Bastiat’s Bastions

Well, this post is not really from a guest blogger, but Gokhan Karahan is, regretfully, no longer teaching and working at Nicholls State University. Dr. Karahan was one of the four founders of Bastiat’s Bastions back in 2005, and we will not let him go. Dr. Karahan sent this to me today to post.-MC

The ill-timed and ill-designed bailout does not seem to show any sign of bringing solutions to the current economic meltdown. Given that there will be a bailout (as soon as Secretary Paulson and his team finally make up their mind on what to bailout and how much!), not attaching strings to how banks may use the bailout money makes one feel that the government’s ultimate objective is to create a “lean” and more competitive banking system. Call it a conspiracy theory but stories available in the Wall Street Journal, New York Times and several blogs, all point to the possibility that smaller/regional banks may be swallowed up by the very banks asking for the bailout money. In other words, it is possible that the government feels that a fragmented banking system may be a bigger threat to the US financial dominance than a short run credit freeze.

About a quarter century or so ago, the manufacturing share of the US GDP was about twenty-five percent. The financial services industry had a twelve percent share. We succeeded in reversing it in less than two generations. With the advances made in the computing and telecommunication technologies, this “new service” economy was to increase our standard of living to unimaginable levels. Smart people came up with financial products that were sold as “high return” investment vehicles. We were led to believe that those conventional thinkers arguing otherwise were all wrong when they questioned where the “beef” was coming from. Moreover, some financiers even bet that the stock market would hit 36,000!!!

Well, it has not and will not for a long time to come! Easy credit and imprudent government policies encouraging “ownership” have led to financial practices, some of which were outright fraud and speculation. We now realize that the “new” economy is still the old one with a bruised face. This time, however, it will take a lot to make the rest of the world believe in our “high yielding” financial products as well as credibility. In other words, a good portion of the US GDP may be in trouble. Unfortunately, the manufacturing sector does not have the muscle it had not long ago to help us out.

Where do we go from here? Given the recurrence and the magnitude of the financial crisis since the 70s, moral hazard does not seem to be a part of the government’s calculus in bailouts. In fact, the bigger the failure, the bigger the bailouts. One way this vicious circle could be prevented and excesses in the economy can be corrected is to live through a severe recession now and not bailout anybody. This would mean a shrinking economy but over the long run it would make us learn not to live beyond our means. If not, there will be a time when this country would not be able to spend its way out with borrowed money from overseas. And, I truly fear that we are not too far from it.

Gökhan Karahan
Associate Professor of Economics
College of Business
Delta State University
662.846.4195
gkarahan@deltastate.edu

The news is definitely not good for the markets. We have an enormous amount of stock-price volatility, and the Dow is well below its recent high. Take this quote from economist Mark Zandi:

Stock prices are falling across the globe. The Dow Jones Industrial Average fell 550 points or just over 7%…and is now 13% below its all-time record high set this past summer. The decline in other broader market indices, including the S&P 500, NASDAQ and Russell 2000 has been similar.

Interestingly, Zandi said this back in 1997 (if you sign up for the trial, you can get the full article here). The ellipsis in the quote replaced the words “on Monday , October 27, 1997.” My point is not that we aren’t currently in some sort of tumultuous period. It seems pretty clear that we are. We just have to keep things in perspective.

I’m not really sure if this will work, but I’m going to follow Andy Kessler’s advice and ignore the markets until February. Kessler gives several valid reasons for the recent wild swings in the market, and I suppose he could be correct. Either way, there’s very little I can do about the market, and I’m young enough to maintain a long-term view.

On the positive side for economists, we may have a new opportunity for researching the (somewhat) controversial contagion theory. The name comes from the psychology of crowds; it basically refers to a sort of herd mentality. In the context of the stock markets, once a few big investors get spooked and/or a few large companies’ stocks go down, the herd mentality kicks in. For this theory to be true, the drop in the market could have started based on very real events. The contagion just makes it worse.

There’s actually a pretty good analogy here for the way the financial crisis started. This article, Anatomy of a Meltdown (it appeared in the October 2007 issue of Mortgage Banker Magazine), details some of the intricacies behind the subprime problems. Bear Sterns, for example, probably got into a great deal of trouble due to a herd mentality. Nonetheless, Bear did get into trouble. Hopefully, all of this will be over by February.

