Monday, November 24, 2008

My Short Explanation of the Financial Crisis

Over the last several decades the finance industry has grown to be the largest contributor to GDP. Yet it's difficult to discern what they have been producing, other than bubbles and crises. In the process they have internationalized capitalism. During the same time corporations and the people who own and run them have prospered handsomely while the average workers situation has deteriorated.

This has resulted in huge capital accumulation around the world, way more that can be productively put to use funding real opportunities. With the help of the Fed and the government, providing easy money and reduced regulation, asset values continued to rise, seemingly in perpetuity. This was an opportune situation for the application of leverage to magnify profits. Profits were rolling in at unforeseen rates. With too much capital, and to few places to apply it, banks found it necessary to fund poorer and poorer investments, lest their huge profits be truncated. But, poorer investments necessarily implied higher risk so a method had to be found to hide risk. Into the breach jumped the investment banks, rating agencies, and insurance companies. Securitizing debt obligations was the answer. Pool the risky assets, slice and dice them into tranches of various levels of risk and sell them to all those investors looking for a place to put their unused capital. But, how to rate such assets, no one knew. Rating companies, also wallowing in huge profits and fearing loss of them, threw up their hands. They had no models to do it. So what to do? Rate them highly and continue to make huge profits or rate them realistically and let their competitors reap the huge profits. The decision was easy.

But, buyers of the new assets were asking questions. How risky were they, really. They found it hard to believe that slicing and dicing bad assets could end up with a highly rated asset. Into the breach jumped the wiz kids at the investment banks and insurance companies once again. Guarantee them! Write some insurance guaranteeing the asset. Viola! Credit default swaps. Not only were these magic instruments not covered by insurance regulations, but they could be traded on their own, opening up more opportunities for profit. The investors bought the swaps to guarantee the overrated assets and the profit bonanza continued on.

With all these new assets and guarantees all that was needed was more risky assets to finance. Ah, alas the government had sanctioned expanding home ownership, the new ownership society. Just get rid of all the rules for qualifying home buyers, the problem would be solved and the profits would continue to roll in. No one dared question the infinite wisdom of the finance industry. After all, the industry had soaked up most of the talent from Ivy League schools in the last several decades. And the real estate and construction industries were more than willing to accommodate the new bonanza.

But, ooops! The payments came due, the ARMs (Adjustable rate mortgages) were no longer hugging home buyers, they were strangling them. And securitizing debt had been expanded to auto loans, credit card debt and almost any other kind of debt. The jig was up. Time to pay the piper. The asset value climb was over. Time to get real. The banks found themselves having to come up with additional reserves to cover the falling value of the assets on their books. And they had to pay off the leverage loans. And their investments in swaps were tanking. The couldn't refinance their commercial paper. What would they do? Other banks wouldn't lend to them. After all, they were having their own problems.

Time to play the trump card. Who's running Treasury, one of our own, Henry Paulson, he'll save us. Sure enough, he seems to be doing just that, using the well worn Bush technique of scaring the hell out of Congress to get them to write a blank check, as was done in the Iraq war. Alas, they fell for it again, and here we are, once again, kneeling at the feet of the money changers that couldn't find anywhere to invest their heaps of cash skimmed off the top of every transaction that makes up that holy of holies, the GDP.

Wednesday, October 15, 2008

The Underlying Problems of the Financial Crisis

This financial crisis is not caused by a shortage of capital. The world is awash in capital. Why else would capitalists be making bad investments? When all the good investments are funded the only ones left are the bad ones, or using the money to speculate in financial markets. Now these banks and hedge funds with all the money are pulling their capital out of productive uses and putting it in government securities at little or no interest because they are afraid they will lose it. In short, they are hoarding, instead of investing. The government giving these same banks more money will not fix the problem. Why wouldn't the banks just take the cash and pay it out in dividends and executive bonuses, buy more government bonds, or use it to de-leverage bad investments? The most direct way for the government to solve the crisis would be to take the money they're getting and invest it in productive companies that need the cash to operate or expand, or divert it to infrastructure projects and research that employ people who will spend the money they earn, thus creating demand. To give the money to people who have demonstrated that they won't invest it in productive enterprises is rewarding them for bad behavior. When the private financial system fails, it's an opportunity to show that the federal system works, not a time to be weak kneed and just throw good money after bad and send the bill to the taxpayers of the future.

