Merry Christmas (belated) and a Happy New Year!!!
No post for Loose Ends this week due to the holidays. I was traveling.
Wednesday, December 31, 2008
Monday, December 22, 2008
The Credit Crisis: A Look at LIBOR
For several weeks, I have been promising to take a closer look at the financial crisis, the symptoms and causes, and the effect of the EESA/TARP on the crisis. As I began to do my research and create an outline, I realized that this is too much for one article. So, over the coming days and weeks, I will be writing a series of articles which take a look at the crisis and the impact of the EESA/TARP. This is the first article and it's focus is LIBOR. (It is still long...)
Until a few months ago, I don't think I had ever even heard of LIBOR. But, to understand the financial crisis, you need to understand LIBOR. So, what is it? It is an acronym for "London Interbank Offered Rate" and it is set by the British Bankers Association (BBA). It is an important interest rate for a few reasons. First, LIBOR is the benchmark rate for unsecured (no collateral) lending between banks. Second, many other interest rates and financial agreements use LIBOR as a reference rate. For example, some adjustable rate mortgages reset rates based on LIBOR.
As we've discussed here before, fractional-reserve banking requires banks to hold only a small amount of cash in their reserves. The rest of the cash can be lent. The constant movement of money requires banks to monitor their reserve requirements - remember, (most) banks (usually) want to keep their reserves at the smallest possible level so that they can maximize the amount of money they lend. This places banks in a situation at the end of each day where they either need additional money or have excess that they can lend.
Here's a simple example. ABC Bank has $10M of deposits from their customers. Assuming a 10% reserve requirement, they need to have $1M on reserve. On a given day, let's say that their customers withdraw $100k. Now, they will only have $900k in reserves against $9.9M in deposits which would have a requirement of $990k in reserves. So, ABC Bank needs $90k in cash to cover their reserve requirement.
At the same time XYZ Bank also has $10M of deposits and $1M on reserve. But, let's say on this same day, they actually have an increase in deposits of $100k. That leaves them with $10.1M in deposits, a reserve requirement of $1.01M, and $1.1M on hand. So, they have an extra $90k. This $90k can then be lent from XYZ bank to ABC bank. These are typically very short term loans (sometimes just overnight) which all banks to stay liquid (keep lending money) while maintaining reserve requirements.
LIBOR is the basically the prevailing interest rate for the these interbank loans which are originated on a given day. LIBOR is set each day in London. Banks submit details of the interest rates being used in the interbank lending market to the BBA who then calculates the average interest rate. LIBOR is calculated for ten different currencies and various loan maturities ranging from overnight to one year. We are interested in the rates for loans in US Dollars with overnight, one month and three month maturities.
You've probably heard a lot of discussion that the credit crisis is due, in part, to banks not lending to each other. If banks don't lend to each other, then they have to be more careful managing their reserve requirements. This implies that they take less risk, hold larger reserves, and, thus, don't lend as much to consumers or businesses either. The following graph shows the history of LIBOR (US Dollars, 1 Month) since its inception in 1986.
Source for LIBOR data in this article: BBA, Data here (it was a pain to compile!)
The first thing to recognize from the recent crisis is that there was a large jump in the rate which has been followed by a steep decline in the rate. I also graphed and analyzed the difference in the rate from one day to the next since 1986 (not shown). The interesting thing is that rates are usually remarkably stable. The average daily change in the rate is only 0.12 basis points (a basis point is 1/100th of a percentage point). Even more interesting is that the largest changes in the rate from one day to the next have almost been exclusively at the end of November or the end of December in any given year. I'm not exactly sure why this is, but I would guess that it has something to do with the need for lending increasing at the close of the calendar year for reporting or tax purposes. Outside of those jumps, there have only been 26 days in the last 22 years when there was a one day shift of more than 25 basis points.
As you can see from the above chart, LIBOR is relatively stable. Most of the volatility occurs in November and December (as mentioned above). However, September and October of this year saw seven days with 25+ basis point shifts. We haven't had a period of that much volatility since the summer of 1998 as the Asia was reeling from the effects of its own financial crisis and Long Term Capital Management was in the process of imploding. You should also notice that after the post-September 11 volatility in 2001, there was not a single day where LIBOR moved more than 25 basis points from the previous day until September 2007 when the subprime mortgage mess was unfolding.
It is the recent volatility of LIBOR and not the actual rates which indicate the presence of a problem. It is also important to understand that rates are relative. An interest rate of 5% would seem astronomical today, but this is approximately the historical average for 1 month LIBOR. One way to gauge this is to compare on rate to another rate. This is done by simply subtracting one rate from another and expressing that difference (called a spread) in basis points. So, if you compare 3 month LIBOR and 1 month LIBOR you would expect to see little difference in the rates. The graph below shows the history.
There have been a few periods of volatility in this spread. Notice that the spread recently is at high levels (roughly +50 basis points). There was a shock towards the end of 1999 and some very high spreads (averaging almost +100 basis points) in mid- to late-October of 1987 when the stock market crashed. The other times with very high levels generally correspond to times when 1 month LIBOR was volatile from one day to the next as described above (mostly in November and December). Generally, the spread is positive - 80% of the time it is non-negative. It tends to be negative in December. It was negative for most of 2004.
