Really great links - Greece - Robert Mundell - Scott Sumner is back

Tyler Cowen - Greece - "The assessment seems to be this:

        What a growing number of investors suggest is really needed is a “shock and awe” figure, enough to convince the markets that peripheral European economies will not be left to fail.

        For better or worse, I do not expect such a figure is forthcoming. I also do not see how such a figure would do more than postpone the basic problem, which is that several European economies have been pretending to be much wealthier than they really are and to make financial plans on that basis."

Robert Mundell on the Financial Crisis (Sean Rushton) - "Mundell argues the recent crisis had three distinct parts.
        Part One was the real-estate bubble and subsequent bank-solvency crisis, which began in 2006. He says the bubble was generated primarily by the dollar’s fall after 2001, as U.S. monetary authorities made clear they wanted a lower dollar to improve exports. As the greenback dropped on foreign exchanges and against gold and other commodities, investors pursued the classic inflation hedge: They borrowed and bought hard assets, expecting to repay the debt with cheaper future dollars. Real estate, already roaring due to 1997’s expanded housing tax deduction, went into overdrive, goosed by subprime lending and mortgage securitization.
        Part Two of Mundell’s analysis is the most intriguing and least understood aspect. He argues that, as the real-estate bubble burst, large quantities of fresh liquidity were demanded by the public and banks. In summer 2007, the world’s central banks supplied it and no liquidity crunch developed. But by summer 2008, spooked by rising inflation, the U.S. Federal Reserve failed to provide adequate cash, leading to dollar scarcity. Four key symptoms of tight money appeared within months: the dollar rose 30 percent against the euro; gold fell 30 percent; oil fell 80 percent; and the inflation rate dropped from 5.5 percent to negative levels. As a result, Mundell believes, Lehman Brothers collapsed, the stock market went into free fall, and a near-panic ensued. This phase was entirely preventable and constitutes one of the worst mistakes in Fed history, Mundell says. The crisis eased in early 2009, as the Fed upped the money supply, but the damage was done.
        Part Three of Mundell’s analysis is the recession of 2008–09, with bailouts, rising unemployment, and skyrocketing deficits. He predicts decent growth this year, but believes unemployment will remain high and the recovery will be weak."

Scott Sumner - Goldman Sachs - "I made a nice return on ‘junk bond’ investments in the 1990s, so count me as someone not shocked by the colorful adjectives in GS emails. Does this mean GS did not violate the law? Here is where I would fall back on my post-modernism. There is no yes or no answer to that question. If one wants to get highly technical, I suppose that every single big bank in America is violating the law on an almost daily basis. How could it be otherwise? Our business law system is unimaginably complex, the legal equivalent of the distance to Alpha Centauri. (“Show me the man and I’ll find you the crime.”) The real question is: If the SEC knew these facts about GS, but the 2007-08 financial crisis had never occurred, would GS have been prosecuted? Or to put it another way; is the prosecution political?"

Really great links - The Dodd-Lincoln Frankenstein - China - Krugman - Predatory lending

Craig Pirrong - Bailout fund - "The $50 billion dollar “bailout fund” has drawn the most attention, and the most fire, but it’s small beer compared to other things in the bill.
        Most importantly, as I’ve noted repeatedly, the fundamental source of too big to fail is the inability of the government to commit not to bail out creditors of a failing or failed institution. Increasing the discretion of authorities responsible for resolution reduces ability to commit.
        And the Dodd bill does just that. It gives the FDIC and the Treasury and the Fed tremendous discretionary authority to make creditors whole on the taxpayers’ dime. This discretionary authority is almost completely free from any Congressional check. Moreover, this authority has effectively unlimited access to the public purse.
        To sum up: instead of constraining regulators’ ability to bail out creditors of big financial institutions, the bill expands their discretion; instead of increasing the credibility of commitments not to bail out by limiting access to government funds, the bill undermines credibility by giving the Fed and the executive branch virtually completely discretionary authority to pay as much as they want to the creditors of large financial institutions."

Hans Genberg, Wenlang Zhang - Can China save the world by consuming more? - "Would an increase in Chinese domestic demand meaningfully reduce global imbalances and improve US and European employment prospects? This column says that Chinese policy has a relatively small impact on developed economies' macroeconomic circumstances. It estimates that major reduction in Chinese saving would improve US employment by less than one quarter of a percentage point."

