Road to Sefdom: The Fed and the Henhouse

In an earlier post, I discussed Hayek's The Road to Serfdom. He observed how failures of government are used as excuses to grab more power:

Hayek further argued that the failure of central planning would be perceived by the public as an absence of sufficient power by the state to implement an otherwise good idea. Such a perception would lead the public to vote more power to the state, and would assist the rise to power of a “strong man” perceived to be capable of “getting the job done”.

We see another example of this now with the Treasury Department's proposal to make the Federal Reserve the chief regulatory authority on financial markets. So let's get this straight. The government is largely responsible for this credit collapse and the answer is that we need to give the government more power. The Federal Reserve bears most of the blame of any government agency and so we need to increase its responsibility. Mish does an excellent job making the case for this in his post The Fed and the Henhouse. Here's a taste from the post:

Let's Take a Look at "Timely"

• Housing is imploding.
• There are $500 Trillion in derivatives that no one can possibly understand the financial risks on.
• A huge portion of those derivatives are with JP Morgan (JPM).
• Bear Stearns stock went from $170 to $10 in a year in Shotgun Wedding between Bear Stearns and JP Morgan arranged by the Fed
• Questions Linger Over Lehman's Balance Sheet as Lehman Brothers (LEH) is leveraged 31.7 times.
• Citigroup (C) had to be bailed out by Abu Dhabi Deal Raises Questions About Citigroup's Health
• Merrill Lynch needed $6.6 Billion Bailout From Kuwait, Mizuho.
• Cost of Capital "Ratchets Up" at Citigroup and Merrill
• Morgan Stanley (MS) sold 9.9% of the firm to China after handing out huge bonuses.
• People are walking away from homes
• Businesses Are Advised To Walk Away from agreed upon deals.
• There is an open public debate on Moral Obligations Of Walking Away
• 1 in 10 of the entire state of Ohio is on food stamps.
• Florida, Ohio, and Michigan are in an economic depression.
• There is No market for Asset Backed Commercial Paper (ABCP)
• German Banks Fears Global Meltdown caused by US subprime debt
• There is a $1.1 Trillion HELOC Problem
• Unemployment is poised to soar.
• Commercial real estate is massively overbuilt and poised to plunge.
• Goldman Sachs (GS) is calling for another $460 billion in writedowns.
  
• The SEC Openly Invites Corporations To Lie.

Gee, that sure looks "timely" to me.

Who is to blame for the mess we are in?

And who is to blame? The Fed course, with help of Congress, and the SEC.

Congress passed legislation to create GSEs to foster affordable housing. Now the definition of "affordable" is over $700,000, and calls to reduce the role of the Fannie Mae are now calls to increase the role of Fannie Mae in the wake of the housing crisis. There were 300 some programs to create affordable housing and every program made the situation worse. All those programs really amounted to was handouts to the building industry and banks.

And if Congress would stop wasting money on needless programs the dollar would stop sinking. Of course the government is wasting trillions of dollars trying to be the world's policeman, a role we can no longer afford.

The SEC in its infinitely poor wisdom, decided to give government sponsorship to Moody's, Fitch, and the S&P and this led to extremely risky garbage being rated AAA. I talked about this problem in Time To Break Up The Credit Rating Cartel.

But the Fed deserves the brunt of the blame for micro-managing interest rates like some central planners from the Soviet Union. The Fed does not know how to set the correct price for money (interest rates) any more than it knows how to set the correct price for orange juice. Only free market forces can properly set prices so that economic distortions do not occur.

Unfortunately, every problem Greenspan faced was an excuse to cut interest rates. Even non-problems like the silly Y2K (year 2000) scare was an excuse to cut rates.

When the dotcom bubble collapsed, the Fed slashed interest rates to 1% to get the economy moving again. The housing bubble was the result. Greenspan added more fuel to the fire along the way by openly praising ARMs and derivatives.

Greenspan May 5th 2005: "Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth."

I compared Greenspan to Buffett in Who's Holding The Bag?

