Too Big To Liquidate, Destroying Jobs by Regulation, the 26 Million Persons in Job Stress and the Global Debt Crisis

Too Big To Liquidate, Destroying Jobs by Regulation, the 26 Million Persons in Job Stress and the Global Debt Crisis
Carlos M Pelaez

The motivation for financial regulation consists of four major objectives: (1) preventing speculators from taking risky positions in expectation of bailouts with taxpayer funds; (2) creating the tools required in preventing another crisis; (3) holding Wall Street accountable and protecting consumers; and (4) providing transparency and oversight of derivatives to avoid risks that can undermine the economy (http://www.whitehouse.gov/blog/2010/04/16/every-member-congress-going-have-make-a-decision ). The objective of this post is to analyze the adequacy of the Senate proposal for a Financial Stability Act in attaining the four goals that motivate financial regulation. The first section below provides (I) analysis and an example of the role of transaction costs and the following three sections consider the proposed legislation of (II) consumer protection, (III) systemic risk oversight council and (IV) derivatives regulation by appeal to their potential effects on transactions costs, employment and stability. The analysis evaluates the effectiveness in attaining the four goals of the financial overhaul effort. The remainder considers (V) current economic conditions, (VI) interest rates, the fiscal situation and brief (VII) conclusions.
I Transaction Costs. Neoclassical or mainstream economics analyzes an abstract firm managed by entrepreneurs incurring costs of production such as labor, capital and natural resources and occasionally transportation costs. In his 1937 magnum opus that only received the Nobel Prize in 1991 (http://nobelprize.org/nobel_prizes/economics/laureates/1991/coase-autobio.html ) the British economist Ronald H. Coase explored a more complex “coordinator” in corporations making decisions on “transaction costs” that can be defined as all costs other than those incurred in production and transportation (Pelaez and Pelaez, Globalization and the State, Vol. I, 137-43, Government Intervention in Globalization, 81-4). John Wallis and Douglas North estimate that the transaction sector in the US economy is equivalent to about one half of GDP (cited in Pelaez and Pelaez, Government Intervention in Globalization, 82, 191). Higher additional transaction costs that will be created by the proposed financial regulation in Congress increase costs of business, preventing investment, production and job creation.
Trade finance provides an example of transaction costs from actual banking experience (Pelaez and Pelaez, Globalization and the State, Vol. I, 140). In short, trade finance converts a future commitment of a US company to sell manufactured goods at a future date, say in 90 days, to a foreign buyer into bank credit received today by the American company with which to pay for costs of hiring labor and initiating production of goods for future delivery, or in 90 days. Consider a small manufacturing business in the US seeking buyers for its products. There are myriad transaction costs in developing the export business that can create jobs: (1) acquiring knowledge in foreign markets to find buyers and product prices; (2) spending in financial planning in calculating if the price in foreign markets is more attractive than selling in the US; (3) negotiating contracts with foreign buyers among many potential clients; (4) developing or outsourcing staff with language and cultural skills; (5) spending on specialized attorneys in various jurisdictions or through large law firms with foreign relations; (6) negotiating trade finance with a domestic international bank or a corresponding bank of foreign banks to receive immediately the proceeds of future sales required to hire employees, buy inputs and pay all production expenses; (7) supervising compliance of the contract by the foreign client; (8) spending by the bank in evaluating credit perhaps using costly infrastructure of relationship banking that increases the costs to the client; (9) vigilance by the exporter that the foreign buyer will comply with the agreement; and (10) arranging with the bank tailor-made derivatives contracts for delivery of a future foreign exchange rate that prevents changes in prices to the foreign buyer in his/her currency at the time of closing the sale. The Senate Financial Stability Act is job destroying by increasing transaction costs through this chain and similar ones that inhibit business and job creation. The large international bank required by US small and large companies for business abroad will be dismembered arbitrarily and surviving business and jobs will be transferred to foreign jurisdictions with more appropriate regulation. The required derivatives contract will be provided by a bank in a foreign jurisdiction, destroying jobs in domestic banks. Instead of parsimony in government expenditure, trial balloons by insiders propose a national value added tax (VAT) and taxes on energy or stealth taxes that would exacerbate adverse effects of higher transaction costs by taxing almost everything, eroding competitiveness and destroying jobs (http://professional.wsj.com/article/SB30001424052702303720604575170320672253834.html ). The tax is stealth because consumers will see a higher price but no tax breakdown. The poor with higher consumption as percentage of income will pay more dearly for those taxes.
