Comment on Sumner's article on Reallocation to housing in 2001

Scott Sumner has an interesting article today about reallocation into housing in 2001.

1. I agree with Professor Sumner's general view that during a slump (or reallocation) the right metaphor is like a bicycle going uphill. Fed is the cyclist pedaling vigorously. But if the effort is not about a certain threshold (NGDP) the bicycle will roll backward. You argue that the effort was below the threshold. I agree with this.
2. While I understand the simplification, I am not convinced with housing vs tech. The reallocation should search for better (more investment worthy) assets. I don't think housing was "better" asset. It was chosen (I think it was deliberately chosen) as it was the only one that could absorb large volume of investments. I believe, had we not interfered, markets would have discovered alternate energy or some other investment-starved sector. 
3. Housing is wrong choice. It is a dual-good. It sometimes works as consumption good other times it is investment good. Possibly housing as a consumption good may have been a cushion. But as investment good, it was only other bubble. Subprime is not a shock but a logical conclusion of an investment good being pumped with excess investment.
4. I think there is a threshold level for money ( I use term loosely) in the economy. If total money in the system goes higher than this the system (if we let it be) creates deflation to destroy this excess. This deflation happens at the hands of those who have money invested. It happens in the rich balance sheets. The problem is it often overshoots the ideal level hence we want to control the process. In our zeal to control the process, we shift the deflation hotspot to public balance sheet or citizens balance sheets. This creates a problem of affordability. The few rich balance sheets could have afforded to deflate to a large degree but many poor balance sheets cannot deflate even to hundredth of a degree. Further, the rich balance-sheets willingly took the risk of investment while poor balance sheets were stuffed. This is the socialization of losses we talk about.

I have discussed some of these ideas in my book "Subverting Capitalism & Democracy". 

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The Problem of Regulation

The regulatory juggernaut has slowly and eventually reached the gates of wall street.

Regulation, it appears, needs to tackle three issues. First, it should clarify the parties involved. In other words, regulation clarifies attribution or ownership. Secondly, it defines the action required. Finally, it defines the timing for the action. The rest of regulation merely defines the referee and the incentive structure to encourage or prevent the actions. Any regulation without these parts is open to be hijacked or misinterpreted. 

Regulation must clearly specify the action that should or should not be taken by the participants. In most cases, regulation must be designed to rebalance the bargaining power equation. The objective is to prevent the stronger player from taking advantage of the weaker player. The consumer financial protection agency is ideally defining such actions. This part often suffers from necessary and sufficient condition dilemma.

Necessary condition and sufficient conditions are best understood through the example of fire. The existence of fuel, air (or oxygen to be specific) and a spark are necessary conditions for a fire. However existence of a fire is sufficient to prove existence of fuel, air and the spark. Regulators often go to depths defining necessary conditions but often do not define the sufficient condition. Over time, the necessary conditions increase as new special cases are discovered. It makes the regulation unwieldy and creates loopholes in the regulatory paradigm. 

However, just defining the sufficient condition leaves the law ambiguous. This is the type of ambiguity that Paul Volcker likes. However, in the wrong hands such an ambiguity corrupts the system.

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Excerpt from my book "Subverting Capitalism & Democracy" is available on Amazon.

Real Estate Mortgage problem and deflation

Barry Ritholtz links to a post by Dhaval Joshi, chief strategist at RAB Capital about size of the housing mortgage debt problem. Dhaval Joshi quantifies the size of the problem. He believes the value has to drop by about $4 Trillion to revert to mean values. This is approximately 27% of annual US GDP. This size of deflation has repercussions.

In whose hands assets deflate matters

Typically, asset price increases happens at the hands of the rich. (The causality is inverse - asset price increases result in wealth.) However, where does the asset price decrease happen? The answer to this question determines the power of the corresponding economic slowdown. 

When housing asset prices declines, the asset is usually at the hands of common person and the downside impact of price decline hits the common person's financials. In that context, the current crisis was safer (we may say most crises are). In this crisis, we can argue, a dotted line ownership of the assets, through MBS and related derivatives, was in the hands of the financial institution. The devaluation of assets, thus, was happening at the hands of the rich. (It was also happening at the hands of the poor is incidental for what I am saying).

