Wednesday, July 22, 2009

CIT Update

CIT did obtain a loan from its bondholders after the government refused to step in. However, the terms of that loan make me think their prospects are bleak and that they are still very likely to declare bankruptcy. A Bloomberg headline said the interest rate on the loan was more than 25 times the LIBOR rate. From that story:

"“This is called Don Corleone financing,” Egan said, referring to the patriarch in the organized-crime family depicted in the 1972 film, “The Godfather.” “You can’t lose money on this deal.”

Outside of the “urban underworld,” Egan, 52, said he couldn’t recall seeing a loan backed by as much collateral that paid interest rates so high. “These terms would make a pawn- shop operator blush.”

Tuesday, July 21, 2009

Why I'm not worried about inflation

No matter how much money is printed it can't cause inflation if it's not in circulation, i.e. being spent by individuals and businesses. So as long as people keep losing their jobs and banks continue to issue very few loans, there's no way for available money to get out there where it can be used. Obviously the money supply isn't simply increased by the printing press, there are many things that can have the same effect: lower interest rates, making credit easier to get, etc.

When someone who is unemployed gets a job, suddenly they have more money to spend. When we are close to full employment you are more likely to get a pay raise, and again have more money to spend. In this job market you are likely to get a pay cut and be thankful that you still have a job, which means you have less money to spend. If you can get credit easily then you're more likely to buy a car or a house, etc. If a business can get credit and it knows that people are spending money because they can get credit then that business is more likely to expand, adding jobs, and putting more spending money in people's hands. But right now we see unemployment increasing and credit hard to come by. So I have no fear of inflation any time soon.

With one big caveat: inflation is no threat to our domestic economy, but the devalued dollar (a direct consequence of our soaring national debt and our increased money supply) has huge implications for our import trade. As you know we are dependent on imported oil in order for our society to function. And it seems that we have become dependent on imported food judging by the contents of the local supermarket, in spite of the fact that we could be producing our food locally. A devalued dollar will mean that at some point we won't be able to import oil and food, at least not in the quantities we are accustomed to. This will adversely impact our domestic economy by making it grind to a halt. This will then result in "inflation" in the sense that goods will become very scarce as production and imported goods greatly decrease. This inflation will occur regardless of the money supply, it will be based on unavailability of goods.

So I suggest that we go into debt now (increase the national debt) but that we use that money to become self-sufficient as a nation. Add public transit and train systems to reduce our dependence on oil. Encourage small local organic farmers who can raise food with very little petroleum input in the form of fertilizers, pesticides, and tractor fuel. Restore our manufacturing base so that we can produce the items we need in this country. This will take some time, but eventually will produce a healthy economy. At that point we can worry about inflation.

Tuesday, July 14, 2009

More on CIT Group

Referring back to yesterday's post about CIT Group facing collapse, CIT Group is important right now because it is one of the few sources of short-term credit for businesses. In spite of the government TARP assistance or even after returning the TARP money, banks are not making loans. Maybe they have rightly concluded that the potential clients are in fact poor risks in this economy. This is part of the reason why CIT is in trouble; their loan clients have been defaulting.

Even for very simplistic business models you can see how a restaurant, for instance, would need credit to pay for this month's supplies and maybe even employee salaries in order to be open for business and make money. I suppose they could save up a cash buffer first before starting (probably some economic arguments for why this is unlikely) but in the real world this is not the reality. So if CIT goes away, things like restaurants and retailers go out of business very quickly (I would guess within a month or so). This means many more people unemployed and further reduced revenues for cities, counties, and states; in short, continued severe economic contraction.

So Paul Krugman is right, at least in the strictly mechanical sense of how our economy works: we really do need more money quickly thrown into the system to keep this from happening. The Fed is powerless to do this since interest rates are already zero, so options like the government stimulus are about all we have. If the money is not provided, I guarantee that we will see the great economic contraction; it is like a law of physics applied to our economic system.

Where I part with Krugman is on whether it is desirable to keep the system going. If it is, then it doesn't matter if the stimulus money does anything useful or not. Keynes made this point blatantly when suggesting the benefits of burying bottles of coins in the ground so mining companies could dig them up, providing jobs and profits. The whole idea is that any kind economic activity and available credit will get the system moving again so it can return to its former task of doing useful work and providing value. Our problem, as I have pointed out before, is that our system was not doing useful work or providing value even before it seized up, and the changed global economic environment makes returning to that previous model impossible anyway.

Since a further stimulus seems politically impossible, we should expect economic contraction.