II Consumer Financial Protection Bureau. The need for change here according to the Financial Stability Act is because “the economic crisis was driven by an across-the-board failure to protect consumers” (http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf ). The proposed solution is to politicize consumer credit by creating an agency “led by an independent director appointed by the President and confirmed by the Senate.” The result is likely to be higher interest rates and lower volumes of available credit as caused by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 (http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders) and subsequently by lower growth and employment creation. Investors will not purchase stocks of financial institutions engaged in consumer credit, reducing banks’ equity capital required for lending. Consumers of credit will pay in higher interest rates and lower credit limits for the increased transaction costs to banks that remain in the business of consumer lending resulting from a new costly and politicized consumer protection agency.
III Financial Stability Oversight Council. The need for this new agency according to the Financial Stability Act is “identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across firms.” Alan H. Meltzer reminds that this council will be controlled by Treasury, which has been behind all past bailouts (http://www.house.gov/apps/list/hearing/financialsvcs_dem/meltzer.pdf ). Treasury has a political conflict of interest. The proposal of this council is not operational. If large, complex and “interconnected” financial institutions pose systemic risk, the regulator without theory, measurement and experience will trigger that risk worldwide by attempts to dismember these institutions. The regulatory agency would become a laboratory of detonating systemic risk with the public in the role of the controlled patients exposed to the toxin of the ill-devised experiment. Of course, there are no controlled experiments especially of these dimensions in economics. It would be like “detonate the big banks and run for cover.” How does the council dispose of trillions of dollars of assets without causing a major upheaval in world financial markets and another global recession? Viable institutions may become unviable after dismembering with the government taking over permanently the remainder of the worthless corpus. The $50 billion of the proposed bailout fund or the $150 billion alternative would not have been enough for the hundreds of billions of dollars of the bailouts of Fannie and Freddie but the new bailout activity or “business as usual” of the government could induce growth of larger firms that could become the future Fannie and Freddie (Peter Wallison and David Skeel in http://professional.wsj.com/article/SB20001424052702303493904575167571831270694.html ). There is the danger in the new liquidation authority, with or without bailout fund, that a troubled bank could become state-controlled or the banking equivalent of Fannie and Freddie by replacing “too big to fail” with the more political “too big to liquidate.” Government ownership and control of banks over the world has been disastrous (Pelaez and Pelaez, Regulation of Banks and Finance, 227) and the Swedish bank workout was successful with an agreement by the major political parties of not nationalizing the banks (Financial Regulation after the Global Recession, 170-1).
IV Derivatives. The stringent derivative rules simply increase transaction costs and rapidly export the financial industry to other jurisdictions, resulting in the loss of jobs and business. US banks would not be able to compete with large international banks, which are the ones prevailing in foreign jurisdictions. The large number of smaller banks in the US is a relic of past regulation (Pelaez and Pelaez, Regulation of Banks and Finance, 72-7, 82-99, 203-5, Financial Regulation after the Global Recession, 20-1, 56-61, 63-8). Problems occurred only with derivatives written on cash flows of underlying nonprime mortgages. Starts of privately-owned housing in Mar stood at the seasonally-adjusted rate of 626,000, 1.6 percent above the revised Feb estimate of 616,000 and 20 percent above 521,000 in Mar 2009 (http://www.census.gov/const/newresconst_201003.pdf ) but well below by 71 percent of rates around 2.2 million at the turn of 2005 into 2006 (http://www.census.gov/const/newresconst_200601.pdf ). It is difficult to find physical rates of declines such as these ones in historical data, which illustrate that the housing subsidy by interest rates, housing policy and Fannie and Freddie is the main culprit of the credit/dollar crisis and global recession. A combination of near-zero interest rates, housing subsidy of $221 billion per year and purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie created a flood of nonprime mortgages that eroded the credit quality of segments of financial assets and their derivatives ((Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). There was a credit/dollar crisis, and not a financial crisis, resulting from nonprime credit in mortgages induced by housing and interest rate policy stimuli. Job levels lost in construction and real estate may not be recovered, forcing millions of workers into tough adjustments in different occupations.
