Monthly Archives: May 2015

“For the history of our race, and each individual’s experience, are sown thick with evidences that a truth is not hard to kill, and that a lie well told is immortal.”, Mark Twain

“The purpose of this blog is to get the facts and truth about the major causes of the 2008 financial crisis out there for all who are interested. Why? Because the liberals who have been in charge of our government since the crisis (and wrote the one-sided Financial Crisis Inquiry Commission Majority Report), the FED, the SEC, and the banking regulators (who were all involved), the plaintiffs’ attorneys who want to sue everyone for losses from the crisis, the short-sellers who made a fortune coordinating their bets and driving markets and individual companies down (and don’t want to be blamed for that), and most of the mainstream media have been telling a lie; that reckless and greedy Wall Street and bankers were the primary cause of the crisis.”, Mike Perry, former Chairman and CEO, IndyMac Bank

Notable & Quotable: Mark Twain

Advice to the youth.

From Mark Twain’s essay “Advice to Youth” (1882):

You want to be very careful about lying; otherwise you are nearly sure to get caught. Once caught, you can never again be, in the eyes of the good and the pure, what you were before. Many a young person has injured himself permanently through a single clumsy and ill-finished lie, the result of carelessness born of incomplete training. . . . Think what tedious years of study, thought, practice, experience, went to the equipment of that peerless old master who was able to impose upon the whole world the lofty and sounding maxim that “Truth is mighty and will prevail”—the most majestic compound-fracture of fact which any of woman born has yet achieved. For the history of our race, and each individual’s experience, are sown thick with evidences that a truth is not hard to kill, and that a lie well told.

“Pre-crisis (likely 2006 or 2007), I recall that I received a private mortgage insurance report (on home prices) like the one below from IndyMac’s chief risk officer. My recollection was that it expressed concerns about housing prices in certain regions of the country. (I always felt the private MI companies would really have a strong handle on the direction of home prices, because they insure Fannie and Freddie mortgage amounts above 80% LTV, all the way up to or near 100% LTV, for various insurance fees.)…

…IndyMac’s Chief Risk Officer said to me, “What do you think we should do?” I said, “Well what are they doing? Are they pulling out of these markets and stopping writing insurance? She said, “no”. I said, “Are they reducing their insurance coverage limits to say a maximum of 90% LTV’s?” She said, “no”. I said, “Are they raising their insurance premiums to compensate for this risk they are saying is there?” She said, “no.”

I said, “These are the experts on high LTV mortgage risk and they will be hurt the most if housing prices decline and they aren’t doing anything to heed their own report?” She said, “no, it doesn’t seem like they are.” I then asked, “Are you aware of anyone else taking some action based on these concerns?”. She said, “no.”

I said, “Well, I don’t know. I don’t see how we can act unilaterally here, with no other evidence than this report, whose author took no action. Please alert me if you hear about any MI or anyone taking steps to address this concern.”

To my recollection, she never did.”, Mike Perry, former Chairman and CEO, IndyMac Bank

Excerpt from a May 2015 Mortgage Industry Newsletter:

Speaking of state-level news, Arch MI has published its spring 2015 edition of the Housing and Mortgage Market Review. Highlights of the article include the latest results from the Arch MI Risk Index, ranking the overall risk of home price declines at 8%. The states with the highest risk of potential home price declines are North Dakota, Oklahoma and Texas largely in part to the high employment rates in the oil industry.  There is also a higher risk of falling home prices in Louisiana, Mississippi, New Mexico and Wyoming. North Dakota is also of concern due to the decline in oil prices which may negatively impact the rapid home price appreciation and population growth the state experienced from the boom in oil extraction the last few years. According to the December Case-Shiller index, home prices increased 4.7% YoY, whereas home prices increased 5.5% according to the FHFA December Purchase-Only Index. The fastest growth in home prices was evident in the West, Florida and Texas and mortgages past 90 days late or in foreclosure fell to 4.7% at the end of 2014. Mortgage originations for purchase loans were $150 billion in Q4 of 2014, which was 13% lower than the previous year and mortgage originations for refinances was $128 billion a 16% decline from a year earlier. Finally, the lowest levels of unemployment are in the farming and energy industries but unemployment levels remain high in the West, South and in Michigan.

“The Federal Housing Finance Agency just released the results of the annual stress tests for Fannie Mae and Freddie Mac. Under the severely adverse economic scenario, the companies would need $157.3 billion in capital…

…Before you jump to the conclusion that this number is too high (or too low), let’s put this in context. Fannie Mae has $3.25 trillion in assets and Freddie Mac has $1.95 trillion in assets. That’s $5.2 trillion combined. As a percentage of the total, the $157.3 billion is 3.0%.”, Excerpt from May 2015 Mortgage Industry Newsletter

“Why, post-crisis, would this undisputed fact be allowed to continue unresolved? It was one thing to do so pre-crisis (and pre- Fannie/Freddie taxpayer bailouts), but how can we allow ALL U.S. taxpayers to continue to assume this level of catastrophic risk on behalf of the housing industry and some homeowners? I am an industry veteran and post-crisis I no longer think this is right. What do you think? ”, Mike Perry, former Chairman and CEO, IndyMac Bank

 

Entire Excerpt from May 2015 Mortgage Industry Newsletter:

“Keeping on with agency chatter…

 

The Federal Housing Finance Agency just released the results of the annual stress tests for Fannie Mae and Freddie Mac. Under the severely adverse economic scenario, the companies would need $157.3 billion in capital. Before you jump to the conclusion that this number is too high (or too low), let’s put this in context. Fannie Mae has $3.25 trillion in assets and Freddie Mac has $1.95 trillion in assets. That’s $5.2 trillion combined. As a percentage of the total, the $157.3 billion is 3.0%. This comes on the heels of another interesting story of a leaked Treasury memo. These two things tie together quite nicely actually. The Treasury memo says that a private Fannie and Freddie would need capitalization of 3% to 4% of assets. So, this recent stress test actually confirms that the ratios found in the memo are correct.”

