Liar’s Poker – A Popular Book Predicts Our Demise

When asked, the average, eager, Wall Street bound undergraduate would tell recruiters their favorite book is Liar’s Poker and their favorite movie is Wall Street. Michael Lewis’s semi-autobiographical book, Liar’s Poker, is a first hand account of the rise of Salomon Bond traders, junk bonds, and mortgaged backed securities in the 1980’s. The 1980’s was an era of deregulation; the deregulation that in part lead to S&L Crisis of the late 1980’s and early 1990’s. Lewis’ 1985 Salomon Brothers analyst class is in large part running Wall Street in 2008 and those eager undergrads that so idolized the trader lifestyle, big money and even bigger egos, are left holding the bag – a largely empty bag containing pink slips and severance checks.

The flood of new mortgage instruments and consumer debt did not come without its skeptics. It appears however that this skepticism skipped a generation. With little regard to the continued escalation of debt in the US, structured products ruled the day for the past decade. Lewis highlights on page 60 of the book,

But a few of the old hands within Salomon Brothers suffered a more complicated response to their money…they were uneasy with the explosion of debt in America. (In general, the better they recalled the Great Depression, the more suspicious they were of the leveraging of America)

“That is where we are: wild, reckless, and deeply in hock, ” Lewis comments as he further points to an article in the Institutional Investor of July 1987 by Salomon Brothers’ Head of Bond Research, Henry Kaufman,

One of the most remarkable things that happened in the 1980’s was [the] sharp explosion of debt, way beyond any benchmark. It was way beyond anything you would have expected relative to GNP, relative to monetary expansion that was taking place. But it came about, I think, as a result of freeing the financial system.

Unfortunately the explosion did not stop. According to The Federal Reserve Board, the household debt ratio (ratio of debt payments to disposable personal income) increased from 10.6% in 4Q80 to 12.3% in 2Q87 (the time of Kaufman’s article). This ratio continued to balloon to a maximum 14.42% in 4Q06, settling at 13.85% for the most recent quarter ended 2Q08. Mortgage debt has lead the way growing from 8% in 1980 to nearly 14% in recent quarters.

Household debt to gross disposable income paints an even uglier picture. … UK consumers narrowly defeat the US as the most levered consumers. US household debt as a percent of household disposable income as exploded from less than 80% in 1985 to nearly 140% in 2007. The rest of the G7 has followed suit with Japan, Italy, and Germany showing substantial declines in consumer savings rates coinciding with large increases in consumer debt.

Kaufman highlighted the growth of debt as a percent of GNP. Household debt to GNP rose from 47% in 1976 to 65% in 1989. Household debt as a percent of GDP has continued to skyrocket from 49% in 1980 to nearly 99% in 2008. The substantial debt burden left little room for error for the US consumer. Slight increases in interest rates (adjustable ARMs), decreases in income (rising unemployment), and deterioration of disposable income (rising commodity prices) has rendered the US insolvent.

Deregulation brought a lot of LUV to air travel; unfortunately, similar love has not been shared with Wall Street, Main Street, or Joe the Plumber. Remember, “objects in mirror are closer than they appear” – here’s to 2028.

Ask not what your country can do for you...

During the second presidential debate the candidates were asked about sacrifice:

“Since World War II, we have never been asked to sacrifice anything to help our country, except the blood of our heroic men and women. As president, what sacrifices will you ask every American to make to help restore the American dream and to get out of the economic morass that we're now in?”

Both Senators’ answers focused on government action, only briefly mentioning individual sacrifice. But individuals can contribute to the nation’s economic recovery, and sacrifices – time, money, or lifestyle – are necessary to do so.

So what exactly can we as citizens do? A list might include:

1. Spend less and save more. Americans spend too much and save too little, causing the nation to take on unsustainable amounts of debt. Citizens who reduce debt and increase savings by deferring purchases, increasing 401(k) allocations, and paying down credit card debt help reduce our economy’s reliance on unsustainable consumption.