So, what factors drive this spread? First of all, let's think about the purpose of interest rates. If you are going to lend someone money, there are two key factors that are involved: the value of money and the risk of the loan. What do I mean by the value of money? Money represents an opportunity to spend it on something. If money is lent, it obviously cannot be used by the lender. There is an opportunity cost to this which is equal to the value which could be created by other investments with the money. Risk is a bit more obvious. If the lender deems the loan to be risky, they will ask for a higher interest rate to hedge against default.
Generally speaking, it should make sense for interest rates on a 3 month loan to be slightly higher than rates on a 1 month loan. There is more time for an event to occur which increases the risk of a default by the borrower or an increased need for cash by the lender. Also, for most of the last 100 years, the U.S. has experienced inflation. As money loses value (due to inflation), more money is required to be paid back to be cover the original value. The longer the period of the loan and the higher the expectations, the larger the spread will be. If you graph the interest rates against different loan maturities, you get what is called the yield curve.
When the yield curve "flips", it means that interest rates are actually higher for shorter-term loans. This can occur when things are not "normal". If you expect money to gain value (due to deflation), you would accept lower rates on longer-term loans. If you expect rates to decrease, due to either macroeconomic factors or central bank policy, you would also consider lower rates on longer-term loans.
As mentioned earlier, there has been a positive spread (3 month higher than 1 month) 80% of the time. The three periods of time where the spread has been very high were after the market crash in 1987, late 1999, and the recent crisis. All three of these periods correspond to high-risk environments (I'm assuming that the high spread in 1999 was due to Y2K fear). In 2004, the spread was negative for much of the year as interest rates were falling all year, and banks were willing to bet on that.
One more graph... In 2001, an overnight rate for LIBOR was introduced. This graph will look at the spread between 3 month and 1 month as well as the spread between 1 month and overnight.
Notice here that the spread between 1 month and overnight (1m-o/n) is more volatile than the 3m-1m spread that we already looked at. There were shocks after 9/11 and then off-and-on for the last year or so. In the weeks leading up to the week of September 15, 1m-o/n hovered around 30 basis points. Then Lehman Brothers announced they were going bankrupt and Merrill Lynch was in trouble. Overnight LIBOR jumped 96 basis points and 1m-o/n went negative. It got worse the next day when overnight hit 6.4375% (a 333 basis point increase); 1 month remained somewhat stable moving the 1m-o/n spread to -369 basis points. This was the day that AIG failed. By the end of the week, Paulson and Bush announced they had a plan, overnight LIBOR had settled to 3.25% with a -6 basis point spread on 1m-o/n.
The next week, 1 month and 3 month LIBOR grew while overnight fell placing 1m-o/n spreads north of +100 basis points by the end of the week. On September 29, the original EESA plan failed to pass in the House. The next day, overnight again shot up, this time to 6.875%. It settled back down and positive spreads returned until October 8 after Iceland's economy collapsed, stock markets around the world had large losses, and AIG received more funding - all this despite rate cuts by central banks around the world. Overnight again spiked for two days until the beginning of a sharp decline which has continued (with a few bumps) until rates stayed under 0.2% for the entire week of December 8 (data from the BBA is only available through December 12 at this point). This has left 1m-o/n spreads between 100 and 150 basis points for nearly two months.
It is safe to say that the interbank lending market has been a bit crazy lately which is at least a symptom of the market turmoil. There are some reports out there which have questioned the relevance and accuracy of LIBOR in the last year or so. It is argued that the increased role which central banks have played in lending has diminished the need for interbank lending. This leads to a less efficient market and less accurate LIBOR quotes. The BBA has disputed this. Further, a recent article by the Wall Street Journal discusses how the BBA has clarified that loans which are secured by the government cannot be used in defining LIBOR which is intended to represent unsecured lending rates. The BBA has another announcement here discussing the steps they are taking to add more transparency and trust in the process.
Ok. I know that is a lot of information. I hope it is helpful in understanding this important component of the financial system. The next article in this series will take a look at the FED and the famous FED funds rate.
Until a few months ago, I don't think I had ever even heard of LIBOR. But, to understand the financial crisis, you need to understand LIBOR. So, what is it? It is an acronym for "London Interbank Offered Rate" and it is set by the British Bankers Association (BBA). It is an important interest rate for a few reasons. First, LIBOR is the benchmark rate for unsecured (no collateral) lending between banks. Second, many other interest rates and financial agreements use LIBOR as a reference rate. For example, some adjustable rate mortgages reset rates based on LIBOR.
As we've discussed here before, fractional-reserve banking requires banks to hold only a small amount of cash in their reserves. The rest of the cash can be lent. The constant movement of money requires banks to monitor their reserve requirements - remember, (most) banks (usually) want to keep their reserves at the smallest possible level so that they can maximize the amount of money they lend. This places banks in a situation at the end of each day where they either need additional money or have excess that they can lend.
Here's a simple example. ABC Bank has $10M of deposits from their customers. Assuming a 10% reserve requirement, they need to have $1M on reserve. On a given day, let's say that their customers withdraw $100k. Now, they will only have $900k in reserves against $9.9M in deposits which would have a requirement of $990k in reserves. So, ABC Bank needs $90k in cash to cover their reserve requirement.
At the same time XYZ Bank also has $10M of deposits and $1M on reserve. But, let's say on this same day, they actually have an increase in deposits of $100k. That leaves them with $10.1M in deposits, a reserve requirement of $1.01M, and $1.1M on hand. So, they have an extra $90k. This $90k can then be lent from XYZ bank to ABC bank. These are typically very short term loans (sometimes just overnight) which all banks to stay liquid (keep lending money) while maintaining reserve requirements.
