Financial Crisis-- Who gets the blame?

Ever since the beginning of 2009, the focus of most inquiry into the financial crisis has been on laying blame.  While most mainstream thought has focused on a range of factors, from deregulation/lax enforcement of existing regulations, to too much faith in the power of securitization to mitigate risk, to overly loose monetary policy on the part of Greenspan's Fed, to over-reliance on unrealistic risk models that led financial institutions to take too many risks, the political far right resorted to its go-to explanation: the government did it.  Now, in this case, finding a government agency to blame was especially hard, so they figured they would blame a financial crisis that started building in the early 2000's (though the seeds were probably planted in the late 70's) on a piece of legislation from 1977 (the Community Reinvestment Act) that encouraged banks to lend to minorities and the poor, as well as on a couple of public companies with implicit government guarantees on their debt in Fannie Mae and Freddie Mac.

Now, a paper published a few weeks ago by a couple of economists at the Fed more or less debunks that narrative, though there isn't enough data to make a conclusive statement.  Without getting into the technical details, what the study essentially does is an apples-to-apples comparison of loans conforming to the CRE guidelines, as well as the GSE's underwriting standards, and comparing their performance to loans to similar loans that would have not qualified.  The result (predictably) was that GSE and CRE-qualifying loans performed better than did non-qualifying loans.  The authors also run regressions to determine whether the existence of these guidelines contributed notably to the appreciation of home prices between 2001 and 2008 in a way that they would not have in the absence of the regulations.  Again, the result is pretty clear: the "government did it" narrative is a conclusion looking for evidence, and that evidence is scant.  

Hedge Funds In Trouble

The Financial Times had a nice piece yesterday about hedge funds and bond funds bleeding money during this slump.  The article focuses specifically on John Paulson (who made $4 billion in the mortgage crash, but is down an astounding 40 percent just this year) and the bond fund PIMCO (which dumped its Treasury portfolio, betting that bond prices would tank and yields would spike once QE2 petered out... and lost a fortune on that bet).  But those are far from the only ones who are struggling.  Philip Falcone's Harbinger is on its third crummy year in a row (after hitting it big shorting subprime), and while Steven Cohen's SAC is doing pretty well, and even David Einhorn's Greenlight is having a bad year.

Now, in part these problems are predictable-- the markets haven't done so hot this year, which is when investment funds tend to struggle most: they thrive on at least somewhat efficient markets, and they do well when they can bet on past patterns repeating themselves.  Any time there's a slump, a high-profile few win big (in this past slump, it was Paulson, Soros and Einhorn; in 1987's stock crash, it was Julian Robertson's Tiger and Tudor, and when the British left the European Exchange Rate Mechanism, Soros made a killing).  I think the problems of a lot of these high-profile funds reflect different factors in each case: PIMCO used to be really good on macro... but in retrospect a lot of that seems to be on the shoulders of Paul McCulley, a managing director there who really understood the bond market in a way that I think even Bill Gross probably doesn't.  Paulson was really a schlub who won big on a single bet; it was a huge bet, but he's shown nothing to prove that he can consistently make money, or even outperform the market, in a variety of economic environments.

For me, what these problems show is that finding a really good money manager is incredibly hard.  Sure, in a given year, Greenlight might do great, or Paulson might do great, or SAC or D.E. Shaw might have a huge year.  But the real test of a great manager is one who can outperform the market year over year.  And, in all honesty, I don't think that more than a handful of the tens of thousands of funds can actually do that.  Sure, Warren Buffett will still give you great returns if you can get money into Berkshire Hathaway... but I think about 95% of that is that Buffett's success feeds on itself at this point-- he gets terms better than anyone else because getting an investment from him inspires confidence by itself; put me in charge of Berkshire, and the terms on these investments instantly get worse, and money-making opportunities disappear (there isn't a single money manager in the world who was going to get the terms Buffett got when he put $5 billion into Goldman in 2008; it was essentially free money for him).  But otherwise, I think the super-charged hedge funds of the last few decades are a relic.  For instance, through the 1970s (when the economy was unusually volatile), Soros returned over 30% in his WORST year.  He lost some money in '81, and in the slump of '87, and some more in the tech bust and in his Russia investments (which I think reflected his desire to be viewed as a "messiah" more than any real faith in Russia's markets in the late '90s.  But it's almost impossible to imagine a manager returning over 30% year over year for a decade straight, even in boom times, let alone volatile ones.

So I think the lesson to take is to be wary-- rich people chasing hedge funds who made big returns in the past is a pretty certain recipe for future disappointment.

New Music

After a summer in which nothing good came out for most of June or July, 3 new, high profile albums have come out in August.  First, the Kanye/Jay-Z joint album, Watch the Throne; then came The Game's album, The R.E.D. Album.  Today, I downloaded Tha Carter IV from Lil Wayne.  Since I haven't had class, I've spent the last few weeks listening through them enough to get a good sense.  So I guess I'll cram my review of all three into one post.

The first to come out was Watch the Throne.  I had really high expectations for this album.  Every time Kanye and Jay have collaborated in the past, the result has been pretty explosive.  On Kanye's last album, "So Appalled" was a great track.  "Run This Town" was memorable.  Kanye produced "Heart of the City" from The Blueprint.  So, judging by that bar, the album was a disappointment in the sense that not EVERY track was as great as their previous collaborations.  But, objectively, it was still a pretty good album.  "No Church in the Wild" with Frank Ocean is a really good track-- Kanye's verse in it is unreal.  Jay comes back and does great things in "Murder to Excellence".  And, while the boasting on "Otis" isn't necessarily original, it showcases both Jay and Kanye at their best.  The rest of the tracks aren't necessarily bad, but there's nothing else that's memorable.  And, given that I expected half the album to be memorable, I'm a bit disappointed.  But, still, objectively, this is a B+ album.

Next was The R.E.D. Album.  Now, I'm not a huge Game fan.  His lyrics are pretty simplistic.  His flow is pretty solid, though, and this album is about as good as he gets.  "The City" starts the album off well-- a dark beat with a heavy bass highlights Game's flow.  "Drug Test" is also solid-- I'm not a big fan of the flow; it's quicker than is ideal for Game, and Dre is a bit out of place on the track: his flow is heavy and he doesn't do well with quick beats either, but it's still a pretty good track.  "Martians vs. Goblins" with Lil Wayne is pretty good.  The beat is more in line with what both Wayne and Game excel in.  I think the best part, though, might be a new artist named Tyler, the Creator, who comes in and lays down an absurd verse that reminds me of what Bizarre used to do for D-12: hate on everyone and drop occasionally amusing punch lines.  But my favorite track on the album is "Red Nation", which samples the old stadium track "Zombie Nation" for its beat.  The beat is ideal for Game's flow, covering up the silly lyrics.  And the Wayne hook is great.  I wish Game and Wayne would put out an album together-- they tend to do real well when they collaborate.  The two collabs on this album are great, and they're just as good together in "My Life" from Game's last album, LAX.  Overall, I think I give this one a B: solid, but a lot of filler at the back.  But then I can't imagine giving a Game album better than a B, so I guess I like it.

Tha Carter IV is an especially weird album.  It's the first solo album Lil Wayne's released since he spent the better part of a year in jail on weapons charges.  Before he got locked up, he was putting out a top-notch mixtape every 3-4 months (No Ceilings and Dedication 3 were my personal favorites); plus, one of the better hip-hop albums of all time in Tha Carter III.  Literally half of the 16 tracks were top-notch.  So I didn't really know what to expect from this one: since getting out of jail, Wayne's mostly done collaboration on others' albums, and he's done pretty well; his appearance on Eminem's last album in "No Love" was great.  When I started this album, I thought this would be a historically great album.  The very first track, "Blunt Blowin", is, for my money, one of Wayne's best ever.  The beat is incredible, Wayne is lyrically on top of his game, and he's really on his game.  But, as I listened more, I felt like this was an album recorded in one sitting in which Wayne smoked a blunt, and waited as his high kicked in.  The crisp delivery disappeared a few songs in, and by the time I got to "How to Love" it felt like Wayne was blazed out of his mind, and also half asleep.  He recovered a bit and put together a couple of solid tracks in "President Carter" and "It's Good", but I still don't think it's anywhere near his best effort.  While getting high probably helps him write his lyrics, I kind of wish he'd put down the weed and the codeine syrup when he goes to record, since he sounds like he's half-asleep on most of his tracks on this album.  While this is still a solid album, all things told, it definitely doesn't live up to the early promise.  For me, this is a B/B- album.

