Month: September 2008

China wailing market of the day, a continuing series

I entered the mourning profession at the age of twelve.  My teacher forced me to practice the basic suona tunes, as well as to learn how to wail and chant.  Having a solid foundation in the basics enables a performer to improvise with ease, and to produce an earth-shattering effect.  Our wailing sounds more authentic than that of the children or relatives of the deceased.

Most people who have lost their family members burst into tears and begin wailing upon seeing the body of the deceased.  But their wailing doesn’t last.  Soon they are overcome with grief.  When grief reaches into their hearts, they either suffer from shock or pass out.  But for us, once we get into the mood, we control our emotions and improvise with great ease.  We can wail as long as is requested.  If it’s a grand funeral and the money is good, we do lots of improvisation to please the host.

"How long can you wail?  What was your record?"

Two days and two nights…Voices are our capital and we know how to protect them…

…Frankly speaking, the hired mourners are the ones who can stick to the very end.

That is from Liao Yiwu’s excellent The Corpse Walker: Real-Life Stories, China from the Bottom Up.  Here is a previous installment in the series.  Here is an out of date book, by comedian Eddie Cantor.  Here is a photo:

Shanghaisept1508

Incentives matter

As it turn out, the really risks in the system were being created not
by hedge funds but by boring old investment banks and insurance
companies. Sure there have been hedge fund failures but none on the
scale and with the repercussions of the recent failures of Bear
Stearns, Lehman Brothers, and the government sponsored mortgage
companies. Hedge funds might not have had all that many rules governing
their behavior but their incentive pay structure seems to have
regulated their risk far better.

Here is more.  On the other side of the governance fence:

The Wall Street Journal is reporting that the Federal Reserve has asked
Goldman Sachs and J.P. Morgan Chase to help make $70-$75 billion in
loans available to the AIG.

That’s a lot of money to "ask" for.

The Glass-Steagall Act: A History of Thought

Me in 1985: The Glass-Steagall Act should be repealed.

Me in 1989: I’m not so sure about repealing the Glass-Steagall Act.  Repeal would, in effect, extend the protection of deposit insurance to investment banks and other risky entities.  Moral hazard is a real problem.

Me in 1996: It doesn’t seem to matter that much that they haven’t repealed Glass-Steagall.  The Fed is relaxing restrictions on banks in any case.

Me in 1999: What?  Did they repeal Glass-Steagall?  I wasn’t paying attention.

Me in September 13, 2008: Whew!  I’m sure glad they repealed the Glass-Steagall Act.  My 1989 worries were not crazy but I did not see that counterparty risk would spread the safety net to risky entities in any case, with or without explicit merger.

Me next week: How are we going to stop all these consolidated financial entities from taking advantage of deposit insurance and other public sector guarantees?

Econ Journal Watch

Table of Contents with links to articles (pdf)

The worst case scenario?

My take on the B of A buyout is that Hank is piling up all the ****
into one huge **** on B of A’s books so that when they go under it is
clearly too big to fail and can be handled in one fell swoop.

That’s from a comment at calculatedrisk.blogspot.com.  That view is an outlier, but it’s always worth knowing the worst case scenario.  At least it explains why B of A is interested in such a hasty deal with a losing business partner.  Here is Paul Krugman’s column.  Here is Felix Salmon on the unlucky Damien Hirst.  Arnold Kling outlines the best case scenario, which is right now a better forecast than the worst case scenario.  On another front, maybe Lehman bonuses will be clawed back.

Derivatives contracts are exempt from normal bankruptcy law

More or less (there are complex details).  Here is one account:

…in a series of amendments through the 1980s US bankruptcy law was
altered to provide extraordinary protection to over the counter (OTC)
derivatives. This favorable treatment under the law is undoubtedly one
of the reasons that markets in these derivatives did not follow the
historical pattern and move onto centralized exchanges. [TC: heterogeneity of contracts is an issue as well]

By providing over the counter derivatives extraordinary protection
under the law, the bankruptcy amendments dramatically reduced the need
for market participants to monitor the financial health of their
counterparties. One of the principal reasons that financial market
participants choose to establish cooperatively run exchanges (recall
that the NYSE is to this day a private organization) is to protect
themselves from counterparty risk. The exchange is the counterparty to
every trade, so the only concern is whether the exchange itself is
well-capitalized and well-run.

Here is more detail.  Here is again more detail, with this as the bottom line:

…counterparties to derivatives contracts are free to terminate the contracts and then seize collateral to the extent that they are owed money…

In other words, there is no bankruptcy stay.  That’s not obviously a good arrangement and it can lead to hair trigger failures (sound familiar?) by implicitly subsidizing these transactions.  I first heard of this reading the excellent Felix Salmon.  Here is yet further detail.  Here is how some of it came from the 2005 Bankruptcy AmendmentsCongress thought, at the time, that this would limit systemic risk. 

