St. Freddie and St. Fannie

Brad DeLong and other commentators seem to have an unnecessary need to prove that Fannie and Freddie's hands were clean with respect to the credit crisis.  The Republican narrative about the mortgage crisis originating with government forcing lenders to loan to unqualified minorities is indeed a bunch of nonsense; the volume of those programs never amounted to anything and subprime borrowers had no particular racial skew.  However, Freddie and Fannie played a significant role in the mortgage crisis because they enabled the market bubble to grow so big.

Fannie and Freddie are $5 trillion dollars worth of the mortgage market.  Their "implicit government guarantee" allowed them to operate at 200:1 leverage ratios, which blew up when not only their subprime portfolio did, but also when their conforming mortgages delinquency skyrocketed.  Fannie and Freddie bought hundreds of billions  worth of subprime and Alt-A-backed securities, which made them a big part of the market for Wall Street to sell their CDO sausages to.

Now, to their credit, the GSEs never touched the most egregious loans like no-docs, "liar loans", and the like that raged at the top of the bubble.  That stuff was the true toxic waste.  But the fact is, the GSEs are in conservatorship right now, pushing losses of tens of billions of dollars a quarter onto the taxpayer, because they took on too much risk with too little capital buffers.  That is what caused this crisis, and Fannie and Freddie definitely contributed to the problem.

What They Never Told You About "Comparative Advantage"

"If there were an Economist’s Creed, it would surely contain the affirmations 'I understand the Principle of Comparative Advantage' and 'I advocate Free Trade'."

-Paul Krugman

David Ricardo first articulated the concept of comparative advantage in 1817.  In a nutshell, it suggests a happy world where each country is better at producing some goods than others, and it pays for each country to specialize in producing goods in which it has the greatest comparative advantage.  In the classic example, Portgual can product both cloth and wine at 90 and 80 labor units, while England can produce them at 100 and 110 respectively.  Even though Portugal is the low-cost producer in both instances, there is more relative profit in wine (30) than in cloth (10), so collectively Portugal can trade wine for English cloth and both parties profit from the relationship.  How all of this magically balances out trade deficits and improves quality of life for everyone is an article of faith within the Economists' Creed.

A key assumption that Ricardo made is today ignored by modern economists:

" ... if capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit, and no other difference in the real or labour price of commodities, than the additional quantity of labour required to convey them to the various markets where they were to be sold."

Guess what?  Capital flows freely around the world today, to every country, except oddballs like North Korea.  Mobile capital seeks cheap labor, cheap land, lax regulatory rules, and low taxes.  Therefore "comparative advantage" is now a race to the bottom for labor, environmental regulation, and progressive taxation.  With free capital, Portugal's low labor costs can now produce both wine and cloth and drive English businesses out entirely.

Modern economists look back upon the 19th century United States with disdain, a country that had booms and busts, no social safety net, little government economic intervention, and no central bank.  It was also strongly protectionist, starting with Alexander Hamilton and maintained by the Whig and later Republican parties.  This was known as the American System, which stood in contrast to the free trade-oriented British System.  These terms are quaint today, but the conflicting worldviews can still be identified in modern free trade debate.

Tariff rates bounced around from a low in 1857 of 18%, to 40-50% that was characteristic of the Gilded Age.  Abraham Lincoln raised tariffs to 49% during the US Civil War.  During the period 1865-1890, America experienced the most rapid growth of its entire existence, hitting 6.8% annual GDP growth and doubling its GDP during the 1880s.  By 1890, in but 100 years, America had eclipsed Great Britain as the world's largest industrial power.  Commitment to protectionism then began to falter, leading to conflict between free trade Democrats and protectionist Republicans.  Future President William McKinley said of this:

"Under free trade the trader is the master and the producer the slave. Protection is but the law of nature, the law of self-preservation, of self-development, of securing the highest and best destiny of the race of man. [It is said] that protection is immoral…. Why, if protection builds up and elevates 63,000,000 [the U.S. population] of people, the influence of those 63,000,000 of people elevates the rest of the world. We cannot take a step in the pathway of progress without benefiting mankind everywhere. Well, they say, ‘Buy where you can buy the cheapest'…. Of course, that applies to labor as to everything else. Let me give you a maxim that is a thousand times better than that, and it is the protection maxim: ‘Buy where you can pay the easiest.' And that spot of earth is where labor wins its highest rewards."

