Tuesday, April 27, 2010

Goldman in the Crucible

A bit of a witch trial in Washington today. I cannot say that the Goldman folks acquitted themselves well, but that’s not really very interesting. What was interesting was that Senator Levin had a mission to make Goldman look bad, so when they didn’t, he simply said they did. He asked stupid, unanswerable questions, or questions in service of non-sequiturs as if the answers mattered, and got all steamed when the Goldman guys refused to pretend that he was making sense. I thought of that Congressman worrying about whether too many marines would cause Guam to capsize. What do you say to the man who asks whether you walk to school or carry your lunch?

Two examples. In an email, one Goldman guy writes to another, referring to the portfolio in the SEC case as having been picked by “ACA/Paulson.” According to the author of the email, who was sending it to someone who fully understood Paulson’s role, whatever that was, “ACA/Paulson” was shorthand for that relationship, not an indication of Paulson’s status as an equal partner in the deal. Levin only wanted to know if the email was “accurate.” Well, as between the sender and the recipient, it was accurate if the recipient understood it to mean what the sender intended it to mean. But to Senator Levin, the email, if it were “accurate,” would prove that ACA and Paulson were equal partners in the selection process, because that’s what the words would mean to an outside observer. Now, it’s entirely possible that the author of the email is lying about the import of the note, but Levin didn’t say that. He simply acted as if his interpretation of the note matters more than those of the sender and the recipient, and that’s beyond stupid.

But Senator Levin wasn’t done. He grilled Goldman’s CFO over whether the firm was “short” the mortgage market throughout 2007. This is important to Sen. Levin because he wants to say that Goldman was peddling mortgage paper during the year despite being short all year. The CFO said that the firm’s net position was mostly short during the year, but not consistently so, and not significantly so. Well, that didn’t help the Senator, who wanted no part of the CFO’s obfuscatory use of the word “net.” “I don’t care about net,” said the Senator, or words to that effect, “I just want to know if you had a short position throughout the year.” The witness tried to explain that the firm had short positions at all times, but was net long at times, which, one would think, would be what matters in determining whether the firm had a conflict of interests. But not to Senator Levin. He just wanted to establish that the short positions were in place, no matter what the firms’ uses for them or its net position on the mortgage market. Since witnesses don’t get to ask questions, the CFO never got to say “What the fuck difference does it make, you moron?” But the thought was hard to escape.

Well, they say we get the government we deserve. What we did to deserve Sen. Levin isn’t clear to me, but I want to apologize from the bottom of my heart for my part in whatever it was, because it must have been a doozy.

(None of this is meant to deny that investment banking has lost its way or that Goldman Sachs has some ‘splainin’ to do. But that’s sort of the point. Intelligent questions from Senators who actually wanted real answers would have been very helpful in illuminating what has gone wrong. Instead, we got theater intended to promote the regulatory bill making its way through the sausage factory. Pity.)

Sunday, April 25, 2010

Goldman’s Super-Senior Moment

Not by Damon Runyan

Johnny the Hedge walks into Goldy’s bookie joint and says "I think the Mets lose big this year. Here’s my bet:

I'll pay you $100 if the Mets win at least 60 games. But if they win fewer than 60 games, you pay me $25 per game under 60. And just to pay you for the trouble, we’ll start with a $15 credit to you."

Goldy says, “I’ll get back to you. I have to see if I can lay the bet off.” She then looks through her rolodex for Mets fans and finds two that interest her.

Ikey B. loves the Mets, always has. Goldy offers Ikey B. a deal:

"I’ll pay you $79 if the Mets win at least 60 games. You pay me $25/game for every game fewer than 60 that the Mets win, up to $150 max."

Ikey B. is sure that the Mets will win at least 60 games, so he takes the bet. But Goldy isn’t done. She has laid off $150 of her risk on Johnny’s bet, but what if the Mets win fewer than 54 games?

So Goldy turns to Al “Citifield Action" (ACA to his friends). Al’s a really well-heeled Mets man. Goldy says to Al:

"I’ll pay you $10 if the Mets win at least 54 games. Otherwise, you pay me $25 per game fewer than 54 that the Mets win."

Goldy offers ACA so little because, well, winning fewer than 54 games? C’mon, no one ever does that. ACA sees a chance to pick up an easy ten-spot, and he jumps at the chance.

