Tax Policies Created a Real Estate Monetary Standard

Michael Sankowski, at Monetary Realism, asks us to consider the possibility that we are on a Real Estate Monetary Standard:

I’ve been thinking a lot about this over last few weeks when I have the chance to think. It seems like we are on a real estate monetary standard. Much like how we can use assets like gold to create a commodity money system, it seems like we operate our current monetary system as a real estate standard.

Banks create money against real estate assets. We use this money in our day-to-day transactions, without much thought about what stands behind this money, but most loans are for residential and commercial real estate.

If we did operate under a real estate standard, we would expect to see the larger economic business cycle greatly impacted by the real estate cycle, far more than the declines in real estate activity would predict.

The impetus for this discussion is a recent paper by Ed Leamer, “Housing is the Business Cycle,” that confirms Mike’s prediction. The following graph shows real estate loans at all commercial banks as a percentage of total loans and leases:Notice that the percentage held relatively steady around 25 percent for nearly 40 years following the end of WWII. Then, in the mid-1980’s, the percentage surged higher. This massive change may have been a consequence of the Tax Reform Act of 1986 that included “ increasing the Home Mortgage Interest Deduction,” a “Low-Income Housing Tax Credit,” and changes to “ the treatment of imputed rent, local property taxes, and mortgage interest payments to favor homeownership.” After leveling off in the mid-1990’s, the percentage of real estate loans once again spiked higher beginning in late 1998. Once again, changes in tax policy may have played a substantial role. The Taxpayer Relief Act of 1997 substantially lowered the capital gains rate and “exempted from taxation the profits on the sale of a personal residence of up to $500,000 for married couples filing jointly and $250,000 for singles.”

The shifting of bank lending from primarily commercial to real estate loans has clearly been accompanied by shifts in policy to vastly reduce taxes accompanying rents, interest and capital gains. These changes, as well as other public policy initiatives, have helped significantly increase the value of homes that could be borrowed against. As Michael Hudson argues in The Bubble and Beyond, the overall effect has been to transfer former tax payments to private financial institutions, ultimately increasing wealth inequality and making the economy (and government) more beholden to the banks.

Although total real estate loans have actually fallen during the past few years, they still account for nearly 50 percent of total loans. This real estate monetary standard is certainly not restricted to the U.S. and actually appears to be prominent in Europe, as well as several other developed nations. To the degree that bank lending affects aggregate demand, real estate will clearly continue to have an outsized effect on the global business cycle.


(Note: For those interested, Leamer actually discussed this paper during an episode of EconTalk with Russ Roberts back in May 2009.)  

Shinzo Abe: Monetarist or Keynesian Hero?

A couple weeks back, Tim Duy argued that many economists were missing the big story in Japan:

Ultimately, it is the story of the end game of the permanent zero interest rate policy.

In a follow up post, Duy noted that:

a thread is making the rounds claiming that Japanese Prime Minister Shinzo Abe is all bark, no bite. Joshua Wojnilower argues that Abe is a closet austerian, thus ultimately the actual stimulus enacted will be of the short-term, low-power variety. Noah Smith is less diplomatic, pointing out that Abe's first time at the helm was something of a disaster because Abe fundamentally has a narrow focus:

"I of course don't mean to imply that Abe's cultural conservatism makes him unlikely to experiment with monetary policy (unlike in America, in Japan "hard money" is less of a conservative sacred cow). Instead, what I mean is that Abe really just does not care very much at all about the economy. I mean, of course he wants Japan to be strong, and of course he doesn't want his party kicked out of power. But his overwhelming priority is erasing the legacy of World War 2, with the economy a distant, distant second."

I highlighted the following chart in my previous post:

Abe’s previous leadership entailed the smallest budget deficit during the past 12 years, by a wide margin (Source: IMF): 

Although Abe may be willing to accept short-term fiscal expansion this time around, his medium and long term views still seem focused on reducing public debt.

Now Abe’s government is following through with a $116bn stimulus package that sent the Nikkei shooting higher and pushed the Yen even lower. Supposedly:

the stimulus will boost Japan’s economy by 2% and create 600,000 jobs.