NM

Over the weekend, Senator Jim Inhofe (R-OK), who voted against the bailout, criticized Treasury Secretary Paulson for “not telling the truth” about what Treasury would do with the bailout money. As I posted here, I don’t buy this at all. If the intent was as specific as Inhofe seems to think it was, there was no reason to have “any other financial instrument” in the text of the bill.

Regardless, this is what Inhofe said:

“It is just outrageous that the American people don’t know that Congress doesn’t know how much money he (Treasury Secretary Henry Paulson) has given away to anyone,” the Oklahoma Republican told the Tulsa World. “It could be to his friends. It could be to anybody else. We don’t know. There is no way of knowing.”

I can’t be certain, but it’s almost as if Inhofe was referring to Paulson’s “friends” in an off-hand manner. But I wonder, is there a simple rent-seeking story here? Paulson, after all, was an investment banker, starting at Goldman Sachs in 1974, and ending up its CEO in the late 1990’s. And, we know that the current crisis showed up in the investment banks, not the commercial banks. We even know that some in the commercial banking industry didn’t want any part of the bailout money.

Could the explanation for this bill be as simple as: investment bankers went to Paulson for help with their financial problems?

NM

It looks as though there is at least some resistance to extending “bailout money” to the U.S. automakers, although I’ll only believe it’s over when it’s over. And, of course, universities and big-city mayors are looking for some of the money too. (I have to thank Chad Turner for the university link, I had completely missed it.)

Anyway, according to this AP article, “bailout fatigue” has set in on Capitol Hill. The article says:

The Senate Democrats’ measure would carve out a portion of the Wall Street bailout money to pay for loans to U.S. automakers and their domestic suppliers, but aides in both parties and lobbyists tracking the plan acknowledge they do not currently have the votes to pass it.

But why would automakers need a special loan package, direct from Treasury, when all the banks are now flush with excess credit? After all, the original bailout bill was (supposedly) passed so quickly to avoid the problem of non-financial companies being frozen out of the credit markets. If, even after all of these low-cost “injections” of capital, banks still won’t loan money to the car makers, maybe it’s not a good idea to loan them money?

I know, I know, I’ve heard all the “too big to fail” arguments; if GM and Ford fail, it’s not just those workers who lose their jobs, it’s the suppliers and dealers, etc. The problem is that we can make the same argument about any large industry – the airlines, the banks (I hate using that one), telecom – all of these industries have various suppliers and other businesses connected to them. If we just keep shoveling tax dollars into “troubled” industries, we won’t have industries, we’ll have large government agencies.

We simply have to realize that (1) we’re talking about using tax dollars to bailout private companies; and, (2) when we “bail out” companies in this manner, we’re prolonging the pain of business failure, not preventing it. It’s not like the U.S. car companies have been a glaring example of efficiency. These guys have been limping along for years.

Faced with serious competition from the Japanese in the 70’s, the U.S. automakers were forced to deal with (among other things) grossly underfunded pension liabilities. The “big 3″ became the “big 2,” and they’ve been trying to unwind those bad deals ever since. In fact, one of the reasons 401k plans (and defined contribution plans, in general) became prevalent is that corporate America realized they could not keep going with defined benefit plans.

Of course, if you have high fixed costs and a shrinking market share, you keep your debt down, right? Not these guys.

If you look at the balance sheets from Ford and GM for the last several years, you find debt-to-asset ratios near one (i.e., their total debt is at/above what their total assets are worth). Honda and Toyota, on the other hand, have debt-to-asset ratios near 60 percent.

What are some of the high fixed costs GM and Ford face? According to a Standard & Poor’s market report: “Even labor costs have become largely fixed because of union contracts, which may restrict layoffs or require automakers to pay certain laid-off workers benefits worth up to 95% of their take-home pay.” (I am unable to provide a link to non-subscribers.)

It’s bad enough that our government is seriously considering loaning billions of tax dollars to unproductive, highly levered companies. But it’s even worse when you compare the amount of the proposed taxpayer loan ($25 billion) to the market capitalizations of Ford and GM (approximately $4 billion and $2 billion, respectively).

What’s the market capitalization of Honda? Nearly $40 billion. Toyota? About $100 billion. Which one would be the better investment for your money?

NM

A little extra: For anyone interested, there’s a nice debate at The New Republic and the Corner (National Review); read both pieces to get both sides of the argument.

Lately I’ve been preoccupied with studying the financial crisis. In particular, I’ve been looking for an angle to test whether the credit markets really did freeze prior to the $700 billion bailout. I’m not having great success, but I have come across several unexpected findings.