2. Take greater responsibility for personal financial security. Americans have been making financial decisions that resulted in responsibilities consumers neither understood nor were capable of fulfilling. Citizens who invest the time to understand financial choices – particularly loans– and make prudent future plans will restore sustainability to the economy.

3. Invest in education. American workers are becoming less competitive as the economy demands an increasingly skilled labor force. Citizens who invest in education – whether by enrolling in higher education or job retraining themselves, volunteering at a local school, or reading to their children – help create and keep high-skilled, high-wage jobs in the U.S.

4. Live healthier lifestyles. America is experiencing a healthcare cost crisis, and lifestyle factors greatly contribute to these costs. Citizens who exercise more, eschew smoking, and take preventative health measures improve their health and thereby reduce the healthcare burden on the economy.

5. Conserve energy. America imports a significant proportion of our energy needs. Citizens who save energy by carpooling, taking public transportation, turning down the heat, and investing in insulation and CFL light bulbs help break the reliance on foreign energy and contain costs.

This list is by no means exhaustive, and the examples are but a few ways to move forward on these five priorities. But for those Americans considering “what you can do for your country,” these sacrifices will aid the changes that need to be made in Washington and on Wall Street.

US Corporate Taxes - The Reality

In recent days, the McCain campaign has sought to refocus the 2008 Presidential issues on the two candidates' tax policy proposals. The first piece, which Mr. Hart wrote about last week deals with the federal personal income tax. The Obama and McCain campaigns also differ on the what to do with federal corporate income tax.

Obama's campaign is not specific on what it plans to do with the statutory rate, but has a number of potential tweaks to the corporate tax code including: offering tax credits for job creation, healthcare coverage for employees, investing in R&D, and "closing" special loopholes.

McCain's tax plan is a little more straightforward. He plans on convincing congress to cut the corporate tax rate from 35% to 25%.

It's a little hard to compare these two proposals, but the simple fact of the matter is that US corporate tax rates are higher than much of the rest of the world. This has some dramatic implications with the way in which businesses conduct their operations and structure themselves.

1. High corporate tax rates are very instrumental in creating an incentive to add leverage in the US. Firms will increase in value (to a certain degree) as they are able to deduct interest from their taxes. This results in wealth transfer away from the government despite higher tax rates. Additionally, it has increased the overall structural risk in the economy (as we are seeing today).

2. The US has a worldwide tax system, in which US domiciled firms are subject to US corporate tax on their worldwide earnings less credit companies get for paying foreign taxes. Foreign companies are also subject to paying taxes on any US earnings. Most countries have a territorial tax system, in which they only collect tax on earnings within their geographic borders. Why has this created a distortion? US domiciled companies have begun to incorporate outside the US in order to shield their foreign income from higher tax rates. Also, most foreign earnings do not get taxed unless they are repatriated in the US. These games are only effective if the US has a higher tax rate than the rest of the world.

3. It is a terrible way to generate revenue. As the tax foundation's article states, the US tends to have a much narrower base of corporate profits from which it can extract revenues than do other countries. In this way, high US corporate taxes help support the country's current system of personal tax rates. If corporate taxes are cut, there are more targeted methods to maintain current wealth distribution and revenue profiles: VAT, luxury tax, dividend tax, as well as higher personal tax rates.

If the country implements some of these changes, there is a great opportunity to reduce distortion in the system and putting the government's revenue generation model on sound footing.

Domestic Energy: A Supply and Demand Primer

Before the financial crisis emerged as the chief economic issue in this election cycle, the political discussion had focused on the United States’ energy needs. Oil prices were for a period of time, almost at $150 a barrel , and prices at the pump seemed outrageous to many consumers who were used to paying between $1.00 and $2.00 for a gallon of gasoline.

