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    Free Trade with a Hostile Mercantilist Empire?

    Posted by Kevin Villani on 14th March 2017 (All posts by )

    2017 marks the 200 year anniversary of David Ricardo’s publication on the theory of comparative advantage that underlies the economic case for free trade. Several years later Frederic Bastiat wrote the satirical Candle Maker’s Petition debunking the arguments in favor of protectionism. This was an ironic choice, as candle makers were politically protected by the Founding Fathers as necessary for the Revolutionary War. These protections lasted several centuries, and in 2016 Senator Chuck Schumer sought it re-instated on grounds of unfair competition from China.

    President Trump’s trade representative economist Peter Navarro is making both the political and economic case against free trade with China, which he considers a mercantilist trader with military ambitions hostile to the U.S.

    Navarro’s political case is an update of that faced by the Founders regarding candle making. China is viewed as pursuing a trading strategy to accumulate wealth and technical know-how to challenge the U.S. militarily in the South China Sea and globally. China’s mercantilist trade practices result in huge export surpluses with the U.S. He argues that China uses this advantage to weaken America’s industrial base and future defensive capability.

    While economists can’t reject this political concern out of hand, it does seem several decades premature given the relative size of the two countries’ navies. At present the US could quickly secure sources of supply for military purposes, and protectionism tends to linger for decades or even centuries.

    The second case against free trade with a mercantilist trader relates mostly to the loss of jobs due to “unfair” competition, i.e., not due to inherent comparative economic advantages as much as political subsidies, in China’s case a purportedly cheapened currency and weak labor and environmental protections. The standard argument is that such trade generally benefits consumers at the expense of high cost producers, resulting in a less political more fair distribution of consumption as well as a higher overall level. Read the rest of this entry »

    Posted in Big Government, Business, China, Economics & Finance, International Affairs, Japan, Markets and Trading, Politics, Public Finance, Trump | 10 Comments »

    Dodd-Frank, Obamacare grew out of same faulty reasoning

    Posted by Kevin Villani on 6th March 2017 (All posts by )

    The current partisan war over the Dodd-Frank Act is just one dispute in a broader ideological divide about the government’s role in industry. This dispute, which has deep historical roots, includes a similar battle over Obamacare. The common disagreement at issue with both laws — now in the cross hairs of a GOP-controlled Washington — is the extent to which politicians should subsidize their constituents indirectly through regulation of private companies.

    The Affordable Care Act governing health insurers was about 1,000 pages, and Dodd-Frank governing most other financial institutions was more than twice that. Both stopped short of nationalizing their respective industry, instead generating more than 10 pages of regulation for every one page of legislation, although many view nationalization as an eventual but inevitable consequence, particularly for health care.

    The distinction between public control and public ownership is the primary distinction between the competing mid-20th-century ideologies of fascism and communism. In contemporary terminology, this distinction is between crony capitalism and nationalization, neither of which can be reconciled with competition and freedom of choice.
    Read the rest of this entry »

    Posted in Big Government, Business, Capitalism, Crony Capitalism, Economics & Finance, Health Care, Obama, Political Philosophy, Public Finance, Systems Analysis | 10 Comments »

    The Boom/Bust Cycle Isn’t about Emotion

    Posted by Kevin Villani on 27th February 2017 (All posts by )

    My first experience with manias was in the 1950’s. As a pre-schooler, I was dragged along to the Filene’s Basement annual designer dress sale. Thousands of women of all types and sizes pressed against the glass doors opening into the subway station. Within minutes of the doors opening, these “maniacs” cleared all the racks and, holding armfuls of dresses, began stripping to their slips. That’s when I panicked.

    Looking back, those women acted rationally. There was a limited supply of deeply discounted dresses available on a first come basis. They traded among themselves to get the right size and their most desired dress. Buyer’s remorse was cushioned by Filene’s liberal return policy.

    The premise of U.S. financial regulation is that actors within private markets are irrational, but the evidence shows that it’s not maniacal, illogical behavior that sends markets into freefall.

    Great Depression and Recession

    Now in its seventh edition, Manias, Panics and Crashes: A History of Financial Crises, Charles Kindleberger’s seminal work provides the narrative that underlies virtually all public financial protection and regulation: First, the irrational exuberance of individuals transforms into “mob psychology” and fuels an asset bubble. Then, when the exuberance of a few turns to fear, the mob panics and overreacts, causing a crash that brings down both solvent and insolvent financial institutions.

    In his memoir, the former Federal Reserve Bank President and Treasury Secretary Timothy Geithner, who was at the epicenter of the last crisis, concluded, “It began with a mania — the widespread belief that devastating financial crises were a thing of the past, that future recessions would be mild, that gravity-defying home prices would never crash to earth.”  

    Most U.S. federal financial regulation originates from the Great Depression and the subsequent introduction of federal deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC), which was established in 1933 to protect “small” savers. All prior state attempts to provide insurance failed. Because there were no effective, non-politicized regulations that could prevent the moral hazard of insured banks and savings institutions taking on excessive risks, an extensive regulatory infrastructure was put in place.