LIBOR is the basically the prevailing interest rate for the these interbank loans which are originated on a given day. LIBOR is set each day in London. Banks submit details of the interest rates being used in the interbank lending market to the BBA who then calculates the average interest rate. LIBOR is calculated for ten different currencies and various loan maturities ranging from overnight to one year. We are interested in the rates for loans in US Dollars with overnight, one month and three month maturities.
You've probably heard a lot of discussion that the credit crisis is due, in part, to banks not lending to each other. If banks don't lend to each other, then they have to be more careful managing their reserve requirements. This implies that they take less risk, hold larger reserves, and, thus, don't lend as much to consumers or businesses either. The following graph shows the history of LIBOR (US Dollars, 1 Month) since its inception in 1986.
Source for LIBOR data in this article: BBA, Data here (it was a pain to compile!)The first thing to recognize from the recent crisis is that there was a large jump in the rate which has been followed by a steep decline in the rate. I also graphed and analyzed the difference in the rate from one day to the next since 1986 (not shown). The interesting thing is that rates are usually remarkably stable. The average daily change in the rate is only 0.12 basis points (a basis point is 1/100th of a percentage point). Even more interesting is that the largest changes in the rate from one day to the next have almost been exclusively at the end of November or the end of December in any given year. I'm not exactly sure why this is, but I would guess that it has something to do with the need for lending increasing at the close of the calendar year for reporting or tax purposes. Outside of those jumps, there have only been 26 days in the last 22 years when there was a one day shift of more than 25 basis points.
As you can see from the above chart, LIBOR is relatively stable. Most of the volatility occurs in November and December (as mentioned above). However, September and October of this year saw seven days with 25+ basis point shifts. We haven't had a period of that much volatility since the summer of 1998 as the Asia was reeling from the effects of its own financial crisis and Long Term Capital Management was in the process of imploding. You should also notice that after the post-September 11 volatility in 2001, there was not a single day where LIBOR moved more than 25 basis points from the previous day until September 2007 when the subprime mortgage mess was unfolding.It is the recent volatility of LIBOR and not the actual rates which indicate the presence of a problem. It is also important to understand that rates are relative. An interest rate of 5% would seem astronomical today, but this is approximately the historical average for 1 month LIBOR. One way to gauge this is to compare on rate to another rate. This is done by simply subtracting one rate from another and expressing that difference (called a spread) in basis points. So, if you compare 3 month LIBOR and 1 month LIBOR you would expect to see little difference in the rates. The graph below shows the history.
There have been a few periods of volatility in this spread. Notice that the spread recently is at high levels (roughly +50 basis points). There was a shock towards the end of 1999 and some very high spreads (averaging almost +100 basis points) in mid- to late-October of 1987 when the stock market crashed. The other times with very high levels generally correspond to times when 1 month LIBOR was volatile from one day to the next as described above (mostly in November and December). Generally, the spread is positive - 80% of the time it is non-negative. It tends to be negative in December. It was negative for most of 2004.So, what factors drive this spread? First of all, let's think about the purpose of interest rates. If you are going to lend someone money, there are two key factors that are involved: the value of money and the risk of the loan. What do I mean by the value of money? Money represents an opportunity to spend it on something. If money is lent, it obviously cannot be used by the lender. There is an opportunity cost to this which is equal to the value which could be created by other investments with the money. Risk is a bit more obvious. If the lender deems the loan to be risky, they will ask for a higher interest rate to hedge against default.
Generally speaking, it should make sense for interest rates on a 3 month loan to be slightly higher than rates on a 1 month loan. There is more time for an event to occur which increases the risk of a default by the borrower or an increased need for cash by the lender. Also, for most of the last 100 years, the U.S. has experienced inflation. As money loses value (due to inflation), more money is required to be paid back to be cover the original value. The longer the period of the loan and the higher the expectations, the larger the spread will be. If you graph the interest rates against different loan maturities, you get what is called the yield curve.
When the yield curve "flips", it means that interest rates are actually higher for shorter-term loans. This can occur when things are not "normal". If you expect money to gain value (due to deflation), you would accept lower rates on longer-term loans. If you expect rates to decrease, due to either macroeconomic factors or central bank policy, you would also consider lower rates on longer-term loans.
As mentioned earlier, there has been a positive spread (3 month higher than 1 month) 80% of the time. The three periods of time where the spread has been very high were after the market crash in 1987, late 1999, and the recent crisis. All three of these periods correspond to high-risk environments (I'm assuming that the high spread in 1999 was due to Y2K fear). In 2004, the spread was negative for much of the year as interest rates were falling all year, and banks were willing to bet on that.
One more graph... In 2001, an overnight rate for LIBOR was introduced. This graph will look at the spread between 3 month and 1 month as well as the spread between 1 month and overnight.