Paul Krugman - Epistemic Closure In Macroeconomics - "Also, a macroeconomist emails:
...

        With perhaps some exaggeration … editors at four out of five top journals simply refuse even to read papers which feature nominal rigidities! With the promotion criteria of way too many departments being simply counting publications in top five journals anybody can pretty much guess what sort of incentive structure this has created in the profession …

"

Arnold Kling - Predatory lending - "Finally--and this will get me in big trouble--I have to rant about the notion of a consumer financial protection agency. I know that it's axiomatic that poor people are helpless victims. But in the case of these mortgages, that is a really hard sell. The banks did not take from poor people. They gave to poor people. If you were lucky enough to get one of these exotic mortgages when house prices were still going up, then you got to reap a nice profit on your house. If you were not so lucky, you lost...close to nothing. I'm sorry, but if you borrowed up to 100 percent of the value of the house or more, then all you really lost were your moving expenses.
        What about predatory lending? As I understand it, the idea of predatory lending is to saddle the borrower with an expensive mortgage so that you can foreclose on the property and sell it at a profit. How many times did that happen? Have you read of a single instance in the past three years where the bank made a profit on a foreclosure?
        I am always ready to feel sorry for poor people because of their poverty. But I cannot feel sorry for somebody who was given a basically free option on a house and the option didn't happen to come into the money."

Really great links - Greece - Greece II - Paul Krugman - Resolution Authority - Monetary policy and bubbles - Goldman

Nick Rowe - Greece - "It's difficult to know what will happen in the Eurozone. My own guess, for a worst-case scenario, is that we will see multiple Argentinas. No country will want to leave the Euro, but some might have no choice. The only way for a government to pay wages will be in scrip. That scrip will become a new national currency. They will rewrite the laws to make debts payable in the same national currencies."

Tyler Cowen - Questions that are rarely asked - "Was it predatory lending when they gave money to Greece?"

Paul Krugman - Ponzi and financial sector profits - "So I’d suggest that what we did between 1980 and 2008 was to replace a financial system in which profits were created by lack of competition with a system in which profits were created by misinformation and misperceptions — a giant, if mostly (not entirely) unintentional Ponzi scheme, which finally went bust."

Adam Levitin - Resolution Authority: What's Wrong With the Dodd Bill - "The Dodd bill gets things right on first principles: there needs to be some type of resolution authority, and it needs to provide the ability to impose haircuts on creditors. The bill accomplishes that much. But it goes way off the rails on a critical issue that has received virtually no discussion: how the resolution authorization process is supposed to work.
        There's been a good deal of ink spilled recently over how to regulate systemic risk, but little consideration of the institutional design of resolution authority. Who gets to decide to pull the plug on a troubled firm? And who gets to decide to provide support for other firms or sectors of the economy? "

Masaaki Shirakawa - Governor of the BoJ - Monetary policy and bubbles - Austro-Japanese economic theory - "There has already been considerable debate about the relationship between monetary policy and emergence of bubbles. One thing is clear: over-confidence is the core factor which breeds a bubble. In that sense, bubbles do not transpire from expectations of a continuation of low interest rates alone. This is, however, only a half of the truth. The other half is that bubbles do not materialize without expectations that low interest rates will continue. For me, the key question, which applies to many central banks including both the Bank of Japan and the Federal Reserve, is that, why we, as central banks, maintained interest rates at such a low level, in spite of the uneasiness we felt at that time toward the bubble-like symptoms."

