Archive for June, 2009

Random Links LX

Posted in Links on 20090629 by Avenging Sword

Credit Cards:,9171,1893507,00.html,8816,1897362,00.html

McCain Alternate Economic History:  Why the economy might be much the same had McCain beat Obama.

Obama Stimulus Timing:

McArdle & Co. Critique Warren’s Medical Bankruptcy Study:


Critiques by McArdle et al:

Phosphorous & Agriculture: Recall that there’s a difference between running out of phosphorous, & running out of _cheap_ phosphorous.  Note also the exported half of our agricultural production is (effectively) optional, insofar as it’s unnecessary for supplying American food needs.  See also Peak Oil Debunked, as well as USGS Mineral Commodity Summary for phosphate rock.

Bare Branches & Polygamy Redux:

Income Growth, Deleveraging, & Consumption Stabilization

UK Austerity

Second Amendment Incorporation


Risk Aversion & Financial Death Penalties

Posted in Econ on 20090624 by Avenging Sword

A while back I read about Canada’s banking system.  It seemed to me that one of the main reasons why Canadian banks have fared relatively well in the crisis was the prevalence of a risk-averse culture among not only Canadian regulators, but also Canadian bankers.  The former, admittedly, appear to be aided by “principles-based regulation” – whose vagueness ironically (and beneficially) tends to induce a “chilling effect” (*) amongst those who’d take risks in Canada’s banks.  While I’m no fan of vague legal provisions, they may well have their place in financial regulation.  Still, the effectiveness of such laws would still depend on regulators; and regulators didn’t exactly acquit themselves well in the build-up to the financial crisis.  It’d be nice, therefore, if we could somehow induce American bankers to permanently adopt the same sort of risk-aversion that dominates their Canadian counterparts.

Now comes Delong with the following proposal (HT Steve):

I believe we need compensation reform: compensation schemes that make it a complete personal catastrophe for the CEO and all other employees if their bank fails. If managers and traders are, personally, wiped out–reduced in assets to their last two cars and their last four-bedroom house–if any financial institution they worked for goes bankrupt anytime in the next two years, then we have a chance of creating sufficient caution. Otherwise, I don’t see how we do it.

This reminds me of Kling’s proposal to jail the executives of failed banks.  Imprisonment seems a bit harsh for “mere” malfeasance; I like Delong’s better.  Let’s pass a law:  If financial firm requires a government bailout or resolution (e.g., via FDIC), all of its executives, traders, & loan officers shall be required to file for Chapter 7 bankruptcy, with the proceeds of the liquidations going to the creditors of their firm.

If bank failure is personally very costly for the executives & traders that run banks, those employees will have far stronger incentives to avoid any action that might result in such an outcome.  Voila:  a culture of risk-aversion among American bankers.  Recall also the “agency problem” that financial firms (and publicly-held companies in general) tend to pose:  If bank failure is either costless (or relatively less costly) for bank employees as compared with shareholders, the former will have greater incentives to take risks that shareholders, with skin in the game, might wish to avoid.  Threatening banks’ Powers That Be with bankruptcy in the event of failure might be a good solution to this agency problem.

We might also get some interesting knock-on effects, e.g.,

  1. Deterring aggressive risk-takers from entering banking;
  2. Deterring complexity in financial engineering (owing to the possibility of failure via unforeseen consequences);
  3. Deterrence, more generally, of the “best & the brightest” from pursuing careers in finance (since #2 creates less demand for their abilities).

Some might consider these downsides, but I’d consider them features, not bugs.  We don’t want risk-takers; we want conservative temperaments who’ll stick with what works.  And I’d much prefer to see our best & brightest designing microchips, or nuclear power plants, or green energy, or the like, rather than figuring out increasingly clever ways of shifting money around.

Another upside to this proposal is its simplicity:  no need for government to get involved in the nitty-gritty of designing banker compensation packages.  Let bankers compensate themselves however they want, so long as their firms remain solvent.  The government only gets involved in the event of failure.

(*) I.e., Since potential risk-takers can’t be sure of a regulation’s boundaries, they’re excessively cautious.  The term “chilling effect” is from First Amendment law; it refers to the ability of a vague law to “chill” speakers’ speech via uncertainty over precisely what sort of speech is illegal.