    Rational Actors

    Now, the U.S. has about 100 financial regulators, including those in the U.S. Treasury and the Securities and Exchange Commission (SEC), the FDIC, and the Fed. With near-universal deposit insurance, bank runs have become a rarity, but systemic crises have occurred more frequently. It is incontestable that big bubbles eventually burst, asset prices crash, and financial crises ensue. What causes the bubbles to inflate to systemic proportions, and to ultimately burst, is more contentious.

    At the time of Kindleberger’s analysis, individuals were assumed to be rational. The latest edition of his book, written after the 2008 financial crisis, postulates numerous theories about mob psychology (mania) that could lead rational individuals to produce irrational markets, but these ideas are all rather lame.

    Read the rest of this entry »

    Posted in Big Government, Business, Capitalism, Economics & Finance, Human Behavior, Markets and Trading, Public Finance, Real Estate, Systems Analysis, Tradeoffs | 9 Comments »

    There Is No Possible Reform for HUD

    Posted by Kevin Villani on 17th December 2016 (All posts by )

    “The Department of] Housing and Urban Development has done an enormous amount of harm. My god, if you think of the way in which they have destroyed parts of cities under the rubric of eliminating slums … there have been many more dwelling units torn down in the name of public housing than have been built.” ~ Milton Friedman, Interview, Hoover Institution, February 10, 1999

    President-elect Trump’s appointment of Dr. Ben Carson as Secretary of Housing and Urban Development is being criticized on the grounds that he lacks the requisite administrative experience. More likely, Carson’s affront was to question why HUD exists.

    Republican presidents have been ambivalent. Having bigger fish to fry, President Reagan appointed Sam Pierce HUD Secretary so that he could ignore it. George H.W. Bush repaid Jack Kemp’s political opposition by first making him HUD Secretary and then frustrating his attempts to eliminate the Department. HUD Secretary Alphonso Jackson, appointed by George W., was allegedly focused on participating in the traditional kickback schemes while his Assistant Secretary for Housing pursued homeownership policies that contributed mightily to the financial crisis of 2008.

    Democratic presidents have used it as a platform to pursue other agendas. Jimmy Carter’s HUD Secretary Patricia Harris introduced Fannie Mae housing goals – quotas – as punishment for not appointing a woman to the Board of Directors. Between scandals, Clinton’s HUD Secretary Henry Cisneros promoted the homeownership goals that left both the financial system and the new mortgage borrowers bankrupt.

    HUD’s budget is relatively small as compared to other federal departments, but it has always punched far above its budget weight in destructive power. To put HUD’s annual budget of about $50 billion in perspective, the cost of the homeowner mortgage interest tax deduction is two to three times greater, but HUD’s “mission regulation” of financial institutions has given it influence or control over trillions more.

    The initial political interest in housing during the Great Depression was entirely Keynesian, i.e., related to the short-term potential to create jobs and relieve cyclical unemployment – the “infrastructure investments” of that era. The Democrat’s approach to construction, management, and allocation of public housing was generally implemented to benefit builders and rife with corruption. FHA and Fannie Mae were chartered mostly as off-balance sheet financial institutions to stimulate housing production on the cheap.

    The problem of urban development, as many politicians and urban analysts saw it in the 1960s, stemmed from the 1956 Eisenhower initiative to build highways financed by the National Interstate and Defense Highways Act, a byproduct of which was that more affluent people commuted from the suburbs while leaving poorer families behind. The pursuit of the American Dream of homeownership left city administrations accustomed to cross-subsidizing municipal services in fiscal distress, creating a vicious cycle: as services declined, more affluent households moved out.

    The Housing and Urban Development Act in 1965 established HUD as a separate cabinet department as part of LBJ’s Great Society to give a greater priority to housing and urban issues. HUD inherited a mishmash of various New Deal federal programs, ranging from public rental housing to urban renewal, as well as financial oversight of FHA and Fannie Mae.

    Faced with steep “guns and butter” budget deficits, LBJ focused on ways to further encourage off-balance-sheet financing of housing construction through “public-private partnerships.” Republicans, led by Senator Edward Brooke of Massachusetts, convinced by academic studies that the urban riots of the 1960s were the direct result of poor quality housing and the urban environment and by lobbyists for housing producers, supported the Housing and Urban Development Act of 1968. The “goal of a decent home and a suitable living environment for every American family” was first introduced in the 1949 Housing Act. Title XVI of the 1968 Act “Housing Goals and Annual Housing Report” introduced central planning without specifying the goals, a timetable for implementation, or a budget.

    In the late 1960s, the Weyerhaeuser Corporation produced a forecast of single-family housing production in the coming decade to assist with tree planting. Congressional math wizards divided the total forecast by 10 to produce HUD’s annual housing production goals for the nation. For the next decade, HUD Secretaries were annually paraded before their Senate oversight Committee on Banking, Housing, and Urban Affairs to explain why they did or did not meet these production goals.