 

Fannie Mae and Freddie Mac remain in conservatorship despite discussions to make changes, write Mark Calabria, director of financial regulation studies at the Cato Institute, and Alex Pollock, resident fellow at the American Enterprise Institute. Practical steps, including ending all the special privileges the mortgage giants enjoy, need to be taken, and then they could be allowed out of conservatorship to operate in an acceptable manner, according to the authors. The Hill/Congress Blog (4/27)””

“In the past 50 years, valuations of U.S. stock prices have been higher than they are now for less than 10% of the time, and similar figures hold for bonds and houses. This kind of synchronized boom has never happened, not even before the last two major meltdowns. My research team’s composite valuation for the three major financial assets in America – stocks, bonds and houses – is currently well above levels reached during the bubbles of 2000 and 2007…

…Faith in the Fed’s easy-money policies has encouraged a dangerous complacency…. Every major economic shock in recent decades has been preceded by an asset bubble: housing and stocks both before Japan’s meltdown in 1990 and before the Asian financial crisis in 1998; stocks before the U.S. dot-com bust in 2000; housing again before the crisis in 2008. Strikingly, even as asset prices were climbing before the busts of 2000 and 2008, the Fed kept monetary policy loose because consumer prices were rising only moderately. That is the same excuse we hear now, amid a price boom in stocks, houses and bonds….. The Fed now leads a culture of central bankers who see their job as reducing unemployment and stabilizing prices for consumer goods only, come what may in the markets. This needs to change. In a world in which high trade and money flows tend to restrain consumer prices but magnify asset prices, central banks need to take responsibility for both. After all, asset price inflation is as dangerous as consumer price inflation.”, Ruchir Sharma, “The Federal Reserve Asset Bubble Machine,” The Wall Street Journal, May 12, 2015

Opinion

The Federal Reserve Asset Bubble Machine

Easy money is driving up the price of stocks, bonds, houses and other assets in a era without historical precedent.

Photo: Getty Images/iStockphoto

By Ruchir Sharma

Janet Yellen’s comment last week at the International Monetary Fund headquarters in Washington, D.C., that stock prices are “quite high” hardly captures the frothiness in U.S. financial markets. The Federal Reserve chair’s admission also stopped short of acknowledging the role of free money in inflating the price of stocks—as well as the price of bonds, houses and every other financial asset.

At Morgan Stanley Investment Management, we have analyzed data going back two centuries and found that until the past decade no major central bank had ever before set short-term interest rates at zero, even in periods of deflation.

To critics who warn that pumping trillions of dollars into the economy in a short period is bound to drive up inflation, today’s central bankers point to stagnant consumer prices and say, “Look, Ma, no inflation.” But this ignores the fact that when money is nominally free, strange things happen, and today record-low rates are fueling an unprecedented bout of inflation across asset prices.

The Fed’s defenders quibble that houses are less pricey than in the bubble of 2007, or that stocks are less pricey than in 2000, which misses the difference this time around. In the past 50 years, valuations of U.S. stock prices have been higher than they are now for less than 10% of the time, and similar figures hold for bonds and houses. This kind of synchronized boom has never happened, not even before the last two major meltdowns. My research team’s composite valuation for the three major financial assets in America—stocks, bonds and houses—is currently well above levels reached during the bubbles of 2000 and 2007.

Faith in the Fed’s easy-money policies has encouraged a dangerous complacency. The mantra on Wall Street is that good economic news is good news for the markets, but that bad news is also good news, because it will encourage the Fed to keep rates lower for longer. This has led to one of the longest rallies the U.S. stock market has ever experienced, without even a 10% correction. Returns since 2012 are the highest for any three-year period in recorded history, after adjusting for the risk of holding stocks.

The Fed’s approach has spread to central banks in Europe, Japan and China, creating a new world in which investment decisions are guided by the availability of easy money, not opportunity. Over the past three years, global stock prices have risen rapidly despite tepid economic growth. Oh well, the central bank responds: We target consumer prices, not assets.

This job description is outdated, because the task is largely done. In emerging nations, the average annual growth of consumer prices now hovers around 5%, down from a peak of 116% in 1994. Add in the rich countries, which are generally more stable, and global inflation has fallen to 2% today from near 20% in the early 1970s.

Central bankers are still fighting to control consumer prices, only now for the opposite reason. Rather than raising interest rates to contain consumer spending and inflation, they hold rates down to encourage spending and induce inflation, because the global inflation rate of 2% is dangerously low in their view. The fear is that slowly rising prices will tip into falling prices. The boogeyman is not hyperinflationary Germany of the 1930s, but deflationary Japan of the 1990s, when the country fell into a downward spiral of falling prices, weak demand and stagnant growth.

Japan taught the world two lessons: that consumer price deflation is bad for growth and that it is hard to shake. Both are inaccurate. Before World War I, many nations experienced deflation, sometimes driven by weak demand and leading to weak growth, but as often driven by rising productivity and accompanied by strong growth.

A recent Bank for International Settlements study on the postwar period found that long bouts of deflation were exceedingly rare, but short bouts were common. More important, average annual GDP growth was roughly the same regardless of whether prices were rising or falling. The upshot: Consumer price deflation is not necessarily bad for growth.

One problem is that the world changed faster than the Fed. Trade has jumped to 60% of global GDP from 40% in 1980, and increasing competition puts downward pressure on consumer prices. The forces of expanding supply from China to Mexico are pushing the global average inflation rate down to a level that looks scary low only when compared with the 1970s highs. In fact, consumer price inflation is still above the long-term average, dating to the year 1200, which is 1%.

But global competition wields the opposite effect on asset prices. The opening of financial markets means that many more buyers are bidding up prices for stocks in New York, or real estate in Miami or bonds in Chicago. The result is that central banks are unleashing easy money to fight an imaginary villain, consumer price deflation, at the risk of feeding a real monster, asset price inflation.