Has the Monetarist hero suddenly become a New Keynesian icon? For the time being, maybe so, but I maintain my reservations about the mid-to-long term stimulative plans of this government. Fortunately, for me, Noah Smith also remains pessimistic given Abe’s and the LDP party’s history of waste and favoritism accompanying stimulus measures:

Anyway, the tweaked electoral system, lower "clientelist" pork spending, and the disastrous unpopularity of Abe's first tenure as prime minister helped ushed the DPJ into power, breaking the LDP's 55-year run. But now the LDP is back, and they need to re-establish their base of support. This means re-establishing the back-scratching relationship with those construction firms (and, by extension, rural Japan, right-wing Tea Party type groups, and the mafia). The LDP needs to say "Hey, guys, things are back to the way they were." This, I suspect, is the main reason for the "emergency stimulus".

…

To sum up: Once again, I think that Abe's appearance as a bold Keynesian experimenter is a cover for a program of traditional mercantilism and corporatism. I guess we'll see how well that program works.

Is the Return of Auto Subprime Lending and GM "Channel Stuffing" Connected?

Cardiff Garcia over at FT Alphaville has a recent post up on the return of auto subprime lending. Apparently lending standards are being increasingly relaxed, leading to an increase in lending activity. Garcia questions whether this news is good or bad, coming to the conclusion (my emphasis):

Whatever the case, we noted in May that while the pace of car sales in the US has picked up this year, it’s still much slower than for most of the past decade. More and more it’s clear that this is an ongoing rebound following the end of a depreciation cycle. (The pickup in lending activity is at least a sign of expected sustained demand in this sector, so there’s that.)

This sounds plausible enough but my nature involves being skeptical. Let's consider a different thesis on the rise in subprime lending. 


Over the past couple years auto manufacturers, namely GM, have been loading up dealer inventories to falsely promote higher sales. What many people may not realize, is that sales are booked when the cars are “sold” to dealers regardless of whether the dealers are able to sell the vehicle to end users. Here is a chart from Zero Hedge depicting the rise in GM dealer inventory:

This practice, known as “channel stuffing”, is actually part of a recent class action lawsuit filed against GM by investors. As the dealers are left with increasing unsold inventory, costs of storage are certainly rising. If sales to end users are not keeping pace with the desire of GM to unload inventory (clearly the case), one way to spur increasing end sales would clearly be lowering lending standards. The pickup in lending is therefore not a sign of expected demand but rather a means to increase demand. Is it possible the decline in credit quality of auto loans is a means to cover-up “channel stuffing” practices? If so, when subprime defaults eventually rise, who will be left with the losses?

Do Business School Ethics Lead to Financial Industry Scandals?

The financial sector has had a difficult time getting any positive press recently following the LIBOR scandal, loss of customer funds at PFG, hidden losses at JPM and money-laundering at HSBC. As we wait to see what criminal activity pops up next week, one has to question why so many of these illegal actions seem centered around business and finance. Luigi Zingales, a professor at the University of Chicago Booth School of Business poses the related question, Do Business Schools Incubate Criminals? In his view, the manner by which ethics are taught might suggest these actions are reasonable. Acknowledging this deficiency, Zingales provides a potential solution:

The way to teach these ethics is not to set up a separate class in which a typically low-ranking professor preaches to students who would rather be somewhere else. This approach, common at business schools, serves only to perpetuate the idea that ethics are only for those students who aren’t smart enough to avoid getting caught.

Rather, ethics should become an integral part of the so- called core classes -- such as accounting, corporate finance, macroeconomics and microeconomics -- that tend to be taught by the most respected professors. These teachers should make their students aware of the reputational (and often legal) costs of violating ethical norms in real business settings, as well as the broader social downsides of acting solely in one’s individual best interest.