Once the debate reached the forefront of public consciousness, the scope of discussion crept out of control. The debate cascaded into concerns about security (sources of supply), social welfare (heating needs in the winter), and environmental impact (carbon emissions and global warming). Thus, domestic energy policy was not only proved to be an issue which was top of mind for voters, but an incredibly complex issue to discuss and balance.

Alternative energy will not sufficiently close the gap between the country’s demand and the supply. Renewable energy and nuclear power, will only serve as means to reduce independence on natural gas, and only in the residential, commercial, and shrinking industrial sectors. The transportation sector has been driving energy demand, and this sector is petroleum intensive.

One solution to the problem is then to improve the global and domestic supply of oil. Any improvement in the domestic supply of petroleum will reduce the US’s reliance on imports, but it is unlikely to make a dent in global supply , and therefore will not translate into any price alleviation for consumers. Therefore, it is not a sustainable long-term solution.

The best method for fixing the imbalance is to reduce demand created by the transportation sector, but prior methods to improve efficiency and reduce demand have had mixed results. Both candidates have laid out policies to curb petroleum demand in the transportation sector: increased use of public transit, solar and electric cars, and more efficient batteries. These are the only measures which will solve the US’s energy needs by cutting reliance on imports as well as shift consumers over a source of energy which is not supply constrained, and therefore cheaper.

Below are some facts pulled from government sources to call out the data underlying these conclusions:

Demand:

According to the Energy Information Administration, from 1997-2007 energy consumption has grown by roughly 1% per year from 94.2 Q (quadrillion) BTU to 101.6 Q BTU. Fossil fuels (oil and coal) constitute the vast majority of consumption (~85%), which hasn’t changed over time. Meanwhile, nuclear power as a share of overall consumption has increased from 7.5% to 8.3% at the cost of renewable sources, which has gone from 7.6% to 6.7%.

Fossil fuels consumption consists primarily of petroleum, which constitutes 46.2% of the consumption in 2007, which is up from 44.7% of fossil fuel consumption in 1997. This share has come primarily from natural gas, which has gone from 28.9% to 27.4%.

In 2007, the residential sector consumed 21.4% of the energy, commercial consumed 18.1%, industrial consumed 31.8%, and transportation consumed 28.6%. This marks a dramatic change from 1997. During the last ten years, the industrial sector’s share of energy consumption has dropped by 540 bps as energy intensive manufacturing and industrial activities have become a smaller part of the US economy. The other sectors gained share relatively evenly during this time period reflecting an improvement in overall economic activity despite the drop in the industrial sector.

What is the net result of all of this? Commercial and residential energy consumption consists almost entirely of natural gas for heating premises and not petroleum. However, the transportation sector consists entirely of petroleum energy use: trucks, automobiles, and airplanes. Uses of coal or other fuels are insignificant in this particular sector.

The response to help keep energy prices and low and curb demand in these areas has been in the form of government mandated fuel standards. As shown by the data, this has largely worked. In aggregate, gallons of petroleum consumed per vehicle has held fairly steady since the late 1970s. Improvements in fuel rate (miles per gallon) have been eaten up by an increased mileage rate (miles per vehicle). Meanwhile, as reported by the Bureau of Transportation Statistics the number of registered motor vehicles has increased from 161.5M to 250.9M from 1980 to 2006, which implies an annual growth rate of 1.8%.

Supply:

Given these demand trends in energy, it is important to look at trends in supply in order to real understand where today’s energy concerns lie.

While overall consumption has grown at 1% from 1997-2007, domestic energy production as actually remained flat to slightly decline at -0.1%. Nuclear power has grown steadily over the last ten years at 2.5%, but it has been outweighed by declines in both fossil fuels and other renewable sources. This can be seen in shifts in the share of energy production. Nuclear power has gained 280 bps of share at the expense of both fossil fuels and renewable energy.

In order to plug the gap between energy supply and demand, the US has actually turned to imports. Net energy imports have gone from 21.8% of total consumption in 1997, to 28.8% of total consumption today, have grown at 3.5% during the last ten years.