The Gorgon in the room

The empirics on beautiful women imply that, in a great many cases, a) they have their own agendas, b) they stick to those agendas, no matter what they may say in public, or no matter what "more experienced" men tell them to do, c) they are very good at fooling the men they associate with and they are used to thinking they can get away with it, and d) agendas are often more local and less global than you think.  If you don’t believe me, read the final act of Henry V.

Andrew Sullivan is calling Sarah Palin "Rovian."  Maybe, but her first order of business has been to fool the Republican establishment, not
the American people.  (Read this silly AEI guy.)  Her few genuine words on foreign policy indicate her positions are hardly the modern Republican norm.  She is "unusual" on pot smoking and benefits for gays and juror nullification.  The Republicans are underestimating her role as a Hegelian agent of world-historical change, just as the Democrats did at first.

Which narrative do you find more plausible?:

"Lovely Sarah, she’s saying and doing everything we want her to.  What a quick learner.  How pliable she is.  Remember Descartes on tabula rasa?"

"Once John and I are elected, they’ll need me more than I need them."

The people who are right now the happiest may end up the most concerned.  For better or worse, they’re about to lose control of their movement.

I don’t mean to overwhelm you with posts, but…

It’s hard not to report this:

$$$ On CNBC they are saying that AIG has asked the
Federal Reserve for some kind of emergency bridge loans. Can the Fed
lend to an insurance company?

$$$ Federal Reserve is dramatically expanding its emergency lending program. It’s now going to take all sorts of collateral, including equity.

$$$ "Take a very deep breath. It looks almost certain
that this week will be the one where we see the financial implosion in
U.S. banking and brokerage that many have been expecting for some
time," Paul Kedrosky says.

$$$
With Merrill Lynch, Lehman Brothers and Bear
Stearns gone, everyone is asking whether Morgan Stanley and Goldman
Sachs will survive as independent investment banks.

Addendum: Here are Dow futures, at 10:21 p.m. down about 300 points.  All things considered that counts as good news.

What was the problem with financial regulation?

Here is my NYT column from today.  Excerpt:

In short, there was plenty of regulation – yet much of it made the
problem worse. These laws and institutions should have reined in bank
risk while encouraging financial transparency, but did not. This
deficiency – not a conscientious laissez-faire policy – is where the
Bush administration went wrong.

…the Bush administration’s many critiques of regulation are
belied by the numbers, which demonstrate a strong interest in continued
and, indeed, expanded regulation. This is the lesson of a recent study,
“Regulatory Agency Spending Reaches New Height,” by Veronique de Rugy,
senior research fellow at the Mercatus Center at George Mason
University, and Melinda Warren, director of the Weidenbaum Center Forum
at Washington University.
(Disclosure: Ms. de Rugy’s participation in this study was under my
supervision.) For the proposed 2009 fiscal budget, spending by
regulatory agencies is to grow by 6.4 percent, similar to the growth
rate for last year, and continuing a long-term expansionary trend.

For the regulatory category of finance and banking, inflation-adjusted
expenditures have risen 43.5 percent from 1990 to 2008. It is not
unusual for the Federal Register to publish 70,000 or more pages of new
regulations each year.

…The biggest financial deregulation in recent times has been an implicit
one – namely, that hedge funds and many new exotic financial
instruments have grown in importance but have remained largely
unregulated. To be sure, these institutions contributed to the severity
of the Bear Stearns
crisis and to the related global credit crisis. But it’s not obvious
that the less regulated financial sector performed any worse than the
highly regulated housing and bank mortgage lending sectors, including,
of course, the government-sponsored mortgage agencies.

There is much more at the link.  Mark Thoma adds comment.  So does Arnold Kling.

Response to my Mother

My wonderful mother is upset, like pretty much everyone else, at the price of gas.  "Well, the hurricane has knocked out a lot of production on the gulf coast," I say.  "Yes but there’s plenty of gas in the pipes that was produced before the hurricane – the suppliers are gouging." she responds.  Arrghhh….must resist, must resist, must be ….nice.  "mmm," I say.  You and my Econ 101 students (103 actually), however, are not so lucky.

