchange rate and the extremely high real interest rates used in a vain attempt to defend that overvalued exchange rate.

Interesting Reading

Michael Rozeff writes about how today's financial markets are anything but free markets, and are instead state-subsidized markets, and how the state now uses this failure to further increase its power. That is of course what we see in all too many cases, that government intervention creates problems, which are then used as an excuse by the government to further increase its power

Vox Day
delivers a very harsh attack on the modern financial industry and its reliance on government subsidies in the form of Fed inflation and points out how the long run has now arrived. Every time Austrians have attacked monetary inflation and bailouts for their negative long run impact, we are told that we shouldn't think about that when we have a immediate problem in the form of a downturn because of previous inflation and bailouts, and how we shouldn't think about long term effects because in the long run we will all be dead as Keynes put it. But what that misses is that the downturn only exist because of how we previously ignored the long term effects, and that trying to ignore it again only means we will again experience this kind of crisis in the future. Keynes is dead now, but we are living in his long run now.

Ann Wollner writes
about how about how the obscene salaries and bonuses of some of the Wall Street executives should be taken back. What she misses, apart from also making Alan Greenspan and other Fed officials accountable, is the fact I mentioned in the previous post how the bailouts prevents this from happening. Had the banks gone bankrupt, it would have been possible under current bankruptcy law to take back at least the bonuses of executives, but now that they are bailed out that will be very difficult.

Caroline Baum presents a pessimistic, but not entirely unrealistic, vision of the future where the Democrats and most Republicans collaborate in greatly increasing government control of the economy (With the risk of being considered nitpicky, I would like to point out that government spending is currently a lot higher than 17.5%, even if you only look at federal spending). This illustrates the point I have been trying to make for some time now, about how the official right if it continues to reject Austrian economics and sound money, will pave the way for more socialism and regulation.

Monday, September 22, 2008

Republican vs. Democratic Bailouts

As I pointed out before, the plan favored by Hank Paulson is simply terrible. It will grant dictatorial powers to the Justice department, and transfer hundreds of billions of dollars of wealth from the American taxpayers to incompetent Wall Street bankers.

Does that mean that the Democrat's bailout plan is better? Yes and no, is the answer to that. In some aspects, it will clearly be better, or more accurately, it will not be fully as bad.

There are three main differences between the version favored by Paulson and the version that Democratic congressional leaders favor. One is that the Democrats want some form of accountability for the Treasury department so that they can't get away with doing anything. A second is that the Democrats want executive pay to be curbed at companies that receive this subsidy. A third is that the Democrats want to insert other forms of spending into this legislative bill, such as extended unemployment insurance and subsidies to prevent foreclosures. Some left-liberal pundits, such as Paul Krugman, also wants the government to receive shares in the companies the government help, and now it appears that some Democratic congressional leaders are adopting this idea too.

With regard to the demand for accountability, the Democrats have the better proposal, clearly. Giving a government agency a blank check to do whatever it wants without any overview is not just a bad idea, it's creepy.

With regard to the demand for curbs on executive pay, that seems reasonable too given that these companies receive government aid. However, what would really be needed would be some retroactive curbs. Curbing pay now won't do much about the moral hazard created by the massive bonuses and severance packages awarded to executives whose decisions created multi billion dollar losses. Since these curbs will likely be gone by the time of the next boom, the lesson for executives is that they can earn enormous sums by making risky and stupid investment decisions. Had the banks gone bankrupt, it would have been possible under current bankruptcy law to take back at least the bonuses of executives, but now that they are bailed out that will be very difficult.

On the spending proposal, the Democrats are worse than the Republicans. While it may seem just that more than just Wall Street bankers should receive government aid, this implies a further damaging increase in the already too high government spending and deficit level.

With regard to the proposal that the government should receive ownership in the bailed out firms, just like in the cases of Fannie Mae,Freddie Mac and AIG, this has both good and bad sides. The good part is that this will reduce the redistributive effect and for that reason also limit the moral hazard effect. Still, it will not come even close to eliminating any of them because not only will creditors and former executives be bailed out, but shareholders will still benefit, only somewhat less so than under Paulson plan. The bad part is that further increasing government ownership in the economy will unless the stakes are later privatized further increase government control of the economy, which would be bad for both liberty and long-term economic efficency.

To summarize, both the Republican and Democratic bailout plans stink and should be discarded. While the Democratic plan is in some aspects less bad, they are in other aspects worse.

As usual, the only politician with a sound approach is Ron Paul.

Swedish Government Fight Recession The Right Way

As Sweden in the wake of global unrest and even more importantly, home grown problems, risk falling into a recession, the Swedish centre-right government today presented its budget. As previously reported, the budget is largely good news as the government tries to fight the recession with tax cuts, with corporate income taxes, payroll taxes and personal income taxes all being reduced (although not dramatically).

Austrians, when opposing more monetary inflation and bailouts of bankers, are often accused of opposing any relief to the economy, because of some moral imperative that the economy must suffer (see for example Krugman make that accusation here).

But that is not true. We do favor solutions that will provide relief as long as they do not create even more future problems. Because we realize that the crisis was the result of previous monetary inflation and previous bailouts and that more of that will create more problems in the future, we oppose monetary inflation and bailouts.

However, solutions that do not create future problems, such as marginal tax rate cuts, are welcomed and that is why I am glad that the Swedish government now appears to fight the problem the right way.