Perhaps unsurprisingly, petroleum imports have led the way. Petroleum importation was 83.6% of gross energy imports in 2007, and is the backbone of the driver of the growth in energy imports. What is surprising, however, is that the mix of countries the US is importing petroleum from has actually not changed during the last ten years. The Persian Gulf has gone from supplying 17.3% of the total petroleum imports to 16.1%. OPEC import share has moved from 45% to 44.5%. Thus, while the US continues to rely on the same nation to provide it oil, the degree of dependence has increased over the last ten years.

Summary:

The facts indicate that the US economy has undergone a structural shift in which its reliance on fossil fuels, specifically petroleum, has continued to increase during the last ten years. The country has not been able to increase petroleum production, and has thus had to rely on imports to feed consumption.

Capital Purchase Program

This morning Secretary Hank Paulson made a statement regarding the $250B Capital Purchase Program component of the financial rescue package. Critics of the CPP and TARP question the role of government in the capital markets and believe that the US Government is privatizing profits, while socializing losses.

Although drastic, CPP and TARP are well within the bounds of Treasury’s duties. The following is an excerpt from Department of the Treasury’s mission:

The Treasury Department is the executive agency responsible for promoting economic prosperity and ensuring the financial security of the United States. The Department is responsible for a wide range of activities such as advising the President on economic and financial issues, encouraging sustainable economic growth, and fostering improved governance in financial institutions.

CPP is the direct result of the later two goals. Paulson notes in his statement, “Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital.” The restored confidence should open up the credit markets, prudent deployment of capital will enable sound businesses, aspiring students, and honest homeowners to continue the sustainable growth the United States has exhibited since 1776.

Additionally, the Treasury is utilizing market mechanisms to institute additional regulation. Qualifying Financial Institutions (QFI) will only have access to CPP if the institutions agree to caps on executive compensation, clawback provisions, and bans on golden parachutes. The Government is not ruling with an iron fist, rather the Treasury is providing a carrot for banks and thrifts to exercise increased prudence and to incent greater alignment of interest between all stakeholders.

In the near-term, the Treasury may have socialized losses; however, Paulson highlights the CPP is an investment by the Treasury, not an expenditure of the Treasury. The CPP investments will be in the form of preferred stock (5% dividend yield) with warrants for common stock. Assuming confidence is restored and sustainable economic growth persists, the warrants should provide the Government with substantial upside. As Tier 1 Capital, CPP investments will improve the banks’ capitalization and coupled with an improved balance sheet through other TARP initiatives, bank common equity valuations should improve.

Such investments are not risk free; the Treasury cannot guarantee a return OF capital, never mind a return ON capital. In April TPG appeared to have structured their way into a sound investment of preferred equity in Washington Mutual; however, the investment has turned out to be an expenditure. In reviewing the Interim Final Rule for the TARP CPP, as noted earlier, the qualifications are focused primarily around corporate governance and are not focused on the soundness of the preferred equity investment. A return on capital should yield a return to a prosperous United States.

For more information see the CPP FAQ and Application Guidelines.

Don't mortgage the future to save the present

At the core of the recent financial mess is a simple fact: Americans consume too much and save too little. Barack Obama, in a policy speech given in the battleground state of Ohio, outlined a plan permitting withdrawals from IRAs or 401(k)s without penalty. These withdrawals divert savings to consumption. Changing the withdrawal penalty incentivizes Americans to increase consumption and decrease savings. These changes make it more difficult for the American economy to return to health. Instead, Senator Obama should have proposed an expansion of loans against retirement accounts.

Senator Obama’s stated intentions are reasonable: to ensure families are not “being forced to make painful choices like selling their homes or not sending their kids to college.” There are two objections to this line of reasoning.