Economic Thoughts for the Week

There are two topics I feel like should be addressed coming out of the news.  One is a piece of news and the other is an interesting opinion piece.

I'll start with the news: President Obama nominated Alan Krueger to head his Council of Economic Advisers , replacing Austan Goolsbee at the helm.  Krueger's a good appointment, given the constraints-- he's a well-known labor economist from Princeton who's more or less a mainstream, middle of the road thinker when it comes to macro.  Which, of course, means Republicans will denounce him as Karl Marx's bastard son (even as George W. Bush and Reagan's CEA chairmen, Greg Mankiw, and Marty Feldstein, praised him).  Even though I like Krueger, the politics dictate that not much will be done on the jobs front-- we might get some tax incentives to create jobs, but we're not going to get the kind of massive action we need to get the economy on a sustainable recovery track.

The second interesting article comes from Bush II's speechwriter, David Frum, suggesting the three big mistakes Obama made.  As has usually been the case with Frum lately, his arguments are pretty spot-on in substance, but he's pretty awful at apportioning blame.  So, in order, the mistakes Frum cited.  First, he suggests that Obama left writing the stimulus to Congressional Democrats, and got an ineffective stimulus.  I'd argue that, yes, Obama can be blamed for the stimulus, but not because it was Democrats who wrote it, but because what he suggested was too small and was designed to be able to win Republican votes.  As mistaken parts of the stimulus, Frum points out $15 billion for Pell grants, $9 billion for rural and community development, and a $20 billion renewable energy tax credit.  All of which are pretty much direct stimulus, aside from maybe the Pell grants, which allow the extremely poor to go to college.  That's not really direct stimulus, but it's certainly not a waste of money, as it's an investment in the future.  Then he attacked aid to state and local governments, which is probably the most direct job-saving there is.  States (stupidly) can't borrow to meet budget shortfalls from bad economic times, so without federal funds, the depressed economy would have meant millions of teachers and firefighters would have had to be fired in response to the recession.  Then, the last thing Frum argues is that the tax cuts from the stimulus were ineffective.  Well, yeah.  But it's not Congressional Democrats who are desperate for taxes, under all circumstances (Nonsense from the Fox News types aside, we collected under 15% of GDP in taxes the last two years, despite GDP being depressed.  That's the least we've collected at the federal level since 1949 and 1950, before Medicare or Medicaid existed).  So, while it can be argued that Obama was insufficiently proactive with the stimulus, the problem isn't what Frum listed, but the insufficient size of the stimulus, and the compromises made in it to appease Republicans.

Second, Frum argues that Obama didn't "mobilize the Fed to support his fiscal stimulus" or get his nominees confirmed to the Fed board.  Which is just silly.  The Fed is an independent agency.  And Obama nominated very, very qualified people to the Fed board, most notably MIT economist Peter Diamond.  But confirming Peter Diamond isn't Obama's job, it's Congress's.  I suppose he could have recess-appointed Diamond, and you can fault him for not doing that, but Frum essentially acknowledges that Republicans are nuts for obstructing monetary stimulus and refusing to appoint extremely qualified people to the Fed board... then faults Obama for somehow not forcing a party that considers him Hitler reincarnated to confirm those nominees.  Again, on substance, Frum is right, but choosing this as a "big mistake" on OBAMA'S part is kind of bizarre...

Third, Frum argues that Obama planned his presidency around the best-case scenario.  In that regard, he's spot on.  Obama's habitually bet on outcomes that were unlikely, and assumed that the best would happen instead of preparing for the worst.  His stimulus was too small, and, crucially, rather than acknowledging that it was too small at the time, Obama pretended that it was just the right size.  In essence, instead of doing the maximum and hoping that it was too much, he did the minimum and didn't prepare for scenarios in which that would be insufficient.  In that regard, Frum captures the biggest habitual problem of Obama's presidency.

More Gold

I've written about what a terrible idea the gold standard is in the past.  Today, I was reminded of a particularly good distillation of why the mystical power of gold is mistaken by Keynes.

The argument Keynes made was that a depressed economy could be stimulated if the central bank or Treasury were to bury bank notes far underground in designated areas around the country.  They would then sell the right to excavate those bank notes to the private sector.  The private sector would then put unemployed people to work digging for those bank notes.  Given that there's no reason those bank notes won't retain value, that's an expansionary exercise.  And the private sector would certainly do it, especially at times like this, simply because the demand for safe assets like bank notes is so much greater right now than the demand for consumer goods (as reflected by the super-low interest rates on Treasuries.

Now, is this a productive use of government resources? Of course not.  You could do qualitatively the same thing by hiring those same private sector companies to build bridges or rail networks or to create wireless internet networks in big cities.  But government spending is disfavored by the powers-that-be.

Before you go out and dismiss this as a stupid idea, as Keynes notes, digging up buried bank notes is essentially what the gold mining industry is.  We devote a whole lot of resources to digging up ore, extracting shiny yellow metal from it, and melting the shiny yellow metal and sending it to sit in big bank vaults in the Swiss Alps and under the New York Fed in downtown Manhattan.  But Ron Paul would tell you that we've valued gold for a long time.  And it's fungible.  And there's a limited amount of it.  Which is all well, good, and irrelevant.

Conan the Barbarian: G.O.A.T.

I never thought I could ever like a movie better than I liked the original "Conan the Barbarian".  That movie had everything.  It had Arnold Schwarzenegger being awesome with a wig on.

It had James Earl Jones with great hair fighting Arnold.

And when Arnold's lover dies, she begs him to let her breathe her last breath into his mouth.  Which would be bizarre if it weren't hilarious.

So I came in thinking that this new Conan didn't have any chance to match the old one.  I was wrong.

The first thing I noticed in the first scene of the movie was what an interesting group Conan's tribe is.  They're having some kind of war, and Ron Perlman (who's apparently the Rabbi/Chief/President of their club) is walking around stabbing everyone with his sword.  But his wife is standing in the middle of the village, wearing war gear... and obviously about 14 months pregnant.  Shockingly, she's dying not from being stabbed by someone who's 1) male and 2) not carrying a fetus, but is dying of pregnant (yeah, apparently "pregnant" was a common cause of death in wherever Conan was from).  So Ron Perlman waddled over, cut the kid out of her womb, and asked her what she wanted to name him.  In what must have been a delirious fit, she decided her barbarian-child would be named "Conan".  Then she died.  I'm guessing her second choice name was "Letterman".

So then we learn a little bit about the village.  Ron Perlman, by virtue of being named Ron Perlman, is obviously a very Jewish barbarian.  Conan, by virtue of not being able to talk properly (he mostly made lots of grunting noises and sneered a lot) and having a rather dark complexion, is obviously a very not Jewish barbarian.  Which invites the obvious conclusion that Conan's barbarian-warrior mother was sheathing more swords than she let on, but that's an issue best left for another day.  In this village, the movie establishes that everyone does one of three things: forge swords, race around the mountain, and worship the hawk.  Possibly all the above, but definitely not more than 2 at the same time.

The next thing the movie establishes is that, for the most part, the village sucks at all three.  Somehow, Colonel Quaritch (Noah Lang's dad) from Avatar rolls up, except this time instead of an Army haircut and a Mech Warrior, he brings Freddy Krueger.  Except she's a woman, so I guess it's Freda Krueger... Either way, they proceed to beat up on the village, jack their swords, and pour hot steel all over Ron Perlman.  Which I'm 98% sure is a hate crime, so you know they'll get theirs in the end.  But for whatever reason, Quaritch decides he likes Conan.  Probably because he's got a fat friend, and Conan cuts the fat friend's nose off.  Quaritch knows cutting his fat friend's nose off is hilarious, so he lets Conan of the hook and doesn't kill him.  But at this point, Conan doesn't have a Dad, and everyone else in the village is dead, so he's gotta figure out what to do with himself.

