Showing posts with label Federal Reserve. Show all posts
Showing posts with label Federal Reserve. Show all posts
Sunday, October 23, 2011
Sunday, October 2, 2011
Thursday, August 12, 2010
The Federal Reserve, Price Stability, and CPI
The Federal Reserve, Price Stability, and CPI
by Alex Merced
While here at LibertyisNow.com I've been discussing several economic and philosohical concepts regarding individualism and Liberty, no war is won over night yet strewn across many hard fought battles. The battle at hand is similar to the battle fought by Andrew Jackson/Martin Van Buren against the entrenched banking and government interests protected by a central bank. Aiding in the battle against these interests was treasury secretary under both presidents Levi Woodsbury who I'm now currently researching to write a book on his role in this time period and in the panic of 1837. Any primary sources you can direct me too on these subjects please send over.
So to understand the battle ahead let's go back understand why the fed was created, what was the feds purpose, and their performance.
Why the fed was created?
In the early 20th century the country was subject to very regular banking panics, a large part due to branching restrictions on banks known as Unit Banking. Although you can take a look a look at the Canadian banking system at the time which didn't have these restrictions (and no central bank) did not have the same problem with banking panics as we did. In this interview on EconTalk, economist Charles Calomaris discusses this part of history in building the context for the recent financial crisis.
Part of what really made these banking panics frequent and regular was that agriculture was a bigger portion of our economy that it is now. So in farm towns, between harvests you'd have panics at the local bank. So there were two options on how to deal with this problem:
1. Lift the Branching restrictions to allow banks to diversify their deposits geographically
2. Create a central bank to inject liquidity into these banks between harvests
As documented in the book "Creature from Jekyl Island" by Edward G Griffith many prominent bankers got involved in the creation of the policy that followed to address this problem. Bankers did not want to the extra competition that would come from having banks branch out, so the central bank was the favored route since it preserved bankers local monopolies.
In beginning (1913) the Federal Reserve only lent to banks through it's discount window where banks could bring "high quality" collateral (usually in the form of government bonds/treasuries) in order to get overnight loans to meet their reserve requirement, which is a fixed percetage of their liabilities they must have deposited at the Federal Reserve (currently 10%). This was for the most part the extent of the Federal Reserves actions till later on.
In 1920 a large Recession took hold in the economy during the end of Woodrow Wilsons administration and the beginning of Warren G Harding. As Harding took office, his Secretary of Commerce (Herbert Hoover) and his Secretary of the treasury (Andrew Mellon) did not see eye to on what actions should be. Herbert Hoover advised that Harding should conduct protectionist high wage policies and also advocated spending increases to which advice Harding ignored and allowed deflation to take hold and unemployment had started going down. The federal reserve had taken little action, cause at this point they had not yet entered something called open market operations.
Come 1924 the Federal Reserve was having problems covering it's operation costs with only the proceeds from loans of the discount window, so it began the purchasing and selling of government debt better known as open market operations. These OMO's had great effects on interest rates and mid-decade began to push interest rates down from these actions which arguably triggers the Austrian Theory of the Business Cycle which I explain in this video.
This leads to the recession of 1929, yet now the president was the former Secretary of Commerce Herbert Hoover. Now that he was the one calling the shots, he conducted the expansionist schemes he wasn't allowed to under Harding and Coolidge. Having increased spending to historical highs, enacting the smoot hawley tariff, and establishing informal cartels in most industry to prop up wages; the economy had only worsened unlike in 1920 which saw a relatively speedy recovery.
As things get worse, a Charismatic contender from the opposing party comes along calling Hoover out and extravegant spending and intervention. This candidate, Franklin Delano Roosevelt, wins handidly and yet increases the spending and intervention well beyond his predeccessor (sound familiar).
At this point the rest is history, but now you have a foundation in where the Fed came from, now let's talk about their dual mandate.
The Federal Reserves Dual Mandate
The Federal Resere has dual Mandate to Carry out...
1. The Pursuit of Price Stability
2. The Pursuit of Full Employment
So let's see their score card since 1913...
- Recession in 1920 w/ double digit inflation
- The Great Depression in the 1930's one of the most dire economic event in history
- Major Rationing and Price Controls during World War II
- Intense Stagflation in the 1970's
- High Interest Rates in Response to Inflation in the 80's
- Dot Com Bubble at the turn of the Century
- Housing Bubble in 2008
Let's also sprinkle on a series of mini recessions in between all of that... although to be fair many of those recessions may be over-pronounced due to how GDP is calculated and the effects of deflation, for example the 1870's was known as a long depression but was actually one of the most robust periods of growth in the country. So when looking at a recession one must take a look with a critical eye.
Although, one can clearly see even if the federal reserve was the benevolent overseer of the economy with which it's avocates paint it as, the concept of price stability is a flawed one. Often price drop due to productivity increases as I explain in this article on deflation, this is a great thing that you can now buy the same goods for lower prices and have more to spend elsewhere in the economy. Although when the fed conducts policy for price stability it uses a method called inflation targeting, which very often is keyed to s statistic called CPI, the Consumer Price Index.
What is the Consumer Price Index?
By current day definitions, we look at inflation as an increase in the prices around us and the Keynsian/Monetarist Orthodoxy believes that a moderate amount of inflation is necessary so the federal reserve should target it at some arbritrary number like 3%. So how do we know how much price inflation is? We use CPI which takes a basket of goods and measures it's month over month price increase, so if CPI is up 3% then the basket of goods has increased in price 3%.
So what is in the basket of goods?
We take all the goods that an AVERAGE purchase purchases using the AVERAGE price from many urban cities
There are many obvious problems with the calculation of this number
- Who is this average person? How do we know what goods they buy?
