2008 Financial Crisis

The mean teeth of he Great Depression still have bite

Posted on by j.giglio

To paraphrase T.S. Eliot, the only major British poet born in St. Louis, September 2008 was the cruelest month. As America marks the sixth anniversary of the financial meltdown which began that month and drove the global economy off the cliff and into the worst economic crisis since the 1930s, the damage it did is still being felt. Last year, middle-income families earned 8 percent less, adjusted for inflation, than they did in 2007.

But not everyone was so profoundly affected. Commuter helicopter traffic at the East Hampton airport this summer increased by close to 40 percent over last year. Yet while there is a pretense of recovery and conditions are marginally better, most Americans are still living in the mean teeth of the Great Recession. The U.S. economy is facing many challenges, especially the rising financial inequality between the top 1 percent and everybody else.

You would be right to conclude that the fed’s attempts to deal with the Financial Apocalypse of 2008, reminded you of the note your grade school teacher scrawled on too many report cards: “Could have done better.” To help put this in perspective, here’s a chronology of key events in September 2008.

On Sept. 7, the Federal Housing Finance Agency, backstopped by the Treasury Department, placed Fannie Mae and Freddie Mac into conservatorship. A week later, Merrill Lynch avoided oblivion by hastily selling itself to Bank of America. In the early hours of Sept. 15, Lehman Brothers CEO Dick Fuld, aka the gorilla of Wall Street, announced that his firm was seeking bankruptcy protection after the feds refused to step in and provide financial assistance.

Within hours of the Lehman bankruptcy, the feds rushed forward with an initial $85 billion in taxpayer cash to bail out the giant insurance company American International Group (AIG), essentially nationalizing the firm. AIG had mismanaged itself to the verge of bankruptcy by stuffing its portfolio full of derivative products whose value had collapsed.

Then on Sept. 16, the shares in the world’s oldest money market fund fell below $1 because of losses incurred on the fund’s holdings of Lehman commercial paper and medium-term notes.

To help stabilize the financial system, on Sept. 21 the feds declared Morgan Stanley and Goldman Sachs to be bank holding companies. Five days letter, in the biggest bank failure in American history, the government seized the assets of Washington Mutual, the nation’s sixth largest bank, and its banking operations were sold to JP Morgan Chase.

As the month mercifully wound down, the House of Representatives on the 29th voted down the Bush administration’s Troubled Assets Relief Program (TARP), which would have invested 700 billion taxpayer dollars in troubled banks by purchasing their distressed assets. Needless to say, the stock market reacted with panic to this “failure of democratic government” and suffered one of its worst single-day price declines, with the S&P 500 Index plunging a horrendous 8.8 percent.

Finally, rattled by the market’s obvious panic, Congress passed the Emergency Economic Stabilization Act of 2008 on Oct. 3, which included a cosmetically revamped version of TARP.

The financial markets were still in turmoil over the ensuing weeks. In terms of sheer dollar losses, the “fall of 2008” (along with the fall of many other illusions) was probably the greatest financial disaster in world history. Throughout the world, its cost in terms of shattered wealth and wrecked lives is still being calculated.

The fallout even reached Iceland. The country’s entire banking system collapsed in October when it became apparent that its bank portfolios were stuffed full of American-made toxic derivatives that had little value.

The collapse led to the following exchange on a late-night TV talk show: “What is the capital of Iceland? About $25, give or take.”

Sadly, Iceland was hardly alone.

originally published: September 27, 2014

Alan Greenspan’s downfall

Posted on by j.giglio

In the wake of the 2008 global economic crash, the once-esteemed name of Alan Greenspan doesn’t carry much weight. In the final analysis, his downfall came because he just couldn’t bear to close down the party.

Greenspan was appointed Federal Reserve chair by President Reagan in 1987. He succeeded the legendary Paul Volker, who is credited with having broken the back of virulent 1970s inflation by choking off growth in the money supply.

Because of his business background and admitted “Libertarian Republican” ideology , Greenspan was expected to continue emphasizing his predecessor’s low-inflation policies.