So let’s take a look at where Goldy sits:

If the Mets win 60 games or more (the most likely outcome, if history is any guide), she collects $115 from Johnny and pays out $89 to Ikey B. and ACA, netting $26.

If the Mets win 54 games, she pays $10 to ACA, collects $150 from Ikey and pays it to Johnny, less the $15 she gets to keep for her trouble, netting $5.

If the Mets win 50 games, she collects $150 from Ikey, $100 from ACA, and pays $235 to Johnny, netting $15.

If the Mets win 20 games, she collects $150 from Ikey, $850 from ACA, and pays $985 to Johhny, netting $15.

In the quaint patois of Wall Street, Goldy’s bet with ACA is called a super-senior tranche. The concept is very simple. Ikey B.’s bet – that the Mets would win at least 60 games, is rated AAA by the mavens because it is (apparently) risk-free. But, in the strange world of investment banking, some risk-free investments are more equal than others. If a bet that at least 80% of mortgages will pay off is rated AAA, what about a bet that at least 60% will pay off? By breaking its bet with Paulson up into tranches, GS was able to arbitrage the spread between what Paulson was willing to pay to bet against 80% of the pool and what ACA would demand to insure the top 60%. (These numbers are illustrative, not actual.) All that was required was for someone to take the AAA-rated tranche represented by pay-offs in the 60-80% range, and IKB did that.

Thus, the money for GS was not in its deal with IKB. The money was in the arbitrage between what GS was charging Paulson for its bet on the whole pool vs. what it was paying ACA to cover the “super-senior” tranche of the pool. That super-senior opportunity is what drove the synthetic CDO market.

Saturday, April 24, 2010

Basel II and the Goldman Thing

This is one of those posts where the logic is more important than the facts assumed because, if those specific facts are wrong, the logic still holds for a large number of actual situations.

Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. I wasn’t there, and I haven’t studied the workings of the conference, but here’s the logic that seems to have led to the conclusion that was reached:

1. Banks that lend to good risks need less capital than banks that lend to bad ones.

2. Under current standards, the amount of capital required does not adequately reflect the relative safety of the loans being made, i.e., too much capital is being required for very safe loans.

3. With the growth in imbalanced international trade (think oil and China), the financial system has an ever-increasing need to convert surplus countries’ reserves into deficit countries’ capital.

4. If capital standards are reduced for highly-rated loans, more money can be repatriated.

5. Therefore, banking standards should allow significantly higher leverage for highly-rated loans.

The flaw in this logic is the unstated assumption that premises 1 and 2 are independent, that the safety observed for highly-rated loans is independent of the rules limiting their amount. I believe that implementing the conclusion – reducing the capital required for highly-rated loans – actually caused the safety of such loans to suffer. As the folks in the philosophy biz might say, making the descriptive prescriptive has made the description false.

The weakest link in the financing chain holding up Basel II is the ratings system. Highly-rated loans are safer than non-highly-rated loans for one simple reason: they deserve to be highly rated. They are not less risky because they are highly rated; they are highly rated because they are less risky. So, if something changes in the financial system so that ratings are no longer reliable, capital standards based on ratings become dangerous.

What can cause the ratings system to become unreliable? How about an exponential rate of increase in the demand for highly-rated paper? That demand creates a demand for investment bankers to spin Baa straw into AAA gold, and investment bankers, in case you haven’t noticed, have lots of money to spend to make the lots of money they make. The demand for highly-rated paper after Basel II was unprecedented, and the pressure on the ratings agencies to polish turds became overpowering. This is not to excuse the raters. To the contrary, I see them as the biggest culprits in the whole mess, the people with the last clear chance to stop the madness. But their fallibility still needed to be reckoned with in the human engineering of Basel II.

Of course, blaming the whole thing on our trade deficit as I do, I see Basel II as just another inevitable consequence of too many dollars needing to come home and us having to take them in. The bandwidth of the financial system had to be increased, and increased bank leverage does provide increased financial bandwidth. The alternative to more leverage would have been more capital. Foreign-held reserves would have to be used to capitalize new or existing banks, something that the owners would have resisted. It’s hard to imagine the political will to reach that result absent a crisis, so Basel II seems like the natural domino to fall once the trade deficit ballooned. Now that we’ve had the crisis, if capital levels are restricted, capital infusions will follow. Goldman, Sachs, & Al-Waleed Sinobank. Ick.

But I digress. Today’s moral is simply that you cannot codify an observation and expect that the observation will not change. Much of our regulations make this mistake. We should be on the look-out for examples in the big policy prescriptions coming along in healthcare, energy, and financial services.

