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What's the Best Policy for a "Balance Sheet" Recession?


txlaw
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To add some more fuel to the fire regarding our discussions on the macroeconomy and what the right policies should be to get us through this time of sustained deleveraging (see McKinsey study), I am attaching an interview with Richard Koo that I found via Zerohedge.  Can't say that I agree with everything he says, but this is definitely a must read if you're interested in macro. 

 

So what do you think?  Is sustained government spending the answer?  Is monetary policy, both regular and extraordinary, useless in this particular situation?  Can we distinguish the U.S. situation from the Japanese situation?

 

Hopefully you Austrian economics guys won't go into an apoplectic rage after reading this interview and will provide some well reasoned critiques that don't resort to uncalled for disses and conclusory statements.

 

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Keep in mind that this debt is relative to income & it doesn't have to be paid back strictly from cashflow; debt to equity swaps, asset sales, & higher income would all contribute to a solution. The issue is not new, & there are many well worn local level solutions.

 

Eg: A common failing in many 2nd world countries is debt overextension by younger couples, buying all the 'must haves' being sold to that generation. Big wedding, Mc Mansion, 2nd car, etc with negative cashflows financed via various forms of credit.

 

The solution is usually a 51% sale to 'family', at market price, with the 'family' paying the bank vs the couple. The couple gets told to put up some nephews (so they can get a job, & pay the 'family' rent) & use their cash flow savings to pay down their debt. The couple either accepts or goes bankrupt, if they change their mind/divorce the 'family' uses the majority control to sell the Mc Mansion. Deleveraging, moral suasion, additional income (nephew earnings), etc ...  & the same end solution.

 

Of course the couple isn't thrilled, but the 'family' didn't f**k *p either.

 

SD

   

 

 

 

 

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Nice to have that update on Richard Koo's views.  He was mentioned about a year ago, on either this board or Chuck's angels, and I read his book and listened to audio of CSIS lecture of fall-2008.  Very good analysis - he combines realistic view of businessperson's behaviour with macro economic perspective.

 

Two things I would add to supplement Mr Koo's advice:

 

1) Spending (hence borrowing) can be stimulated without direct govt expenditure.  For example, in Canada there was a home renovation tax credit of $1350 off taxes for home renovation spending, ie 15 pct return via tax system of spending up to $10k, after first $1k per household.  Worked very well at getting ordinary folks employed, encouraging homeowners to open purse strings a bit, and cost govt only 15 pct of GDP increase produced.  (Well, maybe 30 pct, considering some home improvements would have happened anyway without stimulus.  But certainly less than 100 pct if had to be direct govt expenditure, and less than 50 pct which is nominal govt percentage of economic activity - so a net gainer to stimulate private sector.)

 

Another way for govt to stimulate economy, without much direct spending, is by regulation and standards setting.  Eg, must buy new types of TVs, or have to replace old deteriorating underground gasoline storage tanks if want to stay in gas station business, etc.  Argument is often heard that regulations should be delated because of slow economy, but in fact, that is actually very good time to create more work on secondary aspects of having good quality of life.  Primary is being looked after of necessity, and secondary stuff is being deferred eg entertainment, dining out, so govt can regulate some of the secondary back into action.

 

Would be interesting to hear Mr Koo's take on such matters.  He might feel private sector being encouraged to spend would delay repair of balance sheets.

 

2)  Other item I differ from Mr Koo is re comment he made in fall-2008 CSIS presentation, that most effective govt spending would be what does not improve productive capacity.  eg, war spending is best, because destroys capacity (physical and human capital) instead of increasing it.  My take is opposite - better to improve productive capacity, but maybe capital investments that take long time to return net positive benefits flow.  Eg, education, health care of younger folks, pollution reduction.  Wish he would comment on that matter as well.

 

Thanks for posting the Koo interview.

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Hi Kumar... Those are good questions.  Here from my limited understanding of Koo's ideas is a partial answer.

 

1)  You refer to GE not acknowledging they have a balance sheet problem.  That is correct behaviour for them, or any other enterprise which is long term viable but needs to repair their balance sheet.  Emphasizing the negative can cause collapse of confidence - ratings decline, financing costs rise etc.  If company is able to earn its way out of trouble, it should do so.  So actually I have some affinity with mark-to-business-plan accounting.  It is routinely done in energy industry for instance.  Prospective investor needs to evaluate quality of business plans, personnel who will implement, etc.

