Gut Check

By Steven Pearlstein
You're angry. I'm angry. House Republicans are angry. We're all angry at having to put up huge amounts of cash to rescue a financial system because a lot of very rich people rolled the dice with other people's money and lost.

Now let me tell you something very simple and very important: You can try to prevent a financial meltdown or you can teach Wall Street a lesson, but you can't do both at the same time.

So which will it be?

You say you want straight talk -- no spin, no bull, no sugar-coating. Okay, here goes.

First, stop fixating on Wall Street executives -- there will be time to deal with them later. Even if you clawed back every dime they made over the past decade, it would come to several billions of dollars. That's a rounding error compared with the size of the financial problem we're facing here.

Second, we need to act quickly. The financial situation is now downright scary. Don't look at the stock market -- that's not where the problem is. The problem is in the credit markets, which are quickly freezing. I won't bore you with technical indicators like Libor and Treasury swap spreads, but if you talk to people who work these markets every day, as I have, they report that the money markets are in worse shape than they were last August, or even during the currency crises of 1998.

Banks and big corporations and even money-market funds are hoarding cash, refusing to lend it out for a day or a week or a month. Even the best companies are having trouble floating bonds at reasonable rates. And the shadow banking system -- the market in asset-backed securities that ultimately supplies the capital for most home loans, car loans, college loans -- is almost completely shut down.

People are so nervous, and there is so much distrust, that all it would take is one more hit to trigger the modern-day equivalent of a nationwide bank run. Financial institutions would fail, part of your savings would be wiped out, jobs would be lost and a lot of economic activity would grind to a halt. Such a debacle would cost us a lot more than $700 billion.

Third, the latest proposal hammered out between the Treasury and Democratic leaders won't cost anywhere near $700 billion unless we get a 1930s-like Depression, in which case we'll have much bigger problems to worry about. Depending on how the program is managed, and how things turn out with the economy and the housing market, the best guess is that the government could wind up either losing or making a couple of hundred billion dollars. The final tab is simply unknowable -- it depends on how much the government winds up paying for the securities it buys from banks and other financial institutions, and what price it resells them at after the market and the economy recover.

Fourth, this isn't primarily a bailout for Wall Street -- it's an attempt to jump-start certain credit markets that have broken to the point that nobody is buying, driving down prices to the point where they are well below any reasonable estimate of their long-term economic value.

The basic idea is to use special auctions to recreate a market for these securities with many competing sellers and one buyer (the Treasury), so that a credible "market" price can be established. If that price turns out to be below what those securities are now valued at on the banks' balance sheets, then banks will have to take the loss. If the price turns out to be higher, then banks may be able to record gains. The point isn't to bail out institutions that have made bad bets and suffered credit losses, but to provide a buyer of last resort so the market can begin pricing again.

Are there other ways to structure this market rescue? Sure. You could try to deal with the underlying problem by taking additional measures to prevent foreclosures. Or you could create a mechanism for the government to invest fresh capital in troubled banks, in exchange for stock. In fact, both approaches are possible and envisioned under the administration proposal now under discussion. But neither, by itself, is likely to quickly restore confidence in the financial system and relieve the current crisis.

My own suggestion would be to structure the rescue around a new government-owned corporation that would be capitalized, initially, with $100 billion in taxpayer funds. The company would use auctions or other mechanisms to buy the troubled securities from banks and other regulated institutions, but instead of paying for them in cash, the government would swap them for an equal number of preferred shares in the new company. (Preferred shares are something of a cross between a bond and common stock.) Those preferred shares would pay a government-guaranteed dividend and could be redeemed by the government at any time. But they could also be used by banks to augment the capital they are required to maintain by regulators.

The beauty of this arrangement is that, rather than protecting taxpayers by having the government take an ownership stake in hundreds of privately owned banks, it would be the banks that would own a stake of the government's rescue vehicle. The government would suffer the first $100 billion in losses from buying and selling the asset-backed securities, but any further losses would be borne by the other shareholders. And should the rescue effort actually wind up making a profit, then the banks would share in that as well.