Notice here that the spread between 1 month and overnight (1m-o/n) is more volatile than the 3m-1m spread that we already looked at. There were shocks after 9/11 and then off-and-on for the last year or so. In the weeks leading up to the week of September 15, 1m-o/n hovered around 30 basis points. Then Lehman Brothers announced they were going bankrupt and Merrill Lynch was in trouble. Overnight LIBOR jumped 96 basis points and 1m-o/n went negative. It got worse the next day when overnight hit 6.4375% (a 333 basis point increase); 1 month remained somewhat stable moving the 1m-o/n spread to -369 basis points. This was the day that AIG failed. By the end of the week, Paulson and Bush announced they had a plan, overnight LIBOR had settled to 3.25% with a -6 basis point spread on 1m-o/n.The next week, 1 month and 3 month LIBOR grew while overnight fell placing 1m-o/n spreads north of +100 basis points by the end of the week. On September 29, the original EESA plan failed to pass in the House. The next day, overnight again shot up, this time to 6.875%. It settled back down and positive spreads returned until October 8 after Iceland's economy collapsed, stock markets around the world had large losses, and AIG received more funding - all this despite rate cuts by central banks around the world. Overnight again spiked for two days until the beginning of a sharp decline which has continued (with a few bumps) until rates stayed under 0.2% for the entire week of December 8 (data from the BBA is only available through December 12 at this point). This has left 1m-o/n spreads between 100 and 150 basis points for nearly two months.
It is safe to say that the interbank lending market has been a bit crazy lately which is at least a symptom of the market turmoil. There are some reports out there which have questioned the relevance and accuracy of LIBOR in the last year or so. It is argued that the increased role which central banks have played in lending has diminished the need for interbank lending. This leads to a less efficient market and less accurate LIBOR quotes. The BBA has disputed this. Further, a recent article by the Wall Street Journal discusses how the BBA has clarified that loans which are secured by the government cannot be used in defining LIBOR which is intended to represent unsecured lending rates. The BBA has another announcement here discussing the steps they are taking to add more transparency and trust in the process.
Ok. I know that is a lot of information. I hope it is helpful in understanding this important component of the financial system. The next article in this series will take a look at the FED and the famous FED funds rate.
Sunday, December 21, 2008
Loose Ends... Vol. XXII
Holy Blagojevich!
I've intended to write about the Rod Blagojevich situation for a while now. A few weeks ago, over the Thanksgiving holiday, my brother, an Illinois resident, was in town. We actually had a conversation regarding the corruption and arrogance of Blagojevich as we read his Wikipedia entry and discussed the news which swirled around him. This was before the current scandal. Funny.
Anyhow, Blago had his first press conference since the charges were leveled against him. Wow! This man is something else. I think that he must have some information that he can either use as leverage in negotiations or that will take down someone big with him. Maybe not... he might just be a bit crazy. Either way, this will be interesting to watch. In terms of Chicago politics, I'd be shocked if there isn't at least some embarrassing dirt on Obama. We'll see...
*****
President Bush again showed his arrogance by performing an end-around on Congress and giving GM and Chrysler emergency loans. Technically, this was not illegal since they used the EESA/TARP funding - although, I'm not convinced that was constitutional in the first place.
I continue to find the terms of this loan interesting in that the funds can be called back if proper restructuring does not take place or long-term viability is not evident. But, it is my understanding that these loans are necessary to fund basic operations and debt repayment. Once they get these loans, the money will be spent. There won't be anything to get back.
The most interesting thing about this story is that Paulson will now ask Congress to release the last $350B installment of the EESA/TARP funds. On December 10, Neel Kashkari testified before the House Financial Services Committee and was asked explicitly if the funds would be requested. He, of course, danced around the question. Congress is adjourned for the holidays. Once Paulson requests the funds, Congress has 15 days to pass legislation to block the funding. Otherwise, the money is released.
After Kashkari's testimony on the 10th, Paulson appeared on CNBC for an interview. He stated that the Treasury Department had no plans to ask for the remaining $350B. This is after GOP Senators blocked the auto bailout legislation. This is after Bush stated that the White House would act. Paulson had to know that TARP funding would be used at that point. He would have known that giving GM and Chrysler $17.4B would pretty much exhaust the first $350B. Three days after the CNBC interview, he indicates that he will ask for the $350B.
Now, Congress is adjourned. Tomorrow is the 22nd, fifteen days from then will be January 6. The 111th Congress officially starts on January 3, but will not meet until January 6. It might be a bit difficult for them to pass legislation to block the funds.
*****
The mayor of Beech Grove, IN, an independent city surrounded by Indianapolis, released a statement to city employees this week. They are in the midst of a budget crisis. Discussion can be found here.
I've intended to write about the Rod Blagojevich situation for a while now. A few weeks ago, over the Thanksgiving holiday, my brother, an Illinois resident, was in town. We actually had a conversation regarding the corruption and arrogance of Blagojevich as we read his Wikipedia entry and discussed the news which swirled around him. This was before the current scandal. Funny.
Anyhow, Blago had his first press conference since the charges were leveled against him. Wow! This man is something else. I think that he must have some information that he can either use as leverage in negotiations or that will take down someone big with him. Maybe not... he might just be a bit crazy. Either way, this will be interesting to watch. In terms of Chicago politics, I'd be shocked if there isn't at least some embarrassing dirt on Obama. We'll see...
*****
President Bush again showed his arrogance by performing an end-around on Congress and giving GM and Chrysler emergency loans. Technically, this was not illegal since they used the EESA/TARP funding - although, I'm not convinced that was constitutional in the first place.
I continue to find the terms of this loan interesting in that the funds can be called back if proper restructuring does not take place or long-term viability is not evident. But, it is my understanding that these loans are necessary to fund basic operations and debt repayment. Once they get these loans, the money will be spent. There won't be anything to get back.