V Economy. Net long-term purchases of US securities by foreigners totaled $47.1 billion in Feb with domestic securities purchased by foreigners of $51.4 billion and foreign securities purchased by US residents of $4.2 billion (http://www.ustreas.gov/press/releases/tg642.htm ). Total foreign holdings of Treasuries were $3750 billion of which the two largest were $877 billion or 23 percent by China and $768 billion or 20 percent by Japan for combined concentration of 43 percent in those two countries (http://www.treas.gov/tic/mfh.txt ). Exports of goods and services of $143.3 billion less imports of goods and services of $182.9 billion in Feb resulted in a trade deficit of $39.7 billion, which is higher than $37.0 billion in Jan (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). While the deficit in trade in goods was $51.3 billion, the surplus in services was $11.6 billion. The US is a net exporter of services with high-paid domestic-created jobs in contrast with the critical literature blaming loss of jobs by “offshoring” or contracting services abroad (See Gregory Mankiw and literature cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 192-7, Government Intervention in Globalization, 101). The trade deficit of goods and services jumped by $13.2 billion relative to that of Feb 2009, raising concern that global trade imbalances (Pelaez and Pelaez, The Global Recession Risk, Globalization and the State, Vol. II 180-94, Government Intervention in Globalization, 167-70) may recur in the recovery phase. Imports increased by $31.1 billion or 20.5 percent while exports increased by $17.9 billion or 14.3 percent. The increase in imports of goods from Feb 2009 to Feb 2010 in industrial supplies and material, automotive vehicles, capital goods and others confirms the recovery of the economy. Retail and food services sales increased in Mar by 1.6 percent relative to Feb and by 7.6 percent relative to Mar 2009. Sales in Jan-Mar 2010 increased by 5.5 percent relative to Jan-Mar 2009 (http://www.census.gov/retail/marts/www/marts_current.pdf ). The inventory/sales ratio declined to 1.27 in Jan 2010 much lower than 1.46 in Feb 2009 and close to 1.25 in 2005 well below the 2001 recession level of 1.45 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). The Empire State Manufacturing Survey of the FRBNY increased by 9 points to 31.9 showing rapid pace of improving conditions for New York State manufacturers (http://www.ny.frb.org/survey/empire/Empire2010/empiresurvey_20100415.html ). The index of current activity of the Philadelphia FRB survey increased from 18.9 in Mar to 20.2 in Apr for the third consecutive monthly increase and positive reading in eight consecutive months (http://www.phil.frb.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0410.pdf ). The index of industrial production of the Fed estimates an increase of 0.1 percent in Mar and an annual rate of increase of 7.8 percent in the first quarter of 2010. Capacity utilization in industry increased in Mar to 73.2 percent from 73.0 percent in Feb, which is still significantly below the average capacity utilization of 80.6 percent in 1972-2009 and the 1994-5 high of 84.9 percent (http://www.federalreserve.gov/releases/g17/Current/g17.pdf ). The consumer price index (CPI) increased by 0.1 percent in Mar and by 2.3 percent in the prior 12 months (http://www.bls.gov/news.release/pdf/cpi.pdf ). Initial jobless claims seasonally adjusted were 484,000 in the week ending Apr 10, increasing by 24,000 from the revised 460,000 for the previous week. Seasonally adjusted insured unemployment in the week ending Apr 3 was 4.639 million, increasing by 73,000 from the prior week’s 4.566 million (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). The Easter holiday week may mask numbers that could be lower. The Beige Book of the FRS finds that “overall economic activity increased somewhat since the last report” in all FRS districts except St. Louis (http://www.federalreserve.gov/fomc/beigebook/2010/20100414/default.htm ).
