The World is Not as Safe as Wall Street Thinks

Felix Salmon posts this chart from a recent Basel report and repeats the familiar observation that "it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds." True enough: everyone wanted super safe investments, so Wall Street cranked out boatloads of allegedly super safe investments. As the Basel report states, "Between 1990 and 2006, the year in which the series of ABS issues peaked, assets with the highest credit rating rose from a little over 20 per cent of total rated fixed-income issues to almost 55 per cent." (That's the heavy green line in the chart.)

But I think this misses the point a bit. The problem is that the Basel report cherry-picks its timeframe. Try this instead: "Between 1994 and 2006, assets with the highest credit rating rose from about 47 per cent of total rated fixed-income issues to almost 55 per cent." That doesn't seem quite so scary. But surely that's a better timeframe to use since global issuance of fixed income securities was pretty negligible before that.

What is scary in this chart is the huge growth of debt in general over the past two decades, and in particular the boom in ABS debt during the aughts, which tripled between 2000 and 2006. These are the CDOs and structured products that fueled the housing boom, and there's not much question that most of them should never have been allowed to join the AAA hit parade. They're largely gone now, but unfortunately, Felix points out what's next:

Finally, look at the way that the maroon bars — structured products, basically — have given way to a scarily large purple bar at the far right of the chart. That’s sovereign debt, and it tells you all you need to know about where the next crisis is likely to come from.

The share of debt rated AAA may be only modestly higher now than it was in the late 90s, but it still strains credibility to believe that half the debt in the world is truly AAA — i.e., essentially completely free of credit risk. The world just isn't that safe a place.

From influential RedState editor and CNN analyst Erick Erickson, advising House Republicans to reject President Obama's compromises on raising the debt ceiling limit:

Obama has a legacy to worry about. Should the United States lose its bond rating, it will be called the “Obama Depression”. Congress does not get pinned with this stuff.

OK then. I guess a massive new depression is fine as long as Obama gets stuck with the blame. It's heartwarming to see such concern for the working families of the country, isn't it?

But then, Erickson's also one of the guys who continues to be under the impression that Congress has banned incandescent light bulbs. How many people are going to have to point out that this is untrue before conservatives finally get the message?

Carmageddon: LA's Billion-Dollar Car-Pool Lane

Interstate 405 ("the 405") in Los Angeles, California.

Midnight tonight marks the beginning of Carmageddon in Los Angeles: For two days and five hours, Interstate 405 between I-10 and US 101 will be completely shut down. Since the 405—and yes, we always use "the" in front of our freeway numbers in Southern California—is the main artery between Los Angeles and the San Fernando Valley, everyone expects total chaos as drivers jam up every available alternate route into the city (and into LAX, which is, inconveniently, located right on the 405). City and transit officials are treating this about the same way they'd treat a tsunami warning, telling residents in increasingly apocalyptic tones to either leave town or else just stay inside for the duration. Their message, broadcast across every medium known to science for the past two months, is pretty simple: Don't even think about taking your car anywhere if you live within a 30-mile radius of the construction.

So what's the reason for this mind-boggling closure? Answer: Caltrans is adding a 10-mile northbound car-pool lane to the freeway. The Los Angeles Times' architecture critic, Christopher Hawthorne, has some questions about this:

To begin with: Is widening the 405 (to add one solitary carpool lane on the freeway's northbound side) really something that we should be spending $1 billion on? Will it actually make traffic through the pass better? And if so, for how long?

After all, study after study has shown the ineffectiveness of this approach. As soon as you open up new lanes, drivers adjust: A few more decide to take the newly widened route each day, and before long the congestion is just as bad as before.

In this case, because an HOV lane is being added, some of the change in behavior will be virtuous, turning drivers into passengers. It's still tough to think of a less cost-efficient way to spend a billion dollars of public money.

Actually, it might be even worse than Hawthorne thinks. For the past two decades Los Angeles has gone on a binge of increasingly expensive car-pool construction, but the benefits of these new lanes are surprisingly equivocal. The lanes are always additions to freeways (no previously existing lane has been converted for car-pool use since the Santa Monica diamond lane debacle of 1976, which set back car-pool lanes by a decade), so they always ease traffic for a while. But as Hawthorne points out, the phenomenon of "traffic generation" has been known for decades. More lanes just attract more drivers and more congestion.

