Marked to Market?

Travis Fast

Does anyone remember the 1990s? Does anyone remember the deafening drone coming out of almost every mainstream think tank from the OECD to the CD Howe about how governments are necessarily inefficient because the goods and services they produce are not marked to market prices and incentives are misaligned; and about how capitalists markets are a superior mechanism for everything from the supply of water to old age pensions because by definition everything is marked to market and incentives are properly aligned?

In the FT today Bernake is quoted as saying that the wretched state of affairs in the credit market was caused by:

the failure of investors to provide adequate oversight of originators and to ensure that originators incentives were properly aligned.

Translation: The credit market failed to generate the right prices for its goods and services because incentives were misaligned.

This odd because the one place orthodox price theory should really perform well is in large, diverse, and liquid markets. Large they were, products quite diversified and thanks to the internationalisation of global savings, liquid they were. All of which was aided and abetted by lots of deficit spending in the big economies and a couple of very supplicant central banks.

It is clearly too early to engage in a massive bout of Schadenfreude but it is fun watching the complex interplay of system maintenance, bravado in the face of a wavering confidence, and sneaky manoeuvres. Bernake has a real problem on his hands. Perhaps Greenspan is having the best laugh of all.

The joke, however—should we get to the penultimate punch line—is going to be on us because we spent a good fifteen years or more trucking even the most basic necessities of life to market only discover that just because you are in the market does not mean that your investments are marked to market or that incentives are properly aligned.



Time to batten down the hatches

Travis Fast

I gave a friend a solid piece of advice back in June. Call your broker and get him to put you into safe waters if he can find it: low risk, no return is better than what is coming down the pipe. That is the only piece of investment advice I have ever given and perhaps ever will.

Well save for perhaps what follows. If I were a betting man I would do the following:

1.) Take a defensive stance with my investments. Try to meet inflation not beat it.

2.) Work off consumer debt, starting from least flexible and the highest interest rates and progress down the consumer financing chain.

3.) At the same time keep cash on hand. Yes it is time to save your money. Home equity is almost finished as a piggy bank and the banks are not going to take property values at face value for a while.

4.) Adjust your savings so that you have the capacity to finance three months of obligations. We may be headed into a cycle of higher and longer unemployment.

5.) If the economy continues to stay relatively strong and employment continues to hold having completed steps one through four will put you in a sound position to resume spending. OTOH if the real economy tanks it will give you a good night’s sleep to know that you have a Plan B which does not require the liquidation of your assets, a trip to bankruptcy court or slavish devotion to your boss.

NB: the advice given above is free advice, therefore, price it accordingly.

Moral Hazard

Travis Fast

Do you feel better now that the world has been made safe from the prospect of moral hazard by rewarding the financial markets with massive liquidity on the cheap and easy?

The problem with the Keynesian notion of irrational exuberance is that given the amount of liquidity that had been sloshing around, and further given the werewolf like hunger of investors for better returns; the rational thing to do was innovate in financial instruments and products. But then maybe that is the rub: there are different rationalities floating around out there.

The Fed cut its so-called discount rate – the rate at which banks can borrow directly from the central bank against a wide range of collateral, including subprime mortgages – from 6.25 per cent to 5.75 per cent. That is only 50 basis points above its main interest rate, the federal funds rate.

Also, the Fed said it was extending the period for which these loans would be available from one day to up to 30 days, renewable at a bank’s request.

But the real gem in this article from the FT is here:

The New York Fed convened an extraordinary conference call for leading Wall Street banks to explain its move and encourage them to use the so-called discount window, saying to do so would be a “sign of strength”.

In recent years, few banks have used the discount window, fearing that going to the Fed for cash might be interpreted as a sign that they were in trouble.

The Fed hopes that if banks know they can always access cash at not-too-punitive terms against mortgage and other securities, they will jumpstart the frozen markets for asset-backed commercial paper and securities backed by “jumbo” mortgages.