Tuesday, April 20, 2010

Top Ten Bad Apologies for Goldman

[This post was last revised on April 25, 2010.]

For future reference, linking purposes, and the general edification of the bloggerati, I want to catalog the excuses Goldman is making and why the ones I’ve seen so far seem bogus to me.

1. Big boys don’t cry.

The argument is that IBK and ACA should have inspected the mortgage pools themselves and made their own judgments, whatever Paulson’s role may have been. On this score, IKB and ACA stand in different positions, but not necessarily with different outcomes.

IKB is a foreign investor buying US RMBS. It turned to a gilt-edged investment bank and demanded that a respected, independent bond-picker select the assets and that the CDO be rated AAA. If a foreign investor has to do more than that, then the dollar has no business being the world's currency, because it's too damn risky to hold. I mean, all this boils down to GS saying "You trusted me?"

ACA is in a slightly different position. As the selector of the reference portfolio, it cannot claim to have “relied” on anyone, and, in that role, I think it acted negligently in allowing itself to be fooled about Paulson’s game. IKB, I would think, has a case against ACA (if it or its assets can still be reached!) for simply not doing what it was paid to do.

But ACA’s parent, which was not getting paid to select the portfolio, took the biggest loss in this game, and the fact that it was foolishly separated from its money does not mean that it was not defrauded and does not have a cause of action against GS and/or Paulson if the facts support that position. Yes, as insurer, ACA Holdings had an opportunity to inspect the insured portfolio. (I hate to use insurance words about a contract unsupported by insurable interest, but it saves time.) But insurance is a subtle thing. A good underwriter will take into account perils “known and unknown,” including unquantifiable adverse selection. Paulson’s involvement in the selection process raises a serious issue of adverse selection, and, despite being dumb enough not to dope out Paulson’s role when he rejected the Wells Fargo bonds, ACA can certainly claim that Paulson’s role as insured and portfolio selector, if known, would have posed too great a risk of adverse selection to permit the CDS to be issued.

2. For every long, there’s a short.

IKB and ACA are supposed to know that every sale has a seller who thinks that the assets are worth less than they are, so they should not have been surprised to learn that there was a short on the other side of their deal.

Not every sale is a bet against the buyer. When I buy a car, I am betting that it will run. Is the dealer betting that it won’t? When I buy a Treasury bond, I am betting that the Government will pay it off. Is the Government betting that it won’t? If I buy the bond from a private party, is he betting against me? Maybe, but maybe not. Maybe, he just needs some cash to buy a hot stock. There is no implication that he believes the bond will fall in value on account of something other than a general rise in interest rates. Thus, serious mispricing is not a necessary element to a sale.

IKB’s piece of the synthetic CDO in the Goldman case was nothing more than a loan from IKB to GS on which GS did not have to pay in the highly unlikely (according to the AAA-rating) event that the bonds defaulted. IKB was entitled to believe that GS was doing this transaction for the super-senior opportunity, or to provide a real hedge against securities they or a customer owned and liked, and not because anyone thought the bonds would fail. Indeed, just in case GS might be betting against it (and might, therefore, pick a weak reference portfolio), IKB insisted that ACA be brought in to pick the portfolio. IKB thus tried to assure that, whether or not there was a short, the portfolio was picked by a long.

ACA Holdings, the issuer of the CDS did have reason to assume that someone was shorting the portfolio, but, again, the short could have been hedging a long position or betting on interest rates, and ACA Holdings did not know, and had a right to know if it asked, that the short player had in fact helped to pick the portfolio. Thus, the “for every long there’s a short” argument is simply a non sequitur as to ACA Holdings. ACA knew there was a short, but it did not know about the adverse selection in the pool it was insuring.

3. Investment bankers do not reveal counterparties.

This argument assumes that Paulson was “the other side” of a trade with IKB and/or ACA. As to IKB, that argument has no place. IKB did not have the right to know who, if anyone, was on the other side of the trade. But it did have a right to know who picked the mortgages.

As regards ACA, this confidentiality thing is one of the places where the failure to treat CDSs as insurance contracts turns things upside down. Whereas a broker is expected to maintain the confidentiality of the people on each side of a financial deal, an insurance underwriter must take into account adverse selection and moral hazard, both of which are unique to the identities of the ultimate insured and its actual interest in the risk. ACA needed to know at least that the portfolio was chosen by a short and that the CDS was actually reinsurance of GS’s CDS to that very same short. Those are relevant underwriting facts because ACA’s CDS was not a “derivative security” any more than a horse with feathers glued on is a bird.

