Understanding Geithner's "Financial Engineering"

I'm not a fan of Geithner's plan to use "financial engineering" to get the US out of the economic catastrophe that Wall Street's "financial engineering" created.

Here's a Wall Street type explaining in plain English how the Geithner system works. This is the first few paragraphs from David R. Kotok's explanation. If you read the whole thing, you will arrive at Kotok's assessment of Geither's plan: "As a private citizen concerned about my country and its policy direction, I think this reeks and stinks."

Dear Reader: Please give me 8 minutes to explain the $1.1 trillion federal government Public-Private Investment Program (PPIP).

Start here with this simple example. It’s a coin toss. Heads you win $100; tails you get nothing. How much would you pay to play? You can play as many times as you wish. Answer: not more that $50. For less than $50, you would play as often as you can. $50 is your breakeven; only a fool would pay more.

Now add Tim Geithner as your partner. He matches what you invest but you, and only you, get to set the price to play. Answer: you put up no more than $25 as the investor and that means he matches your number. At under $25 you play as much as you can. $25 is your breakeven as the investor; $50 is still the breakeven for the coin flip.

Now let’s add some of the leverage from the FDIC. ...

Read the whole thing.

How to Fix a Problem

Here is a very simple, effective, and cheap solution to the problem of food safety. It is probably too simple, too effective, and too cheap to be adopted by any government, but I like it and think it will work. Here is the key bit from the Ian Ayres blog entry on Freakonomics:

By now, virtually everyone in the country has heard that the Peanut Corporation of America knowingly shipped peanut products contaminated with salmonella bacteria, leading to the deaths of at least nine people and sickening 22,500 others. Last year, the Westland/Hallmark slaughterhouse processed meat from “downer” cattle that were too sick to stand, forcing a recall of 143 million tons of beef. President Obama has spoken of a food-safety “crisis” confronting the country, and that over-used term does not seem to be an exaggeration in this case.

So what should we do? Government inspectors are too few in number to visit all of the thousands of food preparation facilities, let alone conduct thorough inspections. Some large-scale purchasers conduct their own inspections of their suppliers, or the suppliers themselves pay for inspections, as was apparently the case in the peanut incident. But private audits have not proven to be much more effective than, say, the private credit-rating agencies that gave AAA ratings to all those mortgage-backed securities.

Maybe we should take a lesson from the 1980’s commercials for the Hair Club for Men. You may remember those cheesy ads, which concluded with the pitchman declaring that “I’m not only the Hair Club president, I’m also a client.” The right way to align the incentives of management with those of the customers, in other words, may be to make sure that the managers are customers. One way we could implement this would be to require inspectors to certify that they saw the president of the company (or perhaps the plant manager) eating a substantial helping of the product being sold. (Maybe the inspectors should be required to eat some as well!) Someone who knows that his downer-burger was made from a cow that was too sick to stand, or his salmonella-butter-and-jelly sandwich contained infested nuts, might not be so happy about his working lunch.

Republicans are Allergic to Numbers

Here is Ezra Klein in his blog at The American Project having fun at the expense of the number-phobic Republicans. This is just the first couple of paragraphs and I've bolded the funny bits. You have to read the whole thing to get a really good chuckle:

If you're having a bad day, I highly encourage you to spend some quality time with the Republican budget proposal. It's reads like what would happen if The Onion put together a budget...

Bush, famously, described his first budget by saying, "It's clearly a budget. It's got a lot of numbers in it." Indeed it was, and did. This isn't. There are no numbers. Let me repeat that: The Republican budget proposal does not say how much money they would raise, or spend. The Oxford English Dictionary defines a "budget" as "an estimate of income and expenditure for a set period of time." This is not a budget. It talks about balancing the budget but doesn't explain how. It advocates tax cuts but doesn't estimate their costs. It promises to cut programs but doesn't name them...

The health care section, for instance, says that Democrats propose "nearly $1 trillion" in health care spending as a "downpayment" on reform. The actual number is $634 billion, which someone who's more familiar with, you know, numbers, might have characterized as "more than $600 billion," or, alternately, "$634 billion." The Republicans say that "the prime focus of [the Democrats] agenda is the establishment of a government-run health insurance plan," a policy idea that doesn't appear in the President's budget. They say that the Lewin Group has analyzed this policy that doesn't exist and found that it will force three out of four Americans onto government-run health care (the Lewin Group analyzed the Economic Policy Institute's proposal, which is not the President's budget). And so on, and so forth.

