Consulting by RPM || Free Advice Blog

“We Have Always Been At War With the Private Mortgage Market”

A headline from CNBC: “Who Would Finance Mortgages Without Fannie, Freddie?”

I know, it’s crazy! I mean, without the government propping up home prices, they would probably fall until people could afford them without government assistance. And except for the US losing to another country in basketball in the Olympics, I really can’t think of anything worse than falling house prices.

In case my sarcasm is too thick for you, that headline annoys me because, until recently, we had a semblance of private financing for mortgages. I could understand someone today asking, “Who would pay for widows and orphans without Social Security?” So the CNBC headline is worse than that, though better than, “Who would make Detroit cars without the federal government?”

Incidentally, you will be pleased to know that CNBC did contact some people familiar with history. Apparently we have already tried the free-market in this country for mortgages, and it didn’t work:

But without the guarantees [from Fannie and Freddie], experts say, there would be no securitization, no capital from the rest of the world for long-term fixed rate mortgages and banks would have to hold on to them.

“We’ve been through another crisis, the S&L (Savings and Loan), where banks indeed held long-term mortgages on their books,” said Susan Wachter, professor of real estate and finance at the University of Pennsylvania’s Wharton School. “That’s a recipe for disaster.”

God and Truth

One of the things I love about Christianity is the identification of Jesus with truth itself. For example, the gospel of John opens like this:

In the beginning was the Word, and the Word was with God, and the Word was God. ²He was with God in the beginning.

³Through him all things were made; without him nothing was made that has been made. ⁴In him was life, and that life was the light of men. ⁵The light shines in the darkness, but the darkness has not understood^[a] it.

In John 14:6 Jesus says, “I am the way and the truth and the life.”

Continuing with the imagery that the word of God is itself a weapon, in Revelation 19 we read:

¹¹I saw heaven standing open and there before me was a white horse, whose rider is called Faithful and True. With justice he judges and makes war. ¹²His eyes are like blazing fire, and on his head are many crowns. He has a name written on him that no one knows but he himself. ¹³He is dressed in a robe dipped in blood, and his name is the Word of God. ¹⁴The armies of heaven were following him, riding on white horses and dressed in fine linen, white and clean. ¹⁵Out of his mouth comes a sharp sword with which to strike down the nations.

And in one of the most gorgeous passages ever penned, Ephesians 6:10-17 instructs us:

¹⁰Finally, be strong in the Lord and in his mighty power. ¹¹Put on the full armor of God so that you can take your stand against the devil’s schemes. ¹²For our struggle is not against flesh and blood, but against the rulers, against the authorities, against the powers of this dark world and against the spiritual forces of evil in the heavenly realms. ¹³Therefore put on the full armor of God, so that when the day of evil comes, you may be able to stand your ground, and after you have done everything, to stand. ¹⁴Stand firm then, with the belt of truth buckled around your waist, with the breastplate of righteousness in place, ¹⁵and with your feet fitted with the readiness that comes from the gospel of peace. ¹⁶In addition to all this, take up the shield of faith, with which you can extinguish all the flaming arrows of the evil one. ¹⁷Take the helmet of salvation and the sword of the Spirit, which is the word of God.

I simply adore this aspect of Christianity. Arrayed against the physical might of Satan and his earthly armies, what does God do?

He writes a book.

And because it contains the truth, the people who believe in this book will eventually be victorious.

More Post-Modern Financial Analysis From Scott Sumner

Why do I keep torturing myself by going back to Scott’s blog? (Actually I have an answer: because I have a paper due tonight, that’s why.)

Here’s Scott on those nutty goldbugs:

I learned an important lesson by reading newspapers from 1933 showing Wall Street’s reactions to FDR’s New Deal policies.  They were sort of OK with his outrageously statist NIRA, which had the government herd companies into cartels in order to raise prices (although interestingly they weren’t too crazy about the later high wage add-on.)  But Wall Street was absolutely apoplectic about the one FDR policy that actually worked–dollar depreciation.  Tinkering with the value of the dollar–which had been fixed to gold for 54 years–was considered an outrage.  But then I noticed something interesting; every time the dollar fell a bit more after some sort of action and/or signal from the Administration, stock prices soared.  Wall Street was like some sort of masochist.  Ow! . . . hmmm, I like that, hit me again.

Later on Scott gives his punchline:

My theory is there are two kinds of economists:

1.  Those who look smarter than they really are, because they rely on the EMH to predict

Paul Krugman

Scott Sumner

etc

2.  Those who look dumber than they really are because they rely on their own models to predict:

Conservatives predicting inflation based on Quantity Theory models or Fiscal Theory models.

etc

I bet you never thought you see a list that had Paul Krugman in the pro-EMH camp.  But just as with Wall Street in 1933, look at what people do, not what they say.

