This post draws significantly on an Op Ed from the WSJ, 2/1/2011
Federal Judge Robert Vinson's decision declaring Obamacare unconstitutional opens with a passage from James Madison's Federalist No. 51 "In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself."
The case is not about health care at all. At the heart of the state's lawsuit is the individual mandate which requires everyone to purchase health insurance or be penalized for not doing so.
The legal justification for the law according to the Obama administration is the Commerce Clause. The original purpose of the Commerce Clause was to eliminate interstate trade barriers that prevailed under the Articles of Confederation (amongst the major national problems that gave rise to the Constitution).
After the New Deal, The Supreme Court dramatically expanded the scope of the Commerce Clause as justification for Congressional regulation. (In 1942, the Court held that growing wheat for personal use affected interstate trade, and so justified Federal regulations of the use of agriculture).
Regardless of the interpretation of the Clause, it only applied to "clear and arguable activity", Judge Vinson writes, emphasis his. It never applied to inactivity. Crossing this threshold converges the clause into general police power of the kind the Constitution reserves for the states.
The law is justified on the grounds that "inactivity" (not buying health insurance) is really an activity because everyone eventually needs medical care and those costs will be transferred to the insured.
"You can't opt out of health care." You can't opt out of eating. Under this interpretation of the Commerce Clause, laws could be passed mandating that citizens eat wheat on the grounds that not eating wheat transfers the cost of not eating wheat onto the rest of the market. "Congress could do almost anything it wanted," writes Judge Vinson.
Tuesday, March 29, 2011
Monday, March 28, 2011
Essence of Information
This post draws significantly on William Poundstone
I. INFORMATION
Information, unlike, say water, can be compressed so that we can fit more it through a communication channel. This implies that messages are like sponges; preserve the substance and you can squeeze out the air. Morse code accomplishes this by frequent letters having efficient symbols, and infrequent letters having inefficient symbols.
What is the "substance" of a message? What is the part of a message you cannot do without?
We now know that information exists only when the sender is saying something that the recipient doesn't already know and cannot predict. Because true information is unpredictable, it is essentially a series of random events like spins or a roulette wheel, or rolls of a dice.
The essence of information is its improbability.
For information, this means we encode information (compress) sufficiently that the chance of "noisy" errors virtually non-existent, no matter how noisy the communication channel.
Which leads, of course, to physicist John Kelly's paper "Information Theory and Gambling".
The best gambling strategy (or so we can debate) is the one which affords the highest compound return consistent with no risk of going brok. Just as it is possible to send messages through a communication channel with virtually no chance of error, its is possible for a bettor to compound wealth at a certain maximum rate with virtually no risk of ruin.
We wager: Edge/odds
Edge is the amount of profit we expect to win, on average assuming we can make the same wager over and over with the same probabilities.
Odds is the profit if we win. Odds is not a good measure of probability, because odds are set by market forces (i.e. everyone else's probability of winning).
When the edge is zero, you don't bet. Equivocation is the measure of ambiguity (the noisy channel). Equivocation describes the chance that the message we receive is wrong.
Gmax = R
Where G is the growth rate of the gamblers money (a way of saying compound rate of return) and R is the information transmission rate in Shannon's theory. Money = information.
I. INFORMATION
Information, unlike, say water, can be compressed so that we can fit more it through a communication channel. This implies that messages are like sponges; preserve the substance and you can squeeze out the air. Morse code accomplishes this by frequent letters having efficient symbols, and infrequent letters having inefficient symbols.
What is the "substance" of a message? What is the part of a message you cannot do without?
We now know that information exists only when the sender is saying something that the recipient doesn't already know and cannot predict. Because true information is unpredictable, it is essentially a series of random events like spins or a roulette wheel, or rolls of a dice.
The essence of information is its improbability.
For information, this means we encode information (compress) sufficiently that the chance of "noisy" errors virtually non-existent, no matter how noisy the communication channel.
Which leads, of course, to physicist John Kelly's paper "Information Theory and Gambling".