    Republicans have historically supported rental housing vouchers for existing private rental units for privately built housing to minimize market distortions. Republican HUD Secretary Carla Hills in the Ford Administration pushed HUD’s Section 8 subsidies for existing housing – something arguably better administered as a negative income tax – as a political alternative to the Democrats’ push for a return to public housing construction. But as a further political compromise, the largely autonomous local public housing authorities would administer these vouchers, leading to the same concentration of crime and urban decay as public housing. To borrow a phrase from former House Speaker Newt Gingrich, “Republican social engineering” isn’t necessarily better than “Democratic social engineering.”

    The economic goals of “affordable” housing have generally been in direct conflict with urban development. When I proposed demolishing the worst public housing projects and redeveloping the land, using the proceeds to fund subsidies for existing private market housing (something partially achieved during the Reagan Administration), Clinton Administration officials scoffed at the idea.

    HUD combines socialist goals and fascist methods that seriously distort and undermine markets. There is neither market nor political discipline on the enormous scope of its activities. HUD met unfunded goals through financial coercion, undermining both Fannie Mae and Freddie Mac, and their commercial banking competitors, with the collusion of the Senate Committee responsible for both financial and housing oversight, leading to the sub-prime lending debacle of 2008.

    There is no economic rationale for a federal role in housing or urban affairs in a market economy. HUD represents a continuing systemic threat for which there is no cure. May it RIP.

    Kevin Villani


    Kevin Villani

    Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He has held senior government positions, been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath.

    This article was originally published on FEE.org. Read the original article.

    Posted in Big Government, Economics & Finance, Politics, Public Finance, Real Estate, Urban Issues | 4 Comments »

    Can Donald Trump Prevent the Economy from Falling Into a Black Hole?

    Posted by Kevin Villani on 13th December 2016 (All posts by )

    Interest rates will eventually rise without an even more devastating policy of financial repression. When they do, rising interest costs will produce a vicious cycle of ever more borrowing. We are already approaching the “event horizon” of spinning into this black hole of an inflationary spiral and economic collapse from which few countries historically have escaped. A substantially higher rate of growth is the only way to break free.

    National economic growth is typically measured by the growth of GDP, and citizen well being by the growth of per-capita GDP. The long run trend of GDP growth reflects labor force participation, hours worked and productivity as well as the rate of national saving and the productivity of investments, all of which have been trending down.

    The population grows at about 1% annually and actual GDP growth averaged 2% overall for 2010-2016 (using the new World Bank and IMF forecast of US GDP at 1.6% for 2016), hence per capita GDP grew at only 1%. Moreover the income from that 1% growth went primarily to the top one percent while 99% stagnated and minorities fell backwards.

    Why we are approaching the Event Horizon
    The Obama Administration annually predicted a more historically typical 2.6% per capita growth rate, consistent with the historical growth in non-farm labor productivity. How could their forecasts be so far off?

    The Obama Administration pursued the most massive Keynesian fiscal and monetary stimulus ever undertaken. Such a policy generally at least gives the appearance of a rise in well being in the near term, as the government GDP statistic (repetitive, as the word “statistic derives from the Greek word for “state” ) reflects final expenditures, thereby imputing equal value to what governments “spend” as to the discretionary spending of private households and businesses in competitive markets. But labor productivity gains stagnated at only about 1%, most likely reflecting the cost and uncertainty of anti-business regulatory and legislative policies that dampened investment, something the Administration denied, trumping even a short term boost to GDP.

    As a result the national debt approximately doubled from $10 trillion to $20 trillion, with contingent liabilities variously estimated from $100 to $200 trillion, putting the economy ever closer to the event horizon. Breaking free will require reversing the highly negative trends by reversing the policies that caused them.

    Technology alone isn’t sufficient
    Obama Administration apologists argued that stagnation is “the new normal” citing leading productivity experts such as Robert Gordon who dismissed the potential of new technologies. Many disagree, but Gordon’s findings imply even greater reliance on conventional reform.

    Fiscal policy won’t be sufficient
    Raising taxes may reduce short term deficits but slows growth. Cutting wasteful spending works better but is more difficult.

    The list of needed public infrastructure investments has grown since the last one trillion dollar “stimulus” of politically allocated and mostly wasteful pork that contributed to the stagnation of the last eight years. Debt financed public infrastructure investment contributes to growth only if highly productive investments are chosen over political white elephants like California’s bullet train, always problematic.

    Major cuts in defense spending are wishful thinking as most geopolitical experts view the world today as a riskier place than at any prior time of the past century, with many parallels to the inter-war period 1919-1939.

    The major entitlement programs Social Security and Medicare for the elderly need reform. But for those in or near retirement the potential for savings is slight. Is Medicare really going to be withheld by death squads? Are benefits for those dependent on social security going to be cut significantly, forcing the elderly back into the labor force? Cutting Medicare or SS benefits for those with significant wealth – the equivalent of a wealth tax – won’t affect their consumption, hence offsetting the fall in government deficits with an equal and offsetting liquidation of private wealth. Prospective changes for those 55 years of age or younger should stimulate savings and defer retirement, improving finances only in the long run.