 

2) How to determine that balance sheet recession is over?  Koo addresses that in pp 39-51 of his book.  Several metrics can provide information:

 

a) Companies have stopped paying down debt.  pg 40 chart - credit extended to companies by banks (seasonally adjusted currency measure, and pct of GDP).

 

b) Businesses have cleaned up their balance sheets.  pg 41 chart - leverage at companies, Japan vs US.

 

c) Corporate fundraising trends contain signs of real economic recovery.  pg 48 chart - proportion of listed companies paying down debt.

 

d) Companies are now accumulating financial assets.  pg 49 chart - increase/decrease in net financiall assets at nonfinancial corporations.

 

The above is very partial understanding - Koo followers could no doubt provide other and better answers.

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Txlaw, this is shockingly good.  Thanks.  Any of his other work worth checking out?

 

I actually have not read any of his other stuff.  This interview caught my eye when I was sifting through my RSS feeds because I remembered seeing a post on this board discussing his work, which had in turn led me to find a presentation by Koo on the need for fiscal stimulus to break the vicious cycle of debt-deflation. 

 

When I read this interview, I knew it was too good not to post here.  His book, The Holy Grail of Macroeconomics, is going on my list of things to read, but that list is so vast that it will probably be years before I get to it.

 

 

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Echoing others' appreciation for the posting, thanks txlaw, that was a good read indeed.

 

First and foremost, macro-economics is not my strong suit, so I am looking at this with an admitted amount of naivety. That said, I would really like to see/hear a similarly well-thought-out counter-argument to the thesis Koo presents. Much of the conservative ramblings I hear are a collection of 7-second sound bytes or arrogant declarations of how liberals' spending habits are a combination of foolhardiness and pure evil. If anyone knows of a cohesive counter-argument, irrespective of whether or not they agree with it, then please post it.

 

All above being said, I am not sure that I agree with Koo's assertions of the ineffectiveness of tax cuts. His referencing that 88% of the Bush Tax Rebate being used to reduce debt may be factually correct, but as the recipients of those rebate checks knew full well that those rebate checks were a one-time "windfall", they most certainly would spend those checks differently then small to medium businesses would a permanent (or as close to permanent as any governmental policy driven) tax-cut could be. I agree that tax cuts for individuals may generate more debt-reduction than spending, but for small to medium businesses, I would opine the opposite. This would, presumably, also stimulate the employment situation as well.

 

Also, I would add onto Woodstove's point #2 regarding the capital investments. If the government needs to spend money, would it not make sense to spend money on reducing the US's dependence on foreign energy? This has the advantage of "spending our way" out of the Balance Sheet Recession (supposing that this is indeed the situation in which we find ourselves, which I am not totally sure is correct, but will use that assumption for this suggestion) and stemming a transference of money from the US to those countries who, frankly, do not like the US? Furthermore, if this investment is, at least in part, in the form or renewable or inexhaustible (Wind, Tidal, solar, etc) energy, then the result would be easing of the recession, reducing dependence on foreign energy and ecological benefits.

 

-Crip

 

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That is a nice article.

 

Here are my toughts on this:

 

He is right, this is most likely a balance sheet recession. The amount of wealth destroyed will need to be filled by savings or other means.

 

I disagree with it's opposition to monetary easing, I believe it's a much more intense solution then deficit spending. When the US government buys back toxic assets, it is actually cleaning the balance sheet much faster then trough government spending, therefore has much more chance of starting lending again.

 

Nobody knows what that monetary easing will cause in the mean term but it's funny how he praised the Chinease that apply a solution and then worry about the effect... it seems to me both are actions with unknown effect.

 

I hate when some economist tells people we should start doing unproductive work to start consumption again. There is a billion of investments more productive to society then building bridges that lead nowhere. As stated previously, how about using the money to reduce our dependence to energy consumption?