Needless to say, like any orphaned barbarian, Conan gets a full-time job.  From what I could tell, this job consisted of rolling large rocks down hills for the purpose of breaking topless women out of cages in which they were enslaved.  They then proceeded to drink beer and arm wrestle while ignoring the topless women completely.  So for awhile, Conan is having a great time with his life of freeing naked women and getting wasted.  But then his buddy with no nose showed up, and things got real.  And by that I mean Conan decided being MLK of topless women wasn't for him anymore.  So he went looking for Quaritch.

Now, at this point, a bunch of stuff happened, but the basic point is that Quaritch was after a particular girl, who for various reasons that aren't really clear was hanging out in a monastery with a bunch of other pretty girls and an old man who kind of looked like Raiden from Mortal Kombat.

But subtlety isn't Quaritch's style, so instead of rolling up and grabbing his woman from the monastery, he ran over the wall with his super-Jeep.  Oops.  So of course she ran away and found Conan.  Actually "found" Conan is kinda strong... What really happened was Conan told her she wasn't allowed to talk or have opinions because she was a woman.  Apparently, not keeping topless woman caged made Conan Susan B. Anthony in the barbarian world, but allowing them to talk was still preposterous.  Needless to say, she doesn't appreciate Conan's misogyny and lets him know about it vocally.  Just kidding-- he stuffs a cloth in her mouth, which leads her to fall in love with Conan and sleep with him.  That decision also forced her to forfeit her "Pure Blood" title.  But that's neither here nor there.  Instead of making Conan get her breakfast after giving it up to him, she went to pick mushrooms.  And got kidnapped by Freda Krueger.  Whoops.

The rest of the movie primarily involves Conan bailing his woman out of jail and killing Quaritch.  Needless to say, it's awesome.  At this point, I'm not actually sure what the next movie I'm going to see is, but when I do, I'll be sure to write another review.  And it'll be just as unproductive and useless as this one was.

Mata to Chelsea: My Take

Chelsea officially added Valencia winger Juan Mata today, strengthening the squad further in the run-up to the season.  Really, this is the first buy that will actually help the squad immediately-- the keeper Thibaut Courtois from Genk is one for the future (and was loaned to Atletico Madrid right away); Oriol Romeu couldn't break into Barca's squad, so he'll have trouble unseating Chelsea's central midfield veterans, and Romelu Lukaku is probably the fifth choice at striker right now, and is still only 18.

Mata, on the other hand, slots in instantly.  He's still young (23), and since breaking into Valencia's squad four seasons ago, has scored between 8 and 11 goals every year, and had double-digit assists twice in three years.  For the 4-3-3, he's just what the squad needs.  Now here's the problem.  Right now, the team has, by my count, 8 guys who can play in the front 3 slots: Drogba, Torres, Anelka, Sturridge, Malouda, Kalou, Lukaku, and now Mata.  Of those, FIVE are ideally central forwards (all but Malouda, Kalou and Mata), and three (Drogba, Torres, and Lukaku) can't really play out wide.  So by my reckoning, this means one of Malouda, Sturridge or Kalou will be starting wide left, one of Torres, Drogba or Lukaku will be starting centrally, and one of Mata, Anelka, and Kalou again will be starting wide right.  But Drogba is still probably the most effective central striker in the squad, and Torres cost 50 million pounds, so he'll be in the lineup most games too.  That leaves a whole bunch of bodies for only a few slots.  And there's still no creativity in midfield.

I think the next move here is clear-- trim some fat by dumping Anelka, Kalou and Alex (Ivanovic can slide over to RB, so he's cover at two different spots).  Then use that money in part to finance a deal for Luka Modric.  Now all of a sudden, you've got a pretty formidable lineup:

Cech; Cole, Terry, Luiz (or Ivanovic), Ivanovic (or Bosingwa or Luiz); Ramires, Lampard, Modric; Malouda (or Sturridge), Torres (or Drogba), Mata.  Then you've got a bench of Hilario,  Bosingwa, Mikel, Essien McEachran, Sturridge, and Drogba.  Of course, this means leaving Benayoun, Lukaku and Gael Kakuta out of most squads, but I think this should probably be Drogba's last year in the squad (and maybe Malouda and even Lampard's too), so you can plug them in next year and hopefully not miss much.

But I think Chelsea are a creative mid from having easily the best squad in the Premiership; and I think Modric is that creative mid.

Jobs!

Apparently, Obama is set to start talking about jobs now that the debt ceiling fiasco is over.  My first reaction is that it's about time.  Jobs are definitely the most pressing economic issue the country faces.  Deficits right now are a made-up problem.  There's a long-run health care cost problem, and a short-run growth problem.  Logic and reason say we should address the short-run growth problem, and deal with the long-run health care cost problem later.  But politics says we ignore the short-run growth problem and... pass a deficit-reduction plan that doesn't restore growth or fix the deficit.  The worst part is it doesn't have to be this way: most Americans' primary concern is (rightly) jobs, and it's what the political system should be dealing with.

This article provides two competing solutions, one of which makes sense, the other of which doesn't.  The correct suggestion is that the government subsidize private-sector jobs.  This has two positive effects.  First, it gets long-term unemployed workers back to work, which keeps their skills from eroding and thereby improves their long-term productivity.  Second, it is a backdoor way to get demand into the economy-- if the government pays workers' wages, those wages will be spent, which stimulates demand and encourages other firms to hire.  The obvious alternate demand-side policy option is for the government to hire workers directly. There are benefits and drawbacks to the subsidy approach in this regard.  The benefit is that, by getting workers into private sector jobs, it better prepares those workers for the kinds of jobs that they will be doing when the economy returns to something resembling full employment (whenever that might be).  The biggest drawback, though, is that you're left with the same chicken-and-egg problem as you have with tax cuts: sure, hiring workers is cheaper, but hiring workers means expanding, and if consumers aren't buying products, there's no market to expand into.  So you'll be making it easier to hire... but companies don't have any reason to hire anyway because the demand isn't there.  So the effects are less direct than if the government hires workers directly and puts them to work.

But this option is still superior to the alternative, which is government-sponsored job training.  This approach is pretty nonsensical, given the nature of the issue.  Does improving workers' skill make them more attractive to hire? Sure.  But the training does absolutely nothing to resolve the demand problems the economy has.  This approach would make sense if our economy had some sectors with too many workers for too few jobs, and other sectors with too many jobs for too few workers.  That's not our problem.  Our problem is an across-the-board lack of demand in all sectors, a finding which is borne out by the data.  So training workers isn't going to do any good if the demand isn't there.

But, while the latter approach is a waste of money, the former approach would have to be implemented on a large scale to be effective.  Given all the deficit scaremongering, it's not going to happen.  Never mind that fixing the employment problem is the best way to shrink the deficit...

Save Us From Rick Perry (And Other Thoughts on the Republican Nomination Race)

With the Iowa Straw Poll done, it's looking like the Republican presidential field is starting to take shape.  Ron Paul has loud supporters, but he'll fizzle out like he always does because he's not religious enough, and business interests won't back him because they know his nutty economic ideas are going to run them off a cliff were he to come anywhere near power.  Then Tim Pawlenty just dropped out after finishing third in the straw poll.  Honestly, Pawlenty's no big loss either.  The guy talks and acts like a serious person, but every time he opens his mouth to talk about the economy, anyone with a clue realizes that he's just not very bright.  Sarah Palin keeps buzzing around, driving her Constitution bus to these events, but people have heard her speak enough to realize that a Palin presidency would go nowhere.  This leaves a few contenders, who I'll write some stream-of-consciousness thoughts on, mostly about their economics, since that's what I pay most attention to.

1. Michelle Bachmann-- I hate to acknowledge that there's any chance that she'll become President, but she presents herself well (in the sense that she occasionally looks and acts "serious," even though she definitely has crazy eyes.  Don't believe me? Check out her Newsweek cover.

Her ideas are equally nutty-- she's an ideologue who "doesn't compromise".  Her idea of economic policy is to cut taxes and hope magic happens.  With a Republican Congress, the prospect of a Bachmann presidency is terrifying.