Random Links LVIV

Posted in Links on 20090623 by Avenging Sword

Nuclear Energy Costs:  What’s unclear from the article is the extent to which these cost issues may be permanent (as opposed to temporary).  Government-imposed delays (e.g., unwillingness to approve rate increases) are removable via proper policy (as the article acknowledges WRT India & China).  Moreover, I wonder how much of Finland’s cost & delay problems are due to the fact that the country hasn’t built a nuclear plant in 30 years (in which case, teething problems are inevitable on the first few plants, owing to lack of skills & experience on the part of those doing the construction).  Again, this latter problem wouldn’t be a long-term issue in a sustained campaign of nuclear construction; the first few plants would of course experience delays & cost overruns, as we scaled the learning curve, but the later ones would not (once we arrived at the maximum of said curve).

Reasoning by Analogy:  “…intelligence is the ability to use analogies validly.”

How & Why to Learn About Everything:

How Oil Pricing Works:

Terror Presidency Watch, Detainee Shell Game Edition:  To have clean hands is to have no hands at all.  A while back, I idly speculated that extending habeas & other rights to terrorist suspects at Gitmo & elsewhere (such it became effectively impossible for the USG to hold them w/o trial anywhere in the world) would result in the USG, military, etc., simply killing such suspects instead of capturing & interrogating them.  The inability to extract information from a dead (potential) terrorist would be (somewhat) balanced by the neutralization of the individual in question.  Looks like that might be happening.

Frannie Duration Mismatch: So long as securitized mortgages are turned into pass-through MBS, duration mismatch is irrelevant, since such MBS basically toss interest-rate risk onto investors.  If, however, these mortgages were purchased using agency debt, & interest rates increase, we could end up w/ a Frannie version of the S&L crisis (recall how the latter got killed when high interest rates both devalued their mortgage portfolios while blowing up their funding costs).  OTOH, if Hempton is to be believed, Freddie was on the lookout for this sort of risk, and acted appropriately to reduce it.

Squid Sight: “…certain squids can detect light through an organ other than their eyes as well.”

Nostalganomics:  So, mass low-skill immigration exacerbated US inequality, both by depressing low-skill wages, and by importing more poor people.  It follows that restricting low-skill immigration would halt/reverse these effects.  (It also suggests that increasing high-skill immigration while restricting low-skill types might actually reduce inequality, by exerting downward pressure on the upper end of the wage scale.)  This needn’t be done for racist reasons, simply out of a recognition that the interests of US citizens outweigh those of foreigners.  Domestic inequality has costs, in polarization, alienation between rich & poor, etc.  We shouldn’t want to import more of these costs just to benefit foreigners.

Megan McArdle on Abortion:  Interesting to see a self-avowed pro-choicer condemning both Tiller’s murder _and_ Roe.

Voodoo Correlations in Social Neuroscience: Impressive.

UPC Birthday

GM Downfall Fallout

Wealth Effect Transmission Channels

Interest-Rate Swaps Explained

Thoughts on the Constitutionality of DOMA

Posted in Law on 20090621 by Avenging Sword

With J’s Blog noting the “constitutional issue” raised by the Defense of Marriage Act & Obama’s defense thereof, I figured I’d offer a few thoughts.  In brief, I believe that DOMA is consistent with the original meaning of the Full Faith & Credit clause of the Constitution.  Note that, lacking time & resources, I’ve not thoroughly researched the primary sources from the Founding era (e.g., ratification conventions, dictionaries, correspondence, etc.); rather, I’m mainly working off secondary sources [1].  And for any lawyers out there…my apologies in advance for screwing up any of the legal concepts & terminology, and failing to more thoroughly footnote this post.

By way of introduction:  Sec. 2 of DOMA, codified in Title 28 of the United States Code, reads:

No State, territory, or possession of the United States, or Indian tribe, shall be required to give effect to any public act, record, or judicial proceeding of any other State, territory, possession, or tribe respecting a relationship between persons of the same sex that is treated as a marriage under the laws of such other State, territory, possession, or tribe, or a right or claim arising from such relationship.

Although nowhere stated in the DOMA itself, the phrase “public act, record, or judicial proceeding” in the aforementioned excerpt clearly suggests that DOMA is being passed under the Full Faith & Credit Clause of the Constitution.