The genesis of this whole problem is the world wide financial pyramid that allows corporations to divert most of their profits to executives and stockholders, while squeezing labor costs to the bone. They spend huge sums lobbying for special treatment and tax loopholes. This is the whole reason that corporations exist. Over the last several decades wages have stagnated while capital has been accumulating. People have even been encouraged to borrow against what few assets they have to spend more on products and services, allowing corporations to divert even more to executives and stockholders. Why should they do otherwise? Only the government has the power to balance the creation of capital against the welfare of the general public, through regulation and taxes. Call it class warfare, or whatever you want. That's what happening. There is no need for government to pay people to do nothing. Our infrastructure is falling apart, research on new technolgies is suffering, and demand is falling because consumers have exhausted their credit, prices for goods and services continue to rise, while paychecks stagnate. The government needs to play a positive role in countering the excess accumulation of capital at the expense of the standard of living of average citizens.

International trade has exacerbated the problem. Having goods made offshore, where labor is cheaper makes for higher profits and greater opportunity for diverting more to capital, less to labor. Profits of offshore enterprises mount and what do they do with these profits? They invest them in US government securities, fund US consumer debt, or bid up the price of assets around the world, creating the bubbles we've seen. Petroleum exporting countries pile up huge cash reserves looking for a place to make more money. The answer is to put this excess capital in the hands of consumers that will spend it instead of hoard it. This can only be done through progressive taxation, direct government investment in enterprises that produce useful goods, or government funding of infrastructure or long term projects for which there are long gains. Corporations will only invest for the short term. Their stock is valued on current or short term profits, not long term success. That's why they show little interest in future technologies and keep building gas guzzlers until oil prices skyrocket. The conservative distrust of government has been a primary reason why we are in this fix, since government is the only solution to correcting it. If this financial crisis doesn't demonstrate this, I don't know what will.

Saturday, October 04, 2008

Capitalists vs. Businessmen

I think it's time to clarify the distinction between capitalists and businessmen. We sometimes consider them one and the same. Capital is life blood of business. If businesses want to innovate or expand, capital is almost always needed beyond that which the people running the business can provide. So they turn to capitalists to provide it.

Capital is accumulated when individuals or businesses earn more than they need for day to day operations or consumption. So, they look for a place to put it where they can access it later, or where they can earn a return on it by lending it to someone else. Banks used to be businesses that fulfilled this role. They take deposits from people or businesses, pay them a return for the use of their money, and lend it out to others who can use it to innovate, expand or acquire infrastructure like homes, land, buildings, transportation, machinery, etc. Such assets have value to those who acquire them and value to the society in improving our standard of living.

So what is a capitalist? Anyone who accumulates wealth beyond their needs and lends it to others. This can take the form of bank deposits, stock or bond purchases, or personal loans. In this sense, a capitalist can be an individual, a small business, or a mega-conglomerate.

So what is businessman? Anyone who starts or acquires an enterprise which provides goods or services to others for a profit.

So what is the distinction? If a capitalist operates a bank, brokerage, or other business strictly as a service to others for a profit, they are a businessman. But, if what the capitalist is doing no longer becomes a service to others but an impediment to needs of others to innovate, expand, or acquire infrastructure to facilitate their operations, they are no longer a businessman, but only a pure capitalist.

The distinction is easily seen by considering what is happening in our financial markets now. Our financial system, when run efficiently, provides the necessary capital to allow the smooth functioning and funding of our productive enterprises. The stock market and banks provide the capital for companies like GE and Home Depot to innovate or expand their operations, and to provide the necessary cash flow for day to day operations. This is often called liquidity. To maintain liquidity, banks have to provide reserves to allow withdrawals by depositors, and they must take care to assess risk properly and limit leverage so they don't get caught in a bind if asset values start to fluctuate wildly. They must take care not to get trapped in viscous cycles by assuming conditions will continue to progress as they have in the past. In short, they must be always vigilant that they are there to provide a valued service and not to take advantage of their position to enrich themselves at the expense of the economy they are serving.