By any objective measure, Greenspan merited the title “History’s most qualified central banker.” He was, after all, no ivory tower academic lost in the stacks of some dusty library without hands-on experience in the real world. In fact, his vast and varied range of life experiences truly made him a quintessential man of the world.

As an undergraduate during the 1940s, he studied clarinet at the Julliard School of Music. He then toured the country as a saxophonist in a popular jazz band.

During this time he developed a sideline preparing income tax returns for fellow musicians. He then enrolled at New York University to study economics and became a member of an informal discussion group led by Ayn Rand, the famous libertarian philosopher who, through her best-selling novels “The Fountainhead” and “Atlas Shrugged,” was instrumental in resurrecting free market economic theory.

After NYU, he went to work for an economics consulting firm whose clients included Fortune 500 companies. He eventually became the firm’s owner and CEO (so he knew what it was like to have to meet payroll) and made himself a nice fortune in the process, earning an honorable discharge from the financial wars.

He had his first federal government experience during the Ford administration, when he chaired the President’s Council of Economic Advisors. After that, he returned to his consulting firm.

Almost immediately after being named Fed chair, Greenspan was confronted by the massive October 1987 stock market crash. He responded by flooding the financial markets with liquidity, which prevented a Wall Street bloodbath from laying a glove on Main Street.

During all these years, he led an exceedingly full life as an active pursuer of interesting women. His romantic targets included celebrities like Barbara Walters and NBC’s Andrea Mitchell, who became his second wife while he was Fed chair.

When a 1998 hedge fund meltdown triggered concerns that sizable losses to the firm’s creditors (mainly large Wall Street banks) would cause credit markets to freeze up, Greenspan worked behind the scenes to have the Federal Reserve Bank of New York orchestrate a bailout of the hedge fund by these banks. The Fed pumped up the money supply to depress interest rates, thereby making life easier for the banks.

Then the dot-com bubble burst, wiping out more than $5 trillion (that’s “t” as in “trauma”) in stock market value among tech companies by the end of 2002, helped along by the 9/11 terrorist attacks.

These events and others gave Greenspan plenty of excuses to keep interest rates low by pumping up the money supply, to oppose financial regulation, and arrange bailouts when banks got into trouble. All of which he repeated to the point where they opened wide the door for the housing and derivative booms.

He largely ignored the ruling guideline expressed by former Fed Chair William McChesney Martin, who supposedly said, “The Fed’s job is to take the punch bowl away just when the party’s going good.”

So when it comes to managing the money supply, the Fed should presumably grow it more slowly during good economic times and more rapidly during recessions.

But Greenspan’s guideline was to keep the party going full blast with generous bowls of vodka-spiked punch until the guests were staggering around the room, stumbling into the furniture, singing bawdy songs, knocking over floor lamps and throwing up on the carpet.

And then bring in the Fed to clean up the mess.

originally published: April 26, 2014

America’s financial ‘Guns of August’

Posted on by j.giglio

The Financial Meltdown of 2008 was one of the most critical events in American history. As we mark the 100th anniversary of World War I, there are a number of parallels that can be drawn between these two events that changed the course of history.

The financial meltdown wiped out some $11 trillion of the nation’s wealth. It eliminated more than eight million American jobs, many of which are gone forever. It froze the nation’s vast financial credit system, leaving millions of businesses without the cash needed to operate. It forced the federal government to spend $2.8 trillion and commit another $8.2 trillion in taxpayer funds to bail out crippled corporations deemed “too-big-to-fail.” It cost millions of Americans their homes, life savings and hopes for a decent retirement.

The New Year is a time to reflect on lessons from the past. Scholars still study World War I and the changes left in its wake. Like the Financial Meltdown of 2008, the war was one of the most critical events in American history.

In 1914, Archduke Franz Ferdinand was heir to the throne of the multi-ethnic Austro-Hungarian Empire. On the bright Sunday morning of June 28, he and his wife, Duchess Sophie, made an official state visit to the Bosnian city of Sarajevo, which was then an occupied province of the empire.