Every major economic shock in recent decades has been preceded by an asset bubble: housing and stocks both before Japan’s meltdown in 1990 and before the Asian financial crisis in 1998; stocks before the U.S. dot-com bust in 2000; housing again before the crisis in 2008. Strikingly, even as asset prices were climbing before the busts of 2000 and 2008, the Fed kept monetary policy loose because consumer prices were rising only moderately. That is the same excuse we hear now, amid a price boom in stocks, houses and bonds.

It is true that bubbles are most dangerous when people are borrowing heavily, and are buried by debt when the bubble collapses. Because U.S. households have been cutting debt, Ms. Yellen says the situation is not unduly risky. But U.S. corporations are borrowing heavily, and not all bubbles are fed by rising debt.

The Fed now leads a culture of central bankers who see their job as reducing unemployment and stabilizing prices for consumer goods only, come what may in the markets. This needs to change. In a world in which high trade and money flows tend to restrain consumer prices but magnify asset prices, central banks need to take responsibility for both. After all, asset price inflation is as dangerous as consumer price inflation.

Mr. Sharma is the head of emerging markets and global macro at Morgan Stanley Investment Management and the author of “Breakout Nations: In Pursuit of the Next Economic Miracles” (Norton, 2012).

“I agree with the NY Times Editorial Board…I have always thought the cost of title insurance was outrageously high, relative to the risk. The reason is simple. There isn’t enough free market competition. Consumer Financial Protection Bureau where are you on this simple, but costly (to American homeowners) issue?”, Mike Perry, former Chairman and CEO, IndyMac Bank

The Opinion Pages

The Title Insurance Scam

By THE EDITORIAL BOARD

Credit Nick Ut/Associated Press

When you buy or refinance a home, you have to get title insurance, which protects both you and the lender if ownership of the property is ever challenged. Shopping around for title insurance is rare; if you are like most people, you buy the insurance from a title agent referred to you by the loan officer or someone else involved in the transaction. All of which makes buyers of title insurance sitting ducks for abuse. Congress is aware of the situation — and is determined to keep things just as they are.

It is no secret, for instance, that many borrowers are overcharged for title insurance. In 2007, the Government Accountability Office warned that the price of title policies was inflated by lack of competition in the title-insurance market, as well as apparently illegal kickbacks paid by title agents to realtors, mortgage brokers, loan officers and others who sent business their way.

The 2010 Dodd-Frank law called for cleaning up title insurance, and, in 2014, regulators from the Consumer Financial Protection Bureau issued a rule to carry out the law. Basically, the rule created a safe harbor from liability for regulatory violations, but only for loans with closing costs of less than 3 percent of the total loan, including fees to title companies affiliated with lenders. In effect, the rule uses market incentives to limit title costs by offering lighter regulation in exchange for keeping costs down.

Congress is resisting. A bipartisan majority in the House recently passed a Republican bill to exclude title fees from the calculation that determines the level of regulatory scrutiny. The White House has threatened a veto. But, in the Senate, Republicans could add the bill to other legislation that Democrats may want.

The bill ignores evidence of kickbacks unearthed by the consumer bureau and by New York’s Department of Financial Services. The public corruption case against Dean Skelos, who stepped down Monday as majority leader of the New York State Senate, and his son Adam, involves title insurance. The elder Mr. Skelos is alleged to have pressed a real estate executive to send title-related business to his son, who had worked in insurance. The executive had a title company pay the son a “commission” of $20,000 for no work — which is another way of inflating the price paid by consumers for title insurance.

A version of this editorial appears in print on May 12, 2015, on page A22 of the New York edition with the headline: The Title Insurance Scam .

“In some of his most definitive statements about the postcrisis landscape and the legacy of banks being “too big to fail,” (FDIC Chief) Gruenberg said in an interview that if a major financial firm ran into trouble today “they would be allowed to fail and suffer the consequences of that failure. That was not an option available to us in 2008,” he added.”, The Wall Street Journal, May 12, 2015

FDIC Chief Martin Gruenberg: Big Bank Failure Won’t Imperil System

If major financial firm runs into trouble, it will be allowed to fail

Martin Gruenberg, chairman of the Federal Deposit Insurance Corp. Photo: Drew Angerer/Getty Images

By Victoria McGrane

WASHINGTON—Nearly seven years after the financial crisis, Federal Deposit Insurance Corp. Chairman Martin Gruenberg said U.S. regulators can safely guide a major financial firm to failure without taxpayer bailouts or catastrophic consequences for the financial system.

Mr. Gruenberg, in a speech on Tuesday, plans to say the disruptive collapse of a firm like Lehman Brothers Holdings Inc. is less likely to happen again given regulators’ ability to force structural changes on banks, new powers to seize and dismantle failing firms and global regulatory coordination.

In some of his most definitive statements about the postcrisis landscape and the legacy of banks being “too big to fail,” Mr. Gruenberg said in an interview that if a major financial firm ran into trouble today “they would be allowed to fail and suffer the consequences of that failure.”

“That was not an option available to us in 2008,” he added. “I think it is an option available to us today.”

Whether Mr. Gruenberg is correct remains a major debate among lawmakers, policy makers and big banks. The FDIC and Federal Reserve in August told Wall Street banks they aren’t doing enough to ensure they can fail without damaging the economy and threatened to slap them with regulatory penalties if they don’t show significant progress in the next year.

Lawmakers like Sen. Elizabeth Warren (D., Mass.) say more needs to be done to push the banks to simplify and reduce risk—including, possibly, their forced breakup. Some Republicans say the postcrisis regime only makes bailouts more likely. Others doubt regulators could handle the failure of multiple major firms at the same time.

Standard & Poor’s Ratings Services’ credit ratings of the biggest banks still assume the government would rescue a major financial firm, though the firm acknowledges the likelihood of government support is fading as regulators continue to build out the new resolution regime.

“What changes have [the big banks] made that make them more transparent, simpler, smaller, easier to fail? I honestly can’t think of anything,” said Simon Johnson, former chief economist at the International Monetary Fund and a professor at the Massachusetts Institute of Technology’s Sloan School of Management.

Without more significant changes, “it’s inconceivable” that a giant financial firm could successfully go through bankruptcy, which is the preferred path under the Dodd-Frank financial- overhaul law, Mr. Johnson said.

