Paul Krugman’s Return of Depression Economics

A few months ago I commented on Dr. Paul Krugman’s receipt of a Nobel Memorial Prize for Economics. Well he just recently released an update of a ten year old book he has called, The Return of Depression Economics and the Crisis of 2008. Personally, I don’t see how Dr. Krugman is qualified to talk about the return of the current financial crisis given that he didn’t see it coming. However,  if real insight or predictive power were required for macroeconomists to write books, the field wouldn’t exist. 

I haven’t read the book, so I’m not going to judge the proverbial book by its cover, but judging by the reviews off of Amazon Dr. Krugman doesn’t spend much time in this book addressing our current financial crisis. It would seem that the theme of the book is that more regulation is needed to correct various situations that he feels are excessive and most of the situations he presents (such as Long Term Capital Management) are ten years old. Towards the end of the book, Krugman presents his analysis of the current financial crisis. I am not the least bit surprised to read that he feels that our current crisis was the result of insufficient demand. Continue reading Paul Krugman’s Return of Depression Economics

Answering Cathy’s Questions

Cathy, good friend and frequent blog commentator, recently left the following comment:

A nice series, even if it doesn’t have a happy ending. For those of us who already live austere debt-free lives yet have no money to invest, how would you suggest we prepare for what is coming?

I am also curious as to how guys like Madoff figure into all of this. If the SEC wouldn’t investigate when told the fund was likely a Ponzi scheme, then the SEC is useless. We should get rid of it. What would be a Libertarian answer to fraudsters like this?

So far, most “Libertarian” answers I have heard (from those who claim to be party members) involve non-answers like, “don’t get fooled, protect yourself”. I call it a non-answer because it means that everyone would have to be superhumanly smart and educated in order to know everything. It means that those unable to care fully for themselves would still be at the mercy of shysters. You’d still need somebody whose opinions you trusted… and Madoff was a very trusted name!

What would be your solution? Cheers!

For your first question, that fact that you are out of debt is very important. You also seem well-prepared for whatever calamities might next befall our society. But, if you’re looking to do more than just survive — and actually prosper — then I’d recommend you pick up a copy of my book. I give some very practical advice in there about how to save money including a section on how to get credit card fees refunded — yes, even if customer service denies you the first time around. In addition, I go over the specifics of how to start and grow a portfolio that’s going to do well over the next few years.

Going forward, America will still have an economy and building wealth will require that you participate in it. So you’re going to need to find that niche in that economy that best pays you for the talents and training you already possess. (If you’re lacking, then this is a good time to acquire it.) That the dollar will eventually default is almost a given in the future, so any student loans you take out to go back to school may end up being a free roll.

In terms of picking out skills for the economy, keep in mind you need to look to the economy of the future — not the present. Language skills will be at a premium. I can think of no language that wouldn’t be useful in some way. Asian languages such as Chinese would suggest themselves, but Europe will remain a training partner of ours as well which means that any of the traditional languages commonly accessed through your local college will be in demand.

Now as far as the SEC goes, I’m afraid I have the same non-answer as the other Libertarians: “Caveat Emptor”, (‘let the buyer beware’). Yes there will be frauds in the areas of finance just as there are frauds and cheats in all walks of life. The individual needs to be very aware of where his money is and how it is being put to work — which, incidentally, is called “transparency” in the field of accounting. Bernard Madoff did not have any transparency to his operation. His operations were a black box into which people out money. In return for it, Madoff would send them statements telling them they had made a profit when they really hadn’t. He didn’t provide any explanations for how their money had grown, just that it had.

Meanwhile, private industry will respond to the investors’ needs for information on where they can safely put their money. Accounting firms will audit records, and those with audited seal of approval from a prestigious accounting firm (which Madoff also did not have) can also go a long way towards keeping the cheats out of the system.

Now, I know this isn’t a perfect answer — in fact, you seem to feel it’s a “non-answer” — but keep in mind that the traditional answer failed, too: the Government’s oversight group, the Securities and Exchange Commission, investigated Madoff twice in the past 4 years and both times came up with nothing. All that did was give people the illusion that Madoff was running a clean ship when, in fact, he was not. Regulatory agencies such as the SEC and the FDA tend to have a horrible record in terms of fulfilling their charter. There have been a number of drugs that made it to market only to kill people under the watch of the FDA just as the largest financial scandals in history have been under the SEC. These agencies do little but chew up taxpayer money and give the organizations they preside over an aura of legitimacy.