The most interesting thing about this story is that Paulson will now ask Congress to release the last $350B installment of the EESA/TARP funds. On December 10, Neel Kashkari testified before the House Financial Services Committee and was asked explicitly if the funds would be requested. He, of course, danced around the question. Congress is adjourned for the holidays. Once Paulson requests the funds, Congress has 15 days to pass legislation to block the funding. Otherwise, the money is released.
After Kashkari's testimony on the 10th, Paulson appeared on CNBC for an interview. He stated that the Treasury Department had no plans to ask for the remaining $350B. This is after GOP Senators blocked the auto bailout legislation. This is after Bush stated that the White House would act. Paulson had to know that TARP funding would be used at that point. He would have known that giving GM and Chrysler $17.4B would pretty much exhaust the first $350B. Three days after the CNBC interview, he indicates that he will ask for the $350B.
Now, Congress is adjourned. Tomorrow is the 22nd, fifteen days from then will be January 6. The 111th Congress officially starts on January 3, but will not meet until January 6. It might be a bit difficult for them to pass legislation to block the funds.
*****
The mayor of Beech Grove, IN, an independent city surrounded by Indianapolis, released a statement to city employees this week. They are in the midst of a budget crisis. Discussion can be found here.
Friday, December 19, 2008
Free Market?
There is no such thing as a true "free market" and who would want it anyway. A lawless, unregulated, and volatile "free market" would be disastrous from a social standpoint.
Laws and regulations that protect possessions and their value create incentive to work for those possessions (and the "Invisible Hand" brings the whole economy up). When the ability to hold on to your possessions or to value them (through a stable-ish currency) ceases to exist, you have no incentive other than to fight for shelter and food (Maslow stuff).
Maintaining a stable-ish "value" of possessions (assuming the legal ability to protect possessions) is done by managing their demand, right? Increasing demand (by interest rates or quantitative measures) has proved to be fairly useful over the course of time, no? Also, decreasing demand through the same tactics has been useful too, though the political implications of doing so have left the practice used all too infrequently.
Let's throw away the "free market" discussion in lieu of something more practical. Societies need to ensure safety and relative stability of the value of possessions. To do this, economies need some "tinkering" to ensure possessions maintain their value to avoid "adjustments" that are too painful for modern societies to bear.
Bush and his team are doing the right things. Flooding the markets with cash (among other tactics) to increase demand at a time the taxpayer can get paid to do so (borrowing at negative real interest rates) is a no brainer tactic to protect price stability. Let's not overthink this!
I'll take orderly over free any day!
Laws and regulations that protect possessions and their value create incentive to work for those possessions (and the "Invisible Hand" brings the whole economy up). When the ability to hold on to your possessions or to value them (through a stable-ish currency) ceases to exist, you have no incentive other than to fight for shelter and food (Maslow stuff).
Maintaining a stable-ish "value" of possessions (assuming the legal ability to protect possessions) is done by managing their demand, right? Increasing demand (by interest rates or quantitative measures) has proved to be fairly useful over the course of time, no? Also, decreasing demand through the same tactics has been useful too, though the political implications of doing so have left the practice used all too infrequently.
Let's throw away the "free market" discussion in lieu of something more practical. Societies need to ensure safety and relative stability of the value of possessions. To do this, economies need some "tinkering" to ensure possessions maintain their value to avoid "adjustments" that are too painful for modern societies to bear.
Bush and his team are doing the right things. Flooding the markets with cash (among other tactics) to increase demand at a time the taxpayer can get paid to do so (borrowing at negative real interest rates) is a no brainer tactic to protect price stability. Let's not overthink this!
I'll take orderly over free any day!
Wednesday, December 17, 2008
Bush "Saves" The "Free Market"
This is the best transcript I could find so far - go about 1/3 or 1/2 way down to get Bush's comments.
I'm almost at a loss for words. First off, anyone who describes our existing system as a free market system is fooling themselves. I know, I know... "this is the most free market system in the world." Well, perhaps. I really don't know how we could objectively go about measuring that.
But,
a system where a central bank can manipulate interest rates by means of fiat currency is not free market;
a system where legislators can manipulate investment decisions by providing tax subsidies is not a free market;
a system where legislators can modify tax policies on income, consumption and imports which are de facto subsidies to other activities is not a free market;
a system where private property is only protected when it is convenient as the judiciary has ruled that the government has almost complete authority in eminent domain is not a free market;
a system where the executive branch is asleep at the wheel by not enforcing regulations - despite the inherent validity of the regulations - is not a free market.
This is not a free market system. I'm not calling it socialism. I'm not exactly calling it fascism or corporatism. But, central planning is a key component of our system.
The free market is not failing. Our hybrid system which uses central planning to intervene in the free market based on the whims of Washington is failing.
I feel a sense of obligation to my successor to make sure there is not a, you know, a huge economic crisis. Look, we're in a crisis now. I mean, we're in a huge recession, but I don't want to make it even worse and on the other hand, I'm mindful of not putting good money after bad so we're working through some options.
I've abandoned free market principles to save the free market system. I think when people review what has taken place in the last six months and put it all in one package, they'll realize how significantly we have moved.
I'm almost at a loss for words. First off, anyone who describes our existing system as a free market system is fooling themselves. I know, I know... "this is the most free market system in the world." Well, perhaps. I really don't know how we could objectively go about measuring that.
But,
a system where a central bank can manipulate interest rates by means of fiat currency is not free market;
a system where legislators can manipulate investment decisions by providing tax subsidies is not a free market;
a system where legislators can modify tax policies on income, consumption and imports which are de facto subsidies to other activities is not a free market;
a system where private property is only protected when it is convenient as the judiciary has ruled that the government has almost complete authority in eminent domain is not a free market;
a system where the executive branch is asleep at the wheel by not enforcing regulations - despite the inherent validity of the regulations - is not a free market.