I contend that bailouts are causing a change of hands. Through bailouts, the burden was passed from financial institutions to the tax payer who is the common person. I think the bailout may have doubled the burden on the US tax payer. Can we say, US tax payer will effectively bear a burden of nearly $6 trillion?

In this context my public bank proposal seems more effective
If the government had set up a public bank to buy back mortgages from current banks, we may have avoided twin problem. I had proposed that the bailout money be used to create a public bank that will buy existing mortgages from the home-owners allowing them to reduce their debt while pushing money in proportion to asset quality. This solution appears more favorable to me now. First, the large burden of bailout would not rest on tax payers. It would have gone to other investors when the bank is finally privatized. Second, it would put a bottom on the home prices and thus not allow household financial to deteriorate drastically.

Given the options on the table, even now this looks better.

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My book "Subverting Capitalism & Democracy" is available on Amazon.

Healthcare and Pension - Unkept Promises?

The US deficit situation is dire. The option proposed is a drastic cut in healthcare and pension. Aside from the economic imperative, we need to ask if it is fair.

It was an unfair promise

One can say that American workers (including knowledge workers) overestimate their contribution, at least compared to the workers (note-1) globally. On the flip side, we can say that the wages the world over are depressed.  In whatever terms, option of cheaper workforce existed. Prior to the tech boom, such a workforce was not accessible (note -2). Thus the dependance on American workforce was higher which reflected in the wages and benefits. We may conclude that on the whole, American workers were promised higher benefits in terms of healthcare and pensions.

But it was a promise nevertheless

But whatever the promise was, the benefits were promised to the workforce. It gave the population a feeling of comfort about their future. It is possible that this comfort allowed them to spend more than otherwise acceptable. To renege on this commitment can be viewed, to a large extent, as a betrayal of the population.

On the other side, I cannot see why the ratings agencies cannot consider this as a default? At the very least it is restructuring and definitely not a behaviour fitting a AAA institution. The problem, I think, is how a government and its people are perceived. The sovereign ratings refer the ratings of the government. Can we think of government as different from its people? In spirit of the political set up, no. But reality suggests differently. 

Political setup is far removed from the general population

The political establishment is no longer a true representative of the general population. There has been a systematic undermining of legitimate political rights of the general population as I argue in my book. That we are discussing openly laws or portions of laws being thwarted by big institution is a disgusting reality. Just today, Barry Ritholtz highlights on the Times covers about lobbying efforts.

In such a scenario, is it fair that government should be seen as acting in connivance with the general population? I don't think so. This does turn many assumptions about "investment grade" upside down. Even then, I do not see investors discussing these issues.

Worse, the population is too naive to understand

The final straw is the reluctance of the population to understand. As if it is in a deep slumber, the general population does nothing! To a certain extent, they deserve it. 

Notes

1. For the purpose of the discussion we adjust for productivity - implying we are comparing workers with similar productivity level.
2. The tech boom combined with globalisation enabled better access to such cheaper workforce option. It is one possible causes that may have resulted in wage stagnation in US.

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My book "Subverting Capitalism & Democracy" is available on Amazon.

Measuring real value

What is a measure of real value?

Now we cannot measure value but in terms of money. It means all our measurement of value is relative. It is like measuring time in terms of heart beats - 1 minute is 60 beats. Now if you start running (say printing more money) then will you have more minutes? Of course not! We will have to adjust the equation of how many beats make up a minute.

Modified Gold standard or constant money
Let us look at the modified gold standard - modified for simplicity. The total amount of gold in the world would remain constant. We would keep creating more value. So there will be natural deflation. The amount of deflation will tell us how much value we created. This is fine overall but total amount of gold is not fixed. It grows arbitrarily. So when Spanish empire discovered huge silver mine (also used like gold) they had a problem. So will we if some buried gold is suddenly discovered. Further, as I argued in my book, gold promotes hoarding while slight inflation promotes transactions (or velocity hence GDP). So gold may not be appropriate.

I believe real analysis will only come if we use absolute metric for value. Why can't there be a debate about possible metrics? It is remarkable that for all the human progress we are not able to create an absolute metric for value.