The best gambling strategy (or so we can debate) is the one which affords the highest compound return consistent with no risk of going brok. Just as it is possible to send messages through a communication channel with virtually no chance of error, its is possible for a bettor to compound wealth at a certain maximum rate with virtually no risk of ruin.
We wager: Edge/odds
Edge is the amount of profit we expect to win, on average assuming we can make the same wager over and over with the same probabilities.
Odds is the profit if we win. Odds is not a good measure of probability, because odds are set by market forces (i.e. everyone else's probability of winning).
When the edge is zero, you don't bet. Equivocation is the measure of ambiguity (the noisy channel). Equivocation describes the chance that the message we receive is wrong.
Gmax = R
Where G is the growth rate of the gamblers money (a way of saying compound rate of return) and R is the information transmission rate in Shannon's theory. Money = information.
Friday, March 25, 2011
We Learned the Wrong Lesson
David Einhorn at Greenlight Capital said, "We learned the wrong lesson."
We should have learned that existing capital requirements were insufficient and that regulators needed legal authority to safely wind down non bank financial companies. Instead, we learned that some institutions are too big to fail.
We learned that we live in a world where reckless misallocation of capital is not punished and bondholders do not take losses. We learned that rules of capitalism are arbitrary and unstable.
Depositors and consumers responded by fiercely reigning in credit to any and every institution (except the US Government!). Confidence collapsed. The negative feedback loop created the Great Recession.
Somehow, the sanctity of the creditor preempted the rules. Markets hate that. On the other hand, markets are perfectly capable of taking (assigning) losses. The bond market gains and looses trillions of dollars every single day. Creditors lend at a spread which compensates them for the risk they take. If things go wrong, they know they don't get their money back.
Receivership that cuts away and transfers operating assets of a financial institution in a clean and efficient manner bolsters solvency of they system and preserves its operations. Losses taken by bondholders can be recouped, in aggregate, by repricing the assets to generate sufficient returns. There is a whole industry of distressed specialists.
Appendix 1:
http://www.cnbc.com/id/15840232?video=3000012150&play=1
On CNBC, the former auto task force chief Steven Rattner argued (convincingly it seemed at the time to a truly stunned and undermanned Ken Falcone, founder of Home Depot) that the reason it was necessary for the U.S. government to step in and finance General Motors was because there was no private capital available at that time (at 4:30 mark). The crisis was so bad, the government had to act.
What makes this argument so apparently strong is the simple truth of it. This is also the argument's weakness: its too simple.
There was no private capital available because the policy makers were applying arbitrary rules, leaving decision makers, the risk takers, frozen.
Wednesday, March 23, 2011
European Solvency
This post significantly draws on George Soros, Michael Pettis, Martin Wolf.
Europe's banking crisis is a currency crisis, sovereign debt crisis, and a banking crisis.
At the heart of this crisis is the need to protect creditors.
As we look at the data, we see countries with contrasting fiscal narratives. Greece had its huge public deficit, Ireland a huge private deficit, Spain, with no deficits.
Following the formation of the Euro, perceived sovereign credit risk converged, such that Greece could borrow at very similar interest rates compared to Germany. The ECB treated all sovereign debt as riskless and accepted them at its discount window on equal terms.
Meanwhile, Germany sharply reduced relative unit labor costs following reunification. As such, a wide divergence in competition emerged in Europe between Germany and the peripherals. In Germany, low labor costs provided the edge to grow through trade surpluses. In the peripherals, the lower interest rates allowed them to finance growth through debt. The excess savings in Germany provided the credit channel.
Because extended credit was perceived as riskless in the case of sovereigns and banks, banks held too little capital against it. Thus, Europe has a solvency problem, not a liquidity problem.
Insolvency requires appropriating losses on liability holders (equity first, then debt). The largest creditors, or course, are German savers. A necessary restructuring will impose losses on the politically powerful Germans. This is why taxpayers are shouldering the cost of Irish and Greek debt.
In the meantime, the European Fiscal Stability Fund (EFSF) provides liquidity necessary to prevent contagion. The EFSF is in part a loss sharing mechanism, but more so it is a way to punish debtor nations. Paradoxically, Germany's economic competitiveness and savings are equally to blame.