2. Jon Huntsman-- I admittedly don't really know much about him.  I get the impression he's very similar to Romney: a Mormon who can think straight.  So, given the state of the modern Republican Party, not a bad proposition, though I don't see much enthusiasm for him.

3. Mitt Romney-- As governor of Massachusetts, he passed state-wide ObamaCare.  As a presidential candidate, he's running as fast as he can away from it.  But, all things considered, Romney isn't stupid, so I think taking a nuke to the American economy thinking it'll fix it is unlikely if he becomes President.  He's certainly a voice for low taxes and (some) deregulation, but I think a Romney presidency wouldn't be a disaster.  I could actually see substantial good coming out of it on the economic front-- Republicans in Congress are opposed to further stimulus under Obama because the Republican Party's current policy platform is, roughly speaking, "Do the opposite of what Obama wants."  But Romney's top economic adviser is Greg Mankiw, who, while conservative, still uses models in his economic analysis and as such has no choice but to realize that the economy needs... more stimulus.  And, while stimulus under Obama is "job-killing," the same stimulus under Romney could probably pass a Republican Congress, and I would take that in a second.

4. Rick Perry-- This one scares me more than any other.  Perry is an evangelical Christian with conservative social views.  Fine.  So was George Bush, but the only thing that came out of that was some noise about gay marriage which ended in nothing, and died down after a couple of years.  What really scares me about Perry is that he'll run on his "Texas jobs miracle" platform and people will actually buy it.  I wrote about the Texas "jobs miracle" here.  Put simply, Texas has been adding jobs... because it has a rapidly-growing population putting downward pressure on wages, and the cost of living (thanks to lack of zoning laws) is low enough that people take those jobs.  Now, the rapidly growing population aspect is neither good nor bad, and the low cost of living is actually a good thing, I think (cheap housing in general is good).   But here's where the "solution" falls apart.  Texas's low wages, lack of state-level regulations, and low taxes attract businesses from other states, which like cheap labor and don't like taxes.  Now, that would all be well and good, except that it doesn't make for a national solution.  As I pointed out in that earlier post, a huge chunk of the jobs being added are minimum-wage jobs that attract immigrants (legal and illegal) and migrants from other states.  So, while the state is adding jobs, it's not adding them nearly as fast as it should be to keep pace with the population growth, so unemployment is actually higher than it is in places like New York, Maryland and Massachusetts (which passed "job-killing" RomneyCare).  So it doesn't take a genius to realize that Perry's "solution" is likely to be the same as it was in Texas-- low taxes and deregulation.  But if you turn every state into Texas, there's nowhere for those jobs to come from-- all the states can't lure jobs away each other.  Meanwhile, individuals are still overindebted, so the depressed wages that would come with a rise in business power would actually make the debt problem worse-- if people have less income, they can't pay down debts.  If they don't get their balance sheets in order, they won't spend.  And the economy will stay depressed.  But I'm afraid America could well elect Rick Perry, watch him push through dangerous policies by promising a national "Texas miracle," and end up with a persistently depressed economy.

EPL Week 1/NFL Thoughts

EPL Week 1
The English Premier League kicked off its season this weekend, which marks the beginning of the new sports year.  This summer was particularly brutal for me, in large part because 1) I was in Kansas, which has some of the nicest people in the world, but where I didn't really know anyone and didn't find people to watch sports with, and 2) It was one of those off summers where no major sporting events were going on.  No World Cup, no Olympics, just the moderately small-time Copa America, where the US got pounded by Mexico and Bob Bradley got the boot.  Once the NBA Finals (which were phenomenal this year) ended, there was nothing.  Not even NFL and NBA free agency, since the leagues were both locked out most of the summer.  Sure, there was baseball, but 1) The Orioles will never, ever go to the playoffs, 2) The season has too many games, and 3) Baseball is mostly boring.

So I'm thankful that sports are officially back.  But, despite that, the first week of the EPL season was brutal.  There are still 2 more matches left (Spurs-Everton and Man City-Swansea), but the early ones were snoozefests.  Arsenal played a typical Arsenal game-- held the ball for 60 minutes without putting a shot on target, Gervinho gave Joey Barton a love tap on the face and got himself sent off on his debut, and Arsenal looked like a candidate to finish 8th with Fabregas and Nasri on the way out.  United also played a typical United game against West Brom-- didn't look particularly good, struggled the entire time, then got bailed out by a late own goal.  Liverpool managed to draw Sunderland at home.  Sure, Luis Suarez missed a penalty... but he dove flat on his face to win it, so he got what he deserved.  Have I mentioned that I can't stand Luis Suarez? The guy spends more time on the ground than Cristiano Ronaldo, and is possibly even more arrogant.  But, on the field, Luis Suarez is a good player, but he can't carry Cristiano Ronaldo's bags.  As much as I love Diego Forlan, I pull against Uruguay because I want Luis Suarez to lose.

But the real clincher this weekend was the Chelsea match.  They're my favorite team, but I'm afraid that they're headed for (another) downer of a season.  This was an ugly performance.  Not just because the team dropped points at Stoke (they're a tough road match), or because there was no score.  Heck, even Fernando Torres looked pretty good today.  No, the big issue was the lack of invention in midfield that got me.  Since I've been following them, Chelsea have been a ruthlessly efficient team.  The midfielders have been powerful, clinical and strong-- guys like Makelele, Essien, Lampard, Ballack and company covered ground.  And Drogba has always been a beast up front, terrorizing center backs with his size, strength and speed.  But there's never been much in the way of creativity.  Against tightly-disciplined sides like United, they dominated play more often than not, but a creative player to unlock the defense was always lacking.  Lampard's a fine midfielder, and he scores a lot of goals, but he's not a playmaker.  Neither is Essien.  And the only effort Chelsea made to bring in a creative midfielder, Scolari bought Deco's corpse, which played well for about 3 weeks, got tired, and then found itself buried on the end of the bench.  Anyone watching knew the squad needed that creative spark-- a Modric or a Sneijder or a Pastore (though I think Pastore is a big risk).  Instead... they added another striker.  And while I love Romelu Lukaku's potential, this gives the team, by my count, five central strikers (Drogba, Torres, Anelka, Sturridge, Lukaku), only one of whom can play in his natural position at a time.  Meanwhile, the creative midfielders include... Yossi Benayoun.  And only him.  Benayoun's OK when he's healthy (OK, not special; for a Champions League team, he's a squad player), but he's coming back from a torn achilles.  If this squad doesn't pick up another creative mid, I'm afraid it'll be a lot more of the same-- a lot of possession, danger on set pieces, rock-solid defending and goaltending, but none of the spark that you need to win trophies.  Ideally, I would unload Anelka, buy Modric or Sneijder, and go with a 4-3-3 (or 4-2-3-1, depending on how high you play the wide forwards) with a back four of Cole/Terry/Luiz/Ivanovic (Bosingwa), a midfield trio of Lampard, Essien (or Ramires until Essien's back from injury) and Modric/Sneijder, and a central striker (rotation of Drogba and Torres), with two of Malouda, Sturridge, and Salomon Kalou playing in the wide-forward spots.  Then I'd sell Anelka and ship Lukaku out on loan to pick up some experience.  That lineup gives you a nice balance of wide and central players, goalscorers, destroyers, and creators, and some push from the back too in Cole.  As is, though, the squad is shallow and lacks invention.  Without another creative piece, they won't challenge for the league.

NFL
At the same time, the NFL preseason is up and running.  I've never really liked the preseason.  To me, the games are worthless and a waste of time.  The league insists on four preseason games because NFL fans are so rabid, they'll still go out to the stadiums even though the games don't matter and convince themselves that their third-string QB is the best thing since sliced bread.  I really realized just how much of a joke it is when the Redskins hired Steve Spurrier.  Under Spurrier, we buried everyone in the preseason.  Danny Wuerffel (Wawful to Skins fans) looked like Peyton Manning 2.0 all preseason, Sugar Shane Matthews tore defenses apart, and the University of Florida national championship duo of Reidel Anthony and Jacquez Green was massive.  Then the REAL season started.  All the coaches who ran the Madden playbook in the preseason dusted off their real plays, starters got to stay on the field for more than a drive, and the Skins fell off a cliff.