Neal Soss, chief economist at Credit Suisse, said: “This is a masterful move because it doesn’t actually feed some of the concerns about moral hazard’’ of bailing out investors who took risks.

The Fed announced the changes in its policy statement following a video conference of its open market committee on Thursday.

I know I feel reassured.

The Invisible Hand and the Central Banks Handouts

By Travis Fast

What a week hey! Do you remember that econ class where right after you were introduced to the invisible hand in the form of some bullshit general equilibrium model and then you were led to the inextricable conclusion that there is no free-lunch? And can you recall in that ideological daze masquerading as value free and clear thinking rigour you still could not square your education with the reality which appeared in the business pages?

Well this week is a particularly bad week for those still clinging to an ontology of capitalism which requires little state intervention. No less than 285 billion US dollars worth of liquidity was pumped into the markets on Thursday and Friday with the ECB kicking in a whopping 213 billion and the US Fed kicking in another 62 billion. And the markets want more! (See this weekend’s WSJ and FT for a fuller account).

But that is not all; the Fed did not just open the window wide open, it did not just provide short term liquidity, it actually directly bought morgage backed securities. That is right folks the Fed is propping-up prices in the securities market. And I thought Liberal Market Economies (LMEs) did not require any form of coordinated government intervention. I wonder if the executive officers are going to get paid according to their marginal contribution this year. Don’t hold your breath that tends to only work in one direction.

Moreover, I doubt we are going hear too many REAL economists cry about the massive government intervention (Austrians do not count as REAL economists) into the markets. Nor are we likely to hear too many cries to let the market choose its own equilibrium. The situation will of course be different if this “perfect financial storm” does real damage to the real economy and real workers start hitting the unemployment line.

Then you can bet when the first bright politician suggests state intervention into labour markets we will be retold some bullshit story about the invisible hand, Say’s Law and the litany.

Political Scientists are Smarter than Economists?

Travis Fast

Now I do not know what the scores are for Canada but according to the GRE statistics reported hereit appears that in two out of the three categories political scientists have superior GRE scores relative to their cousins in economics. But then this should hardly be surprising given that political scientists receive better training in their undergrad in verbal and analytical writing skills than their counterparts in economics. And, as it turns out, economists receive superior training in math in their undergrad education than their political science counterparts.

Thus, each scores better in what they were most heavily trained. Wow who would have thought education works?

This just in: those receiving training in plumbing are better at plumbing than your average DIY weekend warrior. I guess plumbers are smarter than the rest of us.

Note this post is a response Mankiw’s faux humility.

A lesson for Minister Flaherty on perfect competition

Yesterday, Federal Finance Minister Jim Flaherty asked business leaders to pass on savings on imports from the higher Canadian dollar:

“I won’t name the companies, but have spoken to some business leaders about ensuring that they pass along savings … price reductions that should follow the higher Canadian dollar”

Minister Flaherty, permit me to give you a lesson (surely a review) in what you’re supposed to believe. If the price of imports is above cost, an individual importer will have the incentive to lower its prices and take all the market share. Competition theory predicts that each importer will undercut the other until price equals the marginal cost of the imported good. Perfect competition.

In other words Minister, in the theoretical world you live, you need not call on business leaders to reduce prices. They’ll figure that out.

A quick thought on Miller’s budget play

Here’s what I don’t understand about Toronto Mayor David Miller’s failed attempt to introduce new taxes, including those on land transfer and vehicle licensing. Immediately after the vote, Miller suggested that a wide range of services would have to be cut, ranging from snow clearing in North York to policing to the Sheppard subway. If the city has to cut existing services because it cannot raise additional revenue, doesn’t that imply that the city was spending money without the revenue sources to support the spending?

I agree that the city is in the midst of a structural fiscal crisis and that the service cut announcement is an attempt to push the provincial and federal governments into providing more funding. But the threats to current services border on outrageous to the point of being irresponsible.