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When Government Is Like A Box Of Chocolates…


I don’t know if it was Reagan who said it first, but he was the first person I am aware of who said that government’s approach to a problem is often “If it moves, tax it; if it keeps moving, regulate it; if it stops moving, subsidize it.”

This appears to be exactly what has happened in a number of cases recently, but we have discovered that the cycle doesn’t stop there but actually repeats. Financial companies have long been taxed and extensively regulated, but despite all of that earnest oversight, it turned out to be necessary to move to the “subsidization” round. Now, after extensive mollycoddling to rejuvenate the industry, the Obama Administration wants to tax the surviving and thriving companies – including those who have paid back TARP funds by issuing stock and borrowing heavily – to reimburse the country for all those recipients who are highly unlikely to ever repay the government (AIG, GM, etc).

The TARP recipients may not have taken the money originally if they knew that part of the terms included having to pay back not just their own loans, but everybody’s loans. Although, come to think of it, most of the TARP banks had no choice as the Treasury and Fed forced them to take money (to avoid “tainting” the ones who really did need it). The reasoning appears to be that some nebulous banking collective is what benefited from TARP, not just the specific banks in question, and now we must take “from each according to their needs,” as someone once said.

To boot, Vermont Congressman Peter Welch proposed today to copy the 50% tax on bonuses that the British and French are levying. So, rather than accepting the exodus of talent from those countries to our shores, we figure we’ll squeeze our guys too. Clever.

What is really damaging in all this, though, are not the policies in question but the increasing tendency for stochastic/spastic changes in rules.

I recently read a very good book, The Forgotten Man: A New History of the Great Depression, by Amity Shlaes. It is the most unique treatment of that historical period that I have ever read. One of Ms. Shlaes’ implied theses is that overwhelming government intervention during the Depression was partly responsible for extending the duration of the Depression even if it also (perhaps) lessened its depth. She shows how FDR’s Administration’s celebrated progressiveness unsettled the predictability of business relationships and the regulatory structure; this prodded entrepreneurs to be more timid – which is hardly what the economy needed! It is a good book and I recommend it.

This is, of course, what happens when smart people are trying to steer the economy instead of letting the economy steer itself. There must be lots of mid-course corrections because no matter how smart Obama, Geithner, Bernanke, and friends are, they aren’t smart enough to understand the totality of the economy in all its dynamism. When they move this lever here, they realize that it creates a need to turn that knob over there, which further necessitates a button-push way over there. The economy naturally handles many of these things if left along, because businesses have financial incentives (if allowed to keep their gains for their shareholders) to handle those levers, knobs, and buttons that are their own specialty.

Now, whenever I think about volatility in any form I can’t help but think of options, as readers of my book will already know first-hand. One of the best non-financial uses of options theory I can remember hearing was when an old boss of mine, who was otherwise an ogre, explained why New York Knicks guard John Starks was a good player for a bad team but a bad player for a good team. Starks was a streak shooter, which is another way of saying his output in terms of points-per-shot was highly volatile. When he was on, he lit up the scoreboard; when he was off, as Knicks fans recollect to their sorrow, he could drag a team down in Game 7 of the NBA Finals. My former boss observed that on a bad team, this volatility was good because a “win” was an out-of-the-money option and an increase in volatility increases the delta of such an option. In other words, if you were unlikely to win anyway then Starks’ cold periods wouldn’t hurt, but his hot periods would cause you to win some games you wouldn’t have otherwise. However, on a good team that expected to win, a “win” was an in-the-money option and an increase in volatility decreases the delta. So the hot hand doesn’t often help (you were likely to win anyway), but the manos de hielo sometimes sinks you.

This is the key point to be drawn from options theory: if an option is in the money, then an increase in volatility lowers the delta (and the delta can be thought of roughly as the probability of winning); if the option is out of the money, then an increase in volatility raises the delta.

The extension of the option analogy to business may be clear. If the economy is collapsing (I mean, really collapsing), then trying a whole mess of things to stop the implosion of the financial system is arguably warranted, because survival is an out-of-the-money option. But in most cases, the financial/economic system works pretty well, and adding a lot of regulatory volatility to the mix runs the risk of taking that in-the-money option out of the money!

It occurs to me that I am make a presumption here, and that is that the financial/economic system works pretty well if left alone. That laissez-faire philosophy is typical of Republican (old style) or Libertarian thought – the system naturally works. But there are plenty of people who believe that the system doesn’t work if left alone; for example, it doesn’t distribute income “properly.” I suppose if you don’t grant my presumption, then it doesn’t necessarily follow that adding regulatory volatility is bad because even the economy of the mid-80s to mid-90s wasn’t doing what you wanted it to. If a rising tide does not in fact lift all boats, then it is necessary to erect boat lifts.

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Categories: Book Review
  1. Andy
    January 13, 2010 at 7:51 am

    Apparently, you are not the only bear around. Alas, I find myself leaning in your direction.

