In a typical economic downturn, where aggregate demand falls short of supply, the Keynesian solutions that President Obama employed in the Troubled Assets Relief Program (TARP) and the American Recovery and Reinvestment Act (ARRA) would probably succeed; government spending would stand-in for the absent consumer, and a rise in inflation and interest rates would go largely unnoticed.

This recession, however, wasn’t caused by a lack of demand.  It was caused by the skyrocketing interest rates that stemmed from the financial crisis—interest rates that prevented people from buying new homes and businesses from stocking shelves, something that they do by purchasing goods on credit, selling them, paying back their creditors, pocketing the difference, and refreshing the cycle.

When banks stop offering corporate loans, other businesses can’t buy goods, which means they can’t earn money.  When unemployment jumps, people fear the worst, and so the personal savings rate rises indicating a drop in aggregate demand.  Two months later, Uncle Sam flies to the North Pole to redeem a favor.

The danger with this kind of stimulus—where ARRA infrastructure programs seek to raise the employment rate and with it consumer demand—is that its method of funding could drive the recession.  Because the federal government lacks the money to pay for TARP and the ARRA, it has been auctioning long-term Treasuries to finance its stimulus, and since it has been trying to sell so many to a limited number of buyers, the Treasury has needed to offer higher-than-normal yields to unload all of them.

This hurts the economy in two ways.

First, higher yields on Treasuries are intended to make them a more desirable investment.  While that means people might use unused money to buy them, thus funding the stimulus, it also means people, fearing market volatility, might move money from stocks to Treasuries; this slows the recovery of the market, and could lengthen the recession.

Second, high yields on Treasuries crowd out private lending.  Treasuries are by design low-interest, low-risk loans.  But when the yield rate rises, they become medium-interest, low-risk loans.  As a result, banks buy Treasury notes and bonds instead of providing loans to businesses and families that don’t have the untainted two century credit history of the federal government.  Of course the allergy to risk that has developed in the financial system only exacerbates the flight to Treasuries.

In the long term, this makes for higher interest rates on mortgages and higher interest rates on bridge loans to businesses.  If these interest rates get high enough, people won’t buy homes and retailers won’t stock shelves: the triggers of the recession reemerge.

Indeed, Mr Obama and the 110th Congress have correctly recognized that the economy needs government intervention—specifically stimulus in construction and real estate—if it is to recover before 2010.  However any fiscal stimulus ought not to undermine the recovery of private lending.  It may be politically painful, but Congress will most aid long-term economic growth by funding its stimulus with income tax hikes.

Not only would higher income taxes discourage people from working multiple jobs, thereby opening more work to the unemployed, but they would also help create a broader stimulus—since the government regains a greater percentage of salaries paid to ARRA workers, it can sponsor more infrastructure improvements and employ more Americans.

Otherwise Mr Obama’s next biography may take a more unfriendly look into the power of audacity—namely how it can drive an earnest attempt at saving the economy into a fiscal race to destroying it.

-David Lamb and Nicole Adams

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When the subprime mortgage industry collapsed in the summer of 2007, the Fed cut its Federal Funds Rate for the first time in nearly four years and continued to lower the interest rate until it reached a range of 0-0.25%.  At first, yields on Treasury securities fell as uncertain investors pulled money from the stock-market and used it to purchase Treasuries—traditionally the safest ways to store money.

But in recent months the Fed’s low interest rates and a growing perception that housing and banking stocks are a once-in-a-century bargain have provoked the beginnings of an economic recovery: investors are withdrawing money from low-risk savings like time deposits and Treasuries and investing them in higher-return areas like real estate and stocks.  Fewer investing in Treasury securities means higher yields are required to sell Treasury securities.

Mr Bernanke seems to think he can change that.

Last March, he announced that the Fed would buy $300 billion in Treasuries—a move this column has already criticized—over the following six months.  Employing the theory of supply and demand, more buyers for Treasuries ought to decrease yields at which Treasury bonds are sold.  Yet phantom buyers don’t have the same effect.

Reserve funds at the Fed are given to the Federal Reserve Bank by the Treasury.  Thus, using them to buy Treasuries—loans to the Treasury that allow it to create money—amounts to what economists call “quantitative easing” or what the layperson calls “printing money.”  And whatever you call it, it results in inflation.