For instance, I’ve noticed that the U.S. financial crisis is now, supposedly, a leading cause of a global recession. This sort of story, being repeated all over the news, seems a bit peculiar to me. We don’t even have clear evidence that there was a credit freeze in the U.S., much less the entire world, but whatever happened has caused a world-wide recession?

Now, I’m not saying that there is no problem with the derivative securities tied to the sub-prime mortgages; that’s evident. But the notion that these derivative securities, tied to (mostly) a few parts of the U.S. housing market, could cause a global economic recession seems a bit odd. Maybe this scenario is possible, but we need to investigate the cause, not just repeat the mantra.

Yet, the story is getting repeated. In today’s Wall Street Journal, an economist from Wachovia Corp. says “It is clear that the combination of global recession and the global credit crunch is causing world-wide trade to dry up.” An early October article in the Economist is subtitled: At best, the world economy is on the brink of recession. The article starts off:

DEPRIVE a person of oxygen and he will turn blue, collapse and eventually die. Deprive economies of credit and a similar process kicks in. As the financial crisis has broadened and intensified, the global economy has begun to suffocate.

No wonder people dislike economists so much. Let’s assume, for the sake of argument, that we are in a global recession; that trade has slowed, people are buying less, and even investing less. Would the financial crisis be the only explanation? Could there be any other causes?

I had a talk with Morris Coats, and we came up with a brief list of possibilities concerning people’s expectations. In other words, perhaps we are witnessing a global slowdown right now because people expect:

- Higher taxes in the U.S.;

- More economic regulation (Obama promised to let the EPA regulate CO2);

- Less global trade (Obama promised to renegotiate Nafta unilaterally (or not));

- Obama to reinstate the ban on offshore drilling that was recently lifted;

- Democrats to nationalize the U.S. healthcare system;

- Democrats to take over 401(k)’s.

Or, perhaps investors are nervous because the U.S. government has started to nationalize the world’s most formidable financial industry and appears ready to nationalize the auto industry. Or, maybe people in foreign countries are doing worse because the U.S. has stopped importing cheap labor, relegating would-be workers to countries with few jobs.

All of this adds up to heightened uncertainty regarding a significant portion of the world’s commerce. Why would added uncertainty be a problem, you may ask? Here’s the basic story:

People invest based on the return they believe they will get over time (i.e., in the future); when something happens to make that future even murkier, they tend to require a greater return on their investment; If they don’t think they will earn that rate, they won’t invest; If they don’t invest, we end up with fewer goods, services, and jobs.

Financial crisis? Expectations? I suppose I’ll have to pick one, but I’d prefer to wait till the whole thing is over.

NM

Late last night, I came across this article which explains the latest twist in Treasury’s Troubled Asset Recovery Program (TARP). It turns out the Treasury Secretary doesn’t plan to purchase many troubled assets – at least, not the residential mortgages people assumed were the “troubled assets.” I guess this comes as a surprise to many, but the text of the legislation actually defines troubled assets very broadly. Directly from the bill, we learn:

(9) TROUBLED ASSETS.—The term ‘‘troubled assets’’ means—
(A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and
(B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.

So, basically, the bill gave Secretary Paulson the authority to buy anything he and the Fed Chairman decide they need to buy. The fact that the Treasury is buying stocks in companies doesn’t really require a renaming of the plan. Stocks, after all, can certainly be defined as “any other financial instrument.” Under the language of the bill, these actions are completely justified.

The bigger problem is all the “credit” we keep throwing at the “credit crisis.” According to this article, a New York research firm estimates the U.S. government has committed nearly $5 trillion to solving the crisis (so far). That’s a bunch of tax dollars, and represents about 40 percent of GDP. I’m sure 95 percent of us will get a tax cut pretty soon, though.

NM

When the Federal government announced it would “set aside” about half of the $700 billion in taxpayer funds for the financial industry bailout, some people may have held out hope we wouldn’t need to “spend” the other half. Anyone who pays attention to how things work in Washington, though, could never have been so naive.

It was easy to predict, for instance, that companies from other industries would soon have their hands out. Now, it seems that the U.S. automobile industry will be one of the first non-financial companies to line up for some tax dollars. Credit card companies, such as American Express, may also begin getting in on the act, though the line between non-financial and financial is a bit blurry for these guys.