- If we did know what good, don't those good change over time, so the basket of good must change over time as well which you might remember in any science class is a problem, cause if you constantly change your control variable your information is useless.
- Don't prices even differ in the same city, and what about replacement goods, if a price goes up of one good I may just replace it with another good essentially negating the effect of the price increase in my daily life.
- Also how about regional cultural difference, I imagine the prices in New York will be higher than prices in Detroit, and also the brands of goods and specific good will change due to regional cultural difference.
This all hints at the fundamental problem with all Macroeconomic indicators they destroy valuable information needed to understand why certain phenomena occurs. If I see an increase in CPI, sure this tells me certain prices have gone up but without further inspection I don't know which ones and where.
So in General, the Federal Reserve acts like all prices go down and up together uniformly and adjust the money supply to get CPI to hit their target which ignores so many regional factors that it ends up causing regional and microeconomic problems... but as long as those aggregate numbers like CPI and GDP look good, right?
For example, what if CPI drops and it's actually due to productivity gains in technology (cheaper laptops), it'll show up in CPI as a drop in price which doesn't fit the Federal Reserves definition of Price Stability so they put money into the economy to push the price back up to hit their inflation target and essentially erase that productivity gain. If this had not occured, the savings for people from that productivity gain could of been use to buy other goods which would allow more sectors of the economy to grow. Instead all prices have gone up, and generally wages move slower than consumer prices so if prices are increasing wages arn't increasing fast enough to keep up for a net loss. Vice Versa, in a deflation prices more down faster than wages move down, for example if prices dropped 20% and wages drop 11%, you're actually able to buy more stuff which will then again re-stimulate the economy.
Of course the Federal Reserve would never let prices drop for political reasons which I explain in the Deflation article I linked to earlier.
How about maintaining Full Employment?
Another bizzarre goal, cause for a economy to have a healthy transfer of resources from growing industry from a matured industry you'll have some frictional unemployment. For example as the industry for audio cassette manfuacturers died down unemplyment had to come from that industry before those jobs got replace with jobs manufacturing Compact Discs and other goods. So it's not neccessarily imperative to force the economy to constantly have little to no unemployment, (usally they have an arbritrary target). So by injecting money into the economy resources get diverted from transitioning industries into something else which may or may not be sustainable such as New Internet Start-ups or New Housing Construction, get the picture. It's not that the money wouldn't of been invested, it just would've been invested somewhere else that was sustainable. So if jobs get create in an unsustainable industry instead of an sustainable industry their may be an increase in jobs and consumption until it's realized that the job was unsustainable (AKA a recession).
Bottom Line:
While historically it has been shown that an economy can thrive without a central bank (early 1900's canada) or thrive during deflation (1870's USA) we still insist we cannot exist without a Central Bank who's mandates contradict basic economics who operate based on statistics that tell them very little about what is actually going on it the world. Maybe it's time we start taking economics and history a little bit more seriously...
by Alex Merced
While here at LibertyisNow.com I've been discussing several economic and philosohical concepts regarding individualism and Liberty, no war is won over night yet strewn across many hard fought battles. The battle at hand is similar to the battle fought by Andrew Jackson/Martin Van Buren against the entrenched banking and government interests protected by a central bank. Aiding in the battle against these interests was treasury secretary under both presidents Levi Woodsbury who I'm now currently researching to write a book on his role in this time period and in the panic of 1837. Any primary sources you can direct me too on these subjects please send over.
So to understand the battle ahead let's go back understand why the fed was created, what was the feds purpose, and their performance.
Why the fed was created?
In the early 20th century the country was subject to very regular banking panics, a large part due to branching restrictions on banks known as Unit Banking. Although you can take a look a look at the Canadian banking system at the time which didn't have these restrictions (and no central bank) did not have the same problem with banking panics as we did. In this interview on EconTalk, economist Charles Calomaris discusses this part of history in building the context for the recent financial crisis.
Part of what really made these banking panics frequent and regular was that agriculture was a bigger portion of our economy that it is now. So in farm towns, between harvests you'd have panics at the local bank. So there were two options on how to deal with this problem:
1. Lift the Branching restrictions to allow banks to diversify their deposits geographically
2. Create a central bank to inject liquidity into these banks between harvests
As documented in the book "Creature from Jekyl Island" by Edward G Griffith many prominent bankers got involved in the creation of the policy that followed to address this problem. Bankers did not want to the extra competition that would come from having banks branch out, so the central bank was the favored route since it preserved bankers local monopolies.
In beginning (1913) the Federal Reserve only lent to banks through it's discount window where banks could bring "high quality" collateral (usually in the form of government bonds/treasuries) in order to get overnight loans to meet their reserve requirement, which is a fixed percetage of their liabilities they must have deposited at the Federal Reserve (currently 10%). This was for the most part the extent of the Federal Reserves actions till later on.
In 1920 a large Recession took hold in the economy during the end of Woodrow Wilsons administration and the beginning of Warren G Harding. As Harding took office, his Secretary of Commerce (Herbert Hoover) and his Secretary of the treasury (Andrew Mellon) did not see eye to on what actions should be. Herbert Hoover advised that Harding should conduct protectionist high wage policies and also advocated spending increases to which advice Harding ignored and allowed deflation to take hold and unemployment had started going down. The federal reserve had taken little action, cause at this point they had not yet entered something called open market operations.
Come 1924 the Federal Reserve was having problems covering it's operation costs with only the proceeds from loans of the discount window, so it began the purchasing and selling of government debt better known as open market operations. These OMO's had great effects on interest rates and mid-decade began to push interest rates down from these actions which arguably triggers the Austrian Theory of the Business Cycle which I explain in this video.