Since higher inflation makes lenders require higher interest rates, fears of future increases in inflation drive up yields on Treasuries, particularly long-term securities like the 10-year note and the long bond.  In the end, this means having the Fed buy Treasuries in order to decrease their yields will have the opposite effect—it will increase yields.  And if Mr Bernanke continues to implement simplistic view of supply and demand, he might misinterpret the rising yields that will result as a sign that the Fed isn’t buying enough Treasuries.

By September we could have high yields on Treasury bills and hyperinflation.

And the difficulty in controlling inflation, especially once it passes 10%, is the reason that it’s such a thorny issue.  Even if high inflation doesn’t originally result from the Fed buying Treasuries, economists predicting high inflation could trigger it.  When workers observe high inflation or think they observe high inflation they demand higher wages; then when wages rise, inflation results, and workers continue to demand raises.  As long as people expect high inflation to continue, the economy won’t escape the wage spiral, inflation will continue to chase its tail, and economic resources will be poorly allocated, all because the Fed wanted to lower Treasuries’ yields.

Mr Bernanke should understand this: the recent climb in yields on Treasuries is of his own making—it is the product of thirty months of a low Federal funds rate, which is intended to goad Americans into taking money from places like Treasuries and spending it.  If Mr Bernanke thinks the yields can be lowered by any means other than an interest rate hike, then there’s a space for at the Psychiatric Institute of Washington DC.  It’s safe, small, and only three miles from the Federal Reserve.

In the meantime, the Fed can advertise the job opening.  It has one hundred twenty million toddlers to choose from.

-David Lamb

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Eight months later Harvard University’s Oliver Hart and University of Chicago’s Luigi Zingales want to use CDS prices—from AIG and companies like it—to dictate the total reserves banks are required to keep on hand.

Yet in their rush for the tenure that could follow a successful bid at controversy, the two professors seem to have avoided making a legitimate case for their brand of financial industry reform, instead vying for a geography lesson on the distance between Wall Street and the University of Chicago.  That distance, in miles 710, appears to be larger in economics.

Mr Hart and Mr Zingales suggest that government regulators use the price of CDSs on banks—a measure of banks’ perceived health—as trigger mechanism for intervention.  Their argument for doing so rests on the doctrine that private investors can better interpret risk and reflect it in CDS prices than the government can in looking at bank reserves and fundamentals.

But the Dow Jones reaching thirteen-thousand points, even after the subprime mortgage crisis started in 2007, and results from Federal Reserve’s “stress tests” only partially being released to the public suggest that private investors lack the expertise and the information to judge the risk of bank defaults on both macro- and micro-economic levels.

More importantly, CDSs probably won’t be around long enough to become a barometer of financial strength.

Like all credit derivatives, CDSs transfer risk.  Unlike funded credit derivatives, however, CDSs leave the buyer with the risk that the default insurer—the largest of which was AIG—will default on its credit protection payout.  In other words, they function like a form of unregulated insurance where the insurance company can fail.  Not only does that possibility defeat the purpose of insurance, but it also means that CDSs provide financial firms and investors with a false sense of security.

Because CDSs and their sense of security led America into the worst recession in seven decades, the Securities and Exchange Commission has begun a campaign to regulate credit derivatives.  And once CDSs are strictly regulated, their costs won’t purely reflect the market forces that Mr Hart and Mr Zingales praise.

Having investors regulate banks’ required reserve ratio—the proportion of their equity to their debts—through the fluctuating price of a regulated product is like having Former President George Bush treat cancer patients through a nineteenth-century telephone: one party is making decisions that it isn’t qualified to make through a channel that distorts its message for another party whose life is on the line.

There’s a better way.

If the Federal Reserve collaborates with President Obama to perform a more rigorous “stress test” on Wall Street banks and uses the findings to create a temporarily-mandated reserve ratio, it can use the findings to make realistic required reserve ratios for individual banks.  In the short-term, the Federal Reserve should allow banks to use more leveraging than it currently permits; keeping a tight hold on asset leveraging will only require more government loans and make the bailout more expensive.  But in the far-term—once banks have recovered enough money to lend conservatively without chocking domestic credit—the Federal Reserve needs to require a reserve ratio closer to 18%.