    The remaining bureaucracies are in need of major pruning and in numerous cases elimination but they evaded even budget scold David Stockman’s ax during the Reagan Administration.

    Americans will have to work more and consume less
    That is the typical progressive economic legacy of excessive borrowing from the future.

    The first Clinton Administration created the crony capitalist coalition of the political elite and the politically favored, e.g., public sector employees and retirees, subsidy recipients and low income home loan borrowers. The recent Clinton campaign promised to broaden this coalition, which would have accelerated the trip over the event horizon.

    Reform that taxes consumption in favor of savings and a return to historical real interest rates could reverse the dramatic decline of the savings rate. Regulations redirecting savings to politically popular housing or environmental causes need to be curtailed in favor of market allocation to productive business investment.

    Repeal and replace of Obama Care could reverse the trend to part time employment. Unwinding the approximate doubling of SS Disability payments and temporary unemployment benefits could reverse the decline in labor force participation.

    Service sector labor productivity has been falling since 1987, the more politically favored the faster the decline. Legal services are at the bottom, partly reflecting political power of rent-seeking trial lawyers, followed by unionized health and then educational services. Union favoritism through, e.g., Davis Bacon wage requirements and “card check” increases rent seeking, particularly rampant in the unionized public sector.

    Competition, of which free but reciprocal trade has historically been a major component, has traditionally provided the largest boost to well being by realizing the benefits of foreign productivity in a lower cost of goods while channeling American labor into employment where their relative productivity is highest. The transition is often painful, but paying people not to work long term is counterproductive. Immigration of both highly skilled and low cost labor (but not dependent family) generally contributes to per capita labor productivity in the same way as free trade.

    None of this will be easy. The alternative is Greece without the Mediterranean climate or a sufficiently rich benefactor.

    —-

    Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He has held senior government positions, been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath.

    Posted in Big Government, Current Events, Economics & Finance, Politics, Predictions, Public Finance, Trump | 13 Comments »

    A Really Big Short Still Awaits

    Posted by Kevin Villani on 24th September 2016 (All posts by )

    When testifying in 2010 before the Financial Crisis Inquiry Commission into the financial crash, then Federal Reserve Board Chairman Ben Bernanke recommended only one reference, Lords of Finance: The Bankers Who Broke the World (2009), presumably for the narrative that insufficient money printing in the aftermath of the Great War lead to the next one. Right idea, wrong narrative!

    The US homeownership rate peaked at a rate well above the current level almost a half century ago mostly funded by a system of private mutual savings banks and savings and loans. The historical justification for federal “secondary market” agencies was political expediency – exemption from now obsolete federal, state and local laws and regulations inhibiting a national banking and mortgage market. Now government-run enterprises account for about 90% of all mortgages, with the Fed their primary funding mechanism, what the Economist recently labeled a de facto nationalization.

    The Historical Evolution

    How did the private US housing finance system repeatedly go bankrupt? To quote Hemingway: Gradually, then suddenly. The two competing political narratives of the cause of financial market crises remain at the extremes – either a private market or public political failure – with diametrically opposite policy prescriptions. The politician-exonerating market failure narrative has not surprisingly dominated policy, with past compromises contributing to the systemic financial system failure, the global recession of 2008 and subsequent nationalization.

    The Great Depression stressed the S&L system, but the industry’s vigorous opposition to both federal deposit insurance and the Fannie Mae secondary market proved prescient as the federally chartered savings and loan industry eventually succumbed by 1980 to the federal deposit insurer’s perverse politically imposed mandate of funding fixed rate mortgages with short term deposits and competition from the government sponsored enterprises.

    The S&Ls were largely replaced by the commercial banks. To make banks competitive with Fannie and Freddie, politicians and regulators allowed virtually the same extreme leverage, in return for a comparable low-income lending mandate – CRA requirements leading to a market dominating $4 trillion in commitments to community groups to whom the Clinton Administration had granted virtual veto power over new branch and merger authority.

    The Financial Crisis of 2008 and the aftermath

    The Big Short by Michael Lewis and more recent movie portrayed not just banker greed but the extreme frustration of those shorting the US mortgage market stymied by a housing price bubble many times greater than any in recorded US history that refused to burst. The reasons: 1. the Fed kept rates low and money plentiful, and 2. whereas banks would have run out of funding capacity, the ability of Fannie and Freddie to continuously borrow at the Treasury’s cost of funds regardless of risk and their HUD Mission Regulator requirement to maintain a 50% market share kept the bubble inflating to systemic proportions.

    The Obama Administration fully embraced the alternative private market failure narrative in Fed policy, regulation and legislation:

    • To partially ameliorate the effects on the real economy of disruption to the global payments mechanism the Fed had to bail out the banking system. QE1/2/3/4 and ZIRP (zero rates), now NIRP, did this by re-inflating the house price bubble, postponing defaults while allowing banks risk-free profits. The Fed – and taxpayers – would lose more than the entire S&L industry did should rates rise by a comparable amount if it marked its balance sheet to market.
    • Regulators had to appear to punish the banks. In response to paying hundreds of billions of dollars in what the Economist labeled “extortion” – some of which ironically went to populist political action groups – and the subsequent oppressive regulatory regime, U.S. commercial banks are exiting the US mortgage market in spite of ongoing profits enabled by extreme leverage.
    • One legislative centerpiece, the Dodd Frank Act passed in July 2010 in direct response to the financial crisis, doubled down on political control of financial markets without addressing the future of Fannie and Freddie. The other, Obamacare, enacted four months earlier, was similarly premised on regulating private health insurers to make health insurance simultaneously cheaper and more widely available.