This leads to the recession of 1929, yet now the president was the former Secretary of Commerce Herbert Hoover. Now that he was the one calling the shots, he conducted the expansionist schemes he wasn't allowed to under Harding and Coolidge. Having increased spending to historical highs, enacting the smoot hawley tariff, and establishing informal cartels in most industry to prop up wages; the economy had only worsened unlike in 1920 which saw a relatively speedy recovery.
As things get worse, a Charismatic contender from the opposing party comes along calling Hoover out and extravegant spending and intervention. This candidate, Franklin Delano Roosevelt, wins handidly and yet increases the spending and intervention well beyond his predeccessor (sound familiar).
At this point the rest is history, but now you have a foundation in where the Fed came from, now let's talk about their dual mandate.
The Federal Reserves Dual Mandate
The Federal Resere has dual Mandate to Carry out...
1. The Pursuit of Price Stability
2. The Pursuit of Full Employment
So let's see their score card since 1913...
- Recession in 1920 w/ double digit inflation
- The Great Depression in the 1930's one of the most dire economic event in history
- Major Rationing and Price Controls during World War II
- Intense Stagflation in the 1970's
- High Interest Rates in Response to Inflation in the 80's
- Dot Com Bubble at the turn of the Century
- Housing Bubble in 2008
Let's also sprinkle on a series of mini recessions in between all of that... although to be fair many of those recessions may be over-pronounced due to how GDP is calculated and the effects of deflation, for example the 1870's was known as a long depression but was actually one of the most robust periods of growth in the country. So when looking at a recession one must take a look with a critical eye.
Although, one can clearly see even if the federal reserve was the benevolent overseer of the economy with which it's avocates paint it as, the concept of price stability is a flawed one. Often price drop due to productivity increases as I explain in this article on deflation, this is a great thing that you can now buy the same goods for lower prices and have more to spend elsewhere in the economy. Although when the fed conducts policy for price stability it uses a method called inflation targeting, which very often is keyed to s statistic called CPI, the Consumer Price Index.
What is the Consumer Price Index?
By current day definitions, we look at inflation as an increase in the prices around us and the Keynsian/Monetarist Orthodoxy believes that a moderate amount of inflation is necessary so the federal reserve should target it at some arbritrary number like 3%. So how do we know how much price inflation is? We use CPI which takes a basket of goods and measures it's month over month price increase, so if CPI is up 3% then the basket of goods has increased in price 3%.
So what is in the basket of goods?
We take all the goods that an AVERAGE purchase purchases using the AVERAGE price from many urban cities
There are many obvious problems with the calculation of this number
- Who is this average person? How do we know what goods they buy?
- If we did know what good, don't those good change over time, so the basket of good must change over time as well which you might remember in any science class is a problem, cause if you constantly change your control variable your information is useless.
- Don't prices even differ in the same city, and what about replacement goods, if a price goes up of one good I may just replace it with another good essentially negating the effect of the price increase in my daily life.
- Also how about regional cultural difference, I imagine the prices in New York will be higher than prices in Detroit, and also the brands of goods and specific good will change due to regional cultural difference.
This all hints at the fundamental problem with all Macroeconomic indicators they destroy valuable information needed to understand why certain phenomena occurs. If I see an increase in CPI, sure this tells me certain prices have gone up but without further inspection I don't know which ones and where.
So in General, the Federal Reserve acts like all prices go down and up together uniformly and adjust the money supply to get CPI to hit their target which ignores so many regional factors that it ends up causing regional and microeconomic problems... but as long as those aggregate numbers like CPI and GDP look good, right?
For example, what if CPI drops and it's actually due to productivity gains in technology (cheaper laptops), it'll show up in CPI as a drop in price which doesn't fit the Federal Reserves definition of Price Stability so they put money into the economy to push the price back up to hit their inflation target and essentially erase that productivity gain. If this had not occured, the savings for people from that productivity gain could of been use to buy other goods which would allow more sectors of the economy to grow. Instead all prices have gone up, and generally wages move slower than consumer prices so if prices are increasing wages arn't increasing fast enough to keep up for a net loss. Vice Versa, in a deflation prices more down faster than wages move down, for example if prices dropped 20% and wages drop 11%, you're actually able to buy more stuff which will then again re-stimulate the economy.
Of course the Federal Reserve would never let prices drop for political reasons which I explain in the Deflation article I linked to earlier.
How about maintaining Full Employment?
Another bizzarre goal, cause for a economy to have a healthy transfer of resources from growing industry from a matured industry you'll have some frictional unemployment. For example as the industry for audio cassette manfuacturers died down unemplyment had to come from that industry before those jobs got replace with jobs manufacturing Compact Discs and other goods. So it's not neccessarily imperative to force the economy to constantly have little to no unemployment, (usally they have an arbritrary target). So by injecting money into the economy resources get diverted from transitioning industries into something else which may or may not be sustainable such as New Internet Start-ups or New Housing Construction, get the picture. It's not that the money wouldn't of been invested, it just would've been invested somewhere else that was sustainable. So if jobs get create in an unsustainable industry instead of an sustainable industry their may be an increase in jobs and consumption until it's realized that the job was unsustainable (AKA a recession).
Bottom Line:
While historically it has been shown that an economy can thrive without a central bank (early 1900's canada) or thrive during deflation (1870's USA) we still insist we cannot exist without a Central Bank who's mandates contradict basic economics who operate based on statistics that tell them very little about what is actually going on it the world. Maybe it's time we start taking economics and history a little bit more seriously...