Mr Hart, Mr Zingales, and other like-minded free-market economists ought to acknowledge that market failure in addition to weak government oversight caused the financial crisis.  The free-market and government intervention will get America out.

Denying that government is part of the solution is saying that the marketplace knows how to price CDSs—a claim that the Dow Jones can dispute six-thousand times.  And if the free-market can calculate financial risk, then Mr Bush is a doctor.  Perhaps Mr Hart and Mr Zingales could volunteer to be his first patients.

-David Lamb

Mr Hart and Mr Zingales explain their argument for using CDS price to regulate banks here.

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The recent two-month stock market rally—only now beginning to falter—and results from the Federal Reserve’s bank “stress tests” have persuaded Treasury Secretary Geithner and Reserve Chairman Bernanke that America has avoided  the worst banana since the Great Depression.  Before passing such judgments, Mr Geithner ought to examine President Obama’s 2010 budget.

The budget resolutions currently in both houses of Congress are unlikely to reduce the $1.17 trillion deficit that Mr Obama’s plan forecasts.  If that federal deficit—the second largest ever—remains, it will be all but impossible to finance.

When the House and Senate settle differences in their budget resolutions and approve an identical plan, the budget will come into effect for the fiscal year that starts on the first of October and the Treasury will be responsible for bridging the gap between federal revenue and federal spending.  During normal times, faith in the U.S. government and an international need for secure investment allow the Treasury to finance the national debt through Treasury securities and government bonds with low interest rates—something that will prove difficult if China isn’t a returning customer.

Over the past two decades, the Chinese government has reliably invested its annual surpluses in U.S. Treasury Bills.  By doing so China secures its wealth and, more importantly, helps the U.S. government to continue running the deficits that allow Americans to afford Chinese imports; if the federal government were unable to easily finance deficits, it would need to raise taxes enough to remove them, thereby decreasing every taxpayers’ disposable income—much of which is spent on products manufactured in China.

If nothing else, this recession has shown China how much it needs American demand: since the U.S. recession began, China’s exports have dropped more than 18%.  And combined with its own domestic recession, this drop has produced China’s largest fiscal deficit in sixty years.

So China’s government needs to buy Treasury Bills so that the federal government can stimulate demand for Chinese exports, but China’s government can’t buy Treasury Bills because it’s as bankrupt as the federal government.

What’s Mandarin for “pickle?”

America has been in this situation before—where Congress ran massive deficits without sufficient demand for government bonds.  The time was 1978 and the result a 12% inflation rate.

Instead of raising bond yields to rates at which they would be purchased, the Federal Reserve decided to purchase long-term Treasury Bills, thus funding federal deficits.  In effect the Treasury printed money, put it in the hands of Congress, and promised that it would later re-purchase the money and remove it from circulation.  While issuing currency financed the federal budget it also created inflation, which functioned as tax on everyone holding the U.S. Dollar.  Since less affluent people tend to hold more of their wealth in the form of cash savings—instead of in a home, a car, or the stock market—the tax was regressive.

Mr Geithner should ensure that this doesn’t happen again.  He should testify before Congress, advising its members to minimize deficits in their budget resolutions and explaining to them why “free lunch,” at least in fiscal policy, is so elusive.  In a global outlook where the Treasury’s best customer—China now owns 24% of the national debt—has a deficit, Congress needs to decrease spending or create sufficient revenue to close its budget shortfall.  Otherwise Congress will unknowingly levy a tax on the poor.

That’s a recipe for one very bad banana.

-David Lamb

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The subprime mortgage crisis that became the financial crisis that became the recession that became the Great Recession wasn’t a consequence of market failure or misguided risk-taking.  Rather it was the result of individuals—bankers and homeowners—behaving like individuals at the expense of the broader economy: exploiting bankruptcy laws that mitigate their own risk, not by removing it, but by imposing it on third-parties.

Subprime mortgages are called “secure” because their loan value is designed not to exceed the value of the property.  This means that if a homeowner becomes delinquent on a mortgage, the lending party can foreclose on the home and recover the loan’s entire value.  As long as real estate prices are static, banks don’t carry significant risk writing mortgages without down payments.