Of course, no amount of instruction can prevent some people from engaging in bad behavior. It can, however, contribute to a social consensus that would discourage diffuse fraud, like the widespread misreporting of Libor rates or the willful self- delusion and dishonest dealing that helped turn the subprime crisis into a global financial disaster. The daily scandals that expose corruption and deception in business are not merely the doing of isolated crooks. They are the result of an amoral culture that we -- business-school professors -- helped foster. The solution should start in our classrooms.

The Necessity of Private Banking

Yesterday, Rodger Malcolm Mitchell offered a second part to his view that private banking should be ended. He begins by accurately acknowledging the difficulty in writing and enforcing sufficient regulation, along with the bankers’ success in using the government system to bolster profits. The apparent impossibility of eradicating rent-seeking from bankers leads Mitchell to conclude:

When private individuals control vast amounts of money, and when they are compensated according to their control of this money, even the saints among us would be tempted. Bottom line, private banking is, and always has been, crooked, the bigger the bank, the greater the temptation, the more crooked.

In banking, the profit motive corrupts. And combining the profit motive with short-termism corrupts absolutely. Always has; always will.

All banks should be federally owned.

Although I agree that the profit motive “corrupts” (though not absolutely), it dawns on me that this view can easily be extended to the entire private sector and holds a strong parallel in the public sector if one alters profits with power. All individuals, at some point, are tempted to work the system in their favor. Banking, whether done through the private or public sector, will therefore always be subject to some level of corruption.

Apart from the reasoning on corruption, there are two other discrepancies I brought up in the comments. First, removing the profit motive from banking effectively eliminates the market (price system) for credit/lending. Government agents will therefore have full discretion over who receives a loan, as well as the size and price, without an incentive to determine the borrower's ability to repay. As many economists in the Austrian tradition have previously explained, without knowledge from a market (i.e. prices), the allocation of resources will be highly inefficient.

Second, Mitchell’s usage of the term “money” to include credit obscures an important distinction between money and credit. Kurt Schuler of Free Banking recently addressed this confusion:

Money in the narrow sense is the monetary base, which, at least from the standpoint of the domestic monetary system, is a pure asset and not somebody's IOU. Payment with the monetary base extinguishes IOUs.…“Money” in the looser, broader sense includes IOUs, particularly those issued by banks, that are readily convertible at 1:1 into the monetary base.

Private banks are the majority supplier of credit (IOUs)*, which acts as a money-like instrument. The Arthurian explains the significant difference:

The cost of interest is an "extra" cost, a largely unnecessary cost in our economy. Yes of course we need to use credit. But we don't need to use credit for everything. But we do. So, we have this extra cost to deal with, the factor cost of money. And it creates cost-push conditions. And cost-push conditions cause inflation. Inflation, or decline.

Further, the added interest cost transfers wealth from borrowers to lenders. This increasing reliance on credit in the past three decades, supported and subsidized by government, is largely behind the enormous rise of profits in the financial sector and current economic struggles. Considering the public support for use of credit, making banks publicly owned is unlikely to address this issue.
I entirely agree that the financial sector is a source of corruption and prime example of problems with rent-seeking. However, turning over the role of banking to the government will not reduce corruption or the country’s reliance on credit and will be significantly more inefficient.


*Ralph Musgrave, who also got involved with comments on Mitchell’s post followed up with a post of his own seeking clarity on the proportion of the money supply (broad version) created by private banks. Presumably, since loans create deposits:

to get at the proportion of money created by central bank it strikes me we need take physical cash add total deposits and subtract total loans.

This site gives the deposit to loan ratio of U.S. FDIC insured banks as 79%. (loans are $7.28 trillion while total deposits are $9.22 trillion).

From that I deduce that about 20% of money in the U.S. is central bank created.

JPM Displays Pervasive Desire of Traders to Hide Losses

JPMorgan reported its second quarter earnings this morning and provided an update on the CIO situation. While the company continues to be very profitable, losses from the CIO disaster were revised higher to over $5 billion and part of the position remains open. What is more striking is the following quote highlighted by Zero Hedge:

'the recently discovered information raises questions about the integrity of the trader marks, and suggests that certain individuals may have been seeking to avoid showing the full amount of the losses being incurred in the portfolio during the first quarter. As a result, the Firm is no longer confident that the trader marks used to prepare the Firm's reported first quarter results (although within the established thresholds) reflect good faith estimates of fair value at quarter end.

