March 16, 2009

Clever Outrage

"The AIG Bonuses are Outrageous" seems to be the message of the week from the White House, Fed, Punditry, and Congress. The coordinated rage at AIG about $170m in bonuses seems almost engineered - actually, maybe it is engineered.

The concerted political messaging against the AIG bonuses feels like clever misdirection to me. Washington politicos are trying to control the headlines this week, to make sure public anger is channeled towards AIG executives instead of toward European bankers.

If they did not foment domestic rage, we would probably be facing a replay of Smoot-Hawley.

Imagine if the week's headlines said: "America Secretly Bails out Europe." Americans are not feeling charitable enough to save an all-American name like GM. How would they respond to a bailout of such unfamiliar (and snooty-sounding) institutions as Société Générale, Deutsche Bank, BNP Paribas, Crédit Agricole, Barclays, Dresdner Kleinwort, UBS, DZ Bank, Rabobank, KFW, Banco Santander, Danske, Royal Bank of Scotland, and HSBC?

For many months, Treasury has been trying to avoid revealing the fact that much of the American-taxpayer-funded bailout is going to save the largest banks in Paris, Frankfurt, and London. If the populist rage turned against our trading partners, the march towards protectionism - and a complete replay of the Great Depression - might be unstoppable.

Now that keeping a lid on the secret of the American-funded European bailout has proven politically untenable - this weekend AIG is finally revealing that a large portion of its bailout is going overseas - our leaders have identified a different object of popular rage to take our eye off the ball.

Our anger is being purposefully directed at 400 bonus recipients at AIG. Even though the amount is only $170m - a tiny tiny fraction of American bailout dollars - it is something we should and safely can get angry about. And something to take our mind off all the real amounts of money going overseas.

The Great Depression was not caused by withholding some bonuses from some executives.

Posted by David at 06:50 AM | Comments (3)

March 19, 2009

Helicopters Arrive Under Cover Of AIG Testimony

The Administration is running the economic bailout like a war.

While the Congressional testimony of AIG CEO Liddy dominated business news with wall-to-wall media coverage from about 11 am to 7 pm, Bernanke launched his first airstrike on the financial collapse at 2:15 pm yesterday.

The enemy forces? Fear, distrust, and public rage against the financial system. The objective? Quantitative easing: print trillions of dollars - which bankers will have to distribute. The noisy battle against a few million dollars of AIG bonuses has successfully diverted the force of negative public opinion away from the decisive battle: the helicopter drop of a colossal pile of U.S. dollar cash, about 8% of GDP. The torrent of money will be funneled through Fannie Mae and Freddie Mac, and purchases on the long-term treasury market. The media circus around AIG is shielding this inflationary tactic against the risk of public rage.

Last time the Fed has bought back its own treasuries in a big way like this was apparently during World War II.

This week will be the week that history says that Obama, Geitner and Bernanke stealthily launched the decisive battle against the second Great Depression. Obama is proving to be a master at messaging. This week he has taught us that you don't need to keep a secret to move a trillion dollars quietly.

WSJ article here; NYT article here.

Nate Silver has a nice graph showing the spread of the AIG story, starting with a Washington Post article the night before the AIG counterparty press release. I disagree with Nate that the meme spread organically or that it was driven by bloggers: Geithner, Frank, and Summers simultaneously called AIG "outrageous" on the Sunday talkshow circuit, and strikingly Bernanke and Obama - not known to respond to bloggers - also went out of their way to draw attention to AIG that day. Meanwhile the real action was about to be launched at the Fed, without a single media comment from that same group.

Some have noted that the Bernanke move is only likely to succeed if the world is looking the other way.

It is information warfare, executed with military precision.

Posted by David at 07:40 AM | Comments (1)

March 22, 2009

How Big Is It?

Bernanke announced repurchases of $1.2T of various forms of debt with U.S. cash last week, financed by the printing of money. The move was noted in the press in passing, as a side note underneath the AIG executive bonus scandal.

