Carbon Futures Price A Cheese Danish

December 22nd, 2009

A nice thing about markets: they have a way of expressing themselves with minimal spin. Just consider the eight point seven percent plunge of futures on EU carbon dioxide permits after the Copenhagen climate “deal” was announced (UN contracts took a similar dive). The message in this swoon is that the understanding in Denmark has a lot in common with the pastry named for the host country: sugar-coated, not particularly nourishing, and yes, rather cheesey.

The so-called Copenhagen Accord, negotiated between the US, China, India, Brazil and South Africa, is not binding, and despite this fails to reach UN targets to prevent “catastrophic” climate change even if it were implemented. Everything from developing nation aid to China’s willingness to accept compliance verification is left squishy, another trait shared by Accord and pastry. Twenty some-odd nations signed on (whatever that means) while many of the rest of the 193 countries represented only consented to “take note” of the document, which is to say acknowledge its existence.  – very postmodern, no?

Unsurprisingly, those who trade and utilize the right to pollute evaluated the odds of Obama, Hu & Co.’s fluffy and legally vacuous understanding having any effect on future restriction on carbon dioxide emissions and responded accordingly: they sold. Carbon rights are worth a lot less in a world where the ability to pollute is unlikely to be diminished in the foreseeable future.

There may be some lessons to be learned from the fiasco in Denmark. If any progress is to be made in limiting pollutants it may have to be achieved in negotiations between the principal polluters, as opposed to a forum with almost two hundred nations, many of whom are simply being asked to accept some degree of first-world largesse. Moreover, the governments of the G20 and their industrializing like may have to be motivated by demands from their own (currently otherwise engaged) populations before they take real action on global warming. That popular will may only come from locally oppressive climactic change, or else as a side effect of the increased cost of scarcer fossil fuels. Not a recipe for either rapid or painless progress.

Paul Samuelson taught that consumers’ desires, as represented by what economists call “utility” could be studied through the theory of “revealed preference”, essentially by analyzing purchasing behavior. It is perhaps appropriate in the wake of that grand old man’s passing that we have been given a peek at the preferences of polluters (who are, in the end, all of us)  though the purchasing of  carbon futures. Though it was known for some time that the chance of anything of substance coming out of Copenhagen was vanishingly small, the ability to pollute is held so dear that even the removal of an infinitesimal chance of its attenuation succeeded in engendering a marked sell-off in futures of that right. We are, it seems, a species determined to foul its own nest, or at least to consume that whose byproduct has this effect. The question is, how uncomfortable will we have to become before we give this planet a break?

New York’s New Darling

December 10th, 2009

If you love New York, you have to love Alistair Darling.

The United Kingdom’s Chancellor of the Exchequer yesterday told Parliament he proposes to slap a 50% tax on bank employee bonuses in excess of 25,000 pounds (about $40,633). This new levy might be the greatest escape from peril the British have allowed Americans in New York since Howe let Washington retreat into Manhattan after the Battle of Brooklyn Heights in 1776.

The recent crisis has left the U.S. financial sector facing a rising tide of regulation, which, combined with the prospect of healthcare reform-driven tax hikes, have made the States a considerably less inviting abode for banks, hedge funds, private equity firms and the like. Onerous NY state and city taxes have only compounded a situation Britain might have taken advantage of by holding taxes steady or even (perish the thought!) easing off on banks. This would have allowed City of London-based firms to bid up for talent while restoring their capital. But Darling and the rest of Prime Minister Gordon Brown’s Labour Party are facing bleak prospects in an election that must be held by June of next year. By sticking it to the City, Brown, Darling & Co. hope to play on populist resentment enough to narrow the electoral gap, at least to the point of creating a hung Parliament and denying the Conservative Party a clear majority.

To this end, Darling’s latest proposal is part of a larger program of eye-popping tax increases. Indeed, the bonus tax, to be paid by the banks themselves as opposed to employees, comes on top of an increase in the marginal personal tax rate from 40% to 50%. Throw in National Insurance and Bloomberg reports the British Treasury will receive 103% of every quid paid to top City earners.