What's more, although it's true that car-pool lanes carry more passengers than general purpose lanes, this is a meaningless statistic. If all of a freeway's existing car-pools move into a newly constructed HOV lane, all you've done is juggle the traffic around. In fact, since HOV lanes generally have lower capacities than multiuse lanes (thanks to the "snail" effect, which is exactly what it sounds like), you actually lose some overall traffic capacity.

But here's the worst news. What we really want to know is how many drivers are motivated by HOV lanes to form new car pools. Surprisingly, though, considering the thousands of miles of HOV lanes constructed in the United States over the past two decades, this is a hard number to get a handle on. There have been a few studies of new car-pool formation, however, and here's one of them from Caltrans showing the number of car pools on LA freeways over the past 20 years:

The good news is that HOV lane construction during the '90s appears to have genuinely spurred more carpooling. True, adding 25,000 new car pools doesn't seem like much for a region the size of the LA basin with hundreds of miles of freeways, but at least it's measurable progress. The bad news is that despite the billions of dollars spent since then, new car-pool formation during the past decade has been...zero. All that money seems to have had no effect on car-pool behavior at all. Nor is this limited just to Los Angeles. Pravin Varaiya of the University of California's PATH program came to the same conclusion for the Bay Area's HOV lanes in a 2007 study. Over both the near and long term, the shorter commute times of HOV lanes apparently has almost no effect on the willingness of drivers to form car pools. What's more, census data suggests this is a nationwide phenomenon. "Over time the attraction of HOV travel appears to be weakening," Varaiya concludes.

None of this should be taken as a definitive takedown of car-pool lanes. The data on their effectiveness is murky, to say the least, and a lot depends on where the lanes are built and how well they support bus traffic. But that murkiness is surprising all by itself considering the HOV spree the country has been on over the past two decades. Even after 20 years of nonstop construction, we still don't really know how effective HOV lanes are at promoting car pools.

For Angelenos, however, the news is almost certainly bad. For starters, the I-405 shutdown is going to produce two rounds of chaos (the second one coming at the end of the project). And the project is sucking up a billion dollars that could almost certainly be used more efficiently on other transit projects. But that's the least of it. If Caltrans' own chart is to be believed, LA's willingness to carpool was saturated over a decade ago. Adding another billion dollars in new HOV lanes won't produce even a single new car pool. Now that's Carmageddon.

Plus even Hitler doesn't like it. And he's the guy who built the autobahns.

China Housing Bubble Update

So is China in a housing bubble? In a recent paper, Christian Dreger and Yanqun Zhang say yes:

Our results indicate the presence of a house-price bubble. In Figure 1 it can be seen that increasing imbalances have emerged over the past two years. For example, real house prices in Shanghai have been 28% above the long run equilibrium in 2008, and 35% in 2009. While the evidence is similar for Beijing, the increase is more spectacular in Shenzhen....In general, the bubble is more pronounced in the special economic zones and the south-eastern coastal regions. Overall, the size of the bubble is 20% in 2008 and 25% in 2009, regardless of whether GDP or population weights are applied.

If their numbers are correct, the Chinese housing bubble isn't as bad as the American housing bubble of the aughts. What's more, it's not fueled by borrowing as strongly as ours was. And what's even more, Chinese borrowing has largely been to buy actual property, not to finance home equity loans.

All of these things together suggest that China's property bubble might not be that bad. On the other hand, it's pretty bad in certain areas, and if the Chinese economy starts to go south it could touch off a vicious cycle of slowing domestic demand and plummeting house prices. It's still something to keep an eye on.

A Closer Look at the Tea Party's Utopia

From Benjy Sarlin:

Republican lawmakers are pushing President Obama to put seniors, troops, and bondholders at the front of the line should Congress fail to raise the debt ceiling. The rest? Well, that's up to him.