So this preseason, I'm "paying attention" mostly to see who gets hurt (Mikel Leshoure, my backup fantasy running back, is already on the shelf for the year) and which players I remember from college are on NFL rosters (Josh Portis, infamous at the University of Maryland for coming in for 5 plays a game to run right, then cheating on a quiz and transferring to California University of Pennsylvania, is on the Seahawks now).  So even though the Skins beat defending AFC champ Pittsburgh in the first preseason game and Rex Grossman tore it up, I'm still thinking we're gonna stink this year because 1) Rex Grossman is horrible, and came into camp fat, and 2) There really isn't a single impact player on either side of the ball for this team.  I wouldn't mind a 2-14 season (so long as at least one and preferably both of the wins was over Dallas), so long as it meant drafting Andrew Luck.  But, knowing our track record, we'll go 5-11, pick 6th, and trade for Tarvaris Jackson next summer.

Fareed Zakaria Strikes Out

Fareed Zakaria's a super-sharp person, and a very good writer.  Most of the time, I agree with what he has to say.  But in this week's Time, he has a column that I think really misses the point  (password protected).  The gist of it is that liberals shouldn't be disappointed with Obama because he is essentially a pragmatist who is willing to make tough choices for the sake of getting things done.

The line that strikes me is when Zakaria accuses Obama's base of "making the best the enemy of the good."  But I think he misses the distinction between good "pragmatic" policy and bad pragmatic policy.  Essentially, no one faults Obama for compromising (besides Tea Party nuts who can't see reality and realize that the President is an ideological moderate who thrives on compromise).  Obama's critics on the left don't suggest that the issue is his willingness to compromise-- the issue is his acceptance of bad ideas.  The latest case of this was the debate over the debt ceiling.  To start with, as Robert Rubin pointed out in a recent interview (I THINK it was in Business Week, but I'm not sure), the debt ceiling ideally wouldn't exist, but, given that it does, would not be a political issue.  Instead, Obama not only allowed the fringe of the Republican Party to hold the nation's credit hostage, but also came to a deal that is, at heart, bad for the economy.  The "best" deal would have combined significant short-term stimulus with a long-term project aimed at increasing revenue and cutting health care costs.  A good deal might have put social security on the table.  An acceptable deal might have cut $2 of spending for every $1 of tax hikes.  Instead, we got a deal that makes no effort at health care cost control, raises no revenue, and slashes spending in the short term in an economy that suffers from... a short-run lack of demand.

In other words, it's frankly terrible policy.  Those who worked with Bill Clinton say that he would go into a debate looking to find the "best" answer (and he had a very competent technical staff to do that).  Once he arrived at that answer, he compromised and might have whittled away at it, but still gotten to an acceptable result.  Obama begins by getting to a best answer (using many of the same experts Clinton had at his disposal), proceeds to weigh what the counter-proposal might be, splits the difference, and then capitulates in negotiations.  The result is terrible policy that encourages ideological extremists to hold the country hostage.  And it's threatening to turn Obama's presidency into a failure, even with know-nothings like Rick Perry, Michelle Bachmann and Tim Pawlenty real challengers for the presidency (I think Mitt Romney is smart enough to realize that, regardless of what he has to say on the stump, the Tea Party's dream government is nothing short of disastrous policy).

Tuesday Musings

Looks like the ECB's effort to stop the fire in Europe is actually working. Italian 10-year bond yields dropped significantly today after the ECB's bond-buying program, meaning there's a bit less fear of contagion. Some might claim that this is obvious-- if the ECB is buying bonds, of course the yield will go down. But the alternate scenario would be bondholders revolting at holding bonds they see as risky that don't yield enough to compensate them for the risk. Luckily, they aren't. And, on the fundamentals, I think they're right. Italy is running a primary budget surplus, so as long as the interest payments on their large debt burden stay manageable, they should be able to tread water and avoid contagion from the Greek travesty.

In other news, since S&P "downgraded" the US, yields on 10-year Treasuries have fallen by 38 basis points, and rates on 30-year Treasuries have fallen by 26 basis points. And real yields (which take into account inflation expectations are at 0 for 10-year Treasuries and about 1% for 30-year Treasuries. The real yields are actually NEGATIVE for 5- and 7-year bonds, meaning that you're essentially paying to lend the government money for that length of time (people still lend to the government at negative real rates because nominal rates are positive, so holding cash always has a negative real return over time unlses inflation is negative). The point to take from this is: so much for S&P's downgrade throwing the US's solvency into question.

What's Causing the Sell-Off?

An interesting theory on the Bronte Capital blog about a potential reason for today's significant market downturn.  The speculation is that a major hedge fund is getting margin calls (calls to put up extra collateral for lenders), and the way to meet those margin calls is to liquidate big positions in large-cap liquid stocks (i.e. the Dow).  That liquidation drives down the price, which is what we may have seen today.

But what's most interesting is the comments section of the Bronte post.  Seems like the speculation is that it's John Paulson's fund that's getting the margin calls.  Paulson is most famous for making about $4 billion when the housing market tanked.  His prime broker was Goldman, and he was on the short end of the infamous Abacus deal that got Goldman into trouble with the SEC.  Paulson has been on the talk show circuit the last year or so calling for a renewed boom in the housing market and a quick recovery from recession.  He's been wrong, and it looks like he made big bets on that wrong position.

Zero Hedge is also speculating that Paulson is down quite a bit.

News Organizations: Dropping the Ball... Again

This morning, the market tanked.  Normally, the first thing I do in the morning is open CNN.com to see what the conventional wisdom is on the downgrade.  In this case, both CNN and the AP are claiming that the sell-off is a reaction to S&P's downgrade.  Now, who knows, maybe I'm missing something, but this seems like a remarkably... wrongheaded assessment.  Really, wrongheaded is MUCH too weak a word, but I'm trying to figure out understatement, so bear with me.

If the US's creditworthiness was in question, any elementary schooler should be able to tell you how investors would react.  They know that if Little Jimmy isn't going to give your red ball back if you lend it to him, you're not going to lend him your red ball anymore.  So if investors didn't expect the US to pay back its debts (or to inflate them away), those investors would charge high premiums for that debt.  Instead, Treasury yields... dropped.  The yield on 10-year Treasuries fell from 2.56% to 2.44%.  And CNN knows this as well as I do because that's where I got the information; it's buried at the bottom of their article about how worried investors are about the US's solvency.  The whole thing is a painful comedy of errors.

So why did the market tank? Same reasons it usually tanks: economic fundamentals are pretty bad, and Europe is still in trouble...

Europe: A BIG Problem

Lost in the pointless S&P downgrade debate is the fact that Europe is a HUGE problem.  And it's getting bigger.  For proof, take a look at what Italian 10-year bond yields are doing.  Also, Spanish 10-year bond yields.  In response, the European Central Bank has apparently decided to "intervene decisively on markets" once trading open tomorrow.  What that means, it's not fully clear.  If I had to guess, the European Central Bank is going to start buying up Spanish and Italian bonds.  Maybe both.  Why now? Well, the Eurozone can afford to bail out Greece, Ireland and Portugal indefinitely.  Greece's GDP is about $330 billion.  Ireland's and Portugal's are about $230 billion each.  Spain's is almost double those 3 combined.  Italy's is almost triple Greece, Ireland and Portugal combined.  The EU can't afford to bail either of them out.  Contagion to Spain or Italy would spell big trouble for the EU and the world economy.  In all likelihood, it would mean collapse of the Euro.  And that would be a massive problem.  Think Lehman Brothers times 1000.

So what will buying up Italy and Spain's bonds do? Well, for one, it will allow them to borrow.  And neither of their problems look anything like Greece's.  Whereas Greece had a massively distorted economy with a bloated public sector, along with a massive debt burden and a huge primary budget deficit, Italy has a big debt burden, but a primary budget surplus (meaning that, debt interest payments aside, its government actually takes in more than it pays out), while Spain had a fairly small debt burden and a primary budget surplus when its real estate bubble collapsed in 2008.  Capital market access would buy them time to improve their outlook while Greece gets its act together (and Ireland tries to pay down the debt the EU has shoved down their throats by forcing them to bail out their wildly irresponsible banks).  Realistically, it's not a way out as much as a stabilization mechanism meant to avert disaster.  But that disaster is scary enough that the ECB taking this action is without a doubt the right move.