Buffett in stark contrast to Greenspan called the explosive use of derivatives an "investment time bomb".

It's perfectly clear now who was right. For those who have not pieced the story together properly, it was fear of a dominoes style chain reaction collapse of Credit Default Swaps starting with Bear Stearns that caused Bernanke to force a shotgun wedding between Bear Stearns and JP Morgan.

So what does the Treasury Department propose? The Orwellian answer of course is to give the Fed still more power to wreak havoc.

I couldn't say it better myself.

HBO: John Adams Miniseries

I started watching the HBO John Adams Miniseries last night. It is totally awesome. Thank you HBO for making this and reminding us about the ideas of liberty and freedom.

Washington Post Explains Leverage

For those who are wondering how the stock of a bank can fall from $60 to $2 in two business days, the Washington Post has an explanation in comic form.

The Rubber Room

This American Life has an amazing episode called Human Resources with a segment on the NYC public school system. When teachers in the NYC public school system break some serious rule or cross the wrong principal, they are assigned to a relocation center, affectionately known as the "Rubber Room." They are assigned there until they have a hearing. It is typical for hearings to take over a year to schedule. So these teachers are basically paid their full salary to come in for 40 hours each week to sit in a room and do absolutely nothing. At any one time, there are typically 700+ teachers assigned to these centers. And many have been there for years.

The stories of these teachers are incredible. One teacher accidentally said the word "shit" in a hallway to another teacher and was accused of "verbal abuse" of students and sent to the rubber room. Another teacher ended up there and was never told the reason why. The rubber room resembles a prison where the teachers segregate themselves by race and territorial fights break out over who has the rights to a certain chair or spot in the room. It's a pretty amazing commentary on the human condition.

Only the government could run a business where they pay tens of millions of dollars each year to employees to come in every day and do absolutely nothing. It a shameless waste of taxpayer money and it just is another small example of why government rarely gets anything right.

Offering $10,000 to Get Bad Teachers to Quit

Critics Hope to Teach Unions a Lesson

BOSTON (AP) — Critics who say unions block education reforms and make it virtually impossible to fire bad teachers will offer 10 instructors it deems the nation's worst $10,000 to quit their careers.

The Center for Union Facts, a Washington-based nonprofit, will launch a campaign Tuesday spending $1 million on ads and a billboard in New York's Times Square. It also says it's starting a Web site with data documenting how far unions go to protect bad teachers.

It's also inviting nominations for a contest to determine the nation's worst unionized teachers. The "winners" will be offered $10,000 each if they permanently resign or retire from any career in education — if they sign a release agreeing to have their name and the reasons for their selection published by the group.

Democracy?

The people don't rule according to Fred Reed.

This Spitzer Scandal: Government Destroying our Civil Liberties

This scandal bothers me on multiple levels.

First, if two consenting adults want to make a private transaction for sex, that's their business. If Spitzer is cheating on his wife, that's a private matter for him and his family. It's not the business of the government. Some people will argue that prostitution results in a negative impact to society, but most of the negative effects are the result of it being illegal. This results in an unregulated, black market. This is no different than the war on drugs or prohibition. If prostitution were legal, state and local governments could regulate it and tax it.

Second, it bothers me that Spitzer's bank basically was spying on him on behalf of the government. They noticed that there were some unusual transactions and they reported it to the IRS. The IRS then reported it to the Justice Department and thus the investigation began. They aren't just spying on governors. Our banks are spying on all of our transactions and since more and more of transactions are now electronic, this means that more and more of our transactions are available to the spying eyes of the government. The relationship between a bank and a customer is a private business relationship and it is an invasion of our civil liberties that banks are forced to spy on us on behalf of the government. If banks can spy on us today, who will be spying on us tomorrow? Our telecommunication providers are already spying on us on behalf of the government. Will our doctors and lawyers be spying on us in the future?