I mention this idea to make a final point -- namely that it is important to give the Treasury secretary and the people he hires a good deal of flexibility in designing and experimenting with the mechanics of this rescue. The reality is that these guys will be operating in uncharted territory, making things up as they go along. That means there are no assurances that any particular approach will work and no assurances that this will be the final solution. It also means that, just as we entrust generals to fight a war, we are going to have to trust the Treasury to find a way out of this crisis.

It doesn’t add up

source : articles.latimes.com
Evolution accounts for a lot of our strange ideas about finances.

Would you rather earn $50,000 a year while other people make $25,000, or would you rather earn $100,000 a year while other people get $250,000? Assume for the moment that prices of goods and services will stay the same.

Surprisingly – stunningly, in fact – research shows that the majority of people select the first option; they would rather make twice as much as others even if that meant earning half as much as they could otherwise have. How irrational is that?

This result is one among thousands of experiments in behavioral economics, neuroeconomics and evolutionary economics conclusively demonstrating that we are every bit as irrational when it comes to money as we are in most other aspects of our lives. In this case, relative social ranking trumps absolute financial status. Here’s a related thought experiment. Would you rather be A or B?

A is waiting in line at a movie theater. When he gets to the ticket window, he is told that as he is the 100,000th customer of the theater, he has just won $100.

B is waiting in line at a different theater. The man in front of him wins $1,000 for being the 1-millionth customer of the theater. Mr. B wins $150.

Amazingly, most people said that they would prefer to be A. In other words, they would rather forgo $50 in order to alleviate the feeling of regret that comes with not winning the thousand bucks. Essentially, they were willing to pay $50 for regret therapy.

Regret falls under a psychological effect known as loss aversion. Research shows that before we risk an investment, we need to feel assured that the potential gain is twice what the possible loss might be because a loss feels twice as bad as a gain feels good. That’s weird and irrational, but it’s the way it is.

Human as it sounds, loss aversion appears to be a trait we’ve inherited genetically because it is found in other primates, such as capuchin monkeys. In a 2006 experiment, these small primates were given 12 tokens that they were allowed to trade with the experimenters for either apple slices or grapes. In a preliminary trial, the monkeys were given the opportunity to trade tokens with one experimenter for a grape and with another experimenter for apple slices. One capuchin monkey in the experiment, for example, traded seven tokens for grapes and five tokens for apple slices. A baseline like this was established for each monkey so that the scientists knew each monkey’s preferences.

The experimenters then changed the conditions. In a second trial, the monkeys were given additional tokens to trade for food, only to discover that the price of one of the food items had doubled. According to the law of supply and demand, the monkeys should now purchase more of the relatively cheap food and less of the relatively expensive food, and that is precisely what they did. So far, so rational. But in another trial in which the experimental conditions were manipulated in such a way that the monkeys had a choice of a 50% chance of a bonus or a 50% chance of a loss, the monkeys were twice as averse to the loss as they were motivated by the gain.

Remarkable! Monkeys show the same sensitivity to changes in supply and demand and prices as people do, as well as displaying one of the most powerful effects in all of human behavior: loss aversion. It is extremely unlikely that this common trait would have evolved independently and in parallel between multiple primate species at different times and different places around the world. Instead, there is an early evolutionary origin for such preferences and biases, and these traits evolved in a common ancestor to monkeys, apes and humans and was then passed down through the generations.

If there are behavioral analogies between humans and other primates, the underlying brain mechanism driving the choice preferences most certainly dates back to a common ancestor more than 10 million years ago. Think about that: Millions of years ago, the psychology of relative social ranking, supply and demand and economic loss aversion evolved in the earliest primate traders.

This research goes a long way toward debunking one of the biggest myths in all of psychology and economics, known as ”Homo economicus.” This is the theory that “economic man” is rational, self-maximizing and efficient in making choices. But why should this be so? Given what we now know about how irrational and emotional people are in all other aspects of life, why would we suddenly become rational and logical when shopping or investing?

Consider one more experimental example to prove the point: the ultimatum game. You are given $100 to split between yourself and your game partner. Whatever division of the money you propose, if your partner accepts it, you each get to keep your share. If, however, your partner rejects it, neither of you gets any money.

How much should you offer? Why not suggest a $90-$10 split? If your game partner is a rational, self-interested money-maximizer – the very embodiment of Homo economicus – he isn’t going to turn down a free 10 bucks, is he? He is. Research shows that proposals that offer much less than a $70-$30 split are usually rejected.