This of course has happened before: Latam in 1980s. The model is to provide liquidity to problem debtors for long enough to recapitalize the financial sector (see appendix at the end), at which point bad debts will be restructured.
In the meantime, Europe is forced into slow growth and fast growth economies ("multi speed world says Pimco). The surplus/creditors build on their competitiveness and shift surpluses onto new trading partners. The deficit/debtor countries buckle under the weight of their debt, cannot devalue (Euro!), and cannot compete.
So to recap, Europe has a currency crisis: the single currency prevents adjustment and competition; a sovereign crisis: too much debt and not enough growth; and a banking crisis: under capitalized banks that cannot survive unless creditors are protected.
The current solution is to treat the problem as a liquidity crisis until the banking system is sufficiently rebuilt to restructure the debt. The result will be a two speed Europe and lower aggregate growth.
The alternative is to use EFSF to recapitalize the banks now, as Tarp did when it bought equity in banks, restructure debts now, force creditors to take losses as they should, and lay the seeds for future growth. In short, kick the can back up the road.
Appendix (this draws on John Hussman):
When the book value of equity of bank A falls below zero, the bank declares bankruptcy and the losses fall onto the creditors of the bank who also become the new equity holders. Repricing the liabilities as equity and/or raising new equity (recapitalization) forms a value creating institution.
The problem arises because the liabilities of bank A are also the ASSETS of bank B. The write off bank A's assets causes the book value of equity of Bank B to fall.
So if a large portion of German bank assets are the sovereign and bank debt of peripheral states, which should be restructured, that would imposes large losses on German financial system.
The sub optimal solution is to preserve the value of all the assets, temporarily, through excessive liquidity provisions for long enough for the banks retain earnings sufficient to absorb future losses. At that point, the bad debt can be sold at a loss without harming the capital position of the bank.
The optimal solution is to impose losses immediately while simultaneously recapitalizing the problem banks through "super equity" investments, ideally from the private sector.
Europe's banking crisis is a currency crisis, sovereign debt crisis, and a banking crisis.
At the heart of this crisis is the need to protect creditors.
As we look at the data, we see countries with contrasting fiscal narratives. Greece had its huge public deficit, Ireland a huge private deficit, Spain, with no deficits.
Following the formation of the Euro, perceived sovereign credit risk converged, such that Greece could borrow at very similar interest rates compared to Germany. The ECB treated all sovereign debt as riskless and accepted them at its discount window on equal terms.
Meanwhile, Germany sharply reduced relative unit labor costs following reunification. As such, a wide divergence in competition emerged in Europe between Germany and the peripherals. In Germany, low labor costs provided the edge to grow through trade surpluses. In the peripherals, the lower interest rates allowed them to finance growth through debt. The excess savings in Germany provided the credit channel.
Because extended credit was perceived as riskless in the case of sovereigns and banks, banks held too little capital against it. Thus, Europe has a solvency problem, not a liquidity problem.
Insolvency requires appropriating losses on liability holders (equity first, then debt). The largest creditors, or course, are German savers. A necessary restructuring will impose losses on the politically powerful Germans. This is why taxpayers are shouldering the cost of Irish and Greek debt.
In the meantime, the European Fiscal Stability Fund (EFSF) provides liquidity necessary to prevent contagion. The EFSF is in part a loss sharing mechanism, but more so it is a way to punish debtor nations. Paradoxically, Germany's economic competitiveness and savings are equally to blame.
This of course has happened before: Latam in 1980s. The model is to provide liquidity to problem debtors for long enough to recapitalize the financial sector (see appendix at the end), at which point bad debts will be restructured.
In the meantime, Europe is forced into slow growth and fast growth economies ("multi speed world says Pimco). The surplus/creditors build on their competitiveness and shift surpluses onto new trading partners. The deficit/debtor countries buckle under the weight of their debt, cannot devalue (Euro!), and cannot compete.
So to recap, Europe has a currency crisis: the single currency prevents adjustment and competition; a sovereign crisis: too much debt and not enough growth; and a banking crisis: under capitalized banks that cannot survive unless creditors are protected.
