More arguments against mark to market acounting

I have twice posted arguments against the practice of mark-to-market accounting, here and here.

Now Brad deLong recently posted another concise takedown of mark-to-market practice. If you believe in organizational capital--in goodwill--in the value of the enterprise's skills, knowledge, and relationships as a source of future cash flows--then marking it to market as if that organizational capital had no value is the wrong thing to do.

Especially times in which asset values are disturbed and impaired are likely to be times when the value of that organizational capital is highest.

If you believe in mean reversion in risk-adjusted asset values, mark-to-market accounting is the wrong thing to do.

If you believe that transaction prices differ from risk-adjusted asset values--perhaps because transaction prices are of particular assets that are or are feared to be adversely selected and hence are not representative of the asset class--then mark-to-market accounting is the wrong thing to do.

If you believe that changes in risk-adjusted asset values are unpredictable, but also believe: in time-varying required expected returns do to changing risk premia; that an entity's own cost of capital does not necessarily move one-for-one with the market's time-varying risk premia, then mark-to-market accounting is the wrong thing to do.

There are of course good arguments favouring the continuation of mark-to-market, and many of those arguments are reiterated in the comments section of Prof. deLong’s post. However, I stand by the argument that mark-to-market is a destabilizing force, particularly during times of extreme volatility. It is pro-cyclical, and creates artificial and fleeting capital buffers during times of bullishness, only to take it away, and then some, during bearish periods.

It is detrimental to long-term planning, to long-term financial strategies, or to long-term policy implementation. While it is true that a world without mark-to-market is, arguably, a less transparent world, a world with mark-to-market is a world ripe for manipulation, destabilization, and perhaps, even less transparency. Yves Smith posts about recent bank practices coming to the fore, that serve to sidestep around the original intent of mark-to-market.

What we can use in place of mark-to-market is, of course, the historical cost accounting method, long used before mark-to-market was ever conceived of as an alternative. While historical cost may hide the true liquidation value of securities holdings of financial firms at current mark-to-market prices, a liquidation scenario is only realistically imminent for a few firms at a time.

But in an mark-to-market environment, a liquidation by a single firm can cause a domino effect of forced liquidations scenarios across an entire class of securities, or even the entire financial industry. The capitalist system is already precarious as it is, without having to add more potential sources of debilitating contagion.

Using mark-to-market in accounting for liquid securities is counter-productive, and at best, incomplete. After all, if you really wanted to account for the potentially greater source of instability in the banking industry, you shouldn’t be keeping score on just their liquid securities holdings. Commercial banks, in their regular course of business, mismatch funds when they lend medium and long-term loans to borrowers, while funding/backing these with short-term deposits.

Now, if we were truly supposed to account for complete transparency, shouldn’t we also be requiring the booking of these loans at bank liquidation value? What will that tell us about the viability of banks?

The case for government takeover of banks receiving bailout

In a previous post, I opined that the best TARP plan is the one calls for the government acquiring active stakes in the banks, in exchange for taking bad assets out of their books. Nationalizing the banks completely is a move that the government has been reluctant to take. Policy makers believe that government will never be as good as the market in allocating capital, a principal function of the banks. That’s true, but we may have to make an exception this time around, given the market environment we currently have.

When the crisis has been contained and people are investing again, then the banks that are able to raise private capital can get out of outright government ownership. But for now, my instinct tells me that government ownership of banks makes a lot of sense. Here are some reasons why:

1. The Government already guarantees most bank loans, deposits, and assets anyway. Remember the Citibank deal? Government has nationalized the bank, but in return for a guarantee amount that would otherwise have necessitated a full takeover, government acts as a backstop to the bank’s liabilities. Should Citibank’s assets continue to decline, the government will end up paying much of the bank’s liabilities. Government would have to put up the funds, either depleting Treasury funds, or printing more money.

Financial markets have come to expect the Fed to come and bail out troubled large financial firms institutions, with the rationale that there are firms too big to fail. With the financial markets more inter-connected than ever, there is widespread belief that a failure by a large counter-party is bound to spread to the rest of the financial system, and hence, widespread sentiment that prudent policy dictates lifelines be extended during times of trouble for said privileged firms.