The problem is that this system depends on home values not falling below mortgage values.  When they do—when delinquent borrowers owe more than their houses were worth—creditors can be stuck with a deficit: their collateral—the house—is worth less than their credit—the mortgage—which means foreclosure doesn’t bring all of their money back.

Non-recourse loans, which protect borrowers and compose the majority of American mortgages, compound the problem.  These loans stipulate that debtors whose houses have been foreclosed on have no responsibility to pay the remainder of the mortgage if one exists.  In other words, if the value of Mike’s house drops enough that his mortgage is larger than his home’s value and he stops paying his mortgage, his bank can foreclose on his him, but can’t seize his car or his television.

By defaulting on his mortgage and walking away, Mike earns money.  By continuing to pay the mortgage, Mike overpays for his house.

As the last eighteen months have shown, the bank isn’t the real loser in this arrangement.  After all, the bank can declare Chapter 7 bankruptcy protection and its debts become an externality forced on its creditors—often the federal government, which has attempted to avoid bankruptcy among large financial firms by loaning them money.

Banks realized that bankruptcy was a possibility, and, knowing that bankruptcy laws had them covered, made a calculated decision to trade risk for return.

In finance, risk is directly related to profit—the riskier the borrower, the higher the demanded interest rate.  The more risks a firm is willing to take, the more it can earn.  Because bankruptcy protection shelters irresponsible risk-taking, banks have an opportunity to take more of it.

Limited liability laws mean employees and owners of defaulting companies can’t be pursued by the companies’ creditors.  Thus when payment bonuses are structurally related to immediate profit, financial managers can accept excessive gambles, earn excessive payouts, and, worst-case scenario, lose their jobs when their gambling leads their employers into failure.  The more likely situation seems to be that the Federal Reserve saves the companies and most managers’ jobs with them.

Consider, too, that there’s something in this for borrowers.  If Mike, in an alternate scenario, has no mortgage and is having trouble selling his house, he may be able to find a bank that overvalues it and offers him a non-recourse mortgage with a five percent down payment.  Once he signs the mortgage he can ditch the property and walk away with the money.  That the bank can’t recover the value of the mortgage by selling the house isn’t Mike’s liability.

And yet it could unhinge the economy or necessitate a taxpayer-funded bailout.  If Congress wants to avoid future bailouts, it needs to reform bankruptcy laws so that they don’t allow for individuals to profit from risks that were forced upon the entire economy.  Otherwise bankers and homeowners will continue to abuse the spread between personal risk and economic dangers.

Indeed, if individuals behaved with macro-economic outcomes in mind, recessions wouldn’t exist; Americans wouldn’t have overspent when they should have been saving and wouldn’t be saving now, when they ought to be spending.  However individuals largely look to individual outcomes, and these outcomes have awoken the bears on Wall Street, and it’s the taxpayers who are being mauled.  It’s open season.

-David Lamb

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Former presidential candidate Mitt Romney recently joked in a CNN interview that his National Council for a New America colleagues—and in particular Sarah Palin—“aren’t that cute.”  But Mr Limbaugh didn’t find Mr Romney’s words cute.  Instead he attacked the week-old Republican council, saying “they despise Sarah Palin. They fear Sarah Palin. They don’t like her either.  According to them, she’s embarrassing.”

Ignoring the political implications of Mr Romney’s comment, the situation ought to signify the end of Republican patience for Mr Limbaugh.  As the GOP tries to find a footing in its new grassroots conservative movement, he simply isn’t a positive addition.

Since Mr Limbaugh has always targeted his show squarely at Republicans, he has built an audience as closely the Republican base as any.  As recent fallout from his reluctance to go along with the GOP’s new  aspirations proves, this isn’t healthy for the Party.

MNSBC’s Rachel Maddow articulates well the dilemma that Republican politicians face: “disagree with Rush Limbaugh, and you risk alienating your base, but agree with Limbaugh and [you] risk alienating everyone else.”

What are Republicans to do?

A Think Progress video recently showed Republican Tom DeLay expressly agreeing with Mr Limbaugh’s desire for President Obama to “fail.”  More such leaders joining Mr Limbaugh could make for a rocky road ahead for the Republican Party.