This is not a free market system. I'm not calling it socialism. I'm not exactly calling it fascism or corporatism. But, central planning is a key component of our system.
The free market is not failing. Our hybrid system which uses central planning to intervene in the free market based on the whims of Washington is failing.
Tuesday, December 16, 2008
FED Drops Rates Again
The FED announced today that it would lower its target for the federal funds rate to a range of 0-0.25%. This unprecedented move allegedly was the catalyst for a 359 point gain for the Dow Jones. It was also the catalyst for a 2.7% drop in the U.S. Dollar Index. However, the effective funds rate has been in this range for a while now. More on this in the coming weeks...
This is, of course, short-term noise - so what will the longer-term impacts be? I still don't know. I've been worried about hyperinflation for some time, but have read some things lately which make a decent argument for deflation. If I had to bet today, I'd bet on deflation for luxury goods and investment assets such as homes, cars and stocks. On the other hand, I'd be on inflation for commodities and basic staples.
At some point, I'll dig deeper and provide my final analysis.
This is, of course, short-term noise - so what will the longer-term impacts be? I still don't know. I've been worried about hyperinflation for some time, but have read some things lately which make a decent argument for deflation. If I had to bet today, I'd bet on deflation for luxury goods and investment assets such as homes, cars and stocks. On the other hand, I'd be on inflation for commodities and basic staples.
At some point, I'll dig deeper and provide my final analysis.
Ponzi Schemes and Social Security
In light of the recent Bernard Madoff investment scandal, I wanted to investigate the definition and structure of a Ponzi scheme. Ponzi schemes and pyramid schemes are similar in that new investments of money are used to pay other investors. However, Ponzi schemes are generally positioned as investments in a central fund where pyramid schemes pay investors who recruit new investors.
Here's a simple example. Let's say there is a fund which touts the high yield return of 5% per month by some sophisticated and complex investment techniques. This initially attracts 10 investors with $100 each. At the end of one month, the fund shows growth for each account to $105. Realizing that this type of return yields almost 80% annually, it attracts more investors. So, 10 more investors each invest $100. Let's say this continues for one year without any sign of problems.
At the end of the first year, the fund would have collected $12,000 (12 months * 10 investors per month * $100 per investor). Each investor would have an account balance which reflects the 5% monthly yield. The total sum of all investors' account balances would show as $16,712.98. But, since this is a fraudulent scheme, none of the extra $4,712.98 actually exists. However, as long as the investors don't "cash out", the scheme continues. Meanwhile, typically, the fund manager has probably "cashed in" some of the original $12,000 for personal purposes. This game can be played as long as new investment capital exceeds the demands for cashing out (or until the fund manager gets caught).
So, this brings me to Social Security. I have a new article this morning on United Liberty discussing this topic. I contend that Social Security is nothing more than a structured Ponzi scheme. Workers "invest" into Social Security (via forced taxation). The money from those investments are used to pay off previous investors (current retirees and beneficiaries). Today, the amount of money coming in exceeds the money going out. This excess cash is then used by the government to fund other spending, so there is no money in the investment fund. Technically, the Social Security program takes this excess cash an purchases government bonds. Today, the value of bonds held equates to over $2 trillion. This will all get interesting in the next 10-20 years when the amount of new investment is not enough to cover the money required to be paid out.
This scheme will collapse.
Here's a simple example. Let's say there is a fund which touts the high yield return of 5% per month by some sophisticated and complex investment techniques. This initially attracts 10 investors with $100 each. At the end of one month, the fund shows growth for each account to $105. Realizing that this type of return yields almost 80% annually, it attracts more investors. So, 10 more investors each invest $100. Let's say this continues for one year without any sign of problems.
At the end of the first year, the fund would have collected $12,000 (12 months * 10 investors per month * $100 per investor). Each investor would have an account balance which reflects the 5% monthly yield. The total sum of all investors' account balances would show as $16,712.98. But, since this is a fraudulent scheme, none of the extra $4,712.98 actually exists. However, as long as the investors don't "cash out", the scheme continues. Meanwhile, typically, the fund manager has probably "cashed in" some of the original $12,000 for personal purposes. This game can be played as long as new investment capital exceeds the demands for cashing out (or until the fund manager gets caught).
So, this brings me to Social Security. I have a new article this morning on United Liberty discussing this topic. I contend that Social Security is nothing more than a structured Ponzi scheme. Workers "invest" into Social Security (via forced taxation). The money from those investments are used to pay off previous investors (current retirees and beneficiaries). Today, the amount of money coming in exceeds the money going out. This excess cash is then used by the government to fund other spending, so there is no money in the investment fund. Technically, the Social Security program takes this excess cash an purchases government bonds. Today, the value of bonds held equates to over $2 trillion. This will all get interesting in the next 10-20 years when the amount of new investment is not enough to cover the money required to be paid out.
This scheme will collapse.
Sunday, December 14, 2008
Loose Ends... Vol. XXI
After Thaddeus disappointing me this week, I have to say I'm a little disappointed in myself for being less than active here over the last few weeks. The Thanksgiving holiday, illness, and other excuses come to mind... but, it's time to get back to business here and help readers in their resistance to government- and media-induced soma consumption.
