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.
Sunday, August 7, 2011
Saturday, August 6, 2011
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.
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.
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.
Friday, August 5, 2011
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.
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.
Thursday, August 4, 2011
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.
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.
Tuesday, August 2, 2011
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.
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.
Monday, August 1, 2011
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.
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.
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