jducoeur

Some time back, I was saying that I expected gas prices to stay lowish for the time being -- that the economy should prevent rises to the level that we saw last summer, at least for a while. That seems like basic supply and demand: demand has softened enormously, so prices *should* remain low. And yet, prices are rising fairly sharply. Why?

As usual, The Economist comes to the rescue: in last week's issue, they have an article largely on this topic. More specifically, it is talking about why we might get another sharp spike in prices sooner than expected.

The article runs a few pages, but the summary seems to be that everyone is anticipating supply problems, possibly serious ones, in the moderately near future. The oil industry is extremely dependent on investment: to maintain production at current levels, they need to keep finding ever-more oil in new places, and that process isn't cheap. (Even if you don't believe peak oil is nigh or passed, it takes real work to find it.) But at the moment, investment has been falling off, for a variety of reasons including the economy. So while current production is well above demand (and may yet cause prices to go down again for a while -- everyone is building stockpiles now, but that can only go so far), in the medium term there is a general nervousness that prices could skyrocket again, because there hasn't been enough investment lately to meet the demands of a more normal economy.

All of which goes to illustrate how the world economy is a *very* complex dynamic system, and there are a lot of feedback loops in it...

[Caveat upfront: I'm slightly out of my depth here. I know a fair amount about economics, but not the Treasury Bill market specifically. If I am making errors of fact here, or missing critical nuances, feel free to correct me.]

I was listening to the radio the other night (NPR's Marketplace), which had a piece by sometime Labor Secretary and now pundit Robert Reich. The main upshot was poo-pooh'ing Obama's plans to cut the deficit as soon as is practical. The official plan is to reduce it by 50% by the end of his first term, which means starting to slice pretty aggressively as soon as the current free-fall is over.

Reich's main point was that the deficit doesn't *really* matter all that much in practice, at least not in the near term, because it's being funded by countries like China, and they don't have any choice. They have to keep buying Treasury bills because they've already bought so many. If they and other countries stop doing so, or worse yet, sell T-bills, the dollar will begin to sink, and all their existing holdings will be worth far less. They don't want that (for several reasons), so they need to keep buying.

We have a word for this, boys and girls: "bubble". When one asset class is providing excess returns, people pile into it because it is doing so. This causes the returns to continue to inflate, so others continue to pile in. In this particular case, it's not so much returns as security -- since everyone else is betting that T-bills are secure, everyone keeps making that bet. In this case, there are also additional reasons, particularly that everyone desperately needs the US economy to restart, so they can start selling us stuff again, and they need the dollar to remain strong relative to their own currencies so they can afford to do so.

Of course, the problem is that bubbles pop, and it doesn't take much to do so. Say it isn't China that starts pulling out, it's some smaller country -- pulling a name out of a hat, Thailand. In and of itself, that makes little difference. But it makes a somewhat larger country -- say, Indonesia -- notice, wonder what *they* know, and start to weaken its support. Before long, you have a full-scale panic, because nobody wants to be the last one left in a sinking market. And as it happens, the dollar crashes, quickly and ever-further. (Which, granted, suddenly gives us export power. But having export power in the resulting world depression is a mixed blessing at best.)

Everybody keeps talking about the "bubble" in credit card debt, which is at best a half-truth. There is probably a bubble in the securitized obligations built on credit card debt, and some of those will pop. But by and large, credit card debt isn't likely to cause bubbles, because you defaulting on your credit cards doesn't make me any more likely to do so, at least in any direct way. (Whereas you getting foreclosed *does* reduce the value of my house -- hence the mortgage bubble.) But it sounds to me like Treasury Bills *are* a bubble, and one that is several orders of magnitude bigger than... well, anything.

And *that* is why reducing the deficit matters. The US needs to get serious about its debt, precisely because it is the only way to bleed pressure out of that growing bubble. That, in turn, reduces the likelihood of a sudden day of reckoning that would make the current credit crisis look like a sideshow.

