The Reconstruction

This week: the failure of the bailout.

Possibly. If I had to bet at even odds, I’d bet against near-total seizure of global credit markets, but it’d be a closer call than I think I want to admit to myself.

If it does fail, however, it’s likely to do so sooner rather than later, and it will do so because the bailout wasn’t extensive enough– it didn’t give enough probably-unconstitutional authority to Henry Paulson (or, as was never seriously discussed, someone else, a point to which I will return later). My great concern is that the crisis hits Europe with full force, bringing down a major European bank or two– not banks on the scale of Fortis, but larger ones that couldn’t be easily bailed out by their home countries’ banks. This scenario that keeps me up at night starts with the TED (Treasury-Eurodollar) spread, which is the interest rate spread between the inter-bank borrowing rate (as represented by the three-month LIBOR, or London Inter-Bank Offer Rate), and the cost of “riskless” lending (as represented by three-month T-bill interest rates). The TED spread is an indicator of risk in credit markets: as the risk of borrowers defaulting on their debt rises, lenders require a higher rate of return to justify taking the risk of lending to those borrowers. At the moment, it is quite high. This increases the risk that firms that rely on short-term borrowing to cover debts won’t be able to meet their obligations, and will go bankrupt as a result, creating chain reactions that ripple through the economy as their creditors are unable to meet their obligations. Obviously, this has already occurred with the highly-leveraged investment banking firms in the US, but it could spread to other sectors of the U.S. economy, which is what the bailout plan is supposed to avert. Unfortunately, to the extent that the crisis spreads to related sectors of foreign economies, the bailout plan won’t do a thing to help. Given the difficulty of passing the plan through the House the first time, what are the chances that the Treasury secretary is going to be able to get the second $350 billion if he spends the first half rescuing foreign banks? I consider this a real threat; the fact that every student learns the lesson of Smoot-Hawley, that passing protectionist tariffs in the face of a massive downturn in the economy will only make things worse, does not mean that politicians will not make slightly-different-but-equally-crippling populist mistakes.

It’s for this reason that I’d like to give Mr. Paulson the benefit of the doubt. It’s entirely likely that some of the very smart people over at the Treasury considered the possibility of foreign bank failure and a populist backlash against using U.S. taxpayer funds for a bailout and added the language to the “Paulson Plan” that stated:

“Sec. 8. Review.

“Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.”

Of course, such language would also provide certainty to the markets– a government bailout in limbo, awaiting a decision on a motion for summary judgment on an appeal, etc., etc., would be worse than none at all. What the Treasury clearly didn’t anticipate, however, was that there would be such a powerful backlash to their brazen grab for power. Were the administration more credible, the Treasury’s proposal might have had a chance. As things are, any talk of a crisis from the administration sounds an awful lot like “The Boy Who Cried Wolf”, and it would clearly have been a wiser move to give much of the authority sought by Mr. Paulson to an explicitly bipartisan oversight board constituted in such a way as to be insulated from political pressures.

So– back to my nightmare– we’re in a situation where major global banks could fail, and the U.S. would be unable to do anything. It’s natural to ask, why wouldn’t other countries be able to step in to save their own banks? The answer is twofold: first, when dealing with very large global banks, like RBS or Deutsche Bank, they’re so large relative to their home countries’ economies that the fiscal constraint would be crippling, as there’s simply a lack of necessary capitalization; second, it’s not clear that the European Central Bank or its member nations have the authority or competence necessary to take coordinated action on the necessary scale. Thus, we face the possibility this week that major European banks will fail, seizing up credit markets and causing a global economic contraction, as the only bailout plan that can pass is one that is too weak to actually help.

And that is why the quality of governance in relatively stable times matters more than the hot-button social issues used to manipulate the populace– it sets the constraints of governance in times of crisis.

This evening, Goldman Sachs and Morgan Stanley both received approval from the Fed to convert from investment banks to bank holding companies. With this, the great majority of the US investment banking sector has effectively re-regulated itself. To quote Tyler Cowen, “Whew! I’m sure glad they repealed the Glass-Steagall Act.” The repeal of Glass-Steagall has had the interesting effect of allowing firms to choose between two very different institutions: the laissez-faire system of market discipline imposed through availability of funds on the money market, and the government-backed system of more highly-regulated depository institutions. For the moment at least, it seems that firms are willing to sacrifice flexibility and submit to greater oversight in exchange for public sector guarantees and access to more stable financing.

