David Rosenberg, he of Gluskin Sheff, checks in, a bitter wind from the North:
Never in recorded history has growth coming out of a string of declines been as weak as what we just witnessed. Considering all the government efforts to usher in a V-shaped recovery, what we saw unfold in the real economy in Q3 – admittedly quite divorced from the action in financial markets – was, in a word, sad.
On the WSJ blog, Raghuram Rajan makes sense, which seems increasingly unusual in this difficult period:
The question is how you get the benefits without the excess volatility that’s now in the system. I think that’s what we will tackle over the years. We are going to question whether we need a better safety net, we are going to question whether finance should be as risky as it has been.
We may well want to choose more safety and less risk, but we should go into it with open eyes. We can’t have the dynamism and at the same time expect a lot more security.
David Rosenberg of Gluskin Sheff provides an interesting picture of life across the border, and just how much different the economic mess looks from Toronto:
If there is one thing that Canadians are never happy with (in addition to their local hockey team) it is the Canadian dollar. When it was flirting near that record low of 62 cents nearly a decade ago, everyone lamented the future of the Loonie and closer ties to the U.S. were being recommended from various corners of Bay Street. It was too expensive to buy anything that was imported, it was too costly to make that annual trip to Florida, and tickets to a Broadway play were prohibitive. We felt poorer. We must have been doing something wrong.
Fast-forward to today. Canadians are now fretting about a strong currency. After all, it is going to crush our manufacturing sector, kill our export base and undermines our domestic competitiveness. Even the Bank of Canada commented on how the strength in the CAD is dampening our growth prospects, cutting its medium-term GDP growth forecast.
Remember, when currencies move there are going to be winners and losers. In its latest policy statement, the Bank of Canada said that “persistent strength in the Canadian dollar” is going to “slow growth and subdue inflation pressures.” So, in return for softer economic growth coming from a more challenging export outlook, what we get back is lower “inflation pressures.” The winner here is anyone who is seeking to borrow money to buy something because the stronger Loonie will prevent the BoC from taking the interest-rate punchbowl away any time soon.
For Canadian businesses, the silver lining is that it will be easier to attract talent today compared to a decade ago when the Loonie was sinking. Call it the reverse brain drain. Whatever it is, it is a good thing from a productivity standpoint, which is the cornerstone to our standard of living. That is why I think we should embrace this new era of Canadian dollar strength as opposed to resisting it.
For those who remember his dad, Mike, on Boston local news (circa 1970s), Matt Taibbi’s rollicking style is a delight, full of genetic echoes. His Rolling Stone article on Bear Sterns and Lehman — and the naked short-selling behind their demise — is a good read:
Six months after Bear was eaten by predators, virtually the same scenario repeated itself in the case of Lehman Brothers — another top-five investment bank that in September 2008 was vaporized in an obvious case of market manipulation. From there, the financial crisis was on, and the global economy went into full-blown crater mode.
FT’s Willem Buiter makes good points about how we’ll need to devalue the dollar in order to grow the market. He skewers Casey Mulligan on the way to his point:
For those who would like to dip their mental toes into the ‘Long Vacation’ tradition, a good place to start is a paper written by Casey Mulligan of the University of Chicago (Casey Mulligan, “What Caused the Recession of 2008? Hints from Labor Productivity”, NBER Working Paper No. 14729, February2009). It pays to have a sense of humour when attempting to wade through this paper, as can be gleaned from the Abstract which starts with the following assertion: “A labor market tautology says that any change in labor usage can be decomposed into a movement along a marginal productivity schedule and a shift of the schedule.”
Nothing like big economic yuks to lighten the mood of bad economic times.
Sorry for bringing more cold water, but David Rosenberg provides a valuable service by preaching caution:
The Chicago Fed’s national activity index, which is arguably the most reliable economic barometer around given its breadth of subcomponents, posted a -0.90 print in August and the key three-month average came in at -1.09, which, to be sure, is much better than the -1.61 figure in July, the -2.15 reading in June and the horrendous -3.63 posting at the turn of the year. However, the Chicago Fed warns that anything at -0.70 or more negative than that still signals an economy that is in contraction mode, though it is certainly not uncommon at all to be seeing a number like we saw in August occur after GDP has had its inflection point.
Our contention is that the equity market priced out the recession six-months ago and is now basically discounting three years worth of economic and profit growth. Indeed, on some valuation metrics, the S&P 500 is now trading at peak, not merely mid-cycle price-book, price-earnings and price-dividend ratios. Remember, the reason why the tortoise won the race in the end was because the hare tired himself out.