Late that morning the cars in their procession made a wrong turn on the unfamiliar streets of Sarajevo and halted to get their bearings. At that moment,   Gavrilo Princip, a young Bosnian Freedom Fighter – or terrorist, depending on your point of view – fired two shots into the back seat of the open car carrying the archduke and duchess and killed them both.

Europe proceeded to come apart at the seams. Fewer than six weeks later, on Aug. 3, the armies of Kaiser Wilhelm’s Germany invaded Belgium. By the middle of August, the lineup of combatants was basically complete. Britain, France and Russia were formally at war with Germany and Austria-Hungry.

The war’s staggering costs horrified the world. All told, the 16 nations that ended up involved spent the equivalent of $3,000 trillion (in inflation-adjusted 2009 U.S. dollars) and mobilized 65 million troops, 12 percent of whom were killed. Another 33 percent were wounded.    ·

Three of Europe’s four leading monarchs were toppled. Only Britain ‘s royal family survived.

The Austro-Hungarian Empire collapsed and was replaced by some half-dozen ethnically based nations, most of which were overrun by Germany in World War II and became puppet states of the Soviet Union thereafter. And of course, the war spawned communism and fascism.

Europeans, having borne the brunt of the suffering, lost confidence in the so-called ideals of western civilization they’d taken for granted before 1914. The credibility of their governments was particularly hard-hit. Citizens were convinced that those governments had persistently lied to them to protect the elites at the cost of everyone else and squandered millions of lives by mismanaging the war.

Victors and vanquished alike were left bankrupt, owing more to the United States (which sat out most of the war and became the world’s leading creditor nation) than they could ever repay and cementing America’s rise as an industrial power.

And all for a war that settled virtually nothing.

Our generation experienced its own version of the “Guns of August” when the world of international finance melted down so catastrophically in 2008. The meltdown drove the country into the worst economic crisis since the 1930s.

Some people may find obvious parallels to 1914 in the fall of the famed investment banking house of Lehman Brothers, which the federal government allowed to collapse into bankruptcy in September of 2008.

But a more telling parallel to Gavrilo Princip drawing his pistol may have occurred more than a year earlier in July of 2007, when investment banking firm Bear Stearns & Co. placed two of its hedge funds in bankruptcy because they had run out of cash.

Little more than a year later, the chain of events that bankruptcy started had changed the world forever.

originally published: January 25, 2014

A glossary to the Great Recession

Posted on by j.giglio

Five years ago this month, a financial meltdown didn’t merely plunge America into the Great Recession, it drove the country into the worst economic crisis since the 1930s. It’s not hyperbole to call the 2008 meltdown one of the most critical events in American history.

This was a cataclysm far worse than any natural disaster in the nation’s experience and it has given rise to its own terminology.

Financial Meltdown: A biblical-style plague that drained nearly 60 percent of the stock market’s value and killed off other financial and credit markets in the process. Banks and other businesses either vanished into bankruptcy as the nation’s credit system froze up and forced the federal government to spend $2.8 trillion and commit another $8.2 trillion in taxpayer funds to bail out major corporations like General Motors, Chrysler, Citigroup, Bank of America, AIG, and a host of other “too-big-to-fail” private-sector institutions even as those taxpayers were themselves crippled by some $11 trillion of wealth and eight million jobs being wiped out.

Economic Crisis: What we seem to be stuck in right now. Middle America struggles with rising food and gas prices, finding or keeping a job and simply keeping their heads above water. The rich get richer and everyone else gets poorer. It is marked by an economy that can’t seem to grow its way out of a paper bag. Instead of early retirement, countless Americans will have to keep working until they drop because half the value of their 401(k) vanished into thin air. Paying for their children’s college education is entirely out of reach.

Lascivines: The CEOs of these firms were the modem equivalent of saloonkeepers in classic Westerns who paid the usual “gaudy ladies” to hover at the bar and sweet talk us into drinking overpriced, watered-down whiskey while their painted eyes promised that we can “take them upstairs” later.

