Plato on Being Governed

Cafe Hayek: Macroeconomic Policy As If There�s No Tomorrow

            by DON BOUDREAUX

            Suppose that the Almighty announces at 12:00am that the world will end at 11:59pm � a mere 24 hours hence.  This announcement, though, is heard only by government officials.  In the announcement the Almighty also commands these officials to do their best to ensure that humankind�s remaining time in this vale is spent as economically sensibly as possible.

            In this world, aggregate demand would matter greatly.  The intensity of spending over the next 24 hours would loom large, with any declines in that intensity not being balanced by any offsetting improvements in human welfare.  If Dick or Jane choose to save more today, the consequent reduced demand today for the meat sold by Dick�s butcher or for the earbuds sold by Jane�s consumer-electronics retailer will cause pain for employees of those establishments � pain not offset in any way by the increased demand for more R&D resources or for building-construction materials that would otherwise have come from Dick�s and Jane�s higher savings.

            Savings and investment, by their nature, are oriented toward the future.  And time takes time to pass.  Economic actions � such as saving and investing (both financial and real) � that take place across time take real, tick-tocking, actual time to play out.  The higher demand for investment goods today � and for consumer goods tomorrow � won�t, in this world, ever materialize because there is no tomorrow.  Firms will have insufficient time to adjust to the changed pattern of demand.  A government devoted to promoting the public welfare would be well-advised, in this world, to do all that it can to counteract immediately any decline in demand in any existing markets.  With no tomorrow, it�s just as well that our leaders mortgage it in order to prop up today those demands that would otherwise fall because of a greater desire of people to save.

            Why have even a single worker suffer unemployment today simply because people are saving more for tomorrow? Tomorrow we�ll all be dead.  Government activities that prevent a better tomorrow are justified, in this world, as long as they also prevent a worse today.

            Indeed, any economic changes � such as changes in consumer preferences across the range of consumer goods, changes in the flow of imports, improvements in labor-saving techniques of production � would cause unjustified trouble.  Any changes would cause trouble not offset by future benefits.  Even, say, an increase in consumer demand for chicken made possible by a decrease in consumer demand for pork would cause unjustified trouble.  Because adjusting to any change takes time, with only one day left on our earthly clock, the economic harm suffered by workers laid off from their pig-farming jobs likely would not be offset in time by the benefits to workers from greater employment opportunities on chicken farms.

            In such a world, economic change becomes a curse.  Better that government prevent such change.

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            But the world hypothesized above is not the world we inhabit.  We live in a world in which economic growth occurs through innovation and change � change that typically harms some people today, but which bears fruit tomorrow.  Yet only tomorrow.  The fruit from today�s change isn�t available to be enjoyed today.

            And time, again, takes time to pass.  Real, tick-tocking, actual, minutes/hours/days/months/years time to pass.  In this world of real time, aggregate demand no longer looms with the importance that it does in a world with no tomorrow.  Artificially propping up demand today � preserving today�s pattern of production and consumption � no longer can be done without preventing the emergence of a new pattern of production and consumption tomorrow.  And tomorrow�s new pattern of production and consumption, if it is allowed to emerge in response to the voluntary spending and saving and investing and innovating plans of millions of consumers and entrepreneurs � will likely be more productive than is the pattern of today that it displaces.  At least, history suggest that this claim is correct.

            It�s true that this process of innovative change requires that some people suffer reduced demands today for their services.  It�s also true that the market processes � the price adjustments; the interest-rate adjustments; the capital-structure adjustments; the adjustments in workers� skill sets � that govern these changes take real, tick-tocking, actual time to occur.  The shorter the time span, the less likely are many prices to adjust downward when necessary.  The less likely are workers to adjust to new job opportunities.  The less likely are established yet declining firms to realize that, yes, they must shutter their doors because their economic time has passed.