The practice of bailing out institutions in financial distress creates the moral hazard that these firms will continue to take ever-larger risks in the future. This has created a breakdown in market discipline, as market participants take on larger and riskier bets, with the expectation of benefiting from the higher potential up-side, while being bailed out by taxpayer money in the event of a down-side. Government takeover will teach these banks that in the future, untamed risky behaviour can have bad consequences, and government bailouts come at a price.

2. Banks are inherently risky, and the current crisis of confidence is not helping any. So here we are, with giant, inter-connected banks loaded with toxic securities, and no willing market to buy them out. No bank would of course unload them at firesale prices, and no body knows how much of these toxic securities are in each bank’s books. A consequence of course, is the loss of credibility of banks among each other. No bank will lend to another bank that can, at an instant, need to liquidate at firesale prices, and default on its borrowings as a result.

Asymmetrical information abounds in most financial transactions. This creates an imbalance of power in transactions, which have great potential to go awry. Because of increased economic concentration among financial institutions, and asymmetrical information, there are now, more than ever, greater opportunities for moral hazard. Market actors have lately been acting with impunity, with the expectation of relatively low downside due to societal bailouts of failure. This was the case in many of the recent financial transactions that have recently undermined the capital markets. This is a principal reason the financial crisis has reached epic proportions.

Government takeover will help stabilize the financial markets, as bank equity will no longer be driven by risk-averse private sector speculators. It will help shore up waning confidence among counterparties, depositors, and creditors, who need to know that they are dealing with a stable entity that is not out to unload questionable risk on to unsuspecting parties.

3. Banks are still populated by risk-chasing, bonus-obsessed me-first capitalists. This cultural mindset is deep-set, and comes from more than quarter century of unrelenting encouragement of cowboy risk-taking by ‘big swinging dick’ traders and bankers. This needs to change, and may only come under government ownership.

Wall Street still believes, often rightfully, but many more times not, that its biggest assets are the ones who go down the elevator every evening. As a result, many firms are always apprehensive that, if unhappy, their biggest producers could leave any time to go to the first competitor willing to pay more. So, in the midst of a big recession, when the rest of the economy goes down the toilet, while bank after bank requests, and receives, a government bailout, financial firms are still handing out generous bonuses. Even the very same firms who have received the bailouts!

4. Pursuit of profit sometimes goes in the way of banks’ ultimate goal – facilitating trade. A private, for-profit company’s objective is first and foremost to make a profit. If the company’s shareholders are of the shareholder value maximization school, they will want to maximize profits first and foremost. Any gains in monopolistic power that translate into greater economies of scale can therefore lead to greater opportunities for these same players to further increase their gains over competitors.

In frantic efforts to chase after profit during the boom, banks continually undermined their own lending standards. More and more aggressive practices emerged, as bankers tried to outdo one another in landing the transactions that seemed theirs for the taking. All were done to keep the juicy profits flowing to their own institution. It was always easy to justify that, since every other financial institution was doing the same, keeping their banks out of the game would only make their own shareholders unhappy, and encourage their more ambitious employees to jump ship, and do the same scams elsewhere. As one famously put it, when the music started, you had to dance.

Remember the proverbial “the bank gives an umbrella to you when you don’t need it and takes it away when you need it”? Well, now, to keep their financial institutions viable, particularly in a declining economic environment as this one, bankers have had to pull the plug on their crucial lending activities at the worst possible time, when borrowing firms need money to remain viable themselves.

To keep the corporate market afloat, the Fed has now been buying commercial papers itself. It is jumping into the market because banks have been hoarding capital, and have been reluctant to lend money out at any cost. It is guaranteeing all inter-bank lending, also with the aim of jumpstarting a non-existent inter-bank credit market.

It’s becoming more evident that the US Treasury’s capital infusion into the banks is unsuccessful in jumpstarting lending. Lenders have been pulling back on credit lines for businesses, mortgages, home equity loans and credit card offers, and analysts have said that this was unlikely to be reversed by the government’s money. Outright government ownership would now seem much more effective in getting credit flowing again, given the reality we are seeing.

5. It is getting harder to regulate banks, who are always a step ahead in arbitraging regulation. Ideally, the banks remain private institutions, regulated with great scrutiny by the Fed. But to be able to this monitoring adequately, the Fed will have to drastically increase its personnel. It needs to do so to beef up its expertise in watching over securities firms, whose activities have been becoming more complicated, thanks largely to the accelerating pace of financial innovation. Actively regulating the new and much-broader activities, especially of the financial supermarket firms, will only increase the federal budget, and yet, in my opinion, bankers who still wish to circumvert the Fed’s policies and regulations will always be one step ahead of the regulator.

