Symptoms of misallocation

There are several glaring signs of misallocation of resources in our economies.

I noticed one of these today in my economics studies. One of the other students had worked for a few years in a cardboard factory, making pizza and takeout fastfood boxes. He reported that despite being in one of the better run, more efficient factories, the price competition was wicked and they continuously lost money.

This is likely what has been happening on the coast of China in spades. There has been too much money available for capital investments, leading to excess, unprofitable manufacturing capacity. Along with this, major manufacturing firms were no longer making money in their mainline businesses, and depended on investments, loans, financial products or speculation to stay in business. [P.S. For a delightful report on the enormity of the misallocations in China, see Inside China: A Sculptor's View, a post on Mish's blog, dated Feb 20, 2009]

Other signs of misallocation were the housing bubble, McMansions for NINJA applicants, millions of sudden profits for young hotshot traders on Wall Street, the humongous increase in derivative, swap and other leveraged financial paper, the weakening book to price, earnings to price and dividends of public companies, and the mushrooming, opaque, and entangled debt markets.

A giant house of financial cards provided a massive influx of investment and credit money for both expanding production capacity and consumption. Then the house collapsed.

We need to learn how to develop more robust global financial and credit markets.

Production and consumption are signs of prosperity, and the rapid expansion of both led us to think we were robustly healthy. Like the athlete winning on high doses of steroids, we didn't notice that our liver was getting destroyed ... or in this case our global financial system.

Economics as nutrition

Economics considers itself the study of scarcity, and allocation of resources to counter scarcity. Even the Austrian school complains that the problem with misallocation is that then there are not enough resources left where they need to be, once again assuming that "The Economic Problem" is
scarcity.

That would be as if nutrition considered itself the study of starvation.

Nutrition and such other measures to improve ones health are not simply "getting enough food". They are about understanding fairly complex bio-chemical systems and providing the right measures, and minimizing the wrong, at various times. Sun, exercise, sleep, various potients, stimulants and relaxants, and a seeming unending variety of nutrients.

What's more, notice how poorly nutrition is understood and much abused by those who can profit the most, and expect no less in our common understanding of economics, even if we could do more.

What's even more, we are still lacking general competence in handling matters of nutrition, after studying the same human biological subject for millenia. The world economy has some aspects that are at least in enormous degree unlike anything that existed even earlier in my life. The truth will elude us, and would be treated as a lie even if stumbled upon.

Standards for monetary reform, such as returning to a 100% gold reserve based currency or returning to private banks which have no special government powers or bailouts or insurance, are better than nothing. But this is like noticing that people whose diets are constrained to fewer calories live longer than those who pig out and become obese. Such simple metrics are crude guides to optimum economic or biological health.

The proper goal of nutrition is health, substainable and consistent with the well being of ones fellow beings and natural surroundings. The proper goal of economics is prosperity, substainable and consistent with the well being of ones fellow beings and natural surroundings.

Mother broke her hip

My mother broke her hip yesterday. She lives in Florida with my sister. My time may be needed there, which could interrupt my Economics studies at UNT, where I had attended my first college classes in 30 years earlier this week.

Bank deposit reserve ratios and ever increasing debt

When I claim that the deposits made in a bank by its customers serve to increase the banks reserves against which they can make further loans, I sometimes get the rebuttal that such deposits aren't assets to the bank, but liabilities. The rebutter notes that ones checking and savings accounts deposits represent liabilities to the bank, not assets.

This rebuttal is a half-truth talking point that is absurdly misleading. Banks don't and wouldn't just generate liabilites without a compensating asset. My cash deposit in my bank account represents two bookkeeping entries (as is typical with double entry bookkeeping) to the bank. The cash I handed over to the teller goes into their vaults, increasing their assets. The corresponding and balancing debit entry describes the IOU they essentially give me in return for my deposit, where that IOU grants me the right, under specified conditions, to demand the return of my money.

The bank can loan out the money it has, though it also has to retain some regulated amount of reserves to cover the liabilities of the potential withdrawals from the demand deposits it holds.

On related issues ...

We commonly account in blog discussions for this reserve requirement as requiring that the bank hold 10% of its demand account liabilities in reserves. However I seem to recall reading that the actual reserve requirements vary between 0% and 10%, depending on the size of the account, where small accounts have a 0% reserve requirement. I also seem to recall reading that actual reserve ratios of the major American banks is more like 3%.