Now of course, my immediate reaction to this was, “Are you kidding me Scott? When people think the dollar is getting devalued, they bid up the most flexible dollar-prices of financial assets…and you think this is a contradiction?”

But forget that. Take a step back and look at what Scott is saying. He thinks he is refuting the people who said going off gold would be a disaster…by surveying the implicit predictions (versus their explicit, spoken predictions) of investors on Wall Street in 1933.

But Scott, we don’t need to use expectations of Wall Street investors in 1933 to see if FDR’s plans worked. We can just look at what actually happened.

And guess what? The US, and the rest of the world, went through the most agonizing and sluggish economic recovery in history. What would have had to happen for FDR’s critics to have been deemed right?

And it’s the same thing in our time. After Bernanke doubled the base in 2008-2009, suppose unemployment dropped to 3 percent while price inflation stayed modest, and all other indicators went back to normal. Surely Scott would have been saying, “I told you Austrians so! Jeez you guys are so 19th century.”

But instead, we’re still stuck in a rut 18 months later, and things look like they are about to fall off a cliff (again). (By the way, just how sticky are those wages? I would have thought 18 months would be enough time to pry them loose.) This is just further evidence for Scott that he has been right.

(Normally I email my posts to Scott, but I am going to stop doing that. What usually happens is that he will answer my email, rather than posting his comment here. For some reason this offends me, as if he is afraid he will get Rothbardian cooties if he posts in the comments.)

Old School Econ Versus Modern Financial Economics

OK kids, I am working on something that touches on the Sraffa-Hayek debate. (You know, the one you spent 3 classes on in grade school, right after the Boston Massacre.) Sraffa said matter-of-factly that in (long-run, steady-state) equilibrium, the spot and forward price is the same for all commodities, and that the “natural” or own-rate of interest on each commodity equals the nominal interest rate.

At first this struck me as wrong, because I vaguely remembered the arbitrage-free relation between spot and forward prices, and they sure as heck weren’t equal. So I went to my trusty research assistant to find:

For an asset that provides no income, the relationship between the current forward (F₀) and spot (S₀) prices is

F₀ = S₀e^rT

where r is the continuously compounded risk free rate of return, and T is the time to maturity. The intuition behind this result is that given you want to own the asset at time T, there should be no difference in a perfect capital market between buying the asset today and holding it and buying the forward contract and taking delivery. Thus, both approaches must cost the same in present value terms.

I’m pretty sure Sraffa is right, and that therefore the above block quotation is a little off. For one thing, how in the world is “buying the asset today and holding it” equivalent to “buying the forward contract and taking delivery”??

Instead, I think the argument should be that the above condition is an upper bound on the forward price, because if it were higher than it would be cheaper for the investor to simply pay the money upfront (i.e. with present dollars) and hold the asset. But in that case, the person gets strictly more out of it; he has the asset at least as long as in the original scenario (i.e. starting at time T), and also in the interim from now until then. So he can sell the asset if he changes his plans before then; he has strictly more options at his disposal, and for a lower price (in present value terms).

Now wait a minute, let’s give the Wikipedia article a chance. After all, Sraffa was a neo-Ricardian; maybe he screwed up here too. After giving the above “intuition” (which made no sense to me) behind the result, the article then tries to prove it like this:

If S_t is the spot price of an asset at time t, and r is the continuously compounded rate, then the forward price at a future time T must satisfy F_t,T = S_te^{r(T − t)}.

To prove this, suppose not. Then we have two possible cases.

Case 1: Suppose that F_t,T > S_te^{r(T − t)}. Then an investor can execute the following trades at time t:

1. go to the bank and get a loan with amount S_t at the continuously compounded rate r…

It’s not important for us to worry about this case. We want to see what Sraffa did wrong. Remember, Sraffa is claiming that in a steady-state equilibrium, the spot and forward prices on commodities are the same, even though the nominal interest rate is positive. So that means we need to see why Case 2 leads to a contradiction, so let’s jump ahead in the Wikipedia article:

Case 2: Suppose that F_t,T < S_te^{r(T − t)}. Then an investor can do the reverse of what he has done above in case 1. But if you look at the convenience yield page, you will see that if there are finite stocks/inventory, the reverse cash and carry arbitrage is not always possible. It would depend on the elasticity of demand for forward contracts and such like.