Government ownership of banks will put a momentary brake on unbridled financial innovation, limit the need for more expert bank auditors who at the end of the day can do nothing more than arms length examinations, and, with a first-hand view of banks, get the government up to speed on what the financial market has been up to these past few years.

Government-sponsored healthcare during a recession

One of the questions during the US presidential debate was whether healthcare was a right, a privilege, or a responsibility.

In an ideal world, this should be a right. If one is sick, one should be able to expect from his government the care deserved by any human being.

Healthcare is scheduled to become the largest expense, and most possibly, the largest sector in the global economy in the coming decades. With the continuing increase in life expectancy, more and more people are rushing into the senior demographic. Many of today’s seniors are likely going to be still around in ten years, but more are going to be joining them in the coming years. And with the baby boomers of the developed countries joining this demographic en masse in this coming decade, we are bound to see a boom in the number of retirees, and in healthcare expenses nationally.

Unfortunately, unlike manufacturing, trading, or many service industries, healthcare is not value-creating. It is, by its essence, value-consuming. Most other businesses, those that sell tangible products are able to create livelihood for their employees, promote trade, and generate profit for the business, or surplus for the economy - profit or surplus which can then be used to fund more activities. Healthcare, meanwhile, while providing livelihood for its medical practitioners, eats away from its patients’ incomes, and the more healthcare needed, the more income eaten away.

Healthcare takes away resources that might have been used to grow the economy. The more sick people a country has does not bode well for the country, no matter how much income that could mean for its domestic healthcare economy. Sickness is always value-consuming, and the more that it spent on it, the less is spent elsewhere on value-creating activities.

With a long and protracted recession world-wide, governments will be hard-pressed to maintain many of its existing expenditures. Any expenditure that governments maintain, and even more so, increase, need to help jumpstart economic activity. These should therefore be expenditures that result in the creation of jobs.

In today’s recessionary environment, healthcare is more a privilege than a right. It is a provision that will be given only if there are any funds left over after all other national expenses. What is necessary, going in the direction of solving the problem, is to increase society’s over-all ability to pay for healthcare.

Firstly, people will need to be able to continue working, to help pay for their healthcare, for as long as they need it. Secondly, the number of people in working age should increase proportionately to the number of people taking healthcare benefits. That means that the larger the number of people expected to enter their senior phases in coming years, the greater the proportion of working people need to enter the workforce to help pay for these government expenditures. And third, more activity has to be put in value-creating economic activities. Any and all incentives needed to encourage more investment in job-generating economic activities will have to be put in place.

Local consumers and world trade parity

For decades, for much of the developing world, the principal strategy of economic development has been to run trading surpluses, and to use this surplus as the fuel for domestic economic growth. Continuous trade surpluses were possible for these nations when much of the high valued –added manufacturing of the most commonly-demanded goods of the world have been outsourced to their domain. Outsourcing production to low wage countries grew out of Western corporate strategy of increasing shareholder returns on investment, by constantly lowering over-all expenses of the firm. Major activities were uprooted from their home countries and transferred to other countries that could offer lower input labor costs.

Low wage advantage resulted in more and more processes being outsourced to these low wage countries, resulting in economic growth for their nations as a whole. But low wages is a double-edged sword. Low wages meant that, on an individual level, most of these same workers toiling to create most of the world’s goods did not earn enough to afford these same goods for themselves. So no significant market arose in the developing markets for the very products these factories and companies were creaking out. For many of those toiling in the factories, the goods they made were a luxury they can only dream of.

This is how it's always been in much of the developing world. Years of economic growth may have resulted in constantly improving national accounts, but comparative advantage that comes from maintaining low wages across the board for entire swathes of the local population, instead of true value creation, does not a vibrant domestic consumer economy make. So their countries’ continued growth has rested on the Western, and particularly, the American consumer continuing to buy their excess production.

The displaced workers in the developed countries likely found new jobs in other companies, but the transition wasn't equally easy for everyone. Moreover, because of the downward effects of the globalization, many of the displaced workers in the developed countries could no longer demand increasing wages from their employers. Because much of the work they did could now be standardized, codified, and therefore, be done in any other place in the world, this constrained their ability to negotiate increasing amounts of compensation. For a while, the decreasing cost of goods mitigated this stagnation in wages. But now, with a full-blown credit crisis, and a rollback from the longest over-expansion in the world economy, the reverberations in the consumer side of the economy are only beginning to be felt.