The big Wall Street banks have sold off assets and business lines and in some cases reduced some of their thousands of legal entities. They contend they are responding in good faith to regulators’ requests but in many cases are waiting for rules to be written, such as with a planned requirement that the parent companies hold a set amount of long-term debt. Eighteen global banks signed a voluntary deal last fall agreeing to wait up to 48 hours before seeking to terminate derivatives contracts if a counterparty bank starts to fail, a change sought by regulators.

Mr. Gruenberg isn’t declaring too big to fail over and said until Washington actually has to reckon with a big bank failure, “I’d be a little cautious about making any heroic claims.”

But the next time a large, global firm runs into trouble, he said it is realistic to believe the firm would be able to go through bankruptcy or a government-run resolution in which shareholders would be wiped out, creditors suffer losses and culpable management would be fired—all without bailouts or damage to the economy.

“I think they’re well on their way” to being able to handle a major financial failure, said former Fed Chairman Paul Volcker, who is part of an advisory committee to the FDIC on resolution issues. He said he has been particularly impressed with what the FDIC has achieved internationally. “I’m amazed they’ve been able to do the amount of coordination that they have in fact done. That makes it all the more practical,” he said.

Regulators, following a mandate in the 2010 Dodd-Frank law, have moved to develop a strategy for carrying out the new powers they gained to seize and dismantle a big financial firm if bankruptcy would hurt the financial system. Mr. Gruenberg said this ensures regulators won’t face the same impossible choice as in 2008: bail out a firm or let it collapse in a destabilizing way. The FDIC also has worked with foreign regulators—particularly in the U.K. and Europe—on how they would collaborate during the collapse of a global financial firm, he said.

Banks are also on notice to make big changes or face consequences such as being forcibly dismantled. Last August, regulators sent letters to 11 of the largest banks telling them they need to do more to make it easier to be dismantled in bankruptcy. The step taken by the Fed and FDIC, which included pointed instructions that the banks must simplify their tangled legal structures and make other operational changes, is evidence of a major development since the 2008 crisis, enabling regulators to force the banks to make “real time changes…to enhance their resolvability,” he said.

Mr. Gruenberg said the letters make it clear that if banks don’t show progress, regulators will find the plans not credible, a step that triggers penalties such as stricter capital and leverage rules and, eventually, can lead to a forced breakup if a bank fails to produce a satisfactory plan.

“It’s my perception that the firms are taking this process very seriously,” he said of the living-will process, “but it still remains to be seen the quality of the submissions that we receive on July 1. We’ll evaluate them when we get them.”

“Hand waving is required because there is nothing in the workings of markets that turns otherwise normal human beings into “Econs” (Highly intelligent beings that are capable of making the most complex of calculations but are totally lacking in emotions.). For example, if you choose the wrong career, select the wrong mortgage or fail to save for retirement, markets do not correct those failings…

…In fact, quite the opposite often happens. It is much easier to make money by catering to consumers’ biases than by trying to correct them.”, Richard H. Thaler, “Unless You Are Spock, Irrelevant Things Matter in Economic Behavior”, The New York Times

“Pre 2008 financial crisis, my entire career was focused on the easy path of catering to consumers’ (investors, and well-intended governments’) biases. My prospective home buyer application is going to try to correct them. I am even toying with the idea of calling the application “Don’t BUY and Borrow” or something like that, as the seller/home builder, Realtor, mortgage lender, and home appraiser all don’t get paid unless you BUY and Borrow!!!!”, Mike Perry, former Chairman and CEO, IndyMac Bank

Unless You Are Spock, Irrelevant Things Matter in Economic Behavior

By RICHARD H. THALER

Early in my teaching career I managed to get most of the students in my class mad at me. A midterm exam caused the problem.

I wanted the exam to sort out the stars, the average Joes and the duds, so it had to be hard and have a wide dispersion of scores. I succeeded in writing such an exam, but when the students got their results they were in an uproar. Their principal complaint was that the average score was only 72 points out of 100.

What was odd about this reaction was that I had already explained that the average numerical score on the exam had absolutely no effect on the distribution of letter grades. We employed a curve in which the average grade was a B+, and only a tiny number of students received grades below a C. I told the class this, but it had no effect on the students’ mood. They still hated my exam, and they were none too happy with me either. As a young professor worried about keeping my job, I wasn’t sure what to do.

Finally, an idea occurred to me. On the next exam, I raised the points available for a perfect score to 137. This exam turned out to be harder than the first. Students got only 70 percent of the answers right but the average numerical score was 96 points. The students were delighted!

Credit Emily Cross

I chose 137 as a maximum score for two reasons. First, it produced an average well into the 90s, and some students scored above 100, generating a reaction approaching ecstasy. Second, because dividing by 137 is not easy to do in your head, I figured that most students wouldn’t convert their scores into percentages.

Striving for full disclosure, in subsequent years I included this statement in my course syllabus: “Exams will have a total of 137 points rather than the usual 100. This scoring system has no effect on the grade you get in the course, but it seems to make you happier.” And, indeed, after I made that change, I never got a complaint that my exams were too hard.

In the eyes of an economist, my students were “misbehaving.” By that I mean that their behavior was inconsistent with the idealized model at the heart of much of economics. Rationally, no one should be happier about a score of 96 out of 137 (70 percent) than 72 out of 100, but my students were. And by realizing this, I was able to set the kind of exam I wanted but still keep the students from grumbling.

This illustrates an important problem with traditional economic theory. Economists discount any factors that would not influence the thinking of a rational person. These things are supposedly irrelevant. But unfortunately for the theory, many supposedly irrelevant factors do matter.

Economists create this problem with their insistence on studying mythical creatures often known as Homo economicus. I prefer to call them “Econs”— highly intelligent beings that are capable of making the most complex of calculations but are totally lacking in emotions. Think of Mr. Spock in “Star Trek.” In a world of Econs, many things would in fact be irrelevant.

