Treasury Secretary Geithner’s OTC Derivatives Letter to Congress:

On May 13, 2009 the United States Secretary of the Treasury-Timothy Geithner-sent a letter to members of the United States Senate urging them to adopt new regulations in the over the counter (OTC) derivatives markets. Many economists blame the opaqueness and uncertainty of the credit markets on the mostly hidden transactions involving OTC derivatives. Geithner emphasis that under current law these transactions are exempt for regulations and that bringing them under a regulatory framework will eliminate many abuses. These abuses include, “1) preventing activities in those markets from posing risk to the financial systems; 2) promoting efficiency and transparency in those market; 3) preventing market manipulations, fraud, and other market abuses; and 4) ensuring that derivatives are not marketed inappropriately to unsophisticated parties.”

Geithner’s letter addresses the details and laws that are needed to ensure that the broad objectives are meet in OTC derivative regulation he is proposing. The new regulations proposed are larger capital requirements, increased requirements to margin purchases, financial reporting requirements, and standardization of derivatives contracts. Reporting transactions and volumes should be available to government regulators much like they are required in standard equity markets. In the end of the letter the Secretary of the Treasury expresses his commitment to help shape regulation that does not impede on the enforceability of OTC derivative contracts. The adherence to the contractual law appears to be a concern for Geithner but this concern should also be warranted to the financial obligations of other sectors of the bailout-automobile industry- which have not received their ordinal priority in recent months.

Inflation Nation: Article Summary

The article “Inflation Nation” was written Allan H. Meltzer Professor of political economy at Carnegie Mellon University. This article compares and contrasts the current economic policies of the Federal Reserve under the Obama administration with the Paul Volker Federal Reserve of the 1970's. The major differences are the current administrations large budget deficits which will constrain the Feds’ open market activities and also the decreasing independence of the current federal reserve.

Mr. Meltzer is concerned that there is an increasing danger for inflation given the policies of the current administration. The inflation fears turned to reality in the 1970’s and that is when the Volker Federal Reserve allowed interest rates to increase despite the high levels of unemployment. Mr. Volker was admired for this determination to make the tough decision to let the interest rates rise that would undoubtedly create higher unemployment in the short run, but decrease high inflation that would hurt productivity growth in the long run. Given that Volker is a close advisor to Obama, him and “many economic advisors are fully aware of the inflationary dangers ahead”. The dangers according to Meltzer is not the technical knowledge of Obamas' economic advisors, but that under Bernanke, the Fed has become less independent than the Volker Fed was and that will hurt their conviction to make the tough decision which will come once the price levels begin to rise.

Two Rules That Could Have Prevented the Current Financial Crisis

Future Financial Regulation: Two Simple Rules to Prevent AIG-like Blowups Without Hampering Economic Growth; Summary

This paper was written by Romain Ranciere and Aaron Tornell and it proposes a couple of regulations that would be helpful for preventing future financial crises similar to the one we are experiencing today. The regulation of the financial industry carries a great degree of exigency due to the economic crisis whose’ epicenter was in the United States. This paper summarizes the two ways in which financial derivatives can be regulated to ensure market efficiency and transparency. The authors argue that financial regulation of derivative markets should occur and that the regulations should be simple and act as facilitators to the free market as opposed to stifling economic growth.

The two rules that are proposed are,” 1) Financial Derivatives should only be traded through public exchanges and 2) Large financial institutions would finance themselves with only with equity, deposits and standard debt contracts.” The creation of financial derivative markets would increase liquidity of derivatives so that we would not be in this illiquid situation and there would not be such asymmetrical information as we have today. The second financing rule would limit the sources of funds in the form of unorthodox funding but would have positive benefits in the form of limiting the amount of insurance type contracts without restraints. Many off balance sheet activities would be reduced if these rules where implemented according to Tornell and Ranciere and they would do so with limited market interference by actually increasing market efficiency.

Question: What do you think about the notion that in order for a country to become more financially liberal its trade balance should be close to zero and its exchange rate should be close to the real exchange rate?

Law, Opportunity Cost and the Chrysler Deal

In a recent article written by Todd Zywicki titled, “Chrysler and the Rule of Law” the Obama administration is also criticized for its handling of the Chrysler deal. Todd Zywicki is a professor of law at George Mason University and argues that the Obama bailout plan for Chrysler infringes on the rights of priority creditors laid out in the U.S. Constitution. He challenges the constitutionality of the Chrysler plan and explains that, “the close relationship between the rule of law and the enforceability of contracts, especially credit contracts, was well understood by the Framers of the U.S. Constitution. The redistribution of priority credit contracts in Obamas’ plan is evident by secured creditors receiving only 30 cents on the dollar while the United Auto Workers Union-a junior creditor-will recuperates 50 cents on the dollar.