Wednesday, June 30, 2010
Regulating Enterprise
Regulating Enterprise
by Alex Merced
Time and time again we hear in the news that we need stronger regulation on Oil, Housing, and Banking to prevent all the problems we've seen over the last few years. Today, I'd like to make the argument that the problems with all three of these sectors has everything to do with government intervention in the market and that the best regulation would be the natural regulation of natural risk in the markets. In the name of populism much of this natural risk has been removed from these enterprises in the name of "promoting business", "job creation", and "economic growth".
The initial problem with this rhetoric is that growth is always good, so rushing growth or artificial growth must be good too. For example, if I want to bulk up quicker I could begin to take steroids, although while that is growth it's not sustainable since I haven't built the discipline and lifestyle needed to maintain that bulk, so I become dependent on the steroids to maintain it.
So let's take a look at three types of natural risk that effect the entrepreneur when they are making the decision to enter an enterprise, and on how to run the enterprise. We'll see that these policies remove the aforementioned risks and like steroids prevent the kind of discipline needed to create sustainable businesses and growth.
Risk # 1 - The Ability to Raise Capital
Arguably, if an entrepreneur can't raise the money then he may never start the enterprise at all. Why would raising capital be difficult? This could be for a variety of reasons that all have to deal with he viability of the business and if potential investors/lenders see a demand for product/service, are the potential liabilities addressed, are the margins too thin, is it profitable in the short term? If government were to intervene to make capital easier to raise for such enterprises, it's easy to see how more of them would exist despite these typical investor concerns.
Oil - Oil is a very difficult business without government aid, because investors aren't typically very optimistic about the chances of finding oil when doing exploratory drilling. So to encourage investment into oil in the 60's and 70's tax shelters were created for oil investment in the form of Direct Participation Programs, and during a time of 70% tax rates one can see how a tax haven can be quite a benefit, you'd actually profit from the tax savings alone. So capital was being sucked into oil cause of the tax benefits, not cause of the merit of the enterprise... actually you'd lose money if they found oil cause it'd create a paper gain which you'd pay taxes on. So the capital raising issue was now done away with for Oil drilling at the expense of driving capital away from technology, medicine, alternative fuels that would've meant that the BP spill might've never happened cause the oil rig would've never been there since we would have divested from oil long ago.
Banking - Banks can be a risky proposition with tight margins. The problems being if the bank takes too much risk then depositors begin to take money out to move it to a safer bank, which would cause a bank run since banks don't have enough money to cover all their deposits in the FRACTIONAL RESERVE banking system we have now. On the other hand, if they practice safer banking practices and keep their depositors then their margins are very low and the growth of the company is low which is not what investors want to hear. So if we could prevent investors from worrying about risk that the banks taking, then the bank take on the risk necessary to get all the investment they need, so FDIC/SIPC are born. By creating a mandatory deposit insurance depositors feel at ease and become less concerned with moving their deposits, allowing banks with those deposits to get bigger and bigger by taking on more risk, while making hard and near impossible for newer banks to compete for those deposits without taking more risk as well.
Housing - Houses are a great investment but a house can take a long time to turn over, especially these days. If you factor in all the maintenance costs it can require a lot of upfront capital and not much in return in the mean time. Countless institutions were created to encourage investment in housing:
- Fannie and Freddie were created to buy mortgages from banks, so banks could keep making more and more mortgages which solves the demand/turnover issue that made investment in development weary.
- Housing which by all means is a capital good doesn't get taxes as a capital gain when sold for a profit, maximizing it's after-tax return versus stocks or bonds which are more liquid.
- REITS which are just real estate company shares get special Subchapter M tax treatment getting the same tax exemptions that mutual funds get.
- Mortgage Tax Credit
- Tax Shelters like the ones created for oil were created for housing, which actually allowed you invest non-recourse loans (loans in which they CAN'T garnish your wages or repossess your assets if you don't pay)
... a lot lot more...
Risk # 2 - Liabilities
Liability is a huge issue to any investor or entrepreneur, the more likely the chances of being sued or a disaster occurring that would incur lots of liabilities the less appetizing the reward becomes versus the risk. So if the liabilities aren't mitigated through government intervention, needless to say a lot of these risks would drive entrepreneurs and investors to more safe sustainable ventures where they can make a similar return. Even if the if they do decide to go into the enterprise, liability will keep the entrepreneur disciplined or else lose his hard work and more.
Oil - Everyone has heard about the liability cap set on Oil companies, on top of it you had tax incentives to drill farther off shore then drilling on shore (less royalties needed to be paid the father out you drilled) which combined makes the risk/reward calculation on drilling offshore a no brainer.
Banking - Once again you had very huge liability in the case that a risky investment didn't pan out, or if depositors suddenly began withdrawing money despite the the cover of FDIC. To prevent the liability of these scenarios the Federal Reserve was created as the lender of last resort, originally created in 1913 to address problems from severe branching regulations in the early 1900's. So with FDIC and keeping depositors feeling safe and the Federal Reserve coming to the rescue when excessive risk catches up with the banks... owning a bank is great idea, especially since it's the bankers who are the entry point of new highly powered money.
Housing - The major liability in investing in housing is well... not being able to sell the house or the person you lend to not making their mortgage payments. Fannie and Freddie combined with loose monetary policy from the fed really fed the demand so that these houses were more liquid and that mortgages could be affordable to the least qualified of borrowers. If you don't have to worry about these factors well... then why not invest in housing.
