It's hard to be a bear

Stock market keeps climbing, oblivious to unemployment, oblivious to the continuing housing crash, and oblivious to the rising deficit. What gives?

Two great posts to read.

It's hard being a bear begins with this shocking line: "If the economy does in fact recover from the Global Financial Crisis—without private debt levels once again rising relative to GDP—then my approach to economics will be proven wrong."

Someone actually open to changing their mind driven by reality and data. Read the whole post for that alone. I don't know enough about the difference between various schools of post-Keynesianism (Chartalism vs Circuitist), and it may get too inside baseball, but certainly worth reading.

The response is also equally worth reading, if for nothing else, an appearance from JKH:

I have a visceral negative reaction to the apparent econo-blogosphere virus of making up definitions that conflict with standardized double entry book keeping definitions that the creators of those conflicting definitions actually rely on in order to source the data that supports their new creation …

Moreover, the monetary system as a whole does not have negative net financial assets. That is logically incorrect. Every financial obligation is mirrored by a corresponding financial asset. This holds for money, debt, and equity. This is double entry book keeping …

If the common ground between Circuitism and Chartalism is that both camps understand how the monetary system works, that would be enormous common ground. I’m absolutely convinced that the Chartalists understand it, and that understanding is provable by operational fact and pure accounting logic. The accounting paradigm as between government and non government financial balance is absolutely indisputable in that sense. Conversely, if the primary distinction between Chartalists and the neo-classicals is on the same point, that is enormously important. It is enormously important because there is no way you can understand economics if you don’t understand how the monetary system works. It is a necessary condition. Otherwise, it would be like monkeys typing Shakespeare for the neo-classicals to get it right.

Note. that by "neo-Classicist" JKH means both the boys at Chicago Krugman keeps beating on in the NYTimes and Keynesians like Krugman himself who believe in the "money multiplier", as well as fads du jour like Sumner (who also believe in the money multiplier).

When talking about PK identities, I often here stuff like "that's just an accounting identity", or "that's just nominal, it isn't real". Accounting matters, it is the operational reality of banking. Nominal matters too to the extent that we interact with banks or money. Which is a lot!

Too much debt

While Paul Krugman argues that Obama needs to completely nationalize the US Healthcare system (which is well on its way to being a branch of the Government already), and Arnold Kling frets about the Great Recalculation (which somehow connects unemployed real estate agents with a collapse in auto sales), and George Mason (who?) economists say whatever they need to say to get in the pages of the Grey Lady this simple graph puts the Nation's problems in a clearer perspective:



US Households cannot afford their current housing stock and have taken on more debt than they can service out of income. At the same moment, the Obama administration is taxing 30% of these same households' incomes and giving them to banks so banks can... further increase the indebtedness of these overstretched households. Banks realize the absurdity of the situation and are sitting on the reserves. But will economists spot the absurdity as well?

FDIC taxing health banks?

Being a currency issuer is hard work. Among your many responsibilities is backing up consumer deposits in banks. If you don't do this, you risk a bank run, which is bad (cue "it's a wonderful life reference"). The US does this through an agency called the FDIC, which basically puts Uncle Sam's printing press behind deposits of $250,000 or less. A few months ago it was just up to $100,000 or less, but there was a crises and people needed more, so they raised it. When there is a bigger crises, they will raise it some more. Raising it before it needs to be raised just seems wasteful, I guess, so let's embrace the "just-in-time" FDIC we are blessed with.

If the FDIC runs dry, it can simply be topped up by the Treasury. After all, it's just replacing hard earned money that people have put in their bank accounts and making them whole -- clearly no risk of inflation there. And both the FDIC and Treasury are playing on the same team.

Instead, the FDIC is "borrowing" from healthy banks to fund losses at unhealthy banks. Here, the FDIC issues Govt money to a healthy bank, and then gives the healthy bank money to an sick bank. Why not just issue Govt money to the sick bank? Well, then there would be no opportunity to pay interest income to the healthy bank.

The FDIC is a branch of the US Govt, and therefore a currency issuer. It should acknowledge and live up to its responsibilities, and use the power that fiat currency has given it. If the Govt finds that one of its accounts has run dry, it should just top it up by issuing some currency.