Unfortunately, there will be spending increases as well (Sweden has until now had a large budget surplus), but not surprisngly the left-wing opposition wants even more of that while having no tax cuts.

Sunday, September 21, 2008

Will The Treasury Department Get Dictatorial Powers?

"It is clear that desa Fed policy interacted with desa Wall Street incompetence. Senators! Dellow felegates! In response to this direct threat to incompetent Wall Street bankers, mesa propose, that the Senate give immediately emergency powers to the Treasury secretary"
(Adapted version of Jar Jar Bink's call for emergency powers to Palpatine in Star Wars Episode 2)

There are many troubling things with the proposed "comprehensive" bailout of incompetent Wall Street bankers. Just how troubling it will be remains to be seen until the final version is announced. I'll certainly return to the subject once the announcement has been made.

One troubling aspect of the version the Bush administration asks for (which they may or may not be granted) is that it will grant the Treasury department complete discretion to buy mortgage backed securities from anyone at any price they want without the reach of courts or really even Congress. Except for the $700 billion quantity limit, there will be no checks or limits or accountability for the actions of the Treasury department. Regardless of how much money they unnecessarily waste on Wall Street banks, whether out of incompetence or out of cronyism/corruption, there will be no possibilty for courts to intervene and no possibility of prosecuting anyone. While there will be a provision saying the Treasury department should safeguard taxpayer's interests, that provision is in practice meaningless as the Treasury department will have full discretion in interpreting what that provision means. And of course, if they really had taxpayer's interest in mind, they wouldn't have come up with this package in the first place.

The Democrats appears to be all for this power grab. The only hope to stop this comes if they insist on putting into this bill their desired various other spending plans and the Republicans insist on stopping those plans. Unfortunately, it appears more likely they in "bipartisan" spirit will agree to a compromise.

Update:: It now appears that the Democrats will in fact oppose giving the Treasury department unlimited powers, while also demanding limits on executive pay and various spending programs. So maybe I was too pessimistic. It remains to be seen however if they will really be willing to block it if Paulson insist on his version.

Saturday, September 20, 2008

Italian Finance Minister: Greenspan As Bad As Bin Laden

Via Tim Iacono I see L.A. Times reports how political leaders in Europe mock America for its messed up financial system.

Most however do not appear to understand the cause of the crisis and instead talks about how the root cause is "savage capitalism". This is of course nonsense. While it is certainly the case that Wall Street with its incompetence and recklessness deserve blame and thus have gotten what they deserve now (or more correctly would have gotten what they deserved if the government hadn't bailed out most of the failed companies), the point is that the government through its low interest rate policy and previous bailout made it profitable for them to create the bubble. Without these government interventions, it would have appeared less profitable and more risky to create the housing bubble.

The politician that comes closest to the truth is Italian finance minister Giulio Tremonti who says that Alan Greenspan is to blame and that Greenspan has harmed America as much as Osama bin Laden. I certainly agree with that assessment, although it appears that not even Tremonti fully understands why Greenspan is the man most responsible for this mess, as Tremonti do not point to his interest rate policy but instead says it was failure to properly oversee Wall Street excesses.

Friday, September 19, 2008

About Flow Of Funds Report

Yesterday, the flow of funds report was published, but it got completely overshadowed by the news of continued socialization of what is now known as the U.S.S.R.A. financial system by comrades Paulson, Bernanke, Pelosi and Reid.

The report did not produce any mayor surprises. The numbers were roughly what I had expected, in that debt growth had indeed slowed dramatically particularly for households, and that net worth had shrinked as did savings. To elaborate on the specifics:

-The one really bullish detail of the report was the sharp deceleration in household debt growth. Household debt grew just 1.4% at an annual rate in nominal terms, which was less than the rate of inflation or nominal income growth (even excluding the effects of the temporary tax rebates), meaning that for the first time in decades, American households are finally reducing their relative debt burden.

-However, this reduction comes in the context of first of all the temporary fiscal stimulus in the form of the so-called tax rebate, which enabled many to spend with the money they got from the government rather than money they borrow. And secondly this came in the context where the value of both houses and financial assets decline. As a result, even nominal net worth fell during the second quarter, and given the inflation rate of more than 4%, the real decline was of course larger.

Note moreover that this modest decline was derived using the OFHEO house price index. While the Case-Schiller index clearly exaggerate the house price decline by excluding the less volatile rural areas, the OFHEO index likely underestimate the decline as it exludes the most volatile forms of loans.

And while the household debt burden finally fell, corporate debt (and government debt) continued to increase faster than national income.

-Another interesting note was how net savings fell to yet another post-Depression low, minus more than 1% in the income accounts, down from roughly zero the previous quarter. As I pointed out before, there is a "statistical discrepenacy" between income based data (national income) and production based data (GDP), and as the production data give a more positive picture of income it also gives a more positive picture of savings. But while the production based levels were more positive, the change was the same as porductiin based national savings for the first time fell below zero after having previously had a large surplus.


There is an old saying that in America there are two parties: the stupid party and the evil party (Usually the Republicans are the stupid and the Democrats the evil, but sometimes the roles are reversed). Sometimes the two parties come together and do things that are both evil and stupid. That is called bipartisanship.

