Spring is here, or at least it is in fits and starts. And I listen for the crack of the bat swatting a ball to the far reaches of the park. My team, the Tampa Bay Rays are smokin’. They have an incredible 8 to 1 record for road games which is the reverse of the usual road record. Teams are suppose to win at home. And the team’s star player, Evan Longoria is proving to be better than ever. I saw one preseason game in which the Rays socked in 6 runs in one inning against Boston. I knew then that my team was ready for great things this season and they have not let me down. Another American League championship, you betcha, and the Series too.
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Of all the people with whom I have worked I probably enjoyed working with the Mexicans best. It is easy to come to grips with Mexico when one accepts that the fourth dimension, time, does not exist in Mexico. The people there have a quaint way of expressing this by using the word, “ahorita,” to imply, “now, and I really mean now.” Once you accept this reality you have an easy time working there.
A traditional task in the Foreign Service is to write a fairwell on leaving a post in which you summarize your work in the country and the understanding you have gained through it. I wrote mine when I left Mexico as the US was finalizing the NAFTA agreement with Mexico and Canada to which I had made a small contribution on trade in automobiles and auto parts.
I stated that the NAFTA agreement was describing history, not charting new directions, since trade between the US and Mexico was already flourishing, led by the use of “maquiladoras,” or special companies created under special tariff free arrangements by US companies to make products in Mexico to bring back to the USA. It was no coincidence that seven of the ten largest Mexican firms in exports to the USA were subsidiaries of US firms.
And this trade was making the US and Mexican economies more interconnected. I predicted that the bonds would become even closer and speculated about a future where we would erase the border, as they have done among the countries in the European Union where they had fought brutal wars for centuries over obscure territorial claims. I warned, however, that there were two things that could sour the closer bond between our two economies and, by extension, countries, drugs and immigration.
Well I had to cancel my planned detour from my cross country motocycle ride to visit Monterrey, Mexico my last Foreign Service post. Too dangerous my friends there warned me. And this week several people were abducted from two Monterrey hotels, apparently in a drug related seizure.
Instead I am in Arizona visiting old friends in Scottsdale. The news here is the new bill passed by the Arizona legislature allowing police to stop anyone they suspect and demand proof of US citizenship or legal residency. All are waiting for the Governor to sign the bill, veto it, or simply do nothing and allow it to automatically become law. You can imagine the usual choruses of pro and con arguments for the bill.
And at this same time in my home state Florida, it looks like a tough on immigration son of Cuban immigrants will be the Republican candidate for the Senate post left by another son of Cuban immigrants because he had a hard time dealing with the party’s stand on immigration.
Yes, my fears have come true. Drugs and immigration are ending my dream of a closer relationship between the US and Mexico. Not much chance the border will be erased in my lifetime.
The Senate bill on financial reform is coming to a conclusion. It appears as though the part setting up a new agency to close down failing financial institutions in an orderly manner, so as to avoid a “too big to fail” case, will be dropped in order to insure that the bill’s imperative, better regulation of trade in derivatives, remains intact. Even the Republicans in the Senate are calling for “transparency” in these trades.
At last, a subject on which both sides of the aisle can agree. I have beaten the subject of trade in derivatives to death. First, I pointed out over a year ago that our problems started from our total lack of understanding of this trade, mainly in mortgage backed securities, that accounted for an estimated $600 trillion (yes, trillions, not billions) worth of trades last year alone. In the absence of information and the lack of an open market to which one could value these securities, a corps of young MBAs valued the market to the prices of residential property. Enter chaos and a tanked economy.
I have lately been pounding the drum for the Senate to follow the House’s lead in rapidly adopting new regulations for trade in derivatives. The financial boys oppose this because the unregulated, closed market now in place allows them to charge whatever they want for their “products.” They do not want to work in the “sunlight.” Fortunately it seems that most of our legislators have seen the “light” and are on board for adopting these regulations.
I applauded Congressman Barney Frank for his brilliant leadership in getting the House to adopt this law. Unfortunately, fellow RPCV Senator Chris Dodd is no Barney Frank and thus this agonizing journey through the Senate.