That’s the point President Obama made recently when he told a reporter that the conservative movement wouldn’t succeed if led by Mr Limbaugh, and the point that a Conservative Political Action Conference (CPAC) presenter contested, saying, “the only way [Republicans] will succeed is to listen to Rush Limbaugh.”

Whether or not Mr Limbaugh should guide the GOP, replacing him will be difficult.  The 2008 presidential elections are proof that no political movement can popularize a leader who they can easily control; Democrats stood behind Mr Obama but now attack him for abandoning his liberal policies and Republicans stood behind Senator McCain but couldn’t get him into the White House.

The GOP can win neither elections nor popularity addressing only its far right base.  No doubt, that phenomenon was behind the collapse of the Republican Party that followed Mr McCain’s selection of Governor Palin.  Besides, he centrist, libertarian, and true conservative voters of America don’t want a presidency that can’t succeed.

A fundamental change must be made in the governing body of conservatism.  If conservatism is to succeed, its supporters must first recognize Mr Limbaugh as the relic that he is—an artifact of a capitalist era that’s not coming back.

Pacer521 is the thirteen-year-old political blogger and author of Politics Decoded. His writing has been syndicated around the web and by newspapers including Boston Globe.

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The Dow Jones spent seven-thousand points trying to find the chalk that regulated the hopscotch game, but the lines were painted in invisible ink.  When the Federal Reserve finally decided that inconsistency wasn’t a viable public policy model, Mr Bernanke introduced the Supervisory Capital Assessment Program, otherwise known as the bank stress tests.

Stock markets began a two-month rally.

President Obama has pledged that the Federal Reserve will provide the capital necessary to guarantee the survival of all nineteen banks surveyed in the stress tests.  Although this promise comes with a moral hazard—that government-backing encourages banks to take excessive risks—a defined federal policy allows investors to better assess banks’ worth, thereby decreasing the instability of financial stocks.  A fifteen percent decrease in the Market Volatility Index (VIX) since the stress tests started shows the new policy is working.

The problem is that insuring the survival of the nation’s largest banks because they’re large, transfers risk to the federal government, an entity certainly too big to fail.  And even though the Federal Reserve socializes the largest private sector losses, the private sector keeps its own profits; it’s called lemon socialism, and it leaves a sour taste in every taxpayer’s mouth.

If government loans work, taxpayers can benefit from the high interest rates written into bank and auto industry loans in the Troubled Asset Relief Program (TARP).  However, the fact that TARP loans were given to companies that no banker was willing to lend to, makes it unlikely many are good investments.  If Congress is committed to making them good and getting its money back, it will be committed to hiding information about which banks are closest to failure.  After all, banks can only succeed if businesses are willing to deal with them.

In other words, taxpayers’ best chance of repayment lies in a consistent message that companies will be bailed out, a nationwide confidence-boost, and no transparency that will show the confidence-boost to be unwarranted .  Sound like the stress tests?

Economists are saying “yes” as they recognize that the tests’ more adverse scenario is more likely to happen than its so-called “baseline scenario.”  Still, many of these concerns only become real once economists vent them: when economists sneeze, the nation catches a cold.  When the media reports that the nation has a cold, the nation catches swine flu.

We’ve been infected, and denial is the best cure.  If Mr Obama wants repayment for TARP loans from Wall Street firms, he needs come through with his promise of giving all necessary aid to any of the nineteen largest domestic banks.  Then he needs to convince businesses that the results of the stress tests aren’t dismal without actually releasing the results and that the Federal Reserve’s investments in companies like Chrysler and Citiroup don’t carry significant risk.

America doesn’t need transparency; America needs a placebo.  Under normal circumstances, Mr Obama might object to misrepresenting the health of Wall Street banks to other Wall Street businesses, but these aren’t normal circumstances and Wall Street businesses aren’t as innocent as they pretend to be.  When in Rome, do as the Romans do.

-David Lamb

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That’s the message that teachers are getting from President Obama’s first hundred days as states begin shovel-ready projects funded by his and the 111th Congress’ stimulus package.  The congressional bill—which finances state-run public works projects—does nothing to fix America’s shovel-ready education system whose problems the recession has exacerbated.

Since state and local governments, unlike the federal government, are required to maintain balanced budgets, they raise tax rates and cut spending during times when fewer residents are working and therefore paying income taxes.  During these times—recessions—the federal government picks up the slack in economic stimulus by granting money to states to hire workers to complete specific tasks.