That saying came to mind when I heard that Republican Treasury Secretary Henry Paulson and Republican Fed Chairman Ben Bernanke will come together with Democratic congressional leaders Nancy Pelosi and Harry Reid to devise a "comprehensive" approach for solving the crisis.

The details of the "comprehensive" approach are not entirely clear, but it seems that the general idea is (in addition to bans and restrictions of short sales) for the government to buy bad assets from the financial institutions, as well as creating a insurance for money market mutual fund assets, similar to the one covering traditional bank deposits. These proposals amount to massive government subsidies of banks and other financial institutions, making it non-surprising that stocks in general and financial stocks in particular soared.

Like the Fannie & Freddie bailout, this will mean another step towards making the government the dominant mortgage lender, something which made Nouriel Roubini refer to the USA as being more like USSRA (United Socialist State Republic of America), and Jim Rogers call America "more communist than China" (see video below).

Thursday, September 18, 2008

Evidence Shows Oil Price Decline Was Driven By Speculation

About a month ago, I argued that although some of the decline in the price of oil was driven by weaker fundamentals (such as falling demand due to weaker global growth, plus a stronger dollar), a significant portion of the decline was driven by pure speculation.

This view is now supported by evidence from inventory accumulation. If the price of oil is too high relative to fundamentals then inventories will rise. If on the other hand the price is too low then inventories will fall. The basis for using this method is simply that if demand is higher than supply then this will result in lower inventories, and similarly if supply is higher than demand then this will result in higher inventories.

And inventory data from the EIA shows significant declines in the inventory level of not just crude oil but oil-based products like gasoline and distillates (diesel and heating oil). During the 5 weeks since my post, crude inventories are down 4.8 million barrels, distillates inventories are down 2 million barrels and gasoline inventories are down a full 18.2 million barrels. While it is not unusual for gasoline and crude inventories to fall this time of the year, particularly gasoline saw an unusually large decline. Moreover, usually distillates inventories are up substantially this time of the year, but in recent weeks they have been falling.

At this point, I can imagine that many of you would object that the numbers were distorted by the effects of hurricane Gustav (Interesting, BTW, with a Swedish name for a tropical storm). This is to some extent true, but there is more to it than that as total petroleum inventories fell a lot more than during the comparable period in 2005, after hurricanes Katrina and Rita. Moreover, to the extent the hurricane reduced oil supply it should in fact have a price increasing effect as it will require higher oil output relative to demand in the future to rebuild inventories to normal levels.

So, it should be very clear that the price of oil has been too low in recent weeks. That does not necessarily imply that prices will rise as the latest financial turmoil could hurt demand, and thus perhaps bring about the elimination of the gap between the actual price and the equilibrium price by lowering the latter rather than by raising the former. But it does mean that the price so far has been too low and it means that even if the equilibrium price fall there won't be any room for further declines (unless the reduction in equilibrium price is really dramatic).

Wednesday, September 17, 2008

Who's The Modern Herbert Hoover?

Paul Krugman notes the eerie similarities between the assurances of President Herbert Hoover in 1930 that "the fundamental business of the country" was sound, and similar assurances today by John McCain that the fundamentals of the economy is sound (whether that is true or not depends on what you mean by fundamentals, see my classic post "the two sides of the American economy" on the distinction between micro- and macro fundamentals).

Perhaps Krugman and other Obama supporters (Krugman was a Hillary supporter during the primaries and so a Obama critic at the time, but being a Democrat he is now a Obama supporter) should instead focus on the similarities of policies. As Murray Rothbard documented in his great book America's Great Depression (available online here, can be ordered in paper format here) Herbert Hoover's economic policies consisted of higher taxes, higher government spending, trade protectionism and government coercion to prevent wages from falling. Fast forward now from 1930-32 to 2008 and ask yourself which candidate propose consistently higher marginal tax rates, higher government spending on for example health care, who argues for protectionist trade policies and higher minimum wages and stronger unions (which will enable them to artificially prop up wages). Well, I think we all know which candidate best fit that description....

Of course, these Herbert Hoover policies weren't the main cause of the Depression (the main cause was monetary policy) but they did make the Depression even worse than it had to be, and so would implementation of similar policies make the current crisis even worse than it has to be.

Financial Crisis In Russia Too?

It seems that America isn't the only country facing a banking crisis. There are increasing signs of a financial crisis in Russia as the central bank has felt compelled to pump $44 billion into the banking system and temporarily halt stock trading, although so far no specific banks have been pointed out as facing collapse.

The Russian economy is highly dependent on exports of commodities in general and oil in particular, meaning that it has suffered greatly from the decline in the price of oil. With Russian oil production at slightly less than 10 million barrels per day, or in other words roughly 3.6 billion barrels per year, this means that a $50 per barrel decline in the oil price reduce the value of its production with $180 billion, a lot in a country where GDP only recently rose above a trillion dollar. Of course, the current price of oil is still above year ago levels, but as America and other have discovered with regard to house prices: if prices rise and then fall, the ultimate effects are not the same as if prices had been flat all along. A lot of people take on debt and make investments based on the higher prices, debts and investments that then turn into bad debt and malinvestments as prices go down.

In addition, Russia suffers from other problems. Apart from having a lower price on its oil production, production volumes are falling too. Moreover, the international financial turmoil and even more importantly, the investor distrust in Russia's geo-political stability created by the war with Georgia have hit Russian financial markets hard. So, unless oil recovers soon and significantly, Russia's economy could face serious problems.