First of all, let me say that the notion traders are marking books in their favor should not be surprising to anyone. What should be surprising is that JPMorgan is being publicly forced to disclose this fact, which I can assure you is far more pervasive than a few select individuals in the previous quarter.

Several years ago I worked as an equity options trader, trading some of the well-known, high priced names within the technology sector. Unlike many highly traded equity securities, most options at that time did not trade at penny spreads. While my positions may not have been large in comparison to those at many banks, they were large enough that moving the mark from bid to ask (or reverse), on certain strikes, could alter my profitability by upwards of 20-30% on any given day. Not surprisingly, since those strikes often represented the largest open positions on the underlying security, trades frequently went through at the market close to make that mark. By frequent, I mean that this occurred daily on several different strikes (often the same ones for a stretch of days). For any trader, this was a cheap and easy way to manipulate the P&L your bosses would see.

Now imagine that you’re a trader and your bonus/review is based on end of quarter or yearly numbers? Or the market value of your stock in the company might be altered significantly based on the publicly reported number? Do you attempt to mark your trades by a slight amount? The incentive is surely not high enough for all traders and other traders may try to mark positions in the opposite direction, but clearly some percentage of traders will attempt to play this game. Now, on an individual basis it might not make much difference, but if the percentage at a firm is high enough or the positions large enough, this game could have a meaningful effect. In the case of JPMorgan, it appears that the latter was the case this time, but we should not write off the possibility of the former (at JPMorgan or any other large financial institution).

This disclosure adds another tally to the list of areas that regulations are clearly not being enforced. After paying billions to cover up the mortgage fraud debacle, the largest banks now face billions more in charges related to LIBORgate. One should expect that many more financial restatements and disclosures of bad practices will be revealed in time.  

How Out-of-Control Credit Markets Threaten Liberty, Democracy and Economic Security

Think back to the Great Depression. What we lost then and now and what we need to regain is trust. To be frank, I don't know how we can win that trust in our system back. But, when it comes to credit markets, I know where we can start.

First, we need to make sure there are no more bailouts. While the bailouts have prevented a Great Depression for now, they have engendered a deep sense of cynicism and resentment which has negatively impacted credit and growth. Second, we need to know that our largest financial institutions are well-capitalized enough to withstand large economic shocks. Without this knowledge, no one can separate liquidity from solvency — exactly the problems banks had during the Great Depression. Third, we need to enforce regulations through sound regulatory oversight and civil or criminal penalties. Self-regulation is a pipedream promoted by corporatists. And we see that time and again where regulations are not enforced, financial institutions turn to excess that leads to panic and crisis.

Doing these three things will not magically turn our economy around and get credit flowing again. But these steps are essential to restoring trust in our financial institutions and government. Restoring that trust is the first and most important step in getting our credit markets to work the way they are supposed to — in a way that enhances and insures our individual liberty, rather than the false privileges of corrupt financial institutions.

Read it at Naked Capitalism
How Out-of-Control Credit Markets Threaten Liberty, Democracy and Economic Security
By Ed Harrison

In trying to understand our modern monetary system and the problems at the heart of the current crisis, the most important aspect is credit. Although I currently believe demand for credit is a greater issue, problems within financial institutions remain serious. Harrison’s third point, which seems to contrast an earlier view about the need for more regulation, is worth highlighting. In the US there are already thousands of regulations for financial institutions. The trouble is that many are simply not enforced or hold penalties so small as to make breaking the rule still worthwhile. Greater transparency and enforcement are clearly needed in light of the recent PFG bankruptcy, LIBOR scandal and countless other known and unknown transgressions.

Crony Capitalism - The Degree Matters

Supporters of free markets seem to be increasingly vocal in their opposition to corporatism or crony capitalism. Whilst I wholly welcome this, I fear that the demand for a proper free market economy without cronyism or special favours is as unachievably utopian as the wildest leftist fantasy.