Why? Because they aren’t fair. Says who? Says the moral emotion of “reciprocal altruism,” which evolved over the Paleolithic eons to demand fairness on the part of our potential exchange partners. “I’ll scratch your back if you’ll scratch mine” only works if I know you will respond with something approaching parity. The moral sense of fairness is hard-wired into our brains and is an emotion shared by most people and primates tested for it, including people from non-Western cultures and those living close to how our Paleolithic ancestors lived.

When it comes to money, as in most other aspects of life, reason and rationality are trumped by emotions and feelings.

Michael Shermer is the publisher of Skeptic magazine, a columnist for Scientific American and the author of “The Mind of the Market: Compassionate Apes, Competitive Humans, and Lessons from Evolutionary Economics.”

Fighting Off Depression

By Paul Krugman

“If we don’t act swiftly and boldly,” declared President-elect Barack Obama in his latest weekly address, “we could see a much deeper economic downturn that could lead to double-digit unemployment.” If you ask me, he was understating the case.

Fred R. Conrad/The New York Times

Paul Krugman

The fact is that recent economic numbers have been terrifying, not just in the United States but around the world. Manufacturing, in particular, is plunging everywhere. Banks aren’t lending; businesses and consumers aren’t spending. Let’s not mince words: This looks an awful lot like the beginning of a second Great Depression.

So will we “act swiftly and boldly” enough to stop that from happening? We’ll soon find out.

We weren’t supposed to find ourselves in this situation. For many years most economists believed that preventing another Great Depression would be easy. In 2003, Robert Lucas of the University of Chicago, in his presidential address to the American Economic Association, declared that the “central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades.”

Milton Friedman, in particular, persuaded many economists that the Federal Reserve could have stopped the Depression in its tracks simply by providing banks with more liquidity, which would have prevented a sharp fall in the money supply. Ben Bernanke, the Federal Reserve chairman, famously apologized to Friedman on his institution’s behalf: “You’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”

It turns out, however, that preventing depressions isn’t that easy after all. Under Mr. Bernanke’s leadership, the Fed has been supplying liquidity like an engine crew trying to put out a five-alarm fire, and the money supply has been rising rapidly. Yet credit remains scarce, and the economy is still in free fall.

Friedman’s claim that monetary policy could have prevented the Great Depression was an attempt to refute the analysis of John Maynard Keynes, who argued that monetary policy is ineffective under depression conditions and that fiscal policy — large-scale deficit spending by the government — is needed to fight mass unemployment. The failure of monetary policy in the current crisis shows that Keynes had it right the first time. And Keynesian thinking lies behind Mr. Obama’s plans to rescue the economy.

But these plans may turn out to be a hard sell.

News reports say that Democrats hope to pass an economic plan with broad bipartisan support. Good luck with that.

In reality, the political posturing has already started, with Republican leaders setting up roadblocks to stimulus legislation while posing as the champions of careful Congressional deliberation — which is pretty rich considering their party’s behavior over the past eight years.

More broadly, after decades of declaring that government is the problem, not the solution, not to mention reviling both Keynesian economics and the New Deal, most Republicans aren’t going to accept the need for a big-spending, F.D.R.-type solution to the economic crisis.

The biggest problem facing the Obama plan, however, is likely to be the demand of many politicians for proof that the benefits of the proposed public spending justify its costs — a burden of proof never imposed on proposals for tax cuts.

This is a problem with which Keynes was familiar: giving money away, he pointed out, tends to be met with fewer objections than plans for public investment “which, because they are not wholly wasteful, tend to be judged on strict ‘business’ principles.” What gets lost in such discussions is the key argument for economic stimulus — namely, that under current conditions, a surge in public spending would employ Americans who would otherwise be unemployed and money that would otherwise be sitting idle, and put both to work producing something useful.

All of this leaves me concerned about the prospects for the Obama plan. I’m sure that Congress will pass a stimulus plan, but I worry that the plan may be delayed and/or downsized. And Mr. Obama is right: We really do need swift, bold action.

Here’s my nightmare scenario: It takes Congress months to pass a stimulus plan, and the legislation that actually emerges is too cautious. As a result, the economy plunges for most of 2009, and when the plan finally starts to kick in, it’s only enough to slow the descent, not stop it. Meanwhile, deflation is setting in, while businesses and consumers start to base their spending plans on the expectation of a permanently depressed economy — well, you can see where this is going.