Tuesday, September 16, 2008

Will AIG Get Bailed Out?

After beginning the day with another sell-off, U.S. stocks recovered and started rising later in the trading day. The reason, apart from the usual technical tendency for stocks to rise after sharp declines because of the perception that they're at that point oversold, appears to be rumors that AIG will after all be bailed out by the Fed, in sharp contrast to the action it took on Lehman.

It remains to be seen whether this rumor is true or false. If false, then we will see another sharp sell-off. If true, then this will destroy most of the positive effect in reduced moral hazard that the refusal to bail out Lehman created.

Meanwhile, On The Supply-Side

In a desperate attempt to distract attention from how ridiculuos the recession denial of him and other supply-siders now look, Mark Perry says that there is no need to worry because the unemployment rate is significantly below the level of the 1930s.

Which is of course true, but first of all, a crisis can be very serious without being fully as serious as in the 1930s. And secondly, few if any have claimed that things are as bad as in the 1930s. What many instead argue is that it is the worst crisis since the 1930s. "The worst since the 1930s" is not the same thing as "as bad as the 1930s". And thirdly, unemployment is usually a lagging indicator in a crisis. The increasingly severe financial crisis which is certainly the worst since the 1930s could by contrast be characterized as a leading indicator of a much more severe economic downturn than the relatively mild recession seen so far.

Meanwhile, taking the price for the most ill timed, and also one of the most misleading, article this year, Don Luskin assures us again that there is nothing wrong with the U.S. economy. This was published just before not only the financial meltdown of the last few days, but also just before the news that industrial production plunged by 1.1% in August.

He presents various misleading statistics, such as the phony 3.3% growth number for the second quarter and the second quarter savings rate which was temporarily boosted by the tax rebates, while saying the financial crisis isn't so bad because the number of failures so far is fewer than in previous periods of crisis (overlooking that the failures this time involves very large companies, as opposed to the small local Savings & Loans banks of previous periods of crisis) while omitting the overwhelming number of statistics (such as the sharp increase in the budget deficit and unemployment, the falling real wages and plunging corporate profits) which clearly indicates a recession. That clearly indicates that he is not stupid, as Brad DeLong claims, but is instead dishonest.

But despite being a clever con artist, he will end up hurting McCain by presenting himself as a McCain advisor making assertions that are so out of touch with the experience of most Americans, indicating that he cares more about promoting himself than promoting McCain.

Lowering Credit Rating After A Company Fails

So apparently, credit rating agencies Moody's and Standard & Poor today cut the rating of insurer AIG, who appears to be the next financial company to fail. They did that the day after the company's shares fell more than 60%. Similarly, after Lehman Brothers declared bankruptcy, they lowered the credit rating of that company from A2 (very high) to junk status. Isn't that a bit too late given the fact that investors have already lost the money? And what does it say about the value of their ratings when companies hold a A2 rating on the moment they go bankrupt?

They sound sort of like fictional investment banker George Parr who when confronted with the fact that they despite their million pounds salaries didn't foresee the banking crisis in the strictest sense of the word, or in any sense of the word, replied that they did notice it when it happened.

Monday, September 15, 2008

U.S. Industrial Production Plunge

In my commentary to the latest employment report, industrial production was likely to fall significantly given the reported plunge in hours worked in manufacturing. And fall significantly it did, 1.1% to be more specific compared to the previous month and 1.5% compared to August 2007. Manufacturing alone fell 1.0% compared to the previous month and 1.9% compared to August 2007. Also, previous industrial production numbers were downwardly revised by a total of 0.2%.

Mining have long been the strongest component of industrial production, and while it fell less than manufacturing and utilities, it too fell 0.4%. It is however up 3.5% compared to August 2007. If the downturn in commodity prices is sustained (increasingly likely after the Lehman collapse) then this source of strength will be removed too.

Lehman Fails-Merrill Lynch Is Acquired

It is now confirmed that Lehman Brothers will go into bankruptcy. The chicken race between U.S. Treasury Secretary Henry Paulson who refused to offer government support and the potential acquirers who demanded government support to go in ended with neither side yielding, causing Lehman Brothers to crash.

Meanwhile,Bank of America announced
it will acquire Merrill Lynch for $29 a share, a surprisingly high price (70% above the Friday close, although it is still 70% below year ago levels). They would most likely have gotten it cheaper if they had waited longer so it might seem puzzling that they now offer such a high price. Perhaps they want to be sure the deal goes through and also wish to avoid a general run on Merrill Lynch in the wake of Lehman's collapse, which would lower the price but also the underlying value of the company.

It is too early to estimate of this. I will almost certainly have to return to this issue in future posts. However, a few things seem immediately clear:
1) This will not be the last financial institution that collapses. A lot more companies have suffered great losses related to the bursted housing bubble and so a lot more will approach insolvency. And this collapse will in itself cause further losses for those with stakes in Lehman. Moreover, the loss of confidence created by this will create "runs" on many financial institutions, causing them to collapse in a self-fulfilling prophecy. The sell-offs on global stock markets and rally in Treasuries are early indicators of this.
2) There is now simply no way that the Fed will raise interest rates. Indeed, this will likely open up the possibility of future interest rate cuts.
3) This as well as point 1 will likely cause credit to contract which in turn will likely cause monetary contraction, which will lower inflation and deepen the economic downturn in the short term.
4) Because of point 2, and because it will scare away investors from almost all American assets except Treasuries (U.S. government bonds) this will be bearish for the U.S. dollar.