I don’t think that this is a temporary shift. It’s my opinion that markets tend to systematically underestimate risk for a number of reasons, not least of which is a lack of data. By way of example, it turns out that while it’s relatively easy to estimate the probability of a 100-year flood, it’s much more difficult to estimate the term risk of massive defaults on a package of securitized 30-year loans, because the data we have available simply doesn’t allow for a sample of similar width, nor do we have data for a similar length of time. Given this, and given how closely intertwined the world’s financial institutions are, a phenomenon augmented by the proliferation of instruments to distribute risk– the fact is, none of the major investment banks could actually state its net position at any given point in time– it’s silly to expect that sufficient information exists in the market to accurately price in those events on the tails of the probability distribution. Moreover, the lack of transparency in the shadow banking sector, due in part to the complexity of the instruments being used, but also in large part due to the fact that the instruments are traded primarily in bilateral agreements rather than in an open market, further complicates efforts to understand any one firm’s exposure to a given form of risk, let alone the ripple effects that could occur as a result.

If I’m right about the above, then it’s worth considering also that the same interdependence that frustrates any attempt at isolating a single firm’s risk profile also means that when one firm is in need of capital to remain solvent, it’s likely not the only one. The availability of funds through repo loans and other standard instruments is thus prone to feedback loops that can amplify any disturbances larger than some (unknown) magnitude. As a result, I’d argue that the entire model of investment banking that finally vanished this evening was inherently unstable, and that while we will see a return of many of its elements, they will not take on the same form as they did before. Most notably, we should look for more transparency in formerly opaque instruments, possibly including a central clearinghouse for many types of transactions, and a much more conservative approach to debt financing. While I can’t pretend to know what the future regulatory environment will look like, I do think that such changes would be a positive step in reducing the risks posed to the greater economy as a result of disturbances in the financial sector.

From the WSJ:

A Chaotic Sunday Opens Wall Street’s Week
Moral Hazard’s Exit
Leaves Investors
To Sort Out the Mess
By ANNELENA LOBB
September 15, 2008; Page C1

Investors are going to be staring in the face of moral hazard when markets open Monday.

The collapse of Wall Street firm Lehman Brothers Holdings Inc. coupled with a restructuring of insurer American International Group Inc. and a deal by Merrill Lynch & Co. to sell itself to Bank of America could cause a decline, particularly among financial stocks, when markets open.

Despite serious efforts by potential bidders and Lehman, a deal never came together over the weekend, largely because the federal government refused to put up any cash. After backstopping Bear Stearns, Fannie Mae and Freddie Mac, the Treasury and Federal Reserve said no more.

The government’s logic was that if investors were bailed out again, they would expect a bailout every time, and the so-called moral hazard would disappear, making people willing to take massive risks in the belief they would be saved.

No. That is not what ‘moral hazard’ means. Moral hazard is, as Wikipedia so eloquently puts it, “the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.” Thus, in this case, it wasn’t a risk that moral hazard would disappear; it was instead a risk that a bailout would create moral hazard, by insulating investors from the consequences of risks they had taken on, and thus encouraging similar risky behavior in the future.

In response to Tim Haab’s question as to whether gas prices are becoming more volatile… I argue that it’s lower inventories at work:

CNN, on this breathtaking development:

As gas goes up, driving goes down

(CNN) — At a time when gas prices are at an all-time high, Americans have curtailed their driving at a historic rate.

The Department of Transportation said figures from March show the steepest decrease in driving ever recorded.

Tomorrow, a special report: “Fire is hot.”

If anyone remembers the old internet joke theory known as the “Dark Sucker Theory“, the one in which light bulbs do not emit light but instead suck dark, they might be surprised to learn that this piece of silly internet humor is pretty well-aged. In a New York Times article on Daylight Savings Time, a reference to a letter written by Ben Franklin notes an 18th-century jokester’s “insistence that opening the shutters to greet the dawn lets out the darkness rather than bringing in the light.” The article itself reports more evidence that the provision in the generally-awful Energy Policy Act of 2005 that changed the dates for Daylight Savings Time has probably increased overall electricity usage. No surprises there.

The word “genocide” carries with it powerful emotional and political implications. As such, there are always those who will attempt to deny or belittle an actual genocide, or claim as a genocide something that is not.

In the former category, there are those like Ann Coulter, herself a joke, who here makes a poor attempt at one:

Saddam’s barbaric rape rooms, chemical attacks and torture – those, liberals could live with. But now they want us to send troops to Darfur, a country from which no one anticipates terrorism anytime in the next millennium. If you’re looking for a good definition of “no imminent threat,” Darfur is it. The climate change “emergency,” set to start taking effect sometime during the next century, is a more imminent threat to the United States than Darfur.These people can’t even wrap up genocide. We’ve been hearing about this slaughter in Darfur forever – and they still haven’t finished. The aggressors are moving like termites across that country. It’s like genocide by committee. Who’s running this holocaust in Darfur, FEMA?