    The Long Term Consequences

    Bernanke’s focus on choosing the narrative was useful, but the political choice of the market failure narrative appears to reflect convenience rather than conviction. The direct taxpayer costs of implicit or explicit public insurance and guarantees come with both a whimper – tax savings amounting to tens of billions annually due to the deductibility of interest costs – and a bang – future taxpayer bailouts generally delivered off-budget.

    Fannie and Freddie conservatorship deftly avoided debt consolidation while dividends reduced reported federal deficits. The student loan market has also been de facto nationalized, with potential unbudgeted losses totaling hundreds of billions. Obamacare was similarly premised on regulating private health insurers to make health insurance simultaneously cheaper and more widely available, but under-budgeted health insurance subsidies predictable caused massive losses and health insurers are now withdrawing from the market.

    Monetary policies caused household savings to stagnate as returns to retirement savings evaporated. Defined obligation public pension funds were all rendered technically insolvent when funding is valued at current market returns rather than the assumed rate as much as ten times that. The failure of the economy to grow per capita was explained as the “new normal”. But politicians made no attempt to reflect the implied technically insolvency of public pensions or Social Security and Medicare.

    Private firms fail, but private markets rarely do. Public protection and regulation makes firms “too big to fail” until markets fail systemically. The current and projected future public debt bubble is unsustainable, and financial markets will eventually ignore the accounting deceptions and pop it. The relative weakness of other sovereign debt is delaying the inevitably, making The Really Big Short a good title for a Michael Lewis’s sequel. Politicians and central bankers will again say “nobody saw this coming”. What then?

    ====
    Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He has held senior government positions, been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath. This article was originally published at FFE.org

    Posted in Big Government, Economics & Finance, Markets and Trading, Predictions, Public Finance, Real Estate, Systems Analysis | 21 Comments »

    Who’s More Fascist: Presidential Candidate Donald Trump or Former Federal Reserve Chairman Ben Bernanke?

    Posted by Kevin Villani on 19th March 2016 (All posts by )

    How Economists Facilitated the Transition of Erstwhile “Market” Economies to Fascism

    The Left calls Donald Trump a fascist invoking the memory of Hitler and Mussolini, to which Trump might reply: “they were losers; I’m no loser.” Fascism is in essence the political control of the private economy, historically justified by democratically elected leaders to defend against perceived or orchestrated external threats. Progressive war politicians from Presidents Wilson and FDR to Johnson and Obama and now candidate Clinton have pursued this same goal in the US as has the social democratic European Union.

    At the recent meeting of the G20 leaders and central bankers political responsibility for and control over their respective economies was assumed, but their Alfred E. Newman “what, me worry” smiling faces belie the fragility of the current global economy. The political distortions to both the financial and real economy have arguably never been greater, to which politicians and their economist enablers prescribe more of the same mostly wasteful public spending financed by money printing, a cure reminiscent of medieval bloodletting.

    Having never been of much use to business, economists mostly followed “Say’s Law” that supply creates its own demand (for academic economists). They got their first pervasive shot at political power when President Wilson – an academic who chafed at constitutional constraints – created the Federal Reserve which helped US bankers fund the Allies until he could mobilize a war economy, making the first WW “Great.” The unprecedented death and destruction of the Great War knocked the global economy off kilter and the massive international war debts made stabilization politically difficult. As the creditor and least damaged victor, the US economy boomed in the roaring ’20s, followed by a bust.

    Purveyors of the “dismal science” had previously counseled that politicians had to own up to the cost of war until the private economy recovered. While the “arts” of manipulating the value of currency and public spending financed by coercive taxes and often uncollectable debt as well as coercive regulation were as old as politics and war itself, post WW I economists became noticeably less “dismal” and purportedly more “scientific,” believing that such “macroeconomic” interventions could be calibrated to “tame business cycles” in part by transferring or defaulting on war debts. This was complemented by “microeconomic science,” the recent objective of which has been to prove that individuals aren’t always perfectly rational (and by inference in need of paternalistic political protection and direction). Macroeconomists contend that this psychological defect is contagious, conjuring irrational mobs running on banks (or attending Trump rallies).

    Read the rest of this entry »

    Posted in Big Government, Crony Capitalism, Economics & Finance, Public Finance, Trump | 5 Comments »

    Macroeconomic Fallacies, Fed Chairman Bernanke’s Delusions and the Rise of Donald Trump

    Posted by Kevin Villani on 2nd March 2016 (All posts by )

    The G20 leaders recently called upon the leaders of the developed nations to employ more massive amounts of debt financed government spending to ward off the current economic stagnation and in some instances the early stages of recession. That fits Einstein’s definition of insanity: “doing the same thing over and over again but expecting a different result”. The pursuit of so-called “macroeconomic (fiscal and monetary) policies” has produced a quarter century of economic stagnation in Japan, a $30 trillion debt bubble in China with little to show, and stagnation and looming recession in Europe and increasingly in the US.