Like I wrote earlier, I will certainly return with more on this issue later, so stay tuned.

Sunday, September 14, 2008

Lehman Headed For Liquidation?

Despite rumors to the contrary it appears that there will be no bailout or other deal to save Lehman brothers from going under.

Apparently, the sovereign wealth funds got out early and at the end the two leading contenders for taking over Lehman was Bank of America and the British bank Barclay's. However, both demanded some form of government support and at least for now it appears (though it can't be ruled out that this will change) that Henry Paulson stands by his earlier opposition to this.

This means that unless someone change their attitude Lehman brothers will be liquidated, something which will cause downward pressure on the price of financial assets. In the long term, this would be good as it will speed up the adjustment process and discourage future reckless behavior but it will in the short term aggravate the economic downturn.

As more news arrive, I'll probably return to this story.

Saturday, September 13, 2008

Lehman Brothers Next Bank To Fail?

After the spectacular near-collapses and bailouts of Bear Stearns and Freddie Mac and Fannie Mae, the next bank that appears to be on the verge of collapse is Lehman Brothers. Lehman Brothers has suffered hugh losses related to the bursted housing bubble, and appears likely to collapse if it isn't re-capitalized.

Apparently, Treasury secretary Henry Paulson opposes bailing out Lehman in a similar way that Fannie & Freddie were bailed out so the New York Fed is now trying to arrange a different way of re-capitalizing. And although Lehman can cover some of its liquidity problems by selling off assets, that won't do anything to improve solvency. Most likely this will be done in a manner more similar to the Bear Stearns bailout, with some other institution buying Lehman for a symbolic price with some form of backing by the Fed. It remains to be seen exactly who and under what conditions this will happen, and since I am not involved in these discussions I obviously can't give any specifics now. However, it should be noted that speculation is growing that some sovereign wealth fund will be involved. If that is the case, then that could be seen as returning the favor they received when the U.S. government bailed out Fannie & Freddie and thereby also the Fannie & Freddie bonds held by the sovereign wealth fund.

Friday, September 12, 2008

Terms Of Trade Strikes Back?

During the last five quarters, and by that I mean Q2 2007 to Q2 2008, the terms of trade adjusted GDP number that I have discussed frequently here has increased slower than the unadjusted headline GDP number that the financial press usually focus on.

This, and also the fact that nominal national income has usually increased a lot slower than nominal GDP, suggests that economic growth was likely a lot weaker than the headline number. Now during the third quarter this distortion will likely be temporarily ended. The reason is that terms of trade is highly correlated with the oil price, and since that has fallen significantly recently, terms of trade might temporarily start to strengthen for the U.S. By looking at the import and export price news release, it is clear that although terms of trade in the first month of Q3, July was weaker than 3 months earlier, it was stronger in August than in May. And the June to September change is likely to be far stronger, meaning that there is a high probability that terms of trade will actually strengthen in Q3, although not by much.

The bad news for the U.S. economy is that underlying economic growth hasn't strengthened, and so the implication of the stronger terms of trade is instead that the headline number will be a lot weaker. Negative volume growth therefore seems almost certain for Q3.

Thursday, September 11, 2008

Bill Gross Makes $1.7 Billion Of Fannie & Freddie Bailout

Tyler Cowen defended the bailout of Fannie & Freddie bond holders by writing that:

"In essence we already agreed to the bail out some time ago. Have you ever spent $17,000 on a car and asked the dealer what the warranty for the car "really meant"? Well, the Chinese spent $340 billion on agency debt and probably asked the same question at least once or twice."

While he is in one sense right that "we" (by which he means the U.S. government) agreed to a bailout by designating Fannie & Freddie government sponsored enterprises and by the informal pledges that those bonds would be safe, it is as some commentators point out something perverse about the fact that these bonds have for a long time (but most particularly in recent months) had a higher yield than Treasuries, yet they are still now supposed to be as safe as Treasuries. Since they have enjoyed higher yields as a risk premium, it is not self-evident that tax payer money should used to completely insulate them from losses. This in fact constitute a massive subsidy of those bond holders, such as the government of China.

Some people argue that the Chinese could threaten to stop buying American securities, but isn't that exactly what the Bush administration and Congressional leaders (both Democrats and Republicans) have claimed to want for a long time? Haven't they always told us how they want the Chinese to stop holding down the value of their currencies by accumulating American securities? Making the Chinese suffer a bit here can perhaps persuade them to stop holding down the value of the yuan, which would the best solution for everyone, at least in the long term.

In a related matter, we can now see why bond fund manager Bill Gross wanted this so much. Apparently, he has in recent months been selling Treasuries and corporate bonds and used the proceeds to buy Fannie & Freddie bonds, while at the same time appearing in the media repeatedly and advocated that the government should bail out owners of Fannie & Freddie bonds, such as himself. Meaning that he can reap the benefit of the higher yields while sending the cost of the defaults he won't be (but should be) affected by. This little arrangement will earn a nice $1.7 billion.

Pretty good deal for him. Not a very good deal for others.

Weaker Currency To Lower Inflation?