With his latest move, the Chancellor has, for the moment, decisively ceded the competitive advantage back to Wall Street, even with New York and America’s challenging tax and regulatory environment. Darling’s tax, not to mention uncertainty about future British taxes, should mean more jobs and revenue for NYC as international banks and financial firms move easily transferable personnel to offices and trading desks to the western shore of the pond.

When you think about it, it’s the least Darling could do, since the UK’s refusal to back Barclay’s bid for Lehman last year helped usher the later firm into bankruptcy (and its choice assets into Barclay’s hands at fire sale prices). A bit more than a year later it’s another story for the Yanks: Darling’s gift comes just as Bank of America repays its TARP loan and Citi appears poised to do the same, which would remove the largest US banks from Washington-imposed pay caps and enhance their ability to poach London-based talent.

There remain, however, several flies in the Big Apple’s sauce. Darling’s bonus tax is currently envisioned to be a one-time “raid” through April (i.e. just before the election) and once this pandering expires, so will much of NY’s newfound advantage. Higher UK taxes may encourage yet more levies on US firms, dulling the edge Labour has granted America. And the authorities in Beijing seem to lack Downing Street’s generosity, meaning Shanghai may do to NYC what London has demurred from. Further, NYC  need not look across oceans for potential rivals – Greenwich has already taken half the hedge fund business and Jersey City is siphoning away back office jobs from Lower Manhattan.

On the other hand, today French President Nicholas Sarkozy is said to be considering matching Darling’s bonus tax, and, being this is France, at a lower level (27,000 euros, or about $39,750) Of course the land of the 35-hour work week has been a self-hamstrung global competitor for a long time; this move simply safeguards Paris aginst acquiring any unexpected competitive advantage.

Financial service jobs, like money itself, can and do move across boarders with relative ease. High taxes and stiff regulation in one financial center will often only encourage rivals to take the opposite tack so as to garner a greater share of an industry which, lest we forget, remains a huge generator of both jobs and tax revenue. If Wall Street and the United States hope to remain the center of global finance, Washington would do well to remember what London has been kind enough to forget.

China Brings Home the Gold

November 6th, 2009

Seems China waited until after the Beijing games to really go for the gold. The People’s Bank of China, the nation’s central bank, has of late stocked up on the precious yellow to the tune of about a thousand tons, and is said to be hunting for more. Why?

The PRC’s export-driven growth has put China’s central bank in a spot. Selling all that stuff to the American consumer means importing trillions of US dollars. Financing America’s trade deficit (and thus China’s surplus) necessitates lending those greenbacks back to the United States, which the People’s Bank does by buying Treasuries. But,  in order to keep interest rates low, the Fed has been doing the same thing; buying US debt and effectively printing the money to do so, flooding the globe with dollars. The result has been a precipitous decline in the dollar’s value against most major currencies. A crucial exception has been China’s renminbi, with the yuan remaining steady at about 6.83 to the buck for most of this year.

Without intervention by the People’s Bank, the yuan would appreciate sharply against the dollar, making it cheaper for the Chinese to buy imports and helping to equilibrate China’s balance of trade with the world, especially the US. But China’s central bankers know the nation’s domestic demand cannot yet support the production necessary for the nine percent annual growth the country currently enjoys, and indeed may require for social and political stability. So the People’s Bank goes on buying yet more dollars and suppressing upward pressure on the renminbi.

Thus, the PRC is left with huge and growing dollar reserves, subjecting it to further potential losses from a deteriorating greenback, while its artificially low yuan makes importing raw materials necessary for production  increasingly expensive. This latter price pressure can, of course, lead to domestic inflation, which has never been a recipe for the civil contentment China’s leaders seek.