Moreover, the law treats an insurance contract as being uberrimae fidei – of the utmost good faith. Because of the asymmetry in knowledge, the buyer is required to disclose all relevant underwriting facts. But a CDS isn’t insurance, right?

4. Any portfolio of Sub-prime mortgages would have cratered, so no harm, no foul.

IKB’s claim against ACA for bad portfolio picking might indeed run into trouble if IKB cannot prove that its portfolio actually underperformed because of how it was selected. But ACA is not the interesting defendant here. That would be GS and maybe Paulson as co-conspirator.

If fraud is proved against GS and/or Paulson, IKB may be entitled to rescission of its deal, whether or not it would have lost money on another pool. Why should the defrauder have the benefit of that doubt?

ACA Holdings should have an easier time getting rescission as a remedy. It can reasonably claim that it would not have issued its CDS had it known the facts, so its damages are whatever it lost. ACAH did not pay GS to find it a portfolio to insure, so it does not make sense to me that ACAH’s remedy should be measured by reference to some other portfolio it might have insured. ACAH should be entitled to rescission of the contract.


I know. That’s not 10. But the night is young..

Sunday, April 18, 2010

I Hate to Say “I told you so,” but…

Here’s an excerpt from my very first blog post:

Credit Default Swaps violate every relevant principle of underwriting and public policy. Why, then, are they legal? I can only guess that insurance people were not asked to think about them, or if they were asked, that their answers were ignored. (Insurance is such an arcane thing and all.) Instead, in what can most charitably be called an act of boneheaded stupidity, Congress tried in the Commodities Futures Modernization Act of 2000 to put CDS contracts outside the reach of state insurance laws.

John Paulson bought a CDS on bonds he did not own. Not only that, he created the bond pool himself from assets he thought would crater. Yes, he and Goldman Sachs had to fool some folks into thinking that Paulson had not suggested mortgages that he thought were undervalued, but that’s the point: if it weren’t possible for Paulson to buy a CDS on assets he did not own, the assets in question never would have existed, and no one would have had any reason to defraud anyone else into buying them.

The preventable causes of the Goldman case are the massive trade deficit that put so much money on Wall Street and the deregulation of derivatives, which made it possible to cheat people out of that money. Bill Clinton says that Rubin and Summers, who argued against regulation of derivatives, underestimated how much money they would involve. Maybe they didn’t grasp the importance of our growing trade deficit. But, in any event, an insurance contract without an insurable interest is a prescription for trouble, and trouble is what we got.

It did not occur to me that players would be able to invent their own assets to short, but there is no point in trying to guess what form of mischief a stupid rule will enable. Insurance people speak of “perils known and unknown.” I know that if you can insure something you don’t care about, trouble follows. The shape of the trouble is really irrelevant. Just give the worst and the brightest a financial regulation that makes no damn sense. They’ll figure out the rest.

(A follow-up: Roger Lowenstein joins the call on April 20, 2010: "Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy credit default swaps." Lowenstein also calls for transparency in trading derivatives, but that seems wholly unnecessary once the ones with no skin in the game are banned.)

Thursday, April 15, 2010

A Place for Prosperity

Thomas Hobbes observed that man’s life without government was no bargain:

In such condition there is no place for industry, because the fruit thereof is uncertain: and consequently no culture of the earth; no navigation, nor use of the commodities that may be imported by sea; no commodious building; no instruments of moving and removing such things as require much force; no knowledge of the face of the earth; no account of time; no arts; no letters; no society; and which is worst of all, continual fear, and danger of violent death; and the life of man, solitary, poor, nasty, brutish, and short.

Governments were instituted to solve the problems of uncontrolled competition, to, among other things, make "a place for industry." Why is a place for industry a good thing? Obviously, industry creates goods, the ones we need and the ones we want. It creates sustenance and it creates wealth. But, in a society in which the government gets its legitimacy from the consent of the governed, exactly what should that "place for industry" be? If we are to enable the production of goods, should we also permit the accumulation of wealth? And how should the goods, and such wealth as is permitted, be allocated among the people who have enabled their creation?