 

Here is a funny story from Phil Fisher. On one of it's trip to China in the beginning of the 90's he was with some government officials and they were showing him how a canal was being built. There was thousands of workers with shovels digging. So Fisher goes:

 

Fisher: "Surely you guys have mechanical equipment to do all that digging, why do you have manual labor here?"

 

Gov official: "This is a work program, not a building program:

 

Fisher: "Well is it work you are trying to do or building a canal? Because if you want to do work, then they should be digging with spoons"

 

BeerBaron

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Richard Koo had an insight into "Balance sheet" recession sometime AFTER the fact, already deep in  recession.

 

Kumar, I believe that Koo had his insight well before we entered into this recession.  He came to his conclusions after studying Japan's lost decade.  He also mentions in his interview that many mainstream economists, especially in the U.S., ridiculed him for his views until just recently.

 

The question is how do you determine if we are in "Balance sheet" recession (for example, we still do not know if GE is out of "Balance sheet" recession. In the first place, they did not even acknowledge they had a problem and continue to do so).

 

In addition to looking at the metrics that Woodstove mentions, I think this is where you also have to bring in Irving Fischer's debt-deflation theory and Hyman Minsky's financial instability theory to recognize the signs of a bubble in leverage that could lead to (or that already has led to) a "balance sheet" recession.  Ideally, you'd catch this stuff before going into the balance sheet recession, but that was never gonna happen with guys like Greenspan at the helm and with the amount of regulatory capture we had and still have.

 

You also have to do some micro work, where you are scrutinizing companies' balance sheets across the economy.  That's why it makes a lot of sense for economists to look to intelligent capital market participants to see what their takes are on the sustainability of what is going on in the economy.  You also need these smart market participants' help to figure out what's actually going on in with the plumbing of the financial markets that could possibly cause a blowup and then a downward spiral in the real economy.  I'm thinking of smart, honest people like Prem Watsa and the FFH team, who realized the risk of a possible Japanese-style situation occurring in the U.S. and who invested accordingly.  And Buffett, of course, who mentioned the possibility of a derivatives blow up.

 

All easier said than done, of course, and with 20/20 hindsight.

 

After the government stimulus, how do you determine "Balance sheet" recesssion is over so that you withdraw the stimulus? Is this just a big guessing game? Unless accounting regulations make balance sheet statements we can believe in, we may be just shooting in the dark?

 

I suppose you have to look at the metrics mentioned by Woodstove that are found in Koo's book.  

 

But note that when a recession is over is also dependent on how we define the word "recession."  If we find a "jobless recovery" unacceptable as a society, we will also have to make additional policy decisions with employment in mind because just because companies have repaired their balance sheets and have increased their investment spending does not necessarily mean that this spending will be recirculated in a way that creates job growth.  

 

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That's a very enlightening read, txlaw. Thanks! (and an awesome Phil Fisher quote, BeerBaron!)

 

The savings rate is another guide to how much fiscal stimulus to apply (an exact match, as Koo put it should put that saved-and-not-lent-out money back into circulation). An exact match should also stop true inflation (properly defined as inflation of the money supply, where money supply = cash + credit). I dare say there is plenty of published data to get it roughly right, rather than precisely wrong.

 

If there were a free market for interest rates (as suggested by Austrian-school economists), rising interest rates on government debt would be a signal also, demonstrating more competition for the loans from private sector. However, we don't have a free market for interest rates thanks to the monetary policy makers of our economies (The Federal Reserve, The Bank of England Monetary Policy Committee, etc.) who decide instead to set the interest rates, apply Quantitative Easing and distort the market to meet politically set objectives, and the vagaries also of fractional reserve banking, which accompanies our fiat currencies, and can expand the supply of money rapidly when people are prepared to borrow.

 

Where we go from here certainly needs to be taken in the context of the mess we're actually in, rather than from the point-of-view that "we shouldn't be in this mess, and wouldn't be if, say, we'd followed Austrian School prinicples and fully-reserved banking and currencies with nobody pulling interest rate levers to steer the economy (and distort the supply and demand messages that money propagates so effectively when unfettered)."