Rocket Scientists: Bright young nerds with Ph.D.s in math or physics from major universities who found that earning a decent living in the academic world was tougher than earning a decent living by becoming the intellectual equivalent of Broadway actors. Their technical backgrounds let them quickly master the intricacies of”Quantitative Finance Theory” and engineer all kinds of wild derivative securities that are too complicated for most people to understand, but very profitable for their employers.

Master of the Universe (actually the reincarnation of 1980s terminology): An infantile term of “respect” for anyone in the financial industry who’s aggressive enough to generate big dollars for his firm (by hook or crook).

Is it any wonder that increasing numbers of outraged Americans are screaming that there ought to be laws against allowing just anybody to hold senior positions in industries so important to the public welfare? Shouldn’t they be required to possess licenses testifying to their qualifications, like physicians and lawyers? Accountants are prohibited from expressing formal opinions about the “adequacy” of corporate financial statements until they’ve passed the Certified Public Accountants exam and worked in their field for a number of years. Why not have the same kind of rigorous licensing requirements for top management jobs in critical industries, including administering competency tests to all graduates of MBA programs.

After all, the senior managers at Lehman Brothers, Merrill Lynch, Bear Steams, AIG and so many other financial-services firms were totally clueless to the dangers of undue risk, excessive leverage and abusing lax regulations, all while being more outrageously overpaid than top managers in any of the world’s other major industries.

Americans can’t forget the financial meltdown of 2008 because they are still dealing with its effects. Like any victims, two things that would help them process the trauma would be for those responsible for it to finally be brought to justice and for safeguards to be put in place to prevent a reoccurrence.

originally published: September 14, 2013

‘Caveat Emptor’ no help to investors

Posted on by j.giglio

In the wake of the 2008 financial crisis, the conventional wisdom is that financial markets need to be more tightly regulated. That is certainly true, but the problem is as much about who is doing the regulating as it is about the regulations themselves.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act represents America’s biggest financial regulatory reform since the Great Depression, but its success will ultimately depend on having competent and honest regulators who cannot be compromised by lucrative employment opportunities dangled by the regulated.

The dominant global financial players’ failure to rein in their greed set the stage for the last economic crisis, and it was hardly the first time; under-regulated markets went on a murderous rampage.

Common-sense regulation ensures that a buyer can be confident that the item being purchased possesses all the advantages the seller claims, and that any disadvantages are clearly identified. This allows the buyer to make a rational decision about whether the item is actually worth the price. Many libertarians assume sellers will always inform the buyer of pertinent factual information because the seller knows that economic success ultimately depends on a reputation among potential buyers.

At the other extreme is the idea that sellers are inherently Times Square shell-game scammers who can’t be trusted to provide clear, honest, information about their products’ advantages and disadvantages, so  the buyer must accept sole responsibility for obtaining all necessary information about whatever products he or she may purchase. This is the spirit behind the popular Latin phrase: “caveat emptor,” or “let the buyer beware.” Responsibility for regulating private firms rests with government agencies staffed by highly qualified managers and analysts who regard “public service” as the noblest of callings and their surest path to heaven. ·There are at least two real-world problems with this concept.

The first is that it depends on a large supply of trust fund babies to staff these government agencies free to devote their professional lives to “public service.” Sadly, the supply is nowhere near sufficient. Most of the intelligent and well-educated people they require emerge from graduate school burdened by crushing student loan debt that forces them to opt for the most lucrative job they can find.

The second problem flows naturally from the first. Many gifted, well-educated, young people see government regulatory agency job as stepping stones to lucrative private sector careers. They can develop useful contacts with key players with the firms they are supposed to regulate and impress the contacts that their “hearts are in the right place” as far as the regulated firm is concerned.

So it’s scarcely a surprise that there’s a parade of people marching back and forth between lavish private sector executive suites and the basic steel-desk offices of agencies like the Securities and Exchange Commission.