Production does not just happen, nor can it reasonably be compelled. It must be enabled by a legal infrastructure. First come enforceable property and contractual rights. But property and contractual rights merely do for production what geography and climate do for life: they make it possible, not good. Just as government regulates primal competition, it must regulate capitalism if the economy is to be anything more than a subset of Hobbes's mayhem. Government must not only create a place for industry; it must create a place for prosperity. But how?

If, as I and many Americans believe, that government is best that governs least, we should start by allocating the fruits of production to those who make it happen. And we should allow those who have capital to seek out those who have talent on their own to make it productive. And allow those with talent to organize enterprises as they see fit (for, if we could do better, we should be doing better).

Unfortunately, history teaches that this minimalist approach to political economy causes wealth to be created but also to be concentrated. The problem is labor. Aside from returns on capital, compensation for work is the only satisfactory alternative to largesse for delivering goods into people's hands. But there is no guaranty that the supply of labor will not outstrip the demand for it, that competition for jobs wil not force down the standard of living of those with only their labor to sell. That has been the case in the early days of all capitalist economies, including some now in their infancy.

The competing capitalist must extract the most he can from the labor pool at the least cost. Demagogs attribute such competition to some moral failing among capitalists, but unilaterally raising wages drives away customers or capital, so no other path is available in a laissez-fiare system. Consequently, where labor is abundant and competition for jobs unregulated, only the barest subsistence finds its way to the mass of people. As a result, much of their labor is directed toward producing luxury goods for the few who get to keep the fruits of the laborers' toil. Because the number of people needed to make such goods is limited by the relatively small size of the market, the system equilibrates at a level that is far from satisfactory for most of its participants.

How, then, is prosperity to happen? It won't do just to confiscate the capitalists' wealth and give it to the poor workers to make them rich. Wealth will not be created if capitalists and entrepreneurs are not allowed to benefit disproportionately for their risks and exertions. Still, shouldn't society aim to minimize the disproportional allocation of the fruits of production? We all voted to make capitalism possible, and we all pay taxes to support the enforcement of property and contractual rights. Shouldn't we all benefit from it?

How about laws protecting labor from the natural consequences of its meager bargaining position? Imposing a minimum wage (the simplest way to protect workers from selling their services too cheaply) would surely increase the money in the workers’ pockets, but then what? If the government orders capitalists to pay their workers enough money to buy a lot of stuff, will production shift to the things workers want and, thanks to the higher wages, have money to buy? Or even better, will new production of such goods be undertaken, requiring more labor and thus making the minimum wage merely a bridge, taking wage rates to where they would be set by the market if workers were customers, too. If so, business might see government's "intrusion" not as a restriction, but as a boon.

The "bridge" scenario assumes certain things about the nature of production and distribution. Capitalist systems equilibrate within technological limitations. What if we don’t know how to build a factory that can produce a car for every garage? What would then be the point of paying people enough money to buy a car, or of establishing a bank to lend them the money or insurance companies to insure them, or building roads on which to drive them? A minimum wage – any accommodation to workers, really – is only viable if the productive and distributive technologies are adequate to serve a nation of well-paid workers. Otherwise, we have the classic Soviet worker's lament: we pretend to work, and they pretend to pay us.

Certainly, the case could be made that labor laws would have hastened the invention of technologies that would make them affordable, but as things worked out, the opposite occurred. Henry Ford invented mass production, and American business faced the excellent problem of excess capacity. Rather suddenly, it became possible to produce enough stuff for a whole lot of people, but the people weren't earning enough to buy them. So, almost like magic, despite the assumed (feigned? half-hearted?) resistance of big business, we got anti-trust laws for the consumer and labor laws for our workers. The result was a massive, temporary diversion of revenue from master to servant, who then spent it on what the boss had to sell. The poor got less so, and the rich got more so. Together, Henry Ford, and We, the People, in Congress assembled, made a place for prosperity.

Laissez-faire types oppose economic regulation. They say that the market is a better regulator of excesses than is the government. They argue, for example, that if the economies of scale make higher wages more profitable than lower ones, then higher wages will emerge through market forces. I see two objections to that view.

First, as Hobbes might have said had he been able to study game theory, the emergence of higher wages presents a coordination problem. Raising wages does not make a company more profitable unless other do it, too. So no one company could ever raise wages in the hope that national wages will rise. Or, as Hobbes did put it:

From this fundamental law of nature, by which men are commanded to endeavour peace, is derived this second law: that a man be willing, when others are so too, … to … be contented with so much liberty against other men as he would allow other men against himself…. But if other men will not lay down their right, as well as he, then there is no reason for anyone to divest himself of his: for that were to expose himself to prey, which no man is bound to, rather than to dispose himself to peace.

