Monthly Archives: March 2009

AIG Bonuses – The Fix Is In

This AIG business is so transparent and I’m afraid Timothy Geithner is in it up to his eyeballs.  President Obama may be too.  He probably is.

They are using a well known trick in negotiating with unsophisticated buyers.  Every hondler in every stall in every market in the Middle East knows this trick like his mother’s own face.

You go in with a price that is sure to create sticker shock.  Then you negotiate down from there giving the buyer credit for this, and savings for that, and a discount for the other thing, and a tax break here, and oh, my manager says I can throw in the DVD player for free… and at the end of the day the unsophisticated buyer walks away happy because he only got screwed by 20% instead of the 50% he was initially afraid he’d get screwed by.

By the time AIG and our worthies are done with this charade, the bonus pool for this round (this is only the first round of three) will be reduced from $165 million to just a sliver under $100 million.  AIG will walk away like the car salesman… bonuses in hand and alive to fight another day, Obama and Geithner will walk away “heroes” for having fought for justice and the American way and saved the us a shred of our pride, and $70 million or so, and we’ll walk away happy we only got screwed by $90 million and change instead of $165 million.

Mark my words.

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Market Rally Taking Lambs to the Slaughter

I’m as ready as anybody to see the market rally that becomes the leading indicator of economic recovery… but this one isn’t it.  This is a fool’s rally that is going to take retail investors to the cleaners.

This rally began with Citibank’s statement that their core banking business was profitable in the last quarter if you discount write-downs of toxic assets, the fact that they are earning money on tens of billions of “free” dollars injected by the government, etc.  Retail investors have focused on “profitable” and ignored “if you discount”.

The government’s stress tests are still a month away from completion and when they wrap up they are going to show that core business profitability or not, several of the largest US banks, probably including Citi, are insolvent and will need to be nationalized in deed if not in name.  When the results of the stress tests re-assert reality, this boomlet is going to fall like a house of cards.

The real rally will not occur until the banks are fixed with no “if you discount”‘s.   That could be as soon as June or July if

  1. the results of the stress tests come back dire enough that
  2. the administration is forced to face reality, nationalize the zombie banks, and take over the damaged assets on their balance sheets and
  3. sell clean, chopped up, smaller banks back to the public
  4. with new regulations in place reinstating the firewalls between commercial banks, investment banks and insurance companies; forcing limits on the size of financial institutions, and putting concrete limits on the overuse of leverage anywhere and everywhere in the economy.

If these things do not happen, the real rally will be delayed months or years more until banks slowly work through the realization of their asset losses.

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Taxing the Super Rich Does Not Reduce Jobs

Enough already!  Increasing taxes on the super rich does not harm the economy in any way whatsoever.

There are two popular theories about why taxes on the super-rich should be avoided and both are flat out wrong.

The first theory is that taxes shift spending power from consumers to government, and consumers spend money more effectively than government.

This does not apply to the super-rich though.  While a family making $250,000 a year may consume nearly all of what they make, the average annual income of the top 1% of families is over a million dollars a year.  At anywhere near a million dollars a year of income, the vast majority of families have reached a lifestyle they are comfortable plateauing at, they have saved enough to secure that lifestyle in retirement and “lean” times, and they are banking money away for their estates and heirs.  Once people reach a threshhold where additional income goes into inter-generational savings rather than consumption, additional income to them does not stimulate the economy.   Sure, there are exceptions.  Paris Hilton undoubtedly spends way more than a million dollars a year and every dime she spends creeates jobs for someone, somewhere.  Paris and her breed are the exception though.  Of the tens of thousands of families with million dollar plus annual incomes, most live in nice houses, in nice neighborhoods, with nice cars, they send their kids to nice schools, etc. but they don’t convert anywhere near their total income to economiic demand for goods and services.  Reducing that income by taxing it more will not reduce demand in the economy until tax levels get very high indeed.

The second theory is that wealthy people hire people and therefor they are the ones that create jobs.  If I may be so bold… bullshit.  Demand for goods and services on one side and investment capital on the other side is what creates jobs.  One million dollars of investment capital can come just as easily from ten people with one hundred thousand dollars, or a thousand people with one thousand dollars, as it can from one person with a million dollars.  Savings are pooled all the time… hell, the entire idea of publicly owned corporations is to pool savings.  If there is demand here and capital there, there will be jobs.  The capital does not need to be in the hands of a few very wealthy individuals.

