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Credit Suisse Pulls Up the Firetruck After the Building Has Burnt to the Ground Print
Wednesday, 16 May 2012 15:33

The Wall Street Journal gave considerable play to a new report by Credit Suisse that warns about the condition of multi-employer pension plan. The article tells readers that the Department of Labor:

"uses an 'actuarial' reading of the numbers, which envisions an average (and hefty) 7.5% rate of return on investments, smoothed over five years."

Actually, given the current price to earning ratio in the stock market, a 7.5 percent nominal return assumption is perfectly reasonable for funds that are 60-70 percent invested in stocks. (Fans of arithmetic can try playing with the numbers themselves with CEPR's pension return calculator.)

It would have been helpful if Credit Suisse and the Wall Street Journal made similar warnings about excessive return assumptions back in the late 90s when the price to earning ratio in the stock market was crossing 30 to 1. At that time, the 7.5 percent return assumptions of pension funds really were "hefty." In fact, they were ridiculous, but there was no interest in listening to those of us who were issuing such warnings.

[Addendum: CEPR's pension calculator shows the future price to earnings ratios (value of all corporate equity relative to all after-tax corporate profit) under a baseline projection that assumes the same profit growth rate as the Congressional Budget Office and a 9.5 percent nominal rate of return on stocks. We allow users to vary assumptions on growth rates and rates of return to see how that would affect price to earnings ratios. Enjoy!]

WAPO Wrong Again: Spain and Ireland Did Not Overspend and Overborrow Print
Wednesday, 16 May 2012 07:03

As President Reagan used to say, "there you go again." Yes, the Washington Post is once again telling its readers that the problem in Europe is profligate spending by the crisis countries. The fact that this is not true apparently does not concern the paper.

At one point a front page article on the governmental crisis in Greece tells readers:

"Governments have dramatically cut spending in Greece and other euro-zone members — including Spain, Italy and Ireland — to try to restore investor confidence in nations that drastically overborrowed and overspent during the past decade."

Fans of arithmetic know that Italy's debt to GDP ratio, although high, was actually declining in the years just before the crisis. Spain and Ireland were both running budget surpluses. So this story does not fit the facts.

What did happen was that these countries, especially Spain and Ireland, had unsustainable housing bubbles that were fueled by foolish bankers in Germany and elsewhere in northern Europe. The bubble is the story of the crisis in these countries, not profligate government spending.

The Washington Post Says That Critics of European Austerity Don't Say How Spending Would be Funded Print
Wednesday, 16 May 2012 04:21

I think what we have here is a failure to communicate. All the critics I know, like Paul Krugman, Brad DeLong, Mark Thoma and myself, have been very specific that the European Central Bank (ECB) will have to provide some form of guarantee for the debt of the crisis countries. It will also have to promote higher inflation in the euro zone as a whole and particularly in Germany and other core countries. The former step would allow countries to borrow, while the latter would provide the basis for regaining competitiveness in the long-run.

In my case, I have been regularly ridiculing the ECB's obsession with fortifying its Maginot Line of keeping inflation under 2.0 percent. That accomplishment will be long remembered after the collapse of the euro. 

Anyhow a Post editorial told readers that:

"In their demand for growth, however, the critics fail to explain how to fund it."

This raises the question of what critics the Post is referring to. Is the Post referring to the most prominent economists who have been arguing against European austerity and somehow cannot figure out what they are saying, or is there a whole different group of people who the Post turns to as the major critics of austerity? Inquiring minds want to know.

Robert Samuelson's Lessons from Jamie Dimon's Bad Bet Print
Wednesday, 16 May 2012 04:40

Robert Samuelson says that people are taking away the wrong lessons from JPMorgan's $2 billion loss on a proprietary trade gone bad. He has some legitimate points but carries his case too far.

First, he notes that this bet did not threaten either the banking system or JPMorgan. He points out that JPMorgan is a huge and highly profitable bank. Its books look to be in reasonably good shape. A $2 billion loss will be felt, but this is less than the normal profit in a quarter. It does not come close to threatening the bank's survival and certainly poses no risk to the financial system.