The laissez-faire supporter will purport to agree with Hobbes, but the liberty he is willing to grant other men against him exceeds what most people would allow. Maybe, he believes that he has the wherewithal to win the war that coordination would avoid. Or maybe he just doesn't understand how things work.

Second, and this is something laissez-faire capitalists refuse to recognize, politics is often just market economics continued by other means. If political action is seen as a tactic available to market participants, rather than as some external feature of the world, political action can be seen as the market’s response to business’s coordination problems.

How, for example, in the absence of government coordination, would the market bring about wage increases? Two thoughts come to mind: collusion and unionization.

By collusion, I mean all of the employers in America getting together and agreeing to raise the wages of all of their employees to a level that will produce enough demand for their products to offset the increase in costs. Obviously, not all employers will see the light, so getting such an agreement would be impossible. But even if only a substantial majority of employers need to join the wage cartel for it to be effective, think of the logistical difficulties in creating and enforcing such an agreement. (Let alone the genuine anticompetitive collusion such a scheme might engender.) A far better approach for the same employers would be to go to Washington and lobby for a minimum wage, or at least not to object too strongly when labor does so.

And what about unionization? Employees are an even more fractious bunch than employers. How would union discipline be enforced short of thuggery? Would employers negotiate with a union that purports to speak for a whole industry but has no legal status? Would a collective bargaining agreement be enforceable? (Early "labor law" consisted of court rulings that treated unionization as a tortious interference with the employer's business.) The emergence of a practical labor-relations scheme cries out for codification. And, because of the aforementioned economies of scale and all, employers really have no reason to resist, if the productive and disributive technologies to exploit a well-paid workforce exist.

Labor laws provide a mechanism for allowing wages at all skill levels to keep up with gains in productivity and distributive capacity. It’s what the market would do if it could. So, perhaps political action regarding at least some labor laws should be seen not as intrusions by government but as enlistment of government. (I refer here to some labor laws, not all of them, so don’t tell me about every silly OSHA rule that makes your life needlessly difficult.)

Because of (in my view), or despite (in others' view), government action, the diffusion of prosperity in the US over the past 100 or so years was remarkable. The inherent tension remained between the need to create wealth and the need to distribute it in a politically satisfactory way, but, until recently, and with some notable busts, the wealth kept growing and the income disparity kept shrinking. The movement toward equality, however, must at some point end lest the incentive disappear and the revenues with it. From that point, expansion of the pie, everyone getting richer, becomes the source of perceived improvement in our national lot.

One thing that can contribute to growth is international trade. Natural resources and the skills to turn them into useful products give localities comparative advantages in the production of those goods. Trade between countries in the goods as to which each has such a comparative advantage can bring additional revenue to each country, maximizing the aggregate revenues of the traders (but not necessarily maximizing the revenue of each). If trade brings more revenue to a country, then that country is better off, but only if the usual revenue allocation structures apply. Otherwise – if, for example, the trade process itself adversely affects the revenue allocation mechanism within the borders of the trading partner – trade cannot be counted as “advantageous,” no matter how much revenue it generates. And if trade causes revenue to fall, and the allocation mechanism comes to be perceived as less equitable, and the financial system becomes overburdened by capital seeking repatriation, then trade can be a very bad thing indeed.

If economic benefit is defined as increasing national revenue (or decreasing national expense) without decreasing the politically perceived equity of the revenue distribution, then free trade can fail to benefit a trading partner in two ways.

First, if a nation runs an aggregate (i.e., worldwide) trade deficit, repatriation of money spent abroad must occur through the capital markets. That process may or may not be benign, depending on those markets' ability to process that money into revenues that are shared consistently with the pre-trade regime. For example, if the US ran a trade deficit equal to its deficit with oil exporters, and the petrodollars were invested to make housing more affordable for people with otherwise good credit, the trade for oil might be beneficial as I have defined the term. But if the deficit is so large that the money cannot be invested soundly, it will either be invested unsoundly, or it will be lent to the government, which then incurs ongoing interest costs until tax revenues increase, which cannot happen if money is leaving the country and returning as loans to the government.