 McKinley successfully passed  through Congress a namesake tariff act in 1890.  To its critics in retrospect he commented:

"What has this Protective Tariff law of 1890 done? Why, it has increased factories all over the United States. It has built new ones, it has enlarged old ones.... [For example, we] used to buy our buttons made in Austria by the prison labor of Austria. We are buying our buttons today made by the free labor of America. We had 11 button factories before 1890; we have 85 now. We employed 500 men before 1890, at from $12 to $15 a week; we employ 8,000 men now, at from $18 to $35 a week."...|Well, but, they said, this tariff law of 1890 was going to increase the price of necessaries of life, and was going to diminish the wages of labor. It has done neither. The necessities of life are cheaper today than they were 18 months ago. The commodities that go into the household of every man and woman are cheaper today ... and the price of labor has increased to some extent."

Contrast this today with those who told us NAFTA and MFN status for China would create American jobs.  Do any pundits today set higher wages and lower product costs as a policy goal today?  No, we are told that higher wages leads to bad "price spiral" inflation, but higher product costs reflect more "quality", demand growth, and other positive things.

McKinley had this to say about land owenership:

``We must avoid in this country the holding of large tracts of land by non-resident owners for speculative purposes, and set our faces like flint against alien land-holding in small or large tracts. Our public domain must be re-dedicated to our own people, and neither foreign syndicates nor domestic corporations must be permitted to divert it from the hallowed purposes of actual settlement by real farmers."

You don't expect to hear Republicans talking like Marxist land reformers.  No doubt the Monsantos of the world are happy to keep this bit of US history dead.

Henry Carey, advisor to President Lincoln and a forgotten economist who promoted the American System, expressed some loftier goals for the battle between the American and British systems:

``Two systems are before the world; the one looks to increasing the proportion of persons and of capital engaged in trade and transportation, and therefore to diminishing the proportion engaged in producing commodities with which to trade, with necessarily diminished return to the labour of all; while the other looks to increasing the proportion engaged in the work of production, and diminishing that engaged in trade and transportation, with increased return to all, giving to the labourer good wages, and to the owner of capital good profits. One looks to increasing the quantity of raw materials to be exported, and diminishing the inducements to the import of men, thus impoverishing both farmer and planter by throwing on them the burden of freight; while the other looks to increasing the import of men, and diminishing the export of raw materials, thereby enriching both planter and farmer by relieving them from the payment of freight. One looks to compelling the farmers and planters of the Union to continue their contributions for the support of the fleets and armies, the paupers, the nobles and the sovereigns of Europe; the other to enabling ourselves to apply the same means to the moral and intellectual improvement of the sovereigns of America. One looks to the continuance of that bastard freedom of trade which denies the principle of protection, yet doles it out as revenue duties; the other to extending the area of legitimate free trade by the establishment of perfect protection, followed by the annexation of individuals and communities, and ultimately by the abolition of custom-houses. One looks to exporting men to occupy desert tracts, the sovereignty of which is obtained by aid of diplomacy or war; the other to increasing the value of an immense extent of vacant land by importing men by millions for their occupation. One looks to increasing the necessity for commerce; the other to increasing the power to maintain it. One looks to underworking the Hindoo [sic], and sinking the rest of the world to his level; the other to raising the standard of man throughout the world to our level. One looks to pauperism, ignorance, depopulation, and barbarism; the other in increasing wealth, comfort, intelligence, combination of action, and civilization. One looks towards universal war; the other towards universal peace. One is the English system; the other we may be proud to call the American system, for it is the only one ever devised the tendency of which was that of elevating while equalizing the condition of man throughout the world.

Once again we see Republicans calling for workers of the world to unite, even using rhetoric reminiscent of historical dialectics.  A far cry from modern Republicans, who have fully bought into the "British System".