The current solution is to treat the problem as a liquidity crisis until the banking system is sufficiently rebuilt to restructure the debt. The result will be a two speed Europe and lower aggregate growth.
The alternative is to use EFSF to recapitalize the banks now, as Tarp did when it bought equity in banks, restructure debts now, force creditors to take losses as they should, and lay the seeds for future growth. In short, kick the can back up the road.
Appendix (this draws on John Hussman):
When the book value of equity of bank A falls below zero, the bank declares bankruptcy and the losses fall onto the creditors of the bank who also become the new equity holders. Repricing the liabilities as equity and/or raising new equity (recapitalization) forms a value creating institution.
The problem arises because the liabilities of bank A are also the ASSETS of bank B. The write off bank A's assets causes the book value of equity of Bank B to fall.
So if a large portion of German bank assets are the sovereign and bank debt of peripheral states, which should be restructured, that would imposes large losses on German financial system.
The sub optimal solution is to preserve the value of all the assets, temporarily, through excessive liquidity provisions for long enough for the banks retain earnings sufficient to absorb future losses. At that point, the bad debt can be sold at a loss without harming the capital position of the bank.
The optimal solution is to impose losses immediately while simultaneously recapitalizing the problem banks through "super equity" investments, ideally from the private sector.
Tuesday, March 22, 2011
Primer On Inflation
This post draws substantially on John Hussman
Marginal Utility: Price of a good in dollars is the ratio of the marginal utility of that good and the marginal utility of the dollar.
How Inflation: Increase the numerator, the marginal utility of that good. We increase the marginal utility of a good by supply becomes more scare or if demand becomes stronger.
Or...
Reduce the denominator, the marginal utility of the dollar. This happens if supply of dollars increases or if demand to hold dollars declines.
So - inflation occurs when you have an increase in the marginal utility of goods relative to the marginal utility of money. During the later stages of an economic expansion, the capacity for the economy to grow diminishes. The inability for the economy to grow fast enough to satisfy demand means the marginal utility of goods goes up. This is why monetary authorities increase interest rates - to contain the demand side of the economy. The recession realigns demand sufficient to bring down the marginal utility of goods in the economy.
Deflation occurs when you have a decline in the marginal utility of goods relative to the marginal utility of money. Think about the Great Depression. Demand collapsed even though production constraints made goods scarce. The utility of money, or course, soured as people frantically converted deposits into cash.
Curve Ball: Long Term Inflation is NOT caused by the growth of money. It is caused by the growth of government spending.
When government spending appropriates goods and services in an economy in exchange for an increasing supply of government liabilities, the ratio above sharply tilts higher and you get inflation. It does not matter if the government finances its spending with cash or debt, because both pieces of paper fiercely compete as stores of value and means of payment. The values of currency and government securities are set in tight competition.
So, the expansion of government spending, regardless of form, will tend to raise the marginal utility of goods while lowering the marginal utility of money: inflation. The mechanisms are: supply constraints, unsatisfied demands, excessive growth of government liabilities, or a reduction of willingness to hold those liabilities.
Marginal Utility: Price of a good in dollars is the ratio of the marginal utility of that good and the marginal utility of the dollar.
How Inflation: Increase the numerator, the marginal utility of that good. We increase the marginal utility of a good by supply becomes more scare or if demand becomes stronger.
Or...
Reduce the denominator, the marginal utility of the dollar. This happens if supply of dollars increases or if demand to hold dollars declines.
So - inflation occurs when you have an increase in the marginal utility of goods relative to the marginal utility of money. During the later stages of an economic expansion, the capacity for the economy to grow diminishes. The inability for the economy to grow fast enough to satisfy demand means the marginal utility of goods goes up. This is why monetary authorities increase interest rates - to contain the demand side of the economy. The recession realigns demand sufficient to bring down the marginal utility of goods in the economy.
Deflation occurs when you have a decline in the marginal utility of goods relative to the marginal utility of money. Think about the Great Depression. Demand collapsed even though production constraints made goods scarce. The utility of money, or course, soured as people frantically converted deposits into cash.
Curve Ball: Long Term Inflation is NOT caused by the growth of money. It is caused by the growth of government spending.