Alternatively, repatriated trade deficit dollars can be invested in corporations. But that brings us to the second way that trade can fail to benefit us. Trade is trade, but competition is competition, and the two can co-exist most unhappily. The classic Ricardian example of comparative advantage posits England’s advantage in wool vs. Portugal’s in wine. In Frederic Bastiat’s defense of free trade, Belgium is said to have a comparative advantage in iron, presumably for geographic reasons. In neither case is it assumed that a country has an advantage in labor per se. Rather, for any skill level, the assumption is made that each trading partner has a comparative advantage in a product that will employ anyone who might otherwise be employed in making the imported product.

Where a country has a comparative advantage in labor costs, it will tend to make the things that require the most workers, and its trading partners will make the things that require the fewest. Such trade can be entirely balanced. Indeed, China is running a trade deficit against the world, primarily because it is importing natural resources, which no amount of cheap domestic labor can produce. But the US is not a major exporter of natural resources (maybe because we’re too dumb to use our natgas and sell our oil, but that’s for another day). So, we export food, which has become increasingly capital intensive, and we export high-tech things made by other high-tech things. That trade, too, could be balanced; it’s not, but, even if it were, it would still be a problem for us, because it would mess up our revenue allocation mechanism, aka the labor market.

So we have another of what so-called perfect storm: a massive global trade deficit that generates larger capital inflows than we can put to productive use and massive trade with low-wage countries, which disrupts our labor market’s ability to distribute the revenue such trade generates (such as it is).

Again, free traders assert that absolute free trade is best, that displaced workers will find new work, funded by trade deficit dollars, if a deficit there be. I have never understood the economic basis for the claim by laissez-faire supporters that government intervention hurts business but trade with low-wage partners does not. If you say that cheap foreign labor destroys jobs, they say that the workers need only find something else to do in a more productive industry. But then they turn around and say that labor laws cost jobs by raising costs. I don't see how foreign labor's downward pressure on prices and domestic government's upward pressure on costs can be distinguished in terms of the adjustments that businesses and workers can make to them.

Free traders also complain that protective tariffs on cheap-labor goods transfers wealth from those who have it to those who don’t. They argue the case as if the alleged transfer were from the oppressed consumer, who would have to pay more for imports, to the entrepreneurs who own the protected industries. Such a transfer, they say, is morally indefensible. Sort of like bailing out European counterparties to US banks. Or bailing out the banks themselves. Of course, such transfers are only incidental. The real transfer – the one that makes a tariff good policy – is the one from consumers to the workers whose jobs are protected, people who not only are like those consumers, but sometimes are those consumers, or would be, if they could get jobs.

Finally, the free traders get all upset about their liberty. But I think Hobbes (and Kant) put that one to rest. There are no formal lines between liberties we are willing to give up (e.g., murder) and those we are not. Libertarians try to draw bright lines, but at the end of the day, the matter is entirely subjective: we are willing to give up the liberties to do what we would not want done. Unfortunately, not only is that judgment contingent on our own perception of our strengths and vulnerabilities, but it is also dependent on our grasp of how things work.

Free traders, who are, of course, laissez-faire capitalists, simply do not get that an economy exists at the political sufferance of the citizenry, and that it has two purposes, the creation and distribution of outputs, both of which are essential to analysis of any economic policy. Viewed through the right lens, then, protectionist tariffs, here and now, however they might in other places and times, protect neither workers nor industries as such. They protect our national system of distributing revenues in a politically acceptable way. That distribution is as essential a goal of government as enabling the creation of wealth in the first place.

Without a politically viable distribution of revenue, why would We, the People, give a rat’s patoot about the creation of wealth? We wouldn’t, and that’s a scary thought, because if the golden eggs aren’t getting to the far end of the table, the only logical move for the folks down there is to rise up and cook the goose.

Wednesday, April 7, 2010

They can have my Chinese cell phone when they tear it from my cold, dead hands-free bluetooth device!

How people think is often way more interesting than what they think.

I visited a site called the Hayek Cafe recently. It’s run by a guy named Don Boudreaux, who seems to get off on defending free trade with inane analogies. Here’s an example from an open letter to Lou Dobbs:

A few years ago I bought your book Exporting America. Have you bought my book, Globalization? If not …, was I made worse off by my purchase? Were you the only party to gain from that trade? Should I be concerned about the trade deficit that I now have with you? Were you practicing “unfair” trade? Was I “exporting” a part of myself – a part never to be regained unless and until you buy my book?