Risk #3 - Attracting Talent
In order to grow a large and ever growing enterprise one must attract the talent to do so. The problem if your business isn't very sustainable cause of excessive liabilities or low margins then compensation becomes difficult to afford for good talent. Also, the best talent seeks to be somewhere that the job seems safe and secure so if you decide to run a high risk business this may detract talent cause the risk of unemployment becomes to penalizing and the cost of private unemployment insurance would lower your wages you'd make more paying a much smaller premium for a safer company. In this Free Market environment the best talent would gravitate towards sustainable enterprise unless government reduces the risk of working for risky unsustainable enterprise.
For All Industries - Government Mandated Unemployment insurances creates non-variable cost for working for anyone, so it doesn't matter how safe the job is the payment into unemployment is the same, so then you might as well work for the high risk taking high salary company. Worse comes to worse you will not get a fraction of a larger salary for the next 6 months, so you get rewards for taking the riskier job since you benefits key into what you made before becoming unemployed.
Conclusion
If the government makes it easier for capital to gravitate towards riskier business, makes it easier to take more risk without incurring large liabilities, and allows these firms to easily make grabs at all the greatest talent around the globe... what do you expect to happen? Overpriced Housing, Overleveraged Banks, Oil Spills
Greed is not alone powerful enough to cause these kinds of problems, but with the helping hand of government big business can have all the roadblocks removed from becoming... "too big to fail" or better put "too big to succeed"
by Alex Merced
Time and time again we hear in the news that we need stronger regulation on Oil, Housing, and Banking to prevent all the problems we've seen over the last few years. Today, I'd like to make the argument that the problems with all three of these sectors has everything to do with government intervention in the market and that the best regulation would be the natural regulation of natural risk in the markets. In the name of populism much of this natural risk has been removed from these enterprises in the name of "promoting business", "job creation", and "economic growth".
The initial problem with this rhetoric is that growth is always good, so rushing growth or artificial growth must be good too. For example, if I want to bulk up quicker I could begin to take steroids, although while that is growth it's not sustainable since I haven't built the discipline and lifestyle needed to maintain that bulk, so I become dependent on the steroids to maintain it.
So let's take a look at three types of natural risk that effect the entrepreneur when they are making the decision to enter an enterprise, and on how to run the enterprise. We'll see that these policies remove the aforementioned risks and like steroids prevent the kind of discipline needed to create sustainable businesses and growth.
Risk # 1 - The Ability to Raise Capital
Arguably, if an entrepreneur can't raise the money then he may never start the enterprise at all. Why would raising capital be difficult? This could be for a variety of reasons that all have to deal with he viability of the business and if potential investors/lenders see a demand for product/service, are the potential liabilities addressed, are the margins too thin, is it profitable in the short term? If government were to intervene to make capital easier to raise for such enterprises, it's easy to see how more of them would exist despite these typical investor concerns.
Oil - Oil is a very difficult business without government aid, because investors aren't typically very optimistic about the chances of finding oil when doing exploratory drilling. So to encourage investment into oil in the 60's and 70's tax shelters were created for oil investment in the form of Direct Participation Programs, and during a time of 70% tax rates one can see how a tax haven can be quite a benefit, you'd actually profit from the tax savings alone. So capital was being sucked into oil cause of the tax benefits, not cause of the merit of the enterprise... actually you'd lose money if they found oil cause it'd create a paper gain which you'd pay taxes on. So the capital raising issue was now done away with for Oil drilling at the expense of driving capital away from technology, medicine, alternative fuels that would've meant that the BP spill might've never happened cause the oil rig would've never been there since we would have divested from oil long ago.
Banking - Banks can be a risky proposition with tight margins. The problems being if the bank takes too much risk then depositors begin to take money out to move it to a safer bank, which would cause a bank run since banks don't have enough money to cover all their deposits in the FRACTIONAL RESERVE banking system we have now. On the other hand, if they practice safer banking practices and keep their depositors then their margins are very low and the growth of the company is low which is not what investors want to hear. So if we could prevent investors from worrying about risk that the banks taking, then the bank take on the risk necessary to get all the investment they need, so FDIC/SIPC are born. By creating a mandatory deposit insurance depositors feel at ease and become less concerned with moving their deposits, allowing banks with those deposits to get bigger and bigger by taking on more risk, while making hard and near impossible for newer banks to compete for those deposits without taking more risk as well.
Housing - Houses are a great investment but a house can take a long time to turn over, especially these days. If you factor in all the maintenance costs it can require a lot of upfront capital and not much in return in the mean time. Countless institutions were created to encourage investment in housing:
- Fannie and Freddie were created to buy mortgages from banks, so banks could keep making more and more mortgages which solves the demand/turnover issue that made investment in development weary.
- Housing which by all means is a capital good doesn't get taxes as a capital gain when sold for a profit, maximizing it's after-tax return versus stocks or bonds which are more liquid.
- REITS which are just real estate company shares get special Subchapter M tax treatment getting the same tax exemptions that mutual funds get.
- Mortgage Tax Credit
- Tax Shelters like the ones created for oil were created for housing, which actually allowed you invest non-recourse loans (loans in which they CAN'T garnish your wages or repossess your assets if you don't pay)
... a lot lot more...
Risk # 2 - Liabilities
Liability is a huge issue to any investor or entrepreneur, the more likely the chances of being sued or a disaster occurring that would incur lots of liabilities the less appetizing the reward becomes versus the risk. So if the liabilities aren't mitigated through government intervention, needless to say a lot of these risks would drive entrepreneurs and investors to more safe sustainable ventures where they can make a similar return. Even if the if they do decide to go into the enterprise, liability will keep the entrepreneur disciplined or else lose his hard work and more.
Oil - Everyone has heard about the liability cap set on Oil companies, on top of it you had tax incentives to drill farther off shore then drilling on shore (less royalties needed to be paid the father out you drilled) which combined makes the risk/reward calculation on drilling offshore a no brainer.