Hence, with the fallback in American spending, who is left to plug the gap in orders? Certainly, it’s not going to be their still poor domestic consumers of the developing world. So for as long as the American consumer remained the principal source of growth for the rest of the world, there was to be no decoupling of the global economy from the American economy. In fact, now more than at any time in the world’ history, if America sneezes, the rest of the world will catch cold. The hardest hit will be the developing countries.

Many developing countries therefore need to change their mindset. They need to refocus from encouraging only businesses that strive to be the lowest-cost producers of everything, into encouraging businesses who can transform their countries into more innovative, technology-building centers.

Therefore, they need to develop more local entrepreneurs who will be willing to pay better than low wage, and focus their business-building efforts on developing niche markets in the domestic economy. The goal of becoming the back-end supplier of finished goods for the developed world is now insufficient to guarantee continued economic prosperity. To maintain economic prosperity for all, all countries need to develop DOMESTIC CONSUMERS.

Both the developed and developing worlds will each have to become more equally divided into being both consumer and producer economies. However, these developing country companies will have a natural limit to their growth, and that limit is what local demand can sustain. This limitation is a crucial constraint to how much higher current levels of local wages can increase.

Hence, for this national reorientation to work, change efforts need to be national in scale. Only in an environment where all businesses will be focused on creating greater value for the local consumer, while at the same time creating a local consumer able and willing to buy their goods, will this change work.

When the developing world has succeeded in getting much of its local wages and standards of living to world parity, then maybe globalization can start to work. Because only in such an environment will true comparative advantage among nations exist. Right now, what we have is absolute advantage. And the advantage goes to multinational companies who benefit by pitting off populations against each other.

In 1913, Henry Ford reputedly increased pay for his workers, so that he could create a new class of middle class people who could go out and buy his cars. Now more than ever, the world needs an army of “Henry Fords” the world over, to get itself out of recession. Are they being constrained by world-dominating multinational pricecutters?

The different iterations of TARP

Thus far, we have seen three versions of the TARP. Every iteration has been a case by case reaction to the adverse environment of the moment. But since the financial markets continue to be roiled, and we have as yet to see a version that works, let’s review the versions we’ve seen so far.

TARP 1: Purchase bad assets. This was the original plan. The plan calls for the government to set up an entity that will take out the toxic CDOs from the books of the financial institutions, warehouse these securities while the banks re-build their balance sheets and start lending again, and at some point in the future, resell the CDOs to the market. With CDOs no longer in banks’ books, they will no longer have an asset class with a continuously declining value. They can then focus on re-building their asset base, confident of the stability of their remaining assets.

Worst case scenario – Treasury misprices the toxic assets, and overpays for the assets. This would have proven a bad deal for the taxpayers. Or it underpays for the assets, and ends up destroying bank capital.

TARP 2: Re-capitalize the banks. Because an unintended consequence of underpaying for bank assets is that unless the government’s capital injection is sufficient to provide adequate capital cover for the banks, these banks will have to operate either at sub-standard capital ratios, or start providing loans at more prohibitive rates, to earn back their lost capital. The next iteration, therefore, was to purchase bank equity instead of purchasing bad assets. This iteration would have solved the banks’ equity problem.

Worst case scenario – Since the bad assets in this option remain on bank balance sheets, their continual decline results in further deterioration of bank capital, and the government ends up re-capitalizing the banks repeatedly. Government would have ended up taking over the banks.

TARP 3: Guarantee bank debts. This was the Citibank deal. Government does not buy bad assets, nor does it nationalize the bank. But in return for a guarantee amount that would otherwise have necessitated a full takeover, government acts as a backstop to the bank’s liabilities.

Worst case scenario – Since the bad assets remain on bank balance sheets, their continual decline will result in further deterioration of bank capital, with the government ending up paying for the bank’s liabilities. Government would have to put up the funds, either depleting Treasury funds, or printing more money. By printing money, currency loses value, and results in inflation in basic commodities.