Via David Rosenberg at Gluskin Sheff in Toronto. He’s not convinced, he just reports:
A freshly minted report from the Asian Development Bank forecasting faster-than-expected growth for the region — excluding Japan, growth is seen at 3.9% this year versus the March projection of 3.4%. This is having a fairly significant market impact this morning with credit risk declining, the U.S. dollar under renewed downward pressure (the Euro just crossed 1.48 for the first time in a year), commodities rallying right across the board, resource-based currencies, such as the Loonie and Kiwi (the latter also benefiting from a much lower current account deficit for the year ending June) and global equities, in most jurisdictions, in the green. U.S. equity futures are flying as the buy-the-dips psychology has become tremendously well entrenched — see Optimistic View on Rally on page 25 of the FT. A Barclays survey shows that bears are now capitulating en masse and now fewer than 1 in 5 believe this is a bear market rally ripe for correction.
The Chicago School’s most thoughtful response to Krugman so far comes from an unlikely source: libertarian lawyer Richard Epstein. I’m not in the business of printing long pieces, but lacking a subscription to The National Review, I’m linkless in Gaza. I offer it here (the piece will appear in the Oct. 5 issues) in its entireity.
Krugman’s Scapegoats
Rebutting the Times columnist’s attempt to pin the market meltdown on the Chicago School
By Richarard A. Epstein
Hard times demand scapegoats. And demand in the scapegoat market is high right now, with economic malaise lingering after last year’s financial meltdown and bank bailouts. One much-abused scapegoat is the free-market economics of the Chicago School (after the University of Chicago, where many of the school’s proponents made their academic home). The basher-in-chief is Princeton economist and New York Times columnist Paul Krugman, who demanded, “How did economists get it so wrong?” in a recent essay. Krugman’s answer heaped scorn on his Chicago foes, who, he argues, were so blinded by the beauty of their mathematical models that they drove the nation into a deep recession. The only salvation, he says, is the warmed-over Keynesian pump-priming he has long advocated.
Krugman is wrong about both the cause of and the cure for our current mess. A true academic, he operates under the delectable delusion that a credentialed economist (never mind a Chicago School economist!) has a sole hand on the economic-policy tiller. Though the former Princeton professor Ben Bernanke heads up the Fed, huge swaths of economic policy have been shaped by political operatives such as Karl Rove and Rahm Emanuel. At the same time, Barney Frank and Christopher Dodd — not exactly Milton Friedman acolytes — head key congressional banking and finance committees. Whatever witch’s brew they concoct, they don’t use free-market ingredients.
So it is worth asking two questions. How did we get here? How do we get out?
In Krugman’s macroeconomics-dominated world, the first place to look for answers is monetary policy. His Times tirade gloats that former Fed chairman Alan Greenspan — backed by Obama’s economist-in-chief, Larry Summers — mistakenly rejected calls to rein in subprime lending and to stanch the Fed’s flow of cheap money. A grand blooper, to be sure, but not one that originates in Chicago-style economics: No Chicago economist supports either policy. Cheap money sets interest rates at or below the level of inflation — which is to say, it’s a policy of giving away free cash, but only to those who bid up housing prices.
On top of all that, the lax lending-and-guarantee policies of Fannie Mae and Freddie Mac induced private banks to do exactly what we should expect of rational actors: lend on the strength of Fannie and Freddie’s implicit government guarantee rather than on the dubious value of the properties in question. The Hoover Institution’s John Taylor has offered powerful evidence in his pithy book Going Off Track that these wrongheaded policies led to a huge artificial run-up in housing stock — a development that the Chicago School’s sound monetarist polices would have significantly dampened. So Chicago’s response to Krugman on the first count of the indictment is a proud “Not guilty.”
Krugman also misfires by implicitly treating monetary policy as the only game in town. His article never mentions the roles of securitization and mark-to-market accounting in forcing Bear Stearns and Lehman Brothers over the edge. Securitization turns out to be a mixed blessing. By cutting mortgages into slices that could be recombined in finely calibrated tranches, the wizards of Wall Street diversified geographical risk while allowing financial institutions to buy investments tailored to their portfolios. Credit-default swaps offered the illusion of insurance. Credit-rating agencies offered the comfort of a Triple-A certification.