A.  Background:  Evidence, Terms, & The Prime Facie Rule:

1.  It’s important to understand the context in which the Full Faith & Credit Clause (hereinafter FFC) was drafted & ratified.  Transportation & communication were considerably slower & less reliable than they are nowadays.  In such an environment, it was understandable that greater emphasis might be placed (relative to nowadays) on the importance of determining the authenticity of a document purporting to contain a law or judgment from outside a given court’s jurisdiction.  Moreover, making foreign judgments self-enforcing within a given state, w/o qualification, would appear to be a clear infringement upon the sovereignty of that state.  As such, when presented w/ a foreign law, judgment, etc., courts faced two questions of non-trivial importance:

a) Was the document in question authentic (i.e., did the law, judgment, etc., that it purported to contain actually exist); and

b) Assuming #1 was true, what effect should the evidence presented by said document have upon the merits of the case before the court.  I.e., was said evidence conclusive as to the merits of the case (i.e., conclusively establishing some sort of obligation), or rebuttable?

2.  The terms “faith” and “credit” are originally from English law of evidence.  Over time, they evolved to encompass meanings re. effect, as well as admissibility or authenticity, of evidence.  “Full” could also mean “conclusive” or merely “sufficient” (yet rebuttable).  Even if “full faith and credit” were taken to mean “conclusive”, an out-of-state record could merely be “conclusive” WRT the existence of the law or judgment in question – but not conclusive (i.e., res judicata) WRT the merits of the in-state case.  The fact that there is more than one possible meaning for “full faith and credit” requires looking to original documents (e.g., Convention, Federalist, early judicial decisions) & usage to determine original meaning.

3.  The common law rule for out-of-state court judgments was the “prima facie rule”, under which an out-of-state judgment was viewed as constituting prima facie evidence of an obligation (e.g., debt), but were not granted the same (res judicata, i.e., conclusive or self-executing) effect accorded home state judgments.  Under this rule, the same merits originally decided by the out-of-state judgment could basically be re-tried in the home state’s court, w/ the out-of-state judgment simply being a piece of written evidence (like a contract) rebuttable by other evidence, defenses, etc.  State-level legislation was required to accord out-of-state judgments any greater substantive weight than the common-law prima facie rule.  E.g., under res judicata, re-trial on the merits was not permitted, as the mere existence of a valid sister-state judgment would (basically) conclusively determine the merits of the case in the home-state court.

Hence, under res judicata, if A won a judgment against B in State X, and B moved to State Y, A could sue B in State Y’s courts, and all he’d have to do to conclusively prove the existence of (say) B’s debt to A would be to present an authenticated copy of the judgment from State X.  Under the prima facie rule, by contrast, the State X judgment would be treated merely as prima facie (not conclusive) evidence that B owed a debt to A; and B could basically get the case (originally tried in State X’s courts) re-tried in State Y’s courts.  This would be because, under the prima facie rule, State Y was not obligated to treat State X’s judgments as being inherently enforceable in its own jurisdiction.

B.  Full Faith & Credit Models:

There are two basic models for interpreting the Constitution’s FFC:

1.  Contemporary Model of the FFC:  First sentence obligates states to give some degree of effect to out-of-state “public Act[s], Records, and judicial Proceedings”.  Precise degree of such effect is a judicial question.  Via the second sentence, Congress may (or may not) be able to qualify the courts’ rulings re. effect of sister-state acts, records, & proceedings (ARP).  Hence, by this interpretation, A & B get married in State X, and move to State Y.  Per the first sentence of the FFC, State Y is obligated to recognize A & B’s marriage, notwithstanding any State Y laws to the contrary, and even absent any Congressional enactment to that effect.

2.  Alternate Model of the FFC:  FFC’s first sentence refers to evidence, obligating states to admit authenticated copies of out-of-state ARPs as evidence, and to treat them as conclusive evidence of the existence of the statute, judgment, etc., that they purport to contain.  The second sentence gave Congress authority to prescribe rules re. authentication & substantive legal effect (i.e., on the merits of cases) of out-of-state ARPs.  Absent Congressional enactment re. effects, the effect of out-of-state ARPs on the merits of a given state-level case remained (like anything else, per Article I & 10th Amendment) a matter of state or common law.  By this interpretation, State Y (from above) would not be constitutionally obligated to recognize A & B’s marriage; and it would be well within Congress’s power to pass a law prescribing that marriages of a certain type shall have no effect in states that do not recognize said marriages.