Banking - Once again you had very huge liability in the case that a risky investment didn't pan out, or if depositors suddenly began withdrawing money despite the the cover of FDIC. To prevent the liability of these scenarios the Federal Reserve was created as the lender of last resort, originally created in 1913 to address problems from severe branching regulations in the early 1900's. So with FDIC and keeping depositors feeling safe and the Federal Reserve coming to the rescue when excessive risk catches up with the banks... owning a bank is great idea, especially since it's the bankers who are the entry point of new highly powered money.
Housing - The major liability in investing in housing is well... not being able to sell the house or the person you lend to not making their mortgage payments. Fannie and Freddie combined with loose monetary policy from the fed really fed the demand so that these houses were more liquid and that mortgages could be affordable to the least qualified of borrowers. If you don't have to worry about these factors well... then why not invest in housing.
Risk #3 - Attracting Talent
In order to grow a large and ever growing enterprise one must attract the talent to do so. The problem if your business isn't very sustainable cause of excessive liabilities or low margins then compensation becomes difficult to afford for good talent. Also, the best talent seeks to be somewhere that the job seems safe and secure so if you decide to run a high risk business this may detract talent cause the risk of unemployment becomes to penalizing and the cost of private unemployment insurance would lower your wages you'd make more paying a much smaller premium for a safer company. In this Free Market environment the best talent would gravitate towards sustainable enterprise unless government reduces the risk of working for risky unsustainable enterprise.
For All Industries - Government Mandated Unemployment insurances creates non-variable cost for working for anyone, so it doesn't matter how safe the job is the payment into unemployment is the same, so then you might as well work for the high risk taking high salary company. Worse comes to worse you will not get a fraction of a larger salary for the next 6 months, so you get rewards for taking the riskier job since you benefits key into what you made before becoming unemployed.
Conclusion
If the government makes it easier for capital to gravitate towards riskier business, makes it easier to take more risk without incurring large liabilities, and allows these firms to easily make grabs at all the greatest talent around the globe... what do you expect to happen? Overpriced Housing, Overleveraged Banks, Oil Spills
Greed is not alone powerful enough to cause these kinds of problems, but with the helping hand of government big business can have all the roadblocks removed from becoming... "too big to fail" or better put "too big to succeed"
Sunday, April 25, 2010
Free Market Regulation Explained
Free Market Regulation Explained
by Alex Merced
Everyone always assumes that as free marketers that we advocate there be no regulations at all, but the truth is we think there should be no government monopolies of regulation or violence used in enforcing it. Then the response always is, if the government can do it then people won't. Although there are plenty of ways regulation can be done for profit in a way were the regulators have consumer interest more in mind than they do now. You've probably already read plenty of articles of the effects of government regulation as far as eating up resources and raising the barrier to entry reducing competition for the very firms your trying to control so let's take a different approach.
The intended or perceived intention of regulation is consumer protection, and we've seen that this is not always the result for one key reason, any entity is beholden to the people who fund it's operations in this case government. People think of the government as a intermediary of the people but while they are publically elected they are politically motivated. Since they truly hold the DIRECT power to fund these regulators, the regulators are beholden to them and their political goals (Bush, Dodd, Cuomo, Frank w/ lending regs) instead of pure consumer protection. So as politics distorts the mission or purpose of a regulator, consumer protection falls by the way side.
This is also an issue with private sector SRO's since they are usally funded directly by the firms in the industry they are regulating so they are beholden to those firms. If these's SRO's such as FINRA etc. enforced the rules closely on their biggest constitutents (Goldman Sachs) it'd greatly effect the inflow of cash for their operations so once again consumer protection falls by the way side.
The bottom line, a regulator will always be beholden to those that pay their bills, so if you want them to protect the consumer they must be paid by the consumer directly. Even then, a regulator isn't infallible so allowing a market of regulators that consumers can volunteer to pay into and firms can volunteer to deal with to get to those consumers will allow the correct incentives and pressures for the regulatory firm to advocate on their customers behalf (such as for-profit lawyers, you hire them to protect you. Also this structure is similar to AARP or other groups you pay memberships for).
This market of regulators shouldn't have any type special power handed over the government, since we've seen that ever mixing private/public institutions ends in disatrous results (Fannie, Freddie, FINRA, Sallie Mae, etc.). Industry firms will try to strike deals with as many of these regulatory firms as possible to have access to the consumers who hired them as their intermediary, and the industry firms that strike these deal will voluntarily be monitored by these regulatory firms who will then promote and recommend these firms monitored by them to consumers who pay for the regulatory firms services. Everyone who participates in this protection is doing so voluntarily but cause of the pressure created directly by consumers.
Another way to regulate in the free market is through review publications as we see in entertainment magazines that review the music and movies we enjoy. Musicians and Entertainers operate with the pressure of getting good reviews or have their success effected by it, although if one reviewer were to write good reviews for bad movies his audience would shrink and more over to another reviewer putting pressure to remain honest. Also, if one reviewer opinion is drastically different than other, this would also call into question the quality of his review. Although these review magazines are paid for directly by consumers, so they are beholden consumers.
Although in the case of securities rating agencys, giving them psuedo government power by keying legal regulation into their ratings created a perverse incentive to cater to their clients (the buy side) into rating things highly so they can legally leverage them. If there wasn't these coerced limits by government regulation, these rating agencies wouldn't of had the same pressures to rate the Mortgage Backed Securities AAA.