A third way would be to scrap the former economy and start designing a new one. We would still have the contraction, so people would have to be basically kept alive during this period by massive government direction and intervention. There is no way to avoid this anyway, before too long social services will start to be stressed to the breaking point by the large numbers of unemployed. But if we are intentional about it we could do useful work towards the new economy while meeting these needs.

Monday, July 13, 2009

Watershed week for financial system?

I'll take a page from Paul Krugman's book in not making a prediction here, just raising the question. About a year ago (I think in June 2008) Krugman hedged his forecast of a global economic catastrophe by presenting it in the form of a fictional column from one year in the future. It turned out that he was correct, but this sort of thing is hard to call because of the many ways to forestall the inevitable.

I have no doubt that things will get worse, not better, based on economic fundamentals, but the question is always "when?".

This morning on NPR's "Marketplace Morning Report" they pointed out that earnings reports for the financial institutions were coming out this week, and also ran an interesting story about CIT Group, a major player in the revolving credit market, that keeps places like Duncan Donuts running from month to month. The government was in talks with CIT Group over the weekend (sound familiar?) because of a feared run on their capital.

If the earnings reports reveal anything close to the truth then the illusion that we have a sound banking system should be shattered once and for all. The CIT group problem could have an immediate effect on the real economy, the part that people like you and I will notice.

Thursday, July 2, 2009

Where's the value?

I would like to discuss the idea of value in an economy. The nature of an economy is to abstract value; the most direct abstraction is:

I give you 10 units each for your 10 turnips, you then give the shoemaker 100 units to repair your shoes, she turns around and spends 20 units for a dozen eggs, where a unit might be a penny, for instance. This is the way a simple village economy used to work a couple of hundred years ago. The money in these transactions is just a placeholder for value, whether the value of some produce or some skilled labor. Without this placeholder we would need to come to some sort of barter agreement for every such exchange, which may not be that bad an idea either, but the use of money seems to make these exchanges easier.

You could complicate the picture by adding in a credit element: the bank loans a ship captain 10,000 units to sail to another land and bring back spices. The ship captain must repay the 10,000 plus an additional 1500 units upon return or else forfeit his ship. The captain expects to be able to sell his cargo for 15,000 units, which leaves him with 3500 units profit after paying back the loan.

This still makes good sense, after all the captain has to hire a crew and buy items to trade for the spices. He does not have money on hand for this but does have the expertise to accomplish the trip. The bank has the money, but does not have the expertise.

Where we start getting into trouble is when it turns out that the bank has made 20 loans like this for a total of 200,000 units, and it only has 50,000 units in its vaults. Since it did not have the currency to pay out these loans, it issued notes that were deemed to be good for the face amount, these notes were honored by the vendors and people of the community as if they were cash. This is what we call "fractional reserve banking"; it is how our banking system works today.

Now why did it make sense for the bank to loan more money than it had? Because the odds of the bank getting paid back were judged to be very good.

I'm starting to get a sidetracked here, back to our subject. In the whole scenario above, you can see value being added by each of the participants, including the bank.

I believe our problem today is that we have taken the abstraction of money to an extreme, so that we abstract the sort of situation described above by placing bets on the bank, or on the captain. Then we abstract this by placing bets on the companies placing the first bets, and so on.

Most of the jobs in the developed world involve working for one of the companies placing many-times-removed bets, or providing a service to these companies. Is there any value added by placing bets on other economic activity? If not, then there is no value added by providing services to those placing the bets.

As they say, I believe, but cannot prove, that at some point pretty early in the cycle of betting, value is no longer added and that we are many orders of magnitude beyond that point today.

This is why I was glad to hear Robert Reich say that he doesn't think we will have either a quick or slow economic recovery, because the real question is what sort of economy will we transition to, since the economy we have known for the past 30 years or so is unsustainable?

I thought it was very telling when "This American Life" discussed a lawsuit brought by shareholders against Citigroup and mentioned that the shareholders' biggest complaint was why didn't Citi unload their worthless collateral debt obligations on some other hapless fool. If they had, everything would have been okay, both for the shareholders and even the world economy. Of course this ignores the fact that the counterparty in this trade is also part of the world economy. So ultimately the only way this sort of system can continue is for a "Deus ex machina" to throw money into the system from somewhere outside. We should say "value" here instead of "money", since we are quite capable of printing our own worthless money.

This is where we currently stand with our banks. They have not sold off their bad mortgages but instead are hoping house prices will come back up and make those mortgages worth something again. If only people would start buying houses, then everything would be okay! As Dmitry Orlov slyly puts it, we will be rescued by extra-terrestrials!