Open Thread #86

Linkd’s weekend economic reader:

FT alphaville

“Part of Obama’s $819bn stimulus bill currently being debated in the Senate contains this little gem:

The legislation, entitled “The American Steel First Act,” which the Buy America Coalition was instrumental in helping to develop, would require federally funded construction projects under the Department of Transportation (DOT), the Department of Defense (DOD) and the Department of Homeland Security (DHS) to use 100 percent American-made steel products.

In short – infrastructure projects funded by the stimulus would have to use US-made steel.

The domestic appeal of such a move is pretty obvious. But, should it pass the Senate, it will come at a cost — notably the ire of US trading partners.

Canada has already voiced its concern and the European Union is doing so today. We would hazard a guess that the clause is also unlikely to engender any good feeling from China, currently reeling from its own labour problems. Angering your biggest trading partner and treasury-buyer, during a global recession, when you’re issuing large amounts of debt to fund your own stimulus packages may not be the smartest thing to do.

But aside from the dubious international relations involved, Dartmouth economics professor Douglas Irwin points us to the economic hazard, with a bit of historical precedent:

… history has shown that Buy American provisions can raise the cost and diminish the effect of a spending package. In rebuilding the San Francisco-Oakland Bay Bridge in the 1990s, the California transit authority complied with state rules mandating the use of domestic steel unless it was at least 25 percent more expensive than imported steel. A domestic bid came in at 23 percent above the foreign bid, and so the more expensive American steel had to be used. Because of the large amount of steel used in the project, California taxpayers had to pay a whopping $400 million more for the bridge. While this is a windfall for a lucky steel company, steel production is capital intensive, and the rule makes less money available for other construction projects that can employ many more workers.

Adam Smith would be rolling in his grave.

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Willem Buiter

“The odious US House of Representatives has tagged a Buy American clause onto the Obama administration’s $819 bn (or more) fiscal stimulus bill. If this were to become law, US federal spending would, wherever possible, be restricted to goods and services produced by US companies. The main promotor of this act of global economic vandalism was the US steel industry, but other import-competing industries have lobbied also. It is quite likely that the Buy American net will be cast even more widely when the Senate gets its turn at the fiscal stimulus act.

There is little doubt that if the Buy American provisions of the Economic Stimulus Package were to become law, this would amount to an economic declaration of war on the rest of the world. The response of the assembled non-US finance ministers in Davos made this clear. Retaliation from the EU countries and the rest of the world would follow swiftly. Because this disastrous US Congressional actions follows so closely on Treasury Secretary Geithner’s declaration that China is manipulating its currency, it is essential that the Obama administration draw a clear line in the sand. If anything like the Buy American clause inserted by the House survives in the bill president Obama gets on his desk, he must veto it. The questionable value of the fiscal stimulus is overwhelmed by the unquestionable domestic and global harm caused by the Buy American clause. If president Obama fails to veto a protectionism-laced bill, it will be clear that we have a wuss in the White House. If such is the case, God help us all.”

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AP:

“The compromise reached between a handful of GOP moderates led Susan Collins of Maine, the White House and its Senate allies stripped $108 billion in spending from Obama’s plan, including cutbacks in projects that likely would give the economy a quick lift, like $40 billion in aid to state governments for education and other programs.

Yet it retained items that also probably won’t help the economy much, such as $650 million to help people without cable receive digital signals through their old-fashioned televisions or $1 billion to fix problems with the 2010 Census.

Among the most difficult cuts for the White House and its liberal allies to accept was the elimination of $40 billion in aid to states, money that economists say is a relatively efficient way to pump up the economy by preventing layoffs, cuts in services or tax increases.

“It reduces a number of highly stimulative items like state fiscal relief … and largely substitute for it some large tax cuts that are highly ineffective as stimulus,” said Bob Greenstein, founder of the liberal Center on Budget and Policy Priorities. “So your net result is a bill that gets significantly less bang for the buck.” ”

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Buiter again:

The “Good bank solution”

“…the [IMF] recommends that the authorities take the distressed assets from the banks’ balance sheets through ‘bad bank’ arrangements.