The world's relative silence on the huge infusion of cash is riveting. The lack of news on the buyback represents a remarkable success by the Fed: after announcing a massive quantitative dilution of U.S. dollars, the dollar has lost barely more than a couple pennies of value.

How can a couple points of devaluation be considered a success? Because the trillion-dollar repurchase is an experimental economic shock-and-awe, a daring and unprecedented maneuver that carries the risk of sparking a fundamental crisis in confidence.

How big is it?

Consider: at 1.2 trillion dollars, the Fed move last Thursday was 60% larger than the Recovery and Reinvestment Act that took Congress months of debate and wrangling to assemble - and the Fed acted without a single whisper of legislative debate.

The Fed move is something that could not have been done through a trade move - at 1.2 trillion dollars, the infusion of cash is about equal to the total sum of all U.S. exports of goods, and 50% larger than our massive trade deficit.

The Fed move to print dollars counters China's history of slurping up U.S. dollar cash to keep its RMB low - the 1.2 trillion dollar infusion equals about 63% of total Chinese foreign reserves, counterbalancing approximately three years of foreign reserve accumulation by the Chinese. Will we be buying our treasuries back directly from the Chinese?

The U.S. GDP is about $14 trillion, so if each of the new dollars get spent once this year, they will contribute to 8% of GDP. This huge amount would be more than large enough to counterbalance the 6% GDP shrinkage that is currently being measured by economists.

The U.S. Money supply - M2 - is about 8 trillion dollars. So in one move, Bernanke has expanded the money supply by 15%.

This week Bernanke has done a bit of monetary ballet, showing us how to issue 15% more paper while attracting little more than a below-the-fold eyeblink in the news.

Posted by David at 09:40 AM | Comments (3)

March 24, 2009

What is a Stress Test?

Time to go to school to understand the news. Reading of the day: "Public-Private Investment Program Fact Sheet" from the Treasury explains the structure of the program.

"Bank Capital and the Stress Tests" and "The Public‐Private Investment Program" are papers from the Brookings Institute that give a crash-course on the modern banking system and how the Geithner plan aims to save it.

Posted by David at 07:05 AM | Comments (1)

Obama to the World: Join Us

Obama's makes a pitch for global cooperation in an op-ed that runs in 31 papers around the world, from the LA Times to the South China Morning Post. The message: keep trade flowing - America will do its part. All the guns are out to prevent a replay of the beggar-thy-neighbor protectionism that shut down trade in the 1930's and prolonged the Great Depression.

Posted by David at 09:56 AM | Comments (0)

March 27, 2009

A Cultural Problem

Today Greenspan writes an op-ed in the Financial Times that recognizes that Markowitz has failed us. I also lay the blame at Markowitz's feet. But Greenspan's conclusion that we just need to "increase the financial cushion" misses the problem.

The Problem is Cultural, Not Numerical

The problem is not with regulatory boundaries, but of culture. It is a problem with how we educate our financiers and economists.

Wall Street must get away from the idea that it can always put itself on the winning side. Wall Street must be willing to make real bets and take real risks. It needs to end the flawed and useless concept that risks are unsystematic and unknowable and that a bank's primary mission is to hedge them away.

Wall Street has been running their businesses like the Las Vegas casinos do. A casino knows that there are no good bets or bad bets - the only way to make money is to obey their mechanical models of risk, and blur together millions of gambler's plays. The only business plan in the casino world is to repackage and bundle forever bigger piles of randomness, and to resell it at a markup. There is no insight, no skill - the Blackjack dealer plays by mechanical rules. It is a volume business.

Blame Sharpe Too

The meme that "you can't beat the market" on Wall Street treats ordinary investments like pure gambling.

That idea, which has its roots in Markowitz's Nobel-winning work, is delivered to us ordinary investors using wise words like "indexing", "diversification", and "efficient markets." A generation of sages like William Sharpe have preached that it is futile to invest according to fundamentals, because we can never be smarter than the market in the long run. The best we can do, says this viral meme, is measure risk and diversify it away.