Green shoots -- not so fast

Best two perspectives on the current state of the economy come from Warren Mosler, and Steve Keen.

First Warren with a quick macro update:

Market functioning has finally returned, helped by the Fed slowly getting around to where it should have been even before all this started- lending unsecured to its banks, setting its target rate and letting quantity adjust to demand. It’s not technically lending unsecured, but instead went through a process of accepting more and varied collateral from the banks until the result was much the same as lending unsecured.

It is more obvious now that the automatic fiscal stabilizers did turn the tide around year end, as the great Mike Masters inventory liquidation came to an end, and the Obamaboom began. The ’stimulus package’ wasn’t much, and wasn’t optimal for public purpose, but it wasn’t ‘nothing,’ and has been helping aggregate demand some as well, and will continue to do so. It has restored non govt incomes and savings of financial assets to at least ‘muddle through’ levels of modest GDP growth, and we are now also in the early stages of a housing recovery, but not enough to keep productivity gains from continuing to keep unemployment and excess capacity at elevated levels.

This also happens to be a good equity environment- enough demand for some top line growth, bottom line growth helped by downward pressures on compensation, and interest rates helping valuations as well. There will probably be ups and downs from here, but not the downs of last year.

A nice alternative to the naysayers who take moral opprobrium against the recovery, declaring that the US cannot get its economic house in order without first fixing the banking system. The US has grown economically with a rotten banking system in the past, and can do so with the same rotten system in the future.

A longer term view now from Steve Keen

The final reason for me being a bear is that I am that practitioner of alternative medicine. Minsky’s “Financial Instability Hypothesis” has been ignored by conventional economists for reasons that are both ideological and delusional. A small band of “Post-Keynesian” economists, of whom I am one, have kept this theory alive.

According to Minsky’s theory:

* Capitalist economies can and do periodically experience financial crises (something that believers in the dominant “Neoclassical” approach to economics vehemently denied until reality—in the form of the Global Financial Crisis—slapped them in the face last year);
* These financial crises are caused by debt-financed speculation on asset prices, which leads to bubbles in asset prices;
* These bubbles must eventually burst, because they add nothing to the economy’s productive capacity while simultaneously increasing the debt-servicing burden the economy faces;
* When they burst, asset prices collapse but the debt remains;
* The attempts by both borrowers and lenders to reduce leverage reduces aggregate demand, causing a recession;
* If the economy survives such a crisis, it can go through the same process again, with another boom driving debt up even higher, followed by yet another crash; but
* Ultimately this process has to lead to a level of debt that is so great that another revival becomes impossible since no-one is willing to take on any more debt. Then a Depression ensues.

That is where we were … in 1987. The great tragedy of today is that naïve Neoclassical economists like Alan Greenspan and Ben Bernanke allowed this process to continue for another three or more cycles than would have occurred without their rescues.

In 2008, they did it again—only with methods they would have disparaged a mere year earlier (“Rational Expectations Macroeconomics”, a modern neoclassical fad, preaches that government intervention can’t influence the level of economic activity at all—yet another belief that reality has recently crucified). This time, while the rescue has worked, the recovery they expect afterwards can’t happen—because there’s almost no-one left who will willingly take on any more debt.

Is the US Consumer willing to take on debt levels we saw in 2004-2007? Will they be allowed to?

My take on the former is that the US Consumer did not think they were actually taking on a debt burden during the housing bubble, they believed that rising asset prices would reduce the debt. Without some leading sector fueling private income (from labor or capital) I cannot see much appetite to fork over 40%, 50%, 60% of household income on debt service for a property you can rent for 3-4x less.

My take on the latter is that the Government is under political pressure to not grow the deficit any more. Obama's first stimulus was too politically motivated to enable a second, unless he espouses a payroll tax holiday (which benefits everyone, and is therefore not politically useful). If the private sector is unable to increase its net equity and paid in capital, it will not have a broader base to shoulder additional debt.