Interfluidity - Goldman CDO - Hedging vs. speculation  - (H/T Broken Symmetry) - "As an investor, one always should ask oneself the question, “why would taking this position be more beneficial to me than to a counterparty willing to escape or oppose it?” Here are three answers: i) Personal situation: the asset is more valuable to me than to others (I need wheat in two months!); ii) speculative: I simply know better than my counterparty. iii) hedging: I suspect the average counterparty is overweight this exposure, and is willing to offer what would be a decent value to someone whose portfolio is uncorrelated with the exposure. Unless one assumes both efficient markets and homogenous investors, all three of these things are reasonable to think about, and I think successful investors do think about them routinely. If an investor does not believe herself to have special information about the “fundamental” value of a contract or commodity, she still may believe that hedging demand for a product is one-sided, and that would tilt in favor of taking the other side of that trade at the margin. Obviously, suspecting that wheat farmers need to hedge wouldn’t be sufficient motivation for buying August wheat contracts. But when choosing between a menu of imperfect investments, the existence of imbalanced hedging interest can be important information. With standardized products, that is something one can try to learn and understand.
        With a bespoke product, one cannot. With a bespoke product, there is generally an initiating party (Paulson for our CDO, perhaps an industrial firm looking to hedge an idiosyncratic risk). The counterparty to a bespoke contract (e.g. an investment bank) usually knows something about the initiator and can divine something about its motivation. The counterparty to a bespoke product should generally not be anonymous. If the counterparty remains anonymous, it should at least be identified that there is an identifiable initiating counterparty. Otherwise, there would be terrible scope for tailoring products based on precise information asymmetries that the non-initiating counterparty wouldn’t suspect.
        If Goldman could have met Paulson’s needs by stitching together positions in the CDS market without constructing a CDO, there would have been no issue: Those are standard markets, and participants understand that there is both speculative and hedging demand, and traders with more and less information. Traders make statistical inferences, for better and for worse.
        But Goldman met Paulson’s demand for a bespoke product by creating a new counterparty and pretending the new counterparty was the initiator of the trade, not the responding to external demand for a custom product. Not knowing who is the initiator and who is the respondent is seriously harmful: market-makers and traders pay great attention even in standardized markets to where trades fall in the bid/ask spread, and adjust pricing actively based on that information. Ordinarily, someone who needs a special product that cannot be synthesized (at convenient prices) from available markets has to reveal their need, allowing potential counterparties to evaluate the source (is this counterparty hedging an industrial risk, or do they know something). That information would crucially determine the pricing and willingness of a counterparty to transact.
        Goldman actively camouflaged who initiated and who was responding to Paulson’s demand for short positions in certain securities. It created a single bespoke counterparty that believed itself to be the initiator. Goldman hid from that counterparty information that it knew, and that generally any one party responding to some other party’s complex and specific demands would either learn as a matter of course or demand to be revealed. ABACUS investors thought they were in an ordinary CDO deal, initiated by longs in cooperation with a facilitating investment bank, buying an optimized portfolio in standard markets that included both speculative and hedging demand. That was not their situation at all. Their information was worse than the information an individual transactor would have purchasing a stock or in the RMBS CDS market (no specific knowledge but a decent probability distribution). And the stakes were much higher, because they were entering into a large transaction with one counterparty. If this had been a large transaction spread across many counterparties, their statistical inferences about the degree of spec/hedging interest and information asymmetry might have been accurate. In this case, they would have had to assume an almost worst case scenario to be accurate, but didn’t know that."

Really great links - The power of banks - FOMC - Goldman - Unemployment - SEC

Tyler Cowen - Do big banks control our government? - "If you do wish to break or limit the power of the major banks, running a balanced budget is probably the most important step we could take. It would mean that our government no longer needs to worry so much about financing its activities. Of course such an outcome is distant these days, mostly because American voters love both high government spending and relatively low taxes."

Tim Duy's Fed Watch - The Sweet Spot - "The real question is when will the easy money end. And on that point, Fed officials last week suggested they intend to let the good times roll and remain on the sidelines.
...
        Bottom Line: A more aggressive policy stance might be correct for Main Street, but I suspect would upend what is currently a nice little equilibrium on Wall Street. Raising the prospect that the Fed was trying to raise the inflation target would cement fear that interest rates will move dramatically higher in the years ahead. In contrast, the current state of the economy, with steady growth combined with low inflation and high unemployment, offers considerable certainty for market participants by putting the Fed on the sidelines. And that certainty is a valuable commodity."

Greg Zuckerman - Goldman - "Q.: So do you think even if Goldman had disclosed what the S.E.C. says it should have, regarding Paulson’s role, the investors would’ve made the same decision on it?
        Zuckerman: Yeah, I don’t think many investors would have had a second thought about taking the other side of a trade of John Paulson’s back in 2006 or early 2007. He was seen as a tourist investor dabbling in real estate, and some people thought he was out of his league—even Goldman Sachs thought he was out of his league. Josh Birnbaum, a top trader at Goldman, sat across from Paulson in his office and warned him about what he was doing."