No Econ would buy a larger portion of whatever will be served for dinner on Tuesday because he happens to be hungry when shopping on Sunday. Your hunger on Sunday should be irrelevant in choosing the size of your meal for Tuesday. An Econ would not finish that huge meal on Tuesday, even though he is no longer hungry, just because he had paid for it. To an Econ, the price paid for an item in the past is not relevant in making the decision about how much of it to eat now.

An Econ would not expect a gift on the day of the year in which she happened to get married, or be born. What difference do these arbitrary dates make? In fact, Econs would be perplexed by the idea of gifts. An Econ would know that cash is the best possible gift; it allows the recipient to buy whatever is optimal. But unless you are married to an economist, I don’t advise giving cash on your next anniversary. Come to think of it, even if your spouse is an economist, this is not a great idea.

Of course, most economists know that the people with whom they interact do not resemble Econs. In fact, in private moments, economists are often happy to admit that most of the people they know are clueless about economic matters. But for decades, this realization did not affect the way most economists did their work. They had a justification: markets. To defenders of economics orthodoxy, markets are thought to have magic powers.

There is a version of this magic market argument that I call the invisible hand wave. It goes something like this. “Yes, it is true that my spouse and my students and members of Congress don’t understand anything about economics, but when they have to interact with markets. …” It is at this point that the hand waving comes in. Words and phrases such as high stakes, learning and arbitrage are thrown around to suggest some of the ways that markets can do their magic, but it is my claim that no one has ever finished making the argument with both hands remaining still.

Hand waving is required because there is nothing in the workings of markets that turns otherwise normal human beings into Econs. For example, if you choose the wrong career, select the wrong mortgage or fail to save for retirement, markets do not correct those failings. In fact, quite the opposite often happens. It is much easier to make money by catering to consumers’ biases than by trying to correct them.

Perhaps because of undue acceptance of invisible-hand-wave arguments, economists have been ignoring supposedly irrelevant factors, comforted by the knowledge that in markets these factors just wouldn’t matter. Alas, both the field of economics and society are much worse for it. Supposedly irrelevant factors, or SIFs, matter a lot, and if we economists recognize their importance, we can do our jobs better. Behavioral economics is, to a large extent, standard economics that has been modified to incorporate SIFs.

SIFs matter in more important domains than keeping students happy with test scores. Consider defined-contribution retirement plans like 401(k)’s. Econs would have no trouble figuring out how much to save for retirement and how to invest the money, but mere humans can find it quite tough. So knowledgeable employers have incorporated three SIFs in their plan design: they automatically enroll employees (who can opt out), they automatically increase the saving rate every year, and they offer a sensible default investment choice like a target date fund. These features significantly improve the outcomes of plan participants, but to economists they are SIFs because Econs would just figure out the right thing to do without them.

These retirement plans also have a supposedly relevant factor: Contributions and capital appreciation are tax-sheltered until retirement. This tax break was created to induce people to save more. But guess what: A recent study using Danish data has compared the relative effectiveness of the SIFs and a similar tax subsidy offered in Denmark. The authors attribute only 1 percent of the saving done in the Danish plans to the tax breaks. The other 99 percent comes from the automatic features.

They conclude: “In sum, the findings of our study call into question whether tax subsidies are the most effective policy to increase retirement savings. Automatic enrollment or default policies that nudge individuals to save more could have larger impacts on national saving at lower social cost.” Irrelevant indeed!

Notice that the irrelevant design features that do all the work are essentially free, whereas a tax break is quite expensive. The Joint Economic Committee estimates that the United States tax break will cost the government $62 billion in 2015, a number that is predicted to grow rapidly. Furthermore, most of these tax benefits accrue to affluent taxpayers.

Here is another example. In the early years of the Obama administration, Congress passed a law giving taxpayers a temporary tax cut and the administration had to decide how to carry it out. Should taxpayers be given a lump sum check, or should the extra money be spread out over the year via regular paychecks?

In a world of Econs this choice would be irrelevant. A $1,200 lump sum would have the same effect on consumption as monthly paychecks that are $100 larger. But while most middle-class taxpayers spend almost their entire paycheck every month, if given a lump sum they are more likely to save some of it or pay off debts. Since the tax cut was intended to stimulate spending, I believe the administration made a wise choice in choosing to spread it out.

The field of behavioral economics has been around for more than three decades, but the application of its findings to societal problems has only recently been catching on. Fortunately, economists open to new ways of thinking are finding novel ways to use supposedly irrelevant factors to make the world a better place.

RICHARD H. THALER is a professor of economics and behavioral science at the Booth School of Business at the University of Chicago. He is the author of “Misbehaving: The Making of Behavioral Economics,” from which this article is adapted, and which will be published this month by W.W. Norton.

A version of this article appears in print on May 10, 2015, on page BU1 of the New York edition with the headline: The Importance of Irrelevance .

 

“Around the world, it’s the era of easy money, hard regulation and slow growth. Central banks have made dollars, euros and yen plentiful, but central governments have restrained businesses from putting that money to its most efficient use. Why take a chance trying to create a new product – and persuading the world’s bureaucracies to tolerate it – when you can buy an existing one?”, The Wall Street Journal Editorial Board, May 8, 2015

Opinion

The Deal-Maker’s Economy

Abundant money goes to financial engineering, rather than investment.

Photo: Getty Images

The U.S. economy reported a 1.9% drop in productivity in the first quarter of the year, underscoring the trend of historically slow productivity growth in the current recovery. The slowdown isn’t entirely understood, but one certain cause is slower than usual business investment. Money that could go to wealth-creating innovations is going instead to financial deal-making.

Companies have announced more than $1.3 trillion of mergers and acquisitions world-wide so far this year, a surge of 23% from the same period last year and the most since the financial crisis. It’s not irrational exuberance that’s driving many of today’s deals—just the opposite. With fewer opportunities for growth but plenty of credit available to fund deals, mergers are often the most sensible way for a company to expand.

***

Around the world, it’s the era of easy money, hard regulation and slow growth. Central banks have made dollars, euros and yen plentiful, but central governments have restrained businesses from putting that money to its most efficient use. Why take a chance trying to create a new product—and persuading the world’s bureaucracies to tolerate it—when you can buy an existing one?