Mr. Zywicki also comments on the long term ratifications of disrupting the order of priority among creditors. The opportunity cost of such a change can arise in the form of increased uncertainty in the market for equity and debt financing for companies which have received government funds, like General Motors. This increased uncertainty might reduce the amount of capital available for distressed industries in the economy. The reduction in available funds might keep companies- which are financial feasible but constrained in capital-from attaining the capital necessary to continue operations and go bankrupt. Zywicki points out that if this were to occur the potential losses in jobs might be greater than the gain from keeping United Auto Workers Union jobs safe.

Unions Prevail Over Wall Street in Chrysler Deal: Article Reviews

In a recent article published in Barron’s, Andrew Bary describes the unequal treatment of creditors in the Obama plan to restructure the troubled auto manufacturer Chrysler. This article describes the new deal that President Obama has presented the secured and unsecured creditors of Chrysler auto manufacturer. The deal is intended to keep Chrysler out of bankruptcy by injecting liquidity into the company via government loan and the reduction of their liabilities. The reduction in Chrysler’s liabilities will come from the elimination of most of their bond-holder obligations.

The unions on the other hand are getting a bond from the government paying a fairly high interest rate and an equity position a large equity position in Chrysler. The order of lien priority with regards to the Chrysler deal is turned on its head. The generous recovery by the UAW-which is an unsecured creditor-of almost their entire claim leaves the banks and the U.S. government with highly uncertain recovery on the tax payer bailout money.

Policy Analysis: Financial Crisis and Public Policy (Article Review)

Policy Analysis: Financial Crisis and Public Policy criticizes the effectiveness the U.S. bailout of financial institutions and the policies which lead to the wealth shock the precipitated the recession. The author, Jagadeesh Gokhale, asserts that the theoretical framework for capital injections are solid-he doubts that the implementation of current strategies will be effective to short-term thawing of the credit markets or long-term growth prospects for the U.S. economy. The major impediments to the government current strategy, according to Gokhale, are that the purchase of private equities by the government does not address the problem of undercapitalized banks directly, but instead increase moral hazard and adverse selection problems. This implies that the bailouts will only hinder the ability of future generations to meet the obligations of current social entitlement programs-Social Security and Medicare- by leaving them with high debt and lower economic growth to maintain these social safety nets. Gokhale asserts that this will only lead to higher tax rates in the future or lower public expenditure outlays for social programs or a combination of both.

Gokhale places the blame on our current crisis on a host of factors including the increase in oil prices and congressional mandates to alter financial market regulations to increase homeownership. The commodity price increases prompted structural adjustment in the economy to reduce energy intensive activity at the cost of major discomfort to consumers and producers, but the easing of regulations spurred financial innovations and interdependence among financial institution participants that created a tittering house of cards for the economy to stand on. The financial sector grew in complexity and size, much of difficulty comes from the large uncertainty faced by financial institutions which the government is trying to mitigate by increasing the pool of risk-bearing investors; the taxpayers. The governments’ purchase of preferred stock instead of the “toxic” assets does not alleviate much of the uncertainty in the credit markets.

In principle the governments efforts to shore up balance sheets should increases confidence and restore credit flows, but in practice government acquisition of equity positions in private firms has resulted in further doubts as to the governments long-term intentions. Gokhale believes that the huge equity positions held by the government in private firms is nothing short of long term management control by the public sector to protect its increasing financial stake in the solvency of the institutions to whom it has provided capital to. This is evident in the restrictions on bonuses on bailout recipients which appease the public, “who unjustly blame market forces rather than prior government policy”, but do little to provide incentives for top executives to manage the vital financial sector in our economy. This implies that the talented managers will opt for other sectors to work for leaving a less competent lot to oversee the worse banking crisis in recent memory.

Gokhale points to the double shocks of commodity price increases and decreases in asset values as the main culprits in the initiation of the crisis, but also comments on the dire long-term outlook based the productivity of the labor force, consumption growth, global trade, and low taxes. According to Gokhale, “The two previous recessions (91’, 01’) occurred under sound economic fundamentals…This time around however; those fundamental forces appear to be considerably weaker”. One of the major impacts on economic health will be the retirement of the baby boomers that make up the most experienced workers in our labor force. Their departure from the labor market signals both an decrease in labor quality and an increase in government outlays in the form of Social Security and Medicare cost which “according to government actuaries, unfunded obligations to Social Security and Medicare amount to more than 40 trillion dollars” over the next 75 years. This demographic shift coupled with the huge government debt and decrease in consumption resulting from declining home and 401k values places the long-term prospects for economic growth in peril as the financial crisis is preceded by the entitlement crisis.