Ignore Deficit Accounting at your Peril

I'm naive, but I remain surprised at how difficult it has been to get any traction on Federal Reserve, Treasury, and Bank accounting. Dry topics, sure, but we live in an era of brushed-off Keynesianism and CDS.

Take this recent piece by Krugman who points out that the output gap is, and remains, large. He ends by noting:

In a rational political and policy environment, the implication of all this would be clear: we need more stimulus. Yes, it would add to federal debt — but isn’t that worth doing to help reduce an output gap that’s wasting our potential at the rate of more than a trillion dollars a year?

Apparently not.

He does not mention that people resist additional stimulus because it just amounts to handouts to politically connected constituencies, particularly Democratic ones, whose bad actions got us into this mess in the first place: labor unions (though GM and Chrysler), banks and other financial firms (who own the Republicans as well), and a host of beltway bandits. Individual households got a pitiful amount of the stimulus, I think about $200 each. Pathetic.

Krugman does not know that the Federal Deficit funds private savings, and the simplest, fastest, most equitable, most controllable way of doing that would simply be to declare a payroll tax holiday. Democrats argue against tax cuts because they say they will just be "saved", but think about what saving means: bad debts become good, households shore up their finances for future consumption, and what consumption there is will be directed to productive parts of the economy, not non-productive, but Government supported parts of the economy.

Libertarians and fresh water economists don't like stimulus because they cannot believe that the Government can be good for anything. They also claim that fiscal funding just creates "nominal" wealth, and not "real" wealth, forgetting that "nominal" does not mean "does not matter". Right now, the lack of nominal fiscal funding is destroying huge amounts of real wealth, as evidenced in the output gap and 10% unemployment rate.

The idea that Government 1) has a role, and 2) should do it right is alien to both camps

BTW. Here's your "inventory" for you. Looks good, doesn't it?

Loans Create Deposits -- how banks actually work

I used to believe that banks lent out deposits. So, you deposit money in a bank, and the bank turns around and loans that money out to someone. "Fractional reserve accounting" meant that the bank could lend out more money than it had on deposit, which seemed fishy. As the bank usually made long term loans funded by short term deposits (mismatched maturity) they were always at risk of a bank run, which is where FDIC insurance came in.

I was wrong.

At a macro level, banks create deposits by extending loans. At an individual level they do the same thing, but also need to manage reserve accounts. This is how it works:

Loans create deposits

Banks do not loan out deposits. When you deposit money in a bank, you are not putting it "hard at work" in any way. It is not funding factories, houses, or anything else. Saving money in a bank is the same as putting it under the mattress.

When an individual bank (bank A) makes a loan, it creates (credits) an asset (receivable). To make its books balance, it debits its reserve account at the Fed (also an asset) by the same amount. The loan creates a deposit, say in a different bank (bank B). That bank credits the deposit on the liability side, and credits its reserve account at the Fed. The reserve account debit made by bank A is exactly matched by the reserve account credit made by bank B. While the total amount of reserves in the system is unchanged, bank A is now short reserves, and bank B is long (assuming they had the correct amount of reserves in the first place).

Bank lending is not reserve constrained

So, what will bank A now do, since it is short reserves? It can try to win over bank B customers and get them to move their deposits over, this transferring the reserve account assets bank B has to itself. If bank A fails to do this, then it simply borrows the reserves it needs overnight from... bank B. The overnight lending market is designed to do exactly this. Bank B, in this case, happens to have exactly the quantity of reserves bank a needs, and since reserves earn no interest, is happy to lend to bank A at the federal funds rate, which is the overnight interbank lending rate.

Suppose the system as a whole is short of reserves? In this case, the banks who are short on reserves borrow directly from the Fed's discount window.

Suppose the system as a whole has excess reserves? In this case, the Fed sells treasury securities, which enable banks to transfer assets from their reserve accounts (at the Fed) to their treasury accounts (also at the Fed). The Fed sells treasuries not to "finance" the deficit, but to drain the system of excess reserves, so there will be overnight lending, and thus, a non-zero interest rate. If the Fed did not drain extra reserves from the system, banks would not lend, and the overnight lending rate would be zero.