If we want federal regulatory agencies that prevent financial debacles, we have to end close the revolving door.

To make that work, we will need to address the economic concerns of gifted but highly indebted people. We could pay them much higher salaries for government jobs or subsidize their student loan burdens in return for their committing to careers in public service. Perhaps we could make up some of the difference with generous pensions, health benefits, and perhaps even offer them college scholarship for their children.

It’s awfully hard to be serious about regarding financial markets when you need a program to tell the regulators from the regulated.

originally published: August 31, 2013

Cyprus crisis can’t happen in the U.S.- right?

Posted on by j.giglio

“Neither a borrower nor a lender be,” prattled Polonius to Laertes in Shakespeare’s “Hamlet.” Well, maybe. Last month, the European Central Bank, the European Commission and the International Monetary Fund decided that Cyprus needed a fast 17 billion euro bailout. They proposed to offer the tiny island 10 billion euros and demanded that depositors in Cypriot banks fork over the remaining 7 billion.

Specifically, they proposed taxing bank deposits. Depositors with more than 100,000 euros in their account would be faced with a 9.9 percent tax while those with less would see a 6.75 percent levy.

As you can imagine, depositors rushed to withdraw funds from Cypriot banks before the measure went into effect. So the authorities shut down the banks for several weeks and instituted capital controls. This had to be unsettling for retirees and the working class, as well as small businesses that need to make payroll using their bank accounts.

Setting aside for now how the crisis was averted and whether something similar could happen here, in the real world few businesses of any size can operate without access to short-term credit to smooth out mismatches in their normal cash flows.

Suppose your family’s widget factory pays its employees every Friday. That means a weekly cash outflow. But most of your prime customers are wholesale distributors who pay for purchases from firms like yours on the last day of the month following widget deliveries. So you have four payroll outflows for each injection of cash from sales.

Like the overwhelming majority of businesses, you cover these cash flow mismatches by drawing down a credit line from your local bank each week to make payroll and repay the drawdowns as soon as payment is received.

But one Friday morning when you get on your PC to access your firm’s bank accounts and transfer enough cash from your credit line to cover payroll checks, you see a chilling message on your screen: “All credit lines are frozen until further notice.”

You scrounge around among your firm’s bank accounts and come up with enough cash to cover this week’s payroll, leaving you pretty well tapped out until a big group of customer payments is due to arrive in three weeks. But what about your next three payrolls?

One option is to simply close the factory and lay off your employees until the payments arrive. But a closed factory doesn’t produce widgets, so you can’t deliver to your customers, who may tum to other suppliers. In any case, your future cash inflows will be lower, which means smaller profits.

Another option is to close the factory and lay off your employees for just a week, when you try to find enough emergency cash somewhere to cover the next two weeks of payroll. Losing only one week of production will reduce your loss, but what if you can’t find the money?

The widget company’s experience isn’t just limited to Cyprus. It was repeated a few million times in the United States during the fall of 2008. The results were massive layoffs, lost wages (which meant less consumer spending) and lost company profits. All of which made a disastrous recession even worse.

Why did this happen in the U.S.?

Because too many banks woke up one morning to find that some of the dicey unregulated derivative securities they held in their portfolios had lost most of their value. In a panic, they tried to conserve as much available cash as they could by freezing lending to businesses and individuals alike.

Back in Cyprus, the banks became a tax haven for overseas depositors. They then invested the money in Greek bonds to generate big returns. When the bonds tanked, the banks were on the verge of bankruptcy and needed a bailout.

But there’s no need to be alarmed. It can’t happen here. The American economy has been strong for months now, the stock market is rising, and your 401(k) is going through the roof. Right?

originally posted: April 6, 2013

The tigers of Wall Street

Posted on by j.giglio

The Senate recently held a hearing to look into a series of trades that cost JPMorgan Chase over $6 billion last year, some of which was funded by federally insured deposits. They have come to be known as the “whale trades,” but beyond indicating the scale ofthe loss, the description is a misnomer. You see, likening whales to rogue traders is unfair to whales. A more accurate metaphor is the Siberian tiger, one of the most awesome creatures on earth.