Today in Swedish media, several economists are interviewed about the dollar rally. I'll return later for other aspects of this issue, but for now I will focus on the incredible claim in the article (it is unclear whether one of the economists claimed this or if this was something the reporter made up) that the stronger dollar will lower Swedish inflation.

Since relative exchange rate strength is a zero sum game, a stronger dollar will mean that other currencies, including the Swedish krona will be weaker. A weaker currency will all other things being equal raise the domestic price inflation rate for 3 reasons: 1) because of the direct impact of higher import prices. 2) because of how the higher import prices will lessen the pressure on domestic producers not to raise their prices 3) because higher export prices will similarly lessen the pressure on domestic producers not to raise prices since they will now be able to sell their products abroad if domestic customers don't agree to the price increases, thus strengthening their bargaining power.

"But", the article says, the stronger dollar will push down oil- and commodity prices and thus reduce that price pressure. Actually though, at least in the long run, a stronger dollar will only reduce the dollar price of commodities. It will by contrast raise the price of commodities in terms of the euro or the Swedish krona. While market irrationality can sometimes make the article's claim true in the short term, this will not be sustainable as the too low price will create excess demand and push down inventories to too low levels and push up the price to goods market equilibrium.

While it is true that the oil price has fallen even in terms of the Swedish krona and while probably not all of that decline is attributable to market irrationality, but to another factor, weakening global demand, that is unrelated to the causal effect of the exchange rate movement alone, which will clearly be to raise the oil price in terms of the Swedish krona, which in turn will raise inflation compared to what it otherwise would have been (that doesn't higher inflation compared to now, it could also mean a smaller decline in inflation than otherwise).

Thus, while it is true that a weaker currency will help exporters it will certainly not lower price inflation.

Wednesday, September 10, 2008

Sarah Palin's Non-Gaffe About Fannie/Freddie

Terrified about the enormous popularity of Sarah Palin, and the extent to which this has boosted the McCain-Palin ticket, the Democrats are now trying to dig up any possible "dirt" or mistake from her. I won't here bother trying to comment on most of these accusations, most of which are probably false but some of which might be true . Instead I will focus on the alleged gaffe she made about Fannie Mae and Freddie Mac in wake of the de fact nationalization of these two "government sponsored enterprises". Apparently, what she said was:

"The fact is that Fannie Mae and Freddie Mac have gotten too big and too expensive to the taxpayers."

I have great difficulty in seeing what is wrong with that statement. The fact that they are considered to be "too big to [be allowed to] fail" is clear evidence that they have gotten too big. And with this formal government take over, they will cause hugh losses for the tax payers (wiping out shareholder's equity will only help too pay for a small part of their likely losses).

Some have objected to the temporal form of "gotten too expensive", arguing that it implies that Palin doesn't know they were until just recently private owned and didn't receive any formal payments from the government. Well, I don't know how much she knows about this and it is possible that she did believe it. But it seems more likely that she simply referred to the fact that this takeover will imply losses for the tax payers. It's not unusual for politicians to misspeak somewhat. For example, Obama has said that he will campaign in all 57 states, said that his uncle liberated Auschwitz (which would imply that he was enlisted in the Red Army since it was Soviet troops that liberated Auschwitz), said that he was campaigning in New Pennsylvania (maybe that's one of those 7 additional states Obama has discovered...) when he was campaigning in New Philadelphia and talked about his Muslim faith.

Anyway though, while Palin may not have known about this, the fact is that according to standard accounting principles, the losses that tax payers will suffer should really be considered to be something they have suffer. After all, Fannie & Freddie have long had the status of "government sponsored enterprises", which is to say that they have in effect been subsidized by the government through the implicit guarantee. Moreover, the mortgage lending that caused the current losses was something that happened in the previous years. And since a fundamental (a very sound one, BTW) principle of accounting is that profits or losses should be attributed to the time period of the activities that caused them, this means that the losses very mostly something that arose in the past. While formal retroactive revisions of old earnings statements aren't always recommended for various practical reasons, that does not change the general principle that losses and profits should ideally be attributed to the time period of the activities that caused them and it certainly doesn't make it wrong for analysts to attribute them to the right time period in their analysis.

So far from exposing some embarrassing ignorance from Palin, the left-liberal economists who have criticized her have in fact only exposed their own ignorance of the principles of accounting.

Tuesday, September 09, 2008

McCain & Miss Teen South Carolina

One of the most watched videos (28.5 million hits in one version alone plus several millions more in other versions) on youtube is the answer of Miss Teen South Carolina Laura Caitlin Upton on the question of why a fifth of Americans can't locate the United States on a world map, which she answered by saying we should help people in "everywhere,like such as" South Africa, "the(?)Iraq" and Asian countries so that we shall be able to build a better future over here.

Less known is the fact that during one of the debates during the Republican debates John McCain answered an economics question about the President's working group on financial markets from Ron Paul in a not so dissimilar matter by simply mentioning the names of his economics advisors and then talk about tax cuts. The first video below is an unedited version simply showing the question from Paul and answer from McCain, and the second is a shorter edited one illustrating the similarity between McCain's answer and Miss Teen South Carolina's.

In light of this, Republicans should be a lot more worried about McCain making a fool of himself during the debates than about Sarah Palin making a fool of herself during her debate with Joe Biden.