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Make These Changes This Week, Fix the Economy by Next Week

Paul Krugman recently wrote that what is at the heart of the economic meltdown is a surplus of savings beyond what businesses are willing to invest. These savings have been bouncing around the globe looking for a return for over a decade.

Everywhere these excess savings have landed, they have bid the price of assets up to unsustainable levels, bid down the returns on those assets to zero or negative amounts, and created havoc and dislocation. These savings fueled the dot.com boom in the late 1990s, funded sub-prime mortgages from 2001 to 2006, poured into commodity markets in 2007 and 2008 creating bubbles in crude oil, mined minerals and metals, corn, rice, and other grains and farm goods, etc. These savings have since flooded into United States Treasuries, driving yields to zero and, sometimes, even negative.

To me, this points squarely to the root cause of our economic problems (surplus savings only tells part of the story) as well as the solution. Many will tune out my assessment without making it to the end of the next paragraph. For those with a little more patience than that, hear me out then engage me in debate. I value your constructive thoughts about the substance of this, ways to implement it, and better ways to explain it. Ready for half our friends to tune out?

Too much wealth has gotten too concentrated in the hands of too few people. It needs to be “redistributed.”

Wow! Did you see them go? Anyway, now that they’re gone, lets discuss this, and lets use the words supply and demand a lot.

Business uses people’s savings to create the supply of goods and services that will meet demand. Supplying goods and services to meet demand is what business does, so if business is not willing to invest savings to increase supply, it can only be because it sees no demand for what it would produce.

We can be very confident that there are still needs and wants all over the world. I have many needs and wants myself, and I’m just one me. Demand only occurs when people have enough money to buy the goods and services that will satisfy their needs and wants.

People can escalate through three economic levels. At the most basic level, people spend whatever money they earn trying to meet their basic wants and needs. They are pure consumers. Every dollar they earn becomes demand for a good or service.

As people earn more, they cycle back and forth between increasing their level of consumption and securing their level of consumption against downturns, emergencies and retirement by saving some of their earnings. People at this level, lets call these people the “middle class”, decide how much to consume based on an inverse relationship with savings returns. If there is a great financial incentive to save, they will opt to consume less, while if there is little or no financial incentive to save, they will consume more. To the degree that these people opt for consumption, they generate demand for goods and services. To the degree they opt for savings, they generate the ability to supply goods and services. The relative supply and demand of goods and services in the economy changes the relative value of supply to demand, and changes this group’s behavior accordingly.

Some people earn enough that, while it may or may not be at an extravagant level, they max out their desire or even their ability to consume and they have more than enough wealth to secure their consumption forever. People at the highest level create as much demand for goods and services as they care to, and still have money left over that must be saved. These people generate supply in excess of their ability to create demand.

When supply and demand get seriously out of balance, economics steps in with a heavy hand to pull them back together. If demand gets ahead of supply, inflation will occur. This reduces buying power, which reduces demand. If supply gets ahead of demand, unemployment will occur. When resources (be they land, savings, or labor) go unemployed, our capacity to create supply shrinks back in line with demand.

Lets revisit Krugman. What does it mean if there has been a glut of savings bouncing around the globe for over a decade? One thing it should mean, is that the return on invested savings should be zero and the middle class should be using as much of their wealth as possible to consume and create demand. They should be saving relatively little. Despite the middle class creating as much demand as it can, there is still so much extra supply that all these trillions of dollars of savings are still going… unemployed.

We like to think of markets as perfect. We assume that market prices reflect all known information and that they balance instantly. The existence of arbitrageurs proves to us that even tiny discrepancies in markets are balanced immediately.