In the U.S., the combination of loose monetary policy and restrictive government has created one of the great ironies of the Obama era. The labor-force participation rate of 62.7% persists at a 1978 level, and Americans who have jobs see little wage growth. But it’s a boom time for the Wall Streeters Mr. Obama vilifies, especially the attorneys and financiers who arrange corporate mergers.

Small companies are also struggling to find new customers and markets. A recent survey from the National Federation of Independent Business shows that the availability of credit is not the problem; business owners aren’t borrowing because they don’t know what to do with the money. Merely 5% of business owners reported that all their credit needs weren’t met. NFIB says that interest “rates are low, but prospects for putting borrowed money profitably to work have not improved enough to induce owners to step up their borrowing and spending.”

It is the story of this era. The Kauffman Foundation, which tracks new businesses, says its data show 2013 was “the second consecutive year to show an entrepreneurial activity decline in the United States.” Being an entrepreneur always takes guts. It takes special courage during an Administration that has twice set the annual record by issuing more than 81,000 pages of regulations.

But you wouldn’t know the challenges of the overall economy by observing the financial economy. The boom in corporate mergers has investment banks reporting surging advisory revenue. Dealogic reports that, world-wide, markets posted the best first quarter ever for equity capital deals, with initial public offerings, secondary stock sales and convertible bond offerings up 27% from the same period last year. Corporate debt issuance remains robust.

What are companies doing with all the money they raise? Not necessarily funding future prosperity. A recent note from Strategas Research Partners points out that much of the money flowing into companies in recent years was directed to “financial, rather than economic, risk-taking.” Strategas says that as of the end of last year the dollar volume of stock buybacks had soared 287% since the post-crisis low and the value of mergers and acquisitions was up 179%.

Senator Elizabeth Warren and others on the left want to blame all this on the companies. But what she doesn’t understand is that this is a perfectly rational market response to the sheer weight of the Obama regulatory apparatus that punishes innovation and risk-taking. The progressive urge is to command businesses to make more investments, but if there’s an opportunity, no one needs to be commanded to exploit it. Washington simply needs to allow it.

Capital expenditures support business expansion. In the U.S. they shrank in the first quarter by 3.4%, according to the Commerce Department’s measure of nonresidential private fixed investment. Such investment is needed not only to create new productive capacity, but to replace assets that are worn-out and obsolete. A separate Commerce measure, tracking net investment—meaning new investment minus the capital assets that are consumed—shows that even in an era of easy money, American businesses aren’t eager to spend on expansion.

Commerce has data through 2013 for this statistic. And in constant dollars, over the first five years of the Obama Administration net private nonresidential fixed investment was the lowest since the mid-1990s when the economy was much smaller. Even near-zero interest rates haven’t been able to offset ObamaCare, Dodd-Frank, new EPA emissions rules, the highest corporate tax rate in the developed world, and myriad other threats from Washington.

This White House has offered an abundance of taxpayer-funded stimulus plans. But the only true and lasting economic stimulus is one that gives people a reason to invest their own money. That will require a sharp reduction in the regulatory and tax burden that continues to inhibit business activity. Workers far from Wall Street desperately need relief.

“The (Baltimore) neighborhood was also designated a “homeownership zone” by the feds, who spent $30 million to saddle people with arguably the last thing they needed, a mortgage that tied them down to a community without jobs and decent schools…

…A study by the Abell Foundation about these disappointing results has been widely cited in the past few days, but unmentioned is the apologetic note on which it ends: “While mobility programs and community development are sometimes seen as at odds with each other . . . [m]obility programs allow poor families to leave violent neighborhoods in the short run, instead of being trapped in the low-performing schools and poor quality housing that exist while their communities await larger redevelopment investments.” That’s right, an alternative to shoveling money in has been getting people out.”, Holman W. Jenkins, Jr., “Baltimore and What We Know About Bad Neighborhoods”, The Wall Street Journal

Baltimore and What We Know About Bad Neighborhoods

Even the poverty experts thought the solution for Freddie Gray’s neighborhood was for the people to leave.

A man leads a horse-drawn cart, from which he sells produce, along Mosher Street in the Sandtown-Winchester neighborhood of Baltimore, Md., in April.

A man leads a horse-drawn cart, from which he sells produce, along Mosher Street in the Sandtown-Winchester neighborhood of Baltimore, Md., in April. Photo: The Washington Post/Getty Images

By Holman W. Jenkins, Jr.

The brain works furiously to convince itself that ideas that bring personal comfort are great truths. Thus a noted advocate of reparations visits Baltimore after the riots to renew his call that black Americans be compensated for slavery and Jim Crow. A Baltimore professor writes in the New York Times that poverty persists in certain black neighborhoods because of the “continued profitability of racism . . . to landlords, corner store merchants and other vendors selling second-rate goods.”

A Seattle professor recites her research on discriminatory housing practices from six decades ago to explain riots that happened six days ago.

Yesterdays beget todays, beget tomorrows, so every condition in life can be traced through an ever-receding series of historical causes. The artificiality of such meditations, though, is obvious when you consider that the average male resident of Sandtown-Winchester—home of Freddie Gray whose death in police custody set off the riots—is 28 and wasn’t alive when most of this history was made.

Even in the stagnant neighborhood that Sandtown-Winchester is universally agreed to be, residential housing turnover is 16% a year; the median resident has been in place fewer than four years. Nearly 15% are arrivals from out of state or out of country, and many more (though uncounted) are undoubtedly arrivals from elsewhere in Baltimore and Maryland.

Neighborhoods like Sandtown-Winchester aren’t just places people find it hard to get out of. They are places where people from elsewhere end up when they can’t make a go of their lives.

They are places that people fall into when they don’t have incomes, credit and prospects and suffer from personal or behavioral problems.

There are white versions of Sandtown-Winchester. The literature on “rural ghettos” has grown impressively since the term was coined in the early 1990s.