....But where will the immediate 44% cut in overall spending needed to avoid default come from instead? Michele Bachmann, who has gone so far as to demand the debt ceiling never be raised, dodged questions on the issue Wednesday by simply repeating her assertion that Social Security and troop pay be left sacrosanct.

Asked by TPM about what areas might need to be cut offset their proposed guarantees, Rep. Nan Hayworth (R-NY) offered a similar response, repeating that Social Security, Medicare, military pay, and veterans' benefits should all be off limits. Pressed to name any savings — furloughing federal employees, shutting down various agencies — that might be preferable, she said her focus was only on calling out Obama's threats.

Let's take a brief look at the numbers. The federal government is scheduled to spend about $300 billion in August. Something like $125 billion of that is debt. So if the debt ceiling doesn't get raised, the government can only spend about $175 billion. Very roughly, here's spending for the month of August in the areas Nan Hayworth says are off limits:

Social Security = $60 billion
Veterans benefits = $10 billion
Medicare/Medicaid = $70 billion
Interest payments = $20 billion
Military pay = $15 billion

Total = $175 billion

So there you have it. Nan Hayworth is right: we can fund all of these things without raising the debt ceiling. Unfortunately, that's it. There's really no other prioritizing necessary. There's not a single dollar left for any other function of government. Not defense spending, not the FBI, not foreign embassies, not the court system, not prisons, not disaster relief, not unemployment insurance, not the border patrol, not TSA or the FAA, not roadbuilding, not maintenance of any kind, not national parks, and not pensions for retired federal workers. Not anything. And aside from military personnel, every single employee of the federal government will have to be furloughed.

That's what Nan Hayworth and Michele Bachmann and the rest of the tea party folks apparently want. Quite the small government utopia, isn't it?

Behind the Scenes in Republican-land

Mike Konczal has a post today that provides a rare inside look at what non-insane Republicans think about their more exuberently ideological colleagues. It's long, and might take a couple of readings to fully appreciate, so I'll just set the stage for you. It's about a Republican member of the Financial Crisis Inquiry Commission, Peter Wallison, who seems a wee bit less interested than he should be in actually getting at the roots of the financial crisis (at one point, he tells his fellow conservatives that it's "very important" they do nothing to "undermine" the goals of the GOP caucus in the House).

On a more technical level, Wallison's big hobbyhorse is making sure that Fannie Mae and Freddie Mac get blamed for the financial crisis. The other Republican members of the FCIC, it turns out, basically know that Wallison is nuts, but they're unsure about whether he's independently nuts or merely parroting the views of a fellow nut at AEI named Edward Pinto. The actors in this melodrama are Wallison; two fellow FCIC members, Bill Young and Douglas Holtz-Eakin; and a couple of Republican staff members. You can read the whole thing here. When you're done, Andy Kroll has more on the story here.

From the Time Traveller, in H.G. Wells' The Time Machine:

Very simple was my explanation, and plausible enough — as most wrong theories are!

What was true in the year 802,701 is true in the year 2011 too. Never trust simple and plausible for any problem more interesting than a broken light switch.

Worrying About Long-Term Panic

Generally speaking, I'm part of the crowd that thinks we should be spending more now and tackling the deficit only in the long term. After all, as Paul Krugman and others point out endlessly, the "bond vigilantes" are nowhere to be seen. Interest rates are at historic lows and investors — as measured by their real-world actions — seem to have no concerns at all about America's ability to grow and service its debt.

However, there's one contrary argument that's long given me pause. Carmen Reinhart and Kenneth Rogoff, who have written the standard reference about the dangers of countries piling on too much debt, make it here:

Several studies of financial crises show that interest rates seldom indicate problems long in advance. In fact, we should probably be particularly concerned today because a growing share of advanced country debt is held by official creditors whose current willingness to forego short-term returns doesn’t guarantee there will be a captive audience for debt in perpetuity.

Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today.

Interest rates are low today. Consumer debt overhang continues to dampen demand and generate massive unemployment. Because of this, government borrowing now not only makes sense because it's cheap, it makes sense because it will put people back to work and help get the economy back to its long-term growth trend. Especially given the fragility of the world economy — including but not limited to the property bubble in China, the unsustainable flow of hot money into developing countries, and the crisis of the PIIGS in Europe — this is about the worst possible time to take any chances with economic recovery in America.