Putting all this aside, things have gotten much worse (less conducive to stability in times of economic stress) for the major banks in the last five or ten years, due to their being able to package up the mortgages they hold for their customers into Mortgage Backed Securities and sell these securities for money. Just as the size of the available backing for Treasuries was greatly extended from just the banks to mutual funds and private investors in the 1970's (see the explanation of the "subsequent explosion in the size and breadth of bond markets", at http://www.gold-eagle.com/gold_digest_04/blumen081204.html), once again, in the 2002-2007 recovery following the dot-com bust, the available backing for bank reserves was greatly extended once again using securitized mortgages. Now a bank was not constrained to loan out some (large) percentage of its deposits and capital. Instead a bank could bundle up what loans it had extended so far, sell them for cash, and issue yet more loans. A vastly greater pool of debt was formed.

That pool is now draining.

T-Bill rates usually in backwardation.

T-Bill rates cannot go below zero because their carrying cost is (approximately) zero.

Commodities, such as oil and wheat, incur storage, aka carrying, costs. They are normally in contango, meaning that the cost of a unit of commodity for delivery immediately is usually less than the cost of a contract promising delivery of a unit at some specified future time. Such a contract imposes storage costs on the counterparty, who must store the commodity in the interim, in order to ensure delivery at the future date. That storage cost increases the price of the future contract above the price for immediate delivery.

Money (T-Bills and Dollars) usually have negative carrying costs to banks operating under reserve requirements. For each dollar deposited, they can loan out most of that dollar, typically at higher rates than paid on the deposit, though usually also at longer term, exposing the bank to term risk.

But since the carrying cost to such a bank of currency is essentially negative, currency is usually in backwardation. A dollar now is more expensive than a future dollar. If a savings account pays 5%, I can get a promise from a bank to pay me $1000 in a year at a cost of $952.38 today, whereas it would cost me $1000 today to get $1000 from a bank today. The future contract is cheaper, which is the defining characteristic of being in backwardation.

For debt based currencies, such as the dollar, the central bank wants to keep the rates paid on short term central bank notes, which are the most liquid, least volatile, safest debt instruments available (most easily and inexpensively traded, least term risk and least counter party risk) above zero, but below any other volume rate, such as the inter-bank overnight loan rate. It needs the rates above zero, so that it can fund government debt, as Treasuries need to pay enough that someone will purchase them. It wants the Treasury rates lower than other rates in order to encourage "prosperity", meaning to encourage investors to actively trade other debt paper, besides just short term central bank notes. The central bank attempts to manage the rates paid on short term central bank notes (T-Bills, in the case of the United States Fed) by exchanging between currency and these notes on the open market.

When banks are unwilling to lend, even at rapidly increasing rates, to all but the safest borrower, then the central bank cannot make them lend, no matter how close to zero the rates on short term T-Bills goes. "I don't care if junk bonds are paying 20% interest; I will still invest in Treasuries at nearly zero interest because I fear the junk bonds will default." The pressure to drive T-Bill rates to zero becomes so strong that the central banks open market operations can have little affect.

The rates will not go more than a smidgen below zero because the carrying cost of currency is essentially zero, so no one would -pay- non-trivial interest to exchange dollars for T-Bills. The rates cannot rise much above zero because the demand for T-Bills is insatiable. So the Fed's efforts to manage a controlled rate of investing in riskier debt instruments by means of managing the rates on its own T-Bills become impotent.

Now the Fed is a quasi-official organization of private banks, dominated by such banks as JPMorgan, Citigroup and Bank of America. These banks and some associated bureacracies (HUD, Fannie Mae, Freddie Mac, the rating agencies, former investment banks such as Goldman Sachs, current and former corporations such as Raytheon, Halliburton and Enron, accounting firms such as Arthur Anderson, some corrupt politicians, ...) can make huge sums, both legally and otherwise, off our money. They especially want us to invest vast sums in riskier ventures, such as dot-com companies and NINJA mortgages, to fund their misadventures. It pains them greatly when the market value of our investable assets is declining, and our risk aversion increasing.

The Fed's usual policy response in such times of economic stress, lowering the Fed Funds Rates, is a day late and a dollar short and entirely impotent. The actual market rates on short term T-Bills drove to nearly zero, ahead of even the Feds efforts to lower that rate.

The Fed and cohorts are now trying other means to get us to start "investing" again, to get us to increase the dollar denominated amount of financial paper in circulation, such as loans and stock market accounts, so that they can start skimming off more profits again, and likely so that they can avoid exposing any more of the corruption being exposed by these low financial tides, like barnacles on a ships bottom.