First, the plan overlooks existing safeguards in retirement plans. Families can tap IRAs to fund college, buy a home for the first time, pay medical expenses, purchase health insurance, or in the event of death or disability. 401(k)s allow loans against the account balance. While there are circumstances – like inability to pay mortgages – where Obama’s plan will help, one must also consider the possibility that individuals will use retirement accounts like many used their homes: as ATMs to fund personal consumption.

The second objection is that this withdrawal is bad for both individuals and the overall economy. Withdrawing funds is negative savings; these withdrawals allow individuals to consume more now, at the expense of not being able to consume as much in the future. Unfortunately, Americans do not save enough for retirement as is. Allowing individuals to deplete retirement savings is trading relief from an asset bubble/credit crisis today for a retirement savings crisis in the future.

Mr. Obama’s proposal also exacerbates the inadequate savings that plague the U.S. economy. For twenty-five years the U.S. savings rate has been declining and it is far below the savings rate of other countries. Saving is important because it drives investment in the economy which directly affects American productivity. The U.S. has overcome our low savings rate by investing too little in infrastructure and borrowing from other nations to fund investments. As saving declines, the economy can adjust through two unattractive options: further reduction in investments or increased borrowing from abroad.

Senator Obama recognizes the need for increased savings in the speech that outlined his new relief proposals:

“We’ve lived through an era of easy money, in which we were allowed and even encouraged to spend without limits; to borrow instead of save.

Now, I know that in an age of declining wages and skyrocketing costs, for many folks this was not a choice but a necessity. People have been forced to turn to credit cards and home equity loans to keep up, just like our government has borrowed from China and other creditors to help pay its bills.

But we now know how dangerous that can be. Once we get past the present emergency, which requires immediate new investments, we have to break that cycle of debt. Our long-term future requires that we do what’s necessary to scale down our deficits, grow wages and encourage personal savings again.

The senator’s understanding of economics appears sound; the immediate injection of funds is almost Keynesian and the longer-term need to increase savings is acknowledged by both sides of the aisle. However, substantial discipline is required to switch from increased consumption to increased savings. To ensure that savings eventually increase, Mr. Obama should modify his proposal to allow loans from retirement accounts instead of outright withdrawals.

By utilizing loans the proposal would provide the relief sought by the senator while creating a mechanism to increase future savings via loan repayment. Individuals who borrowed from retirement accounts would be required to contribute money back to retirement savings or face punitive taxes. Borrowers would be incentivized to save.

An example: an individual utilizes the withdrawal plan outlined by Mr. Obama. The crisis passes and the individual again commands disposable income, and considers two options: save $1000 for retirement or purchase a $1000 TV. The cost to acquire the TV is simply the $1000 list price. If one had taken on a loan as outlined above, one would face a different decision. Either save $1000 for retirement or purchase the TV plus pay a punitive tax, raising the effective cost of the TV to, say, $1400. In this scenario, the consumer is highly motivated to save to avoid an additional $400 in taxes.

Setting appropriate tax rates and interest rates would permit the government to encourage substantial savings by individuals. This modified approach to Obama’s plan would ease short-term economic strains without harming the long-term economic health of the nation.

The U.S. tax system: sacred cow or bum steer?

One of the FEW benefits of a major financial crisis is that it gives policy makers the chance to drive sacred cows to the slaughterhouse. In the last month we've seen politicians, business leaders and academics posit ideas that heretofore bordered on political blasphemy. Grass-root, rural Republicans are calling for bank nationalization. Anti-corporate, urban Democrats are opening up the government coffers to buy reams of corporate paper. Global investment gurus are calling for tighter regulatory oversight, and environmental champions are calling for domestic drilling to ease energy prices.