    Einstein was a genius who remains relevant today. Just within the last few weeks evidence was reported of gravitational waves predicted by Einstein almost a century ago. Proving Einstein’s theories has been the focus of physics during the past century, but he maintained that had he been able to get an academic appointment instead of a position at the Swiss patent office he never would have been able to develop and publish his new path-breaking theories.

    In his recently released biography The Courage to Act (2015), former Federal Reserve Chairman Ben Bernanke describes how, initially failing physics, he turned to macroeconomics as an outlet for his mathematical skills. This was auspicious. In physics, when your equations don’t fit the reality it is the equations that must be changed unless there is new evidence to change the understanding of reality. Einstein’s biggest error was rather than waiting for better data when his equations predicted an expanding universe, he fudged the equation (introducing the Max Planck constant) to fit the current understanding of a stagnant universe, then disagreed for most of his lifetime with the next generation of quantum physicists who proved he had gotten it right in the first place. Einstein’s one mistake is the modus operandi of modern macroeconomists.

    Read the rest of this entry »

    Posted in Big Government, Crony Capitalism, Economics & Finance, Elections, Politics, Systems Analysis, Tea Party, Trump, USA | 29 Comments »

    In Defense of Wall Street A**holes

    Posted by Kevin Villani on 11th February 2016 (All posts by )

    Long time Democrat turned Republican Donald Trump, who as a business titan relied more than any of his opponents on “Wall Street” funding, decisively won the Republican primary. In sharp contrast, socialist Bernie Sanders decisively won the New Hampshire Democrat primary by attacking his opponent’s Wall Street ties. Trump supporters apparently believe that the way to deal with Wall Street a**holes is a bigger a**hole who will negotiate much better deals, whereas Sanders supporters believe that “Wall Street (a synonym for the entire US financial system) is a fraud” requiring major extractive surgery.

    Most people within the NY financial community including the numerous mid-town asset management firms agree that many Wall Street players were a**holes during the sub-prime lending debacle leading to the 2008 financial crisis, but surely the Sanders pitchfork brigade wouldn’t travel uptown. This may explain why among the thousands of books and articles written in the aftermath of the financial crisis and the Occupy Wall Street movement, Wall Street hasn’t defended itself and has found few defenders willing to go public.

    Truth be told, Wall Street has always attracted more than its share of greedy a**holes. But historically they discriminated against the less profitable investments in favor of those that had the highest return potential relative to risk. This represented the brains of a heartless US capitalist system. Defenders of capitalism correctly argue that it is the only economic system at the base of all human economic progress, however unequally distributed. Progressive critics argue for greater equality, the poor made poorer so long as the better off are equally so (although this is not the way it is typically represented).

    Read the rest of this entry »

    Posted in Business, Crony Capitalism, Economics & Finance, Human Behavior, Markets and Trading, Politics, Predictions, Public Finance, Trump | 6 Comments »

    Why the Big Short didn’t work but the next one likely will!

    Posted by Kevin Villani on 28th January 2016 (All posts by )

    In promoting the Hollywood version of The Big Short by Michael Lewis, Paul Krugman (NYT, December 18) misrepresents the central point of this excellent book, previously made by Peter Wallison, who Krugman attacks for his Republican dissent to the 2010 Financial Crisis Inquiry Commission (FCIC) majority Report.

    The Hollywood version reflects the Report’s fundamental conclusion that the root cause of the financial crisis was Wall Street greed: hardly newsworthy, disputable or dispositive. The Big Short is about the equally greedy speculators who were shorting the housing market: had they succeeded early on – as they do in less distorted markets – they would have prevented the bubble from inflating to systemic proportions.

    Contrary to the “indifference” theorem (i.e., between debt and equity finance) of Nobel Laureates Franco Modigliani and Merton Miller, both household borrowers and mortgage lenders chose to finance almost entirely with debt, a strategy best described as “going for broke.” The first distortion – tax deductibility of debt – makes leverage desirable until discouraged by rising debt costs. The second distortion – federally backed mortgage funding as Depression era deposit insurance became virtually universal and the Fannie Mae “secondary market” facility morphed into a national housing bank – prevented these costs from rising. This highly leveraged strategy was guaranteed to fail systemically if bad loans entered the system.
    Read the rest of this entry »

    Posted in Big Government, Book Notes, Economics & Finance, History, Markets and Trading, Politics | 9 Comments »

    Economic and Political Turmoil a Century after the Great War: Is it Deja Vu All Over Again?