 

(the part in "quotes" is the sort of thing I'd imagine an Austrian school theorist might say, as an example of something that may have validity but won't get us out of this mess)

 

I agree that if fiscal stimulus is used, it should aim to get long term productive economic value with as little extra bureauocracy as possible (avoiding a growth of big government, at least in manpower, by tendering all work to the private sector). It could aid environmental developments, economic efficiency developments (e.g. road improvements and maintenance, rail, sewers, airports etc without overburdening the taxpayer with, for example, roads that we cannot afford to repair and maintain in ten years' time), and educational improvements (e.g. new schools & hospitals to replace run-down and impractical buildings, new technology and more textbooks for schools etc.).

 

China clearly has great need for new infrastructure so should get long term benefits and few wasted yuan in this way.

 

In getting on with much-needed maintenance, fairly full value should be achieved in the developed countries (the downside being the upward pricing pressure if demand exceeds supply, though at least the excess profits will spread through the economy in other ways).

 

Already-planned and approved infrastructure projects are clearly thought to be useful / valuable to the economy or the public services in the long-run and can put contractors to work in short timescales.

 

New projects (e.g. bridges-to-nowhere-that-we'd-seriously-planned-building-one) will take time to commence, but should be considered and prioritised early so planning & approval can be done. The prioritising will ensure the most valuable (rather than digging with spoons!) will be commenced out of the budget created by offsetting the savings rate exactly, as Koo suggested.

 

If government-owned entities are set up to own the projects, those that can be privatised in years to come could be (e.g. an airport operating company could later be privatised to pay-down government debt and perhaps show an investment return, or perhaps the government could use its debt finance to make an partial equity capital investment in an existing operator keen to add a new runway & terminal now, and be able to sell the shareholding at a later date to pay down debt and make an investment return).

 

Major projects in viable renewable energy could also be undertaken, and with a bottom-up view, underutilised sectors could be matched up with government spending (e.g. a shipyard with a dearth of private sector contracts in light of reduced world trade may agree attractive rates for producing naval vessels that would need replacement soon anyway).

 

As mentioned, tax-break could be used, in particular with a view to long-term investment, such as R&D tax breaks, that help strengthen product mixes to position for the upturn.

 

On the whole, I'm averse to such meddling with market forces and distortion of the economic signals of free-flowing money, and have a lot of sympathy with the Austrian school and with small government, little bureauocracy and simplified taxation. However, given that we have a meddlesome system at the moment and have to unwind a lot of malinvestment it helped create without crippling the economy, it seems necessary to take such actions with a view to obtaining long term value for money and avoiding corruption and waste as far as possible.

 

I think it's important that the government doing the spending is as businesslike and investor-like as possible.

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I have read books by Ron Paul and Murray Rothbard and listen to Schiff weekly.

 

I enjoy the purity of the Austrian School, but thats a bout it. It sounds so simple, but seldom answers many question about how to go forward. They seem to believe we should just let the chips fall where they may and remove all regulation to truly free up the market.

 

It doesnt address pooled needs like education, water, police and fire protection, and also other utilities. It also does little to address externalities and stake holders.

 

What about the environment, safety, and peoples general well being. Its sounds great to say remove the minimize wage and we have full employment, but at what cost. In my opinion a truly free market is just as dangerous as a

top down communist one.

 

-----

 

Its pure, its elegant, its easy to understand. I dont think it would work though in the real world and for most people. Isnt the point of an economy to improve the lives of the majority?

 

Thanks for the link this Koo Guy seems interesting.

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I have read books by Ron Paul and Murray Rothbard and listen to Schiff weekly.

 

I enjoy the purity of the Austrian School, but thats a bout it. It sounds so simple, but seldom answers many question about how to go forward. They seem to believe we should just let the chips fall where they may and remove all regulation to truly free up the market.

 

It doesnt address pooled needs like education, water, police and fire protection, and also other utilities. It also does little to address externalities and stake holders.

 

What about the environment, safety, and peoples general well being. Its sounds great to say remove the minimize wage and we have full employment, but at what cost. In my opinion a truly free market is just as dangerous as a

top down communist one.

 

-----

 

Its pure, its elegant, its easy to understand. I dont think it would work though in the real world and for most people. Isnt the point of an economy to improve the lives of the majority?

 

Thanks for the link this Koo Guy seems interesting.