Note that we are no longer just talking of ‘toxic’ assets, that is, assets whose value cannot be assessed with any degree of certainty because of their complexity. We are now talking about bad or impaired assets that include the toxic stuff but also a large chunk of plain vanilla assets (real estate loans, simple mortgage products, consumer loans, corporate debt) that have become impaired because the borrowers/issuers are at risk of going belly-up the old-fashioned way. With a long and deep recession still ahead of us, the quantity of ‘conventional’ bad assets on the books of the banks will escalate.

There is a problem with creating a government-owned and government-funded bad bank that acquires the bad assets from the existing banks and manages the portfolio of bad assets, unconstrained by liquidity and short-term profitability considerations, either by selling them if and when the markets for these assets recover or by holding them to maturity. The problem is that the bad assets have to be valued. Some bad assets are transparently bad. If there is a liquid market for these assets there is no problem in valuing them. If there is no liquid market and can be valued using reverse auctions or model-based techniques. But much of the toxic stuff is so obscure, so heterogeneous and held by so few parties that they are virtually impossible to value. An auction would become a bilateral negotiation.

The favoured solution of the banks and other institutions holding these toxic assets is that the state pay them over the odds – preferably face value. That would be unfair and costly from a budgetary point of view. It would also represent a massive example of moral hazard by creating incentives for future excessive risk taking in the confident expectation that Mother State will bail you out….

There is an alternative solution to the problem of valuing the toxic assets. It would not involve nationalising the existing banks. Instead the state would create one or more new ’good’ banks – all state-owned and state-funded to begin with. Effectively, some or all of the existing banks would become bad banks. The good banks would acquire the deposits and the good assets of the bad banks or legacy banks. The good assets are, by definition, easy to value. The creation of multiple good banks may be desirable to encourage competition. One could even create a good bank for every existing bank: New Citi, New RBS, New ING etc.

New lending business, indeed all new business activity would be undertaken only by the new good banks. To address the credit crunch, government guarantees or insurance could be provided for new loans and investments made by the good banks. No further guarantees should be extended to existing assets, either in the good banks or in the legacy bad banks. The good banks would receive their capital from the state. Other funding would be provided by the transfer of the deposits from the bad legacy banks, through loans from the state or through the sale of bonds by the new good banks to the state. The state could also guarantee new loans to the new good banks from the private sector or bonds issued by the new good banks and purchased by the private sector.

As regards the the legacy bad banks, the easiest and cleanest way to proceed is to stop them from doing any new business on the asset side of their balance sheets: no new lending and no new investment. They would also not be permitted to take new deposits. A simple way to ensure this is to take away their banking licenses. They would exist only to manage and ultimately to run down the portfolio of bad and toxic assets they hold on their balance sheets. Maturing liabilities could be refinanced if that made more sense than accelerating the sale of the assets.

Taking away the banking licenses of most of the existing large universal banks in Europe and the USA would be appropriate because recent developments have demonstrated that the existing institutions, managements and boards are not fit for purpose. They have failed as banks, even if they have not (yet) failed in the technical, legal sense of becoming insolvent. For most of them the past, present and anticipated future financial support of the state is the only thing that stands between them and bankruptcy….”

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Finally, the comment section on this thread of Brad Setser’s blog is an interesting current discussion, except for commenter Indian Investor, who is kinda like Setser’s wjk, but remains unbanned.

BBC:

The discovery of more than 330 planets outside our solar system in recent years has helped refine the number of life forms that are likely to exist.

The current research estimates that there are at least 361 intelligent civilisations in our Galaxy* and possibly as many as 38,000.

The work is reported in the International Journal of Astrobiology.

Even with the higher of the two estimates, however, it is not very likely that contact could be established with alien worlds.

While researchers often come up with overall estimates of the likelihood of intelligent life in the universe, it is a process fraught with guesswork; recent guesses put the number anywhere between a million and less than one.

“It’s a process of quantifying our ignorance,” said Duncan Forgan, the University of Edinburgh researcher who carried out the work.

In his new approach, Mr Forgan simulated a galaxy much like our own, allowing it to develop solar systems based on what is now known from the existence of so-called exoplanets in our galactic neighbourhood.