C.  Argument:

1.  The Articles of Confederation contained an FFC was similar to first sentence of Constitution’s FFC [2].  Yet Confederation-era state court decisions re. Articles FFC did not [3] view the clause as granting out-of-state judgments conclusive effect on the merits of the cases being decided.  In the view of such these courts, the Articles FFC pertained to the evidentiary weight – as opposed to the substantive effect – to be accorded out-of-state judgments.  The substantive effect accorded such judgments was viewed as being governed by either state legislation (if any), or the common-law, pre-Confederation prima facie rule.

2.  The prospect of sister-state laws being mandatory upon other states was discussed – and rather unwelcomed – at the Convention; Johnson & Randolph apparently objected to language (i.e., “…Legislature shall by general laws prescribe…the effects…”) that arguably required Congress to impose sister-state laws upon other states.  Madison’s motion to change that “shall” to “may” carried.  While not conclusive re. original public meaning, this discussion – in combination w/ the general pro-states-rights milieu of the Founding era – suggests that an FFC clause mandating recognition of out-of-state laws within a given state probably wouldn’t have passed muster come ratification.

3.  Federalist #42 on the Constitution’s FFC:

The power of prescribing by general laws, the manner in which the public acts, records and judicial proceedings of each State shall be proved, and the effect they shall have in other States, is an evident and valuable improvement on the clause relating to this subject in the articles of Confederation [a]. The meaning of the latter [b] is extremely indeterminate, and can be of little importance under any interpretation which it will bear. The power here established may be rendered a very convenient instrument of justice, and be particularly beneficial on the borders of contiguous States, where the effects liable to justice may be suddenly and secretly translated, in any stage of the process, within a foreign jurisdiction.

Worth noting:

[a] Moreover, Federalist #42 clearly contradicts those [4] who held that “thereof” in the FFC referred not to “such Acts, Records, and Proceedings”, but rather “the Manner in which” the ARPs “shall be proved”.  In the first sentence of the aforementioned excerpt, the term “they” (in the phrase, “the effect they shall have in other States”) clearly refers to “public acts, records, and judicial proceedings of each state” in the preceding clause, not to the (singular) term “manner”.  Even if the Constitution’s drafting history – which confirms this reading of “thereof” – wasn’t publicly available, the Federalist obviously was; hence such a meaning of “thereof” was a “public meaning”)

[b] By “the latter”, Madison of course refers to the FFC of the Articles, whose wording was very similar to that of the first sentence of the Constitution’s FFC (except that the Articles FFC didn’t apply to public acts & non-judicial records).  The contrast between how Madison describes the Articles FFC (i.e., “extremely indeterminate” and “of little importance”) – and by implication, the first sentence of the Constitution’s FFC – contrasts w/ the remainder of this passage, whose phrasing (i.e., “prescribing by general laws…the manner…and the effect) clearly refers to the FFC’s second sentence.  IOW, Madison (by implication) ascribes little substantive importance to the FFC’s first sentence; and instead locates the power to determine “effects” in the second sentence.

6.  In 1790, Congress passed a law aimed at implementing the FFC.  The last sentence of that law read,

And the said records and judicial proceeding authenticated as aforesaid, shall have such faith and credit given to them in every court within the United States, as they have by law or usage in the courts of the state from whence the the said records are or shall be taken. [5]

Since, by this sentence, the First Congress arguably intended to give some sort of substantive effect to out-of-state records & judicial proceedings, supporters of the Contemporary Model plausibly might cite said sentence use of the terms “faith and credit” in support of their position.  As noted in A.2, above, using “faith and credit” to refer to substantive effect was plausible.  However, the judicial debate that occurred following passage of the 1790 Act yields little support for this argument.  For many judges, the terms “faith and credit” were indelibly associated with the law of evidence; this led them to conclude that the aforementioned second sentence had no substantive effect whatsoever; and that the 1790 Act merely established procedures for authenticating out-of-state judgments & records.  Hence, e.g., Judge Radcliff of the New York Supreme Court wrote in 1803:

At first view, the framers of this act seem to have intended a regulation beyond the provision contained in the constitution; but if this was their intent, I think they have not accomplished their end. […] The constitution…makes the distinction…between credit and effect. With this distinction, plainly drawn, I cannot suppose that congress meant to confound it by treating the terms faith and credit, as synonymous with effect. […] Nothing more than the mode of authentication was, therefore, provided for by the act of congress. When so authenticated, they are entitled to full faith and credit; but they are to be received as evidence merely, by which their contents are undeniably established, and their effect or operation, not being declared, remains as at the common law [6].