As many riot-aftermath reports in the past week have noted, Sandtown-Winchester was the subject of enlightened urban renewal in the 1990s when Mayor Kurt Schmoke, Jimmy Carter’s Habitat for Humanity, and developer James Rouse poured $130 million into a community of 11,000 residents to fix homes and schools.

The neighborhood was also designated a “homeownership zone” by the feds, who spent $30 million to saddle people with arguably the last thing they needed, a mortgage that tied them down to a community without jobs and decent schools.

A study by the Abell Foundation about these disappointing results has been widely cited in the past few days, but unmentioned is the apologetic note on which it ends: “While mobility programs and community development are sometimes seen as at odds with each other . . . [m]obility programs allow poor families to leave violent neighborhoods in the short run, instead of being trapped in the low-performing schools and poor quality housing that exist while their communities await larger redevelopment investments.”

That’s right, an alternative to shoveling money in has been getting people out. Gautreaux was a public housing lawsuit in Chicago in the 1970s that randomly transplanted single mothers to suburban apartments: Half who had never worked before soon had jobs, and 52% of their kids went to college.

It’s sometimes unpopular to point out that people who behave responsibly and are willing to work generally do not end up chronically poor in America. People who live in neighborhoods where these norms are not respected or even realistically practicable, however, do experience chronic poverty. Using census data to identify those with a high proportion of teenage mothers, high-school dropouts, welfare dependents and jobless men, the Urban Institute discovered a disturbing change: Between 1970 and 1980, the number of such neighborhoods tripled to 880. Their combined population rose from 750,000 to 2.5 million.

Culprits were fingered: the loss of low-skilled manufacturing jobs, the availability of welfare. But neighborhoods themselves are clearly transmitters of poverty. The problem for residents isn’t racism: it’s where they live.

Government programs can’t save everybody in such sad places where people without money, prospects or good life habits tend to congregate. But it can help the willing to get out, by using housing vouchers, say, to transplant individuals to neighborhoods with intact families, intact schools and intact employment opportunities.

Placed-based urban renewal blames outside forces for denying resources to poor communities. It tends to ratify the persistence of concentrated victim communities whose troubles can be gratifyingly attributed to racism. This approach undoubtedly serves a lot of needs. It just doesn’t serve the needs of residents.

“As finance becomes more innovative, money becomes less substantial. It would be nice if a few of Mr. Palmer’s intellectual pioneers could spare some time to improve the quality of the currency – and, while they’re at it, to beat back the depredations of the regulatory state…

…As for the relationship between a bank and the state, it’s been downhill for more than a century. Under the long-ago doctrine of double liability, the stockholders of a nationally chartered bank got a capital call—a dunning notice—if the institution in which they held a fractional interest became impaired or insolvent. It seemed only fair that the owners of a bank should be held responsible for its safety and soundness. Double liability went out the window in the 1930s at about the time that federal deposit insurance came in. The passing decades have moved us ever further away from the ideal of individual responsibility in finance and ever closer to the dubious netherworld of collective responsibility….. Mr. Palmer finds nothing to fear in financial derivatives, though he seems to overlook the most problematical kind of all. You’ll recall that a derivative is a financial instrument that owes its value to some underlying asset—interest rates, say, or the level of the S&P 500 index. The dollar bill is a ubiquitous derivative—actually, a former one. It derived its value from the gold or silver into which it was freely convertible. All that ended during the Nixon administration. In 1971, the Treasury stopped exchanging dollars for gold at the fixed rate of $35 to the ounce (one might call it a default). At that moment, the Federal Reserve “note”—an obligation to pay—became, in the words of the economist John Exter, an “IOU nothing.”…..The dollar’s transformation into pure paper scrip has given the world’s central bankers enormous discretion. They have availed themselves of that power to redefine “price stability” to mean inflation—2% a year would suit, they judge. They have materialized $10 trillion since the financial crisis just as easily as you might send an email. They have caused bank-deposit rates to fall to zero even as they’ve talked up the stock market. The financial inventions that Mr. Palmer extols ultimately owe their utility to free markets. Manipulate those markets and the value of the inventions, whatever they are, becomes problematical…. If American banking regulation peaked in 1842 and the individual responsibility for solvent banking topped out in the early 1930s, the rhetoric of central banking made its high on April 13, 1953. On that day, the chairman of the Federal Reserve, William McChesney Martin Jr., in a speech before the Economic Club of Detroit, celebrated the liberation of interest rates from central-bank control. (The Fed had been holding down the cost of the Treasury’s wartime borrowing.) “Dictated money rates breed dictated prices all across the board,” Martin declared. “This is characteristic of dictatorships. It is regimentation. It is not compatible with our institutions.””, James Grant, “Forging Ahead”, The Wall Street Journal

Bookshelf

Forging Ahead

As finance becomes more innovative and banking more complex, money becomes less substantial.

Big Change

A souvenir from the 1900 presidential campaign.

A souvenir from the 1900 presidential campaign. Photo: Granger, NYC / The Granger Collection

By James Grant

Progress in science is cumulative—we stand on the shoulders of giants. Progress in finance is a little different—here, frequently, we stand on the shoulders of pygmies. Then, too, we seem to keep falling off. It’s up and down, boom and bust—or is it?

Not entirely, according to Andrew Palmer, a London-based editor at the Economist and the author of “Smart Money,” a scintillating brief for financial invention. The long-lingering disaster of 2008, he contends, blinds us to constructive new developments in business credit, public finance, pension management, payday lending and charitable giving. It’s a cheerful and lucid Cook’s tour that Mr. Palmer conducts. You begin to think that there’s hope for the financial trades after all.

If mankind falls short in the quotidian business of buying low and selling high, Mr. Palmer observes, it can’t be for want of practice. Investing, lending at interest and dealing in the rudimentary forms of structured finance are as old as the hills. “Whether providing a way of storing wealth, of connecting capital with investments, of bridging the gap between the present and the future,” he says, finance has played a role in helping people “meet their objectives since the very earliest civilizations.”