Even without the free market of regultors and review publications there is the ultimate free market regulator, consequence. If consumers and providers feel there are consequences to their risks, and there is nothing mitigating this consequence (FDIC, SIPC, Federal Reserve) then the risk will typically prevent them from taking "Irrational" risks, and those that do will suffer the consequence and serve as a warning to others.
At the end of the day, protection of the individual is the responsibility of the individual. If the individual does not take the time and isn't willing to directly be involved in their own protection the protection they do get will never truly be on their side and the world around them will stagnate from the results. To fix the world you need more aware and active individuals, willing to pay for their own protection, willing to get involved in protecting themselves and truly understanding every individual decision they make.
by Alex Merced
Everyone always assumes that as free marketers that we advocate there be no regulations at all, but the truth is we think there should be no government monopolies of regulation or violence used in enforcing it. Then the response always is, if the government can do it then people won't. Although there are plenty of ways regulation can be done for profit in a way were the regulators have consumer interest more in mind than they do now. You've probably already read plenty of articles of the effects of government regulation as far as eating up resources and raising the barrier to entry reducing competition for the very firms your trying to control so let's take a different approach.
The intended or perceived intention of regulation is consumer protection, and we've seen that this is not always the result for one key reason, any entity is beholden to the people who fund it's operations in this case government. People think of the government as a intermediary of the people but while they are publically elected they are politically motivated. Since they truly hold the DIRECT power to fund these regulators, the regulators are beholden to them and their political goals (Bush, Dodd, Cuomo, Frank w/ lending regs) instead of pure consumer protection. So as politics distorts the mission or purpose of a regulator, consumer protection falls by the way side.
This is also an issue with private sector SRO's since they are usally funded directly by the firms in the industry they are regulating so they are beholden to those firms. If these's SRO's such as FINRA etc. enforced the rules closely on their biggest constitutents (Goldman Sachs) it'd greatly effect the inflow of cash for their operations so once again consumer protection falls by the way side.
The bottom line, a regulator will always be beholden to those that pay their bills, so if you want them to protect the consumer they must be paid by the consumer directly. Even then, a regulator isn't infallible so allowing a market of regulators that consumers can volunteer to pay into and firms can volunteer to deal with to get to those consumers will allow the correct incentives and pressures for the regulatory firm to advocate on their customers behalf (such as for-profit lawyers, you hire them to protect you. Also this structure is similar to AARP or other groups you pay memberships for).
This market of regulators shouldn't have any type special power handed over the government, since we've seen that ever mixing private/public institutions ends in disatrous results (Fannie, Freddie, FINRA, Sallie Mae, etc.). Industry firms will try to strike deals with as many of these regulatory firms as possible to have access to the consumers who hired them as their intermediary, and the industry firms that strike these deal will voluntarily be monitored by these regulatory firms who will then promote and recommend these firms monitored by them to consumers who pay for the regulatory firms services. Everyone who participates in this protection is doing so voluntarily but cause of the pressure created directly by consumers.
Another way to regulate in the free market is through review publications as we see in entertainment magazines that review the music and movies we enjoy. Musicians and Entertainers operate with the pressure of getting good reviews or have their success effected by it, although if one reviewer were to write good reviews for bad movies his audience would shrink and more over to another reviewer putting pressure to remain honest. Also, if one reviewer opinion is drastically different than other, this would also call into question the quality of his review. Although these review magazines are paid for directly by consumers, so they are beholden consumers.
Although in the case of securities rating agencys, giving them psuedo government power by keying legal regulation into their ratings created a perverse incentive to cater to their clients (the buy side) into rating things highly so they can legally leverage them. If there wasn't these coerced limits by government regulation, these rating agencies wouldn't of had the same pressures to rate the Mortgage Backed Securities AAA.
Even without the free market of regultors and review publications there is the ultimate free market regulator, consequence. If consumers and providers feel there are consequences to their risks, and there is nothing mitigating this consequence (FDIC, SIPC, Federal Reserve) then the risk will typically prevent them from taking "Irrational" risks, and those that do will suffer the consequence and serve as a warning to others.
At the end of the day, protection of the individual is the responsibility of the individual. If the individual does not take the time and isn't willing to directly be involved in their own protection the protection they do get will never truly be on their side and the world around them will stagnate from the results. To fix the world you need more aware and active individuals, willing to pay for their own protection, willing to get involved in protecting themselves and truly understanding every individual decision they make.
Tuesday, April 6, 2010
Treasuries, Investment, Interest Rates, and Risk
Treasuries, Investment, Interest Rates, and Risk
by Alex Merced
In todays world investment revolves around US Treasury debt cause it's AAA rating. Since the return yielded from treasuries is considered the "risk free" rate of return it establishes the minimum return someone should make from their investments. So since this interest plays sucha pivotal role in the investment decision and risk taking learning a little bit about how it works would be pretty important to understanding excessive risk taking by the banking system.
What is Treasury Debt?
We believe that it's taxes that pay for military, medicare, and all the other government services and programs we may approve or dissaprove of. In Reality, tax revenues are not enough to pay for the growing role of government and the public sector so money must be borrowed via bonds known as treasuries. As any debtor would, the government wants to pay the lowest rate possible so they have an auction for the debt similar to lendingtree in which the largest banks in the world known as primary dealers (for Primary Dealers include Lehman, Bear Sterns, Merrill, etc.) bid on the debt in order for debtor to get the lowest interest rate possible.
What is with all the demand for treasuries?
Now why would banks bid treasuries to near below inflation/CPI levels when they could use that capital for other higher yielding investments? In order for this to be the case there must be some mechanism to stimulate the demand of these banks very similar to what happened in the housing crisis...