Markets are not even close to perfect, however. Markets that are thinly traded often mis-price goods and services. There are seas of information that is legal to trade on that is not available to all market participants. If the employment market was perfect, wages would rise and fall daily, if not throughout the day, to account for the never ending fluctuation of the supply and demand of all the many talents and skills. Most workers, however, only see income adjustments once a year, if that, unless the disparity between what they are worth and what they are making becomes so egregiously great that they either quit or get laid off. The mega-trillion dollar market for unregulated bond insurance is so opaque no two players know the terms of any other players in the market at all. The mortgage backed securities market would require intimate knowledge of individual neighborhoods, houses, and families that just doesn’t exist to be able to accurately set prices.

Markets that are lacking in transparency, information, liquidity, etc. further become distorted by mass psychology. In lieu of useful information about what drives prices, people have a tendency to consider price changes themselves to be information and they, en mass, make erroneous decisions.

The inefficiency of our markets has made it appear, for the entire time that the real yield on savings was zero, that the yield was positive in many areas. The flood of money into mortgage backed securities fueled real-estate prices, which gave the false impression of returns on savings, which shifted the middle class erroneously from consumption to savings, created the illusion of demand where there was none, created the appearance of profits where there were none, etc. The unwinding of all of this distortion puts us in the confusing mess we are in today.

For all its complexity, however, ultimately, the real situation is fairly simple. There are people with huge amount of money who are incapable of creating demand because they are tapped out of goods and services they need or want. There are people with needs and wants who are incapable of creating demand because they have no money with which to purchase goods and services. Because demand for goods and services is so low, the demand for the wealthy people’s savings is so low, that yields on savings remain essentially zero. The excess of supply in the economy has now started a whirlpool in which labor, factories, land, vehicles, and all sorts of other resources are becoming unemployed alongside the excess savings and the cycle is building on itself.

The solution is to stimulate demand. Of course, this comes as no surprise… Congress recently enacted a nearly $800 billion program designed to do just that. But there are problems. The most serious problem is that supply is exceeding demand by trillions of dollars, not hundreds of billions of dollars. Government’s efforts to stimulate demand, while monumental, are tiny compared to what is needed. Another problem is that the stimulus program is a government program in the first place when it needn’t be.

Brief detour.

We can all debate what the proper size of government should be. My own opinion is that government can and does do a lot of great things for us and is not only necessary but wildly beneficial to us. It does many things that only a government can do. I think we often starve government of the resources it needs to do what we ask of it well, then we use its inability to do these things well as as excuse for not having it do them at all, or for further starving it. I think government should be bigger than it is today. Others disagree and that it fine. Ultimately, we should be making decisions about what we want government to do based on getting as close as we can get to a consensus of what things we want and how much we are willing to pay. Whether that is bigger or smaller is why we are a democracy. We should not be making government bigger or smaller because we need it to increase or decrease the demand for goods and services.

Back again.

Ultimately, what is needed are structural changes to the economy that will create disincentives to own wealth that is not stimulating demand. A portion of this excess wealth needs to be paid out, perhaps in as simple a form as a mandatory raise for all employees around the world, to the middle and lower classes that would have the ability to stimulate demand overnight if they only had money to spend! As people with needs and wants become able to stimulate demand, business will finally start to soak up the remainder of the savings in order to meet the new demand with new supply. This, finally, is the only way that the glut of savings can finally be eliminated so that the remaining savings that exist can actually generate returns sufficient to again place the middle class in its proper role of balancing supply and demand.

Additional Thoughts

Inflation

If all employees are given a mandatory raise of, say, 20%, won’t companies immediately need to raise prices by 20%, creating 20% inflation, and nullifying the effect of the raise? No. Labor is not the entire cost of goods and services. Technology, the cost of money (when it isn’t available for free), and raw materials also go into the cost of goods and services but would not see 20% increases. There might be 15% inflation, but that would still create an increase in demand beyond that which would be clawed back by inflation.

More on inflation

Just as unemployment is more harsh on some than others, so is inflation. Is it fair to charge so much of the economic recovery to savers? Our goal should be to have close to full employment of all resources with little inflation. Right now unemployment is ravaging some sectors of the economy. Later on inflation is going to ravage others. I submit that savers are already being ravaged by unemployment, though, because it is their very savings that are going unemployed along with the labor of others. While it is unfortunate that some of their savings will be lost to inflation, this is the only way for their remaining savings to once again start earning a positive return. This glut of savings has turned into an infection. While it is true that some people who have an infection may not want to see it lanced because, after all, it is their infection and they don’t want to lose it, it is the only way they can get healthy again.