We would, if it weren’t so ignorant, ignore the fact that Darfur is not a country– it’s a part of Sudan, which, under the rule of the National Islamic Front (which is still in power) harbored Osama bin Laden for five years. Having noted the sheer ignorance of this statement, however, we should point out that though it may not be proceeding as quickly as Coulter would like, the conflict in Darfur has claimed up to 450,000 lives. Is it a genocide?

According to the Convention on the Prevention and Punishment of the Crime of Genocide:

[G]enocide means any of the following acts committed with intent to destroy, in whole or in part, a national, ethnical, racial or religious group, as such:

• (a) Killing members of the group;
• (b) Causing serious bodily or mental harm to members of the group;
• (c) Deliberately inflicting on the group conditions of life calculated to bring about its physical destruction in whole or in part;
• (d) Imposing measures intended to prevent births within the group;
• (e) Forcibly transferring children of the group to another group.

By the definition of the term– absolutely, yes, what is happening in Darfur is genocide.

In the latter category, that of those who wish to make genocide out of other situations that, while tragic, do not qualify, we have examples like the following, from a Washington Post article about violence in Rio:

“For young people, this is a genocide,” said Raquel Willadino, a director of violence-related issues and human rights for the Observatory of Favelas. “And I don’t mean that as a metaphor. It really is a genocide.”

The violence in Rio is certainly devastating– extrapolating the numbers in the article, 9 people are dying every day from violence– over 3,200 a year. It is not, however, the number dead that makes a genocide what it is. It is that the acts are “committed with intent to destroy, in whole or in part, a national, ethnical, racial or religious group, as such”. This doesn’t appear to be the case in Rio, and so claiming it as genocide doesn’t do anything more than cheapen the word.

From CNN.com:

HANOI, Vietnam (AP) — U.S. President George W. Bush said Friday the United States’ unsuccessful war in Vietnam three decades ago offered lessons for the American-led struggle in Iraq.

“We’ll succeed unless we quit,” Bush said shortly after arriving in this one-time war capital.

It’s a little worrisome that the lesson from Vietnam that our President thinks applies best to Iraq is that “We’ll succeed unless we quit.” Honestly, though, it’s far more worrisome that he extracted that lesson from the Vietnam war at all. I wasn’t alive at the time, so I’m not qualified to judge, but I always thought that even to someone who only made a cameo appearance on a National Guard base in Alabama, the war couldn’t have looked like something that we were guaranteed to win (unless we quit).

To me, a more interesting set of lessons from Vietnam to compare to our policies and experience in Iraq would be those offered by Robert McNamara, Nixon’s Secretary of Defense:

1. We misjudged then – and we have since – the geopolitical intentions of our adversaries … and we exaggerated the dangers to the United States of their actions.
2. We viewed the people and leaders of South Vietnam in terms of our own experience … We totally misjudged the political forces within the country.
3. We underestimated the power of nationalism to motivate a people to fight and die for their beliefs and values.
4. Our judgments of friend and foe alike reflected our profound ignorance of the history, culture, and politics of the people in the area, and the personalities and habits of their leaders.
5. We failed then – and have since – to recognize the limitations of modern, high-technology military equipment, forces and doctrine…
6. We failed as well to adapt our military tactics to the task of winning the hearts and minds of people from a totally different culture.
7. We failed to draw Congress and the American people into a full and frank discussion and debate of the pros and cons of a large-scale military involvement … before we initiated the action.
8. After the action got under way and unanticipated events forced us off our planned course … we did not fully explain what was happening and why we were doing what we did.
9. We did not recognize that neither our people nor our leaders are omniscient. Our judgment of what is in another people’s or country’s best interest should be put to the test of open discussion in international forums. We do not have the God-given right to shape every nation in our image or as we choose.
10. We did not hold to the principle that U.S. military action … should be carried out only in conjunction with multinational forces supported fully (and not merely cosmetically) by the international community.
11. We failed to recognize that in international affairs, as in other aspects of life, there may be problems for which there are no immediate solutions … At times, we may have to live with an imperfect, untidy world.

I leave it as an exercise for the reader to decide which of these lessons apply to Iraq.

I grabbed the list from the Wikipedia entry on Errol Morris’s superlative documentary, “The Fog of War”; it’s the list that inspired the movie, but it is not the one that forms the structure of the film, nor is it the one provided as an addendum by McNamara himself.