What, then, is a central bank to do when it must simultaneously hedge against both weakness in the world’s reserve currency and inflated raw material prices? China’s answer, at least in part, has been to go for the gold, literally. Despite the PRC overtaking South Africa as the world’s largest producer (with an annual production of around 280 tons), China remains a net importer of the metal. To be sure, some Chinese demand for gold is industrial, and with two trillion dollars in foreign reserves, the People’s Bank is arguably underweight in its holding of the metal. But the Bank’s move into gold is hardly a vote of confidence in the dollar. Indeed, China’s leadership surely realizes that sooner or later they will have to let the yuan rise, effectively devaluing the dollar against their own currency, so diversifying into gold amounts to a hedge against their own future policy.

China is not alone in this gold rush. India’s central bank, facing similar dollar diversification issues, just bought 200 tons off the IMF at approximately $1,045 per ounce, and reports have the Fund looking to sell another 200 tons and tipping the probable buyer as… yes, China.

The rising Asian nations are accumulating other commodities, both as dollar hedges and to secure raw material inputs to production. Key among these is “gold” of the black kind: oil. These moves are part of a secular shift in the structure of global trade, one whose roll in the recent crisis has been seriously underestimated in some quarters. I’ll have more to say on this later, but for now, the next time someone tells you the rise in gold and other raw materials is just “rampant speculation,” ask if the central bankers of China and India are to be counted amongst the gamblers. If so, then the punters are policymakers, and wagering against them in recent days would have felt a bit like betting against the house.

Taxpayers Saved from Morally Corrosive Profits As Citi Sells Phibro

October 20th, 2009

Citigroup’s decision to sell its Phibro energy trading unit to Occidental Petroleum for about $250 million saves the partly government-owned bank from paying trading chief Andrew Hall a reported $100 million compensation. The idea of taxpayers footing so princely a bill had raised the ire of the Administration, Congress and the media, who’ve tried to use Hall’s prospective payday to rally public outrage at what they regard as morally repugnant Wall Street profits. Hence Washington’s intense pressure on Citi to unload Phibro.

Well, thanks to the Phibro sale, the taxpayer-shareholders of Citigroup no longer need worry that they might be sullied by such unseemly earnings. You see, in addition to selling Phibro at what some analysts regard as a cheap price, we the reluctant partial owners of Citi will forgo the average $400 million per year Phibro contributed to Citi’s bottom line.

To be sure, some will argue that firms bailed out with public funds should not be taking the risks inherent in trading operations like Phibro, and certainly Citi’s track record on risk management is, shall we say, rather less than completely reassuring. But measures of risk for a firm like Citi must take into account how the bank’s positions are “correlated,” essentially how they tend to move in relation to one another. Two risky but negatively correlated assets or revenue streams tend to have their values move in opposite directions and thus may hedge or cancel some of each other’s risk. In the case of Citi, while lending and other trading activities went south last year it was Phibro’s outsized gains that prevented overall losses (and the subsequent bailout) from being hundreds of millions larger.

So it’s not at all clear Citi is a safer bank for shedding Phibro, let alone a more valuable holding for the taxpayer. But we all have the consolation of knowing it will be Oxy’s shareholders who’ll be paying those big bonuses, even if after meeting that payroll Phibro’s new owners still end up with a truckload of earnings. This sacrifice means we can all feel morally superior to Wall Street, knowing our leaders made sure we dumped a once and perhaps future golden goose before it send any of those shiny eggs our way. No price to high for rectitude, right?

The problem here isn’t that the government sold out of Phibro but rather that it hasn’t gotten out of Citi itself. Continuing to hold a public stake in any bank means strategic decisions driven by a need to appease or otherwise manipulate public opinion. While this may make good short-term political sense, it tends to lead to biting off one’s potentially profitable nose to spite one’s supposedly overpaid face, with results that, for taxpayers, tend to be far from financially beautiful.