*****
Tonight, Nicole and I attended our first Libertarian Party event here in Indianapolis. We saw LP VP candidate, Wayne Allyn Root, speak at a dinner at the Rathskeller, a great German restaurant and bar downtown. Mr. Root gave a pretty good speech discussing libertarianism, the Libertarian Party, Barack Obama, and bailouts. It was no secret that he has already begun his campaign to become the LP candidate for President in 2012. I like Root; I'm not sure how well he'll fare, but he brings charisma to a party that desperately needs it. At times, I fear he has too much charisma and comes across as a used car salesman.
Aside from the speech, the evening went pretty well. I am still struggling with the destination (if any) of my political affiliation. At another time down the road, I will address this topic in more detail. In the meantime, I plan on assisting the local LP and keeping my options open.
*****
As I type right now, I am watching the replay of the hearing before the House Financial Services Committee earlier this week (December 10). This week's hearing starred Gene Dodaro, acting Comptroller General, and Neel Kashkari, Interim Assistant Secretary of the Treasury for Financial Stability (fit that on a business card!). Kashkari received most of the questions as he has been responsible for administering the $700B bailout under the EESA/TARP legislation. This is a popular topic.
It amazes me, at least on some level, that the members of the committee are so surprised with the program to-date. Question upon question indicate a level of shock and disappointment with the use of funds under the program. But, at the end of the day, under the legislation, there was little or no direction given nor strict oversight required in the use of funds. There are complaints that the banks are hoarding money, or using the funds "inappropriately" - what?! The legislation gave almost complete and unilateral power to the Treasury Department. Now that they have acted upon such authority, Congress is grandstanding that they are not doing what they are "supposed" to be doing. Perhaps they should have spent a little more time crafting the legislation rather than giving in to Paulson's threats of martial law. Or, perhaps they should have voted against the legislation! I guess I'm not really that amazed...
On a side note, I have to give some props to Kashkari for his ability to answer questions like a first-rate politician... "Thank you, Congressman, for that question", "I appreciate your feedback, we take it very seriously"... he bobs and weaves with the best of them.
*****
That leads me to the auto bailout. Congress, the White House, and the incoming administration need to wake up and recognize that they cannot solve this problem with legislation. They cannot solve this problem with bad loans. I truly feel bad for those who have made their livelihood in the auto industry - or, even worse, bet their futures and retirements based on the vitality of the auto industry. But, these companies need to fail. The supply chain may need to fail. Voids will be filled. Life will go on. Time heals wounds. There is not an easy answer to this issue.
I found this article at mises.org which discusses the demise of the piano industry in the United States. It is not terribly analytical nor deeply rooted in economics, but it tells a good story that I feel is very relevant as we consider the auto industry.
*****
Finally, I'd like to (again) highlight some upcoming work that I will be posting on this blog. I'm getting closer in some of the analysis and think that I'll be able to begin providing some of it this week. My first series of articles will be a review of the financial markets, specifically the credit crisis and the effect of the EESA/TARP legislation.
*****
Tonight, Nicole and I attended our first Libertarian Party event here in Indianapolis. We saw LP VP candidate, Wayne Allyn Root, speak at a dinner at the Rathskeller, a great German restaurant and bar downtown. Mr. Root gave a pretty good speech discussing libertarianism, the Libertarian Party, Barack Obama, and bailouts. It was no secret that he has already begun his campaign to become the LP candidate for President in 2012. I like Root; I'm not sure how well he'll fare, but he brings charisma to a party that desperately needs it. At times, I fear he has too much charisma and comes across as a used car salesman.
Aside from the speech, the evening went pretty well. I am still struggling with the destination (if any) of my political affiliation. At another time down the road, I will address this topic in more detail. In the meantime, I plan on assisting the local LP and keeping my options open.
*****
As I type right now, I am watching the replay of the hearing before the House Financial Services Committee earlier this week (December 10). This week's hearing starred Gene Dodaro, acting Comptroller General, and Neel Kashkari, Interim Assistant Secretary of the Treasury for Financial Stability (fit that on a business card!). Kashkari received most of the questions as he has been responsible for administering the $700B bailout under the EESA/TARP legislation. This is a popular topic.
It amazes me, at least on some level, that the members of the committee are so surprised with the program to-date. Question upon question indicate a level of shock and disappointment with the use of funds under the program. But, at the end of the day, under the legislation, there was little or no direction given nor strict oversight required in the use of funds. There are complaints that the banks are hoarding money, or using the funds "inappropriately" - what?! The legislation gave almost complete and unilateral power to the Treasury Department. Now that they have acted upon such authority, Congress is grandstanding that they are not doing what they are "supposed" to be doing. Perhaps they should have spent a little more time crafting the legislation rather than giving in to Paulson's threats of martial law. Or, perhaps they should have voted against the legislation! I guess I'm not really that amazed...
On a side note, I have to give some props to Kashkari for his ability to answer questions like a first-rate politician... "Thank you, Congressman, for that question", "I appreciate your feedback, we take it very seriously"... he bobs and weaves with the best of them.
*****
That leads me to the auto bailout. Congress, the White House, and the incoming administration need to wake up and recognize that they cannot solve this problem with legislation. They cannot solve this problem with bad loans. I truly feel bad for those who have made their livelihood in the auto industry - or, even worse, bet their futures and retirements based on the vitality of the auto industry. But, these companies need to fail. The supply chain may need to fail. Voids will be filled. Life will go on. Time heals wounds. There is not an easy answer to this issue.