This time around the business cycle, Congress is calling the federal stimulus the American Recovery and Reinvestment Act (ARRA); the name only applies to the construction industry.

In addition to increasing the nation’s money supply, the ARRA was designed primarily to do two things: stem unemployment among construction workers who have been hit especially hard by the real estate meltdown and counter the tax hikes and layoffs inherent in state governments’ recessionary budgets.

Indeed the stimulus may save America’s construction industry, but it won’t solve states’ chief budgeting problems.  Since money from the ARRA is bookmarked specifically for infrastructure projects, it has failed to prevent state governments from shedding jobs in non-construction areas.  While states begin long-needed expansions in roads and bridges, they are cutting back on education funding of which they provide nearly half—local governments and federal subsidies pay for the rest.

More construction jobs, at least temporarily, and fewer public teaching ones may strengthen some students’ claims that education isn’t necessary to succeed in America.  Along with the larger classrooms that will result from next years’ smaller public school budgets, such an attitude will hurt the American economy in the long run.

Assuming per capita income reflects relative contribution to the economy, the opportunity cost of one American not attending and graduating from a four-year college is $24,000 per year.

If the ARRA produces an increase in construction jobs, more students may pursue careers in that field.  The general uselessness of an advanced degree in that work, along with a poorly-funded public education system, could deter students from attending college.  Project the trend ten years into the future and you will see an America with too many construction workers and not enough construction jobs; infrastructure improvements now will only make that problem worse.

Another construction bailout will be order.

This outcome isn’t an inevitable one.  If Congress amends the ARRA so that it provides money outright to state governments instead of financing specific tasks, states could team with local governments to avoid lay-offs at public schools.  Of course America wouldn’t have as much to show for its stimulus—whereas the current ARRA produces new highways this type of amended version produces a better educated youth—but it would have a sturdier economy.

Besides, if anyone recognizes the importance of learning, it ought to be Mr Obama.  It wasn’t the well-built dorm rooms at Harvard Law School that propelled him into the White House.

-David Lamb

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Its government-led solution—which looks like bank nationalization, swims like bank nationalization, and quacks like bank nationalization—isn’t bank nationalization.  It’s a financial industry recovery program led by President Obama.

The problem is that Mr Obama’s program prevents Wall Street firms from differentiating themselves.

Although the Treasury has been reluctant to confirm reports from large New York banks, many healthy ones claim they were pressured to accept funding from the Troubled Asset Relief Program (TARP).  Others reported that after being asked to participate in the program, funds “showed up,” forcing involvement before a decision had been reached.

Then, when healthy banks like Goldman Sachs and J.P. Morgan requested to pay back TARP money, Treasury Secretary Geithner said that Mr Obama’s administration would only accept repayment if it was in the best interest of “the [credit] system as a whole.”  Mr Geithner’s worry with early reimbursement is the same one that led him to advocate that all large banks accept government financing in the first place—that a few banks rejecting or refunding loans would show consumers which banks are most stable and trigger runs on those that aren’t.

Indeed struggling banks can’t turn a profit if companies aren’t willing to do business with them.  However trying to hide weak ones behind their healthier peers is dangerous and shortsighted.  When stockholders see uncertainty, most assume the worst; that’s why the Dow Jones dipped more than 50% from October of 2008 to last March and why massive Bank of America losses set off declines in Goldman Sachs stock prices last year.  It’s also why President Lyndon Johnson signed into law the Freedom of Information Act of 1966.

We’ve known for more than forty years that markets are unpredictable when denied information.

But instead of undergoing a deep analysis of Wall Street banks to inspire confidence in investors, the Federal Reserve’s Supervisory Capital Assessment Program, known as the “stress tests,” seek to further equalize banks by publicly revealing only certain findings, presumably the positive ones.  The logic is the same that Mr Johnson implemented during the Vietnam War—that releasing exclusively good news leads people to assume that none of it is bad.  Warren Buffet won’t fall for that one.

The stress tests’ positive findings will provoke some level of differentiation among America’s banks, even if that drains business from feeble ones, thereby making the financial bailout more expensive.  As Americans will soon discover, there’s no alternative—forcing profitable firms to accept money they don’t need so that firms that need government money don’t look bad accepting it, makes everyone look unprofitable.  Everyone’s share price will reflect that.

