Kevin Drum - September 2008

Financial Innovation Update

| Wed Sep. 24, 2008 1:28 PM PDT

FINANCIAL INNOVATION UPDATE....Yesterday I passed along Dani Rodrik's question about whether financial innovation has actually benefited the real economy. As he pointed out, it made homes available to a lot more people, but that turned out not to be such a great thing after all. Reader Brian J. then pointed me to Ben Bernanke's take on this issue from last year:

The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks.

Nope, neither of those turned out to be the case either. I'm tempted to say three strikes and you're out, but for now let's keep it an open question.

By the way, yesterday Tyler Cowen recommended this 2006 paper on credit derivatives, so I read it last night. It was quite good, and very accessible to lay readers. I was pleased to see that the authors basically concluded that CDOs are little more than a scam that violates basic economic principles and can only work (for a short time) thanks to industrial size helpings of hooey and sales malarkey. That's been pretty much my conclusion too. Credit default swaps are a different story, but the problem there is that, perhaps, hedging of risk might not really be such a good idea after all if it turns into an economy-wide phenomenon. After all, the people making/taking a loan (or issuing/buying a bond etc.) are the ones who are in the best position to assess the risk of the loan/bond/whatever and monitor its performance. Selling off risk to someone else often has real benefits, but it also produces incentives not to bother assessing risk properly and creates serious problems of nontransparency.

Also, it can cause the global economy to collapse via cascading counterparty defaults that send us back to the stone age. But that's a story for another time.

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Cell Phone Update

| Wed Sep. 24, 2008 12:50 PM PDT

CELL PHONE UPDATE....A new Pew study confirms something that Nate Silver wrote about a couple of days ago: We've finally gotten to the point where there's a serious cell phone bias in political polling:

The Pew Research Center for the People & the Press has conducted three major election surveys with both cell phone and landline samples since the conclusion of the primaries....A virtually identical pattern is seen across all three surveys: In each case, including cell phone interviews resulted in slightly more support for Obama and slightly less for McCain, a consistent difference of two-to-three points in the margin.

Back in 2004 the cell phone effect wasn't big enough to worry about, but cell phone penetration has continued to build, and now it is. A 2-3 point margin is pretty significant in an election cycle where the two candidates have rarely been more than five points apart.

At this point, I think political polls probably ought to routinely disclose whether they include cell phones in their calling samples. If they don't, they should be assumed to be at least moderately inaccurate. They can probably fix part of the problem by overweighting young people in their landline sample, but that's an iffy workaround. It's true that cell phone polling is more expensive since it has to be done by human beings, but I'm afraid that's going to be the price of entry for serious pollsters in the future.

And if that means fewer polls? Consider it a feature, not a bug.

The Real Issue

| Wed Sep. 24, 2008 12:08 PM PDT

THE REAL ISSUE....Michael Lewis summons his inner Jonathan Swift:

America Must Rescue the Bonuses at Goldman Sachs

Indeed.

Meet the New Boss

| Wed Sep. 24, 2008 11:55 AM PDT

MEET THE NEW BOSS....Noah Millman on the future of finance:

If there's a new establishment a-borning, it's not going to be composed of the smartest guys in the room, but the old-fashioned bankers who are worried about being fleeced by the smartest guys in the room.

Seriously: if you were a regulator in 2004-2005, the best way to identify likely problems would simply be to look at which areas are making too much money on Wall Street. Any profit center showing extraordinary growth, extraordinary margins, and/or an extraordinary Sharpe ratio in its returns was likely to be a place where risk-management was not adequately capturing the tails of the risk distribution. The more evidence that risk management had looked at everything and nothing could be found, the more worrisome that should be for regulators.

Now....let's say the regulators actually use this rule of thumb going forward: when someone's making too much money doing something new, our job is to figure out how to stop them. Who rules in that world?

I think he's right. For about five years. Then it'll be time to come out of our holes and par-tay!

Endorphin Branding

| Wed Sep. 24, 2008 11:15 AM PDT

ENDORPHIN BRANDING....Via Andrew Sullivan, Newsweek's Andrew Romano passes along a PR spiel for an innovative new way of selling your candidate to the public:

Endorphin branding is the use of scent as a means of imprinting a highly emotional, positive experience in tandem with a targeted signature scent, which can be reintroduced at a later time to trigger and recreate the desired response. This strategy should be implemented at political events, which are positively charged environments ripe for this type of scent branding.

By coincidence, a few days ago an editor asked me which science fiction book I'd suggest people read before the election. I recommended Fred Pohl's The Merchant Wars. It probably seemed an odd choice, but here's an excerpt:

New York, New York!....I saw a miraculously clear stretch of sidewalk....I walked past — and WOWP a blast of sound shook my skull and FLOOP a great supernova flare of light burned my eyes, and I went staggering and reeling as tiny, tiny elf voices shouted like needles in my ear Mokie-Koke, Mokie-Koke, MokieMokieMokie-Koke!

...."I warned ya," yelled the little old man from a safe distance....He was still waving the signpost, so I staggered closer and blearily managed to deciper the legend under the graffiti:

Warning!
COMMERCIAL ZONE
Enter at Own Risk

...."What's a 'Mokie-Coke'?" I asked.....There was a vending machine, just like all the other Mokie-Koke machines I'd been seeing all along, on the Moon, in the spaceport, along the city streets. "Don't fool with the singles" he advised anxiously. "Go for the six-pack, okay?"....Poor old guy! I felt so sorry for him that I split the six-pack as we headed for the address the Agency had given me. Three shots apiece. He thanked me with tears in his eyes but, all the same, out of the second six-pack I only gave him one.