Great Myths of the Great Depression: Literature Review

Great Myths of the Great Depression was written by Lawrence W. Reed who holds a Bachelor of Arts in Economics from Grove City College and a Master of Arts in History from Slippery Rock State University. According to The Mackinac Center for Public Policy, “In the past twenty years, he has authored over 1,000 newspaper columns and articles, 200 radio commentaries, dozens of articles in magazines and journals in the U. S. and abroad, as well as five books.” Mr. Reed has been the President of The Mackinac Center for Public Policy for the last two decades and is a promoter of free market economics. The purpose of Great Myths of the Great Depression is to criticize the policies of Herbert Hoover and Franklin D. Roosevelt’s during the Great Depression in the United States. According to Reed, the notion that Hoover’s laissez faire approach caused economic collapse is misunderstood, since Hoover was not as passive during the early years of the downturn. Likewise the interventions of Roosevelt’s multiple government agencies might have caused a prolonged and deeper depression, despite the fact that many give credit to Roosevelt for dragging the economy out of the worst slump in recent history.

The research question that Reed poses is one that is normative in nature but also had the buttress of positive economics when dealing with the outcomes of policy making during the Great Depression, namely Reed discusses the huge blunders perpetrated by the Federal Reserve Bank of the United States in tandem with United States Congress. Reed addresses the issue in four parts: I. Monetary Policy and the Business Cycle, II. The Disintegration of the World Economy, III. The New Deal, and IV. The Wagner Act.

Reed points to the fact that during the onset of the Great Depression the Federal Reserve contracted the money supply by one third which made the start of a recession much worse. The end of the roaring twenties was coming to a screeching halt in America and the monetary authorities-fearing inflation as a result of decreased economic activity-slow the growth of the money supply. Many believe that the fear of inflation was unfounded, “pointing to relatively flat commodity and consumer prices in the 1920’s as evidence”, prior to the Feds monetary contraction which Reed believes helped spark the onset of the Great Depression.

Congressional judgment on economic matters also seemed to also be lacking in a few areas which made matters worse in the U.S.. The disintegration of international trade as a result of plummeting incomes was amplified by legislation restricting trade, specifically imports into the United States. The Smoot-Hawley Tariff was drafted for the purposed of protecting domestic producers by discouraging imports, but also had the adverse effect of impacting foreign income which resulted in a decrease in foreign imports-U.S. exports; as foreign income dropped so did their demand for U.S. goods and U.S. exports also feel in unison with the reduction of U.S. imports. Foreign countries retaliated with tariffs of their own and the whole world fell into a concerted contraction orchestrated by the U.S. Congress.

Reed argues that the massive government spending and growth as a result of Roosevelt’s New Deal where detrimental to recovery and growth. The Wagner Act which made resistance to organized labor by businesses difficult circumvented legal procedures for arbitration of labor disputes. New courts were appointed to arbitrate labor disputes and frequently the courts sided with employees. According to Reed, these rulings were biased and served as a deterrent to businesses to implement cost saving measures, like reductions in labor resulting in higher prices. Unions helped increase the minimum wage which in turn placed more of the lowest skilled workers on the bread lines decreasing aggregated demand even further. The populist movement supported by Roosevelt was to the detriment of employers and employees’ alike, huge increases in taxes stifled investment in the private sector and lead to detrimental crowding out effects. All of these actions decreased efficiency and productivity growth which is vital to the health of the economy in both the short run and the long run.

Reed’s Great Myths of the Great Depression serves not only as a warning to current policy makers but also a reminder that bounded rationality and political pandering to constituents often leads a country in dire economic situations towards harmful radical reforms. Reed expressed his ideas in a clear and concise manner; the numerous analogies and descriptive narratives serve to establish an emotional connection to the Great Depression which might not be present with contemporaries until this current economic crisis. The authors’ ability to establish causal relationship is lacking in the sense that events are connected and rarely is the explanation of causes explained convincingly. Reed does however bring a large amount of figures on unemployment and financial market movements during the Great Depression which also establish the relevance of his research to our current recession. Future applications of Reed’s research can be applied to the efficient implementation of fiscal and monetary policy during severe crisis in addition to the study of government inefficiency and bureaucratic impediments to self correcting market forces.