As the financial crisis extends into an economic one, hopefully we’ll begin to cull the herd of sacred economic policies. One possible output could be a complete reevaluation of our national tax system. In this presidential election, the battle over taxes between Obama and McCain has rarely evolved beyond locker room comparisons (see: "My tax cut is bigger than yours, part I"). One can only hope that severity of the times will force us to go deeper, and perhaps question some of the underlying tenets of our tax system:

-Are interest tax shields too generous? In particular, have mortgage interest tax shields helped to fuel the residential real estate bubble?
-Is the corporate/personal tax burden weighted appropriately, or should it be inverted?
-Is a progressive income tax system the right approach for funding the federal government, or like state governments do we need to utilize a mix of income, consumption and property taxes (the so-called "three-legged stool") to more equitably distribute wealth without impeding its creation?

On this last point, it is worth touching on the WSJ’s discussion of the marginal tax rates offered by Obama’s plan.

Their analysis highlights one of the underlying deficiencies of a progressive income tax system coupled with wealth redistribution programs- the marginal disincentive to work. Starting from the middle, as individuals move towards the right end of the curve the increasing tax rate provides a marginal disincentive to work. Starting on the left, as individuals move towards the middle and price themselves out of social welfare programs, they face a similar disincentive. Republicans have traditionally fought to decrease the right hand slope of the curve, while Democrats focused on flattening the left hand side of the curve. The Obama and McCain tax plans reinforce this trend.

While battle has raged on the poles, the equator has remained remarkably stable. The tax rate for median income households has remained relatively constant over the last 40 years, ranging from 25-28%. (It should be noted that despite the mutual animosity between the poor and the rich, both groups have proven remarkably adept at gaming the system through political influence; rich constituents press their Senators to create tax loopholes that violate the spirit of the tax code, while poor constituents lobby their Congressmen to expand and extend spending programs well beyond their original purpose).

Fast-forward to our current crisis. Over the last decade, the greatest relative decrease in earning power has been felt by the middle class. Stagnant growth in real wages, coupled with increased costs of living and the recent collapse in the value of homeowner's equity has left the middle class scrambling to bridge the gap between their lifestyle and their income. The prevailing reaction- largely from Sen. Obama and the Democratic party, but joined by an ever-increasing chorus of Republicans- has been to ante up on our progressive tax system. Crank up marginal tax rates on the rich while raising the threshold used to qualify recipients of wealth redistribution. Get as much money as you can (either from the rich or off of the Fed’s printing presses) and pump it into Peoria. While the short-term, Keynesian effects will likely reduce the depth of the recessionary trough we are sliding into, the long term consequences will be dire.

Those consequences are two-fold. First, increased upper-income tax brackets will create the aforementioned marginal disincentive to work for wealthy individuals. In reality this will be manifested in a small but noticeable exodus of the most productive employees to countries with better tax structures. While the “brain-drain” threat is real, it will likely be concentrated in the financial sector. Frankly speaking, that sector can afford to lose some weight.

The second, much more deleterious effect will occur as the welfare pool (not to be confused with the welfare class) expands. Households making $40,000 a year might suddenly find it economically advantageous not to work longer hours or take on another job to move their income to say, $45,000. In doing so they may decrease their government program eligibility by greater than the salary increase of $5,000. This is precisely what occurred prior to welfare reform that took place in 1996. The record shows that people- irrespective of tax bracket- act rationally to maximize their income, even if that means working less.

But in a time when the productivity of the American middle class is decreasing relative to the rest of the world, we can scarce afford to encourage working less. This could force a destructive cycle, with ever-increasing benefits needed to maintain the same quality of life. The middle class could eventually become a welfare class, a frightening proposition for a country whose economic, political and cultural identity is built on an aspirational middle class.

This is in no way meant to suggest that McCain's proposed tax plan would prove any more effective. The idea that the fruits of wealthy American's labor will- taken alone- sustain economic growth throughout the rest of the economy has been disproven over the last two decades. As the U.S. Gini coefficient sprints towards .5, we find ourselves leaving behind a pack of peer nations and joining the company of such prosperous oases of egalitarian opportunity as Mexico and Brazil.

