The nation that eats its young

I don't have much to say about this article on how the Lost Decade has affected Japan's youth, except to say that where Japan is right now is where we can be in ten years. If we continue with our current economic policies, we will have a lost generation, one that will find it virtually impossible to regain their footing. We must act now, to stimulate the economy further, to boost employment, and increase inflation. Inaction, in this case, is the same as actively making the economy worse.

China, the Renminbi, and Stability

Years ago, when I first read The Tragedy of Great Power Politics, I was somewhat surprised by John Mearsheimer's insistence that China and the United States will sometime in the future be embroiled in conflict. As the years went on, and I absorbed the lessons of that book, I found it to be less and less unlikely, the unfortunate fact being that conflict is sometimes an inherent property of growth, China is large and continuing to grow, and the even more unfortunate fact that China is likely to be a regional hegemon in the coming years.

I count these facts as unfortunate because China and the United States are unlikely combatants. Neither is really interested in conflict with the other, and peace is, I think, generally in the interests of the leaders and the peoples of both great nations. However, conflict is inevitable when interests do not coincide. And in this case the economic interests of China and the United States do not coincide. Strangely enough, it is the political interests of China's elites that cause the economic interests of the two countries to conflict.

China is focused on stability. So much so that rising in the Communist Party is in many ways dependent on how stable you can keep those areas under your control. Social stability is paramount, because without it, the Communist Party would be unable to govern a nation of a billion souls. And this stability is kept in the economic sense, largely by making sure that everyone is employed. To do that, China has been growing its economy at fairly large rates, rates that have been allowed because of export driven growth. This export driven growth has been necessary to keep China stable. Employed people are happy people. Unemployed people are not happy people. Thus, any fall in employment would cause a great amount of instability in China.

China, however, is having trouble keeping people employed. It is having trouble because the population is so big that very large rates of growth are necessary to keep everyone employed, because the number of people entering the work force increases every day. It is also having trouble keeping everyone employed because there is not enough internal demand for goods and services. Many people in China are not wealthy, and the Chinese social safety net is not very good. Like responsible people around the world, that means that many Chinese individuals save their money for a rainy day. They are thrifty and industrious. But the problem is that this industriousness means that there is an excess of Chinese goods, goods that cannot (or will not) be bought by Chinese consumers. Thus, a market has to be found for Chinese goods. If Chinese goods aren't bought, Chinese workers won't be employed, and there goes social stability.

So China tries to make its goods more competitive by keeping the Renminbi at an artificially low level against the U.S. dollar. In usual times, this isn't so bad. The U.S. market takes these goods, Chinese workers are happy, U.S. consumers get cheap goods, and overall, everyone seems to benefit. It's a win-win situation. We live in unusual times, however, so this usual arrangement is not so useful to the U.S. Because the U.S. economy is in a depression right now, U.S. workers are out of work. U.S. consumers want to save. So the only way that U.S. workers could move into certain manufacturing areas would be if they could compete against the cheap Chinese goods. But they can't, because those cheap Chinese goods are artificially cheap, because of Chinese currency manipulation. So U.S. workers lose out, because they can't move into manufacturing areas because there aren't any jobs because U.S. made goods wouldn't be competitive, and Chinese workers win. This is a win-lose situation, and this is the conflict.

Some U.S. economists, like Paul Krugman, have been discussing this issue, and why the U.S. should just go ahead and confront China over this issue. But few of the economic commentators have been mentioning the political reasons why China won't budge on this issue. China wants stability. China needs stability. And if that comes at the price of American, or European workers, that's just fine with Chinese elites. This is why the U.S. will have to confront China, and do so very publicly, and very messily. This is how trade wars start, and if China continues its policies of currency manipulation, it will be responsible for the results.

