Sunday, January 23, 2011

Random Observations that Drive Economists and Regulators Nuts

While each of the following is probably worth a posting, they are worth reading about in their condensed form.

  • The credit crisis ends the myth of the efficient market hypothesis.  The efficient market hypothesis is built on the assumption that all useful, relevant information is available to the market in an appropriate, timely manner and is therefore incorporated in pricing of securities.  The opaque, toxic structured finance securities clearly show this assumption to be false.

  • Zero interest rate policies (ZIRP) and quantitative easing (QE) are barriers to economic recovery.  Your humble blogger divides individuals into three categories:  a) those who spend all their earnings; b) those who earn so much money that it is virtually impossible to spend it all; c) those who recognize that their career earning money is going to be shorter than their life expectancy and therefore save money for after they retire.  As pointed out over a century ago by Walter Bagehot, it is the individuals in category C who hate ZIRP and QE.  It is effectively a tax on them that results in their reducing CURRENT consumption.  This is a natural response as they realize that they are going to need much more money due to lower expected earnings on their savings to fund their retirement.  If the only group that could be expected to increase its consumption is decreasing its consumption, then how can ZIRP or QE add to the economic recovery?  Instead of pursuing ZIRP and QE which are barriers to economic recovery, the Fed should have been raising interest rates to at least 2% to stimulate the economy by allowing the Category C individuals to increase their current consumption.
  • Boosting stock prices does little to influence consumption by Category C individuals.  These individuals maintain a significant amount of their investments in retirement accounts which blunt the potential impact of a stock gain wealth effect. 
  • Also, your humble blogger questions why ZIRP or QE should increase investment by business.  First, businesses can see that category C individuals are cutting back on consumption.  If demand is not increasing, why invest?  Second, when businesses make a decision to invest, the cost of debt, particularly when interest rates are below 8%, has very little impact on a discounted cash flow analysis (remember:  return on equity is still 12+%).  This is particularly true when there are significant concerns about demand.  The conclusion should be that ZIRP and QE are barriers to business investment.
  • Extend and pretend policies make it hard for financial institutions to make loans after a real estate bubble bursts.  By definition, banks are suppose to be senior, SECURED lenders.  The largest asset most borrowers have to pledge is real estate.  When a real estate bubble bursts, it is hard for the bank to determine what the value of the real estate pledged as collateral is.  Why?  Because they have on their books all these real estate backed loans that they are extending and pretending are performing.  If the extend and pretend policy were to end, the loans would no longer be performing and the bank would most likely have to seize the real estate and try to sell it.  Hence, the bankers know that current real estate "market" prices are distorted by extend and pretend policies.  They just do not know how badly distorted.

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