The Truth Behind The Dollar Rally

Very interesting article that I recommend about how the latest dollar rally came into existence despite terrible dollar fundamentals. Regular readers of this blog already know about the main points in the article, as I have already alerted you to the massive increase in foreign central bank purchases of U.S. Treasuries and the market mechanisms created by the existence of "stop-loss" rules among investors, but it is still worth reading as it contains more detailed facts about these things than my posts.

Monday, September 08, 2008

Sweden Lowers Corporate Income Tax

Today, the Swedish centre-right government announced that it is cutting the corporate income tax from 28% to 26.3%, while also implementing a small reduction in payroll taxes. Previously it has been hinted that there will be some form of income tax cuts as well.

As could be expected , business organizations are pleased with the news while the left-wing opposition are not so pleased, although the Social Democrats actually hint that they do not really oppose the corporate income tax cut as they recognice the need for that to be competitive.

This is good news for Sweden as this kind of supply boosting tax cuts are exactly what the Swedish economy needs when price inflation is high while the economy risks slipping into a recession. Still, while it will have positive effects the cuts aren't big enough (At 26.3%, the corporate income tax is still a lot higher than in many other European countries) to have any dramatic effects and it remains to be seen whether it will be enough for Sweden to avoid a recession.

Detroit-The Next Bailout?

With polls moving in McCain's direction after the Republican convention and the choice of the popular VP candidate Sarah Palin, the battle for the White House is bound to get tougher. This means likely that both McCain-Palin and Obama-Biden will focus on winning over the key swing voter bloc of white working class voters, so-called Reagan Democrats, particularly those living in battleground states such as Michigan, Ohio and Pennsylvania. While McCain-Palin will likely focus on the issue of "values", they will have to respond even on the economy as Obama-Biden is likely to focus on that issue.

That in turn means that both candidates will be highly reluctant to reject ideas popular among those swing voters. And with the precedent set by the government bailout of various financial institutions such as Bear Stearns, Fannie Mae and Freddie Mac, this means a risk that Detroit car makers will seize this opportunity to demand a bailout, as Paul Ingrassa points out in Wall Street Journal. Why should only super rich Wall Street traders driving Maseratis and drinking champagne (preferably not at the same time) get bailed out while middle class Detroit auto workers driving Chevrolets and drinking beer (again preferably not at the same time) receive no help, many will ask. As Ingrassa notes, not only Obama, but recently even McCain have expressed sympathy for such a proposal, so there is a significant risk that it might happen, though probably not in the exact same form as the Wall Street bailouts.

Sunday, September 07, 2008

U.S. Government Nationalize Fannie & Freddie

It was inevitable, of course. Given the magnitude of the Fannie Mae & Freddie Mac losses from the housing bust, it was clear that only three options existed and that only one was politically realistic. The first option, to let Fannie & Freddie fail, was the soundest one in the long term, but since it would have produced significant short term pain it wasn't politically realistic. The second option, to bail out Fannie & Freddie including its shareholders, was also politically unrealistic since it would constitute a massive transfer of wealth to Fannie & Freddie shareholders, most of whom are rich Americans (though some may be owned by foreign governments and banks). Not politically realistic either in a time when low and middle income Americans experience falling real income.

The third option was to bail out Fannie & Freddie and its creditors, while wiping out shareholder's equity. While today's takeover by the government won't formally mean that preferred or even common stock holders will immediately loose their money, it will mean so in practice at least for common stock holders (first in line to absorb losses) and probably also for preferred stock holders (second in line to absorb losses).

The decision apparently came after auditors discovered that Fannie & Freddie had cooked the books and that many asserted asset values were inflated well above what honest accounting standards would justify.

Still though, for the foreign governments that have hold stakes in Fannie & Freddie this will likely come as a relief as they have mostly invested in bonds issued by Fannie & Freddie rather than stocks. I'm sure U.S. tax payers will be delighted to know how their tax dollars go to bailing out mercantilist foreign governments.

Saturday, September 06, 2008

Consumption Taxes Vs. Production Taxes

One area where I strongly disagree with Murray Rothbard is his view that consumption taxes cannot cause prices to rise, at least not in the short-term. This disagreement is not just, or even primarily, the anecdotal experience of consumption tax changes in Sweden and neighboring countries which generally tend to more or less immediately impact prices. No, it is mainly based on the fact that his theoretical analysis of this issue is flawed.

In his chapter on sales taxes (the same logic applies to value added taxes) in Power & Market, he argues:

"Prices, however, are never determined by costs of production, but rather the reverse is true. The price of a good is determined by its total stock in existence and the demand schedule for it on the market. But the demand schedule is not affected at all by the tax. The selling price is set by any firm at the maximum net revenue point, and any higher price, given the demand schedule, will simply decrease net revenue. A tax, therefore, cannot be passed on to the consumer......

....It should be quite evident that if businesses were able to pass tax increases along to the consumer in the form of higher prices, they would have raised these prices already without waiting for the spur of a tax increase. Businesses do not deliberately peg along at the lowest selling prices they can find. If the state of demand had permitted higher prices, firms would have taken advantage of this fact long before. It might be objected that a sales tax increase is general and therefore that all the firms together can shift the tax. Each firm, however, follows the state of the demand curve for its own product, and none of these demand curves has changed. A tax increase does nothing to make higher prices more profitable."