And we know prostitution isn't a Federal crime because it's legal in some places like Nevada. So what exactly are the Feds going to prosecute him for? Structuring. According to the NY Times, "The payments were made over a period of several months in a way that investigators believe was intended to conceal their purpose and source, which could amount to a crime called structuring," which is punishable by up to five years in prison. So the mere act of trying to obfuscate your transactions is illegal, even if the transactions themselves are legal. So here's the rub -- this is a pretty shaky federal case. I think the Republican administration just wanted an excuse to make this information public and destroy the career of a rising Democratic governor. They don't really have much of a case. Maybe he violated New York State law or a Washington, D.C. law, but the Federal case seems pretty weak. If the government can spy on one person using their power of warrants and subpoenas to ruin his reputation, none of us is safe.

I am once again reminded of a quote from the Anti-Federalist Papers:

This power, exercised without limitation, will introduce itself into every corner of the city, and country -- It will wait upon the ladies at their toilette, and will not leave them in any domestic concerns; it will accompany them to the ball, the play, and the assembly; it will go with them when they visit, and will, on all occasions, sit beside them in their carriages, nor will it defect them even at church; it will enter the house of every gentleman, watch over his cellar, wait upon his cook in the kitchen, follow the servants into the parlor, preside over the table, and note down all he eats and drinks; it will attend him to his bedchamber, and watch him while he sleeps; it will take cognizance of the professional mail in his office, or his study; it will watch the merchant in the counting house, or in his store; it will follow the mechanic to the shop, and in his work, and will haunt him in his family, and his bed; it will be a constant companion of the industrious farmer in all his labor, it will be with him in the house, and in the field, observe the toil of his hands, and the sweat of his brow; it will penetrate into the most obscure cottage; and finally it will light upon the head of every person in the United States. To all those different classes of people, and in all these circumstances, in which it will attend them, the language in which it will address them, will be GIVE! GIVE!

Ron Paul Interview on CNN

Video

Campaign is not over, Obama is a fraud.

• "If you're in a campaign to influence ideas and the future of the country, the campaign is never over."
• In response to John McCain is trying to unify the party, Paul says, "I would suggest that unity might be secondary to principle...if you can unify a party and reject your principals, what is unity worth?"
• Will Paul support McCain: "He doesn't represent anything I've talked about for 30 years. Non-intervention foreign policy, personal liberties, civil liberties, free markets, no McCain-Feingold, no child left behind."
  
• Would his supporters be better off voting for the Democratic candidate because they are against the war? Paul says, "I don't think they are very sincere. If you look at Obama's voting record, he has voted not to end the war. He has voted to finance the war. So his rhetoric is playing to the people that come my way, but he is every bit as much of an interventionist -- he wants to send more troops to Afghanistan, he wants to broaden the size of the military. So I think it's a fraud what he's talking about when he wants to get out of Iraq, but I think that's politics."
  

Hear, hear!

How government makes things worse

Great opinion piece on the Boston Globe.

Nice Cartoon

Click for full size.

The Wire's War on the Drug War

A wonderful opinion piece in Time from the writers of The Wire about the war on drugs. I had to correct them though and send them a letter:

Thank you Ed Burns, Dennis Lehane, George Pelecanos, Richard Price, and David Simon for writing this opinion piece. I would like to point out though that you are incorrect when you wrote "There aren't any politicians — Democrat or Republican — willing to speak truth on this. Instead, politicians compete to prove themselves more draconian than thou, to embrace America's most profound and enduring policy failure." Dr. Ron Paul is in 100% agreement with you. If elected President, he would end the war on drugs, pardon all non-violent drug offenders, and return regulation of drugs to the individual states, as it is not a power granted to the Federal government under the Constitution.

I am a big fan of The Wire. It is my all-time favorite television show. Thank you for five wonderful seasons.