Many people think that price is determined by historical cost.  Price is never, ever, determined by historical cost. Price is determined by supply and demand.  If supply or demand change then the price changes regardless of historical cost.  Last year’s fashions?  The price falls regardless of cost.  Chopped up dead sharks?  If demand is high, the price is high regardless of historical cost.  If the demand for gas were to suddenly fall, the price of gas would fall too, regardless of cost.  In the present situation the supply of gas has been reduced and the price has gone up.  Historical cost is always irrelevant.

Is the high price due to supplier gouging?  Not at all.  If you want to blame anyone for the high price blame your fellow buyers not the suppliers.  A high price means that some other buyer is outbidding you to obtain the limited supply.  It’s buyers who push up prices in a competitive market and it’s suppliers who push prices down!

It’s true that some suppliers are making big profits but people have the cause and effect backward.  It’s not the high profits which are causing the high price.  It’s the high price which is causing the high profits.  If you were to tax the high profits, for example, you wouldn’t reduce the price.  Indeed, quite the opposite because the high profits motivate suppliers to increase the quantity of gasoline as quickly as possible.

The last point brings us full circle because as the situation stabilizes suppliers increase the quantity supplied until price is pushed down towards long-run costs (which are also historical costs).  Thus, in the usual situation it appears that price is determined by historical cost.  It’s only in the brief time period when a shock shifts (short-run) supply away from historical cost that we can see the truth.  Price is determined by supply and demand.

Addendum: Is it just me or did Ken Arrow ever feel the need to correct his Mom on economic matters?  Did Adam Smith?  "Look Mom, I know you’re upset about the price of mutton but let me tell you about this new theory I’ve been working on…"    

Growth and the real exchange rate

Dani Rodrik, who is back at blogging, also has a new paper.  Here is the abstract:

I provide evidence that undervaluation of the currency (a high real exchange rate) stimulates economic growth. This is true particularly for developing countries. There is also some evidence that the operative channel is the size of the tradable sector (especially industry). These Â…findings suggest that tradable goods suffer disproportionately from the government or market failures that keep poor countries from converging towards higher-income levels. I present two categories of explanations as to why this may be so, focusing on (a) institutional weaknesses, and (b) product-market failures. A formal model elucidates the linkages between the level of the real exchange rate and the rate of economic growth.

No, mercantilism has not made a comeback.  Public choice economics has.  The most plausible mechanism is that most poor countries have dysfunctional interest groups.  Exporters are a relatively growth-enhancing set of interest groups.  So if your policies favor exporters, the quality of your interest groups will increase over time.  Your policy will stay good or get better and your growth will go up.  In other words, what Toyota wants is pretty good for Japan.  China’s hope is that its new businessmen want to keep some modicum of freedom, and so on.

Of course low real exchange rates trickle away over time, as domestic prices rise and markets restore the real exchange rate of their choice.  But low real exchange rates are probably a good proxy for other export-friendly policies, such as predictable regulation and investment in infrastructure.  And so low real exchange rates are only doing part of the work in driving growth and probably not even the biggest part.  If we had an index of "export friendliness" for the countries in this sample, maybe the power of the low real exchange rate would go away.  This explains why wealthier countries, who don’t have dysfunctional interest groups to the same degree, also don’t see comparable growth benefits from low real exchange rates.  Rodrik even points out on pp.14-15 that the countries with the worst governance indices see the biggest growth gain from low real exchange rates.  (By the way, in the public choice story the improvements in the quality of your interest groups and in your policy don’t come until later and thus they are not captured in the current level of the quality of governance index.)

Brad DeLong comments here and here and here.

Can you trust a man who doesn’t trust his wife?

I owe that line to Robin Hanson.  Here is the latest:

Six weeks after Bruce E. Ivins
killed himself, the cremated remains of Mr. Ivins, the Army scientist
and anthrax suspect, are stored at a funeral home here, awaiting the
outcome of an unusual probate court proceeding.

…Dr. Ivins wrote of his wish to be cremated and have his ashes
scattered. But fearing that his wife, Diane, and their two children
might not honor the request, he came up with a novel way to enforce his
demand: threatening to make a bequest to an organization he knew his
wife opposed, Planned Parenthood.

“If
my remains are not cremated and my ashes are not scattered or spread on
the ground, I give to Planned Parenthood of Maryland” $50,000, Dr.
Ivins wrote in the will. Court records value the estate at $143,000.

Ms. Ivins is a former president of Frederick County Right to Life, according to F.B.I. records.

The NYT article concludes (do they ever write contingent contracts?):

The will adds another stroke to the portrait that has emerged from
F.B.I. records of Dr. Ivins, an anthrax specialist at the Army’s
biodefense laboratory at Fort Detrick, in Maryland, as quirky and
mentally troubled.

His wife, at least, says he is innocent.  What would you think of a man who wrote such a contract?