Read it at Stumbling and Mumbling
CRONY CAPITALISM - THE ONLY CAPITALISM
By Chris Dillow

Chris lays out three reasons why capitalism must in practice be crony capitalism. While I don’t disagree with his premise, or even necessarily the conclusion, a more subtle point I would note is that it’s ultimately about degrees. Even if one accepts that capitalism will involve some level of cronyism, that argument suggests nothing about whether cronyism will be limited to a few minor inconveniences or become so widespread as to discourage trust in practically any dealing. The differences between these two outcomes and the vast area in between are, in my opinion, the reason debates among free marketers and those favoring regulation are so meaningful. Any economic system will likely involve some manner of cronyism. Therefore, fighting to reduce the degree of its persistence is and will remain an extremely worthy cause.

John P. Hussman - The Heart of the Matter

The ongoing debate about the economy continues along largely partisan lines, with conservatives arguing that taxes just aren't low enough, and the economy should be freed of regulations, while liberals argue that the economy needs larger government programs and grand stimulus initiatives.

Lost in this debate is any recognition of the problem that lies at the heart of the matter: a warped financial system, both in the U.S. and globally, that directs scarce capital to speculative and unproductive uses, and refuses to restructure debt once that debt has gone bad.

Specifically, over the past 15 years, the global financial system - encouraged by misguided policy and short-sighted monetary interventions - has lost its function of directing scarce capital toward projects that enhance the world's standard of living. Instead, the financial system has been transformed into a self-serving, grotesque casino that misallocates scarce savings, begs for and encourages speculative bubbles, refuses to restructure bad debt, and demands that the most reckless stewards of capital should be rewarded through bailouts that transfer bad debt from private balance sheets to the public balance sheet.

What is central here is that the government policy environment has encouraged this result. This environment includes financial sector deregulation that was coupled with a government backstop, repeated monetary distortions, refusal to restructure bad debt, and a preference for policy cowardice that included bailouts and opaque accounting. Deregulation and lower taxes will not fix this problem, nor will larger "stimulus packages." The right solutions are to encourage debt restructuring (and to impose it when necessary), to strengthen capital requirements and regulation of risk taken by traditional lending institutions that benefit from fiscal and monetary backstops, to remove fiscal and monetary backstops and ensure resolution authority over institutions engaging in more speculative financial activities, and to discontinue reckless monetary interventions that encourage financial speculation and transitory "wealth" effects without any meaningful link to lending or economic activity.

Read it at Hussman Funds
The Heart of the Matter
By John P. Hussman

Related posts:
Tax Law Made Financialization Happen

Trickle-Down Economics: Does Anyone Actually Believe In It?

The words “trickle down” imply that if you redistribute money to the wealthy, they will spend it (say, by hiring workers or by buying products) and it will somehow find its way into the hands of the poor. To the extent that any economists endorse such a notion, they are emphatically not free market economists.

Read it at Neighborhood Effects
Trickle-Down Economics: Does Anyone Actually Believe In It?
By Matt Mitchell

A couple weeks back I offered Michael Edesess mathematical perspective that a Lack of Clarity in Economic Terminology Leads to "Ridiculous Debates". In politics today, but also in economics, terms such as “free market” and “trickle down” are frequently used without any consistency in meaning. This failure of a common definition leads to misunderstanding and lost information. While the ambiguity may be ideal for politicians (each individual can assume what they want to hear), economists hoping to inform policy making need to work on more rigorously defining economic terminology.

Related posts:
Bruce Bartlett's Pessimistic View on Tax Reform
Zero Hedge - Presenting The Greatest ROI Opportunity Ever

Zero Hedge - Presenting The Greatest ROI Opportunity Ever

 

The dream of virtually anyone who has ever traded even one share of stock has always been to generate above market returns, also known as alpha, preferably in a long-term horizon. Why? Because those who manage to return 30%, 20% even 10% above the S&P over the long run, become, all else equal (expert networks and collocated flow-frontrunning HFT boxes aside), legendary investors in the eyes of the general public, which brings the ancillary benefits of fame and fortune (usually in the form of 2 and 20). This is the ultimate goal of everyone who works on Wall Street. Yet, ironically, what most don't realize, is that these returns, or Returns On Investment (ROI), are absolutely meaningless when put side by side next to something few think about when considering investment returns.