Paul Krugman constitutes for me a convenient foil. He is probably the best known commentator on the economy in the USA today. I have used his pronouncements frequently as departure points for my blogs.
In his latest epistle he calls the Republicans in the Senate disingenuous for criticizing the new agency called for in Senator Dodd’s financial reform bill coursing its way through that “august” body that would “resolve” failing financial institutions, i.e. close them down in an orderly fashion rather than let them go into bankruptcy. Krugman chastizes the Republicans for warmng that this is another “bail out for the banks” at taxpayer expense. He claims that, instead of seeking to protect the taxpayer, the Republicans are actually working closely with the financial industry to block any further regulation of its activities.
I have consistently dismissed the “too big to fail” and consumer protection parts of the Senate bill as side shows. The most important part of the bill is to make trade in derivatives more transparent. Krugman reinforces my position by saying near the end of his article, “To understand what’s really at stake right now, watch the looming fight over derivatives, the comlex financial instruments Warren Buffet famously described as ‘financial weapons of mass destruction.’ The Obama administation wants tighter regulation of derivatives, while Republicans are opposed. And that tells you everything you need to know.”
Yes, I agree with Krugman that regulation of derivatives is the essential part of the financial reform bill. However, I believe he could use a lesson in Political Science 101. As I said many moons ago, the Republicans have no incentive to support any legislaton proposed by Democrats. They smell blood and see big gains in this year’s election. They can sit back and let the Dems pass whatever law they want. If a law is a success, it will simply shore up flagging fortunes for the Dems. However, if it fails it could be the “coup de grace,” giving the Reps an unstoppable advantage in this year’s election. We already have the examples of the “Stimulus Bill” and health care reform bill that have forged the Tea Party movement into a major political force this year.
I am touring California. What a place! Every conceivable type of scenary - mountains, valleys, deserts, seasides, forests, farm lands, towns, cities, villages. And all is beautiful. I have visited the state many times and now that my youngest daughter lives in San Francisco I will probably come more often.
I remember when I returned from my Peace Corps stint in Eritrea (then Ehtiopia). If I had not joined the Foreign Service I would have moved to California. In fact for many years it was my “home leave” address which is the place the State Department would send you between assignments. I really enjoy the place and tell all that I have never found a place I didn’t like in the state.
Thus it is particularly sad to see that the state is suffering the highest unemployment rate in the USA save for poor little Rhode Island. The official unemployment rate is 12.6% which is about one percent higher than that for my current home state, Florida.
The state is also suffering from an accute shortage of funds at all levels of government. The state is making employees take unpaid “furloughs” to cut costs. University students protest massive cuts in school budgets and higher fees. And the general public laments the loss of many public services.
Perhaps the most symptomatic issue is the fight over public employee pensions. Many believe these payments are excessive, especially in the current economic doldums. The mayor of San Francisco has taken the extreme measure of firing thousands of employees and then rehiring them as part time employees to lower costs for wages and benefits, read here pensions. The city of Vallejo has applied for bankruptcy in order to lay off all its staff and rehire fewer of them with lower pension benefits.
And this is the “Golden State,” the great shining mecca for so many Americans. I pray that the nightmare soon ends.
I am constantly amazed by business people who do not know what business they are in. I used to ask my staff at the wine importing company we had some years back, “what business are we in?” They would reply, “the beverage business.” I would then correct them by saying, “No, we are in the entertainment business.” Proof came when Sept 11 brought our sales down to zero. If we had been just selling booze our sales would have increased as people turned to alcohol to counter worries and depression. But no, the tragedy kept people out of restaurants and dinner invitations dried up. They no longer needed our products to “entertain” themselves and others.
Similarly I am amazed at how people do not understand what assets they own. And here I speak of investments in mortgage backed securities or “securitized debt” which constitute a “derivative.” I have repeatedly tried to explain that this asset represents shares in a package of loans. The asset are the loans. Thus as long as the loans are paid on time their value is the long term payout of the loan, which for mortgages is roughy equal to the principle, i.e. a $300,000 mortgage will pay $300,000 in interest payments over the life of the loan. Since the foreclosure rate for the USA in 2008 was just over 2% and in 2009 just over 4% the actual payment of mortgages is still relatively sound, i.e. there is an implied loss of 2 or 4%.