The final question, I guess, is what contagion would mean.  My guess is a spiral in which Spain and Italy lose capital market access would end in a forced exit from the Euro for a number of countries (that or the ECB loosening monetary policy in a way that would be highly inflationary for Germany, which seems pretty unlikely...)-- Spain, Italy, Ireland, Greece, and Portugal are the obvious candidates.  Places like Estonia (which, Robert Samuelson nonsense pieces aside, is still suffering enormously; yes, 14% unemployment is down from 19% unemployment, which is better in the same way that losing a leg is worse than losing your head) would also probably have to go, and each of those places would suffer, as Barry Eichengreen detailed, the mother of all bank runs.  Confused? Well, here are the mechanics, as I understand them (as always, bear in mind that I'm no economist, so I'm probably prone to some misinterpretation).  An exit from the Eurozone would mean a massive global financial crisis.  The instant investors were told that the Eurozone would fall apart (or that a country was leaving the Eurozone), it would start a MASSIVE run on all of the country's banks.  The reason is that an exit from the Euro would mean redenominating the bank's assets in the new (old) domestic currency.  So instead of holding Euro-denominated assets, Italian banks would hold lira-denominated assets.  But remember that the lira would be revalued against the Euro, and this revaluation would mean the real value of the assets would fall.  So investors would scramble to transfer their assets from lira-denominated assets into Euro-denominated assets, and the Italian banking sector would collapse.  But the Italian banking sector has a HUGE number of counterparties, which in turn would see their assets and contracts evaporate.  As a result, the global financial system would seize up in a way that makes the crash after the Lehman collapse look like small potatoes.  And even a coordinated effort by global central banks might not be enough to push back against that kind of event.  Which is a scary, scary proposition.

(As a side note, the two best pieces I've read about this kind of problem, for anyone interested, are the Eichengreen piece I linked above and this paper by Maurice Obstfeld which talks specifically about devaluations in fixed-exchange rate regimes (like the ones in Argentina and Mexico), but default within a unified currency follows the same basic pattern.

Keynesian Frustration

In the last few days, I've dusted off my copy of Keynes's General Theory of Employment, Interest and Money, which is still without a doubt the most influential economic book of all time (though you wouldn't know it based on the rhetoric coming from television talking heads), and I've started to reread it.  What's really come into focus is the fact that not a single one of Keynes's supposed "critics" has actually bothered to understand, or even read, Keynes.  I have no clue how conventional wisdom about Keynes became that deficits don't matter (an idea that actually came about under Reagan-era supply siders), government spending is always a good thing, and government should control the economy.  That kind of nonsense not only is nowhere to be found in Keynes, but there's no way a literate person having taken a basic economics class could possibly come to that conclusion from anything in Keynes's work.

None of that is to say that Keynes explains everything, or that Keynes is perfect.  The General Theory was written at a very specific time, and in response to a very specific problem-- a deflationary cycle with persistently high unemployment.  Keynes came under fire during the inflationary 1970's, where supply shocks drove up inflation, while the economy itself was somewhat depressed, and it's certainly true that Keynes's work doesn't have a ready-made explanation for that scenario... but that's in large part because inflation was hardly a problem when Keynes was writing.  Indeed, deflation was the bigger problem in the 1930's, so it makes sense that tackling the possibility of stagflation was not at the front of Keynes's mind.  Before Keynes, classic economics had relied on a maxim called Say's Law.  The exact formulation is disputed, but the basic formulations are that "products are paid for with products" and "supply creates its own demand".  

Keynes's brilliant insight was that a general shortfall of demand can exist, and can explain recessions.  Understanding this is essential to understanding the problem we have now.  Quite simply, interest rates set by the Fed are at the zero lower bound, but unemployment is above 9%, and inflation is low.  Meanwhile, corporations are sitting on huge piles of cash that they aren't putting to work to hire workers because... there isn't enough demand for their products.  The deeper explanation for that comes from some later work by a Taiwanese economist named Richard Koo (and is echoed by a wide variety of people, from the founder of the giant macro hedge fund Bridgewater Associates, Ray Dalio, to Nobel Prize-winning economist Paul Krugman).  Koo argues (and I tend to agree) that we're in what he calls a "balance-sheet recession".  In short, in the run-up to the financial crisis, households in the US became overindebted.  They borrowed against their homes and figured they could always refinance.  Once the bubble burst, the value of people's homes collapsed, but the debt was still there, and refinancing was no longer an option.  So consumers across the board started saving to pay down debts.  But when a huge chunk of the population is saving instead of spending, demand across the economy falls.  As that demand falls, businesses struggle and lay off workers.  And those workers, still in debt, lose their source of income and can't pay down their debts fast enough.  Indeed, totals savings FALL (this is another unique discovery of Keynes's- the Paradox of Thrift).  As a result of this excess saving and lack of demand, the whole economy slides into an extended, painful recession, and lowering interest rates by the Fed to encourage investment has minimal effects because there's no reason for businesses to invest (even at very low costs) when there is insufficient demand for their products.

So how do we get out of this balance-sheet recession? Well, here's where the most-hated portion of Keynes's work kicks in.  It's an accounting truism that aggregate demand (GDP) is the sum of consumption, investment, government spending and net exports.  With consumption depressed as people pay down debts (which explains why tax cuts are rather ineffective at stimulating demand in this particular situation) and investment lagging (there's no reason to invest when companies have excess capacity as is, even if interest rates are super-low), the only real way to stimulate demand is for the government to directly make purchases to jump-start the economy.  By putting people to work on, for instance, repairing bridges, building high-speed rail, and building an infrastructure for national wireless internet, the government can both improve productivity in the future and put people to work now.  The salaries from those jobs help workers pay down their debts, at which point they will have the ability to start spending again.  Once that happens, government can cut back on its purchases as the private sector picks up the slack.

Unfortunately, we have a political system in which no one has read Keynes.  And even though we're in a world in which his models are working more or less flawlessly, we're stuck in a hole that we would be able to get out of if only our decision-makers believed in ladders.

The Next Treasury Secretary

The New York Times is reporting Tim Geithner might be stepping down as Treasury secretary soon.  They float a list of potential successors that looks... ugly.  It includes connoisseurs of (wrong) conventional wisdom like Roger Altman and Erskine Bowles, and CEOs Jeff Immelt of General Electric and Jamie Dimon of JPMorgan.  Now, pretty much all Republicans and probably most independent voters think that running a business is a good proxy for making economic policy because... I don't really know, but I assume it's because both involve money in some way.  But it's worth pointing out that running a country is, you know, nothing at all like running a company.

I looked through this 15-year old piece recently, and, while the problems it addresses are from another day, the basic premise is still really relevant.

S&P Downgrades US; No One Cares

In case anyone doesn't check CNN, S&P downgraded the US's credit rating on Friday from AAA to AA+.  So of course everyone is predictably up in arms.  The right is blaming "runaway spending".  The left is blaming "Crazy Tea Partiers".  The proximate cause is exclusively the latter-- Republicans in Congress decided to make a political issue out of what should have been a routine debt ceiling hike in hopes of extracting a pound of flesh.  Had a clean hike in the debt ceiling been routinely passed, I can say with absolute certainty that S&P wouldn't have blinked.  Instead, months of debate led to a crummy "deficit reduction" bill that won't reduce the deficit, and will hurt the economy, and S&P went ahead with its downgrade anyway.  But the point of this post isn't to point fingers; it's to summarize what the downgrade means.  And what it means is... next to nothing.

First, it's important to note that nothing fundamentally changed between a week ago, a month ago, a year ago, and today in terms of the budget picture, and S&P doesn't have any kind of special knowledge that no one else does.  We've still got a big budget gap that is attributable predominantly to the fact that we're in the longest, deepest period of economic stagnation since the Great Depression, and we've still got a health care sector with runaway costs.  That's all publicly available information, and it's something everyone who was paying attention knew if they could do basic math (which, granted, many Congresspeople either can't or pretend they can't).  And, knowing all of this information, bond investors are still lending long-term to the US government at exceptionally low interest rates.  S&P's opinion isn't going to force them to dump Treasuries that they've been holding for long periods of time.