Very truly,

Jonathan Perlow

Excerpts about Money versus Wealth

There was a discussion on the economics list at work about what somebody had described as an "Austrian purge." This was discussing evidence that the Fed was in fact deflating. This led to a back and forth discussion about how capital was and is allocated. I responded with the following, which Vijay thought was worthy of being a blog post:

It's fundamental when trying to figure these issues out to understand what capital really is. It gets to the distinction between money and wealth. Wealth is the stuff that we want (e.g. healthcare, food, housing, ipods, education for our kids). Money is just an abstraction humans invent in order to facilitate the division of labor. For example, I want to buy groceries tonight from a supermarket and the guy in the supermarket doesn't need any of the software code I write. Money is the intermediate means of exchange that allows this to happen. My employer gives me money in exchange for my code and I give the the supermarket money in exchange for their groceries. It's easy to confuse money and wealth on a microeconomic level because for the average person, they are the same thing. But at a macroeconomic level, money does not equal wealth. If it did, the Federal Reserve could make us all rich by creating billions of dollars out of thin air.

So when we talk about the misallocaiton of capital, it's important to talk about what was misallocated. At the macro level, the reality of what was misallocated can be lost in the abstraction of money. Capital is the means of production that provides wealth. Examples of capital are hard assets like farm land, factories, and machinery. But capital can also be intellectual capital like a medical education or a software engineering degree. It can also be collective capital we build up in a society like an effective legal system or a smoothly operating financial system. A house can be capital because it's hard to imagine anybody being productive if they had no place to live. When talking about capital misallocation, I think it's important to also talk in these terms because things can get lost in the abstraction of money.

So what got misallocated? We probably built around one million more homes than we actually needed. So all that labor that was used for building homes could have been used for more production of things we actually needed. The rapid rise of real estate resulted in millions of people deciding to take employment in the real estate market. So we trained millions of real estate brokers, mortgage brokers, and construction workers to do work that we didn't need them to do. They could have been learning other skills like becoming doctors, nurses, and healthcare technicians of which we actually have a shortage. Then there was the wealth effect of rising housing prices. People thought that their home would always rise in price and so there was no need for savings. So instead, they borrowed against their homes and spent money on consumer items that have no lasting value such as eating out, consumer electronic devices, expensive cars, extra vacations, etc., The money going into these areas resulted in businesses misallocating capital and building too many restaurants, factories, and hotels. It also resulted in a huge savings imbalance. We have huge credit deficits and other parts of the world have huge credit surpluses. Savings is just deferred consumption. That means that we are going to be working really hard in the future to reward the rest of the world for all the hard work they did in the present and past. It doesn't bode well for a country with demographics of an aging population that the United States has.

There is a place where the intersection of money and wealth become important. We have a fiat currency and a fractional reserve banking system. Credit can be created by the government and by the private sector. Our system, for the most part, treats credit and money as the same thing. It turns out that an increase in the supply of money and credit (i.e. inflation) causes misallocation of capital. This is the boom. Eventually, things revert to the mean and you get the bust. Trying to reinflate the bubble as some people would like the Fed to do is no more effective than giving a heroine junky more drugs to stop his withdrawal symptoms. It can feel good for the time being, but it just results in an even bigger bust later on.

Somebody responded and suggested that there was economic value due to the creation of all these consumer products. First, it provided a "safety valve" for all the extra money being created to go. Second, it resulted in efficiency gains for creating those items. And finally, somebody made profits and that somebody, maybe Warren Buffet, will figure out how to create economic value with those profits in the future. I responded to this by saying

The idea of a "safety value on the flow of money" gets at the heart on the confusion between money and wealth. You have to look at the impact on real economic activity. If the economy was distorted causing people to buy too many consumer electronics, it means that producers were shifting resources into figuring out how to produce more of these devices. Those are resources that could have been used for something else. If the resources were being deployed as part of a real economic demand, that is a functional free market. If the resources are misallocated because businesses received bad signals due to monetary inflation, that is not a good use of capital. Yes, Warren Buffet, or whoever profited, can make better decisions in the next round. But the wealth that was misallocated in the first previous round is forever lost. We needed more capital to help us produce X and instead we now have too much capital to help us produce Y. The problem now is the dislocation. All those people that took jobs or trained for jobs or invested in careers have to get laid off and retrain. That is a very painful process. This is why steady real growth is preferable to booms and busts.