Unfortunately, it is a law of practically Newtonian inevitability that every advance in financial technology brings with it offsetting disadvantages. Securitization was intended to help manage banks’ risks, but it took away an important incentive: Banks originating mortgage-backed securities relaxed their underwriting standards because they knew they could count on guaranteed sales. That deterioration in lending quality really bit when bad times hit — but only after those securities had insinuated themselves throughout the global economy. The quantitative analysts (the math geeks who created the new securities) had had to make certain assumptions about mortgage-default rates and what changes in housing prices would do to them. Unfortunately, they had underestimated the volatility that regulation adds to the mix and had failed to account for the legal protections for mortgage borrowers. They had not done well in assessing the negative impact that systemic delays in mortgage foreclosures would have on underlying real-estate values. They had not accurately priced the statutory “rights of redemption” that in many states allowed homeowners to reclaim properties cheaply after foreclosure. And they had badly underestimated how complicated it would be to renegotiate existing loans on a mass basis, especially when many underwater homeowners were opting simply to stop making mortgage payments while barricading themselves in their homes with a big assist from consumer groups.
Other government errors compounded private-sector failures. First, SEC regulations kept new entrants out of the securities-rating game. Weak information led to unwarranted reductions in the credit ratings for some mortgage-backed securities, which in turn triggered demands for massive infusions of capital to bolster the banks and other institutions that held those downgraded assets. That, in turn, required the afflicted banks to call in loans, sell assets, and seek new investors to beef up their capital reserves. At this point, another SEC favorite — mark-to-market accounting — accelerated the downward fall. When one bank was forced to sell assets, mark-to-market required all the banks to revalue similar assets at the new, substantially lower prices, further depleting their capital cushions and triggering further destructive rounds of forced selloffs and revaluations.
When the financial health of competing banks is uncorrelated, one bank can fetch a decent price by selling off its assets in a market with lots of buyers. But when banks’ losses are correlated — and mark-to-market and other regulations helped ensure that they were — there simply is no market. Rational buyers stay on the sidelines, knowing that the coming sale of assets by one bank will send prices tumbling and force other banks holding those same assets to mark down their prices, which means that they, too, will have to sell. What we have then is a downward cascade in asset prices that stops only after they have fallen well below the value of the underlying securities, usually understood as the discounted present market value of their future cash flows. Those cascades exposed the danger of the Bush administration’s decision to ease reserve requirements for fancy interbank transactions. Credit-default swaps, a form of default insurance that, for regulatory reasons, had migrated to AIG, collapsed under the weight of that avalanche. And the whole system went down.
It’s easy to quibble about the relative proportions of private and public mistakes. But however the blame falls, Krugman is wrong to lay it at the feet of Chicago School economics, which holds that if the government offers a guarantee against bank failures it must also exercise bank oversight.
But Krugman needs to knock the Chicago School out of the intellectual marketplace to make room for his preferred policies, especially the use of Keynesian stimulus spending to jumpstart the economy. And if he is lucky, his denunciation of the alleged failures of the Chicago School might distract the public from the fact that his beloved Keynesian stimulus has been a bust. Keynes’s case for pump-priming may have made sense with Depression-level income taxes, which Hoover’s 1932 Revenue Act raised to a top marginal rate of 63 percent. High taxes force the substitution of inefficient public investment for sensible private investment, and FDR compounded the mistake by blessing, between 1933 and 1935, literally hundreds of industrial and agricultural cartels that killed market innovation and price competition. A better strategy today would be to get rid of the pork, lower marginal tax rates, and eliminate agricultural subsidies and protectionism. But the Obama administration is defiantly marching in the opposite direction: Tax rates will rise in 2011, if not sooner; tariff walls will remain high; unions flex their muscles; and free trade remains under siege as Chinese tires face ill-advised anti-dumping duties.
What makes this already toxic environment worse is the heightened risk of regulatory expropriation. The contretemps over the AIG bonuses was not just about $165 million in compensation. It was about the protection of contracts against government interference; if AIG employees can be browbeaten, so can everybody else. The scandalous terms of the Chrysler and GM bankruptcies sent out an equally strong signal that creditors’ established priority arrangements — a Chicago School imperative — could be upset by political interference. Obama’s approach, so far, relies on sham asset sales that allow politically connected unions to receive preferential treatment over other creditors as a payback for their support. It is not liquidity, as Krugman supposes, that keeps cash at home. It is a quiet, desperate want of confidence that business can be done on honest terms.
Matters get worse on the employment side of the picture. The vaunted Obama stimulus package was supposed to keep unemployment rates below 8 percent. Instead they are creeping toward 10 percent, with an attendant fall in real wages. The generic explanation is that higher taxes and heavier regulation drive down the demand for labor when product markets are roiled by political uncertainty.