This is all true, but it misses the point that even in the post Dodd-Frank era, a large financial institution is still effectively able to take big risks with the taxpayers' money. If this bet, or a bigger one, had gone bad when the bank's balance sheets were more questionable (suppose Bank of America or Citigroup had done the same deal -- especially in 2009), it could well have pushed them off the cliff. At the least, this would mean a government payout to cover insured depositors. Since JPMorgan is certainly in the "too big to fail category," it almost certainly would have meant payments to non-insured creditors as well.

Samuelson then tells us that the banks' biggest losses usually come from old-fashioned lending, not proprietary trading. This is right. The huge losses in 2007-2009 were on mortgage loans, but this does not preclude the fact that individual banks can, and often do, put their survival in jeopardy by making big proprietary bets. Again, the point is to not have the banks take big bets with the taxpayers' money.

Samuelson's third point is the most problematic. He tells readers that:

"Government regulation can’t prevent banking or financial crises. .... But regulators’ practical power is limited, because they are no smarter than the bankers they regulate. Sharing similar assumptions, regulators and bankers may recognize a true crisis only when it’s become unavoidable."

This one really gets to the crux of the problem. The housing bubble was easy to see and those of us who are fans of arithmetic absolutely did see it. House prices had risen hugely out of line with their long-term trend with no remotely plausible explanation in the fundamentals of the housing market.

There were people in the financial sector and the regulatory agencies who did recognize that things had gone awry. These people were told keep their mouths shut and in some cases were fired. With few exceptions, nothing bad happened to the people who got things wrong in a really big way. Alan Greenspan and Robert Rubin are both really rich and still feted as wise men who have great pearls of wisdom to share with the rest of us.

As long as this structure of incentive is not changed, then Samuelson will be right, regulators will not be able to prevent financial crisis. However the key point is to change the structure of incentives. There should be no blanket "who could have known?" amnesties.

The people on top should have known. The information was all there. Anyone in a top policy position in the bubble years (2002-2007) who was not screaming warnings at the top of their lungs should be sent packing. They obviously are not qualified for their jobs.

Shareholders in financial institutions should treat their top management the same way, although the corruption of corporate governance makes this sort of accountability almost impossible. At the least, the financial institutions most caught up in pushing and securitizing bad packages should be scrutinized for criminal conduct. Issuing and securitizing a mortgage that is known to be fraudulent is fraud.

Of course none of this has happened. Given the current incentive structure, Samuelson is absolutely right. There is no reason to believe that regulation will prevent a financial crisis. After all, why should a civil servant go out of their way to pick a fight with Lloyd Blankfein or Jamie Dimon? It will always be easier to look the other way when they see dangerous practices and then take advantage of the "who could have known?" amnesty. Unless we change the structure of incentives, we have done nothing to reduce the risk of another crisis.


Washington Post Uses News Section to Bemoan Cutbacks in Government Waste Print
Tuesday, 15 May 2012 13:40

The Washington Post constantly uses both its news and editorial pages to push for its view of fiscal responsibility. While this ostensibly means lower budget deficits, the theme that is most consistent in Post reporting is that programs that benefit the middle class (e.g. Social Security and Medicare) should be cut.

This was very clear in a news story on the prospects for a year-end budget deal. The very first sentence in the piece was:

"defense contractors have slowed hiring."

This is clearly written as though it is a bad thing. Later in the piece we get the specifics:

"Kaman Corporation chief executive Neal Keating said his firm is already scaling back hiring in Jacksonville, Fla., where the company builds cockpits for Blackhawk helicopters. He was hoping for new contracts to refit the nation’s aging fleet of A-10 Warthog attack planes.

“'So many of those things are now uncertain,' Keating said, adding that plans to hire 200 workers have been put on hold. Without further clarity, Keating said, he could be forced to start ramping down purchases and cancelling shifts sometime this summer."

Of course this is what happens when the government makes cutbacks. Businesses lose contracts and people lose jobs. One would have thought that the Post understood this fact, but apparently not.