With the tax plans currently on the table, American middle class voters have the dubious privilege of choosing to become a welfare queen or a member of the working poor. Hopefully, whomever emerges victorious from this election will think about alternative taxation policies, policies that promote savings, discourage conspicuous consumption and asset speculation, reward workers who create real economic value and limit social safety nets to those Americans who truly need a helping hand.

Something radical needs to be done, but as of yet we have not heard any new ideas. The public's negative perception of the federal government seems to suggest that the solution, whatever “it” is, will require turning a few sacred cows into hamburgers.

Weekend Update expresses this sentiment perfectly. (Go to 4 minutes in on this clip)

Fire up the printing press...

The federal government’s field trip into the private sector looks to be taking another weird turn, as Fed officials openly discuss the possibility of purchasing short-term commercial paper to ensure companies don’t start cutting headcount. The Fed has all but stated that they would have to fire up the printing presses to afford any significant portion of the $1.6 trillion in paper that no one wants to touch right now.

This proposed action only deepens the potential legal fallout of the government’s actions over the last six months. To say that both the Fed and the Treasury have been, from a legal perspective, flying by the seat of their pants is a dramatic understatement. A quick stroll through the Fed’s charter revealed nothing that would provide even the framework for such a foray into the public markets. In the absence of any legal authority to buy and sell commercial debt offerings, the best solution they have come up with so far is to create an L.L.C. as a shell company. I mean, it isn’t such a bad plan. Bernanke can get all of the paperwork he needs for a mere $69.99 (shipping and handling not included).

On a serious note, this could get messy very quickly. Consider the following scenario:

1) Fed/Treasury creates private vehicle BadDebt , L.L.C. to implement this strategy
2) Cashco, a financial services firm, experiences cash flow shortages and is in trouble. BadDebt buys $10M in their short-term paper.
3) CashCo, Inc. survives their cash flow hiccup, and within a month is back in the market. Their investment arm buys $10M in commercial paper from Acme Corp, a regional manufacturer experiencing cash flow shortages.
4) Three months later, BadDebt., LLC also buys $10M in a future round of commercial paper issued by Acme.
5) Acme Corp craters, defaults on the paper and files for Chapter 11.

Now, the government finds itself as both judge and claimant in bankruptcy court. By law the Bankruptcy judge must treat BadDebt’s claims as subordinate to CashCo’s. The net outcome is that the government ends up financing and presiding over their own haircut.

One cannot fault the Fed or Treasury for placing these kinds of issues aside for later consideration, given the magnitude of the liquidity crises in which we’re immersed. That being said, I would suggest that Congressional oversight committees leave their calendars open next summer. They are going to have a lot of cleaning up to do.

Fisheries and ITQs

So given the events of the recent few week it seems that issues around the environment and energy have subsided to the back burner for a little while. However, The Economist had an article which talks about a very interesting "tragedy of the commons" problem with fisheries.

Fisheries are a shared resource, and as such, given a completely competitive market, the incentives are aligned for fishermen to over-fish. However, limiting short term fishing would actually help grow the resource in the long run, and thus increase the value for all fishermen.

In light of the market failure, it is important to note that governments have tried bring regulation to solve these problems. Governmental agencies typically put a limit on the season as a way of restricting the total quantity fished. However, as fleets and techniques have become more modernized this has led to an ever shrinking season as market participants race to fill their quotas in the allotted time.

An innovative technique known as the "ITQ" (Individual Transferable Quota) privatizes fisheries and awards "ownership" rights to the market. The incentive of the owners is now to increase the market value of their rights, and is believed to solve the market failure.

While environmental groups and fisheries economists held this to be true in theory, it seems that some economists from the University of California have actually proved that this in a data driven manner.

A few questions given this:

1. Does it make sense to privatize all fisheries? It seems that the incentive to cheat is really high. Obviously, there should be some self-policing involved, but in classic game theory, it probably makes sense for a smaller ITQ holder to over-fish if no one is looking.