...."Dr. Mosskristal will review your medical problem for you." And the tone said bad news...."What you have," she explained, "is a Campbellian reflex. Named after Dr. H.J. Campbell. Famous pioneering psychologist in the old days, inventor of limbic-pleasure therapy."...."Let's just say that you've had your limbic areas stimulated; under the influence of that great upwelling of pleasure you've become conditioned to associate Mokie-Koke with joy, and there's nothing to be done about it."

Doesn't seem quite so much like science fiction after reading about endorphin branding, does it?

Quote of the Day - 9.24.08

| Wed Sep. 24, 2008 10:37 AM PDT

QUOTE OF THE DAY....From Humayun Hamidzada, a spokesman for Afghanistan's President Hamid Karzai, on Karzai's meeting yesterday with Sarah Palin:

"She was asking all the right questions."

Asked what questions those were, Hamidzada said he couldn't exactly recall.

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Fire Away

| Wed Sep. 24, 2008 10:18 AM PDT

FIRE AWAY....Max Boot says that America is still fundamentally strong and will bounce back from its current economic woes. I think he's right about that — though with the caveat that we probably have some tough times ahead as we wind down our current account deficit, as we have to. But then he tells us exactly why America's economy is such a winner:

Looking deeper at the causes of American competitiveness shows that we score especially strongly not only in domestic market size (No. 1 in the world) but also in such areas as time required to start a business (No. 3), venture capital availability (No. 1), the cost of firing an employee (No. 1), ownership of personal computers (No. 2), university/industry research collaboration (No. 1) and quality of scientific research institutions (No. 2).

Italics mine. Look: I'm on board with the idea that many European countries make it so hard to fire employees that it ossifies their economies and hurts growth. Some of their rules pass understanding. Still, is it really something to be proud of that America is the easiest country in the whole world in which to get fired from your job? No wonder Boot's party still can't escape the shadow of Herbert Hoover.

The Bailout

| Wed Sep. 24, 2008 9:48 AM PDT

THE BAILOUT....Matt Yglesias looks at the past year of economic upheaval and says:

This is why the right response to a Bush/Paulson decision that we have to "do something" would probably be to take their specific proposal, light it on fire, and then call up some people who hadn't spent the past 12 months ignoring festering problems and ask them to help you write a proposal.

This is unfair. Bernanke and Paulson have, in fact, taken tons of action over the past year. They've injected massive amounts of liquidity into the market through multiple term lending facilities, slashed the discount rate, opened up the discount window to all comers, passed a big stimulus package, and have become willing to accept everything from double-wides on up as collateral for loans. None of it worked. But even at that, they're still having trouble getting everyone on board for a systemic bailout bill. Does anyone seriously think they could have proposed something like this a year ago and gotten anything but guffaws from Congress?

On the other hand, my left-wing populist instincts are just fine with this:

If anything should be done, the case seems clear for wildly higher tax rates on high-income individuals than prevailed during the Clinton years. Are we afraid of stifling the kind of fat cat activity that's brought us to our current situation?

OK, I don't know about "wildly." But we could use a few more brackets with higher marginal rates for very high earners. The negative effect on the economy, contra modern supply side goofballism, would be about zero.

Obama Up By 9 Points

| Tue Sep. 23, 2008 11:08 PM PDT

OBAMA UP BY 9 POINTS....Some good news for Barack Obama:

Turmoil in the financial industry and growing pessimism about the economy have altered the shape of the presidential race, giving Democratic nominee Barack Obama the first clear lead of the general-election campaign over Republican John McCain, according to the latest Washington Post-ABC News national poll.

....The poll found that, among likely voters, Obama now leads McCain by 52 percent to 43 percent. Two weeks ago, in the days immediately following the Republican National Convention, the race was essentially even, with McCain at 49 percent and Obama at 47 percent.

As a point of comparison, neither of the last two Democratic nominees — John F. Kerry in 2004 or Al Gore in 2000 — recorded support above 50 percent in a pre-election poll by the Post and ABC News.

I'll repeat my prediction from a couple of months ago: with the convention bumps out of the way, I'll bet Obama never has much less than a five point lead in the national polls for the rest of the campaign.

Forecasting the Bailout

| Tue Sep. 23, 2008 10:59 PM PDT

FORECASTING THE BAILOUT....I'm looking forward to seeing responses to this op-ed from Bill Gross of PIMCO fame:

I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent.

....Democratic Party earmarks mandating forbearance on home mortgage foreclosures will be critical as well. If this program is successful, however, it is obvious that the free market and Wild West capitalism of recent decades will be forever changed. Future economic textbooks are likely to teach that while capitalism is the most dynamic and productive system ever conceived, it is most efficient over the long term when there is another delicate balance — between private incentive and government oversight.

Gross provides no clue about why he thinks the Treasury auction is likely to buy assets at 65 cents on the dollar, or why he thinks these assets will eventually sell for 75 or 80 cents on the dollar. And since the bailout plan would obviously help PIMCO, he has a pretty obvious personal interest in painting an optimistic picture of how well it will work.

Still, it's a number, and you can't fight something with nothing. We may now be entering a phase in which the price of entrance into the bailout punditry arena is a dueling estimate of just how well or how badly you think the bailout will turn out. Gentlemen, start your engines.