Blame It On Rio

October 8th, 2009

In the wake of the International Olympic Committee’s decision to award the 2016 Summer Games to Rio de Janeiro there has been no shortage of hand wringing over how Chicago and the United States lost. My personal favorite: Brad Flora’s very amusing “Chicago Loses, Nerds Win” in Slate, in which the city’s bid is hamstrung by “good government” types opposing public funding of stadiums. You know the country’s taken a turn toward state enterprise when a derisive moniker once reserved for bespectacled bookish types is now hurled at anyone against getting taxed to fund a government-sponsored sports complex. Flora’s point that local opposition didn’t help is well taken, but the hard truth is the current political economy made Brazil’s Olympic victory a virtual sure thing.

At a time when the BRIC (Brazil, Russia, India and China) nations are credited as new dynamos of global economic growth and the financial authority of the G7 is discarded in favor of the G20, the zeitgeist favored one of the rising players (I’ll set aside the question of whether Russia’s experiment in secret policing of markets really belongs in this group). Brazil, a nation of whom it was once joked was “the land of the future, and always will be” is now the tenth largest economy in the world and is lending money to the IMF its President often scorned. Its 2008 growth rate was an estimated 5.1% and, despite the global economic slump, managed to expand at a 1.6% annual rate in the second quarter. Though still heavy in agriculture and natural resources, Brazil’s development has been accomplished with impressive diversification of economic activity, as anyone who’s flown in an Embraer jet can attest.

The Rio games will be the first in South America and in the Southern Hemisphere outside of Australia, emblematic of formerly Third World nations asserting themselves in the international arena.  With that new-found self-confidence, and in the wake of America’s image problems in the last few years, I suspect there’s a certain satisfaction on the part of much of the international community in seeing a diminished United States. Obama’s election has surely helped in the public relations department, but when you’re leader is praised by those who are after all not only allies but rivals, some caution is in order. Knocking Chicago out of the running at the start of the Copenhagen round and rebuffing the American President (he was flying home when he got the news) is just part of a process of humble pie consumption. It’s worth noting that Luiz Inacio Lula da Silva, a man not shy in his critiques of the U.S. and a sometime supporter of Chavez and Ahmadinejad, is now provided with a capstone achievement for his own presidency. Take that, Yankee.

It’s likely the White House figured the odds and never thought there was much chance the United States would prevail in Denmark, hence the early reluctance to send Obama to plead the Windy City’s case. But a second calculation obtained, rather along the lines of “Dammed if you do, more damned if you don’t” With Japan, Spain, and Brazil sending their heads of state, had Obama not gone he would have inevitably been accused of depriving the American cause of its strongest possible advocate, and by his hometown supporters to boot. Better to go and take you lumps than be seen as having failed to back your backers.

So no need for a urine test: Brazil won fair and square, a victory that can be credited to economic achievement and a realigned world order (well, in that sense maybe the judges could be said to have been in the bag). That country’s challenge remains translating recent growth into broad prosperity, security against crime and political stability. To this end, it remains to be seen if the Rio games will mean more displacement than development for the teeming poor of the city’s favelas. As for America, conciliation can sooth friends but also encourage adversaries, and Joe Biden predicted Obama would be tested early in his Presidency. Would it not be wonderful if the challenge in Copenhagen represents the zenith of frustrated international ambitions for the new President? Unfortunately, I’m not sure we’ll all be that lucky.

Meanwhile, the nerds had a hard enough time in gym class; let’s stop blaming them for losing the Olympics.

You Don’t Want To Pay Deposit Insurance Premiums A Year In Advance? Fine – Then Pay Three Years Worth! You Wanna Try For Six?

September 30th, 2009

So the FDIC is proposing to have banks pay three years worth of deposit insurance premiums in advance, as opposed to the single year contemplated just a few days earlier. (see “Humpty Dumpty and the FDIC”). This move should raise around $45 billion, replenishing a fund which had fallen to less then $11 billion at the end of the second quarter and apparently slipped into a negative balance this week.