The Siberian tiger was brilliantly engineered to be the world’s ultimate killer, far surpassing the shark, the barracuda and the piranha. Tigers kill with their fearsome combination of size, speed, strength and cleverness, not to mention razor-sharp claws and teeth.

But tigers don’t kill just to meet the Darwinian imperative of satisfying their ravenous hunger. They also kill for the sheer joy of it, preferably while inflicting the maximum amount of torture on their terrified victims. It’s just their nature.

An example of this occurred on Christmas Day 2007 at the San Francisco Zoo, when three teenage boys who had consumed too much beer thought it would be great fun to yell taunts and obscenities at Tatiana, the zoo’s 400-pound Siberian tiger, from outside her enclosure.

After the boys had tired of the game and started on their way, Tatiana sought vengeance. She leaped to the top of the 12-foot wall surrounding her enclosure, hid behind some bushes along the pathway she figured the boys would take, and leaped at them with a mighty roar as they passed.

Tatiana killed the first boy instantly with a bite to the neck . She whacked the other two into semi­ consciousness with blows from her powerful front paws. But as she set upon them, a team of zookeepers reached the scene and killed Tatiana with a shot to the head from a high-powered rifle, saving the lives of the remaining two boys.

For all their strength, intelligence and murderous instincts, Siberian tigers are in danger of becoming extinct in their natural habitats, because each adult requires roughly 400 square miles of unspoiled wilderness stocked with tasty animals to survive on its own. A burgeoning human population and development pressures are making such outsized land hunger increasingly impractical.

So the best future for Siberian tigers is in regulated environments like the Bronx Zoo’s Tiger Mountain. There they can roam large wilderness compounds that replicate their natural habitats as they are fed fresh meat daily so they no longer have to kill other animals. They are tended by skilled keepers who entice them into playing games that delight human spectators and maintain their physical fitness and fighting instincts without requiring them to indulge in the worst aspects of their serial-killer nature.

In many respects, markets are also serial killers. From a social perspective, the best future is for them to also exist in regulated environments where their survival is pretty much assured, their many benefits can be harnessed to serve the public good, and the downsides of their nature are properly restrained.

As the financial meltdown of 2008 reminded us, under-regulated markets have a long history of going on periodic murderous rampages, just like hungry tigers. They rip jobs and homes away from millions of people who depend on them, gulp down trillions of dollars in hard-earned savings, and ravage the flesh of thousands of small businesses whose bones are flung on the ash heaps of bankruptcy.

There are two possible solutions:

One is to learn how to regulate markets and their participants sensibly, to rein in their potentially murderous behavior before it gets out of hand by building a system in which the ups and downs of capitalism are sufficiently tempered to avoid destructive booms and busts.

You don’t want to know what the second solution is. But if you happen to be an immigrant from the former Soviet Union, you already know what it’s like to be subjected to absolute state authority. 

originally published: March 23, 2013

Why the fed’s case against Standard & Poor’s matters to you

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Federal prosecutors filed civil fraud charges against Standard & Poor’s for alleged wrongdoing in rating mortgage bonds. This is the first federal enforcement action against a major credit rating agency over alleged illegal behavior tied to the 2008 financial crisis.

For the uninitiated, Wall Street investment banking firms long ago woke up to the fact that their credibility as sellers of financial securities to private investors could be significantly enhanced if these securities were “rated for safety” by so-called independent and objective third parties.

This was especially true for debt securities like bonds, whose likely buyers were perceived as very conservative. Since the market for bonds and other debt securities is far larger than the market for common stocks, development of a third-party rating system for them became a priority for Wall Street.

Three private firms emerged as the most trusted “rating agencies” for debt securities: Moody’s Investors Services Inc., McGraw-Hill subsidiary Standard & Poor’s, and Fitch Inc.

These firms assign “investment ratings” to debt securities based on their analysis of relevant financial data about the issuers. They charge fees to the sellers for rating the debt securities.