Today China, Japan, South Korea, and other nations pursue protectionist trade policies, while US and many European tariffs remain low due to free trade theorists winning the public debate.  Not only is the comparative advantage theory obsolete in this age of global capital flows, but it has obviously unbalanced the distribution of wealth between labor and capital in the developed world.  These faux progressives who advocate free trade today run under a false flag--the capital class rewards them with academic accolades and media play in order to make the public believe that free trade is in their interest.

So Much for "Helicopter" Ben

Setting aside the merits of Ben Bernanke's famous prescription for addressing a depression by dropping money out of helicopters, where are his helicopters now?  Why is he not showering the public in cash to restart the economy, if that's what he believes in?  Methinks his shareholders have his helicopters firmly moored to the ground, as they have no interest in devaluing their debt product.

Modest IMF Proposal to Solve the Greek Debt Crisis: Introducing HABS

This plan, written by an IMF staffer responsible for scheduling evening social entertainment for Dominique Strauss-Kahn, recently fell into my hands:

To: Jean-Claude Trichet, George Papandreou, maidman@imf.org
Cc: ben-contained@federalreserve.gov, godswork@goldmansachs.com
From: [Redacted], IMF Undersecretary for Married Executive Affairs
Subject: Modest Proposal to Resolve Greek Debt Crisis Using Novel Asset-Backed Security
Date: May 12, 2011

Dear Gentlemen:

The ECB has declared that Greek debt restructuring is "off the table".  As negotiators in Europe struggle with an intractable foe in the Greek debt crisis standoff--mathematics--I believe that there is an unconventional option, that has heretofore not been considered, that may be the only way to keep senior creditors whole.  Which is, after all, the primary directive of modern Western governments.  At the same time, we may be able to get these same creditors to accept impairments, which is the key to achieving political compromise.  Let me elaborate further on how to achieve these seemingly contradictory goals.

The Greek debt to foreigners outstanding amounts to some $481.5 billion dollars.  Most of this debt was created by European financial institutions such as Commerzbank, BNP Paribas, Hypo Real Estate Holding AG, Société Générale, and Crédit Agricole.  US financial institutions are rumored to be on the hook for credit default swaps written against this debt.  Nobody really knows the exposure distribution because BIS keeps that secret.

It turns out that history gives us some guidance in this policy matter.  When Roman tax burdens, debts, and inflation got to a certain point, the middle class sold themselves into slavery to wealthy patricians in order to get relief from bill collectors who wielded unlimited powers to terrorize.  In the 17th century, a more humane institution was introduced, that I am proposing to resurrect with some modern enhancements: indentured servitude.  This admittedly unconventional measure will present creditors with a bond swap deal that is too good to refuse.

Here is the heart of my proposal.  There are approximately 6.6 million men and women of working age in Greece.  Each of the able-bodied will be pooled into Human Asset-Backed Securities (HABS) as indentured servants.  The HABS trust collateral assignments will be enforced by the Greek government (i.e. military), and trust administration will be contracted to a qualified financial advisory firm (you reading this, Lloyd?).  The trusts will then grant shares to creditors in proportion to the debt owed, in exchange for outstanding conventional debt dollar-for-dollar.  These citizens will then be be assigned work by the financial institutions, for example in portfolio companies owned by the institutions' private equity divisions.  They may also be used in trading desks to buy US Treasuries and flip them to the Fed, make buy-side recommendations on whatever the sell-side needs to unload, buy up commodities and store them on leased ships anchored in international waters, etc.  The point is these potential Greek servants are very versatile and represent an undervalued asset both to the Greek government and to European financial institutions.  Average Greek worker productivity is twenty dollars per hour or about $40,000 per year, so the financial institutions should be able to get plenty of value out of the servants.

Each former Greek citizen will be allocated a subsistence wage of $11,500 per year to pay for the cost of living (the income poverty line in Greece is about $8,000/year, so this plan will have the bonus social benefit of ending poverty in Greece).  In exchange, Greek citizens will be generously granted by senior creditors a $15,000/year impairment towards the existing debt balance.  Let us not call this an austerity program; it is highly progressive and technically will lift the Greek masses out of poverty.