In essence, what your question boils down to is, “What can be done about evil in the world?” There is no one answer to that. Evil will always exist and it will never be eliminated entirely. In terms of limiting our exposure to it, there is no substitute for learning the art of skepticism and critical reasoning. Those mental tools will keep most people out of an awful lot of trouble. And, of course, there will always be organizations that will come along and say that they can vouch for various clients of theirs. Then you have to decide whether you want to trust the vouching organization. Sometimes it’s private, and sometimes it’s a government agency.

I haven’t seen any studies to support the notion, but I’m putting my money on the free market to provide better watchdog agencies than the Government.

SEC Decision to Hinder Short Sellers

The first stock market to develop after the fall of the Roman Empire found it’s home in The Netherlands. The Dutch East India Company’s shares of ownership became traded amongst Dutch citizens in coffee houses and soon an exchange was born. To buy a share in the Dutch East India Company was to hope that the company’s health and revenues would be higher in the future and that you would therefore own a piece of a more valuable company. But not long after this first stock market came about, did other kinds of stock transactions come about. Among them was the “short sale”. 

A short sale is where you borrow shares of stock from someone else and enter into a contract to replace those borrowed shares at some future date. You would then sell the borrowed shares on the open market and look for an opportunity to buy them back at some point in the future. If you could buy them at a lower price, then you would have realized a profit on the difference between the price you originally sold it at and the price you were later able to buy it at. It’s a twist on the old axiom of buy low and sell high; you sell high and then buy low. 

Since the practice first came about, short selling has not been popular. Buying stock in a company is basically betting on the company’s future success while shorting stock in a company is betting on the company’s future failure. It’s akin to playing craps and putting your money on the “Don’t Pass” line; you just don’t make friends betting on other people’s failure. And unpopular figures often find themselves the scape goats during a crisis, which is what we’re seeing now. 

For those of you who don’t follow the financial news everyday, the SEC has been taking an increasingly aggressive stance against short sellers. Back in July of this year, the SEC banned a practice called “naked” short selling against a handful of financial firms. A naked short sale is when you sell the stock without having to borrow it first. The strange thing is that this practice is already against the law. So in essence the SEC came out in July and outlawed an already outlawed practice, but only against a select handful of financial firms such as Freddie Mac and Fannie Mae. Clearly this was an attempt to bolster the price of the stock of financial firms who were perceived as vulnerable. 

Fast forward to this month, and the collapse and bailout of Fannie Mae and Freddie Mac. The SEC once again took the bizarre step of banning the already illegal practice of naked short sales, but this time around they extended it to the entire market. Then came the bankruptcy of Lehman Brothers and the bailout of AIG last week. As part of the bailout proposed by President Bush, there are two provisions which specifically target short sales:

1. All investment managers must publicly disclose whatever short positions they have. 

2. Short selling has been out-and-out banned for financial firms.

Clearly the SEC are taking a more aggressive stance against the short sellers in an effort “to maintain stability.” It’s also clear that the SEC is acting on concert with both the Secretary of Treasury Hank Paulson as well as Chairman of the Federal Reserve Ben Bernanke to try to prop up the market. 

Blaming short sellers for market collapses or having the government ban the practice altogether is not an old tactic. Historically it would seem every time a market collapses, the government comes down against short sellers. The US Government outlaws short sellers after that market collapse of 1929, but found that the stock market only continued it’s decline. Similarly, the moves against short sellers this year has done nothing to stem the tide of stock market loses for people who were shareholders in Fannie Mae, Freddie Mac, and Lehman Brothers. 

The reason that banning short sellers is ineffective is that they are not really the cause of the market decline. Short sellers did not force the bankruptcies that have occurred this year. They did not entice prospective home owners with adjustable rate mortgagees they couldn’t afford, nor did they convince Wall Street Firms to buy securities associated with these repackaged mortgage loans. They did place a wager that the enterprise wouldn’t turn out well, and that has allowed them (including myself) to profit off of the demise of others as markets have collapsed this year. But so what? 

It’s the height of hypocrisy for the government to try to protect Wall Street firms, who has always been motivated by profit before anything else, by banning the very tools that many of them are still using to this day to earn a profit. When Goldman Sachs disclosed last year that it had a strong quarter because it had placed short sales against the very credit instruments it was selling to its customers, no one batted an eye. But now that Goldman finds itself the target of the short sellers, it gets bailed out by the government.  And it’s particularly ironic that the this government is run by Republicans who have long been advocates of the “free market”. 

It would seem that President Bush’s free market policies are similar to his policies of against nation building; a convenient sound bite to give out when times are good, but quickly forgotten when it might actually matter.