            It�s also the case that, no matter how bright the future is, it�s never known.  Today�s bird in the hand seems, to each individual bird-gripper, worth at least two birds in whatever bushes might bloom tomorrow.  So each individual bird-gripper is naturally biased toward government policies that promise him or her the prospect of keeping that bird firmly in hand.  Increased government spending seems to be such a policy.  �Whatever you do, feed my bird lest in its desperation it flies from my hand!� pleads the business person.  �If I lose this bird, I have no idea what other sorts of birds I might have a chance of catching tomorrow.�

�.

          The Almighty obvious doesn�t announce to government officials that the end is near.  But such officials behave as if the message is the same.  For them, tomorrow�s � that is, the post-election�s � economy is irrelevant.  That economy might be filled with all manner of efficiently operating and highly productive markets, and be marked by full employment.  But if getting to tomorrow requires the endurance of unemployment today, the typical politician will seek to mortgage that tomorrow in order to save his constituents (and, hence, himself) from the immediate inconvenience of unemployment today.  Raise demand, raise demand, raise demand.  If demand can be raised today, employment today can be kept artificially high.

            Who cares about tomorrow?  Who cares about the counterfactual that is prevented from coming into existence?  It will always be a mere counterfactual.  We have no time for economic policies that allow market forces to play out over time � to play out in all of their rockiness, with their failure-to-keep-everyone-optimally satisfied-at-every-moment.  We have no time to worry ourselves about the microeconomic structure of production, the pattern of relative prices.  Changes for the better in those things take time.  Better that we simply treat with greater government spending the symptom � a symptom, sometimes, of real problems and, at other times, merely of beneficial on-going economic changes � than to be patient and let market processes work their way out over time.

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Happy Birthday Hayek!

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            Our Founder, Bob Chitester speaks at Colorado Christian University Values-Aligned Leadership Summit (VALS) in 2012.  

 

FEE: Risky Streaks and Naked Bankers

         by DOUGLAS FRENCH            

            Everything looks great for U.S. banks. The industry made fourth quarter profits of $34.7 billion, nearly 37 percent higher than 2011�s fourth quarter. 2012's fourth quarter was the best quarter for earnings since 2006. Bank stock analyst Dick Bove believes first quarter 2013 earnings will set new records. 

            What a difference a couple of years and trillions of dollars in taxpayer money makes. In the fall of 2008 the worry was that ATMs would go dark and the financial system would collapse, taking civilization with it. Treasury Secretary Hank Paulson and Fed Chair Ben Bernanke panicked, and we�re told we should be very glad things turned out the way they did. Time magazine was so glad it made Bernanke its 2009 Person of the Year.

            Since those dark days, the banks have rebuilt themselves, their profits, and their bonuses. Meanwhile Chris Dodd and Barney Frank passed landmark legislation to make it safe to go to your bank again. The international banking regulators are cooking up new rules known as Basel III that will supposedly keep us from reliving 2008. 

            Economists Anat Admati and Martin Hellwig would beg to differ. The new regulations do nothing to make banks safer. The authors spell out what will make banks safer and sounder in their new book The Banker�s New Clothes: What�s Wrong with Banking and What to Do About It. The tonic they prescribe? More capital. 

            What most people�even bankers themselves�don�t realize is that modern banking is a highly leveraged business, to the point of being dangerous. How many entrepreneurs have gone into a bank looking for a loan to fund their business, only to be told they were already too highly leveraged? Plenty. Talk about the pot calling the kettle black. But bankers always come across like their operations are all so safe and sound. For instance, bankers never discourage someone from making a large deposit by telling the customer, �No thanks, we�re very highly leveraged already.�

            Admati and Hellwig walk banking neophytes slowly through how banking works, framing examples in a way that most people can understand: borrowing on a home. In very simple terms the authors explain how excess leverage is dangerous. Ironically, bankers are quick to point this out when examining someone else�s credit prospects but not necessarily their own. 