Europe Does Have a Safety Net, It's Called the European Central Bank Print
Tuesday, 15 May 2012 04:44

A Washington Post article on the crisis in Greece and its potential impact on Europe's economy told readers that:

"growth in China slowing and U.S. officials looking to tame record government deficits .....[is] leaving Europe, in a sense, operating without a safety net."

Actually, Europe has a perfectly good safety net. It is called the European Central Bank (ECB). The ECB, if it chose to act like a central bank, could guarantee the debt of Italy, Spain and other heavily indebted countries. This would quickly reduce the interest rate on their debt to near German levels, making their debt burden easily sustainable.

To date, the ECB has maintained its obsession with keeping inflation at less than 2.0 percent, which prevents the sort of adjustment that would allow Greece, Italy and Spain to become competitive within the euro zone. The article should have mentioned the ECB's obsession with maintaining this Maginot Line, which is at the center of the euro zone crisis.

David Brooks Is Disappointed that Politicians Are Not Philosophers Print
Tuesday, 15 May 2012 04:33

In a discussion of President Obama's re-election prospects David Brooks bemoans the fact that:

"this race, like almost all re-election races, is shaping up to be a referendum on the incumbent, not a choice between two visions."

When would an election ever be "a choice between two visions?" Why would anyone expect a politician to have a vision? Do accountants and truck drivers have visions?

Most probably do, but it is irrelevant to their jobs, just as a presidential candidate's vision is irrelevant to their jobs. Winning elections is about getting the support of the people with the money and power to deliver votes. It is not clear why anyone would be looking for vision in this story.

Too Little Trading on Wall Street? The NYT Should be Kidding Print
Tuesday, 15 May 2012 04:14

I had to check repeatedly to make sure that it is not April 1 when I read a NYT editorial complaining about too little trading on Wall Street. The editorial does raise a legitimate point. Many people are wary of Wall Street because they don't trust the financial sector to treat them honestly for some of the reasons mentioned in the piece.

However this has little to do with trading volume. Middle class people should be able to be comfortable putting money in the stock market, but they should also know that they will generally make more money with a portfolio that does not trade frequently. Trading does not on net increase returns, it just redistributes them. Frequent trading means that a larger share of the returns generated by the stock market will end up in the pockets of the financial industry, with less going to investors.

This piece also notes the poor returns from the stock market since 2000. This was not a surprise. It was a direct result of the high price to earnings ratio at the peak of the bubble. Price to earnings ratios in excess of 30 to 1, virtually guaranteed poor returns in the years ahead. People who took third grade arithmetic understood this fact. Unfortunately most of the people with top positions in the government and financial industry are not among this elite group.

The Economic Crisis is Just So Complicated: #54,311 Print
Monday, 14 May 2012 10:17

Andrew Gelman points us to a peculiar Bloomberg column by Reid Hastie that refers to some well-known research results from cognitive psychology with the seeming purpose of undermining efforts to hold anyone accountable for the economic crisis. The piece tells us:

"Just as we are wired to like a diet rich in fats and sugars, we have an appetite for simple, coherent narratives."

which we are urged to remember:

"the next time you hear a good story about why the financial recession, or any other economically significant event, was caused by a single collection of bad actors."

This is a truly bizarre juxtaposition. There is a great deal of evidence that many actors in the financial sector were at least unethical in their behavior (e.g. bond rating agencies giving investment grade ratings to issues they knew were junk), and may well have broken the law. In effect what Hastie is telling us is that we should not be concerned about this evidence and its implications for the markets and the economy because we are hard-wired to like a good story.

Sorry, but this one makes no sense. If the argument is that the bad actors in the financial sector should not be held responsible for the economic crisis, then the argument should be based on the facts and the economics. The assertion that the people who think the financial industry was responsible just have some cognition problem is pretty much just a crude ad hominem argument.

Outstanding Piece on German Labor Markets In Washington Times Print
Monday, 14 May 2012 10:04
The Washington Times showed that it can do serious reporting. This piece on the German labor market is solidly researched and carefully written. At last, the nation's capital has a real newspaper.
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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.