Namely lobbying.

Read it at Zero Hedge
Presenting The Greatest ROI Opportunity Ever
By Tyler Durden

Quote of the Week

...is from page 5 of Milton and Rose Friedman’s classic book, Free to Choose: A Personal Statement:

In the government sphere, as in the market, there seems to be an invisible hand, but it operates in precisely the opposite direction from Adam Smith's: an individual who intends only to serve the public interest by fostering government intervention is "led by an invisible hand to promote" private interests, "which was no part of his intention."

News headlines over the past few weeks have been rife with examples of the invisible hand in reverse that the Friedman’s highlight. The Jumpstart Our Business Startups (JOBS) Act that was signed into law this week exempts small, newly public companies (those with less than $1 billion in revenues...seriously?!) for 5 years from disclosing executive compensation, having “an auditor attest to their internal financial controls” and “comply[ing] with all the accounting rules required of public companies today.” Further, “banks underwriting their IPOs may be able to issue research reports on the stocks ahead of the offerings, a practice prohibited a decade ago after analysts pumped dot-com stocks their firms were helping take public.” While this bill may encourage more companies to become public, it also promotes several types of fraud that have cost investors dearly over the years.

Apart from the JOBS Act, the current debate over the individual mandate is in part due to the stranglehold on Congress held by private health insurance companies. Instead of creating a single-payer health care system, the current bill protects and improves the position of health insurance companies by mandating the entire population by their products.

These are just two recent examples but there are countless others that include special tax breaks for oil companies, bailouts of automotive companies and lax capital requirements for banks. This is not to suggest that individuals’ in government purposefully seek to promote the interests of a few over the many, but rather that the structure of the institutions and personal desire for re-election lead to this outcome.

From an economic perspective, I agree with many individuals on the left that large budget deficits currently continue to play an essential role in reducing unemployment and promoting economic growth. However, in light of this view, it is important to remember that big government increases the returns to and proliferation of crony capitalism. Weighing the benefits and costs of these options is rarely easy, but the wonderful aspect is that we remain “free to choose.”

Points of Public Interest

This week’s best and most intriguing for your weekend reading:

1. Krugman on (or maybe off) Keen

A Nobel Laureate is taught the limit of his own assumptions. Others pile on: Philip Pilkington: Krugman Makes Accusations of Fundamentalism to Defend His Own Dogma and Debt, Income and Aggregate Demand: Scoring Krugman vs Keen

2. Why Some Multinationals Pay Such Low Taxes

Insight into Google’s use of a “Double Irish Dutch Sandwich” and many other clever practices being used by GE, Microsoft, Apple, etc.

3. WHY MINSKY MATTERS: Part One

A former student of Minsky’s elegantly outlines the important aspects for understanding the reality of our financial and economic system. More on Minsky: Was 'Post-Keynesian' Hyman Minsky an Austrian in Disguise?

4. The worst anti-regulatory travesties in the financial sphere have had broad, bipartisan support

Without much fanfare, the “fraud-friendly JOBS Act” passed Congress this week with overwhelming support. William Black, a professor of law and economics, offers a history of anti-regulatory bills over the past several decades. If history is any guide, the JOBS Act will be front and center as having aided and abetted massive frauds during a financial crisis in the not too distant future. More on the JOBS Act: Bill Black: “The only winning move is not to play”—the insanity of the regulatory race to the bottom

5. Liberating The Hunger Games and What Happened to Liberty in the The Hunger Games Movie?

What can I say...talk of The Hunger Games is everywhere these days!

6. The Real Leadership Lessons of Steve Jobs

The bottom 99% fall further behind:

Source: NYT