Today isn't the day for it -- despite being a member of the Concord Coalition from its founding days, I do think the stimulus package was necessary -- but starting to lay concrete groundwork to deal with it tomorrow is absolutely the right thing to do. Indeed, I worry that Obama's plan may not reduce it fast enough, but I think it's probably about as good a goal as is actually plausible in that time frame, and some of his other initiatives (in particular, evaluating the effectiveness of health care) have promise to reduce it further in the long run...

[Happy (now belated) birthday to osewalrus!]

Thanks to mindways for the pointer to this fascinating article about the mortgage meltdown and how it happened. It's pretty long, but well worth reading, being both interesting and informative.

It's kind of based on the classic Wall Street question, "If you're so smart, why aren't you rich?" -- it tells the story of a few traders who saw the disaster coming long in advance, and *did* get pretty rich off of it. Along the way, it describes their gradually wakening horror as they figured out how horrifyingly broken the market was, and the step-by-step description of them discovering the structure of the house of cards is actually one of the clearer outlines of that structure that I've read.

And tying back to the birthday greeting up top, it's kind of an interesting variation of cassandrafreude. These guys reportedly tried fairly hard to wake everybody up to the looming disaster. And while they made a pile off of it (by short-selling the firms that they could tell were doomed), one gets the impression that they were pretty horrified by being proven so terribly correct: even as they were vindicated and made their money, they could see the burning towers of their own city around them...

At the forefront of concerned regulators is Timothy Geithner, president of the Federal Reserve Bank of New York and one of the financial world's most powerful voices. In a speech in Hong Kong on September 14th, Mr. Geithner praised the banking industry for becoming more robust, overseeing growth in the number and size of lending firms and innovating in credit instruments. These, he said, had "strengthened the efficiency and resilience of the overall financial system."

But he gave warning: "The same factors that may have reduced the probability of future systemic events, however, may amplify the damage caused by, and complicate the management of, very severe financial shocks. The changes that have reduced the vulnerability of the system to smaller shocks may have increased the severity of the larger ones."

That snippet is from The Economist, September 23rd 200*6*, in a now quite sobering three-page examination of the growth of credit innovation. Fully two years before it became fashionable to do so, this article laid out the pros and cons of the new credit-default swaps and related instruments, talking about the rise of the shadow credit economy. Geithner is the most-cited person in it, pointing out that the complexity and opaqueness of the new mechanisms were likely to cause big problems down the road, calling for bigger capital cushions and improved transparency, and indicating that he thought more supervision was likely needed.

One wonders if he had any clue that, when those problems arose, he would wind up the person on the hot seat to deal with them. Probably not, and being able to see a runaway train coming doesn't mean that you're going to able to lasso it. But it does increase my respect for the man a notch, that he was beginning to sound the alarm when most in the industry were still slapping each other on the backs for having made the world a better place...

Recent weeks have seen all sorts of panic about the Obama administration's cap of $500,000 per year in salary for the top executives at banks that get rescued by the TARP program. The rationale for the hand-wringing is that these banks are so *terribly* complicated that nobody with the skills necessary to save them would possibly work for so little money.

Enough. This is nonsense, and counter-productive nonsense at that. People are either being careless about the details, or (in best FOX News fashion) deliberately obscuring them.

Let's get it straight: the salary cap isn't a punishment for the greedy, it's incentive. Why do I say that? Because of the other half of the deal: there is no limit to the amount of "restricted stock" that these CEOs can receive. The restriction here isn't trivial: stock that the CEOs receive can't be redeemed until the banks are turned around enough to pay back the TARP money, with interest. But it can be a *lot* of stock.

So if you're a smart, entrepreneurial CEO with a good plan -- the sort of person needed to rescue these banks -- you are going to *run*, not walk, to one of these jobs. And the pay package you're going to ask for is $500,000 per year -- plus $20 million per year in that restricted stock. Now you have plenty of incentive to do your job efficiently, and to get the bank out of the semi-receivership it's now in. Which is, note, the point.