If Mr Obama and the Federal Reserve decide not to reveal any information that the stress tests produce and the Treasury rejects repayment from J.P. Morgan and Goldman Sachs, they may succeed in dressing all banks in the same clothes enough that they look alike.  In effect, that will amount to nationalization of America’s financial landscape.

Even though that route will likely preserve more finance jobs, it will stifle competition and the motivating threat of bankruptcy that Mr Geithner has been reluctant to impose.  In that case, whether or not Mr Obama calls it nationalization, Bank of America will have an all-too-appropriate name, and its customer service lines may start to resemble those at the Registry of Motor Vehicles.

If it looks like it’s run by the government, swims like it’s run by the government, and quacks like it’s run by the government, guess what?

-David Lamb

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As it turns out, the bill was fresh from the Philadelphia headquarters of the United States Mint; what the economist thought was a piece of counterfeit currency was actually bailout money, planted on the other side of the asphalt for the banker who the federal government knew didn’t accept the idea of market efficiency.

President Obama and his administration predicted the banker would reason that if the efficient-market hypothesis (EMH)—the theory that the prices at which all financial assets are traded reflect all known information—held true, then commodity prices never would have spiked in the summer of 2008, real estate prices wouldn’t have increased by 50% from 2000-2007 and then since lost those gains, and the “dot-com bubble” wouldn’t be a case study on human psychology applied to economics.

Although many economic theorists still hold that investors are rational, and use the EMH as evidence that stock prices mirror real stock values and that outperforming the market is therefore impossible through any means other than luck, a growing number of financial economists are beginning to doubt the EMH.  Over the past fifteen years, free stock-trading websites have made available information that was previously difficult, if not impossible, to find.  And yet an increase in real-time financial information has correlated with an increase in bad investing—the dot-com bubble, the oil speculation bubble, and the American housing bubble have all come since then.

Because the price of a share of AOL in 1999, a barrel of oil last July, and a two-bedroom Albuquerque condominium in 2007 had little relation to their actual or potential value, something other than market efficiency must have been at work.

The EMH ignores the fact that humans aren’t good at calculating risk; it’s why we make bad bankers, and why we need to tame our actions by leaning on protocols like laws, etiquette, and ethics to govern our decisions.  But most importantly, it’s why we are subject to the herd mentality that creates the greater fool in the greater fool theory—the man who became a first-time homeowner three years ago or who bought copper last year because it’s month-to-month increases were seemingly guaranteed to continue.

Homo economicus—the “economic human” —doesn’t exist.

Herd mentality does, and it’s leading politicians to the wrong solutions at the wrong times.  Now, when every major investment bank has been closed, General Motors (GM) and Chrysler are nearing that fate, and most major Wall Street banks are in the red, Mr Obama has dismissed GM’s chief-executive, the 111th Congress has passed legislation regulating executive pay, and the president’s administration is working with Congress to force banks into freeing up the funding they received in the Troubled Asset Relief Program.

An investor doesn’t need advice after he’s lost all his money in a speculative bubble; he needed it when he was buying the “sure thing” peacock feathers stock.  Just so, business needs government regulation most during periods of economic growth and least during recession.  While the economy is expanding, lending practices can get sloppy, salaries can become bloated, and undue optimism can lead managers to taking on excessive risk.  Here, at the bottom of the business cycle, banks currently funded by the government are being run how they should have been years ago, lending cautiously and dismissing failing executives like the criminals they are— are now and always have been.

It may be difficult for Mr Obama and his Congress to understand that they aren’t needed during this time of crisis—or rather that their regulation isn’t.  It will surely be more difficult for them to explain that to outraged voters.  But look at the numbers—America’s personal savings rate, 4%, is higher than it has been in fifteen years and average CEO salaries are lower than they have been in nearly that long; the recession is making us all better calculators.

It will be several years into the future, in a world of rising stock prices, when one homo economicus will cry that an industry’s profits are unsustainable or its businesses overvalued.  Then Mr Obama will have a problem best fixed through government intervention.  May he fix it before the herd catches up with its own foolishness.

-David Lamb

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