Such an outcome is more consistent with the Alternate Model mentioned above, than with the Contemporary Model.

Moreover, arguing that “faith and credit” in the 1790 Act refers to effects (either in addition to or in lieu of evidence) necessarily implies the existence of Congressional power to declare such effects.

I tend to agree with Whitten & Engdahl’s take on the 1790 Act:  that the use of “faith and credit” in said act, while although indeed referring to substantive effect, was not so much evidence of the FFC’s original meaning, as an example of sloppy legal draftsmanship on the part of Congress.

7.  The aforementioned judicial debate following the 1790 Act implementing the FFC is illuminating.  Many judges, like Judge Radcliff above, clearly recognized a difference between the evidentiary value of an out-of-state record, & the substantive effect thereof; viewed the FFC’s first sentence as addressing only evidence; and concluded that prescribing substantive effect was left to Congress.  The Contemporary Model – that first sentence of FFC addressed effects, as well as evidentiary value, of out-of-state acts, records, & proceedings – was a minority view in the early Republic, commanding support among only five of the fifteen federal & state judges that considered the question [7].  The remainder took a contrary stance, espousing the Alternate Model mentioned above:  They held that the FFC’s first sentence concerned only evidentiary value, with effect left to Congressional discretion by the second sentence.  Had the aforementioned Contemporary Model been the consensus view, this judicial debate never would have occurred.

8.  Although all of the aforementioned discussions & cases pertain to out-of-state judgments, they are equally relevant to “records” and “public acts”, since these are all mentioned together in the FFC.  If the first sentence of the FFC was not viewed as granting substantive effect to out-of-state judgments, then one cannot plausibly argue that it did grant such effect to out-of-state statutes.

D.  Conclusion

The support of Federalist No. 42 for the Alternate Model (and the inconsistency of the Contemporary Model with the same); combined with the predominance of said model among the judiciary of the early Republic; leads me to conclude that the original meaning of the Full Faith & Credit Clause conforms with the Alternate Model, and not with the Contemporary Model.  That being the case, we can likewise conclude that the Clause does not obligate states to recognize out-of-state marriages absent an Act of Congress; and that, on the contrary, it is well within Congress’s power under the Clause to deny such recognition.  Likewise, under the Tenth Amendment, state governments retain the power to deny recognition to out-of-state marriages if they so choose.

We can therefore conclude that both the Defense of Marriage Act & state laws denying recognition to out-of-state gay marriages are consistent with the original public meaning of the Full Faith & Credit Clause.


[1] See:

  • Engdahl, David E., “The Classic Rule of Faith and Credit“, 118 Yale L.J. 1584 (2009).
  • Laycock, Douglas, “Equal Citizens of Equal and Territorial States: The Constitutional Foundations of Choice of Law”, 92 Columb. L. Rev. 249 (1992)
  • Sachs, Stephen E., “Full Faith and Credit in the Early Congress” (November 26, 2007). Virginia Law Review, Forthcoming. Available at SSRN.
  • Whitten, Ralph U., “The Original Understanding of the Full Faith and Credit Clause and the Defense of Marriage Act”, 32 Creighton L. Rev. 255 (1998)

[2] Compare Article IV of the Articles of Confederation:

Full faith and credit shall be given in each of these States to the records, acts, and judicial proceedings of the courts and magistrates of every other State.

With Article IV, Sec. 1 of the Constitution:

Full Faith and Credit shall be given in each State to the public Acts, Records, and judicial Proceedings of every other State. And the Congress may by general Laws prescribe the Manner in which such Acts, Records and Proceedings shall be proved, and the Effect thereof.

[3] Except for Jenkins v. Putnam, 1 Bay 8, 1 S.C.L. 8 (S.C. Com. P. Gen. Sess. 1784).  Note, however, that this was an admiralty case, and that in such cases, foreign judgments were granted res judicata.