There are two key fallacies with this analysis. First, it is not true that firms typically try to maximize revenues, they attempt to maximize profits. What this means in practice is that they will set the price which creates the highest possible gross profit, given a certain level of fixed costs assuming that fixed costs are lower than gross profits (If fixed costs are higher, than the firm will go bankrupt after a while). Gross profit is defined as revenues minus variable costs.
In practice, the distinction between fixed and variable costs isn't always as clear-cut as there also exist semi-variable costs, but introducing them doesn't change the point of the analysis for this context, it only makes it more complicated so for simplicity I will assume only fixed and variable costs.

Anyway, returning to the issue of profit-maximization given a certain level of fixed costs, it should be clear that maximum gross profit is reached at the point where further price increases will increase gross profit per unit (margins) by less than it will decrease volume sales, and where price cuts would reduce gross profit per unit by less than it will increase volume sales. To use a concrete example, take a firm which sells a certain product for say $40 per unit and which has variable costs of $32, and which has a volume sale of 100,000 units. At this point, gross profit is $800,000 (($40-$32)*100,000). If it is assumed that a $1 increase in price will lower sales by 12%, and that a $1 cut in prices will increase sales by 12%, then $40 is also the profit-maximizing point as a $41 price would create a gross profit of only $792,000 (($41-$32)*(0.88*100,000)), and as a $39 price would create a gross profit of only $784,000 (($39-$32)*(1.12*100,000)).

Consider then what will happen if the government slaps a 12,5% sales tax on the product, and the product is equally price sensitive as before. Then at a $40 price, gross profits would only be approximately $355,556 ((($40/1.125)-$32)*100,000). Cutting the price to $39 would have an even more disastrous effect on profits, reducing it to only $298,667 ((($39/1.125)-$32)*(1.12*100,000). By contrast, raising the price to $41 would now increase gross profits to approximately $391,111 ((($41/1.125)-$32)*88,000). Because of the reduction in gross profit per unit given a certain price that the tax causes, then the profit maximizing price will be pushed upward even assuming unchanged price sensitivity.

Moreover, there are reasons to assume that price sensitivity will fall as a result of this tax. Contrary to what Rothbard asserts the demand curve for individual firms have in fact changed. The reason is that the demand curve for an individual firm is determined in part by how tough competition the firm faces. If an individual firm raises its prices, while others don't then consumers will switch to those other firms to a much higher extent than if all companies raise their price. If both Toyota and GM raises their price by an equal magnitude, then there is not any point in going over to the other company to avoid price increases. If only Toyota raises its price, it would by contrast make more sense to consider going over to GM. And because the profit maximizing price have as we saw above increased even overlooking any change in price sensitivity, then all companies are in fact likely to raise their price.

So, because the consumption tax means that a price increase would increase margins more than before while at the same time reduce the reduction in volume sales, it should be very clear that the tax can and will raise the price and therefore hit consumers.

However, while Rothbard was wrong in stating that consumption taxes will not raise prices, he was right that production taxes (for example income taxes and payroll taxes) will have the same effect on prices as consumption taxes. At least, as we shall see, with regard to domestic producers that sells to domestic consumers and also assuming the absence of transfer payments. Production taxes will, at least in the long run, have identical effects on prices as they too reduce margins, and therefore both by the direct margin reducing effect and the indirect effect of reducing competitive pressure they will raise prices.

And so, in a completely closed economy, with for example a hypothetical world government or with a completely isolated economy like North Korea (almost) is, then it wouldn't matter whether the government would receive its revenues through taxes labeled as production taxes or taxes labeled as consumption taxes. Both would reduce production and therefore also purchasing power, which given a certain money supply would also raise prices.

However, there two ways in which the structure of taxation could matter. One is if we assume that not all people receive their income through production. If for example some people receive hand-outs from the government and if these hand-outs are unaffected by the change in the structure of taxation then a shift from production taxes to consumption taxes would redistribute from receivers of government hand-outs to producers (or more correctly, it would result in reduced redistribution from producers to the receivers of hand-outs). That is because the receivers of the hand-outs pay consumption taxes too, meaning that given a revenue neutral shift in taxation, this will reduce taxes on producers. However, if receivers of government hand-outs are compensated this effect will not appear.

Another effect from a shift from production taxes to consumption taxes would be to increase net exports and reduce domestic demand. The reason for this is that production taxes hits exports, but not imports. By contrast, consumption taxes hits imports, but not exports. The sharp increase in the German trade- and current account surplus in 2007 after Germany raised its VAT and at the same time reduced payroll taxes illustrates this effect.

Friday, September 05, 2008

Summary Of August U.S. Employment Report

Bearish elements: 84K in payroll losses, despite continued increases in imputed jobs through the fraudulent so-called "Birth/Death Model". Plus downward revisions of previous numbers of 60K. Continued decline in aggregate hours worked, particularly in manufacturing (hinting a significant decline in industrial production). 342K in job losses according to the household survey, causing the unemployment rate to soar from 5.7% to 6.1%. 12 month change in payroll employment now is -413K; 12 month change in household survey employment is -653K.

Bullish elements: None. Or actually, there is one thing that comes close. Namely the 0.4% increase in average hourly earnings, but this likely reflects to a large extent workers demanding compensation for inflation as well as the increase in the minimum wage. Still, with monthly all-items inflation likely decelerating sharply in August due to a decline in energy costs, this means that real average hourly earnings likely rose after several months of negative numbers.