Why did lenders make so many bad mortgages, cause they didn't have to hold the loans they could just turn around and sell it to Fannie or Freddie so this created artificial demand for mortgage debt pushing lending rates low. A similar mechanism is used with treasuries since these treasuries can be used in a variety of ways in dealing with the central bank, the federal reserve.
The central banks primary role in this is to keep fueling the demand for treasuries by entering in repurchasing agreements with these primary dealers. In these agreement the central bank promises to buy back these treasuries and to do so the central bank must expand the money supply (inflation). Also, these primary dealers can use these treasuries as collateral for loans from the discount window in order to get emergency funds when these banks overlend or practice bad banking. Essentially, in exchange for facilitating the financing of government operations the banking system are given their own life support system in the form of the federal reserve bank.
So as government increases it's deficits need the demand of treasuries to increase meaning more pressure on the federal reserve to buy these treasuries from the bank with new money (aka monetizing the debt). So as the federal reserve inflates the money supply to facilitate government spending the increase reserves of these bank effectivly lowers lending rates sending a flase signal to the economy of non-existant savings causing the mal-investment charachterized in the austrian theory of the business cycle.
The effects of all this on investment and risk taking
At the same time, this inflation of the money supply will put upward pressure on price levels which increases the neccessary return from investment needed to maintain purchasing power. Also the increasing government debt puts upward pressure on taxes which means even more must be yielded from investment to make up for the tax burden. So effectively, when you combine the burden of inflation and taxes the return needed to make any profit is so high that modest medium risk investing just doesn't yield enough putting pressure on investors and investment institutions to have to take on risker investments to just walk away with anything at all.
Moral of the story:
- Inflation and Taxation only stimulates risk taking and distorts economic calculation of investors
- Inflation and Taxation are a product of growing government spending
- In order to maintain this Government Spending a strong relationship between Government and Banking must be established
- To be truly against bank bailouts and for main street you must be against the central bank and runaway spending which creates the moral hazard that strips the nation of their savings and retirement
- To believe in government entitlement programs you must be for the bank bailouts, cause without the bailout government cannot continue it's funding of programs like medicare and social security
- Money lent to the growing public sector is money not lent to the private sector, so as one grows the other must shrink along with the countries productive capacity increasing the burden over time as more and more people find themselves pushed out of an economy that can support less and less people everyday.
by Alex Merced
In todays world investment revolves around US Treasury debt cause it's AAA rating. Since the return yielded from treasuries is considered the "risk free" rate of return it establishes the minimum return someone should make from their investments. So since this interest plays sucha pivotal role in the investment decision and risk taking learning a little bit about how it works would be pretty important to understanding excessive risk taking by the banking system.
What is Treasury Debt?
We believe that it's taxes that pay for military, medicare, and all the other government services and programs we may approve or dissaprove of. In Reality, tax revenues are not enough to pay for the growing role of government and the public sector so money must be borrowed via bonds known as treasuries. As any debtor would, the government wants to pay the lowest rate possible so they have an auction for the debt similar to lendingtree in which the largest banks in the world known as primary dealers (for Primary Dealers include Lehman, Bear Sterns, Merrill, etc.) bid on the debt in order for debtor to get the lowest interest rate possible.
What is with all the demand for treasuries?
Now why would banks bid treasuries to near below inflation/CPI levels when they could use that capital for other higher yielding investments? In order for this to be the case there must be some mechanism to stimulate the demand of these banks very similar to what happened in the housing crisis...
Why did lenders make so many bad mortgages, cause they didn't have to hold the loans they could just turn around and sell it to Fannie or Freddie so this created artificial demand for mortgage debt pushing lending rates low. A similar mechanism is used with treasuries since these treasuries can be used in a variety of ways in dealing with the central bank, the federal reserve.
The central banks primary role in this is to keep fueling the demand for treasuries by entering in repurchasing agreements with these primary dealers. In these agreement the central bank promises to buy back these treasuries and to do so the central bank must expand the money supply (inflation). Also, these primary dealers can use these treasuries as collateral for loans from the discount window in order to get emergency funds when these banks overlend or practice bad banking. Essentially, in exchange for facilitating the financing of government operations the banking system are given their own life support system in the form of the federal reserve bank.
So as government increases it's deficits need the demand of treasuries to increase meaning more pressure on the federal reserve to buy these treasuries from the bank with new money (aka monetizing the debt). So as the federal reserve inflates the money supply to facilitate government spending the increase reserves of these bank effectivly lowers lending rates sending a flase signal to the economy of non-existant savings causing the mal-investment charachterized in the austrian theory of the business cycle.
The effects of all this on investment and risk taking
At the same time, this inflation of the money supply will put upward pressure on price levels which increases the neccessary return from investment needed to maintain purchasing power. Also the increasing government debt puts upward pressure on taxes which means even more must be yielded from investment to make up for the tax burden. So effectively, when you combine the burden of inflation and taxes the return needed to make any profit is so high that modest medium risk investing just doesn't yield enough putting pressure on investors and investment institutions to have to take on risker investments to just walk away with anything at all.
Moral of the story:
- Inflation and Taxation only stimulates risk taking and distorts economic calculation of investors
- Inflation and Taxation are a product of growing government spending
- In order to maintain this Government Spending a strong relationship between Government and Banking must be established
- To be truly against bank bailouts and for main street you must be against the central bank and runaway spending which creates the moral hazard that strips the nation of their savings and retirement
- To believe in government entitlement programs you must be for the bank bailouts, cause without the bailout government cannot continue it's funding of programs like medicare and social security
- Money lent to the growing public sector is money not lent to the private sector, so as one grows the other must shrink along with the countries productive capacity increasing the burden over time as more and more people find themselves pushed out of an economy that can support less and less people everyday.
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