Again, loans create deposits

So, at an individual bank level, banks make loans as they like, and then either borrow the reserves they need at the discount window or overnight market, OR the grow their deposit base to meet their reserve requirements. But the banks make the loans first, and then do whatever to hit their reserve target at the end of the day.

At a macro level, the banking system makes loans, which in turn create deposits.

Note to Austrians: the problem is not maturity mismatching, the problem is private sector credit extension

You'll note that individuals cannot make loans the way banks can. We do not have the facilities they have at the Fed. Austrians think that it is maturity mismatching that enables banks to lend money, but they are wrong (although maturity mismatching has it's own problems), the issue is private sector credit extension. Private sector credit extension expands private sector balance sheets, can it can do this to whatever level it can get away with.

Capital requirements constrain bank lending

So, if reserve requirements don't limit bank lending, what does? Answer: capital requirements. Bank balance sheets must rest on a certain core of paid-in equity, but unfortunately, regulators frequently fudge, ignore, or otherwise enable banks to ignore those rules and leverage themselves to calamitous levels, getting paid obscenely in the process.

I leave you with one of the most remarkably ignorant posts I've seen on this topic, notable only because the individual actually works within the banking system! On a comment forum in Econlog, he stated

The point here is that a particular bank cannot be sure where any disbursed loan funds may end up and can only count on a small proportion returning. This means that they cannot simply inflate their balance sheet by making loans and counting on the funds to come back as deposits. Additionally, if they did this their liquidity ratios (one of the key measures of any bank's soundness) would steadily deteriorate, restricting their ability to make further loans. Their capital ratios would also steadily deteriorate, reducing their ability to raise funds.

Ozrisk does not seem to realize that making loans reduces a bank's ability to make further loans, which is exactly how capital requirements are supposed to work, and their whole point.

What's really wrong with healthcare

Having spent enough time consulting (where you have data, but don't spend much time in the field), and spending time in the field, particularly in ERs, this interview with Richard Cooper, MD rings 100% true:

Regional variation is a product of regional differences in wealth, overlaid with differences in poverty. It’s not generally appreciated that health care expenditures for people in the lowest 15% of income are 50% to 100% greater than for people of average income. There’s also a difference at the high end. The wealthiest 15% also consume more, but only about 20% more. So there’s greater utilization at both ends of the income spectrum, but for different reasons and with different outcomes...

A good example is the Dartmouth study of academic medical centers. You find that one group of academic hospitals provide more care than another group. The Dartmouth folks say that Mayo is more “efficient” in resources used per patient or in number of doctors devoted per unit of patient care than in LA, Philadelphia, Miami, Chicago, and New York City.

But the so-called “inefficient” hospitals are all in dense urban centers, while “efficient” hospitals are all in smaller cities, often college towns liked Madison, Wisconsin or Columbia, Missouri, or in places like Rochester, Minnesota, where Mayo is located. Rochester is 90% Caucasian with low poverty. But in fact, Mayo is the most resource intensive center in the upper Midwest. Among peer institutions in similar socio-demographic environments, Mayo actually uses more resources.

What drives such appallingly bad "analysis"?

[Dartmouth claims that] Mississippi, the poorest state in the nation [has the most spending, and highest number of specialists, and poor quality healthcare]. It does, indeed, have poor quality, but how could it have the highest spending and the most specialists? The answer is it doesn’t. Mississippi, as you know, has the fewest specialists, and although it does have high Medicare spending, it has very low health care spending overall. It’s not surprising that low total spending and few specialists are associated with poor quality. In fact, when all of the states are examined, more total spending and more specialists are associated with better quality – just the opposite of the Dartmouth-Harvard message but just what you would expect.

You might wonder how they arrived at the opposite conclusion. Well, they never really measured how many specialists were in Mississippi or anywhere else. They did some statistical maneuver where everything was converted into residuals, and I guess that Mississippi has a lot of residuals. It just doesn’t have a lot of doctors.

I published my observations about these studies in two papers in the December 2008 issue of Health Affairs online. But much to my surprise, they were accompanied by two rebuttals from the Dartmouth crowd, each with summary statements by the editor that said I had simply reconfirmed the Dartmouth work.