Second, S&P has a miserable track record in, you know, doing its job.  The most obvious example is the financial crisis, in which all three major rating agencies, S&P included, put their AAA stamp of approval on all kinds of financial toxic waste, and then were humiliated when those products blew up, endangering the entire global economy.  But that's far from their only failure.  As bad as they were at evaluating financial products and corporate bonds during the financial crisis, Mike Konczal presciently points out that they've been worse at evaluating sovereign debt.  So, essentially, these agencies are consistent failures at their jobs.  So there's absolutely no reason to care about what they have to say now.  In 2002, S&P downgraded Japanese debt. In response, the markets... ignored them and continued to lend to the Japanese government at extremely low interest rates.  In this case, markets will almost certainly do the same, mostly because nothing in S&P's track record should give anyone confidence in anything they say.

So do I think the downgrade is completely meaningless? Well, not COMPLETELY.  I know some institutional investors like pension funds are contractually obligated to hold some proportion of AAA-rated securities, so if there are enough of those that have to dump their holdings as a result, there could be some spike in yield.  But I don't think it will be too significant.

In short, don't panic-- the world isn't ending.  What the US needs now is the same thing it needed a month ago and a year ago: more action by the government and the Fed to stimulate spending and job creation, and a long-term plan to raise more revenue and tackle the health care cost issue.

What Economic Indicators Mean, OR Who You Should Listen to On Economics

Today, financial markets had a bit of an off day...  Alright, maybe a rough stretch... Alright, so I guess calling it a rough stretch is a bit of an understatement.  The Dow had its worst day today since we all thought the world was going to end in 2008, dropping 512 points (over 4%), and the index itself has dropped over 10% over the last 10 days (as has the S&P, which is a better measure of broader market attitudes than the Dow; and the Nasdaq).  The first thing to note is that the stock market is a really terrible measure of the country's economic health.  It dominates the news and the talking heads spend a lot of time on it, but, if anyone reads this, relax, the stock market is NOT in any way a measure of how the broader economy is doing.  All a stock price reflects is people's attitudes about companies' future prospects.  In other words, it's a lagging rather than a leading indicator, and it's often wrong: Paul Samuelson, pretty universally regarded as the greatest economist of the second half of the 20th century, famously noted that the stock market had predicted nine of the last five recessions.  That was true, and also prescient.  Sometimes, a dip in the market signals the start of a recession (the burst of the tech bubble in 1999/2000, the stock crash that sparked the Great Depression).  Other times it follows a move back into recession.  Other times, it doesn't mean much of anything at all (in 1987, the major global indices dropped over 20% in a single day, followed by... nothing; last May, the Dow lost 600 points in 5 minutes), besides that trading algorithms were selling off stocks rapidly.  So there's no need to panic because the stock market had a crummy day.

What the lagging stock market recently DOES mean is that investors by and large aren't optimistic about the growth and profitability prospects of listed companies in the near future.  And that has a lot to do with expectations centered around the lagging economy, and Congress and President Obama's inexplicable and inexcusable decision to ignore the job and growth crisis and focus on... the deficit.  A major culprit here is the mainstream press.  The first "expert" CNN quotes in the story I linked is Peter Schiff.  Peter Schiff is an ignoramus.  He's an expert in the economy in the same way I'm an expert at speaking Mandarin Chinese (one of my college friends taught me to say "Hello pretty girl", and spent the next hour making fun of me for speaking Chinese with a French accent).  He has an eminent record of being wrong about everything.  Schiff's incoherent claim is that the stock market tanked because now, all of a sudden, markets realized that "stimulus didn't work."  He'd have you believe that traders woke up one morning in late July and decided, "Gee, that stimulus passed in 2009 really didn't get the job done; I'm selling NOW."  If that sounds stupid to you, that's because it is.

In this case, though, the economy is certainly struggling, and markets clearly don't think the deficit reduction deal is going to do anything to stimulate growth (that much was obvious to anyone with a brain) or even address the deficit (as Herbert Hoover demonstrated).  What we'll most likely end up with is possibly a shrinking nominal deficit (if Republicans get their way and gut everything), but a rising debt burden, as GDP craters (debt only matters as a proportion of GDP; to put it in practical terms, a person making $160,000 a year with $10,000 of debt has a much smaller debt burden than a person making $16,000 a year with $5,000 of debt).  And the US's economy isn't the only one struggling; borrowing costs for Greece have long been skyrocketing, but the spread between Italy and Germany's 10-year rates is spiking.  Now, at this point, I look like I'm being inconsistent: how can I say that it's bad that interest rates on 10-year Treasuries are low (3.125%), but it's also bad that interest rates on Italian bonds of the same maturity are high?

The answer to that is nuanced.  For one thing, a yield by itself doesn't tell you much.  Yield prices in inflation (if the real value of the currency it references is lower, the yield is higher), likelihood of repayment (if a country has a history of fiscal irresponsibility, yields on its debt are higher), and the broader state of the economy (if companies are doing well, investors are more likely to move money out of safe-haven government bonds (specifically, US Treasuries) and into riskier stocks and corporate bonds, which drives demand for Treasuries down, and thereby increases their yield.

So what's the story? Well, to anyone looking at it with a clear head, it's pretty straightforward.  In the US, low stock prices reflect investor pessimism about the state of the economy and the recovery; they're moving their money out of stocks and corporate bonds and into what is still the ultimate safe haven investment (Congress's shenanigans aside): US Treasuries.  Which explains why Treasury yields are so low.  Those yields would be rising significantly if investors expected the hyperinflation Peter Schiff has spent the last 2 years hysterically railing about.  Unfortunately for him, no one is and he comes across looking like the buffoon that he is (no one would take the 4% coupon on 30-year Treasuries that is currently being paid if they thought that hyperinflation was right around the corner).  So in the US, we've got investors who are pessimistic about the recovery but believe that the government will continue to be good for the money it is lent, and won't inflate away its debts.

In Italy, coupons on debt are soaring, but stocks are down.  If investors thought Italy was at risk of high inflation, that inflation would also be reflected in stock prices (explaining the mechanics of inflation will take another post, but basically if prices and wages are spiraling, stock prices will spiral, too).  Very clearly, those same investors aren't bullish on Italy's recovery.  Essentially, they're increasingly worried that Italy will default. This is made even more acute by the European Central Bank's obsession with inflation, which is driving it to raise rates even as its peripheral countries need looser monetary policy to help them address their massive debt overhangs.  But, day by day, I think the Eurozone is coming apart at the seams (and Gillian Tett, my second-favorite English financial journalist, agrees), as the peripheral countries with big debt burdens are swamped by an inability to service their debt.  I think the story will go something like this.  Greece has literally no growth prospects in the medium- or even the long-term without a default.  Their debt overhang is massive, the bailouts they're getting are essentially pushing payment on that debt overhang into the future in the hope that growth will somehow restart, but, without the ability to conduct expansionary monetary policy (since they're in the Euro) or expansionary fiscal policy (because they're locked out of capital markets), there's really no way to see Greece restarting growth.  Eventually, the rest of the Eurozone will lose the political appetite to keep throwing money at Greece, and will decide to draw the line.  At which point bond markets in the other peripheral economies will begin crumbling too.  At that point, we have a repeat of the Lehman Brothers crisis, only way bigger.

Now, I'm not claiming that will definitively happen, but I think it's a semi-plausible scenario.  And that kind of scenario being semi-plausible is a pretty scary prospect.

My Explanation For Why Goldman Sachs Is Headed Downhill

Two years ago, Goldman Sachs was on top of the world, even as its rivals teetered.  Lehman Brothers had disappeared.  Bear Stearns and Merrill Lynch were acquired at fire-sale prices so they wouldn't disappear.  Citigroup was insolvent, kept afloat by a massive $85 billion bailout, and Bank of America was hardly better.  Morgan Stanley wasn't dead, but it was bleeding money, and had to reinvent its business model in the aftermath of the financial crisis.  JPMorgan gained prestige and market share, but even they were a big, stodgy behemoth.  Goldman, meanwhile, made a fortune.  In 2009, when most of Wall Street was conducting a post-mortem and checking its pulse, Goldman reported record earnings of $13.4 billion.  For that success, they had books written about them, and magazine articles and blog posts dissected their success, whether by calling them thieves who profited at clients' expense, or lauding them as visionaries who saw the crisis coming when few others did.  At that point, it looked like Goldman was the undisputed King of Wall Street.  Strangely, though, that hasn't been the case.

