FEBRUARY 3, 2009

A Better Approach?

What would I be proposing if I were Obama? In part, the same thing I would be proposing if there were no crisis; lower taxes for businesses and lower marginal tax rates for everyone (including when Social Security taxes are all you pay). Is there anything specific to the crisis itself that I would propose? Yes. A moratorium on capital gains and income taxes for any investment made in the next two years in perpetuity. If one started a business, or bought any bond or stock this year and next, one would never have to pay capital gains or any taxes on those investments---or maybe no taxes on the next 10 years of gains, but you get the point. Remember, businesses create jobs. I would rather motivate entrepreneurs, other businesses and investors than have some guy in the California Health and Services Department (who receives "grants" in this bill) determine what is best for the economy. This is not obvious?

Why are investors not investing enough today to create growth? We do not ultimately know "why".There is just a straight forward concern that we are in a downward economic spiral and that to try to buck the trend is just to get in the way of a runaway train or to try and "catch a falling knife". No capital gains or income taxes on interest would help for sure, but does this address the problem directly? No, only indirectly. Is it enough? Probably not, but it would be more to the point than the current proposals. Arguably even this approach may be beside the point for the crisis itself. For it to have a positive effect, it may be conditional on the mortgage/housing crisis ending first.

One thing we know for sure is that the crisis was caused by the collapse in housing. What is also known for sure is that there is no liquidity in mortgages. Another thing we know for sure is that fear of a further drop in housing prices has frozen the markets. Any significant increase in foreclosures from here will cause more bank losses. Therefore, one would think it reasonable to at least start there to address the problem. Ironically, this is where Paulson began, then abandoned it within 2 weeks. Treasury is again looking at this problem. FDIC May Run Bad Bank To Buy Toxic Assets. I have not yet formulated any opinion on their proposal, but will do so soon. But clearly there is no obvious solution. I am of he opinion that, in the spirit of Paul Volcker, it is better to take painful medicine sooner rather than later, something politicians despise because they always get blamed. My attitude toward that is too bad, and they should not be so cowardly---but who am I kidding?

Arnold Kling discusses the conundrum faced by officials Economics Liberty--Kling. He references This NYT story . The point is, the price of a mortgage security is the present value of future cash flows discounted based on one's level of certainty they will be received. The latter is a de facto subjective input and is determined by the market at any point in time. Right now, that number is really high (the required rate of return to buy is high, therefore the price is low). So high, in fact, that massive new losses would have to be recognized if we took these prices literally. Is this a good idea? In other words, should the Government sponsor or encourage, or even require in some way (unspecified by me for now) "true" price discovery in mortgage securities? My answer leans toward yes.

But this would only make sense if they were tradeable at those prices. Just "marking" them there does no good, because the problem we have is not accounting but liquidity. It is not inconceivable to me that there is almost no price low enough to clear the market. There is zero incentive today to buy any aged mortgage or mortgage backed security issued near the housing peak. Yet, it is an absolute necessity to somehow get the private sector involved in these securities. One reason the private market is not involved is they have been waiting for the Government to come out with their proposals. Paulson, remarkably, never did have one. He is the worst Treasury Secretary in history. How does one force price discovery? What if Geithner proposed no price guarantees whatsoever and said no way, no how, are we guaranteeing any more losses? Initially prices would fall. But they have already "fallen" as there is no market, or a very weak market.  

I believe the bottom line is we will likely need to see prices initially drop, and drop hard to get liquidity. That will bring in buyers, if anything will bring in buyers. This could cause more banks to potentially fail. Then what? Would all banks fail?  If initial prices got low enough, investors would come in---then prices would gradually find a level closer to a realistic (hopefully) level and could gradually rise for a period of time. Could the Government put a temporary moratorium on capital requirements? Banks that failed could be sold off or combined with other banks and be recapitalized (by who?).

This is where my thought process begins (not ends). The direction the Government has been pursuing is to prop up prices. Again, I have not looked closely at the Geithner proposal. But propping up prices is only good if it can get the liquidity ball rolling. There would need to be a perception that the "propped" price is in fact a good estimate of the real value, even if all market participants are afraid to take that risk initially without that "floor". If this is not the case, then propping the price is harmful and only will make it worse later.

So back to what I would do. The focus needs to be on growth and "fixing" the mortgage problem. The former proposals are based on obvious Microeconomics principles. The latter is a far more intractable problem, to which there is an enormous "confidence" component to it. Not a need for blind confidence, but a need for the market to have confidence that reasonable tradeable values can be found while simultaneously keeping enough banks, and therefore the banking system, solvent. I hope to have some better thoughts on this in the near future.