The financial community accepted this approach for providing debt securities buyers with “objective” information about their relative safety and these rating systems became a popular shorthand way to categorize the securities. Investment banks routinely used favorable ratings as marketing tools.

Some institutional buyers of debt securities (like insurance companies with streams of premium income to invest) announced that they would only buy securities rated “A” or better. Government and private sector regulators often set minimum ratings for the securities firms they regulated (such as commercial banks) were permitted to buy.

During the run-up to the financial crisis, this business was quite profitable. From 2005 to 2007, Moody’s had a return on capital of 140 percent, the highest among all publicly traded corporations listed in the S&P 500 Index. Its operating profit margin was 53.6 percent. And the firm’s revenues from rating corporate bonds grew by 187 percent. In short, the rating agencies made out like proverbial bandits.

So it doesn’t take much imagination to picture how the relationship might have played out on a typical day in 2007 as the mortgage backed securities and derivative products boom was approaching its climax. Wall Street investment banks delivered risk-profile reports for their latest deals that included mathematical risk models.

Except the formulas and equations behind those models were proprietary, meaning that rating agencies’ reliance on them amounted to little more than “trust me.” The agencies happily made that leap of faith, which benefited their bottom lines to the detriment of those who purchased the securities.

In addition to consistently churning out strong ratings for highly questionable debt securities, they also regularly increased the fees they charged for doing so.

If you conclude that the interaction between big banks and the rating agencies was more like a criminal enterprise than an arms-length relationship between a commercial enterprise and an independent , objective third party, you’re not alone. Federal prosecutors feel the same way.

Now where do all the purchasers of those now-worthless debt securities go to get their money back?

originally published: February 19, 2013

Reality check: Myths cloud free-market debate

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In the years since the 2008 financial meltdown, free markets have suffered a shattering loss of credibility, especially among Americans who have lost their jobs, homes and the money they saved for retirement and college for their children.

Since the days of Adam Smith, more nonsense has been written about free-market capitalism than any subject other than religion.

Beginning in the 1960s, ivory-tower economists started developing a host of “rigorous” quantitative models that claimed to show how markets actually work.

These models (expressed in obscure differential equations rather than clear English) focused primarily on markets for common stocks and other financial securities that were assumed to represent the closest real-world approximation of the free-market ideal.

They were all wrong.

But they still became mainstream thinking among 1980s and ’90s Wall Street rocket scientists and remained so right on into the 2008 collapse. Several of the models’ developers even won the Nobel Prize in economics, with its impressive gold medal and seven-figure check.

It may come as a surprise to some, but markets are by no means artificial entities invented in an ivory tower. They are entirely natural and instinctive products of human pragmatism.

Let’s look at some of the popular myths about markets that have brought us so much grief. The first is that the amount of goods and services consumers are willing to buy at the so-called “market price” always equals the amount producers are willing to sell.

The evidence indicates that real-world buyers and sellers are forever chasing transaction prices that coincide just long enough for them to strike deals. The price agreed upon for one deal may be different from that of a similar one struck at the same instant on the other side of the room.

This should come as no surprise to anyone who’s ever bought a knock-off Rolex wristwatch, Mont Blanc pen or Vuitton handbag at a bargain price from one of the sidewalk stalls that line Manhattan’s Canal Street, where the sweaty reality of free markets truly flourishes.

Another myth is that markets are perfectly efficient because decisions to buy and sell are made by coldly rational androids that seek only to maximize their personal satisfaction in objective ways, possess complete information and have absolute freedom to enter into transactions or to pass on them.

But real-world markets are usually chaotic, with the average buyer or seller trying to guess what every other average buyer and seller thinks is the right price. And what about situations like the one faced by a fisherman forced to sell his fresh fish at the end of the day for whatever price a restaurant chain offers, because it’ll spoil overnight?

Many economists claim that market-price changes are entirely random and independent of each other, like consecutive coin tosses. But normal people instinctively know that prices are determined by human beings who negotiate knowing what the last transaction price was. The real world is like an unbalanced roulette wheel, full of patterns and dependencies.