    America slides deeper into depression as Wall Street revels
    December was the worst month for US unemployment since the Great Recession began.
    By Ambrose Evans-Pritchard
    Published: 6:35PM GMT 10 Jan 2010

    History repeating itself? President Obama has been accused by some economists of making the same mistakes policymakers in the US made in the Great Depression, which followed the Wall Street crash of 1929, pictured Photo: AP
    The labour force contracted by 661,000. This did not show up in the headline jobless rate because so many Americans dropped out of the system. The broad U6 category of unemployment rose to 17.3pc. That is the one that matters.
    Wall Street rallied. Bulls hope that weak jobs data will postpone monetary tightening: a silver lining in every catastrophe, or perhaps a further exhibit of market infantilism.
    The home foreclosure guillotine usually drops a year or so after people lose their job, and exhaust their savings. The local sheriff will escort them out of the door, often with some sympathy –– just like the police in 1932, mostly Irish Catholics who tithed 1pc of their pay for soup kitchens.
    Realtytrac says defaults and repossessions have been running at over 300,000 a month since February. One million American families lost their homes in the fourth quarter. Moody’s Economy.com expects another 2.4m homes to go this year. Taken together, this looks awfully like Steinbeck’s Grapes of Wrath.
    Judges are finding ways to block evictions. One magistrate in Minnesota halted a case calling the creditor “harsh, repugnant, shocking and repulsive”. We are not far from a de facto moratorium in some areas.
    This is how it ended between 1932 and 1934, when half the US states declared moratoria or “Farm Holidays”. Such flexibility innoculated America’s democracy against the appeal of Red Unions and Coughlin Fascists. The home siezures are occurring despite frantic efforts by the Obama administration to delay the process.
    This policy is entirely justified given the scale of the social crisis. But it also masks the continued rot in the housing market, allows lenders to hide losses, and stores up an ever larger overhang of unsold properties. It takes heroic naivety to think the US housing market has turned the corner (apologies to Goldman Sachs, as always). The fuse has yet to detonate on the next mortgage bomb, $134bn (£83bn) of “option ARM” contracts due to reset violently upwards this year and next.
    US house prices have eked out five months of gains on the Case-Shiller index, but momentum stalled in October in half the cities even before the latest surge of 40 basis points in mortgage rates. Karl Case (of the index) says prices may sink another 15pc. “If the 2008 and 2009 loans go bad, then we’re back where we were before – in a nightmare.”
    David Rosenberg from Gluskin Sheff said it is remarkable how little traction has been achieved by zero rates and the greatest fiscal blitz of all time. The US economy grew at a 2.2pc rate in the third quarter (entirely due to Obama stimulus). This compares to an average of 7.3pc in the first quarter of every recovery since the Second World War.
    Fed hawks are playing with fire by talking up about exit strategies, not for the first time. This is what they did in June 2008. We know what happened three months later. For the record, manufacturing capacity use at 67.2pc, and “auto-buying intentions” are the lowest ever.
    The Fed’s own Monetary Multiplier crashed to an all-time low of 0.809 in mid-December. Commercial paper has shrunk by $280bn ($175bn) in since October. Bank credit has been racing down a hair-raising black run since June. It has dropped from $10.844 trillion to $9.013 trillion since November 25. The MZM money supply is contracting at a 3pc annual rate. Broad M3 money is contracting at over 5pc.
    Professor Tim Congdon from International Monetary Research said the Fed is baking deflation into the pie later this year, and perhaps a double-dip recession. Europe is even worse.
    This has not stopped an army of commentators is trying to bounce the Fed into early rate rises. They accuse Ben Bernanke of repeating the error of 2004 when the Fed waited too long. Sometimes you just want to scream. In 2004 there was no housing collapse, unemployment was 5.5pc, banks were in rude good health, and the Fed Multiplier was 1.73.
    How anybody can see imminent inflation in the dying embers of core PCE, just 0.1pc in November, is beyond me.
    Mr Rosenberg is asked by clients why Wall Street does not seem to agree with his grim analysis.
    His answer is that this is the same Mr Market that bought stocks in October 1987 when they were 25pc overvalued on Shiller “10-year normalized earnings basis” – exactly as they are today – and bought them at even more overvalued prices in 2007, long after the property crash had begun, Bear Stearns funds had imploded, and credit had its August heart attack. The stock market has become a lagging indicator. Tear up the textbooks.

  2. Dan Walz
    January 13, 2010 at 3:51 pm

    TMike. his comment is great. I love the John Starks Analogy. Is it still okay for me to have the students subscribe to your Blog. This is exactly the kind of information, using the exactly correct terminology,that they need to hear.

    Dan

    • January 13, 2010 at 4:23 pm

      Dan – Knock yourself out! The more the merrier! The web is a free place*!

      Mike
      * except in China

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