So this is our moment of truth. Will we in fact do what’s necessary to prevent Great Depression II?

An output crisis: Manufacturing lags all major economic sectors in growth

By Frank O Smith

A recent study of the performance of economies of eight industrial “battleground” states in the 2008 elections reveals those business sectors most affected by U.S. trade policies grew the slowest over the last 10 years. Manufacturing—commonly thought to be central to the formulation of trade policy—was in fact the loss leader, according to the U.S. Business and Industry Council’s (USBIC) report, released in September.

The eight states studied were Illinois, Indiana, Michigan, Missouri, North Carolina, Ohio, Pennsylvania, and Wisconsin.

“U.S. domestic manufacturing has not only been suffering from an employment crisis that gained so much publicity in the campaign, but also from an output crisis,” says Alan Tonelson, USBIC research fellow and author of the report, Globalization and the 2008 Battlegrounds: How U.S. Trade Policies are Weakening the Economies of Key Industrial States.

Say Tonelson, “Though manufacturing output has gone up—26 percent cumulative growth over the 10-year period—that’s pretty miserable compared with overall GDP grow in all sectors of 66 percent.”

During the period, manufacturing’s contribution to economies of all eight states—as well as to the nation’s—shrank as a percentage of the total economy.

“In our view the key change followed the passing of NAFTA in the 1990s—the first U.S. trade agreement that was an outsourcing deal,” says Tonelson. “Following that, it was China being admitted to the World Trade Organization—which gave them protection from U.S. unilateral action against their predatory trade practices. Washington’s response has been very ineffectual against those practices.”

According to the report, “Trade is widely considered to be a major plus for the U.S. economy and especially for economic growth… but it seems clear that current U.S. trade policies are failing the economies of these politically critical, manufacturing-heavy states—and the U.S. economy as a whole.”

Illinois, cited as a “typical example of a state where growth has been undermined by trade and globalization policies,” saw its share of contribution from manufacturing shrink from 16.10 percent to 12.57 percent.

“The affect of U.S. trade policy on manufacturing in Illinois—in a word—has been devastating. We lost several important customers within months of NAFTA being signed,” says Alan Petrucci, founder of BA Die Mold Inc., a small manufacturer of injection molds based in Aurora, Ill. “Our sales are a third of what they were.”

The mainstay of BA Die Mold’s business used to be automotive and telecommunications, but Petrucci has retooled his business due to diminished business from those industries. “We switched gears and started focusing on specialty products—especially threaded parts for water filtration connections, medical products, and fiber optic connectors.”

Petrucci lost a major customer that moved its entire operation to Mexico immediately after NAFTA was signed.

“It was a bitter pill to swallow," he says. “We probably did a million dollars a year in business with them. We went through some trying times.”

Though several other small manufacturers in the area have since closed shop, Petrucci invested in new automation that enabled him to run 24/7 with significantly reduced labor, enabling him to stay competitive and stay in business.

The report grouped national and state economies into three super categories: 1) most heavily exposed to global challenges and opportunities (manufacturing, agriculture, and mining); 2) partly exposed (finance, retail trade, professional and technical services, hospitality, and IT services); and 3) virtually unexposed (government, health and welfare, construction, real estate, and corporate management services).

Based on data from the U.S. Commerce Department’s Bureau of Economic Analysis, manufacturing saw the least growth by far, lagging agriculture, the second-worst performing sector by nearly 20 percentage points.

OPINION: Americans $1 Trillion in Credit Card Debt

By Jose Garcia

At the beginning of the new year the Federal Reserve announced that in November of 2008 credit card debt totaled $973.5 billion--a decrease of 3.4 percent from October 2008. While that may sound like some good news for consumers, the numbers fail to reflect the debt that has already been written off the books and landed into the debt collection market. The third quarter of 2008 reported the highest credit card write-offs since 2002. While not all this debt will be passed onto debt collectors, enough of it will be snapped up by debt junk buyers to expose consumers to the unscrupulous and minimally regulated world of debt collection.