 

I'm sure there are various flavours of Austrian economists, from the completely dogmatic laissez-faire types to those with a pragmatic desire for regulation, albeit with a preference for a light touch and the damping of mass-participation folly. I'm certainly no expert, no economist, and not much of a macro guy. I hope to be a pragmatist.

 

I think there's a lot to be said for eliminating manipulation of interest rates, keeping the state out of sponsoring projects that ought to be commercially viable and keeping spending of other people's money (i.e. taxation) to those things truly necessary. I also believe it's important to give people a step up onto the economic ladder if they fall on hard times or ill health rather than be callous and lose their productivity. Equally, it's important not to be so generous we remove the incentive to work or create poverty traps and waste of government manpower through excessive means-testing.

 

Hong Kong (before the British lease expired, reverting to China in 1997) was an economic powerhouse under light touch regulation in the period after Japanese WWII occupation. Via Chris Leithner's Austrian-centric newsletters, I found this remarkable Québécoise Libre obituary of Sir John Cowperthwaite, reportedly the main figure behind allowing the Hong Kong citizens to get on with this remarkable transformation with a minimum of government interference or assistance/favour to certain projects.

 

It is difficult to break the dependancy we have on large government, credit/leverage, inflation, and what Leithner calls the Welfare-Warfare State.

 

I think there are ways to gradually strip away layers of complexity and government waste, simplify the tax code and cut taxes (putting many bureaucrats and tax-avoidance experts into productive work instead), making the changes slowly enough to allow people to adjust their long term planning accordingly and to transition the economy slowly but relentlessly without major disruption to one of light government, low taxes, low-to-zero inflation (if the money supply = cash + credit can be made constant by gradual elimination of fractional reserve banking), ever more natural (free-market) interest rates as the central bankers ease off the levers, more personal responsibility and freedom.

 

In the long run, higher quality investments should be made by businesses able to obtain debt at realistic interest rates, raising the hurdle. With natural interest rates, asset bubbles and malinvestments would have a lot less fuel from artificially cheap debt.

 

I do, however, believe that certain focused government expenditures are essential. Defence, education, basic welfare and healthcare, policing and the maintenance of law and order, firefighting, judiciary, libraries, public infrastructures. It's also important to regulate for safety, against unsound financial practices with systemic implications, to reflect environmental costs and free borrowing of other resources from future generations economically and so on.

 

Really, I'm in favour of leaning towards Austrian School principles, towards smaller government, simpler rules, regulations and taxes to eliminate layers of people doing nothing for society's productivity other than work around them. I'm in favour of freeing money's signalling properties to do their silent work with far less state distortion, a large part of which is to avoid printing new money or allowing a favoured class of banks to lend large multiples of what they receive in deposits, thus printing money with our approval and earning disproportionate profits by such leverage. I'm also in favour of disincentivising governments from layering on new regulation and tax complexities in future and providing policies that favour certain groups at the expense of the taxpayers at large.

 

Interestingly, rather than making central control (government) forcibly take people's money to spend on "improving the lives of the majority" at the majority's expense and on their behalf, it leaves those monetary resources in the people's hands to improve their lives as they wish, with money free to signal supply and demand without distortion. It makes saving a good thing, rewarded by natual interest rates and lack of inflation of the money supply, rather than penalised by artificially lowered rates, and it makes speculation using cheap debt rather more difficult and less incentivised.

 

I believe some Austrian economists miss one thing, that money that's out of circulation (e.g. saved in a jar or under a mattress) effectively deflates the current money supply and strengthens the economic signals and economic value of each currency unit that remains in circulation.

 

However, without it all coming back into circulation or leaving circulation at the same time, if it remains in dynamic equilibrium over the economy as a whole, it won't cause major fluctuations in the value of money, but there would still be some scope for individual actions to coincide and cause disruptive economic events, just as deposits and lendings by banks on different terms can allow a run on a bank for withdrawing deposits while their loans can't be called in as fast. (With fully-reserved banks, the effect is much smaller than in fractional-reserving that's commonplace now)

 

Finally, the mess we're in now, certainly doesn't need a sudden move to Austrian School policies, which ought to be better at prevention, but make a very poor cure for the current malaise, if Koo is, as I suspect, largely right about its hidden balance sheet properties en-masse at the micro level.