Goldman announced its second quarter earnings about two weeks ago, and the results were pretty disappointing.  Their earnings per share were more than 20% lower than analysts had expected, at around $1.85.  Breaking down that result further, the biggest reason they struggled was that they had weak earnings in their fixed-income, currencies and commodities division (FICC).  This is the same division that drove their success during the crisis.  The question, then, is why.  A lot of the people who were responsible for Goldman's best trades during the crisis are gone, but Goldman's had constant attrition and still managed to continue to do well-- Wall Street and Washington are littered with Goldman alumni: they become Treasury Secretaries (Bob Rubin and Hank Paulson), governors, senators and White House staffers (Jon Corzine and Josh Bolten),  open hugely successful private equity shops (Chris Flowers and Guy Hands), manage hedge funds (Ed Lampert) and run central banks (William Dudley and Mario Draghi).  All have left, but the profit machine has managed to chug along.  And the leadership hasn't changed at all-- the CEO, COO, and CFO have all stayed on deck.  But FICC's revenue has been down for six quarters in a row now, which is starting to look less like a blip on the radar and more like a pattern of decline.  But why?

Well, I've got a hypothesis, and I think it has to do with Goldman's success sowing the seeds of its downfall (sounds cliche, I know, but I think it works in this case).  Rewind to the days when Goldman was making its most profitable bets.  At that point, the conventional wisdom was still that real estate-related assets were still a great investment.  You could get AAA-rated CDOs that yielded more than similarly AAA-rated Treasuries, and most investors assumed that this was a conservative buy.  Now, I think it's worth pausing for a minute to consider what a fixed-income group actually does.  Generally speaking, they make markets-- they find a long side (a party that wants to make a bet that the price of a certain asset class, security, or other instrument will rise) and a short side (betting that this price will fall), and taking a fee to bring them together.  Until Dodd-Frank passed, they could also put their own money on the line to make these bets (this was called proprietary trading, and Dodd-Frank limits banks form putting more than 3% of their capital into these trades).  The two aren't always easy to distinguish from one another-- sometimes, to facilitate a deal, a market-maker will leave some of the unsold securities from the deal (either on the long or the short side) on its own balance sheet; other times, it will buy up securities as inventory if it anticipates clients placing large orders for them in the near future.

This setup created obvious conflicts of interest.  What if, for instance, Goldman had a client who wanted to take a long position in housing, but Goldman itself was taking a short position in that market? What if Goldman was aggressively limiting its exposure in a certain asset class by dumping its inventory on an unsuspecting client?  There's a compelling point to be made that Goldman shouldn't necessarily care-- its clients are big boys who can take care of themselves, and by and large have access to the same information.  If "the Germans" (there were a lot of German banks that were losing money on Goldman's deals while Goldman was minting it in 2008 and 2009) thought housing was a good bet, they were entitled to make that decision.  The purpose of this post isn't to address that line of argument, but, even if it is valid, it creates serious perception problems for banks that do it.  For example, if a firm makes markets in real estate, but is massively short real estate on net, clients don't look too kindly at a bank that is, essentially, making money at their expense.  In the future, they're likely to be hesitant to do business with that bank, out of fear that they'll be stabbed in the back.

And that, in a word, is what I think is happening to Goldman.  Plenty of financial firms were making markets in housing in the run-up to the crisis.  But when the bubble burst, those firms lost as much money as their clients did, if not more.  Merrill, Lehman and Bear didn't survive, but Morgan Stanley bled money alongside its clients after the crisis.  Citigroup would have gone the way of Lehman if it hadn't been for the government.  But, when Goldman's clients took fat losses, Goldman recorded record profits, largely on the back of their trading operation being massively short housing.  Their executives ended up so embarrassed about this that they went and lied to Congress about it; CEO Lloyd Blankfein called it a "hedge".  Now, that may fly as an explanation for some people, but it's complete baloney.  Yes, there were deals in which Goldman ended up stuck with mortgage-related residuals and lost money (even after taking fees).  But where a hedge is intended to protect your risk, Goldman's short position was a MASSIVE directional bet.  Had Goldman wanted to hedge its mortgage-related exposure, it could have unloaded significant parts of its mortgage-related assets into the market to dial down their risk.  Instead, they took every conceivable step to go short housing.  They dumped their mortgage holdings.  They bought credit default swaps (CDS's; essentially insurance on a bond default, whether a mortgage bond or a sovereign bond or a corporate bond) on mortgage-backed securities and companies that were heavily involved in the mortgage market.  They shorted the stock of those same companies.  In sum, they made a huge bet that mortgage-related assets and the companies that trafficked in them were headed for a fall.  And they were right.

But now the acute phase of the crisis is over.  The economy is still struggling, but, unless the Tea Party decides to shoot the country in the nuts, we're past what Krugman calls the "We're-all-gonna-die" phase.  And now Goldman is in a pickle.  Dodd-Frank limits the amount that they can commit to prop trading, so FICC's lifeblood is now making markets.  But making markets still requires being able to step in and take a portion of the position to facilitate getting a deal done.  And I get the sense that clients don't trust Goldman to do what's in their best interests anymore.  And, until now, FICC was Goldman's biggest profit driver, sometimes bringing in over 40% of revenue and over 70% of profits.  But I get a feeling that what might be happening is that clients are afraid of getting burned in dealing with Goldman and taking their business elsewhere.  Making them, in essence, the victims of their own success.

Of course, memories are short on Wall Street: two years after a lack of regulation almost drove the economy off a cliff, they were pulling out their pitchforks and screaming about Dodd-Frank overreaching.  So I don't think I'm writing Goldman's obituary by any means.  But being branded as a firm that's willing to stab its clients in the back for profit (whether that label/perception is fair or unfair) is something that could be a drag on the firm in the next few years.

What Would I Do About the Debt?

A common refrain in this debate over the debt ceiling was John Boehner's assertion that "at least he had a plan," whereas Obama and the Democrats hadn't offered anything concrete.  This is true.  It's also kind of like saying, "The patient has cancer.  Our proposal is cutting off his head.  Why don't you have a proposal?"  But that got me to thinking about what actually has to be don to reduce the country's long-term fiscal picture.  There are two majors drags on the US's finances, as anyone looking at the numbers can tell.  One is the impact of the recession, and the other is runaway health care expenditures, in the public and especially the private sectors.  Revenue taken in is also inadequate, but that's an easier problem to solve (mechanically if not politically).

But assuming we had to do something, here's what my plan would have included:

1. A trigger for when any tax hikes and spending cuts kick in.  In an economy with already depressed demand, we can hardly afford to depress demand further by cutting spending in a down economy.  So any deal that I wrote wouldn't kick in until unemployment dipped below 6.5% at the most, which would indicate that it might be able to weather contractionary fiscal policy.  In the meantime, I would call for further fiscal expansion to stimulate the economy (fat chance, I know) and get to the point where spending can be cut and taxes raised without harming the economy.

2. Revenues would have to be raised.  I might raise the payroll tax cap, remove a bunch of distortionary subsidies (farm subsidies, capital gains tax hike), and institute a value-added tax, while cutting the income tax rate.

3. Health care would need to be addressed.  This is easier said than done.  I'd institute a panel to work on it.  Not a "bipartisan" panel, but an expert panel comprised of health care economists, practitioners, actuaries and others to look at the current system, identify flawed incentives and sources of waste and recommend ways to fix them.  Health care is, at the end of the day, a technocratic and economic rather than a political problem, so plugging in politicians to fix it is a recipe for disaster.  Especially when those politicians are self-styled "economists" who don't understand the first thing about economics (see: Paul Ryan).

There are some other areas where tweaks could be made-- Social Security could be tweaked around the edges, and defense could be cut, especially the R&D end (we've got billions of dollars in contracts out to defense firms working hard to build sweet weapons to win the Cold War), but the three points I've outlined are the ones that would be crucial to fueling a real recovery.