Tyler Cowen - Is current unemployment all about aggregate demand? - "I don't want to oversell the minimum wage hike + unemployment compensation extension + means-testing hypothesis here, but surely it deserves a mention as one relevant factor. Those are real factors too.
        I also see that wages, and the job market, are more flexible today than in a long time, with so much service sector employment, so much flex-time and part-time, and such a low rate of unionization. In most AD theories that implies the job market bounces back relatively quickly yet that is not what we observe."

Stephen Bainbridge - The Timing of the SEC's Goldman suit - "I agree that there's reason to be concerned about the timing of the suit, but I suspect the suit's not about helping Obama's Wall Street legislation. Instead, I suspect the WSJ got it right:

        Last Friday, the same day that the government unexpectedly announced its Goldman lawsuit, the SEC's inspector general released his exhaustive, 151-page report on the agency's failure to investigate alleged fraudster R. Allen Stanford. Mr. Stanford was indicted last June for operating a Ponzi scheme that bilked investors out of $8 billion. He has pleaded not guilty.

        Guess which of these two stories was pushed to the back pages? The SEC did its part by publishing the Stanford report so deep in its Web site that more than a few of our readers had trouble finding it. Yesterday, the SEC management's response to the report was available on the agency's homepage, yet it provided no links to the report itself.

...

        In its own way, the Stanford calamity is arguably worse than the SEC's Madoff bungle. In the Madoff case, passionate outsider Harry Markopolos could find no one at the SEC who took the time to understand the scam, cared enough and had enough authority to shut down the fraud. In the Stanford case, we see numerous SEC insiders over many years urging—at times begging—the enforcement staff to take action, to no avail."

Really great links - Aggregate demand failure - Goldman - Goldman II - USA vs. China

Bill Woolsey - Aggregate demand failure - "How do you know that aggregate demand is deficient? If cash expenditures have fallen below their trend growth path, and the levels of prices and wages have not fallen in proportion, then the presumption should be that aggregate demand is too low, that there is an excess demand for money, and that the market interest rate is above the natural interest rate.
        Never, never, never look at market interest rates and the quantity of money and compare them with historically "normal" levels.
        If some aggregate measure of production has fallen, and in the particular markets where it has fallen, there are shortages and higher prices, then deficient aggregate demand is probably not the problem.
        If aggregate production has fallen and in the markets where output fell there were surpluses (that is, production was cut because it couldn't be sold,) but that there are other markets where demand, production, prices, employment are all rising. Further, the rate of expansion in production is being limited by bottlenecks of various sorts. Complains about finding workers with specific skills, prices of key materials rising and the like, then there is a difficult judgement call. How significant are these expanding industries relative to the contraction ones. Is the unobservable excess demand in these markets greater than the reduction in output?
        If there are no such markets with increased demand, and every market is in surplus, then it is clear. There is obviously an excess demand for money generating the problem."

Brad DeLong - Goldman - "But in general acts of market exchange are win-win, for people trade off things they don't value very much for the things they value a great deal. I give the barista behind the coffee machine money--generalized purchasing power. She gives me coffee. Beforehand, she had too much coffee and not enough money. Beforehand, I had too much money and not enough coffee. Afterwards we are both happier and both better off.
        Now let's move to finance. The problem with finance is that we are not treating coffee for food, or CD players for clothes, but that we are instead trading money for money. The win-win benefits from exchanges of goods for goods are obviously there. The win-win benefits of trading money for money--where are they? It turns out that they are there. There are, actually, four:
        Trading money now for money later: people who want to save now and spend later can make win-win trades with people who want to spend now and save later.
        Risk: people who are unusually averse to risk in general can make win-win trades by trading off some of the risks that they are bearing to people who are unusually tolerant of risk in general.
        Insurance: people who are holding a lot of one big risk can reduce the risk of catastrophic loss by paying a great many others to each take a small piece of that risk.
        Information: people who have information that prices are going to rise can make win-win deals with people who have information that prices are going to fall--although here the win-win is not for the participants in the trade: for them it is zero-sum, and the winners are those others who observe the market price at which the trades occur.
        And here we come to the crux of the SEC's Goldman Sachs case. The SEC alleges that Goldman Sachs claimed to the buyers of the ABACUS 2007-AC1: $2 Billion Synthetic CDO Referencing a static RMBS Portfolio security that it was a deal of type (3) constructed primarily by ACA Management, LLC when it was in fact a deal of type (4) constructed primarily by investor John Paulson, and that this claim by Goldman Sachs was a misstatement of a material fact--an active attempt by sellers to mislead buyers, and thus to erase the win-win character of the deal."