Table 1: Annual Cash Flow Model For Greek Indentured Servant
Avg Greek Worker Annual Productivity	$40,000
Annual Subsistence Wage	$11,500
Annual Impairment	$15,000
Retained Productivity Per Worker	$29,500

As you can see, the yield on these human assets is very attractive as long as they are performing, and the subsistence wage can potentially be garnished as a form.of credit enhancement to the security.  The productivity value margin is more than 2.5x the impairment credit, and using the same risk models used to predict default rates in CDO^2 deals a few years ago we have calculated that the risk of loss to senior creditors is less likely than the US Congress passing a law to demolish K Street and turn it into a national monument dedicated to the fight against government corruption.

Let us now turn to the debt retirement schedule. We should set a goal of repaying the debt within seven years, which is currently the average maturity of Greek debt, because we don't want to inflict any duration mismatch headaches upon our esteemed financial institutions. With 6.6 million Greek indentured servants being granted $15,000 in impairment credit in exchange for their labor, a total of $99 billion dollars per year in debt will be retired as impairment.  Within seven years, the debt will be entirely extinguished according to this schedule:

Table 2: Greek Debt Repayment Schedule (in Millions)
Schedule Item	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7
Debt Balance	$481,500	$405,612	$326,081	$242,733	$155,384	$63,842	$(32,092)
Interest (@4.8% Avg Coupon)	$23,112	$19,469	$15,651	$11,651	$7,458	$3,064	$(1,540)
Annual Impairment	$99,000	$99,000	$99,000	$99,000	$99,000	$99,000	$99,000

At the end of seven years, the Greek balance sheet will be spotlessly clean, and the Greek human assets can roll off of the HABS, once again free to rack up massive debts while drinking Ouzo.  Whenever the Greek government needs to borrow again, a new HABS structure can be created and citizens rolled back into it.

Since the creditors will eagerly sign up for this plan (once-in-a-lifetime opportunity to grab some yield), no credit event need be triggered, so all of the CDS writers can rest easy.  The latter may now have the opportunity to write life insurance policies against Greek servants with their owning financial institutions as beneficiaries.  One could use Greek underwriters and now it's a job program to improve the Greek government's popularity.  The synergies are self-reinforcing.

The key innovation in this plan is to barter Greek citizens' liberty and labor in exchange for credit impairment concessions on behalf of senior creditors.  This is a win-win for all parties: the Greeks gain a novel way to pay off their debts, the financial institutions receive compensation far in excess of their current yields in exchange for impairment on current assets, and the Greek government gains a whole new asset base against which to borrow.  If we can get the Papandreou government to agree to sell the public (literally), we may yet be able to head off the crisis. In the spirit of compromise, let everybody share in the sacrifice.

Q&A
Q: The term "indentured servitude" has some negative connotations.  How do you propose to handle this?
A: I propose to substitute the term "Financial Freedom Contract" to emphasize the freedom the servant will feel when the debt is paid off in seven years.

Q: If all Greek working age adults are conscripted into indentured servitude, what will happen to the children and the elderly?
A: The children can be held in reserve and periodically sold to the black market to provide fixed income stability for the security trusts.  The elderly can be used to provide extra liquidity, perhaps for a Soylent Green-type secondary market.  Lord knows you can never have too much liquidity.  Perhaps this is something that Lloyd would be interested in making a market in?

Best regards,

[Redacted]

PS Dom I think you'll like the service at the Sofitel, don't be shy about asking if you want anything.

The Return of the Luddite

If the Luddite fallacy were true we would all be out of work because productivity has been increasing for two centuries.

This quote from economist Alex Tabarrok is found all over the Internet as the definitive reductio ad absurdum dismissal of the Luddite fallacy.  It's on Wikipedia, and is almost certainly Dr. Tabarrok's most widely quoted quote.

Let me start deconstructing this by providing a counter example:

Productivity has been exponentially increasing for two centuries, and yet we are not all millionaires working one hour per month.

Back in the 1950s futurists projected that, with wage and productivity trends, there would be a major societal problem by the 1980s regarding what workers would do with all of their leisure time, when working four hours per week.  Needless to say that didn't happen.

There are two primary reasons for this: one, is population growth has kept the supply and price of labor in check, and two, workers have not seen most of these productivity gains reflected in their paychecks.