However, the actual practice is to value mortgage based securities based on the average prices paid for houses. Again, this is done because there is no open market for trade in mortgage backed securities so it is impossible to get a “market based priced” for these assets. When the prices for homes leveled off and then began to fall, those doing valuations of mortgage based securities devalued them as much as 90%. When these assets plummeted in value it destroyed the asset bases of banks and other financial institutions so that they became technically “insolvent,” i.e. they no longer had sufficient assets to support their borrowing. This in turn led to the “credit freeze” and the Great Recession.
So once more, the asset represented by a mortgage baced security is the mortgage itself, not the property which is the collateral. If we would only keep this in mind we could avoid repeating the mistakes made in valuing these assets.
I read a block of reports on reforming our financial system as well as my collegue Harlan Greene’s helpful piece. There are those who argue for a financial “tsar” who will better control our financial markets. There are those who want to dissolve financial institutions that are “too big to fail,” i.e. those whose demise would affect the entire economy. There are those who want better protection for consumers of financial products, e.g. mortgages. There are those who want to regulate “shadow” banks, i.e. the financial groups that trade in unregulated derivatives. There are those who want to do away with government guarantees for financial giants such as Fannie Mae and Freddie Mac. There are those who argue for requiring limits on leveraging by investors, which means less borrowing allowed on a given asset base. And more.
My appeal is simple and direct. The only important new requirement needed is “transparency” for trade in derivatives. The Great Recession came from bad valuations of securitized debt. These debts were devalued by models based on prices in the property market. Not based on adjustable rate mortgages, not based on subprime mortgages, not based on mortgage defaults, and not based on foreclosures, in spite of what you may have heard.
To devalue mortgages based on anything other than the long term value of the mortgage and its payment record is erroneous. The problem was that this erroneous devaluation led to sharp reductions in the asset bases of financial groups and their apparent insolvency. Proof that this was done in error came from the fact that it only took a few months of TARP action for banks to recover their asset bases and regain stability. If the condition of the assets was as bad as these erroneous devaluations had suggested it would have taken much longer for the banks to recover.
And the reason for the erroneous devaluations was that the devalued assets, mainly mortgage based securities, were not traded on an open market with full transparency. If we were able to clearly see the extent, nature and composition of these assets we would have been better able to give them value and thereby avoid errors that led to this financial crisis that then caused the overall economy to tank.
As I have said several times, Congressman Barney Frank, who has successfully managed a bill through the House of Representatives, summed up his bill by saying, “we will make all transactions fully transparent.” He understands what has to be done. We are now waiting for the Senate to pass its companion bill.
A friend of mine eased my concern about the new health care law when she said to me, “don’t worry about the new health care law, in 2400 pages there are bound to be inconsistencies that will cause the law to implode.” Her comment brought back to my mind House Speaker Nancy Pelosi who famously said, “We have to pass the health reform bill in order to see what’s in it.” Her comment was stunning.
I suspect we will find lots of contradictions as we unwrap the leaves of this huge head of lettuce. No doubt there will be surprises for both supporters and opponents.
What a way to run a railroad.
Former Federal Reserve Bank Chairman, and current advisor to President Obama, Paul Volcker sent shock waves through the economic world with his recent public statement that we will have to raise taxes, and not just for the rich. He also suggested that the way to do this may be via a Value Added Tax or VAT which is the tax through which most European Union nations raise the largest part of their income. It may be a surprise to many, but most of these countries raise more income from the VAT than from income taxes.
The main problem with a VAT for the USA is that the various states already use sales taxes as their principle means of raising funds. The VAT would be seen as a national sales tax on top of a state sales tax. Of course those proposing the VAT will be quick to point out that the VAT is charged at various points in the production of a good or service, not at the final sale. But what happens is that the VAT is simply included in the final price as a cost.