Violence again in the Democratic Republic of the Congo:

“IT STARTED with burning tyres and rocks thrown by protesters. Then gun battles erupted between rival soldiers using heavy machine guns, mortars and rockets. The fighting at the weekend in Kinshasa shows that peace in Congo is not yet assured. The battle brought the centre of the capital, a city usually bursting with people, to a standstill.” (from The Economist)

The BBC’s coverage is particularly interesting, however, as it dovetails with the observations of a friend of mine. The BBC mentions that an “analyst who wished to remain anonymous told the BBC that there were serious questions about the validity of some ballot papers, especially a large number of votes cast by voters outside their home areas.” Compare this with a blog entry from my friend Sophie, who was working as an election monitor in the DRC:

“Election day security and proceedings were generally good, with the exception of one potentially unstable situation that we were confronted with involving initially about fifty people unable to vote due to being away from their polling centers. We went into the polling station outside which the very loud and obviously angry crowd was gathered and talked to the chief of the centre de vote. He emphasized that he was following the election code and reported that the crowd was threatening to stone them if they continued to be unable to vote, the police being insufficient to control them…

“On the whole the election was peaceful and pretty orderly, but what we saw represents the psychological aftereffects of a war like the Congo’s – a disrespect for the rule of law and a lingering presumption that when push comes to shove, violence can solve problems. So rather than saying “hey, I’m not able to get back to where I’m registered to vote; I’m really mad about that, but it’s the law and I’ll just have to be prepared to vote next time,” the response is “I’m Congolese, I have my voter’s ID card, but I’m not going to be able to get to the place where I can vote, so I’m going to make them allow me to vote.” It’s going to take a long time for enough trust in the justice of the law and the strength of the state to be established to prevent incidents like that. I just hope the Congolese have enough faith and the new Congolese government can produce enough results for them to stick with it.”

The other day, a friend of mine sent me a link to Malcom Gladwell’s most recent article, entitled “The Risk Pool“. I thought it fell short of Gladwell’s usual quality, and sent to my friend the e-mail that I’ve included below the fold. I’m not the first to get around to criticizing this article, though, so if you want to see the back-and-forth:

1. “Worst Malcom Gladwell article ever?”
2. Malcom Gladwell’s first response
3. Gladwell’s second response
4. Jane Galt’s critique
5. Gladwell’s first response to Jane Galt
6. Gladwell’s final comments

Having read through the back-and-forth, I’m a little disappointed in Gladwell. The basic premise of his article– drawing a parallel between the macro-level phenomenon of dependency ratios and the micro-level failures of a few firms– doesn’t hold up, and he seems either to not understand why or not want to admit having written something so bad. To me, the other disputes are a side issue. That, in combination with the contempt he seems to hold for anyone who happens to critique his work through a weblog, takes my opinion of him down a notch. Of course, that’s only going from “huge fan” to “big fan, with a couple reservations”.

If anything, the existence of such a fundamental error in an article written by a talented and intelligent journalist underscores for me the difficulty of writing about economics. Most economists can’t write well, and most journalists, even the smart ones, don’t have enough economic training to be able to write accurately about it. The subject is a minefield, and there are a lot of people who would like to lead a journalist astray– astray in a minefield is a bad place to be. For that matter, a minefield is also a bad place to be drawing inaccurate parallels…

My own thoughts on the piece follow.I think we both love Gladwell for the same reason– he has an amazing ability to pull together related concepts that haven’t been examined together before and use them to shed new light on a narrative. In this case, though, I think he’s fallen into a bit of a trap. There are similarities between the effects of demographic bubbles on national output growth and thus on social welfare obligations and those of firm output growth on pension obligations, but though they’re similar, they’re not at all the same. The causal relationship is really quite different in the two situations…

In the case of national output growth, it’s true by definition that:

Total Nation Output = Average Hourly Output Per Worker (a measure of productivity) * Average Number of Hours Worked * Number of Workers

Productivity tends to growth with time, and there are a number of things we can do to affect productivity levels, but we only have limited control over it. Likewise, it’s difficult to significantly increase the average number of hours worked, particularly as large increases tend to negatively impact average hourly productivity. Thus, in the case of a demographic bubble, the effects of the bubble will also be seen in total national output. There won’t necessarily be a decrease in total output as the bubble workers age and retire, as much of their impact will be swallowed by productivity growth, but output growth will almost certainly slow significantly. In any situation, though, demographics are a constraint on national output. Holding all else equal, fewer workers means less output.