Yes, it's a bit of a gamble, but if you aren't prepared to make sensible high-stakes bets, you probably don't belong in high finance in the first place. And keep in mind that the bank's stock is probably in the toilet right now anyway, so that nominal $20 million you get promised today might well be worth $100 million after you clean up the mess, if you bring confidence back to the bank. Even by CEO standards, that's serious money. And it's money that is well-aligned with the stakeholders: keeping the bank afloat, getting the stock market behind it again, and paying back the taxpayers.

Mind, it's not perfect -- like all such interventions, it will introduce market distortions. For example, it gives the CEOs massive incentive to pay back the TARP funds, possibly at the cost of the bank's longer-term health. So it's no substitute for improved regulatory oversight. But it's a rather effective (and nicely subtle) measure to help make the new TARP funds under Obama, unlike those from Bush, more likely to actually get paid back in a decently timely fashion...

*Sigh*. This is definitely a week to look at Washington and be annoyed.

On the one hand, I'm mildly disappointed in Obama -- not so much for what he's trying to do, as for being tactically clumsy about it. He was very transparent about his intent to include some of his long-term spending goals in the stimulus package, which in a strategic sense is admirable. Problem is, since this *is* supposed to be an emergency-panic stimulus, anything that doesn't provide extremely immediate relief is arguably inappropriate, so he gave his political enemies a great big wedge issue to hammer him on. It feels very much like he was expecting, if not a honeymoon per se, at least for the Republicans to forego the usual partisan bickering and give his ideas a chance; in the current environment, that was naive.

That said, if I'm a little disappointed in him, I'm appalled by most of the Republicans, whose grandstanding and hypocrisy goes way beyond even their own norms. Hammering the plan for not being immediate and stimulative enough, and then immediately yelling "Tax Cuts! Tax Cuts!", is just galling. Every middle-ground economist I can find agrees that most tax cuts provide relatively weak stimulus, and are an inappropriate way to attack a situation like this. (With one or two *very* specific exceptions, but they aren't focusing on those exceptions.) Mostly, it just illustrates how intellectually bankrupt the Republicans are right now -- instead of hitting back with ideas that actually make sense, they're simply returning to the old well, and being even more nakedly opportunistic than the Democrats.

More than anything, though, I find myself fed up with economic religion. I heard a partial interview the other day with a Cato Institute economist, who was basically saying that Keynesianism was laughably washed up and discredited. But that's only half-true: Keynesian *religion* -- the grossly exaggerated version that says the government can micro-manage and stabilize the economy -- was entirely discredited a couple of decades ago. But the underlying idea that spending can act as essentially a shot of adrenaline -- a blunt but effective tool to revive in a crisis -- still holds some potential.

And on the flip side, I think that market religion -- the notion that the markets always know best, that lower taxes will always make the economy stronger, and that freer markets and less regulation are always better -- has been just as clearly discredited now as Keynesian religion was in the 80's. And for the same reason: too many people took a fundamentally reasonable economic idea, and inflated it into a fundamentalist religion that was a shallow mockery of that idea.

These things are *tools*, folks. Government is a tool. Markets are a tool. Regulation is a tool. Taxes are a tool. Spending is a tool. They are not the be-all and end-all, and no one of them is the solution to every problem. The economy (and the country, and the world) is a gigantic dynamic system, with lots of competing forces and lots of feedback, and it requires all of these tools in order to stay in balance.

So the next time some politician claims that there is one simple way to make things work right, ask yourself whether he's doing so as a student of these tools, or simply as a preacher who is trying to over-sell one of them. At this point, I'd say that the Republicans are almost entirely the latter, just as the Democrats were back in the 70s. We need much less of that, and much more recognition that you have to use *all* of these tools in balance if you want a healthy economy. There's room for reasonable disagreement about what the balance point should be, but the first step is to stop worshipping the idols. The Democrats have mostly gotten that clue; the Republicans need to do so...