If markets have set wages based on supply and demand, and now we’re going to increase them on a whim, aren’t we just adding a new distortion into the markets that will have to be worked out later down the road?

I don’t think so. First, I’ve already discussed the inefficiency inherent in accurately pricing labor. Second, in the decades since the Vietnam War, globalization has increased the labor pool so dramatically that the price of labor has been kept flat or nearly flat for many, many years. Globalization has also opened up new markets, so we would like to believe that the new supply of labor should be sopped up with the new demand for goods and services. This has not been the case though. For the very reason that the increased supply of labor has kept wages down, the increased supply of people with wants and needs has not translated sufficiently into an increase in the number of people capable of creating demand. This is one of the major factors, probably even bigger than US tax policy changes, behind the consolidation of wealth.

Only by increasing the ability of workers to convert needs and wants into demand can the global economy be brought back into balance.

A related factor is time. While it may be true that given enough time and enough cycles of unemployment and inflation that supply and demand will come naturally into balance, this process could will take decades. After all, not only do we need to account for dislocations that have built up over several decades since the advent of global trade, we need to account for the dislocations that haven’t even occurred yet because globalization is still in its infancy. All of the trends it has fostered are still being increasingly fostered today.

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Surprise! Henry Ford was Right. You’ve Got to Pay People!

Op-Ed Columnist – Revenge of the Glut – NYTimes.com.

In the article link above, Paul Krugman puts the blame for our economic mess on a glut of savings that has outstripped business’ interest or ability to invest it in productive things.

Far be it from me to refine Paul Krugman, but I will try anyway.

We’ve seen this glut of savings bouncing around the world and failing to be productively invested for over a decade.  This glut is what created the Internet bubble.  When that bubble collapsed, it created the housing bubble.  When that bubble collapsed it created the commodities bubble.  When that bubble collapsed it created the Treasuries bubble.  The Treasuries bubble hasn’t collapsed yet, but it will.  Warren Buffet knows it, and now the rest of us do too.

Because business has been unable to justify investing this savings in production capacity it has bounced from asset class to asset class looking for a productive, profitable place to land.  Interestingly, I guess because of the global communications efficiency we have now, it is moving largely as a single mass.  When it felt like Internet stocks were the place to be, way too much of this excess savings went into them, thus creating the bubble.  When that bubble popped, this money moved, en masse, into housing stock and real estate.  When this bubble burst, way too much of it went into commodities futures.

Meanwhile, free trade has increased the global supply of labor drastically.  In the world of Henry Ford, new labor markets would create new consumption markets because Henry Ford knew that, whatever the availability of labor was, if he didn’t pay his workers enough to buy the products they made, nobody would be able to afford them and he would never achieve scale.  In our free trade environment, investors have taken full advantage of the labor glut to lower labor costs.  In fact, they have gotten so low that only a small portion of the new labor market actually has the ability to consume what it produces.

Businesses can’t invest in capacity to meet the needs of the millions of laborers with pent up needs and wants but with no money, and has already produced too much capacity to meet even the most exotic of needs of the relative few people who do have money.  The only way to create new markets now that justify building productive capacity that will actually put the excess savings to work is to increase the wages of the global labor force to the point that it can actually consume what it produces.

In a laissez-faire, free-trade, purely competitive environment it is impossible for businesses to do this on their own.  Any company that attempts to “do the right thing” will end up at a price disadvantage, lose market share, and eventually go out of business.  The only way to do this is to force a floor on labor price, either via minimum wages or strengthened unions, so that all businesses are forced to “do the right thing” without giving any of them a competitive advantage.

Traditionally, we would see such a move as being inflationary.  It would be if we were working with a closed system that was not going to increase the supply of goods.  But we aren’t, and that is just the point!  If the wage increases go to people who can create NEW demand that justifies new supply, the demand will justify new investment that will sop up the savings glut.  In the end we will not only achieve greater financial stability and solve the chaos this bubble of unspent money is creating, but we will increase the quality of life for hundreds of millions of people around the globe… which I think everyone has to agree is a good thing!

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