Ohhhh, so you know that “rule” that we were told about at the beginning of the article? It turns out it only works if there are infinite stocks/inventory.

I just love this kind of thing. I bet you if a modern student of financial economics were reading the Sraffa-Hayek debate for some reason–maybe the poor guy lost a bet or was being hazed during frat initiation or something–he would read Sraffa’s claim that spot and forward prices were equal in equilibrium, and think, “What an idiot. We learned in class that the forward price has to rise with the risk-free interest rate. I’m so glad we are rigorous nowadays.” The guy probably wouldn’t even know that the proof relied on an ability to short an indefinite amount of the commodity.

Disclaimer: I am not betting my life that Sraffa is correct, I’m just saying I starting thinking it through and couldn’t spot any error in his claim. And then when I refreshed my memory by going to Wikipedia, I saw that the proof for the different relation relies on something that obviously isn’t true when talking about physical commodities. So my hunch is that Sraffa is right, especially since he wrote a book on this stuff.

A Tribute to My Favorite Blogger

I decided to be the blog I wanted to see in the world…

.
Want to see a live rendition? Then come on out to Nashville on July 16. (Although I will be singing, there will be no zombie appearance, just to be clear.)

Someone New on My Radar

I’m not sure if he wanted to remain anonymous, but someone emailed me this guy’s keynote address at a conference for bloggers. The only vetting I did was to check Wikipedia to make sure this guy is who the video says he is.

Anyway, I watched the 11-minute collage below. The guy is a former CIA analyst who claims that bloggers are going to win in the battle against central bankers and the military-industrial complex. I was intrigued enough to click on the full hour-long talk, but I quit after about 6 minutes. However, I think he gives a plug to Ron Paul in the first few minutes–I’m not sure because there is stuff on the screen that we can’t see.

Little Bit Awkward…

I was in the grocery store getting the Very Vanilla Silk brand soymilk, to which my 5-year-old is physically and psychologically addicted. The guy stocking the shelves was black (this will be relevant in a second). They were out of the Very Vanilla kind, and my wife had told me that the mere Vanilla was not an acceptable substitute.

I was explaining all this to Clark who then announced, “Hey, I wanna tell that brown man something.”

This was quite possibly one of the most alarming moments of my life. I think I saw the guy flinch, but I may have imagined it. I said, “OK buddy, what do you want to tell the man?” Clark then proceeded to tell him quite earnestly that we had earlier bought the last “purple milk” (the color of the Very Vanilla container).

So, in retrospect, did I make the right call? It’s sort of like when you’re telling a story at lunch, and food flies out of your mouth onto somebody else’s shirt. You know you did it, he knows you did it, you know he knows, etc. But yet you act as if nothing happened.

Cash Is Queen, Gold Is King

Over at my #1 financial blog, Robert Wenzel has a post, “The Story of the Second Quarter: Cash (the Dollar) Is King.”

Wenzel shows how the US stock indices are all way down for the 2nd quarter, and that the US dollar index is up 6.19%. Then he says:

To my gold bug friends, unless Bernanke starts printing extremely aggressively, a severe dip in the gold price may be just ahead. Long term holders shouldn’t panic out of their positions. Short term traders should be on the sidelines. The one variable that could negate the short term dip is buying by central banks. Panic buying by individuals will be finite in nature without central bank money printing. Whipsaw action could be the ultimate outcome.

Don’t get me wrong, I’m not saying that gold will march onwards and upwards with the regularity of an atomic clock, but there are two things Wenzel doesn’t tell his readers:

* In the second quarter of this year, according to my eyeballing of the graphs at Kitco (so I might be a bit off), gold was up 10.8%. So cash is queen.

* When Wenzel says that Bernanke isn’t printing dollars, he has in mind the monetary aggregate M2. (If you look at the actual dollars that Bernanke creates by writing checks on himself, then he most certainly has been creating dollars like crazy, without slowing down, since September 2008.) That’s defensible, but it’s worth pointing out that M2 has been fairly flat (only rising less than 2% since 12 months ago) since March 2009. Yet from March 2009 to now, gold has risen (again just eyeballing it) about 33%.

Don’t get me wrong, if Wenzel is right, and ultimately the gold price is constrained by M2 (regardless of what Bernanke does with M0, or what is called the monetary base), then this last point is all the more reason to suspect gold is in a bubble.

BUT, it also makes you wonder if Wenzel is wrong to narrowly focus on M2, and to keep warning his readers that gold is going to correct any day now (as he has been doing for months).

Last point: Yes, I have thus far been crying wolf about price inflation. I am simply pointing out what seems to be a large possible hole in Wenzel’s analysis.