Deviating from these principles is what caused the current economic crisis. Businessmen in the finance industry abandoned their role as businessmen and became pure capitalists. Seeing their competition use leverage and derivatives to increase profits at the expense of risk, they had a choice to make, continue being conservative and providing a business service for a reasonable profit, or jump on the band wagon and do what their competitors were doing to make better returns. This happened at all levels of the economy. Even though the average Joe or Jane didn't come up with any fancy derivatives to increase their return, they were more than willing to use leverage and credit, engage in speculative transactions like flipping assets for a profit, and invest in stocks for no other reason than that they were going up, with little consideration of the value of the underlying investment. They added to their stock of credit cards and borrowed on their homes to increase consumption, paying little attention to what would happen when they had to pay off these debts. Banks stopped being businessman and reverted to pure capitalism, sending out credit cards to people without due consideration of their ability to pay. Instead they just assumed a percentage were going to go bad. As is now apparent, this kind of behavior is what has led to the many bubbles that have formed, and that have now caused our credit markets to freeze up.

So what are bubbles? A bubble forms when asset prices are bid up due to the expectation that a current trend will continue, ignoring the underlying asset value. It's essentially a switch from fundamental investing to speculation. Individuals can get by with a whole lot of speculation for a while, then go broke and start over. But, when the whole financial industry engages in the process we get what we have now, a credit crises, where everyone loses confidence in the people and businesses they do business with in a normally functioning market environment.

What has happened over several decades is the finance industry has syphoned off a sizeable portion of the GDP to enrich those in the industry at the expense of productive businesses who need their capital and services to grow and innovate. We are at a point now where capitalists would rather put their money in treasuries at near zero rates of return, than invest in businesses which need the capital to function and grow. During the housing bubble buildup capitalists, large and small, made abnormal profits by encouraging people to buy houses with little or nothing down, low or zero interest rates initially, and other incentives to unsophisted buyers. The real estate industry and the housing industry went along because it was very profitable. But, anyone could have seen that at some point homes would become too expensive to sustain the rate of sales and the bubble would deflate, which it did. That in itself wouldn't have caused the crisis we are now in, if large financial institutions had not shifted from being businesmen to pure capitalists, chasing profits without regard to risk.

Now we find ourselves in a situation where the capitalists money is sitting on the sidelines in treasury instruments earning little or no return, while businesses and individuals are starved for the lifeblood they need to function efficiently. We should realize that every dollar that goes into a fat salary of an executive is a dollar that could be used by some innovator or businessman to improve the standard of living for all. Every dollar that is tied up in a bank not being used, or is being paid to a congressman to write a loophole for a capitalist is not being used to improve our standard of living. Every dollar that goes to buying the sixth or seventh home, the yacht or private jet for someone who successfully gamed the financial system is not going to improve the standard of living for all in our society. The redistribution that is taking place is not from the rich to the poor, it's from all of us to people in the finance sytem who are gaming the system by being pure opportunistic capitalists instead of business people who provide capital to our productive businesses for innovation and growth.

So how does the government fit into all this? First, is important to recognize, as we have seen historically, that the business environment is not stable without some form of regulation. This can take many forms. Non-government agencies like the Fed are charged with containing inflation and maintaining stable employment and growth by adjusting the money supply and providing credit as needed. But, they are not charged with containing speculation or regulating the business environment, particularly preventing bubbles from developing. They don't have the tools. And government oversight is hindered by the campaign financing and lobbying activity that influences government officials. The revolving door of individuals moving from industry to goverment and back also contributes to a lack of objectivity in regulating business. This must change if we are to secure anything resembling long term stability and an efficient system.

When we have a crisis like the one we have now where the government is receiving funds from capitalists for essentially safe keeping at little or no interest, they must use this money to provide relief to the people and businesses that would normally be receiving it to innovate or expand their businesses or to individuals that can use it to get out of a bind and continue productive employment and purchasing. Instead, they are using it to relieve the pressure on a non-productive finance industry that was instrumental in causing the problem in the first place. This money should go to directly to aid the people and businesses that are productive, to improve infrastructure, and to increase demand for useful goods and services in a declining economy.

The bottom line is that we must come up with incentives for people, businesses and government to keep its eye on how money passing through the economy is being used. Where it is not being put to productive use, government regulations and tax policy should be adjusted to see that it is. The government is charged with promoting the general welfare and this a fundamental role of government.