And yet. Still. Reinhart and Rogoff have a point: investors can get nervous and start fleeing with virtually no notice. One month they're fat and happy, the next they're running for the doors. Although we should be spending more now to get the economy back on track, this is why a long-term deficit deal with teeth is something that both liberals and conservatives ought to be willing to compromise to achieve.

Moody's Ups the Threat Level to Orange

Ratings agencies have started warning us that they'll downgrade U.S. debt from AAA if we don't get a debt ceiling agreement soon. But it's never really been clear to me why anyone should care about this, since no one thinks that Moody's or Standard & Poor's has any special insight into the creditworthiness of the U.S. bond market. If there's no debt ceiling deal, then Treasury rates will probably go up, but they'll go up because investors read the newspaper and think that things are getting dicey, not because they got a press release saying that one of the ratings agencies officially put America on credit watch.

But this is different:

At least 7,000 top-rated municipal credits would have their ratings cut if the U.S. government loses its Aaa grade, Moody’s Investors Service said. An “automatic” downgrade affecting $130 billion in municipal debt directly linked to the U.S. would occur if the federal level is reduced, Moody’s said yesterday in a report. Additionally, top-rated securities with no direct links to the national government will be reviewed for similar action.

....Issuers that are partially dependent on the federal government, such as states receiving Medicaid matching funds, also will be reviewed for vulnerability. Medicaid is a health- care program for the poor that is jointly funded by the states and the U.S. Moody’s said Aaa-rated states on average rely on the federal government for a quarter of total spending.

Investors do care about the credit ratings of state and municipal governments, and if a Moody's downgrade affects them, it will have an immediate effect on their ability to raise money. Moody's, I'm sure, knows perfectly well that their rating of federal debt doesn't really matter that much, so this sounds to me like a case of upping the ante. It's a clear threat to Washington to get a deal done or face consequences from Wall Street.

Protecting the Rich

Back in the late 80s, when I paid only passing attention to politcs, I had lunch once with a sales manager at the company I worked for. We got to talking about the economy, and after a few minutes his face lit up. "What we need to do is get rid of the capital gains tax!" he told me excitedly. The what? I thought. I happened to know that this guy spent pretty much his entire paycheck and probably had a few thousand dollars in his 401(k) and not much else in the way of serious investments. So why was he convinced that eliminating the capital gains tax, of all things, was the key to salvation?

I was young and naive back then, of course. What I didn't know was that although the 1986 Tax Reform Act had lowered a bunch of taxes, it had increased the capital gains rate — and rich people, who do have huge parts of their income dependent on capital gains, had immediately made reduction or elimination of the capital gains tax a right-wing hobbyhorse. Rush Limbaugh and his dittoheads talked about it endlessly, and obviously my friend had gotten sucked into the vortex. Elimination of capital gains taxes would save the country!

Why bring this up? Because apparently this is a sticking point in the debt ceiling negotiations. Conservatives have long since gotten their capital gains preference restored (the rate is currently 15%, compared to a top rate of 35% for ordinary income), but a tax reform deal that broadens the tax base threatens to increase that rate. According to Politico's David Rogers, "there’s resistance from wealthy interests who fear the president will gain too much leverage to impose tougher standards of progressivity in the tax code — and thereby crimp their capital gains tax breaks." Jon Chait comments:

The broader problem here is that Obama seems to be taking Republicans at their word. He wants shared sacrifice, and they say they want to avoid high rates. Tax reform is a way to accomplish both. But Republicans don't just want to avoid high marginal tax rates. They want rich people to pay low taxes, period. It's not clear Obama understands that.

I suspect that Obama understands this just fine. It's not rocket science, after all. Basically, he's calling their bluff, forcing them to publicly oppose literally every tax break the rich currently enjoy. Get them to pound the table and say nyet often enough, and eventually even the vast huddled masses will finally figure out what really motivates the GOP. Maybe.