I’ll even go out on a limb: the homebuilding industry won’t be too far behind. After all, an over-supply of housing is at the root of this crisis.

What’s really interesting is the legislative horse trading going on. Apparently, bailing out the automobile industry is going too far for some Republicans and Bush (though I am surprised to learn there is such a limit). The auto industry bailout is acceptable to the Democrats, though. So, something has to give, right? How about throwing a Columbian free trade agreement into the mix?

The Republicans want a deal, the Democrats don’t. Even though these two events – an auto industry bailout and a free trade agreement with Colombia – have very little to do with each other, it appears the Dems may be willing to cave on the free trade agreement as long as Bush caves on the auto industry bailout.

It’s interesting to observe the horse trading, but it’s impossible to ignore the reality: we’re on the verge of nationalizing the financial industry and the auto industry. For example:

To forestall a voter backlash, Obama aides and Ms. Pelosi separately made clear they intend to impose significant conditions on federal aid. Auto makers would have to offer the government equity stakes or warrants, one Obama adviser said, and would have to accept the same rules on executive compensation that financial-service companies have swallowed with the Wall Street rescue.

It is becoming clearer almost every day that the “financial industry bailout” is badly misnamed.

NM

I will be more interested in the transition to the Obama Presidency than any presidential transition I’ve witnessed. Why? The $700 billion financial industry “bailout.”

One thing that seems clear is that the new Treasury secretary is going to have to deal with a partially implemented (partially developed?) policy. I guess the best we can hope for is that someone comes in with enough experience to deal with the recently invented (complex) financial securities. I have no expectation that the new regime will try to undo what Paulson’s Treasury has started. For these reasons, I don’t think Paul Volcker is the best choice – he has been too far removed from this stuff for too long.

According to this article, though, Volcker is under consideration for the Treasury Secretary position. Volcker was the Federal Reserve Chairman from 1979 to 1987, and he recently headed up the investigation of the United Nations’ Iraqi Oil for Food program. Others under serious consideration include Larry Summers (Treasury Secretary under Bill Clinton and former president of Harvard) and Timothy Geithner (currently the president of the Federal Reserve Bank of New York).

The article I linked to above also names several unlikely candidates, such as Warren Buffet (investor), Janet Yellen (San Francisco Fed president), Jon Corzine (former investment banker/governor of New Jersey) and Alan Blinderm (former deputy Fed chairman). Not that anyone is going to ask me, but it seems like Geithner would be the best choice because he’s most involved in what is currently happening.

The article quotes an economist from Maryland named Peter Morici: “If we can’t get Volcker, I’d prefer they turn to somebody who’s unknown, like a Midwestern banker who has had experience with Federal Reserve affairs, someone who does old-fashioned banking, gives loans and gets repaid,” said Morici.

I guess this sort of makes sense, but old-fashioned banking is the last thing the new Treasury Secretary will be involved in for quite some time. I really think Volcker would be more of a political (safe) pick than a practical pick. But, Obama doesn’t have my email address, so I’ll just wait to see what happens.

NM

In 1944, an Austrian economist, Frederick Hayek wrote the book, The Road to Serfdom. His book was later shortened and released by Reader’s Digest, and even came out in comic book format and distributed by General Motors. Hayek dedicated his book to socialists of all parties. The central idea of the book is that socialism or collectivism has the same result, whether it is the sort we see in the old Soviet Union and China, and now in North Korea and Cuba, or Fascism of the sort we have seen in Hitler’s Nazi Germany, Il Duce’s Fascist Italy. Hayek’s thesis was that collectivism leads down the same road to tyrannical dictatorships by tyrannical dictators, and he has a very intriguing chapter on “why the worst get on top” in socialism. That very same road, of socialism or collectivism, whether the communist or fascist variety, where people surrender their freedom for the good of the country or the good of the universe, and fall under the spell of the idea that somehow something can be good for the country without being good for any particular person in that country.

Hayek put Fascism and the Naziism in the same category of the Marxism of the Russians, incensing political leaders and academicians in the U.S. as well as with our allies.

Why? The Russians were our allies and the Nazis our enemies. Also, many academicians, even academic economists, were taken in by the ideas of the Marxists. Their societies could not possibly be two sides of the same coin. Or could they?

Well, as my title suggests, we are not only on a road to serfdom, but we are speeding down it as fast as we can go, with little to slow us down.

