About that economic crisis...

Two outstanding posts from a guy who, IIRC, works as an analyst for a hedge fund:

... Actually, history demonstrates that the Hippocratic Oath is just as effective in economics as it is in medicine. Or to paraphrase Churchill, market economies are the worst possible structure - except for all the others. I am a free market advocate but in the tradition of Adam Smith, who was rightly skeptical of powerful private interests, as I quoted above. The more powerful government becomes, the worse the disasters it is capable of inflicting upon us. Originally, it seemed that this crisis would be worse than the 1970s but not as bad as the 1930s. I'm no longer sure about the later. But suffice it to say that this will be one of the worst economic crises in our history. I would ask you to consider that the single worst crisis occured AFTER government gained a lot of power that had been denied to it throughout nearly all of our history. Crashes and depressions happened before - they are part of the economic cycle which no form of economy apparently can stop. But it took government intervention to turn the standard 2-3 year depression of the late 19th and early 20th century into over a decade of hell.

The key dates in our slide towards government as destructive leviathan are 1913 and 1934. Prior to 1913, the Federal government lacked the practical means to interfere broadly in the economy. The Constitution specifically prohibited the direct taxation of the population by the Federal government and the national government was funded largely through tarriffs. In that year the 16th Amendment was passed under the false pretense that it would only apply to "the rich" - in that case the promised target was the top 10% of income earners. That promise was quickly broken to fund WWI and we never approached that again; one reason to simply grab your wallet whenever a politician proposes to tax "the rich" - that usually means they will get around to you. This is for a very simple reason government taxes the middle class heavily just like Willie Sutton robbed banks - because that's where the money is. Government has increasingly drained a greater and greater proportion of output away from the productive economy - largely at the behest of private interests. Naturally, as government grows more powerful it also grows more corrupt. I believe it was British historian Lord Acton who said:

Power corrupts. Absolute power corrupts absolutely.
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The reason for this should be clear. In order to sustain corruption, a politician must have something to sell. That something is power. In a truly limited government, the politicians have sufficiently little power that it is not worth expending much effort to control the government - therefore the weaker the government, the more likely it is to be able to operate honestly. The more powerful it becomes, the greater the reward for controlling it and the more effort will be expended to do so - by both legal and illegal means. If nothing else, powerful private interests will attempt to control a government that could threaten them in order to neutralize the threat but the takeover is rarely that benign at the beginning and almost never remains so. The other event of 1913 is arguably even more important: the creation of the Federal Reserve. That event took the power to coin money out of the hands of our elected representative and into the hands of a cartel of private banks - which still control the Fed today. Between the radically expanded power to tax and the tool to manipulate the money supply, financial bubble were enabled to grow larger than ever since the government could now sponsor them.

After the conclusion of WWI, nearly the first act of the "independent" (ie. uncontrolled or rogue) Fed was to deliberately inflate a huge credit bubble. The result of this was The Roaring Twenties, followed inevitably by a major crash and unprecedentedly deep and long depression. At this point, the government had gained the means to interfere in the economy but not the legal justification (aside from the Fed). GD 1.0 provided the legal framework for just such intervention. The Supreme Court struck down many actions of FDR's administration as unconstitutional. Roosevelt succeded over time in getting his appointees on the bench even though his attempt to pack the court failed. NLRB v. Jones completely overturned decades of jurisprudence in 1937 and expanded the Commerce Clause so the virtually all limits on Federal power and jurisdiction were eliminated at a stroke of the pen.

It is no coincidence that the economy and the stock market, which had been slowly recovering collapsed again. The case was decided in the spring of 1937. The Dow formed a double top in the low 190s in the first half of that year and then promptly collapsed, losing 50% in less than a year. The prior restraint on government represented by the SCOTUS position had now been removed and the threat of arbitrary action that might damage one's investment position pushed a bunch of private capital out of the economy and into hiding. Why invest if the goverment could wipe you out with no more thought or effort than an elephant squashing a mouse? The similar arbitrary policies of today are a major factor in drying up capital flows since the rules can be changed at any time.

The Law of Unintended Consequences is a real bitch and and ironcast bitch at that. Given current economic structures and Constitutional intepretation, there are few contraints on government power. What HAS changed is investors' perception that the power will be used in an arbitrary and capricious manner. The government can change the rules of the game at any time but all they have succeeded in doing is convincing investors to opt out of a rigged game. This only applies to L-T investors - short-term speculators in the stock market can get in and out easily so creating greater uncertainty also favors speculation over investment.