What would have been the best option? Given that all options would have had serious consequences, it’s a tricky question to answer. But a hyper-inflation coming right out of a debt deflation environment would have catastrophic results to those worst-hit during the deflation. Option 3 should not be pursued going forward. Option 2, complemented with a little of Options 1 and 3 could be best. It calls for acquiring stakes in the banks, in exchange for taking bad assets out of their books. But it will be for a price that re-capitalizes the banks adequately. If it turns out nationalizing the banks completely, then so be it.

When the crisis has been contained and people are investing again, banks that are able to raise private capital can get out of outright government ownership. Wasn't this the original intent after all?

Recent economist writeups on John Maynard Keynes

There have been several writeups lately about John Maynard Keynes, and specifically of his ideas. There now is a growing consensus that his policy prescriptions could be best to get the market flowing again.

This is from a writeup by Greg Mankiw from the New York Times.

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

The situation reverses, Keynesian theory says, only when some event or policy increases aggregate demand. The problem right now is that it is hard to see where that demand might come from.

Keynesian theory suggests a “paradox of thrift.” If all households try to save more, a short-run result could be lower aggregate demand and thus lower national income. Reduced incomes, in turn, could prevent households from reaching their new saving goals.

That leaves the government as the demander of last resort. Calls for increased infrastructure spending fit well with Keynesian theory. In principle, every dollar spent by the government could cause national income to increase by more than a dollar if it leads to a more vibrant economy and stimulates spending by consumers and companies.

Paul Krugman summarizes Keynes ideas in these bullet points (HT Mark Thoma)

Stripped down, the conclusions of The General Theory might be expressed as four bullet points: • Economies can and often do suffer from an overall lack of demand, which leads to involuntary unemployment
• The economy’s automatic tendency to correct shortfalls in demand, if it exists at all, operates slowly and painfully
• Government policies to increase demand, by contrast, can reduce unemployment quickly
• Sometimes increasing the money supply won’t be enough to persuade the private sector to spend more, and government spending must step into the breach

Robert Reich operationalizes the ideas further:

John Maynard Keynes understood: when the economy has as much underutilized capacity as we have now, and are likely to have more of, government spending that pushes the economy to fuller capacity will of itself shrink future deficits.

Conservative supply-siders, meanwhile, will call for income-tax cuts rather than government spending, claiming that people with more money in their pockets will get the economy moving again more readily than can government. They're wrong, too. Income-tax cuts go mainly to upper-income people, and they tend to save rather than spend.

Even if a rebate could be fashioned for the middle class, it wouldn't do much good because, as we saw from the last set of rebate checks, people tend to use extra cash to pay off debts rather than buy goods and services. Besides, individual purchases wouldn't generate nearly as many American jobs as government spending on infrastructure, social services, and green technologies, because so much of we as individuals buy comes from abroad.

So the government has to spend big time. The real challenge will be for government to spend it wisely -- avoiding special-interest pleadings and pork projects such as bridges to nowhere. We’ll need a true capital budget that lays out the nation’s priorities rather than the priorities of powerful Washington lobbies.

Who ultimately benefits from local fiscal stimuli?

Many governments are coming to realize that the most effective way to get their respective economies moving again is through a fiscal stimulus. With monetary policies and various central bank actions still proving insufficient in jumpstarting capital markets and inducing consumer spending, the only clear government action left is through fiscal action.

Fiscal stimuli can take many forms: tax refunds, transfer payments to consumers (stimulus checks), or direct subsidies to retailers.

There’s just one thing I am wondering about now. There is no denying that world is now more inter-linked and inter-dependent now than ever before. Global trade is deeper now than the last time a major economic stimulus was taken on the scale necessary today.

Given this, just how much of a local stimulus is likely to trickle away to a nation’s top trading partners. In other words, if the US undertakes a huge fiscal stimulus, so as to induce local consumers to consume, who are going to be its direct beneficiaries?

Sure, the local US stores will benefit. The local logistics chains will also likely pick up business. But the ultimate beneficiaries will likely be the manufacturers and high value-added producers that produce the goods that the consumers will buy. These would come from the biggest net exporting nations to the US. In short, a big US fiscal stimulus will likely also pick up the economies of these fortunate nations.

Is this the reason the Harper government in Canada is waiting for the Obama government’s plan before deciding to undertake on its own stimulus? If it is, and the Harper solution is similar to the preferred solution of governments the world over, then we are only going to propagate the unsustainable balance of the US being the consumer of last resort while the rest of the world over-produces. We need to have a new focus of economic development. It is long over-due.