[4] E.g., Justice Livingston in Hitchcock and Fitch v. Aiken, 1 Cai. R. 460, 3 Johns. Cas. 595 (N.Y. Sup. Ct., November Term, 1803):

[M]y opinion is drawn from the constitution, and is altogether independent of this [1790] act; for it is not clear that congress had anything to do with the effect…. It is extraordinary, to say the least, that after the constitution had declared that “full faith and credit” were to be given them, it should be left with congress to vary their operation, if they thought proper.  […] Instead, then, of expecting congress to settle the effect of domestic judgments, we must not  look further than the constitution itself….

[5] Act of May 26, 1790, c. XI, 1 Stat. 122.

[6] Seriatim opinion of Radcliff, J., in Hitchcock and Fitch v. Aiken, 1 Cai. R. 460, 3 Johns. Cas. 595 (N.Y. Sup. Ct., November Term, 1803).

[7] See Whitten, supra note [1], p. 326.

Random Thoughts on Financial Reform

Posted in Econ on 20090619 by Avenging Sword

By request, here are some thoughts on how I’d reform the financial system were I proclaimed High Dictator.

Financial Regulations:

0.  We should remain skeptical regarding efficacy of regulation to prevent crises.  Financials will always find a way around regulations, creating new & unforeseen risks.  W/ lots of $, they’ll always be able to hire better personnel than regulators, and thus (between that & regulatory bureaucracy) will always be one step ahead of the latter.  Regulations re. size & capital are attempt to keep crises manageable.

1.  Higher capital requirements:  to create a larger buffer against losses.  Make capital requirements counter-cyclical, escalating w/ larger size, and applicable to any firm that borrows short & lends/invests long.  Also, make capital requirements the same across all types of assets; e.g., don’t have lower capital requirements for securitization bonds as opposed to loans held in portfolio.

1a.  Subordinated debt:  Require that a certain percentage of each financial institution’s liabilities consist of long-maturity, subordinated, unsecured debt.  Debtholders thus put at risk will provide some discipline to financials, even if shareholders do not.  Also, expectation of loss would make DFE swaps of such debt less disruptive, since anyone buying such debt would know that DFE conversions were a possibility.  For similar reasons, we might want to consider mandating the use of reverse convertible debentures or preferred equity by financials.

2.  Size limits for financials that cover everything.  Reduce the chances that any firm ends up “too big to fail”.

3.  Figure out ways to measure & limit financial interconnectedness.  This would (hopefully) reduce the problem of firms of being “too connected to fail” (ala Bear Sterns or AIG).

4.  Mortgage Lending:  The systemic risk posed by the GSEs is obvious, as is their non-viability absent government subsidization.  So liquidate them (gradually, first by slowing/halting new lending, then by either liquidating existing assets or letting them run down).  Replace them with the Danish mortgage system (also here) of monoline mortgage lenders that retain & service the loans they originate, & are funded by duration-matched covered bonds.  Retention of credit risk upon originator balance sheets eliminates securitization’s agency problem; covered bonds permit mortgage originator access capital markets (thus reducing costs) while shedding interest-rate & duration risk onto parties (e.g., pension funds, bond funds, long-term investors) looking for long-term investments (thus preventing another S&L Crisis).  (A side benefit would be reducing the problem of negative equity.)

4a.  In view of securitization’s agency problems, I’m inclined to replace it en masse w/ the Danish model of covered-bond-financed lenders; however, I don’t know enough about securitization to determine how applicable the Danish model might be to other areas besides mortgages (e.g., car loans, credit card loans).  For any markets wherein securitization survives, we should require that the securitizer retain “skin in the game” (e.g., a residual) equal to the maximum probable loss on the loans in question (determined based on historical loss data from recessions).

5.  Post-Lehman, the danger of runs on MMFs is now self-evident.  MMFs should either accept regulation (e.g., capital requirements) in exchange for LOLR access & guarantees, or disappear.  TANSTAAFL.

6.  Narrow Banking:  not sure how workable this is, but it’s something we might want to consider.  Note that this approach would probably have to be coupled w/ licensing regulations prohibiting unregulated non-banks from entering lending markets normally serviced by banks, lest the unregulated outcompete the regulated (and subsequently implode via excessive risk-taking).