(posted at 2:30 pm by Mike Rulle)

Economist Meghan McArdle this morning makes the same point I made in my "Drug and placebo" analogy below The burden of proof  :

"Let's recall that the evidence for this kind of stimulus working in this kind of situation basically rests on a single instance (World War II)--the other two times it was tried (Japan in the 1990s and America in the 1930s) the economy basically rolled along in the doldrums for the rest of the decade. Proponents say that that's because there wasn't enough stimulus, which is possibly true, but not really satisfying, because first, how do we know this package is enough, and second, that leaves us with a belief in the virtues of stimulus that is essentially non-falsifiable.  We might as well move macroeconomic policy to the Office of Faith-Based Initiatives."

This is the starting point on any scientific endeavor, and every economist knows this---it is not some arcane argumentative theory. Sure, some economists believe the stimulus package will work. Believing, of course, is not the same thing as having evidence, (as every scientist "opposed" to Global Warming theory also knows). Others are also ideologically for and against it. But the bottom line is there is no evidence it will work, so why are we doing it?

(posted at 12;22 pm by Mike Rulle)

  

Since I think the most likely outcome of this stimulus package is worse than doing nothing at all (see below) what should our Government do? Well, first, it should stop lying (if politeness is preferred, they should stop "conflating"). At the very least, do what Alice Rivlin suggests (again, see below): disentangle the social engineering part of the bill from the stimulus part of the bill. It is an exercise in political corruption to pass a bill with "emergency haste" to mask social spending provisions which politicians know would be controversial if the public knew about them. Voters are starting to pick this up as Obama's approval rating, while high, has dropped (predictably, perhaps, given how high it was) materially since inauguration Rasmussen Reports. Polls on the stimulus plan do not show strong support either Only 42% Support Stimulus Plan. The people voted pretty strongly in favor of Democrats in November. So why does the Congress and the President feel the need to mask social engineering policies as "stimulus"? 

(posted at 8:47 am by Mike Rulle)

Russell Roberts writes in the the Boston Globe today,

"there is little or no consensus for what we should do right now to get the economy going and prevent it from getting worse. I wish it were otherwise. People expect us to know the answers. And plenty of economists claim to have the answers. Yet some of the finest economists in the country, including Nobel laureates, are on opposite sides of the current debate. And each side can cherry-pick data or historical anecdotes in support of its position".

What is one to do? I don't know. But let's use an example from the Drug Industry to provide an analogy to what is happening today. Pretend a Nobel Scientist at Pfizer has a theory about a certain chemical's cure rate for some disease. Controlled experiments are performed to test the theory. The experiment fails as it does not outperform a placebo. The scientist rejects the hypothesis and goes back to the drawing board. Notice the phrase "outperforms a placebo". Many scientific experiments involving drugs will show a sugar pill having a 30% "cure" rate. These are just random occurrences and have no medical meaning at all. If the real chemical cannot outperform the placebo, then it is not put into production. Yet 30% may appear to be "cured" by it. What if there were a sudden outbreak of the disease this chemical was supposed to cure? Would it make sense to distribute as much of this drug around as fast as possible, just because some scientist, however brilliant, happened to have a theory about it?  I don't think so. But many people could point to the "30%" success rate and say it is "better than nothing". But it is not better than nothing, it is worse. It is a waste of money and resources that could be devoted to finding the real cure.

Yet, John Maynard Keynes is the equivalent of that scientist. Controlled scientific experiments are not possible at the Macroeconomic level. So what economists do is study policies that have been enacted by past Governments. What Russell Roberts points out is that stimulus policies do not outperform doing nothing. The "cherry picking" he refers to is the equivalent of the "placebo effect". In this context, placebo effect does not mean creating confidence through illusion (which, if possible, but it is not, I would support); it means it does not do what it is supposed to do. Doing it takes resources away from finding a "real cure" and wastes money.

(posted at 8: 32 am by Mike Rulle)

There will continue to be debate on the spending bill before Congress, and then it will be passed. It is admitted, even by its supporters, to be "half stimulus" and "half investment" (using Alice Rivlin's terminology). Rivlin, a liberal Democrat, believes the stimulus portion should be passed quickly, but we should take more time on the investment side. Personally, I am against the term "investment" for Government spending. It is Orwellian. Investment implies there is a measurable return one seeks. There has never been a Government program which has ever been measured for success relative to an a priori objective. But my point is that even a supporter of the spending bill, Rivlin, wants more careful consideration.

(posted at 8:06 am by Mike Rulle)

Why do we all waste time trying to pretend to figure out whether Tom Daschle is lying or not?  How Did Daschle Realize He Had a Limo Problem? How do these brilliant social engineers coincidentally get so stupid when it comes to paying taxes?  How does Rep. Charles Rangel still head the House Ways and Means Committee after being shown to also be a tax cheat? Washington Times - Rangel ethics inquiries vex House leaders. George Orwell wrote a book, Animal Farm, which parodied the absurdity of such behavior. Some people say, "they all do it" as if that is supposed to make us be more "realistic" about these people. It should make us even more determined to "throw the bums out".

(posted at 7:55 am by Mike Rulle)