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Most Austrians like Rothbard argue for no regulation. I have seldom come across one who refers to light regulation so pardon my ignorance. I dont see how any rational person can disagree with much that you have just wrote. I really like the Welfare / Warfare part, very catchy.

 

It seems as though pragmatic thinking is on the decline. People are very polarized these days. Either total free market zero regulation, our current bankster / crony capitalism, or a broke and declining nanny state. I think all the major economic schools have great ideas / principles except for maybe the Friedman efficient market types. I borrow and reference all of them, though my favorite economist currently is Joseph Stiglitz.

 

Where is simple practical regulation which is mainly designed to deal with externatilities and not much else (environment, systemic risk and not increasing home ownership or marriage). Where is telling the people that here are some things that must be provided and here is a base level of taxation. Everything else is fine, but you will have to pay for it.

 

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Mark to business plan accounting is a great term. I am guessing its similar to mark to model. Now GAAP allows you to carry an asset on your books at what you basically think it will be worth. If you plan to hold something for the long term you no longer have to mark it to market if you meet certain terms. That change has basically saved the banks but has killed transparency.

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Guest kawikaho

Both Keynes, and Hayek (an icon of Austrian economics) would support excessive gov't stimulus, and spending financed by the central banks in times like these.  The latest NFIB surveys show that the biggest problem with the largest sector of employment, namely, small and medium businesses, is poor sales--no big surprise there.  With more gov't spending, aggregate demand will increase, and trickle down to small and medium businesses.  As business expands, employment should pick up, and we'll be fine.  

 

I've skimmed through the Richard Koo stuff, and it sounds like he's saying something similar to the above.  

 

 

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Kumar and Myth ... you are right, mark-to-business-plan accounting was intended to convey the good side of mark to model.

 

Any organization which makes things or provides services, is badly managed if they evaluate activities and opportunities solely on the basis of how it affects their balance sheet.  "Solely" is a key word in that statement, one clearly has to have some awareness of balance sheet considerations.

 

For instance, a year or so past, GE announced some sort of retention plan for middle management during anticipated downturn.  Or maybe it was a commitment to continue management development programmes.  I'm not a follower of GE so don't recall the details.  However, middle management is a genuine asset of the company, which does not show up very clearly on the balance sheet.

 

Imperial Oil, whom I do follow a bit, proceeded with their Kearl River oil sands project based on their own estimates of oil prices and future demand.  Those numbers are not the same as balance sheet values of reserves which US GAAP used to require be based on only 31-Dec closing prices, and in a slight concession to reality of the oil business, now I believe may use an average of last quarter prices.  Imperial has a business plan which leads them to keep a second set of books, hopefully closer to reality of their industry and its economic relationships, for making operational decisions.

 

Sometimes the business value of an enterprise makes its way onto the balance sheet of its acquirer or disposer, in terms of cash price paid/gotten. GE does a fair amount of buying and selling of business units, I believe, so one might argue that some of the business value shows up on the balance sheet.  Though there will be historical anomalies - light bulb business maybe overvalued, medical diagnostics maybe under.

 

See's Candy is the classic Berkshire-zone example of how balance sheet does not represent business value.  Would we propose that See's make its decisions on balance sheet considerations?  I think they probably make decisions on the basis of long term return for projected expenditure.  Buffett has reportedly told some managers to go ahead with such-and-such if it will produce meaningful profits over a ten year period.

 

Ben Graham refers in Security Analysis to holding real estate investments until the depressed market returns to normal.  That is not unlike mark to model.  It is ok if one is using an intellectually honest model.

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Its definitely on the reading list.

 

My problem with the changes are that as an accountant it works well and allows Management to execute their plans more effectively. It gives them wiggle room and if they plan on holding an investment till maturity it allows them to carry the asset at the proper value.

 

As an investor its a horrible idea. The balance sheet, cash flow, and income statements are all tools which should be used to show value. Not tools to be crafted when time gets tough. I dont like Management having too much leway and really dont think GAAP should be manipulated when times get tough. Management can easily say GAAP values the assets at this. Held to maturity values the assets at this. We will let you decide the true value.