Goldman II - A Wall Street participant who wishes to remain anonymous says - Naive version of the story - "Perhaps the reason that Goldman Sachs is so outraged at being accused of playing the investors in Abacus by concealing from them material information--that John Paulson played a big role in selecting the portfolio--is that they are totally innocent. Perhaps they were not trying to play the investors in Abacus by handing them a sub-standard produc. Perhaps, instead, they were trying to play John Paulson--a man who showed up with irrational expectations, eager to make bad bets, and who would have lost heavily had not he struck it freakishly lucky.
        The overwhelming probability, GS thought, is that Paulson will be the loser--but because his expectations are irrational he's willing to take the short side. So the important thing is to keep this big fish who promises to give us lots of money on the hook. Let him pick the underlying securities--it really doesn't matter, and it gives him the illusion of an edge. Don't bother telling Paulson's role to IBX and company--it really doesn't matter, and it might spook them off and then we might lose the real pigeon while we hunt for more counterparties to take the long side.
...
        And, the GS people probably still think: It should have worked. Only a truly freakishly freakish mischance produced not only a crash but a freakishly hard and fast crash so that Paulson looks like a genius. But he isn't--he's a gambler who got lucky. And the idea that we weren't doing our duty to our long-side clients while we tried to land this particular fish--well, perhaps the people at GS think, that's simply insulting. We were injured when bad luck not only let this fish get away but get away with some of the money that is rightfully ours. And now we are being insulted by the SEC to boot. This is intolerable..."

Michael Pettis - Chinese savings and the wealth effect - "Declining interest rates in the US usually (but not always) mean that Americans feel richer because the market value of their homes, stocks and bonds has risen. Declining deposit rates in China usually mean that Chinese feel poorer because the return on their savings relative to their implicit discount rate has declined."

Really great links - Bank earnings - Banking crisis - Leverage and cost of bank equity

John Hussman - Bank earnings - "It seems equally unwise to celebrate "favorable" bank earnings reports that are exclusively driven by reduced loan loss provisions, particularly when the volume of impaired loans has not declined proportionately. Keep in mind that Enron and Worldcom were able to report outstanding earnings for a while by adjusting the manner by which revenues and expenses were accrued. I suspect that the U.S. banking system has become a similar breeding ground for innovative accounting."

Andrew Haldane - Banking crisis - "For the authorities, it poses a dilemma. Ex-ante, they may well say “never again”. But the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.
        The “St Petersburg paradox” explains how a gambling strategy which starts small but then doubles-up in the event of a loss can yield positive (indeed, potentially infinite) expected returns. Provided, that is, the gambler has the resources to double-up in the face of a losing streak. The St Petersburg lottery has many similarities with the game played between the state and the banks over the past century or so. The banks have repeatedly doubled-up. And the state has underwritten any losing streak. Clearer practical examples of a policy time-consistency problem are unlikely to exist."