Don't know how much mainstream press this is getting, but today's interesting business disaster is the Satyam mess.

It's the sort of story that I expect we'll see a lot more of in the coming months: a company that was riding high during the boom, that cooked its books just a *little* bit to make things look better. Then, when things started to go sour last year, they committed what clearly was ever-more-outrageous levels of fraud, to keep anybody from catching on, in a desperate hope that something would go right and they could quietly sweep it under the rug. This built and built, to the point where by now they are more than a billion dollars in the hole. In the end, when the chairman finally had to own up to it (his full letter is enclosed in the article), it brought the company crashing down: their stock is down over 90%, and nobody really expects the company to survive in its current form, despite the fact that a week ago most people would have considered it a great success story.

The moral of the story is, as always, that it's the cover-up that'll kill you. If the letter is to be believed (and given that it confesses to massive fraud, I'm inclined to mostly do so), there would probably have been a moderate but survivable scandal if they'd admitted it when it started. But fudging it forced them to require good luck, and luck was not on their side...

Loathe though I am to agree with the Republicans, on balance I'm coming to the conclusion that they're right about the auto bailout.

It's probably true that going Chapter 11 would cause GM an enormous amount of short-term pain (and Chrysler might well just go under), and it's true that there would be a nasty, sharp contraction as a result. That said, if it was packaged correctly, I suspect that it would correct much more efficiently: it would rip the bandage off, and allow the industry to do the necessary restructuring fast. It would to a substantial degree break the UAW (which, even granting that it does *some* good, is doing too much harm at this point), and probably come out with a GM that was smaller but ready to fight back much more quickly.

And I suspect that much of the PR debacle could be offset if the company, from the start, aggressively painted this as "reorganizing to be stronger". (And, frankly, played the national-pride card hard.) They have to move off the defense publically, changing both their thinking and look into that of a scrappy competitor. Granted, they've shot themselves in the foot on this particular point (over and over and over again in recent weeks), but public attention is fickle, and I'd bet that it could still be turned around.

Chapter 11 and the bailout both have essentially the same medium-term goal: restructuring the auto industry to make more *sense*. The difference is that Chapter 11 would probably be much faster and more efficient, because the legal power to change would be stronger. And really, it would be more honest. The bailout has this image of "saving jobs" and suchlike, but that's nonsense -- the whole *problem* is that GM is ridiculously inefficient, and there's no way to save it in the long run without lots of pain. So the choice is between dragging that pain out over the course of years (the bailout) or getting it out of the way in a horrible shock (Chapter 11). The latter would be much nastier in the short run, but I suspect better a year or so down the line...

Y'know, I originally found the claim "nobody would ever buy a car from a technically bankrupt company" a bit strange. It presumes that the consumers are stupid -- that they don't understand the concept of Chapter 11, and that it's not the same thing as "out of business". And the claim that this is because you wouldn't be able to get parts or service for these cars if they were to go under seems odd: with millions and millions of those cars on the road, *somebody's* certainly going to provide for them. The economy is not so broken as to eliminate basic supply and demand.

But now? Well, after weeks of the company CEOs *saying* that nobody will buy from them if they go Chapter 11, I kind of suspect that they've created a self-fulfilling prophecy. It's now conventional wisdom that you *shouldn't* buy a car from them if that happens, and it's entirely their own fault.

Replacing these idiots as a condition of any sort of bailout seems more and more necessary...

The term "Black Friday" has been in common use for at least 20 years now, as the common slang for the day after Thanksgiving, when stores get deluged by shoppers. It's the day every store prays for and dreads: when things get chaotic and uncontrollable, but the sales get really great.

So I'm fascinated that this year, for the first time that I recall, the term seems to have become overt and universal. The email flyers we're getting have pretty consistently stopped saying "Day After Thanksgiving", and simply have "Black Friday" in their subject lines, as if that were a national holiday unto itself. I'm not sure whether that reflects wishful thinking or gallows humor...