The VAT discussion will inevitably raise the question of what is the tax rate in various lands? I have been asked, while working in several foreign lands, and even today, what is the tax rate in Bongo Bongo and how does it compare to that in the USA. I always respond by saying that in all my analytical work related to taxes I never counted the actual tax rates or tax incidence. Rather I simply added up all the expenses of the various levels of government and stated that this constituted the “tax rate” since the expenses have to be paid through taxes.
The reason I counted expenses instead of actual taxes is that it is much easier to count expenditures. To illustrate, one could ask what is the tax rate in the USA? Remember, you have income taxes, property taxes, sales taxes, excise taxes, payroll taxes, and more levied by the federal, state and local governments. It is damn near impossible to calculate the net effect of all these taxes. Consider that over half of all households pay no federal income tax, so is the tax rate 0? However, it is relatively simple to add up all expenditures of all levels of government.
Of course calculating the “tax rate” this way has one major problem, much of government expenditure is paid for by borrowing, not taxes. So the actual calculation is A - B = C where A is the sum of all expenditures, B is the amount of borrowing and C the implied tax rate.
In the USA today roughly 25% of all spending is done by the Federal Government. Add some 15% of all spending that is done by state and local governments and you have a total of 40% of all spending done by government. Thus the implied tax rate is 40%. I doubt many people say that the tax rate in the USA is 40%, since that is higher than the highest marginal rate of federal income taxes.
In the immortal words of my old tax professor, “There are only two elements to a good tax, first it collects sufficient revenue, second it is easy to collect.” Let the debate about the “best way to tax” begin.
For once I agree with Nobel Laureate and New York Times columnist Paul Krugman. He writes that the bill sponsored by RPCV Senator Chris Dodd to put controls on previously unregulated parts of our financial system, principally trade in derivatives, now coursing its way through the Senate, errs in calling for an end to “too big to fail” financial institutions. This was the rationale used by the Feds to inject massive amounts of public funds into large banks and other financial institutions in 2008 whose collapse would bring down our entire financial system. The bill speaks of limiting the size of banks so that they cannot become “too big to fail,” i.e. their very size means that the Feds will be forced to salvage them again in the future.
Krugman says this is not necesary. He notes that the Great Depression came from many smaller banks failing, not from large banks collapsing. He says that no matter what the invidividual size of the bank in trouble, there can be cases again where the Feds will have to shore them up.
Krugman goes on to say that the focus of the new financial regulation bill should be on the nature of the investor (read bank) and the transaction itself. He says that the bill must extend current bank controls to “shadow banks” or the financial entities created to deal in derivatives. We must also control the transactions themselves, with a limit on “leverage” being the key concern. Leverage here means the ratio of the investor’s asset base to his borrowing to buy more assets.
I fully agree with Krugman on all his points. However, I would add that I believe the main goal should be to make trade in derivatives fully transparent, i.e. buyers know exactly what the derivative is with full details, prices offered and paid must be completely visibile on a market similar to those for stocks and bonds, the condition of the buyer and the seller will be known, as well as the amounts of credit used for the sale. Represenative Barney Frank, who already managed to get the House of Represenatives to adopt the companion bill as law, stated this goal elequently by saying, “we will make all trades in derivatives fully transparent.”
While we can debate what should or should not be in the Senate bill that, when adopted, will be blended with the House bill, the main question will not be directly addressed in the law itself. This key question is, “will the new controls act to kill trade in derivatives all together?” Will investors want to buy these assets with new rules in place?
One of the few people on this planet who can offer a valid answer to this key question is our loyal reader, Dennis Grubb, who has spent the last decade or so creating derivative markets in emerging economies. So Dennis, what say you?
About Your Money: In the New Economy
The financial crisis of 2008 has ushered in a new facet of the “New Economy.” Whatever you say about the origins and course of this financial crisis, this new dramatic development will be a major influence in our economic future. I will discuss the financial crisis and where it has led us. I will then look at how this “New Economy” will affect your job prospects, investment strategies, retirement plans, personal finance. We are in an entirely new phase of our economic progress reinforced by a new administration coming into office. It will be exciting to some and of concern to others. But we all must understand it and use it to our advantage. — Leo Cecchini (Ethiopia 1962–64)