But it all made sense when I learned that the new editor of Health Affairs, Susan Dentzer, is a Member of the Board of Overseers of Dartmouth Medical School, the former Chair of the Board of Dartmouth College, a former Trustee of Dartmouth-Hitchcock Medical Center and winner of the alumnus of the year award from Dartmouth. She has a profound conflict of interest which she failed to reveal in her editorial – an egregious ethical breach. So, it all made sense. And it all is rather remarkable. Fortunately, truth has a way of surviving, and the truth is that states with more health care spending and more specialists have better quality health care.

You can read more about Susan Dentzer here and check the boxes: PBS, Robert Wood Johnson, Association of Health Care Journalists, the American Psychiatric Association, US News, ABC, CNN, Harvard, Council on Foreign Relations (no, I am not kidding), International Rescue Committee, Dartmouth, Dartmouth Medical. You need a lot to overcome what anyone can see with their own eyes.

Funny: A Doctor's Plan for Legal Industry Reform

From the WSJ, A Doctor's Plan for Legal Industry Reform

Physicians have never been so insulted. Because of these affronts, I will gladly volunteer for the important duty of controlling and regulating lawyers. Since most of what lawyers do is repetitive boilerplate or pushing paper, physicians would have no problem dictating what is appropriate for attorneys. We physicians know much more about legal practice than lawyers do about medicine.

Following are highlights of a proposed bill authorizing the dismantling of the current framework of law practice and instituting socialized legal care:

• Contingency fees will be discouraged, and eventually outlawed, over a five-year period. This will put legal rewards back into the pockets of the deserving—the public and the aggrieved parties. Slick lawyers taking their "cut" smacks of a bookie operation. Attorneys will be permitted to keep up to 3% in contingency cases, the remainder going into a pool for poor people.

And he doesn't even mention tort reform!

On the healthcare issue, here are my modest two cents, from personal experience. There is a non-Governmental organization called the Joint Commission (or JAHCO) that regulates hospitals. It can accredit and certify hospitals, in effect, shut them down.

Having seen JAHCO in action close up, I can honestly say that may God help us all if American healthcare becomes even more of a Government bureaucracy than it already is. The incompetence and small mindedness is exactly what you would expect from bureaucrats. It is a nightmare straight out of Brezhnev, or if you prefer, Dilbert.

Geithner almost gets something right

NYTimes reports:

The thrust of the plan is to have banks, particularly those deemed too big to fail, maintain larger capital cushions — a move bankers have traditionally opposed because it eats into their profits. The Treasury secretary, Timothy F. Geithner, is expected to outline the administration’s proposals Thursday in a letter to the finance ministers of the Group of 20 industrial and emerging nations, who are scheduled to meet in London this week.

The measures are still under discussion and, if adopted, probably would not take effect for years. But capital levels, once the domain of academics and policy specialists, have quickly become Topic A in banking circles and underpin the administration’s proposals for overhauling financial regulation. Compelling banks to hold more capital could radically reshape the industry.

What I like about this proposal:

1. Capital requirements are a real constraint on lending. Finally the Treasury is focused on something that matters.

2. It increases capital requirements as banks get larger. This weighs against banks becoming "too big to fail".

3. Excess leverage in the financial system drove the calamitous financial crises. Bank leverage is the size of the balance sheet vs. the site of paid in equity, ie. capital ratio.

Problems with this approach:

1. Capital requirements actually constrain lending. Do we really want to do this now?

2. Banks skirted capital requirements in the past, and will no doubt do so in the future. How about enforcing old rules? For example, a bank takes on some credit risk, but then "hedges" that with a CDS. This got them out of higher capital requirements in the past -- similar fraud will get them out of higher capital requirements in the future.

3. There is a more straightforward, and hard to game technique for having banks take credit quality seriously -- eliminate the secondary market. If you have to keep the loan on your book, you will care more about the recipient's ability to pay it back.

One final note: I'm disappointed that the Times decided to have the headline read: "White House to Propose Big Reserves at Banks". There is enough confusion out there between reserve requirements and capital requirements, this just makes that worse.