Economist William Easterly offers the following criticism:

[...]the "fallacy" of the Luddites lay in their assumption that employers would keep production constant by employing a smaller albeit more productive workforce instead of allowing production to grow while keeping workforce size constant.

Dr. Easterly never interviewed any Luddites I am sure, but there is no reason to believe that they expected employers to keep either production or workforce size constant.  Most employers are trying to continuously optimizing to produce more with fewer workers--the definition of productivity.  Automation allows them to do exactly that.  In other words, employers face no fundamental tradeoff between production and workforce size--they can and do have both greater production and smaller workforces as productivity improves.

Agriculture is a perfect example of this phenomenon.  We produce more agricultural products today than ever, with a fraction of the labor required in pre-industrial times, thanks to advancements like combines and fertilizers.  US manufacturing output is higher than ever, yet the manufacturing labor force is less than half the size it was back in the 1950s heyday.  The Luddites didn't make any false assumptions--they knew exactly what the plan was and they were right!

Now, one may point out that the agriculture story demonstrated how the loss of jobs and reduction in the cost of goods in one industry (agriculture) freed up labor and consumer spending to enable the manufacturing revolution, and a similar story can be told as manufacturing industry labor need gives way to that of the services economy.  Ok, but this leads to the key question:

When all goods and services production is automated, what's left for humans to do that someone will pay them to do?

The standard answer that new technologies will create new jobs and services is certainly partly true, but saying that there will be enough jobs created thusly to employ the growing population is an article of faith unsupported by any facts.

Immortalized in the tale of John Henry and the Steam Engine, people have recognized for a long time that technology advancement creates labor winners and losers.  Losers are humans replaced by automation.  Winners are those who fulfill new labor opportunities afforded by the new technology.  Economists usually make the following argument that sounds like a law but has no name as far as I can tell:

1. Technology improves productivity

2. Productivity lowers production costs

3. Lower costs means lower goods prices

4. Lower prices means higher demand

5. Higher goods demand results in more labor demand

There is no doubt that technology destroys some jobs while creating others.  I argue, though, that there is no promise that as technology advances, the process of "creative destruction" as von Mises put it will forever result in a positive job growth balance, which is necessary as long as human population is growing and we have a more or less free market system.

As this chart from Jared Bernstein's blog shows, something seems to have happened in the year 2000 that suggests that we may have reached a point where computers and robots have gained the upper hand:

US productivity per employee has accelerated, while employment growth has decelerated.  Certainly multiple factors are at work here.  One is overseas offshoring, which has contributed to US company topline revenue while suppressing labor growth.  Another is the rise of Internet businesses, which are capital intensive but require very small amounts of very skilled labor.  Google makes more than $1 million dollars in revenue per employee, an incredible productivity statistic.

We need only look outside the US to other countries that have high double-digit unemployment rates to see that there is no mystical rebalancing function in an economy that will create an equal number of similar-paying jobs when technology obsolesces a job function.  If there were, then horses would have found jobs by now after being displaced by motor power a hundred years ago.  And don't tell me horses can't learn new tricks.

The Most Important Issue of the Future

I believe that the most important issue that we face in the future is that technology is eliminating the need for human labor at an accelerating rate, while population grows and the need for people to make a living continues.  Much like we produce orders of magnitude more agricultural products today with a tiny population devoted to farming, the same story has played out with manufacturing, and now with other industries as well.  We face a future where we only need 2% of the population engaged in production.  How will the other 98% make a living?

There are two possible outcomes that I foresee: a Marxist revolution where "the means of production" are socialized, or a drastic Malthusian reduction in human population to a level required by the economy of the future.  Hopefully the proletarian revolutions of the future have better outcomes than the ones of the 20th century.

The consumerist capitalism of the 20th century is in a negative feedback loop that is destroying itself: competition is driving cost efficiencies that reduce labor inputs that reduce disposable income and reduce demand.  This has been occurring for many years, and has been masked by an expansion of consumer credit since the 1970s that exploded in 2007.

I found a blog today that features this theme: http://econfuture.wordpress.com/, and I will be writing about it more in the future here.