When government spending appropriates goods and services in an economy in exchange for an increasing supply of government liabilities, the ratio above sharply tilts higher and you get inflation. It does not matter if the government finances its spending with cash or debt, because both pieces of paper fiercely compete as stores of value and means of payment. The values of currency and government securities are set in tight competition.
So, the expansion of government spending, regardless of form, will tend to raise the marginal utility of goods while lowering the marginal utility of money: inflation. The mechanisms are: supply constraints, unsatisfied demands, excessive growth of government liabilities, or a reduction of willingness to hold those liabilities.
Monday, March 21, 2011
On Rising Price and Declining Value
This work draws substantially from M Pettis.
The price of a currency is driven by several factors:
Inflation Differential: If inflation of country A is below country B, then the currency of country A will have depreciated in real terms.
The kind of Inflation matters. We cannot just assume that the difference in CPI between two countries is an effective metric of the inflation differential. What really matters is the inflation in the cost of tradable goods sector.
Productivity: Wage growth relative to productivity growth affects the real exchange rate. Why? Because ...If productivity growth in country A exceeds productivity growth in country B, and that differential is not offset by wage growth differential, that has the effect of depreciating currency A. Low wage growth relative to productivity is effectively a tax on consumption.
Again - the kind of productivity matters. Tradable Goods.
Cost of Capital: The cost of capital is an important input in production of tradable goods. If country A subsidizes cost of capital relative to country B, it is the same as an import tariff or export subsidy. In either case, the effect is to reduce the real exchange rate of country A.
Other Subsidies: Any other differential in the growth rate of subsidies, including taxes will have the effect of real appreciation of depreciation. Subsidized land, taxes, energy.
So What Next: An undervalued real exchange rate is the same thing as a consumption tax on imports which effectively subsidizes manufacturers in the tradable goods sector. It reduces household income, household consumption, and increases production and the trade gap.
Anytime household consumers are explicitly or implicitly taxed and the proceeds are directly or indirectly used to subsidize manufacturers in tradable goods (example: forcing household depositors to lend to manufacturers at artificially low rates) it is the same thing as a real depreciation in the currency.
Any policy that forces up savings rate (production in excess of consumption) or forces down the consumption rate will lead to trade balances.
In that sense, it is very possible to have the nominal price of a currency going up, while at the same time, differential in subsidies to capital, productivity, and inflation could actually depreciate the real value.
The price of a currency is driven by several factors:
Inflation Differential: If inflation of country A is below country B, then the currency of country A will have depreciated in real terms.
The kind of Inflation matters. We cannot just assume that the difference in CPI between two countries is an effective metric of the inflation differential. What really matters is the inflation in the cost of tradable goods sector.
Productivity: Wage growth relative to productivity growth affects the real exchange rate. Why? Because ...If productivity growth in country A exceeds productivity growth in country B, and that differential is not offset by wage growth differential, that has the effect of depreciating currency A. Low wage growth relative to productivity is effectively a tax on consumption.
Again - the kind of productivity matters. Tradable Goods.
Cost of Capital: The cost of capital is an important input in production of tradable goods. If country A subsidizes cost of capital relative to country B, it is the same as an import tariff or export subsidy. In either case, the effect is to reduce the real exchange rate of country A.
Other Subsidies: Any other differential in the growth rate of subsidies, including taxes will have the effect of real appreciation of depreciation. Subsidized land, taxes, energy.
So What Next: An undervalued real exchange rate is the same thing as a consumption tax on imports which effectively subsidizes manufacturers in the tradable goods sector. It reduces household income, household consumption, and increases production and the trade gap.
Anytime household consumers are explicitly or implicitly taxed and the proceeds are directly or indirectly used to subsidize manufacturers in tradable goods (example: forcing household depositors to lend to manufacturers at artificially low rates) it is the same thing as a real depreciation in the currency.
Any policy that forces up savings rate (production in excess of consumption) or forces down the consumption rate will lead to trade balances.
In that sense, it is very possible to have the nominal price of a currency going up, while at the same time, differential in subsidies to capital, productivity, and inflation could actually depreciate the real value.
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