This is, of course, the “problem” with Social Security. Social Security was designed so that the current generation of workers pays for the current generation of retirees. Moreover, it’s indexed to wages, not inflation– so current retirees don’t just receive benefits that are adjusted for changes in the price level, they also receive much of the benefit of increased productivity, as well. This is great for the recipients as long as it stays solvent, but it makes the funding problem a little trickier because we can’t just count on productivity growth making benefits relatively cheap to pay. That’s why Social Security set up a trust fund to cover the demographic bubble– a system similar to one used by pensions, except fully funded (key point). When that awful year 2040 or whatever rolls around and the trust fund is bankrupt, that shouldn’t be a surprise, because all the people who funded it and whose retirement it was helping to support will be dead. No need for the trust fund, as it got us past the bubble. So long as the population grows on average over any given 80-year span (so far not a problem), bubbles can be dealt with easily.

Gladwell doesn’t address Social Security except to offer it as a solution to the pension situation, though, and instead relates national output and demographics to issues with private company pensions through the idea of dependency ratios. The problem, of course, is that dependency ratios aren’t particularly relevant to private firms. In the following passage, he makes his critical mistake:

“Bethlehem, just shy of its hundredth birthday, declared bankruptcy. It had twelve thousand active employees and ninety thousand retirees and their spouses drawing benefits. It had reached what might be a record-setting dependency ratio of 7.5 pensioners for every worker.

“What happened to Bethlehem, of course, is what happened throughout American industry in the postwar period. Technology led to great advances in productivity, so that when the bulge of workers hired in the middle of the century retired and began drawing pensions, there was no one replacing them in the workforce. General Motors today makes more cars and trucks than it did in the early nineteen-sixties, but it does so with about a third of the employees. In 1962, G.M. had four hundred and sixty-four thousand U.S. employees and was paying benefits to forty thousand retirees and their spouses, for a dependency ratio of one pensioner to 11.6 employees. Last year, it had a hundred and forty-one thousand workers and paid benefits to four hundred and fifty-three thousand retirees, for a dependency ratio of 3.2 to 1.”

Pulling this passage out, the error should be obvious: the retirement of former employees isn’t paid for by the number of current workers, it’s paid for by their output. If workers today are three times as productive as workers 50 years ago, and the demand for cars is the same, one-third the number of workers are necessary to produce the same level of output– and pay for the same level of retirement [note: I am ignoring elasticity and capital costs, etc]. Adding more workers wouldn’t increase output, it would only add costs and reduce the company’s ability to pay pension costs. Thus, with the case of private firms, national demographics is not a relevant concern.

If Gladwell wants to argue that demographics were a relevant concern, it would be possible to do so, because there’s a particular signature to that sort of problem. Namely, we’d see employers bidding up wages in an effort to attract workers from the shrinking labor pool. However, it would be incumbent upon him to explain why it affected General Motors and Bethlehem Steel, but somehow didn’t have any impact on their successful competitors.

The only reason for having a paragraph break right here is that I wanted to give you the opportunity to say in your head, “Hey, wait a minute, but all the American auto and steel manufacturers are having these problems. Doesn’t that undermine your argument?” This would give me the chance to throw out a laugh that was at once haughty and carefree and say, “But they’re losing to Japanese companies, and Japan is actually suffering the effects of a more pronounced demographic ‘bubble’ than the United States.” That’s right– Japan’s bubble is bigger.

So, oddly enough, Gladwell identifies the problem with private pensions as being an issue of demographics, when it is not, and has prescribed as a solution more broadly-based social welfare systems, which are more vulnerable to the problem that he incorrectly diagnoses. The truly strange part is that his essay is littered with the evidence necessary to draw the correct conclusions:

“But Big Steel didn’t get bigger. It got smaller. Imports began to take a larger and larger share of the American steel market. The growing use of aluminum, concrete, and plastic cut deeply into the demand for steel. And the steelmaking process changed. Instead of laboriously making steel from scratch, with coke and iron ore, factories increasingly just melted down scrap metal. The open-hearth furnace was replaced with the basic oxygen furnace, which could make the same amount of steel in about a tenth of the time. Steelmakers switched to continuous casting, which meant that you skipped the ingot phase altogether and poured your steel products directly out of the furnace.”

The problem with the US steel industry wasn’t an issue of demographics, it was the simple fact that it had massive fixed costs in the form of investments in outdated technology that became a liability when the then-infant Japanese steel industry began competing using newer, more flexible methods of production and business methods to match. The same thing has occurred in the US auto industry, which, as a byproduct of the interplay between technology and labor contracts, has so far been unable to create flexible methods of production to respond to shifts in consumer demand.

Likewise, the problem with pensions isn’t a complicated issue of dependency ratios and Debsian Socialists. The problem is twofold: one, companies do fold, and that risk isn’t appropriately addressed by most pension systems; two, for pensions to work over the long run, they have to be fully funded.

Just my thoughts.