Andrew Haldane - Leverage and cost of bank capital - "It is possible to go one step further and argue that higher bank capital ratios could potentially lower banks’ cost of capital. The size of the premium demanded by holders of equity is a longstanding puzzle in finance – the equity premium puzzle. Robert Barro has suggested this puzzle can be explained by fears of extreme tail events. And what historically has been the single biggest cause of those tail events? Banking crises. Boosting banks’ capital would lessen the incidence of crises. If this lowered the equity premium, as Barro suggests, the cost of capital in the economy could actually fall.
...
        In the mid-1980s, an attempt on the world domino-toppling record – at that time, 8000 dominos - had to be abandoned when the pen from one of the TV film crew caused the majority of the dominos to cascade prematurely. Twenty years later a sparrow disturbed an attempt on the world domino-toppling record. Although the sparrow toppled 23,000 dominos, 750 built-in gaps averted systemic disaster and a new world record of over 4 million dominos was still set. No-one died, except the poor sparrow which (poetically if controversially) was shot by bow and arrow. So to banking. It has many of the same basic ingredients as other network industries, in particular the potential for viral spread and periodic systemic collapse. For financial firms holding asset portfolios, however, there is an additional dimension. This can be seen in the relationship between diversification on the one hand and diversity on the other. The two have quite different implications for resilience.
        In principle, size and scope increase the diversification benefits. Larger portfolios ought to make banks less prone to idiosyncratic risk to their asset portfolio. In the limit, banks can completely eradicate idiosyncratic risk by holding the market portfolio. The “only” risk they would face is aggregate or systematic risk.
        But if all banks are fully diversified and hold the market portfolio, that means they are all, in effect, holding the same portfolio. All are subject to the same systematic risk factors. In other words, the system as a whole lacks diversity. Other things equal, it is then prone to generalised, systemic collapse. Homogeneity breeds fragility. In Merton’s framework, the option to default selectively through modular holdings, rather than comprehensively through the market portfolio, has value to investors."

Really great links - Fed funds rate - Lehman fraud - Labor hoarding - HAMP - Urban agglomeration and nazis

John Kemp - Market should prepare for autumn rate “exit” - "To bridge the gap, the Committee has agreed its “forward guidance” is no longer conditioned “on the passage of any fixed amount of calendar time.” Extended period could now mean anything from a couple of months to several years; it is no longer meant to indicate about six months. Instead the forward guidance is explicitly conditioned on the evolution of the economy.
     The extended period language has now been emptied of any useful content. It means the Fed is not ready to raise rates immediately, and sees no imminent reason to boost them, but could do so at any time, with only minimal warning."

James Chanos - Lehman fraud - "I think there ought to be a lot of criminal indictments in what we saw, because you have to understand that the -- what John Kenneth Galbraith called the nub of the crime -- was simply taking aggressive marks on illiquid derivatives and hard-to-value securities, calling it profit, and paying yourself 50 cents on the dollar a bonus. You were stealing from your shareholders."

David Henderson - Tyler Cowen's Speech at APEE - "Quoted "the wise Garett Jones": "Labor hoarding is so 20th century." Translation: because of the web, employers can go out and hire workers when they need them, so why keep them on the payroll.
     During this recession, there is easier substitutability from durables into things that are fun and cheap, like gaming and reading blogs, which is why durable sales have fallen off the cliff.
     There is a substantial probability (0.1 < p < 0.5) that in the next 30 to 50 years we will in the stationary state where the extra wealth thrown off by growth will go almost entirely to the elderly and health care costs of those same elderly. Think Japan, except that there are fewer rent-seeking fights among the Japanese special interests. (On this last, I'm reminded of something Bob Crandall of Brookings said at a conference I was at in 1985 when explaining where there are so many fewer lawyers in Japan than in the U.S. Said Crandall, "In Japan, the fix is in.")"

Arnold Kling - HAMP - "Why is the HAMP program working so poorly? My answer was that what Washington was attempting to do was take two complex business processes--loan origination and loan servicing--that have been developed over a period of years, and mash them together, almost reversing the order, into a completely new process, and to do this on the fly, without any allowance for differences in local conditions or individual circumstances. It did not surprise me that this was not working.
     I did not say this at the hearing, but I will write here that this is indicative of what is wrong with the Obama Administration. These folks with no management or business experience think that they can make all sorts of changes happen by just writing regulations or laws and snapping their fingers. They have no concept of what a business process is, much less how to develop one and roll it out. If you think HAMP is a fiasco, just wait and see what happens with their health insurance reform."

Arnold Kling - "In fact, I would be prepared to argue that the economic advantages of urban agglomeration are the biggest obstacle to libertarian reforms of any sort. The advantages of urban agglomeration weaken the "exit" option for citizens, which in turn gives government officals leeway to conduct all sorts of abuses. If Jews in Europe did not want to leave behind what was familiar in the 1930's in the face of Nazism, then most people are going to put up with a lot of government stupidity and over-reach here."