I found this article at mises.org which discusses the demise of the piano industry in the United States. It is not terribly analytical nor deeply rooted in economics, but it tells a good story that I feel is very relevant as we consider the auto industry.
*****
Finally, I'd like to (again) highlight some upcoming work that I will be posting on this blog. I'm getting closer in some of the analysis and think that I'll be able to begin providing some of it this week. My first series of articles will be a review of the financial markets, specifically the credit crisis and the effect of the EESA/TARP legislation.
Wednesday, December 10, 2008
Thaddeus Disappoints
On September 29, 2008, these words were spoken on the floor of the House:
These were the words of Thaddeus McCotter (R-MI) on the floor of the House opposing the now infamous $700B TARP/EESA bailout. That measure failed that day to the pleasant surprise of most Americans.
Tonight, McCotter led the GOP charge (it was a weak charge) in support of the emergency loans for the automotive industry. The Democrats really didn't need his help, the bill probably would have passed without any GOP support (it would have been really close).
Now, I listened to McCotter's comments at the committee hearings last week and his speech on the floor tonight. I have to say that I'm disappointed. I felt that his impassioned speech against the Wall Street bailout was the most eloquent and succinct argument given on the floor. In his support of the auto bailout, he has done a 180 on his position. At the end of the day, the argument against the auto bailout should have been the same.
He is from Michigan. He is supporting his constituents. This is nothing but a massive dose of pork. He joins the rank and file of Congress in terms of my respect.
I rise today not to change anyone's mind, but to express to my constituents my reasons for opposing this bill.There will always be time and pretext enough for people to compromise their principles and put forward poor public policy that may in the short run be popular, but in the wrong run will be detrimental to the long-term interests of the American people. We learn this through history.
In the 1832 bank panics, Andrew Jackson had the question of whether he would remove the Bank of the United States' charter. The people in the bank did not like that. They threatened the prosperity of the American people. In the middle of the panic, Andrew Jackson looked at these bankers and he said, "There are no necessary evils in government. The Treasury to you, gentlemen, is closed."
This was an act of courage on the part of President Jackson, because he understood what was at stake was not merely an ephemeral prosperity or a panic caused by the very people with their handout. Andrew Jackson understood this was about majoritarian rule; it was about the faith in the people's representative institutions and those who inhabit the seats in which they are entrusted.
Today we are in a global financial bank panic. It is the first of our global economy. We are seeing a leveraged bailout of the United States Treasury. In the end, these interests that want your money are threatening your prosperity, and the choice you face is this: You will lose potentially your prosperity for a short period of time at the expense of your long-term liberty. Once the Federal Government has got you to take that risk and pass it on to you as a "moral hazard", they will be in the marketplace. And as the free market is diminished, your freedom itself is diminished, and as your Congress does not stand up to these and put forward a better plan that truly protects the taxpayers, that truly has the long-term interests of the United States at heart, you will be in jeopardy of losing both your prosperity and your liberty.
The choice is stark, and it was put forward in the book by Dostoevsky. In The Brothers Karamazov, the grand inquisitor came to Jesus and he said, "If you wish to subject the people, give them miracle, mystery and authority; but above all, give them bread."
It has always been the temptation in a crisis especially to sacrifice liberty for short-term promises of prosperity, and it was no mistake that during the 1917 Bolshevik Revolution the slogan was "peace, land and bread."
Today you are being asked to choose between bread and freedom. I suggest that the people on Main Street have said that they prefer their freedom, and I am with them.
These were the words of Thaddeus McCotter (R-MI) on the floor of the House opposing the now infamous $700B TARP/EESA bailout. That measure failed that day to the pleasant surprise of most Americans.
Tonight, McCotter led the GOP charge (it was a weak charge) in support of the emergency loans for the automotive industry. The Democrats really didn't need his help, the bill probably would have passed without any GOP support (it would have been really close).
Now, I listened to McCotter's comments at the committee hearings last week and his speech on the floor tonight. I have to say that I'm disappointed. I felt that his impassioned speech against the Wall Street bailout was the most eloquent and succinct argument given on the floor. In his support of the auto bailout, he has done a 180 on his position. At the end of the day, the argument against the auto bailout should have been the same.
He is from Michigan. He is supporting his constituents. This is nothing but a massive dose of pork. He joins the rank and file of Congress in terms of my respect.
Sunday, December 7, 2008
Loose Ends... Vol. XX
Well, I didn't go out of town this week, but I have a better excuse for abandoning the blog for a full week: I was sick. I caught a "cruddy virus" (as described by my doctor) which had me in bed more this week than since I had mononucleosis.
There is a decent amount of news out there, and I have been slowly working on some of my promised research (and more). But, I have meetings in the morning and need to catch up on my rest. So, not much content tonight either.
Please visit the "Cowboy Ranch" the new blog from my friend, follower of this blog, and brand new father, "RTC". He and I are not exactly on the same page on a lot of issues, but he serves as a great sounding board for me and has greatly helped me to better understand the financial system.
There is a decent amount of news out there, and I have been slowly working on some of my promised research (and more). But, I have meetings in the morning and need to catch up on my rest. So, not much content tonight either.
Please visit the "Cowboy Ranch" the new blog from my friend, follower of this blog, and brand new father, "RTC". He and I are not exactly on the same page on a lot of issues, but he serves as a great sounding board for me and has greatly helped me to better understand the financial system.
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