Smart Money

By Andrew Palmer
Basic, 285 pages, $27.99

Better living through finance is Mr. Palmer’s optimistic theme. It’s not just the corner ATM that’s making life easier, he relates. Good people—idealists in their way—are adapting the once-toxic mortgage-backed security in the hunt for a cure for cancer. To back a single cancer-research study is by definition a long shot. To invest in a diversified pool of such efforts is a less speculative undertaking. To hold a senior claim against the potential future cash flows of a host of cancer-research projects (getting first crack at the income that they might one day produce) might even be construed as a conservative investment. Someday, by Mr. Palmer’s telling, cancer bonds—looking more than a little like the combustible mortgage securities of yesteryear—may raise life-saving billions.

In the same progressive vein, the author says, keepers of “big data” are weighing our creditworthiness more accurately than bankers used to do. Brainiacs are dreaming up new ways to finance higher education—not through conventional student debt but by a kind of equity investment in a student’s future earning power. Public-spirited inventors are creating “social impact bonds” that pay off when, for example, a prison succeeds in rehabilitating its inmates.

Mr. Palmer is a far from uncritical booster of all things new. He is quick to acknowledge how frequently a seemingly useful idea becomes destructive through misapplication or overuse. One thinks in this context of 1987-vintage “portfolio insurance,” the gimmick that led to concentrated selling of equity-futures contracts when the market started to fall (and wound up crashing). One thinks, too, of the May 2010 “flash crash,” in which equity-futures contracts collided with computer-directed common stocks to send the Dow Jones Industrial Average skittering like a billiard ball. “Beyond a certain scale and beyond a certain point of development,” the author observes, “good ideas have a tendency to run wild.”

As an example of benign adaptation, Mr. Palmer notes that new kinds of lenders—lightly regulated and digitally empowered—have sprung up to fill the business vacuum that Washington’s suffocating rules have made. Lending Club, a so-called peer-to-peer lender, and OnDeck Capital, a non-bank lender to speculative-grade small business, are among the author’s favorite creations. What he seems most to admire about OnDeck, which was founded in 2007 and went public early this year, is the speed with which it tells its customers, “Yes!” No need to eyeball the applicant when all the facts you need are online. Speed, accuracy and flexibility are the advertised virtues of the digital method. At last report, OnDeck was borrowing at 5.1% and lending at 36.7%. Oddly enough, the company does not turn a profit even at that shocking interest differential. Credit losses and competitive pressures take a large and growing bite out of revenue even today, a time of ostensible prosperity. Stay tuned for the next recession.

Money—smart or otherwise—is at the center of Mr. Palmer’s narrative, though the raw material itself gets short shrift. As finance becomes more innovative, money becomes less substantial. It would be nice if a few of Mr. Palmer’s intellectual pioneers could spare some time to improve the quality of the currency—and, while they’re at it, to beat back the depredations of the regulatory state.

The centerpiece of post-crisis banking regulation, the asphyxiating Dodd-Frank law, runs to thousands of pages. The substance of the landmark Louisiana Banking Act of 1842 occupies a single page. Edmond J. Forstall, the author of that 19th-century regulatory masterpiece, drew a sharp distinction between what a bank owed and what it owned. A regulated New Orleans institution, for instance, was obliged to hold back the equivalent of one-third of its deposits in hard cash, gold and silver, while placing the rest in high-quality, short-dated, self-liquidating commercial bills. After all, there was no telling when the depositors might want their money back. Bray Hammond, the author of “Banks and Politics in America From the Revolution to the Civil War” (1957), judged the Forstall law to be the acme of enlightened banking legislation. The 21st century seems unlikely to topple it from its pinnacle.

As for the relationship between a bank and the state, it’s been downhill for more than a century. Under the long-ago doctrine of double liability, the stockholders of a nationally chartered bank got a capital call—a dunning notice—if the institution in which they held a fractional interest became impaired or insolvent. It seemed only fair that the owners of a bank should be held responsible for its safety and soundness. Double liability went out the window in the 1930s at about the time that federal deposit insurance came in. The passing decades have moved us ever further away from the ideal of individual responsibility in finance and ever closer to the dubious netherworld of collective responsibility.

Mr. Palmer finds nothing to fear in financial derivatives, though he seems to overlook the most problematical kind of all. You’ll recall that a derivative is a financial instrument that owes its value to some underlying asset—interest rates, say, or the level of the S&P 500 index. The dollar bill is a ubiquitous derivative—actually, a former one. It derived its value from the gold or silver into which it was freely convertible. All that ended during the Nixon administration. In 1971, the Treasury stopped exchanging dollars for gold at the fixed rate of $35 to the ounce (one might call it a default). At that moment, the Federal Reserve “note”—an obligation to pay—became, in the words of the economist John Exter, an “IOU nothing.”

The dollar’s transformation into pure paper scrip has given the world’s central bankers enormous discretion. They have availed themselves of that power to redefine “price stability” to mean inflation—2% a year would suit, they judge. They have materialized $10 trillion since the financial crisis just as easily as you might send an email. They have caused bank-deposit rates to fall to zero even as they’ve talked up the stock market. The financial inventions that Mr. Palmer extols ultimately owe their utility to free markets. Manipulate those markets and the value of the inventions, whatever they are, becomes problematical.

If American banking regulation peaked in 1842 and the individual responsibility for solvent banking topped out in the early 1930s, the rhetoric of central banking made its high on April 13, 1953. On that day, the chairman of the Federal Reserve, William McChesney Martin Jr., in a speech before the Economic Club of Detroit, celebrated the liberation of interest rates from central-bank control. (The Fed had been holding down the cost of the Treasury’s wartime borrowing.) “Dictated money rates breed dictated prices all across the board,” Martin declared. “This is characteristic of dictatorships. It is regimentation. It is not compatible with our institutions.”

Mr. Palmer may be right about the improving uses of financial ingenuity. A dollop of the wisdom of Edmond Forstall and William McChesney Martin Jr. would improve matters all the more. A curious thing is financial progress. Now you see it—and now you don’t.

—Mr. Grant’s latest book, “The Forgotten Depression: 1921, the Crash That Cured Itself,” won the 2015 Hayek Prize.