7.  Prompt Corrective Action (ala FDIC receivership authority) for all financial institutions (not just banks).  Include authority for mandatory debt-for-equity conversions & good-bank/bad-bank split-ups.  Then use such tools next time some financial goes belly-up, so that markets realize regulators are willing to screw over bondholders rather than expend taxpayer funds bailing out financials.  No longer would regulators have to rely on ad-hoc bailouts to prop up troubled financials, or rely on a bankruptcy system (e.g., Lehman) ill-suited to rapidly resolve such firms.  Moreover, the existence of such authority would give notice to all potential investors & lenders, who would thereafter understand the true risks associated with lending to or investing in financials, and price such investment or lending accordingly.

8.  Consumer regulations:  The debacle in mortgage lending makes clear to me that consumers can’t be expected to understand any but the simplest financial products.  E.g., 30-yr FRMs w/ 20% DP.  So, ban all but the simple stuff that anyone can understand.  The resultant credit rationing would be a feature, not a bug, with the inability to customize lending for people w/ poor credit confining credit to the creditworthy.

9.  CDS:  Kling-Salmon notion of treating net sales of CDS as assets on balance sheets (w/ resultant capital requirements).  This would deter institutions (e.g., monolines bond insurers & AIG) from exposing themselves to massive risk by issuing tons of unhedged CDS.

10.  Untried Assets & Financial Innovation:  To shield taxpayers from the risk associated w/ novel financial assets, any government-insured financial would be prohibited from owning untried assets until said assets had been through a failure cycle.  (Prior to such a cycle, it wouldn’t be realistically possible to determine probable losses on, and hence adequate capital ratios for, such assets.)

11.  Stress Testing:  As was once required, anything rated AAA should be able to survive a “Great Depression” scenario.  Similar scenarios should be regularly employed to “stress test” regulated entities’ portfolios IOT determine whether they have enough capital.

12.  Escalating Down-Payments:  While a 10 or 20% down-payments might be mandatory for mortgages, we could require (via regulation) higher DPs for areas deemed overvalued (if, e.g., metrics like price-rent & price-income ratios are above long-term trends).  IOW, cap the loan amount for a given area, such that anyone buying a house in that area must provide the difference via higher DP.  By rendering homebuying less affordable in overheated areas, such a requirement would tend to reduce demand for housing in such areas, and thereby kill off housing bubbles before they started.  Meanwhile, higher DP’s would also reduce the chances of homeowners ending up underwater.

Non-Financial Stuff:

A.  Reducing US current-account deficit via tariffs (& threaten protectionism against anyone using monetary mercantilism on us).  This includes energy independence.  This would eliminate the foreign capital imports that helped finance the current crisis.

B.  Higher domestic savings rate:  encourage via consumption taxation.  A Fair Tax is probably unworkable, but one possibility is to remove all limitations on contributions to, & withdrawals from, traditional IRAs.  Keep contributions tax-deductible & withdrawals taxable.  To ensure some degree of progressivity (given that the rich save more), we could cap the deductibility of contributions at (say) 50% of income for persons making over $100k.

C.  Cheaper housing via deregulation of land use.

D.  Kill off subsidies for housing (we already devote too much “investment” towards it); no more FHA, GSEs, MI deduction, etc.

E.  Eliminate the tax-deductibility of interest payments (for both businesses and individuals).  This would discourage the use of debt financing by both households & companies.

Jubilee & Turbo-Deleveraging

Posted in Econ on 20090618 by Avenging Sword

A while back, when charts like this & this were making the rounds, I occasionally ran across a notion (*) I termed the “Jubilee Solution”.  It basically proposed to restore economic growth via mass debt defaults, using this sort of economic logic:

1.  Consumption spending contributes a lot to US GDP; and

2.  An overleveraged private-sector is less able to spend on consumption, both because

a) overleveraging makes (additional) borrowing for (additional) consumption is impossible; and

b)  private-sector deleveraging (sans default) necessitates increasing the share of income devoted towards debt service, thereby exerting downward pressure on consumption;

3.  Hence, so long as we’re deleveraging, economic growth will remain depressed.

4.  Ergo, the faster we bring down household debt to sustainable levels, the less we’ll have to wait for real (i.e., non-anemic) recovery.

5.  Since private-sector processes take too long to deleverage, government should intervene to rapidly reduce debts en masse, via force majeure processes (e.g., mortgage cramdowns) or subsidies (e.g., HOLC redux).