VI Interest Rates. On Apr 17, the yield curve of Treasuries was: 6-months 0.23 percent, 2-years 0.96 percent, 5-years 2.47 percent and 10-years 3.77 percent (http://markets.ft.com/markets/bonds.asp ). The yield curves for governments of Japan and the Euro Area were similarly shaped, horizontal for the short segment near the “zero bound” and sharply increasing in slope for the long segment. The turbulence with sovereign risks combined with the selloff in equities because of fears of China and US financials lowered the yields of Treasuries causing unloading of risk by investors in pursuit of safety. The 10-year yield spreads of Germany relative to Treasuries was -69 basis points (bps) (3.08 less 3.77) and -9 bps for Canada (3.68 less 3.77) (http://markets.ft.com/markets/bonds.asp ). The ask rate for the 10-year interest rate swap was 3.76 percent, 1 basis point less than the 3.77 percent yield of the 10-year Treasury and the ask rate of the 30-year interest rate swap was 4.49 percent or -22 bps less than the 4.67 percent yield of the 30-year Treasury (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=ICAP-160410 ). Yields of Treasuries are probably beginning to reflect the sharply deteriorating fiscal situation of the US. The First Managing Director of the International Monetary Fund (IMF), John Lipsky, revealed the projection that average government debt of advanced countries will increase from 75 percent of GDP at year-end 2007 to 110 percent of GDP at year-end 2014. The IMF expects that with the exception of Canada and Germany all G7 countries including the US will have debt/GDP ratios above 100 percent by 2014 (http://www.imf.org/external/np/speeches/2010/032110.htm ). The Fed holds a portfolio of $1.98 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) that will cause increases in long-term interest rates when it is sold to the public even using appropriate tools in an optimum exit strategy. Issuance of debt to pay for continuing high government deficits and refinancing of maturing debt together with the sale of the Fed’s portfolio will cause upward pressure on long-term interest rates with likely adverse effects on the rate of economic growth and employment. Chairman Bernanke considers a baseline scenario of the Congressional Budget Office under which the debt/GDP ratio would “be greater than 70 percent at the end of fiscal 2012” and probably continue rising. Under alternative assumptions “the deficit at the end of 2020 would be 9 percent of GDP and the federal debt would balloon to more than 100 percent of GDP. Addressing the country’s fiscal problems will require difficult choices, but postponing them will only make them more difficult” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100414a.htm ). Economic recovery and job creation will be restrained by higher taxes and interest rates for everything and everybody.
VII Conclusion. Government is perhaps the most important institution in modern democracies. Balancing government intervention with private decisions is one of the most difficult intellectual endeavors with many approaches or models but no unified theory (Pelaez and Pelaez, Government Intervention in Globalization, 1-11, 75-88, Globalization and the State, Vol. I, 110-56, Regulation of Banks and Finance, 5-29, Financial Regulation after the Global Recession, 4-44). Each case must be considered on net probable benefits relative to costs. The Financial Stability Act will increase transaction costs inhibiting business activity and job creation. There is risk of financial instability in a risk oversight council lacking credible theory, information, forecasts and policy but with excessive powers in arbitrarily dismembering banks. Arbitrary restrictions on banks by new layers of regulatory agencies not only will increase the cost of credit and reduce its volume but will also cause flight of equity capital that could generate another financial crisis by collapse of bank stocks toward zero. Part of the US financial sector and jobs will be exported to other jurisdictions that are wiser in regulation. The first major country implementing financial regulation is precisely the one exporting its financial sector to other jurisdictions. The approach of a world level playing field in banking by the Basel institutions is superior to regulatory wars. The financial overhaul is inopportune in that it may accentuate the deterioration of the credit quality of the debt of the United States government and of banks and other financial institutions. Economic recovery will flatten without hope for the 26 million people locked in prolonged job stress largely because of misguided interest rate and housing policies. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)