A prepayment of fees is seen by the banking industry as preferable to a special assessment like $5.6 billion they got hit with earlier this year, since rather than being treated as an immediate expense it’s counted as an asset which gets drawn down as the premiums would normally come due. So by this bit of accounting legerdemain a sudden hit to bank earnings is avoided and (regulators willing) the lending capital of the bank may be preserved.

As I noted earlier, insurance premiums should be set counter-cyclically, which is to say raised during periods of strong bank earnings and eased during periods of contraction. And indeed, the FDIC proposes its’ next outright increase in assessments (3 basis points) to be postponed to 2011.

The problem here is that the proposed prepayment constitutes a massive shift on the asset side of banks balance sheets from actual cash to funds pre-paid to the FDIC, and that’s an asset that can’t generally be tapped to meet liquidity needs except in very limited form and under dire conditions e.g. a potential bank failure. The FDIC’s decision to go the prepayment route as opposed to borrowing from the Fed or Treasury may be more politically palatable, but for weak banks that have received government support these premiums will effectively be prepaid with taxpayer money anyway. As for stronger institutions, one has to question the wisdom of weakening the cash position of viable firms just as a wave of commercial real estate mortgage defaults may be about to hit the banking system.

Since we as taxpayers are in essence loaning much of the money to prepay these premiums through federal bailout funds, a more forthright and stabilizing alternative would be to be straight with the American people: have Treasury or the Fed loan the money necessary to recapitalize the FDIC and, for now, let strong banks keep as much cash on the books as possible, facilitating both stimulative lending and confidence in the event of further losses. And then, when the recovery finally does come, have the discipline and recall of history to raise deposit insurance premiums on all sound banks, tapping bank profits to pay back the taxpayer with interest.

After all, haven’t we had enough smoke and mirrors for one crisis?

Humpty Dumpty and the FDIC

September 24th, 2009

As a graduate student in the early 1990’s I developed a mathematical model to explore the question of what the optimal level of bank deposits and deposit insurance premiums should be. For those whose enthusiasm for differential equations is limited, a key conclusion was that deposit insurance rates should be set counter-cyclically, meaning when the probability of a downturn is high  – near the top of an economic boom – rates should be increased, and vice versa. The intuition here is that one does not want to pull capital out of the banking sector during a bust, when it’s most crucial to revive lending. Rather, it’s optimal to build reserves against bank failures when the system is flush and the chance of a bust is most elevated. Note that risk is actually lower post-collapse: Humpty Dumpty may have had a great fall, but afterward, assuming the king’s men know how to make an omelet, it’s all upside (or, in that case, sunny-side up).

At the time, my thesis advisor and I applied this model to the European Union, illustrating difficulties in harmonizing policy if member states differed in risk aversion and economic conditions. (if we failed to convince policymakers of this I suspect the late unpleasantness has done so). But it now appears those who need a lesson in when to raise deposit insurance rates reside not in Brussels but Washington.

Unfortunately, in 1996 Congress capped the FDIC insurance fund at 1.25% of deposits, constraining the FDIC’s ability to raise premiums during economic expansion. With banks able to finance lending through means other than deposit base growth (e.g. bonds, securitization etc.) tying insurance premiums to deposits in a fixed ratio meant the risk level of a bank’s assets could grow faster then either deposits or deposit insurance premiums, a recipe for an undercapitalized FDIC fund.

Now, the insurance fund is down to less than 11 billion and more bank failures loom as the “other shoe” of commercial mortgages gone bad threatens to drop. With newly expanded authority, the FDIC levied a $5.6 billion special assessment in the second quarter and has authorized itself the continued imposition of such fees moving forward. These acts effectively raise deposit insurance premiums during a period of economic weakness, which is precisely the wrong time to do so. Healthy banks are drained of capital needed to revive lending, and, paradoxically, are left more vulnerable to losses. Simultaneously, those supported by TARP, TALF etc. now effectively have those funds prematurely withdrawn, at cross-purposes with the Federal programs’ mission of restoring bank balance sheets.

