Some Chicago Boyz know each other from student days at the University of Chicago. Others are Chicago boys in spirit. The blog name is also intended as a good-humored gesture of admiration for distinguished Chicago School economists and fellow travelers.
I was doing some work in my basement when I came across the following, tucked away out of sight behind a girder.
It is an old grocery flyer from a nearby store. How old is it?
Okay, so it lists the prices from 1979. But how do those prices stack up against the cost of similar items that can be found on the shelves today?
The rare earths are a collection of 17 elements in the periodic table: lanthanum, cerium, and erbium, to name a few. These materials play an important and increasing role in electrical and electronic devices, including batteries and magnets (which are used in electric motors and geherators.) Considerable concern has been raised lately about the concentration of rare-earths production in Chinese hands: see for example today’s Business Insider post, which deals with the Chinese government’s push for consolidation of that country’s rare-earths industry into a smaller number of companies. See also this post regarding dependency of key U.S. military systems on rare earths.
I’m interested in discussing rare earths from two standpoints: overall U.S. economic and security policy, and investment opportunities/risks.
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.
Instapundit’s got a great challenge for his readers:
Staggering deficits. Exploding national debt. Grossly underfunded public pensions. Aging populace. Social Security on track for insolvency. Investors running for precious metals. Higher education bubble. Stagnant economy. Massive new government healthcare program. Words like “unsustainable” in CBO reports.
I have racked my brain and debated with anyone who was willing. I can’t come up with a way out of this that doesn’t involve printing vast amounts of cash, double-digit inflation and interest rates, and the end of the dollar as a global currency because we “soft default” trillions of the national debt. What productive capacity we have left would be gutted by the tax increases needed to honestly pay what we are going to owe. And the people we owe (China, seniors, public pensioners, etc) aren’t going to just write off the debt like a bank short-selling a beach house.
So my challenge to your readers is this: “How do we get out of this WITHOUT printing money?”
Too much national debt can be cured by more national income (GDP). If we had an economy that was four times our present size, the current level of spending would be sustainable. While it’s unrealistic to fix it all through economic growth, we certainly can make it better so that the necessary spending cuts don’t bite so hard or have to come so fast.
We need to identify and reduce our outflow and maximize economic growth. If we do this better than any other 1st world nation, we remain the world’s premier flight to quality country and we will have the money needed to get our fiscal house in order. Our interest rates will stay low because all the rich members of the rest of the 1st world will want to continue to park a good chunk of their money with us.
The top priority is to understand that we’re in this mess because collectively we’re misinformed. The wrong amount of money’s being created, spent, and it’s being spent on the wrong things. The next big priority to realize is that nobody knows the answers and that nobody, individually, will ever know the answers. We have a great system for relatively efficiently getting the answers. They emerge from the interplay of the free market. This system is currently working sub-par because we’ve used the law in complex ways that nobody understands to “tweak” things and the system’s gotten away from anybody’s control.
The people of the USA need to (yes, starting with me) take inventory of all the institutions that they’re supposed to be overseeing and start taking the job seriously.
1. Undo the tweaks (and yes, this one line could be expanded out to book length)
2. Create a fair deal for everybody instead of special deals for the politically connected
3. Promote entrepreneurship by getting out of the way
4. Pursue public sector productivity. It will never match private sector productivity but we certainly can do better.
This lonnnnng post was prompted by an email linking Michael Barone’s latest SF Examiner piece, which asks Republicans “Now what?” after assuming some strong gains in November. I have a few ideas on the “now what?” question, and I can’t think of a better place to post them than on this excellent blog.
First, I can’t thank you all enough for the excellent commentary and critiques on my recent “Swapping a VAT for failing income tax is Good Policy” post a week or so ago. I’ve commented on many of your ideas, and I think you’ve changed my mind on a thing or two, which you will notice below.
I wanted to follow up that post with another proposal that fixes the primary problem with going to consumption taxes, which is their impact on the working poor and middle class. One benefit of a consumption-based tax regime is that it captures money from every transaction, making every one a part of the solution to our fiscal mess. It is also far more stable than a highly skewed progressive system that only taxes the rich. (Social Security notwithstanding)
The most difficult political and policy problem preventing the adoption of a consumption based tax system is that it places a “burden” on the working poor and middle class. (burden being interpreted both in policy and political terms)
Simply put, in a consumption tax system, the lower end of the earning spectrum pays a much greater share of their income in taxes than the rich. Many will argue that this is “unfair.” Leaving that argument aside, it is fair to say that this problem MUST be resolved before any politician is going to risk moving the entire system away from income taxes.
I propose such a solution in this post, beginning with my answer to Barone’s “Now What?”