    Posted by Kevin Villani on 17th October 2014 (All posts by )

    This year marks a century since the outbreak of WW I and coincidently the initiation of US Federal Reserve System operations. Prior to these events, politics were democratizing, economic growth was booming, economies were liberalizing and global trade and finance were growing, all at a pace not seen again for almost another century. Recognizing that achieving these mutual benefits required an externally imposed political discipline, all of the countries participating in this happy situation voluntarily followed a set of rules governing domestic and international trade and finance for automatic and continuous adjustment to changing economic reality, then provided by the gold standard.

    It was during this enlightened period that philosopher George Santayana wrote: “those who cannot remember the past are condemned to repeat it.” Hedge fund manager and Brookings Director Liaquat Ahamed set out to remind us why countries failed to recapture this economic dynamism after the Great War with the publication of the Pulitzer Prize winning Lords of Finance: The Bankers Who Broke the World in 2009. This book took on greater significance when in 2010 Federal Reserve Board Chairman Ben Bernanke recommended only this historical account in response to the Financial Crisis Inquiry Commission’s request for a book reference explaining the 2008 financial crisis. What history had this most recent financial crisis already repeated and what was Chairman Bernanke determined to avoid repeating in the aftermath?

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    Posted in Book Notes, Current Events, Economics & Finance, History, Public Finance, Systems Analysis | 6 Comments »

    Income inequality: Social justice or crony capitalism?

    Posted by Kevin Villani on 26th April 2014 (All posts by )

    The political movement Occupy Wall Street has shaped the tax and spending proposals of the Obama administration’s budget and political debate on the premise that our capitalist economic system is rigged to favor the top-earning “one percenters.” But income inequality can result either from capitalism or politics, each for better or worse.

    Historically, political elites focused on enriching themselves at the expense of the general public: In 1773 patriots threw the tea into Boston Harbor of the East India Tea Company, granted a “royal charter” in 1600. The U.S. system was founded not just on the principles of democracy but on limited government complementing private market capitalism that encouraged individuals to “pursue happiness” — accumulate wealth — on merit rather than political connections. Support for the less fortunate was provided by family members, religious and other charitable organizations.

    Believing (wrongly) that class envy against the new economic elites — innovative entrepreneurs — would cause revolution, Karl Marx offered the socialist alternative “from each according to his ability, to each according to his need” with politics supplanting merit. Despite totalitarian methods universally employed by governments seriously pursuing the socialist model leading to the murder of tens of millions, one historian recently concluded that communism reduced workers “to shiftless, work-shy alcoholics.”

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    Posted in Big Government, Crony Capitalism, Economics & Finance, History, Political Philosophy, Public Finance, Taxes | 15 Comments »

    Fixing the US Housing Finance System

    Posted by Kevin Villani on 29th November 2010 (All posts by )

    This is a summary of a working paper available at the links for which comments are welcome. (An earlier post on related topics appeared here.)

    Download the paper (500KB pdf).

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    The Administration will soon propose legislation to address the future of the US housing finance system, and it’s a sure bet that this will include re-incarnating Fannie and Freddie in some form. Prominent Republican politicians have also recently called for “privatizing” these entities. This is sheer folly. The problem with keeping Fannie and Freddie or an alternative government sponsored capital market hybrid that seeks to limit and/or price government backing is that policymakers have always done just that! It was investors, not policy-makers, who conferred “agency status” on Fannie and Freddie in spite of their prior ill designed privatizations.

    Regardless of whether you believe they were leaders or followers in the sub-prime lending debacle—and the evidence overwhelmingly favors the former view–they have always represented a systemic risk and are inherently inconsistent with a competitive financial system. There are significant roles for government in a competitive market oriented housing finance system, but this isn’t one of them.

    Public deposit protection is here to stay. Nobody is suggesting getting rid of the Federal Deposit Insurance Corporation, but public protection requires appropriate regulation.

    Whether homeownership subsidies such as the mortgage interest deduction are appropriate is an ongoing debate. Nobody is suggesting getting rid of all homeownership subsidies, but credit subsidies for low-income borrowers and other politically preferred groups should be budgeted, targeted and separated from finance.

    Discrimination in lending that is not based on the ability to pay is illegal. Nobody is suggesting relaxing current anti-discrimination laws and regulations, but competition often mitigates all forms of inappropriate lending discrimination better than regulation.

    Capital market financing will remain necessary. Nobody is suggesting getting rid of the FHA/Ginnie Mae program or the almost equally massive Federal Home Loan Bank System, but reforms of these programs are necessary after the housing markets recover.

    Private label mortgage securitization contributed to the sub-prime lending debacle. Nobody condones the abuses, but private label securitization worked well until regulatory distortions encouraged securitizers to bypass the private mortgage insurance industry, the traditional gatekeepers responsible for preventing excessively risky lending.

    A competitive market oriented system serves qualified home borrowers and lenders best but has few political constituents. Politicians much prefer the deferred off budget costs of Fannie and Freddie but the long run costs of delivering subsidies that way far exceed the benefits.

