Crisis of Confidence

Throughout the crisis that has developed over the last year, and now intensified we have heard that is a crisis of confidence, especially in the banking sector. Mainly this lack of confidence was because of the opacity of the assets that various financial institutions held. Lack of confidence in the leveraged financial world quickly can become a death spiral that envelopes the firm in question. We saw it happen in 2001 with Enron, and we saw it with Lehman, Bear Stearns, Washington Mutual, Indymac, etc. Each case is obviously slightly different, but they share a similar characteristic in that the entity was perceived as being weak or unstable, and that led to a run. So in part, real world actions drove uncertainty, which led to the demise of the institution. The interesting thing about this, is that perception was the driving force, not actual facts.

Governments have responded to this by stating that it was because of a lack of regulation that these institutions went down but then, bureaucrats and politicians need to justify their pay checks, so that they say that is quite predictable.

Looking deeper, I think it goes back not to a lack of regulation, but to a lack of information. Lehman, Bear, WAMU and Indymac were unable to articulate or effectivly inform stakeholders of their financial position. Some of it may be because they did not know themselves, but the startling collapse of Bear I think was an indication that fear, driven by a lack of information was running the market.

The solution is not more regulation, but better information, and better distribution of that information. That way each stakeholder is able to accurately guage the situation. To put this in quantitative terms, the discount rate works conversely to the availability of information.

Update

I have a bit more time now, as I have transitioned from a job where I had a TON of free time, to one where I had to learn the ropes a bit more. So I've gotten back to think about posting, but haven't availed myself of the opportunity, and partly I think its because I was gathering my thoughts and trying to understand what is going on in the economic world.

The Gold Standard

I would like to draw your attention to this article by Megan McArdle. Megan does a great job of outlining a lot of the reasons that I too oppose the gold standard. I know that among the Austrians, the gold standard is rather popular, and is supported by Paulities (Ron Paul for President supporters). Megan points out some of the absurdities in their position, but I also especially appreciate that she points out that allowing the currency to fluctuate eases the adjustment process. For the record, I am in favor of a monetarist approach to issue of the money supply, because I believe that the discretionary monetary policy of the Fed does us no favors, and imposes a fixed-rate of interest, that is far removed from the market rate. If you are interested, check out the divergence in LIBOR, and short-term treasuries. Or the spread between three-month treasuries and the Fed Funds rate... Take your pick, but also the Fed will have to bow to reality and make their adjustment, 5% Fed Funds. I don't think it will be lower than that because of the need to keep inflation in check.

Back to the Gold Standard, another important point that Megan makes is that because of the suddenness of adjustments required by a gold standard, recessions were deeper and much more severe, which reminded me of a graph I had put together for a paper I wrote about interest rates and how GDP growth had significantly lower standard deviation over time. I would also posit that the relative predictability of GDP has reduced the overall discount rate, which has foster a higher rate of growth. Risk, you have to remember is tied to volatility, and interest rates are tied to risk, lower volatility (ie. greater predictability) and lower rates will come with it.

That's my two cents for what's it worth. More to come on the 'R' word in the next post

From the Department of Economic Literacy or lack thereof

I was browsing through the news this morning and I came across this lovely item in the Politico by Roger Simon.

THE POINT: Clinton is promising “a national response” to “the crisis of the more than 4 million young people between 16 to 24 who are out of school and out of work.” Barack Obama has announced an “urban poverty” agenda that covers some of the same ground.

The programs are interesting because they show how the conversation in Washington would change with a Democratic president. Some Clinton details from a campaign précis: “She will … launch a $100 million Public/Private Internship Initiative to give at-risk middle- and high-school students job skills and work experience during the summer. … In addition, she will offer 1.5 million disconnected youth a second chance with meaningful job training in growing industries in their own communities, including renewable energy, health care, construction and financial services.”

Thats the meat of it... and the illiteracy part comes in here. Senator Clinton and Senator Obama, who has a similar program both voted for the minimum wage increase. There are numerous studies that talk about the effect (negative) on teen employment prospects because of a minimum wage increase. This one here is my favorite. The totally ironic thing as the study points out, the very people that Senator Clinton hopes to help through her new government program, are the very SAME people the minimum wage bill that she so proudly voted for has hurt the most. The most logical thing would be to remove the distortion and get rid of the minimum wage, but thats not how politicians think. One government mistake, needs another government program to fix it... only in Washington.

A better idea, save $99,999,000 and send all of the senate to Professor Mankiw's ever so popular economics class. :)

Article of the Day

This article by Arnold Kling on TCS Daily is a must-read today if you are at all interested in the health care debate.

Misunderstanding Economists

The latest article in Foreign Policy, entitled "5 Lies My Economist Told Me," is a classic example of a red herring argument. It posits a list of arguments that "Economists" would make. All I can do is laugh. This post does as good a take down of FP as I could. H/T Tyler Cowen.

The Minimum Wage

I know I am few days late and the Federal Minimum Wage jumped up, but I recently came across this article on the minimum wage at the Federal Reserve Bank of Cleveland's website. Their conclusion should be familiar to anyone who has taken Econ 1A, when you increase the price of a good (Or in this case labor), you will consequently lower the demand. More in depth studies I have read, posit that the welfare gains to the lottery winners (those who keep their jobs) are more than offset by the welfare losses to those who gain into unemployment. Another argument is that by reducing the number of low wage (and hence low skill) jobs we are also making it more difficult for the unskilled to gain entry into the work force. Also, whenever you raise the price of something above its market clearing price you create incentives to form a black market. The cigarette market is a perfect example. Before the anti-smoking forces managed to jack up prices, there was very little black market activity in cigarettes. In places like New York City, there is a huge black market thanks to the Indians which do not have to pay the city tax. Regulation in interfering with the price mechanism has a multitude of unintended consequences, and the minimum wage bill, while making for good political theater, will ultimately end up hurting the people it is intended to help.