2. Can you extend this to other game? I'm not sure whether it is feasible to create hunting ITQs. When you create any security, there is a certain amount of regulatory and bureaucratic oversight necessary to make sure that any market is functioning properly. My guess is that most state natural resources bureaus would not be able to handle the complexity of having a large number of these rights owned by a very disaggregated group of individuals.

3. Should this be a method of protecting biodiversity? I don't think so. The value created by biodiversity in the short-term is unclear and if any assets were created the market would award them little if any value. Given this, if oil were discovered in any fishery the market value of ITQs would increase, oil companies would buy them, and then proceed to destroy the fish. In this case, the cost of reduced biodiversity is an externality borne by individuals operating outside this market, as such, these rights can't be used in the name of conservation.

Funding the bailout – nation of debtors & foreign creditors

The US is a nation of debtors and once again the US plans to fix its troubles with nothing else but more debt. According to the US Department of the Treasury’s September 20 Fact Sheet, the $700B proposed “bailout” of mortgages and other troubled assets will be funded through the Treasury’s general fund.

Funding. Funding for the program will be provided directly by Treasury from its general fund. Borrowing in support of this program will be subject to the debt limit, which will be increased by $700 billion accordingly. As with other Treasury borrowing, information on any borrowing related to this program will be publicly reported at the end of the following day in the Daily Treasury Statement. (http://www.fms.treas.gov/dts/)

As of the end of July 2008, $2,676 billion of US treasuries were held by foreign governments and institutions. Nations of Savers are leading the way; Japan and China hold $593B and $519B in treasuries respectively. A similar cast of characters will be the likely purchasers of the bailout financing. Multiple concerns arise from the increase in US national debt balance: (1) Our children will pay for our mistakes in the form of interest; (2) The increased debt burden, debt service and interest, will continue to make balancing the budge more difficult; (3) Significant holdings of US treasuries may have negative implications for the US in the form of a strategic bargaining position.

The January 2008 CRS Report for Congress, “China’s Holdings of US Securities: Implications for the US Economy,” highlights the concerns of many economists with the high level of foreign debt held by our, at times less than friendly, neighbors. The report focused on the comments of two Chinese officials regarding China’s ability to tank the US dollar by liquidating large blocks of US Treasuries. This ability could be used as a bargaining chip in strategic trade negotiations, such as the US protection of the steel industry. A flood of US dollars in the market place would create a rapid deterioration of the US Dollar and an increase in interest rates (bond price declines à increase in bond yield). A decline in the US Dollar would increase the price of imports and put substantial pressure on an economy dependent upon foreign imports. A systematic depreciation in the US Dollar (as noted in my previous post) could lead to a reduction / elimination of the trade deficit (positive), but a sudden drop coupled with an increase in interest rates would make the necessary expansion of exports difficult (negative).

China probably would not have a credible threat. The US accounts for 30% of all Chinese exports, if the US Dollar depreciates substantially verse the Yuan, the US will reduce purchase of said exports. The fourth largest foreign holder of US Treasuries is “Oil Exports” (South American and Middle Eastern nations) many of which are unfriendly. Who needs who more? The US has substantial dependence on Middle Eastern oil; however, oil is denominated in US dollars. As long as oil is denominated in US dollars, major oil exports have an incentive NOT to see a precipitous depreciation in the US Dollar verse major foreign currencies.

Budgetary impact – Prior to the proposed bailout, net interest expense is expected grow by more than 8% in 2008 and 2009. Additionally, net interest accounts for nearly 2% of the US GDP. While near term the added interest expense ($700B x ~3% = $20B in annual interest expense) would have a negative impact on the current budget, the total cost is unknown, as it is unlikely for all the troubled assets to go to zero.

I am certain of two things: (1) While I do not know what, something needs to happen to restore confidence in US & Global financial institutions; (2) Americans need to start saving.