A Depressing California Governor's Race

In an interesting rundown in the Los Angeles Times, Jerry Roberts and Phil Trounstine write that Gavin Newsom's withdrawal from the California Governor's race in 2010 has deprived the race of any candidate calling for sweeping reform. In a way, it's a bit depressing - Newsom was the only declared Democratic candidate, and the only one calling for a Constitutional Convention and sweeping reform. Attorney General (and former governor) Jerry Brown, while an undeclared candidate, has done little to ask for any sort of sweeping reform, merely suggesting that he'd navigate the special interests better. None of the Republican candidates suggest changing the governmental structure, all are calling for some form of tax cuts and spending reductions.

Unfortunately for California, none of this is enough. Governance via initiative has failed. Term limits have failed. Limits on property tax increases (Proposition 13) has failed. Supermajority limits on state spending budgets has failed. California's government has failed. It's gridlocked. Because of the supermajority requirements, it's unable to actually provide the services that California needs because Republicans oppose the taxes needed to pay for them, and it is unable to cut anything the Republicans want because the Democrat control the legislature, just without a supermajority. This has been a recipe for a failed government.

Perhaps California needs to devolve its government down to the local level, so that local governments can provide the services that people need, and taxes across the state could be lower, but that's impossible without the governmental structure at the state level changing to allow that. In the end, California needs a fundamental change. Without it, it will continue its slide to a government that doesn't accomplish anything, doesn't tax enough to pay its bills, doesn't provide the services the citizens want, and continues to drag California down.

Mortgage Servicers Breaching Duties?

This story on mortgage servicers leads me to question how these mortgage backed securities were drafted. One might imagine that when these mortgages were packaged together, they gave wide latitude to the servicers as to how to deal with defaults. If they do have some latitude, then they might be able to say that this is a permissible practice, one where they pay less to related companies than if the companies were unrelated.

Of course, another way to view this practice is that it is a breach of fiduciary duty, a breach of the duty of loyalty to the investors who bought these securities. Failure to mitigate losses for the principal in favor of enriching oneself is a classic breach of the fiduciary duty of loyalty. Even if it isn't that, it might be a breach of the duty of good faith that adheres to all contracts. If these servicers are dinging each of these foreclosures for fees because that means more money for them, versus reduced losses to the investors, that almost certainly is a breach of some duty. I'm just wondering when those who own those securities will begin suing over these types of practices.

Increased Capital Requirements? Yes!

One of the more interesting arguments against increasing capital requirements from banks was in the June 29, 2009 BusinessWeek (you can find the article online here). Avinash Persaud argues that higher overall capital requirements aren't the solution to the problems of the financial system because such a strategy would fail to take into account the differences among institutions and the different types of risks. He suggests that we should aim to build a system where risk is allocated based on how the financial institution is funded. This suggestion is misguided.

He does make some cogent points. For instance, overall capital requirements might be detrimental to new entrants in the banking field, as new and smaller banks would find larger capital requirements a barrier to entry. This is why if we do increase capital requirements on banks, the capital requirements should scale up as the institutions scale up in size. That way, if a smaller bank collapses and is seized by the FDIC, there isn't as much of a problem. If you have a bank that is TBTF, and can't be seized, you want higher capital requirements so it is less likely to get into such a situation in the first place.

Another point he makes is that raising capital requirements would not help match risk taking to risk capacity. As he correctly points out, risk is not a quantifiable property of an asset. There are credit, liquidity, and market risks, and different parts of the financial system do have different capacities to hedge those different types of risks. However, I would also note that almost all of them failed to hedge such risks when they had the capability to do so. The main problem I have with this argument is that most financial institutions aren't going to hedge the risks that they can best handle if it is more profitable to not hedge those risks. And the reason why is because while these are different risks, those different risks can often mutate into the other kinds of risk.

Liquidity risk, which is a risk all banks have due to the nature of deposits, makes it make sense for banks to have to carry extra capital in case there is deposit flight. For pension funds and insurance companies, however, there is less of an issue with liquidity risk, as they have savings accounts and regular premium payments coming in. Pension funds and insurance companies often are more at risk of a credit risk, where a borrower does not pay them back. Banks hedge against that by diversifying lending, using information they have on borrowers, etc. But all of them are vulnerable to market risk, where some assets will lose value because the economy changes. But all of these risks can mutate into other kinds of risk, just like that.