The Power of Advertising

Here's a commercial that makes you want to rush right out and sign up with this company that sounds so knowledgeable, so strong...



Oh... wait a second... this is AIG, the company that blew up, that chewed through $170 billion of taxpayer's money... maybe they aren't quite the "sure hands" and "sure thing" portrayed by this commercial. Wow! And the commercial is so believable.

No wonder Geithner & Paulson have thrown so much money at this company!

The Cure for Our Economic Ills

Here is a call by Matthew Iglesias for us to abandon economic orthodoxy. It is a wonderful essay. Below is the final paragraph that sums up his position. You need to read the whole article to get the full argument:

The Great Depression led to the implementation of a regulatory regime that, though crude, served to prevent panics from becoming contagious and banks from becoming “too big to fail”. This framework was eroded by the belief that a market populated by rational actors could police and correct itself. After all, why would nearly all investors simultaneously make the same mistake, year after year? The answer, of course, is speculative mania – a concept for which there’s ample empirical support but for which a rationalist model has no place. The cure is not to abandon capitalism, but to ditch excessive faith in the rationalist model and make sure that regulations keep us well-clear of the ledge, lest inevitable bouts of irrationality push us into an abyss.

Cliff Diving: The US Economy

image from BMO economics research
The above is the CBO (Congressional Budget Office) estimate for Obama's budget in the context of the recent past. There is no denying that it is a bloodbath of red ink. The tragedy is that the Bush administration didn't nip the problem in the bud back in 2007 when the cost would probably have been one-fifth the size (remember, Ben Bernanke assured everybodey that it was "contained" to the sub-prime market in early 2007 and that was only a few hundred billion dollars, not trillions).

If you look not at dollars, but at GDP percentage, it doesn't look as bad. It is a lot of money, but the other option -- falling into a Great Depression -- is so very, very bad that only ideologues like the Republicans are willing to argue that the costs should be foregone in favour of a complete crash in the economy. Reagan was a happy warrior who ran up a 5.6% deficit and Republicans cheered him on. He did that during a vanilla recession, not a recession threatening to become a depression.

DeLong Weighs & Measures the Bank Plan

Brad DeLong has an interesting piece in The Week in which he looks at the Geithner bank plan and does his assessment of it. The key bit for me is:

Q: How does having the U.S. government invest $500 billion in the world's largest hedge fund operations reduce unemployment?

A: The sudden appearance of an extra $500 billion in demand for risky assets will reduce the quantity of risky assets other private investors will have to hold. And the sudden appearance of between five and ten different government-sponsored funds making public bids for assets will convey information to the markets about what models investors are using to value assets in this environment. That sharing of information will reduce the perception of risk somewhat. When assets are seen as less risky, their prices rise. And when there are fewer assets on the market, their prices rise too: it’s simple supply and demand. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms that make expanding and hiring more profitable, etc.

A: And the recession will end, and unemployment will drop back to normal?

A: I doubt it. My guess is that we would need to take a total of $4 trillion in assets out of the market in order to move financial asset prices to a point at which it becomes profitable for businesses that should be hiring and expanding to actually hire and expand. “Toxic” assets account for only $2 trillion of this total; the government has to sponge up additional assets because the big problem now is not the inability of some people in the desert outside Los Angeles to pay their mortgages. The problem is that among financiers everywhere, the tolerance for holding risk has collapsed. The Geithner plan supplies $500 billion to acquire assets. The Federal Reserve's quantitative easing plan will add another $1 trillion. And I should hasten to say that the administration thinks that the information-sharing effects of the Geithner plan will do three times as much good as the simple supply-and-demand analysis suggests. (I discount that entirely.) So from their perspective, the glass is 3/4 full.

Note how DeLong, who is an optimist, is enough of a realist to admit that the Geithner plan falls short of solving the problem. If you read the whole article you can see that politics is what prevents Obama from solving the problem.