While that may be sound advice for the casual investor, the crime - and the crash - occurs when all participants in the market believe in this Markowitz thread. Once everybody believes you can't beat the market, the market becomes stupid. That is what happened to the market for mortgage CDOs.

Diversification is a disease of intellectual laziness.

Wall Street has been castrated

In a sense, Wall Street has lost its ego: the banks have lost the idea that they can identify sound businesses and genius ideas better than their peers.

Over the decades Wall Street has outsourced on-the-ground gruntwork to credit agencies, mortgage brokers, and VC funds. To the extent that there might be some inaccuracies in their suppliers of numerical data, they dive into their statistical textbooks and hedge it away. Do you get respect on Wall Street by actually talking to the people that you invest in? Pshaw, says the culture of 2008: that is such a small-money idea. That would be like trying to talk with a roulette table.

Wall Street is no longer a business about insight and assessment: it has become a stupid volume business, like Las Vegas.

Instead of doing actual banking, Wall Street has enslaved itself to Markowitz's theory that its role is to bundle huge numbers of bets and repackage risk.

Alan, the real problem is that Wall Street's culture is in tatters.

The world needs a post-Markowitz framework for finance.

Posted by David at 11:30 AM | Comments (0)

March 29, 2009

How To Nationalize

Krugman has been opining (with despair!) that Geithner doesn't have the spine to close the big American banks, and former IMF chief economist Simon Johnson believes that America simply lacks the necessary political structure to nationalize.

They are both wrong - Geithner has both the guts and power to nationalize our big banks. But even so, he cannot show his cards. To understand Geithner, look back a decade ago when he coordinated the international response to the Asian financial meltdown. Then, as now, decades of overaggressive banking ended suddenly in an asset value crash and a complete collapse of commerce - as nicely analyzed by the pre-Laureate Krugman at the time.

In 1997, the difficult part wasn't understanding the problem, but administering the medicine. In the face of the collapse of a constellation of Asian currencies, gradual, piecemeal solutions had failed. The right solution was to raise interest rates (up to 60%!) and to close all but the strongest banks. But these actions could only be done fairly through coordinated international action, which was done by bribing the nations with IMF capital. The Geithner-mediated IMF actions resulted in real pain for Asian bankers, in the end closing 14 out of 30 Korean merchant banks and 56 out of 91 Thai financial companies.

To my eyes Geithner does know how to close banks. And he has the power - that is exactly why he was nominated by Obama. But here is the key. You cannot just close banks one at a time, because that will cause everybody to worry that their bank is next to go - the whole economy would collapse from fear. And you cannot just break up banks based on current market prices: that would just reward the best liars. You need get everybody to beg for salvation on equal terms, pry open their balance sheets and price them fairly, and then pick losers all at once. You need to do it in a way that seems fair and smart. And since this is a global crisis, it is going to take a little bit of time.

Pretend you are Geithner. You have two jobs: one, you need to put domestic banks in line for closures, and two, you need to coordinate international action. How do you do it?

Domestically, you would subject the banks to "asinine" stress tests to force their books open, and you would set up public-private partnership "handouts" to attract vultures to determine a fair value for hard-to-price assets.

Internationally, you would negotiate deals with the biggest economies to work out how to decide which banks need to be shuttered in Hungary, Latvia, Romania - and Britain and Germany and France and Hong Kong and Japan. You would bribe nations to cooperative action by supplying Federal Reserve capital and put a gun to their head by propping up AIG just short of the precipice. You would seal the deal at an international forum like next week's G-20.

Then some Friday evening, probably around the end of April, you would wait for Asian markets to close and then announce a bank holiday. Over the following days, you would roll out complex and comprehensive global bank closures. Carefully justified valuations for the pieces of shuttered banks would be used to chop them up and resell them to private investors. Then after the deed was done, the markets would reopen and the world would know that the crisis was over.

It's the World Series of economics, and we're barely halfway through the game. But we do have an all-star team.

Posted by David at 05:27 PM | Comments (1)