Bloomberg reports that, to his credit, Rep. Barney Frank, Chair of the House Financial Services Committee said yesterday “This is not the time to raise assessments on the banks,” and FDIC Chairman Sheila Bair is said to be considering having banks pre-pay 2010 premiums in lieu of a surcharge. This is a step in the right direction if the prepayments are counted as assets on bank balance sheets, thus avoiding an immediate reduction in lending capital. But those assets would vanish and capital fall next year, just as bad commercial loans come a cropper and the fund is further strained.

Though it might be politically unpalatable, taxpayer-funded Treasury loans to the FDIC, coupled with borrowing from stronger banks would be less counter-productive alternatives. They’d also be more honest, since troubled banks paying premiums with money lent through federal programs amounts to taxpayer support for bank insurance anyway. Borrowing from the Fed is also an alternative, and while I like many others am loath to grow the central bank’s balance sheet further, so long as the FRB and the FDIC are responsible in seeing to it premiums are raised in recovery years so that the loans are repaid, this expansion need not be inflationary.

If the king’s men want to put Humpty back together again, they need to realize you can’t have your egg and eat it, too.

Cadillac Plans and Yacht Taxes

September 21st, 2009

A key component of Sen. Max Baucus’ proposal to pay for health care reform is a 35% excise tax on so-called Cadillac insurance plans, defined as those costing $8,000 for individuals and $21,000 for families. This revenue is designated to cover $215 billion of the $856 billion estimated cost of the bill, while, according to President Obama’s comments, discouraging insurers and employers from offering more coverage then the Administration claims employees need.

Leaving aside the rather dubious claim that $667 per month buys one unnecessary protection (funny how other people’s desire for coverage can seem like hypochondria when a sneeze gets you choppered to Bethesda), you may already have detected some of the contradictions in the reasoning behind this tax. If the President is correct and demand for higher-end plans collapses due to this surcharge, the revenue produced by the excise tax will also vanish, thereby failing to fund reforms at the anticipated level.

It’s a Republican president, George H. W. Bush, whose policies provide evidence Obama’s prediction might be correct. In 1991, Time magazine reported Bush’s tax on luxury boat purchases almost immediately preceded an 88% first quarter drop in  South Florida sales of such vessels (I’ve no stats on Kennebunkport transactions). Of course this was during a period of pronounced economic weakness not unlike the present one, but then that’s when even a 10% levy like Bush’s boat tax can most depress demand.

Unlike would-be weekend mariners hard-pressed to build their own boats, consumers unwilling to accept the government’s judgment on what procedures and treatments they need insurance for have a “do it yourself” option: to save and self-insure against uncovered expenses, perhaps using increased compensation paid by employers in lieu of Cadillac plans. If they can do so in certain retirement accounts, the excise tax and immediate income taxes are avoided. However, depending on income and other factors, some may self-insure with after-tax dollars, meaning Baucus’ surcharge can effectively lead to higher income taxes. If Cadillac plans do disappear, this is one way their demise could lead to at least some revenue for the Baucus plan, though I suspect far less then the projected excise figure.

The bottom line is the tax on Cadillac plans amounts to the government telling citizens that if they buy health insurance in excess of what Washington feels is reasonable they must also contribute to the purchase of coverage for others. This leveling policy’s acceptance depends on voter’s altruism to less fortunate Americans, possibly at the expense of their own health care, and on people’s faith in government deciding how much health insurance they need, inevitably translating into which treatments they receive.

There are strong moral and public health arguments for subsidizing the medical  care of the disadvantaged. But leveling health care is going to mean leveling with voters as well, and when one looks through the rhetoric to the underlying economic reasoning (as many seem to be doing) you can see why this is a hard sell.

Why I am doing this…

September 19th, 2009

While an economist is not yet legally required to have a blog, so few do not these days that I feel conspicuous in my silence. So watch this space for a few of my thoughts on the state of the economy and the world.