This bilateral, one-trade “deficit,” of course, teaches nothing about how a massive, aggregate global deficit might affect a country. I had the temerity to make that point in a couple of other threads on the blog, unleashing a firestorm of angry bullying by the faithful. The high point was this:

Buddy, poor man. You still stand in your room throwing shit at the walls hoping something will stick.

Like I pointed out to JohnK, talking to you is like bouncing a ball against a wall.

Absolutely nothing in all your diatribe, er...debate, addresses the one single point both Scott and I make, which is all your efforts, ideas, and actions (you personally Kramer) have one basic thrust, and that thrust is to remove my liberty, my freedom, and to harm me in the long run. And, you do it all in total disregard to the harm you do me, as long as it seems to mitigate your neighbor's burden of bad choices.

Pay close attention to the word seems, Kramer, because you have no evidence at all that my choice harms your neighbor.

What you do have is evidence that your neighbor's choices have hurt himself.

It is bullshit, Kramer, total bullshit.

You're wrong, you're a statist, aka socialist, a collectivist at heart, and like most of your ilk you seem completely terrified by the concept of freedom.

Like most collectivist you can not give one single good rational logical reason why vidyohs in Texas should part with his wealth to keep Kramer's kinfolks in Michigan (or where ever) alive and healthy. I do not know your kin, I do not care about your kin, I did not bring them into the world, and I probably will never have the occasion to escort them out of this world, I seriously doubt I will ever see the people you are so concerned about, and I resent you and your ideas about redistribution of my wealth. Just as I resent those same ideas as they were presented by Marx, Lennin [sic], Mao, Fidel, et. al.

And, I will not bounce my ball against the wall of Kramer, no more on this topic.

Can it be more clear on where we stand in relation to each other?

This rant came after a whole lot of posting on my part to the effect that tariffs would be in our mutual self-interest, not that we should do something to help those strangers that Vidyohs was so pathologically proud of not caring about. (I knew better than to preach mere compassion in the house of the self-reliant, where the only love is tough love.) But no matter how hard I tried to argue that we were shooting ourselves in the foot, all I got back was venom and stupidity.

The theme running through these rants is that access to cheap Chinese goods is the apotheosis of liberty. It’s all binary to them. A 10% tariff, chattel slavery, just a difference of degree, except that they see no differences of degree. Buying that cell phone is an exercise of a God-given right to control the fruits of their labor, associate with whom they want, and so on. It’s all very bumper-sticker.

These are real people, with real, for lack of a better word, opinions. And I admit, they fascinate me. I simply cannot imagine what it is like to see the world through Vidyohs’s eyes. The rage, the identification of disagreement with enmity. The pettiness. How does anyone come to boast about how callous he is? We’re not talking Keyser Söze here. This is just a pathetic little man living in Texas and raging at the machine (unless it’s from China). And there seem to be so many of them.

I think they all see themselves as elephants, as in “’It’s every man for himself,’ said the elephant as he danced among the chickens.” They don’t realize that they need the eggs. Many don’t even realize that at least some protectionists are claiming that they need the eggs. To them, the protectionists just want to save the chickens because they care about chickens. Others do understand the claim, but they don’t buy it.

Some of the illogic was stunning. I said in one post that if our trading partners have a comparative advantage in cheap labor, they will have a comparative advantage in labor-intensive manufacturing, and we will have a comparative advantage in capital-intensive manufacturing. That bombshell provoked this non-sequitur:

This is the first unrealistic assumption. The businesses of the world do not divide neatly into two categories: the labor intensive versus the capital intensive. There is, rather, a continuum of labor/capital mix with businesses distributed all along it.

That’s all this fellow needed to move on to his real bugbear:

Nor do you take into account the on-going war our Federal and State governments have waged over the last 70+ years against American businesses. The Code of Federal Regulations, which indexes administrative rules, is 161,117 pages long and composes 226 volumes. The great bulk of that regulatory burden rests on the shoulders of America’s businesses. Who can say how much employment has been destroyed -- or run overseas -- by that onslaught of regulation?

Your model ignores all that.

Yeah, who can say? This mess is FDR’s fault.

Of course, empty blue barrels make as much noise as empty red ones, as any visitor to the Daily Kos during the Bush years can attest. Is Al Franken a nicer person than Rush Limbaugh? They’re really the same kind of person, wishing their political opponents personal ill where intellectual argument fails them. Or so it seems to me.