These simulated alien worlds were then subjected to a number of different scenarios.

The first assumed that it is difficult for life to be formed but easy for it to evolve, and suggested there were 361 intelligent civilisations in the galaxy.

A second scenario assumed life was easily formed but struggled to develop intelligence. Under these conditions, 31,513 other forms of life were estimated to exist.

The final scenario examined the possibility that life could be passed from one planet to another during asteroid collisions – a popular theory for how life arose here on Earth.

That approach gave a result of some 37,964 intelligent civilisations in existence.

Form and function

While far-flung planets may reduce uncertainty in how many Earth-like planets there are, some variables in the estimate will remain guesses.

For example, the time from a planet’s formation to the first sparks of life, or from there to the first intelligent civilisations, are large variables in the overall estimate.

For those, Mr Forgan says, we will have to continue to assume Earth is an average case.

“It is important to realise that the picture we’ve built up is still incomplete,” said Mr Forgan.

“Even if alien life forms do exist, we may not necessarily be able to make contact with them, and we have no idea what form they would take.

“Life on other planets may be as varied as life on Earth and we cannot predict what intelligent life on other planets would look like or how they might behave.”

*Wikipedia “galaxies” quotes an estimate that there are 100billion galaxies in the ‘observable’ universe, whatever that is.

In South Korea, a reluctance to issue sell recommendations has already taken hold. Of the 17,335 reports issued by South Korean brokers in 2008, there were 14,903 “buy” recommendations but not a single “sell”, according to FnGuide, a Seoul-based financial-information company. At best, that reflects poor analysis: the stockmarket tumbled 41% during the year.

But something more sinister may be afoot. JPMorgan, an American investment bank, was the target of an investigation by the Financial Supervisory Service after it suggested that problem loans at South Korea’s Hana Bank may be higher than the bank’s own estimates. Switzerland’s Credit Suisse was denounced by Hyundai Securities, which publicly castigated the firm after it halved its target price for the South Korean broker. One analyst recalls a threatening telephone call from a sushi-restaurant owner after he issued a “sell” recommendation: “I have many sharp knives. Stay away from dark alleys,” the man said.

I think economists should do a few undergrad courses in hard science, like physics or chemistry.

Economics uses hard numbers, and you can get into some pretty esoteric algorithms with it. But as you say, it’s still an attempt to characterize the behavior of people.

People who have studied hard science learn when you CANNOT use hard numbers. They can identify situations where the problem that has been proposed simply isn’t one that can be solved using a spreadsheet. Trouble is, the spreadsheets look so beautiful, filled up with all the silly assumptions economists (and finance guys – another topic) stuff them with. Those beautiful and complex spreadsheets create the illusion of rigor.

Hard scientists recognize the limits of their models and methods as a matter of course. Economists, on the other hand, seem all to often to ignore them. In their defense, it is harder to see in their discipline where the science ends and the guesswork begins.

And the dollars to pay that interest come from….where?

Same place all dollars come from: thin air. It is true that every economist, including Roubini, who said America’s deficit would have to reverse course is still waiting to be proven right. But each dollar is still a claim on the US’s economic output. So, let’s see: we’ve been through dot-com wealth creation, you have no heavy industry for manufacturing anymore, you’ve just seen a financial sector crash from a peak of about a third of stock market earnings being generated by financial engineering…so, what sector is the growth going to come from next?

I know, the US is still the pony to bet on, and it has a better chance of “innovating” its way into some sort of growth than any other economy, but in argument against the basic math of exponentially increasing numbers of thin-air-dollars backed by a stagnant or barely-growing economy leading to a necessary devaluation of those dollars you’re unloading onto the Chinese, your only response is “well, it’s always worked before”.

I appreciate that this response is actually a pretty good one. No evidence trumps the empirical. But from the point of view of someone who really wants to understand what the hell is going on, (and who has both scientific training AND money in the US markets), it’s not enough to just sit back and assume that the Chinese will keep swallowing whatever you dish out. They will do whatever is in their interests, naturally, and that is an evolving calculation. If feeding plastic crap into Walmart in exchange for fiat dollars keeps their people working, they’ll do it. If they find something else their people can do that generates something better than devaluing dollars, then they’ll do that.