Sorry this is so long but the history of how destructive government can be is a severely under-taught subject in schools. And our own history is bad enough - don't even get me started on Latin America or Eastern Europe. Few economists have much interest in history beyond their field and almost no historians understand economics. This is another area where our increasing specialization has really bitten us.
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OK, I apparently misread the question, which was clarified while I was writing my response. There are some very clear actions that government can take to get this over with sooner but have not been done because they expose the politically-connected to severe damage. For that reason, I also do not expect them to be taken anytime soon. First, they can ensure real transparency. It is well-known that the valuations many assets are being carried at on the books are a joke. The SEC can enforce the law by prosecuting some high-profile executives as they are now liable for the statements made in their public filings. Second, they can increase transparency by encouraging the creation of centralized secondary markets and requiring all trades to clear through them - similar to the Securities Exchange Act of 1934. The later requirement would give us market pricing information, whereas today almost all the securitized crap is traded privately with little or no price info provided to the public. Incomprehensibly complex instruments with no publicly available price are a standing invitation to fraud and manipulation. I'm not sure how to stop people from investing in things they don't understand, nor am I sure it's a good idea to try but requiring pricing information to publicly disseminated is just common sense. A third aspect of transparency would be to force government agencies (Treasury), quasi-government entities (Fannie and Freddie) and the Fed to publicly reveal what they are doing. Legally and morally, they theoretically are acting on behalf of the taxpayers and voters of this country and with our money (or at least our credit card). It is frankly criminal that they are also acting in complete secrecy. Sunshine should be the key foundation of policy since until we know the truth, how can we formulate a reasonable response to our situation? This of course assumes that we wish to continue being citizens and not subjects of our government.

Second, enunciate clear principles and take action based on those. All the responses so far have been quite ad hoc, which has allowed a lot of stuff to slip through that Congress never would have voted for except for the panic. According to more than one member of Congress, Paulson apparently threatened them with martial law if the TARP wasn't passed. The bailout bill was basically written by Bank of America. I can find the citation if anyone is that interested, thus my Adam Smith quote from earlier. If various branches of government know what the objective is, then it becomes much easier to talk about means and ends in a reasonable fashion. Had the TARP been properly written to serve the stated goal of making mortgage finance more widely available by purchasing MBS, it would not have been possible for Paulson to divert the funding to subsidizing banks' capital. It's clear that Congress got completely duped by the Secretary of Goldman (ie. Treasury). My personal opinion is that government never accomplishes much positive by direct intervention in the economy - by which I mean actions that subsidize certain economic actors at the expense of others. But one need not share that view to advocate a clear enunciation of objectives, the strategy to achieve those objectives and the tactics to implement the strategy. If this is done properly, then economic actors can at least have some idea of where policy is going. That would at least allow people to invest with a timeframe of months rather than days.

Third, I would try to find a way to defuse the CDS time-bomb within the framework of law. There is some precedent for regulating them as insurance since that is the substance of the transaction. That would be a bit radical for me since it would result in most of the swaps simply being voided as fraudulent insurance, written without sufficient reserves. That is a bit drastic IMO. I prefer to sponsor the creation of something like the Options Clearing Corp which monitors and enforces margin requirements by options sellers to ensure that the buyers are adequately protected against a default by the seller. In addition, they also guarantee payment in the case of default. One of the beauties of this structure is that unlike most regulatory bodies, they have matching powers and responsibilities. Under the OCC, there has never been an uncovered default on options they clear (listed options) and very few covered defaults. Like with MBS and CDOs, we need clear market pricing. These derivatives need to be subject to mark to market so that the threat of default and chain-reaction failures will no longer hang over the market. Right now, the SEC and CFTC are trying to accomplish the same thing by ignoring the losses and NOT forcing mark to market - in fact they are doing their best to keep things as opaque as possible. Of course, the market reaction is to treat ALL financial firms with big derivatives exposure as suspect so the lack of transparency caused by the Fed propping up banks secretly pretty much guarantees they will be the sole source of funding for those institutions until this cycle of deception is broken.

My own second point about clear objectives is can be applied here. I think that the most important objective is to figure out how to restore trust (the Latin root of credit is credere, the same root as the word credibility). We've tried it the Keynesian way - bail out most of the big institutions and hope people come back to the game after being burned. That hasn't worked after a year and a half of trying. I thought it was a bad idea from the beginning since history will tell you that once trust is lost it comes back slowly and sometimes not at all. Unless we are willing to stagnate for 20 years like Japan we need to get the crap out in the open and establish who is solvent and credit-worthy and who is not. The current path leaves us hoping the banks fix themselves over time and no other time bombs blow up before then. The next most important principle is that government should take action to enforce the rules, not pick winners and losers. That is my major objection to the TARP - the receipients win, the rest of us lose. Naturally, those getting bailed out under the more transparent programs read like a who's who of contributors to the relevant Congressional committee chairmen. The rationalization is essentially that the government is robbing us for our own good. Winners and losers in the economy are being determined by politics, not economic virtues. Thus we end up with the inefficiencies of socialism without most of the benefits. A key principle is Government should set the ground rules, enforce contracts and avoid picking winners and losers (especially by name as in the TARP, rather than by class of company when regulating). Ensuring sufficient capital for CDS-writers is an example of contract enforcement by mandating that the party to the contract have the ability to deliver the claimed benefit being purchased by the other party.
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About that economic crisis...

Bernard Well-Known Member

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About that economic crisis...

Bernard Well-Known Member

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