 

 

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You mentioned about Irving Fischer's debt-deflation theory and Hyman Minsky's financial instability theory to recognize the signs of a bubble. I am not familiar with any. Any study suggestions for people like us who have not studied Economics formally?

 

There is a short essay that Fisher wrote summarizing his debt-deflation theory that someone posted on this board.  I'm sure you can also easily find it by doing a Google search.  Maybe just read the Wikipedia article on Minsky?  (Not being facetious here.  It's a good way to get introduced to the theory.)

 

I haven't studies economics formally either, so I've pieced together my economics knowledge through reading multiple sources (books, magazines, newspapers, board postings, blogs, Wikipedia, etc.).

 

You suggested listening to smart market participants. WEB warned about Freddie Mac and derivatives several years ago. Nobody listened.

 

Yup, you're right about that.  He also indirectly warned about the securitization market when he talked about the Clayton Homes acquisition and how Clayton had gotten into trouble when the securitization market for manufactured home loans dried up.  In one of his recent letters (was it this last one?) he said that that should have been the canary in the coal mine with respect to subprime loans and the securitization market.

 

This is a major problem we have to address about our regulatory system.  First, we don't want to have people in positions of power who fundamentally believe in no regulation and who think that whatever is happening in the markets is efficient and that the market will always be self correcting.

 

Second, we have to realize that the market participants who the regulators look to for advice may have their own incentives that conflict with the best interests of the country.  The NY Fed had lots of contact with the big bankers involved in the activities that helped precipitate this crisis, but no good came of that.  Now, it's entirely possible that these guys they were talking to didn't understand the risks.  But it's also possible that they simply were not incentivized to disclose these risk because it would have materially affected their businesses (and their bonuses).  And of course, sometimes the regulators and those regulated naturally get too close together, especially when those regulated have lots of financial resources.  This can blind the regulators to the problems occurring or can cause the regulators to be overly concerned with lessening the impact of regulation on the regulated.

 

There's no easy answer to your concerns.

 

"jobless recovery" although unacceptable is better than no recovery. How do you create jobs in this environment?

 

True.  It will be very difficult to create jobs.  Actually, the best we may be able to do with government spending is to keep the level of unemployment from accelerating, thereby keeping GDP stable.  That will buy us time for the private sector to get their houses in order, which we really need because it's the private sector that will create the jobs we need.  

 

As many have pointed out above, more targeted spending is desirable.  However, Koo has also noted in one of his speeches that the type of spending that will prepare us for the 21st century and lay the groundwork for our economy will probably take lots of time to ramp up.  We can't just disburse that money immediately.  We have to do detailed analyses of what's the best way to upgrade our infrastructure or invest in alternative energy.  In the mean time, you have to have spending that may not be so great for long term competitiveness but that will preserve jobs.  That's why we had cash for clunkers and the home buying credit.  It's also why the feds disbursed money to the states to keep the state governments from having to layoff a bunch of state employees.

 

My main point about the "jobless recovery" is that just because businesses start getting on sounder footing and start increasing profits does not mean that things will be rosy on the jobs front.  And it's really the employment figure that matters the most to me.  Remember that Japan had a decade of GDP stagnation but that unemployment stayed very low during that time.  That was a victory in my opinion.

 

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I read the Koo paper yesterday and here is where I'm getting stuck in terms of digesting it:

 

0)  Assertion:  without stimulus spending GDP would shrink as private sector prioritizes debt retirement

1)  Assertion:  increased cash flow from tax cuts are spent in paying down private debt (uses Bush tax rebate as example)

2)  Assertion:  the economy's main issue is that there is too much private debt

 

To me, it would seem that the problem gets fixed when the excess debt is retired.  As Koo points out, tax cuts will get us there the fastest, but advises against doing that because of an expected collapse in GDP while we wait.

 

Now, my question is why wouldn't you want to get back to health as quickly as possible?  That would seem to be debt retirement.  If in a "do nothing" scenario GDP shrinks as people pay down debt, then in a "tax cut only scenario" perhaps GDP shrinks less given that people have new funds with which to pay the debt down.  So if GDP is shrinking less, then why can't the remainder be made up in form of stimulus spending?  Instead of this approach, he seems to be advocating only stimulus spending.