Still another myth is that markets work best when they’re not subject to any meddling by external institutions like government. But markets need regulation  as both President Obama and Governor Romney acknowledged in their first debate.

We can’t rely on the myth that a seller knows his economic success ultimately depends on his reputation among potential buyers. The argument that he has a powerful economic incentive to maintain a reputation for honesty can easily fall prey to natural instincts that may be those of a con artist.

Market myths like these provided justifications for the deregulation mania on Wall Street and elsewhere. If we want to recover from the Great Recession they helped cause and avoid a repeat of it, we’d better learn the difference between myth and reality.

originally published: October 13, 2012

Pension fund safety net doesn’t protect taxpayers 

Posted on by j.giglio

The economic crash that began in 2008 is a triple whammy for ordinary Americans: their jobs, homes and retirement incomes are all at risk.

Too little money has been set aside to keep the promises made by both private- and public-sector pension plans. As a result, the American dream of a golden retirement is fading fast.

Standard & Poor’s estimates that the funding shortfall for corporate pensions and related benefits was $578 billion in 2011.

As bad as that sounds, state and local governments’ problems are even worse. According to the National State Budget Crisis Task Force, public pensions are underfunded by $1 trillion to $3 trillion.

Employers typically offer defined-benefit or defined-contribution pensions. Corporations have gradually closed their defined-benefit plans and replaced them with defined-contribution plans such as 401(k)s, though many still owe money to retirees who were part of the old defined-benefit systems. Most local governments continue to offer defined-benefit plans.

Defined-benefit plans provide post-retirement benefits that are typically a percentage of average salary during an employee’s last few working years. The employer promises to pay a fixed retirement benefit regardless of how the plan’s investment portfolio performs.

When private pension funds cannot meet their obligations, the federal Pension Benefit Guaranty Corp. steps in. This agency guarantees the pensions of about 44 million participants in about 27,000 corporate defined-benefit plans .

The Pension Benefit Guaranty Corp., which is primarily funded by investment income and insurance premiums collected from corporations, pays beneficiaries up to $54,000 annually when a company cannot meet its pension obligations. But the cost of rescuing failed corporate plans has saddled the corporation with a $26 billion deficit.

So who backstops the Pension Benefit Guaranty Corp.? Maybe it is time for the agency to set the insurance premium the way other private insurers and the Federal Deposit Insurance Corp. do. This would avoid a repeat of Fannie Mae.

There is no equivalent of the Pension Benefit Guarantee Corp. for state and local government defined­ benefit plans, which are ultimately backed by taxpayers.

One cause of unfunded pensions is the Great Recession. Pension funds invest in a portfolio of assets whose returns are expected to pay the lion’s share of the plan’s obligations.

The funds commonly assume they will earn 8 percent. With compounding, it is a handsome return. But in this environment, the chances of doing that are between slim and none without shifting portfolio composition toward higher-yielding but riskier assets.

The political class in Washington, D.C., has been less than honest in dealing with the retirement time bomb. Part of the two-year transportation funding bill that was finally signed last month updates the Pension Protection Act of 2006 by increasing the premiums the company sponsors of pension plans must pay to the Pension Benefit Guarantee Corp.

The law allows pension plan sponsors to ignore current interest rates when calculating their obligations and pretend rates are closer to their 25-year average. That means plan sponsors can make smaller pension contributions over the next I0 years.

This will exacerbate the funding crisis, but provide government with a short-term tax windfall. Since firms get a tax deduction for contributions to their pension funds, they pay more taxes if they put less money into them.

As a result, the provision is supposed to generate $9.5 billion for the Highway Trust Fund. The ploy fills the shortfall between current federal fuel tax revenue and projected transportation spending without raising the 18.4-cent federal fuel tax, which has not increased since 1993.

If the pension plan blows up, the Pension Benefit Guarantee Corp. will be the ones to pick up the shortfall. And that, of course, means you.

originally published: August 18, 2012