My, my…

You use the word “rules”, but you know enough to admit that the system is based on faith.

My understanding is that Bretton Woods collapsed because the French called the US on its promise to reimburse every $35 dollars for an ounce of gold. The Treasury didn’t have enough gold, so it simply stopped doing it. Why didn’t it have enough gold? Because it had printed too many dollars to continue the match-up. One option might have been to revalue to $40, or $50. But of course no government wants to give up the right to print as much money as it wants, so it simply canceled the whole idea. It was the honest thing to do, actually. Bretton Woods II followed, a system based purely on faith, not rules. Faith that the US would manage the world’s reserve currency responsibly, and maintain its value.

What is the value of a dollar? A very esoteric question, but at least we have gold. The fact that gold is no longer quite $35 an ounce reflects the profligacy of US printing presses.

I do not deny the importance of reserve currencies for developing countries, and certainly not the importance of the US dollar and US market for stabilizing international finance. Even when the US manages its finances recklessly, you will be given more leeway than other countries precisely because of the importance of US consumers to the entire world economy.

Still, a decade after the launch of the Euro, most countries have shifted about a third of their reserves into Euros. This is simple good sense, given the fact that the US shows little intention of safeguarding the value of the dollar. China has pretty much all its reserves in dollars, though, more a political decision than an economic one, just like Iran’s refusal to accept dollars in payment for oil.

You’ve heard of the ‘financial balance of terror’; the idea that any large dollar holder (NE Asia or the Gulf countries) could collapse the value of the dollar by releasing a large amount into the market, thereby inducing other central banks to dump their dollars too. This is mutually assured destruction, of course, but it clearly illustrates that the value of the dollar is maintained by faith, not by rules. Of course China would take a huge loss on its $1+ trillion of reserves if the dollar tanked. But the goal of China’s government is to stay in power, not to make money.

I can’t see a dollar dump by the central banks happening. It’s too scary to imagine, which seems to be your justification for calling Bretton Woods II a ‘rule’. Sort of like Citi must survive simply because it’s too big to fail. We’ll see…

In any case, it’s like we’re all standing under a platform supported by one perfectly positioned toothpick. On the platform is an elephant who keeps eating. No one will yank the toothpick of course, but we need to keep making small adjustments as the elephant gets fatter and fatter. Sometimes the elephant lurches and we all grab that toothpick and hold on for dear life (the current situation of dollar strength), and in quieter times, we try positioning other supports in case the toothpick breaks (the shift to Euros).

A major complicating factor is that all of us under this platform speak different languages and have different interests, and some of us actively hate each other. More faith.

During quiet times, while the platform is stable, it’s easy to say “See, this is working out just fine! Why rock the boat?” Now that the elephant is lurching, the people who have been trying to point out the relatively ludicrous structure of the world we inhabit are getting more airplay, whereas they used to be more easily ignored.

I’m not fear-mongering. All this stuff just happens to interest the hell out of me. Mrs. Linkd is more of an expert on who’s sleeping with who in Hollywood. The cut/pastes I occasionally put up here are things I provide for the edification of anyone else who might be interested in tuning into the current discussion in the financial press, and perhaps as conversation starters.

To wit: it’s been nice talking to you.

Foaming at the mouth? Is that how I sound? Indeed, I’m in the wrong line of work as a writer if I’ve messed up my tone on this thread that badly.

While I think there is nothing so droll on all the internet as “Go back and read what I said”, I’ll point out that I didn’t write anything myself until #31, which is a sober comment about economists and the scientific comment. Everything before that was 100% cut and paste, and, I think, a pretty good round-up of current economic news. Nobody was treated to an opinion of mine until I read your opinion that debt only matters in relation to GDP.

As for ‘blaming the US’: I am categorically NOT anti-American. Some institutions have made poor choices and implemented poor policies. I thought that was understood when I wrote ‘the US’, but I suppose I should be more explicit. It also should not be assumed that by pasting someone else’s words I fully agree with them.