Beyond eliminating drag of sustained deleveraging, the “Jubilee Solution” would also obviate the need for the government to run up massive debts via fiscal stimulus spending.  However, I was never quite able to convince myself of the efficacy of this course of action.  From the standpoint of property rights, they were basically a massive redistribution of wealth from creditors to debtors.  While lenders were hardly blameless, neither were consumers; as such, I didn’t see much justice in robbing the former’s balance sheets to benefit the latter.  More practically, not only would this involve massive moral hazard – with consumers’ takeaway message being, “If I, and enough others, get into debt over our heads, the government will bail us out,” – but it would also lead to permanently higher cost of credit, as loan prices added the risk of unanticipated government intervention to the risk of default.  This, in turn, would depress consumption & investment (and hence growth) going forward.

(Had we ever seriously considered taking the “jubilee approach” to deleveraging, my preference would’ve been mass bankruptcies & foreclosures – as opposed to the free lunches espoused by Roubini & the like – so as to minimize the moral hazard aspect.)

Well, it turns out that jubilee, of a sort, may come to pass nevertheless, albeit via purely private-sector processes.  Or, at least, it appears we might manage to deleverage more quickly than some (e.g., the Fed study Steve recently noted), according to a couple of Morgan Stanley analysts.  Money quotes:

…[W]e establish what might be a sustainable level of consumer debt service in relation to income; a rough estimate is 11-12%, which might be associated with debt in relation to income of 80-100%. […] Under [optimistic, pessimistic, or intermediate] scenarios, we think the 11-12% debt-service and 80-100% debt-to-income ratios might be attainable by 2011.  [Emphasis added]

They estimate that household debt will shrink by 8% annually from 2009 through 2011; mathematically, such a rate of decline would indeed result in the same ratio of household debt/GDP suggested in the aforementioned Fed paper, albeit several years sooner.  They argue that consumers will be pushed to deleverage by 1) the damage to household balance sheets imposed by shrunken/stagnant housing wealth; 2) increased borrower & lender risk-aversion resulting from the recent financial crisis; and 3) reduced availability & increased cost of credit due to increased financial regulation.  Meanwhile, deleveraging will also occur involuntarily, as consumers shed debt via foreclosure, bankruptcy, & other defaults, and banks charge off & write down the loans in question.

Tallying the costs & benefits of deleveraging, they conclude:

Leveraged losses will hurt both lenders and consumers, the latter as foreclosures and bankruptcies rise.  Adjusting to a new austerity will be painful for many, even in recovery.  But less leverage will leave lenders and consumers better able to withstand financial and economic shocks, promoting financial and economic stability.  And by boosting domestic saving, the deleveraging process should over time further reduce America’s external imbalances, a critical need when global investors are fretting over America’s fiscal sustainability.

IMHO, we should hope for such a (relatively) painless outcome.  Besides the obvious advantages of such an outcome to human welfare, a relatively rapid deleveraging would also eliminate the need for government to rack up massive debt for years on end  – at non-trivial cost to its long-term solvency – via attempts to fiscally-stimulate a deleveraging economy.  The specter of a prolonged “balance sheet recession” (and associated debt-deflation) would likewise fade.

(*)  See, e.g., Wolf, Blodgett, Roubini, Ferguson, Dalio, Hussman.  I neglect proposals – e.g., here – to basically shift private debts onto the government’s balance sheet, in view of the massive cost of doing so:  E.g., reducing household debt (currently ~130% GDP) by a quarter, via this method, would increase government debt by approximately the same percentage of GDP.

Treasury Rout & Inflation

Posted in Econ on 20090618 by Avenging Sword

The recent rise in long-term Treasury rates prompted lots of commentary.  A selection:

Front linesJohn Jansen, Accrued Interest.

Bearish (i.e., herald of a rollover crisis):  Yves Smith, The Economist, Niall Ferguson.

(For those concerned about such things, this post explains what a rollover crisis is, along with its probable effects; the comments thread of said post also contains an interesting exchange between Delong & Roubini.)

Setser on the Foreign CB Aspect: [1][2]

Stagflation danger:

Bullish (i.e., higher long-term rates = return of confidence):  Models & Agents, Martin Wolf

On the Fence:  Duy, Setser, McArdle [1][2][3].

Inflation v. Deflation: Related was the debate over whether inflation or deflation was more likely in the future.

Accrued Interest [1][2][3][4]; Tim Duy; Ed Harrison; Andy Harless; Paul Krugman; Felix Salmon; Econompic Data.