Credit card companies sell their bad debt--debt they have already written off the books--to debt buyers for just pennies on the dollar. The debt buyers then break up the debt into smaller chunks and resell them to collection agencies who try to collect on the old debts for more than they paid.

The growing profitability from debt collection--from the publicly traded firms who buy debt to the local collection agents who hound people at home--has resulted in the creation of an overly aggressive industry with questionable business tactics. The latest numbers from the Federal Trade Commission (FTC) show that in 2007 consumers filed 70,951 complaints against debt collectors up from 13,950 in 2000. The bulk of the complaints were for the misrepresentation of the amount, nature or legal status of the debt by demanding a larger payment than was permitted by law--a violation of the Fair Debt Collection Practices Act (FDCPA).

Debt collectors are not just interrupting families' dinner anymore. Stories abound of calls made to family members, neighbors and even employers in an attempt to track down their target. Worse are the stories of Americans who have been harassed for the repayment of debt that they never even owed.

Consumers have fallen victim to these tactics because consumer protections from debt collection are severely limited. According to a recent article in the New York Times, changes to the debt repayment industry should begin before the collection process. Rather than the current model of individually working with creditors, Financial Services Roundtable, one of the industry's biggest lobbyists, and the Consumer Federation of America recently proposed a credit card loan modification program. As part of the plan, lenders would have to forgive 40 percent of what was owed by the borrower over five years. The benefit to the industry is less to write off while consumers would be able to pay off their debt.

The hard economic times befalling American families calls for a rethinking of fearless competition and greed as standards for determine economic policy. As we just witnessed in the aftermath of the mortgage debacle, little regard for the consumer is an unsustainable guiding principle both for families and the economy. Reacting to this new economic reality, credit card companies have begun to make it easier for borrowers to repay their debt. But in a deregulated market, such as the one we still have today, they are free to do as they please in the realm of debt repayment. If we should walk away with anything from the economic bust of 2008 it is that consumer protections should not only be a priority for regulators but consumer protection should be a guiding principle for market behavior and corporate pricing.

Forbes Opinion Article: Massive Dollar Devaluation will resolve economic woes

Dollar Devaluation To Fix The Great Recession
by Frank Beck
A quick dollar devaluation would work wonders for submerged borrowers. Don't kid yourself: It could happen.

What began as government social tinkering--with implied threats to banks and mortgage companies to extend home loans to even the most marginal of borrowers--led to a greed-blinded mortgage banking business and the meltdown we are experiencing today. Now we are asked by the same congressional leadership to go along with taxpayer-funded bailouts of the very banksters who, while making millions, created the mess.

Despite the trillions of dollars already expended recapitalizing banks, there is very little, if any, progress to show. Will a few trillion more do the trick? That seems to be the consensus among Congress and the banks. "They are simply too big to let fail," or are they really just too big to save? We can go back to "Plan A" and buy the toxic assets. If so, at what price? What if a few trillion does not remove enough toxic waste from the system or doesn't get credit flowing again and the economy bustling?

Some argue that it is time to help Main Street, not Wall Street. So, we should "forgive" some of the mortgages for those who are 90 days or more behind on their payments. Have you quit paying yet?

If we are to save bankers, shouldn't we at least distinguish between those who possess the intelligence to renegotiate their loans to workable terms? If we are to save homeowners, should not we first define the term "homeowner?" Perhaps it is not only someone who agreed to and signed a mortgage and is living in a house. Just perhaps, it should also include the stipulation that this individual paid some amount of a down payment: 20%, 5%, a dollar. I can tell you who is not a homeowner. It is not someone who paid zero down and ridiculously low payments for two years; that, my friend, is a renter.

The problem with all these ideas is the money is only directed at those who created or benefited from the problems. Why not attack the situation in a manner that will benefit most everyone, an approach that has been successful before and, when compared to the current course, has little downside?

Here it is. Stand back. World currencies should be devalued overnight.

It can be done on a country-by-country basis, but a coordinated devaluation would work best. A devaluation of 30% would raise the dollar value of all assets by 43%. A $200,000 home with a $230,000 mortgage would become a $286,000 home with the same mortgage. Presto! The homeowner who was $30,000 upside-down now has $56,000 equity and a good reason to make his payments. Both the homeowner and the bank are immediately better-off.