    The four steps necessary to restore a stable competitive market oriented housing finance system are:

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    Posted in Economics & Finance, Politics, Public Finance, Real Estate, Urban Issues | 4 Comments »

    How Politicians and Regulators Caused the Sub-Prime Financial Crisis of 2007 and the Subsequent Crash of the Global Financial System in 2008, and Likely Will Again

    Posted by Kevin Villani on 9th August 2010 (All posts by )

    This is a summary of a working paper available at the links for which comments are welcome. (A later post on related topics appears here.)

    Download the paper (1 MB pdf).

    That the US financial system crashed and almost collapsed in 2008, causing a globally systemic financial crisis and precipitating a global recession is accepted fact. That US sub-prime lending funded the excess housing demand leading to a bubble in housing prices is also generally accepted. That extremely imprudent risks funded with unprecedented levels of financial leverage caused the failures that precipitated the global systemic crash is a central theme in most explanations. All of the various economic theories of why this happened, from the technicalities of security design (Gorton, 2009) to the failure of capitalism (Stiglitz, 2010) can be reduced to two competing hypotheses: a failure of market discipline or a failure of regulation and politics.

    While still sifting through the wreckage and rebuilding the economy in mid July, 2010, the Congress passed the 2,315 page Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to prevent a reoccurrence of this disaster. The disagreement in the debates regarding the appropriate policy prescription reflected the lack of a consensus on which of these two competing hypotheses to accept. The risk was that, following the precedent established in the Great Depression, politicians will blame markets and use the crisis to implement pre-collapse financial reform agendas and settle other old political scores. By having done just that, this Act  worsens future systemic risk.

    That there was little or no market discipline is obvious. Contrary to the deregulation myths, regulation and politics had long since replaced market discipline in US home mortgage markets. Regulators didn’t just fail systemically to mitigate excessive risk and leverage, they induced it. This didn’t reflect a lack of regulatory authority or zeal, as politicians openly encouraged it.

    The politically populist credit allocation goals that promoted risky mortgage lending, whether or not morally justifiable, are fundamentally in conflict with prudential regulation. The system of “pay-to-play” politically powerful government sponsored enterprises (GSEs) was a systemic disaster waiting to happen. The recent advent of the private securitization system built upon a foundation of risk-based capital rules and delegation of risk evaluation to private credit rating agencies and run by politically powerful too-big-to-fail (TBTF) government insured commercial banks and implicitly backed TBTF investment banks was a new disaster ripe to happen. Easy money and liquidity policies by the central bank in the wake of a global savings glut fueled a competition for borrowers between these two systems that populist credit policies steered to increasingly less-qualified home buyers. This combination created a perfect storm that produced a tsunami wave of sub-prime lending, transforming the housing boom of the first half decade to a highly speculative bubble. The bubble burst in mid-2007 and the wave crashed on US shores in the fall of 2008, reverberating throughout global financial markets and leaving economic wreckage in its wake. 

    By the time the financial system finally collapsed bailouts and fiscal stimulus were likely necessary even as they risked permanently convincing markets that future policy will provide a safety net for even more risk and more leverage. Given this diagnosis, how to impose market and regulatory discipline before moral hazard behavior develops is the most important and problematic challenge of systemic financial reform.

    The public policy prescription is simple and straightforward. Prudential regulation remains necessary so long as government sponsored deposit insurance is maintained, which seems inevitable. Prospectively the traditional regulatory challenge of promoting market competition and discipline while safeguarding safety and soundness remains paramount. But the prudential regulation of commercial banks needs to be de-politicized and re-invigorated, with greater reliance on market discipline where public regulation is most likely to fail due to inherent incentive conflicts. This means sound credit underwriting and more capital, including closing the off balance sheet loopholes typically employed by big banks and eliminating the incentives for regulatory arbitrage. Universal banking should remain, but divested of hedge fund and proprietary trading activity. In addition, firms that are “too big to fail” (TBTF) are probably too big to be effectively controlled by regulators and should either be broken up or otherwise prevented from engaging in risky financial activities by reducing or eliminating their political activities.

    Most importantly, the two main sources of TBTF systemic risk and subsequent direct government bailout cost, Fannie Mae and Freddie Mac, no longer serve any essential market purpose. The excess investor demand for fixed income securities backed by fixed rate mortgages that fueled their early growth is long gone and now easily met by Ginnie Mae and Federal Home Loan Bank securities alone, as fixed nominal life and pension contracts have largely been replaced by performance and indexed plans. Fannie Mae and Freddie Mac should be unambiguously and expeditiously liquidated subsequent to implementing an adequate transition plan for mortgage markets.

    Download the paper (1 MB pdf).

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    Kevin Villani is former SVP/acting CFO and Chief Economist at Freddie Mac and Deputy Assistant Secretary and Chief Economist at HUD, as well as a former economist with the Federal Reserve Bank of Cleveland. He was the first Wells Fargo Chaired Professor of Finance and Real Estate at USC. He has spent the past 25 years in the private sector, mostly at financial service firms involved in securitization. He is currently a consultant residing in La Jolla, Ca. He may be reached at kvillani at san dot rr dot com.

    Posted in Economics & Finance, Markets and Trading, Politics, Public Finance, Real Estate, Urban Issues | 17 Comments »