 

 

 

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Just a guess but he may favour that approach because stimulus spending creates jobs if done correctly - thats why the GDP doesn't shrink. Straight tax cuts might be faster but they may also result in greater short-term pain, i.e. jobs are lost as the GDP shrinks, so this might be more political than anyhthing else....I also want to say thanks to txlaw for the start of a great discussion!

 

cheers

Zorro

 

I read the Koo paper yesterday and here is where I'm getting stuck in terms of digesting it:

 

0)  Assertion:  without stimulus spending GDP would shrink as private sector prioritizes debt retirement

1)  Assertion:  increased cash flow from tax cuts are spent in paying down private debt (uses Bush tax rebate as example)

2)  Assertion:  the economy's main issue is that there is too much private debt

 

To me, it would seem that the problem gets fixed when the excess debt is retired.  As Koo points out, tax cuts will get us there the fastest, but advises against doing that because of an expected collapse in GDP while we wait.

 

Now, my question is why wouldn't you want to get back to health as quickly as possible?  That would seem to be debt retirement.  If in a "do nothing" scenario GDP shrinks as people pay down debt, then in a "tax cut only scenario" perhaps GDP shrinks less given that people have new funds with which to pay the debt down.  So if GDP is shrinking less, then why can't the remainder be made up in form of stimulus spending?  Instead of this approach, he seems to be advocating only stimulus spending.

 

 

 

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I read the Koo paper yesterday and here is where I'm getting stuck in terms of digesting it:

 

0)  Assertion:  without stimulus spending GDP would shrink as private sector prioritizes debt retirement

1)  Assertion:  increased cash flow from tax cuts are spent in paying down private debt (uses Bush tax rebate as example)

2)  Assertion:  the economy's main issue is that there is too much private debt

 

To me, it would seem that the problem gets fixed when the excess debt is retired.  As Koo points out, tax cuts will get us there the fastest, but advises against doing that because of an expected collapse in GDP while we wait.

 

Now, my question is why wouldn't you want to get back to health as quickly as possible?  That would seem to be debt retirement.  If in a "do nothing" scenario GDP shrinks as people pay down debt, then in a "tax cut only scenario" perhaps GDP shrinks less given that people have new funds with which to pay the debt down.  So if GDP is shrinking less, then why can't the remainder be made up in form of stimulus spending?  Instead of this approach, he seems to be advocating only stimulus spending.

 

 

I think the key to Koo's criticisms of the Bush tax cuts is that at the beginning of a "balance sheet recession," you have to do everything you can to counter the aggregate demand destruction that is putting the economy into a deflationary spiral downward. 

 

Tax cuts represent a leakage to the economy because the money goes back to the banks, and the banks can't lend money out because they are in trouble and because loan demand is collapsing.  Therefore, if the government borrows money to pay back to the private sector in tax cuts (we don't want them cutting spending, remember, because the government needs to prop up aggregate demand), it will have much less effect than simply increasing government spending, which is guaranteed to recirculate money into the economy.

 

You have to prop up aggregate demand to stop the deflationary spiral, and Koo believes that there is a risk that even when things appear to have stabilized, the entire private sector is still focused on debt minimization rather than profit maximization, which could potentially put the economy back on the downward path if government spending is reduced. 

 

This is where I begin to question the simplicity of Koo's model.  Clearly, there is a spectrum of business mentality between "everyone minimizing debt" and "everyone maximizing profit."  If the private sector in the U.S. begins to move towards maximizing profit while prudently paying down debt (through cash flow, debt to equity exchange, reorganization, etc.), then perhaps targeted tax cuts or tax credits will help prop up aggregate demand or increase aggregate demand from the lower than normal levels.

 

I think here is where his view is colored by the Japanese experience.  He thinks that it will be along time before we get off the path of debt minimization.  But maybe things will be accelerated in the U.S. because of our business culture.  For example, if the U.S. can have tax cuts targeted towards entrepreneurial small businesses that actually hire people and are trying to grow, then maybe tax cuts at this time are not a bad thing.  But we don't want money just going back to the banks.

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