It would even benefit those who purchased their homes responsibly, as the value of their homes would rise by the same 43%. The current course of throwing trillions of dollars at the culprits is without any benefit to those who acted responsibly.

Admittedly, this is not a solution without the price of inflation, but the inflation would be short-lived. The current course will ultimately cause massive inflation that cannot be accurately estimated, and it may not even solve the problem.

Currency devaluation proved effective in ending the Great Depression. In 1930, Australia was the first to leave the gold standard, immediately devaluing the aussie by more than 40%, and the economy quickly recovered. New Zealand and Japan followed suit in 1931, each with the same result. By 1933, at least nine major economies had enacted a devaluation of their currency by removing it from the gold standard, all of whom emerged from depression.

In 1933, through a series of gold-related acts, culminating in the Gold Reserve Act of 1934, America realized a dollar devaluation of 41% when the price of gold was adjusted from $20.67 per ounce of gold to $35 per ounce. America, like the others before, had its economy bottom and recover as a result. Of the larger economies, only the French and Italians continued to adhere to the gold standard, and their economies remained depressed until finally, in 1936, they allowed their currencies to devalue, and their economies then recovered.

I see no reason to believe we would have any different result today. Only debt would remain the same. All other assets would immediately be worth more (in nominal terms), whether it be a home, a stock, an ounce of gold or a used car. Bank balance sheets would immediately improve, as many loans would be moved from non-performing to performing status. Banks would be paid with devalued dollars, but they made millions creating the mess. The current use of government stimulus through the creation of dollars will certainly lead to a similar or worse devaluation, so this is likely a net gain for the banks too.

Businesses would instantly become more profitable, and workers' pay would increase, allowing each to pay their debts more easily, even while sending more tax dollars to Washington, without raising tax rates. As assets are sold, the capital gains would send even more taxes to Washington. States and locales would receive more revenue via sales and property tax, improving the fiscal condition of school districts and local governments. The national debt would effectively be reduced by the same 25%, giving future generations a chance. Combine the move with a congressional pledge to only raise the budget by half the devaluation, and we could be on track for a balanced budget and paying down the debt.

As the old Saturday Night Live skit said, "Think of inflation as your friend. Wouldn't you like to wear $1,000 suits and smoke $100 cigars?" I know I would.

Frank Beck is Chief Investment Manager of Capital Financial Group and ProPlayer Investing in Austin, Texas, an affiliate of Partnervest Securities of Santa Barbara, Calif. Mr. Beck may be reached at Frank@FrankBeck.com.

Leading article: Mr Clegg makes his mark

source : independent.co.uk

Nick Clegg celebrates his first anniversary as leader of the Liberal Democrats today – and he does have cause for celebration, however muted. After a closely-fought leadership contest, Mr Clegg has established himself, unchallenged, at the head of his party. He has survived several setbacks, not least the contentious walk-out of his MPs over the refusal to allow a vote on Britain's future in the European Union, and most recently the conversation, overheard by a journalist, in which he criticised some of his closest colleagues. In between came much rethinking and a thorough overhaul of the party's economic policies. He enters his second year as leader stronger by some way than he began his first.

The greatest difficulty he has faced, and one he acknowledges with some frustration, is in projecting the policies, even the presence, of the third party at a time when there are two strong main parties in the Commons and a global economic crisis dominates the news. Carving out a distinct identity has been difficult, but his greater difficulty has been to make his voice heard above the two-party hubbub.

In one way, his cause – and his party's appeal – have been greatly enhanced by the authority of his deputy, Vince Cable. As acting leader, he was the right man at the right time and put the party back on the political map. A heavyweight on economic issues, Mr Cable's judgement has repeatedly been vindicated. Solutions he advocates have a way of reappearing as Government or Opposition policy a few months or even weeks later. The trouble is that Mr Cable, through no fault of his own, sometimes seems to be regarded as an economic authority first and a Liberal Democrat second. So while the party remains more forward-thinking than others – especially on ways to help over-mortgaged home-owners and staying "green" in austere times – it has not received as much credit as it deserves.

Still, the party's position in the polls has held up better than might have been expected. And there are signs that Liberal Democrats may be benefiting a little from the dip in the fortunes of the Conservatives. Overall, Mr Clegg has laid a promising foundation. We look forward to his second year.