What's the Fed to do?

Even though Wall Street has suddenly decided that American companies are worth 15% more than they were worth at about 2:00p.m. est on Friday. I still don't think that anyone has any clue what's going on with the American and global economy. Last week was mostly bad news all around. This is a short week here in the States and I expect it to be quiet.

But of interest is a continuation of what I touched on Friday... what is the Fed to do?

Right before Halloween, the Fed set the target rate for federal funds at 1%. But the reality is much lower than that: the effective rate according to the Economist is 0.25% (it is now about 0.50%):

The irony is that, were the gap to disappear, there would be a de facto tightening of monetary policy. On the other hand, if the effective rate remains near zero, the Fed will have to turn to more unconventional means of stimulating growth. Michael Feroli of JPMorgan Chase proposes outright purchases of mortgage-backed securities—another faint echo of Japan.

So what are unconventional means?

I'm not sure, but one suggestion: Don't do what Japan has done since the 1990s.

Moral Hazard and the last few months

I'm not sure where to start since there's so much going on... so I'll just do a bunch of posts and see how many I can get though over the next few hours.

As Congress debates (aka does the political posturing dance) the bailout plan, I have to say I'm pretty much sold on it. Is it perfect? No. In fact, if it was only one company, I'd be all against the bailout. But seeing that we're talking about some really big and important companies, I don't think the government really has a choice. And Gary Becker agrees with me (or more like I agree with Gary Becker).

But as Becker points out, what the bailout does is create a huge moral hazard problem. And by huge, I'm talking $700 billion huge. The lesson learned by these companies is that they can continue to take on bad risks and over expose themselves... and if things don't work out the government will be there to bail them out. As Becker points out, "On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, A.I.G., and Lehman Brothers have been almost completely wiped out, so they were not spared major losses." But on the other hand, these companies have been allowed to survive even though they had been acting irrationally (i.e. stupid and over exposing themselves) and while a lot of people lost their jobs and a lot more lost a lot of money, they didn't lose all their money. As Becker continues, "bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that
are not available to equity participants."

So what has happened is that it looks like the Bush Administration (with an assist from Congress) has created one of the biggest moral hazard problems in human history. Sure, I could go back in history and find other times when the government bailed out a private company or deemed a corporation as too big to fail, but what has taken place over the last few months is unprecedented. I'll say it again, $700 billion dollars of tax payers money will be handed out to a bunch of companies who going under because of their own short sighted stupidity... in other words it's their own fault. But the government is riding into hopefully save the day... at the cost of $700 billion.

(And no one really can imagine how much money $700 billion is, but $700 billion is more than the GDPs of the Netherlands, Taiwan, and Poland; in theory the U.S. government could just buy these conturies instead of bailing out those companies).

But back to moral hazard, it does bring up an interesting debate that Richard Posner sort of digs into... how much blame should be placed on the government? In the case of Fanny and Freddie... a lot. Everyone at both of these quasi-private companies knew that the U.S. government would bail them out of they messed up. And that's what they did. They had nothing to fear... if they could deliver insane profits for a few years it was worth it because they were never going to go down.

However, in the case of Bear Stearns, Lehman Brothers, and A.I.G., it's very hard to place any blame on the government (unless you want to argue about deregulation). There was little prior history or prior history to suggest that the government would come to the rescue of these companies if they went belly up. And I don't think if the Fed and Paulson knew that crisis would only get worse that they would have bailed out (i.e. forced JP Morgan/Chase to buy) Bear Stearns.

Anyway, a great piece from Becker and Poser on what has happened.

SEC to ban short selling

I first read the headline in the Guardian this afternoon that the Brits were going to ban short selling. "Wow, stupid move," I thought to myself.

And then it happened here in the U.S.A.

Stupid would be an understatement.

First short selling. Conceptually, it is a little difficult—by shorting a stock or product, a person is selling a stock/product they do not own, and then buying it back. Obviously they are hoping that the price goes down... in effect it's selling high and buying low—the exact opposite of buying low and selling high.

Which has made the pictures of stressed traders on the floor sort of funny... some of these stock traders have probably made a ton of money this week by shorting stock or other financial products. If anyone is getting 'hurt' this week it's the average American's 401(k).

The SEC wants to put a stop to this. The question is why? And what does the SEC hope to accomplish?

Short spelling is not the reason why Wall Street suddenly found it self collapsing this weekend. They did that on their own by buying a lot of bad mortgagees and over exposing themselves to the real estate market. When that bubble burst, some companies—like Lehman went down—while others like Bear Sterns, Fanny and Freddy, and A.I.G. had to be saved by the U.S. Government.

So why does the SEC want to create an inefficient market? It's probably bad enough that the Fed and other Central Banks pumped in a ton of money today. But no why this? It doesn't make any sense.

To no surprise the SEC won't tell us what they're thinking... so I'll guess.

By banning short selling, or so they hope, they'll slow the fall in the stock market. Are they attempting to play politics with policy? Keep the stock market indices higher than they would be naturally to help out John McCain? Or do they actually believe that by banning short selling that the stock market will rise and everything will recover and in three months time they will have saved the U.S. economy? Coming from the Bush Administration... they probably do believe this just how the believed we could waltz into Iraq and everyone would love us.

But here's the problem... it is a pure market manipulation. And market manipulation is a very very very bad thing. Because eventually things will sort themselves out and it will be much worse than what we're going though at the moment.

This is potentially a very sad and bad day for the United States and the U.S. economy. And this is some of the worst policy making in the last 30 years. But then again, if the Bush administartion has been good at anything, it's bad policy.

The Fall Out Continues

A few good articles I've come across in the last few days:

-- A pretty good run down on the details/behind the scenes look at what did happen this weekend on Wall Street.

-- A "what just happened and why does it matter" from the Freakonomics guys. Also, it's interesting that Levitt is so candid in his "I'm just an economist, I haven't a clue what's going on". I think a lot of people expect economists to understand finance and be some sort of financial genesis... and I guess to a certain degree they do. But economics today is not really about numbers; economics today is the study of human behavior—why people make the choices they make and what our choices mean.

-- Politics and policy are interlinked in this country—even if I don't like it, 'dem da facts—so obviously I'll throw up some interesting political observations and musings. And with the election oh so close, expect a lot political links.

But polling results are starting to show a break for Obama, and now the question/headlines becomes/will become... is McCain in trouble? I think this is a bit of an over reaction (just like the Obama's in trouble! after the GOP convention). But if more polling results over the next week show a swing towards Obama then it goes to show how little of an impact the conventions have, how fickle short term polling data can be, and that no matter what this race is very tight. I don't think McCain is in a lot of trouble, but I was wondering how he would handle being in the lead. The past week, a week with him in the lead, has been less than encouraging. Maybe Obama taking the lead is the best thing for McCain...

-- Who says Obama hasn't done anything and hasn't actually done anything? To anyone who follows Illinois politics, getting this moving is nothing short of amazing.

-- Chuck Hagel, one of my favorite Senators, doesn't think Sarah Palin has the experience to be Vice President.