It is not just that we are about to elect a radical left progressive to the White House. It is also not that both houses of our legislature are also going to have heavy progressive majorities.

No, we are not about to get on the autobahn to serfdom, we have been traveling on it awhile. Certainly policies passed under FDR’s New Deal got us on that road. And that was about the time that the real Autobahn in Germany was being built. It was started before Hitler came to power, but much progress was made on the roads under Herr Hitler, and much of it, fittingly, with slave labor.

The lanes widened with LBJ’s “War on Poverty,” a war that we should all agree did nothing to alleviate poverty, but perhaps only entrenched it and made it more durable, more systemic.

The highway was then super-sized, going from four to eight lanes, and all headed in the same direction, with banking of the curves added to keep us from crashing, but only encouraging us to go faster still. This was accomplished this past month with Bush’s gigantic bailouts with equity positions taken in banks worldwide.

Here are a few signposts along this “Autobahn to Serfdom:”

1. Abolition of property in land and application of all rents of land to public purposes.
2. A heavy progressive or graduated income tax.
3. Abolition of all rights of inheritance.
4. Confiscation of the property of all emigrants and rebels.
5. Centralization of credit in the banks of the state, by means of a national bank with state capital and an exclusive monopoly.
6. Centralization of the means of communication and transport in the hands of the state.

Notice that # 5 was pretty much taken care of in the U.S. and abroad with the giant bailouts. Both #2 and #3 seem to be well on their way with the next president and the next congress. You should note that these signposts are taken from Marx’s own Communist Manifesto.

Zoom, zoom, zoom!

-MC

Many economists have been going back and forth, arguing whether there really was a severe financial crisis that required a massive Federal bailout. I put my initial two cents worth in here.

Now, a new report from the Minnesota Federal Reserve has re-sparked a debate between Alex Tabarrok and Mark Thoma and Tyler Cowen (Joe Weisenthal and Felix Salmon are involved in this too, but, as far as I can tell, they are economic journalists; not that there’s anything wrong with that).

Alex essentially argues (as I have): the question of whether we have a credit crisis revolves around the amount of lending taking place – what quantity of credit is available and who is able to get it. If the majority of both financial and nonfinancial firms cannot raise capital, we have a major crisis (we will quickly lose consumer goods).

Thoma argues (now I’m quoting):

While rates on the highest quality non-financial commercial paper have behaved fairly well in recent weeks, rates for lower quality stuff have soared. The spread between the two, actually, is one of Calculated Risk’s credit market indicators. …we might suspect that the increase in bank lending was itself a product of tight credit conditions elsewhere—that borrowers were falling back onto lines of credit they normally wouldn’t use thanks to the severity of lending conditions.

My translation of Thoma is as follows: The spread between the rates on good and bad commercial paper is out of line, which is an indication of higher risk in the credit markets. Yes, bank lending has gone up, but that’ simply because firms can no longer access non-bank sources of finances (such as commercial paper), so they are using lines of credit they had not previously relied upon.

Although I would like to see more data, I think the Fed paper has some interesting information on the quantity of lending. Here are some highlights (all direct quotes):

– …while commercial paper issued by financial institutions has declined, commercial paper issued by nonfinancial institutions is essentially unchanged during the financial crisis.

- Figures 5A and 5B display data for interbank loans made by all U.S. commercial banks. These Figures show that, at least in the aggregate, interbank lending is healthy.

- bank credit has not declined during the financial crisis.

- Figures 2A and 2B display analogous data for loans and leases made by U.S. commercial banks. Again, we see no evidence of any decline during the financial crisis.

- …no evidence that the financial crisis has affected consumer lending.

- Where are banks obtaining the funds to increase bank credit? The large recent rise in deposits indicates that a substantial amount of these funds is being raised from deposits.

- One story we have heard is the following. The rise in loans is in large part due to nonfinancial firms drawing on their loan commitments and lines of credit and that loans to nonfinancial firms without such commitments have declined. Furthermore, this decline in loans to nonfinancial firms without commitments signals a dramatic future decline in bank lending. Data that support this story, especially data that support the signaling view, would be extremely useful. We have seen no data from the current crisis that support this story, especially the signaling view component of it.

Wow. Unless these Fed employees are trying to sabotage Bernanke and Paulson’s efforts, perhaps someone should listen? At the very least, can we please stop throwing tax dollars at a problem before we can confirm its existence? I’m betting heavily on the negative.

NM