Tuesday, September 09, 2008

Progressive Taxation and the Myth of Redistribution

The problem with conservatives using of the cliche' "redistribution" in response to any question on progressive taxation, is that it assumes that the income going to corporations and wealthy people is earned in the first place. Corporations are chartered by the government and given special consideration, avoiding some forms of liability, to accumulate capital for investment. Corporate charters do not address any aspect of fairness in determining how corporate income will be distributed. Corporations sole reason for existence is to maximize return to shareholders and minimize the cost of the factors of production, including labor, whereas the Constitution charges government with promoting the general welfare. So there is a conflict in the goals of these two institutions. Wealthy people and corporate executives are much more dependent on income from capital than from wages. So benefits accruing to corporations also tend to accrue more to the wealthy than to average wage earners.

In assessing what income is actually earned, all factors must be considered, not just who receives income under current law. Clearly corporations and their largely wealthy benefactors would not prosper to the extent they do if they didn't operate in a country with an established system of laws and infrastructure bequeathed to them by past generations. So it is not clear that just because someone earns an income that it should be attributed only to their own efforts. Some credit must be given to the system they operate under and the contributions of others in generating their income. This is particularly true of corporate income, where executives get to decide where the income goes, without much interference from outside sources. Under conditions of labor surplus this results in most of the income being diverted to owners of capital. Under labor shortages, more would be claimed by labor. But, under our current system, where illegal immigration and outsourcing operates largely unfettered, labor is at a major disadvantage in maintaining it's interest without government assistance.

Aggravating this conflict of interest is the fact that wealthy people and corporations have more influence on government through lobbying and campaign financing, whereas average wage earners have a much reduced voice in how laws are made. This allows the wealthy to create tax loopholes which favor their interests at the expense of the average wage earner.

The solution to this conflict could come from two different directions. First, corporate law could be changed to charge corporations with some measure of promoting the welfare of their workers, not only the welfare of their shareholders and executives. The other way, which is currently used, is progressive taxation. It will be difficult to make major changes in this arrangement, so, at least for now, we must be content with using progressive taxation to promote the general welfare. So the next time you hear a conservative claim income redistribution in response to a question of on progressive taxation, point out to them that it is only a means to compensate for the unfair claims on income, due to the advantages given to corporations and the wealthy by our corporate charters and lobbying laws.

Sunday, September 07, 2008

Advice to My Grandchildren

After living in Sun City Summerlin, Nevada and witnessing world events over the past decade, and the long campaigns over the last year, I've come to the conclusion that the best advice I can give to my grandchildren is to settle in an area with as much diversity as possible. That includes diversity in race, culture, education, lifestyle, income, wealth, and environment.

It seems to me that most problems are created when a majority of people share the same outlook. They come to believe that because they are in the majority their way of thinking and doing things must be the right way, and that people who don't fit the mold must be wrong headed or inferior in some way.

This seems to be true whether it's a country, a small town, a university, a corporation, a club, a religion, or any other organization where like minded people come together. Only if no group predominates do people actually come to think for themselves rather than follow convention to avoid being ostracized, or get in a rut simply because it's the course of least resistance.

I think I first came to realize this by living in a community where people come from all parts of the country. But, even here the people share a common characteristic, age, which seems to be a basis for many of their thoughts and actions. This is mitigated by having close association with family of widely varying age. Living in a city which is a broad mix of people of different backgrounds and wealth was another broadening experience. And, probably, living alone has been an influence on my thinking, not having someone who shares most of my values to reinforce the rightness of my thinking. All of these things have given me a much more open attitude towards life and people.

Seeing how a government controlled by one political party operated was another eye opener. Witnessing how countries dominated by one religion operated was another factor. Observing how the West, the dominant countries of the world over the last century, faced the challenge of new world powers like China, India and Russia was another factor.

And, finally, seeing how the country became polarized to the point of ignoring reality and important issues, to seek belonging to political tribes bound mainly by like identity, was the final factor in my coming to this conclusion. The extreme reactions to a candidate of black/white heritage and to two different women making their first foray into national politics illustrated the point.

It is my hope, that as time moves on, we will come to realize that the right way of thinking and doing things can only be discovered by taking into account the wide variety of ways people live their lives across the world. Only then, can we draw conclusions about the best way to live our lives.