            Banks are always treated as special business cases and the authors don�t see why. If Apple and Bed, Bath and Beyond can do business successfully without borrowing, why can�t banks?  Even European corporations, which borrow more than their American counterparts, still maintain 30 percent equity. Meanwhile, most banks have less than 10 percent equity and many have less than 5 percent.

            Being leveraged 20-1 means, for the bank to survive, that very little can go wrong. If a bank�s assets are mostly mortgage loans at 80 percent loan to value, and property values drop 25 percent, that 5 percent equity is gone. Nationwide, housing values crashed more than 25 percent in 2008 and 2009. In cities like Las Vegas, values plunged by more than 50 percent. 

            It wasn�t always this way. Bank owners once had direct personal liability to the bank�s creditors (including depositors). In those days, equity levels of 40�50 percent were the norm.         

            Since the 1930s, limited liability and government deposit insurance have done away with the need for that sort of conservatism. 

            Government can claim all it wants that it is regulating away a repeat of the 2008 crash, but the fact remains that using high leverage is alive and well, as are limited liability and higher levels of deposit insurance. 

            With government covering the deposit liabilities, banks have over time had more incentive not only to overborrow, but to borrow short term and to lend on assets that are illiquid and long term. This mismatch between asset and liability durations magnifies risk and causes liquidity problems, making banks increasingly dependent on the lender of last resort�the central bank. In the case of 2007�2009, the authors point out that with financial institutions funded with short-term debt owed to each other, atop but tiny slivers of equity, the tripping of one domino set off a contagion. The modern banking world is all interconnected. 

            Layer on top of all of this leverage new financial products like derivatives and the potential for gambling and speculation runs rampant. Derivatives can be a great financial tool to diversify risk. However, as Admati and Hellwig make clear, derivatives also magnify risks in the same way that leverage does. 

The fourth quarter 2012 FDIC Quarterly Banking Profile reports that FDIC-insured institutions held $224 trillion in derivatives at year end. Fifteen years ago that amount was a mere $25 trillion.  

            For the most part this massive derivatives exposure does not appear on bank balance sheets. In an eye-opening part of the book, the authors point out that J.P. Morgan Chase & Co.�s �fortress balance sheet� does not look so sturdy using international accounting rules rather than the U.S. variety. J.P. Morgan had 8 percent equity on its December 31, 2011, balance sheet under U.S. rules. However, using international accounting rules, which count more of the bank�s derivative exposure, the equity falls to 4.5 percent. 

            The authors remind us that Bear Stearns was considered a strong bank in 2006, 18 months before it was picked up in distress by J.P. Morgan Chase. In the next contagion, with equity of only less than 5 percent, J.P. Morgan Chase itself could encounter the same fate. 

            More equity would cure many of these ills, but bankers constantly bellyache that equity costs too much. Equity investors require a higher return than debt investors do. Hellwig and Admati rightly wonder: if equity financing is so expensive, why do other firms in other industries use it so much? Banking, as an industry, is alone in operating with such tiny bits of equity and huge debt. 

            Banking is also alone in having some of the costs of being highly leveraged borne by the government through guarantees and central bank subsidies. These distortions make equity relatively more expensive than debt, leading banks to leverage up and become more dangerous. 

            The authors explain the flawed thinking that equity is too expensive. In a world without government interference, the more debt used, the more risk is associated with the equity, so investors demand a higher rate of return. Conversely, the less debt used, the lower the rate of return required by the equity holders, because the default risk is lower.  But the government turns this logic upside down by having taxpayers absorb much of the risk of bank leverage.  

            Admati and Hellwig urge governments to force banks to maintain more equity. But perhaps the force that keeps banks operating should be simply taken away. Bring back the bank run and let the chips fall where they may. With no insurance and no too-big-to-fail policy, depositors would choose more wisely. Money would flow to the prudent. Banks would maintain more capital as a matter of survival instead of levering up to lend on the latest investment fad.

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