For instance, market risk causes the value of a stock to plummet. This changes the credit risk on a supplier to that stock corporation, and they are unable to pay the interest due on their bonds. The insurance company has to increase premiums, because now they aren't receiving the interest that was from the credit risk. And that mutates into a liquidity risk for the bank because people end up drawing down their bank accounts, because they have to pay more for their insurance premiums. We live in an interconnected global economy – risk is not simply categorized either. One entity's liquidity risk becomes another entity's credit risk. Lehman Brothers had the liquidity problem which turned into so many others' credit problem, which turned into so many others' market problem.

Last, it is hard to take Persaud's suggestions very seriously, especially when they contain such a bold-faced attack on mark-to-market accounting. Let me translate the following paragraph:

By requiring banks to set aside more capital for credit risks than nonbanks must, regulators unintentionally encouraged banks to shift their credit risks to those who wanted the extra yield but had limited ability to hedge this type of risk. By not requiring banks to put aside capital for maturity mismatches, they encouraged banks to take on liquidity risks they couldn't offset. Moreover, by supporting mark-to-market asset valuations (which make institutions value holdings at their current price) and short-term solvency requirements, regulators discouraged insurers and pension funds from taking the very liquidity risks they are best suited for.

This should read:

When regulators made banks keep more money for credit risks than nonbanks, they made it more important for banks to find suckers who wanted to make a quick buck to make up for their shoddy lending practices. By not making banks put aside money for when their toxic waste blew up, they left banks to bankrupt themselves. Moreover, by supporting mark-to-market accounting and basic ideas of solvency, regulators discouraged suckers in insurance companies and pension funds from buying toxic waste and getting taken to the cleaners as well.

Overall, we need to reduce the size of banks, and increase the capital requirements on banks over a certain size. Those are the only two things that will hedge the risks that we face in this economy.

Economic Literacy?

This recent CNN/Fortune article trumpets: "Warren Buffett: Inflation on the horizon." However, it's not entirely clear that's what Warren Buffett said. The article starts out by talking about Buffett's defense of the government efforts to handle the financial crisis, but then goes on with "but warned that the purchasing power of the dollar may fall as policymakers stretch to finance expensive rescue plans." That quote is from Colin Barr, the writer of the piece. This makes it seem like Buffett believes that a period of price inflation is coming.

However, the actual quote in the article from Buffett is this: "My guess is the ultimate price will be paid by a shrinkage of the value of the dollar." This is a much more ambiguous statement, because if the value of the dollar shrinks, the question is, what is it shrinking against? If the value of the dollar shrinks versus the price of goods and services, that would be price inflation, and the article would be essentially correct. But if the value of the dollar shrinks versus foreign currencies, we have a different situation on our hands, a case of currency devaluation. So while the Chinese hold all our bonds, they take a haircut because the value of the dollar goes south against the value of the renminbi, and the U.S. end up paying the Chinese back a much devalued dollar amount.

Why does this matter? If the value of the dollar shrinks, isn't that all inflation? If the government increases the money supply, won't that cause the value of the dollar to shrink? Not necessarily. The value of the dollar can shrink against foreign currencies, but still maintain the same price level versus many goods and services. And the price level can increase, driving inflation, while the value of the currency stays constant. These distinctions are important.

But I've been writing this as if I think the writer got what Buffett was saying wrong. As much as I hope that's the case, I've read more than a few articles mentioning Buffett's views on inflation, and he was probably not misquoted. So I might as well say on my own that inflation won't be a problem for quite some time. As soon as inflation is a problem, the Fed will tighten interest rates again, inflation will fall a bit, and that will be that. Our continuing problem will be deflation, and whether we can escape this liquidity trap that we are in.