Beyond macroeconomics, microeconomic blunders add fuel to the fire. Krugman might have noted that the recent increase in the minimum wage is particularly deadly in the face of falling real wages, especially to workers with few advanced skills. More important, he could have acknowledged that the hare-brained scheme of labor regulation embodied in the misnamed Employee Free Choice Act (EFCA) is a first-class job killer: Who wants to open a business in which a union created by dubious card-check procedures can force the acceptance of a two-year contract dictated by Obama’s Department of Labor? The EFCA is dormant for the moment, but so long as organized labor has clout at the White House, dormant ain’t dead. As if that weren’t bad enough, the prospect of a crudely nationalized health-care system, coupled with the nightmare of a Byzantine cap-and-trade program, will put lots of sensible investments on hold and lots of jobs on ice. Investors want to know what kind of economy they are investing in.
Krugman’s response is to ignore these particulars and issue a call to embrace modern behavioral economics, with its laboratory experiments and endless surveys. But none of that fancy theoretical stuff can begin to justify any of the big-ticket regulatory initiatives Obama wants to foist on the country. Nor can it fix, in some mysterious way, the ills of financial markets. I agree that the Chicago view of efficient markets (the hypothesis that market prices instantly reflect all known information) can’t explain the meltdown, but it helps explain the other 99 percent of the financial landscape. Behavioral economics explains neither. What is needed is some systematic explanation of the linkage between the volatile 1 percent and the predictable 99 percent: When do market trades deviate from fundamental values, and why? My guess is that the answer will likely be found in a better understanding of the interactions between experienced and novice traders.
Krugman offers no fresh ideas of his own; he only vilifies Chicago. His macroeconomic fixation blinds him to the core of good sense in the Chicago School, which argues: Let’s reduce government interference in competitive markets; let’s support strong property and contract rights; let’s invest in sensible public infrastructure, such as law enforcement; let’s adopt a decent anti-monopoly policy; and, yes, let’s promote a stable currency and adopt low, flat taxes.
We haven’t done any of that. So, in a sense, Krugman was right to ask, “How did economists get it so wrong?” He should start by asking himself.
Mr. Epstein is a professor of law at the University of Chicago, a senior fellow at the Hoover Institution, and a visiting professor at New York University’s law school.
Zingales and Cochrane firing on all cylinders in today’s WSJ. Not exactly the message casual observers (Mr. Krugman included) would expect:
The big banks know the government will bail them out, and they are already bigger, more global, more integrated and “systemic” than ever. They are making huge trading profits—profits that must someday turn to losses. If brokerage and banking are “systemically important,” they cannot be married to proprietary trading. Yet the financial-reform plans do not even talk about breaking up this marriage—they hope simply to regulate the behemoths instead.
The blame-it-on-Lehman story leads to a dangerous complacency. If we can persuade ourselves that the fault was just one policy mistake, forced on the feds by silly legal restrictions and not enough bailout power, everything can go back to the cozy way it was before.
This is a convenient story for large banks that dominate the lobbying and communication effort. And it absolves the Fed and Treasury of facing up to their long string of policy mistakes.
We don’t pretend that we could have done any better. That’s the point: A system with so much power vested in so few people, with so few rules, in which crises are managed with 2 a.m. conference calls, cannot possibly do better no matter how good the people at the top. Repeating the Lehman story lets us all ignore the fact that this system cannot go on.
David Rosenberg continues to run counter to the current wisdom, reign in expectations:
Those who believe that the banking sector crunch is fully behind us should read the WSJ article today on the topic — New Phase of Crisis, Securities Sink Banks. And those who believed that the road to recovery rested with the auto sector should also have a read of Rebates for ‘Clunkers’ to End Monday on page A3 of the WSJ. The program, which was creating all sorts of distortions, including higher used car prices, is a regressive tax for the low-income consumer.
As for those who believe that the housing market is stabilizing should have a read of the article Improving Home Sales Belie Market Reality on the front page of the Money & Investing section of the WSJ. The reality is that sales and pricing are currently being distorted by the wave of all-cash deals by investors who are looking to rent out foreclosed units and this wave of competing supply for the apartment market is dragging down rents — a critical driver of the inflation rate — for the first time in 17 years.
According to a survey conducted by the National Association of Realtors, 36% of all sales now involve “non-distressed” properties. And, the article titled Souring Prime Loans Compound Mortgage Woes in today’s WSJ is also worth a read for anyone who believes we are going to see anything closely resembling a normal recovery, and assumes, of course, that the usually wrong consensus is correct that this downturn is completely over and done with. Fully 12.2% of mortgages in 2Q were either in the foreclosure process or in arrears, up from 12.1% in 1Q and 9.0% a year ago.
