August 22, 2007

The Fed's Dilemma: The Moral Hazard

So the Fed has an interesting problem: whatever it does-- raise rates, cut rates, etc-- it causes a Moral Hazard, but to different people.  To whom does it want to teach the wrong lesson?

Or, choose: rich get decimated, poor get poorer; or rich get richer, poor get by? 

This is part 3-- click for Parts 1 and 2


So the Moral Hazard for the Fed is that by cutting rates, it lets the hedge funds know that they will always be bailed out, that losses will always be contained.  So go ahead, take more risks.

If that was all there was to it, the story would be boring.  But there’s more.

Let me state explicitly that the mess we’re in is exclusively due to too much, too easy, credit.  In order to have prevented this, rates should have been higher, but to raise them now—when no one can pay anything back—would be death.  So rates either must at least remain the same, or get cut.

Here's the problem: 

If they don't cut rates, many lose their homes; some hedge funds go under; some franchises, that borrowed money to open their stores, go under; people lose their jobs; so there's less money in the system, and we get a recession.  Divorce inevitably follows.  But note clearly that while everyone loses in this scenario, the poor get hurt much more than the rich do.  (This is why it is a political certainty that they will cut rates, at least four times, before Nov. 2008.)

If the Fed cuts rates, we get a bailout-- people keep their homes, hedge funds don't go under-- but the the rich get richer while the poor simply don't get poorer.  Even the thought of rate cuts has pushed the prices of most stocks back to the levels they were before the correction.  They will only go higher from here.  In fact, the Moral Hazard here is that hedge funds learn that they'll always get a bailout, so they take even greater risks for greater profits. But your house doesn't increase in value, it just doesn't melt in the snow.  Asset prices and profits increase; wages don't.  The gap between rich and poor expands.

This is complicated by a point so obvious that it is never mentioned: rich and poor are experiencing two entirely different economies-- one with inflation, and the other in recession.

Here's an example of this wealth gap. One metric the Fed used to measure inflaiton is the Consumer Price Index, which is an aggregate of prices across sectors: food, energy, clothes, etc.  But in the past few years, the important metric has been the CPI omitting food and energy prices, because, supposedly, food and energy prices fluctuate wildly and thus are not stable enough to measure inflation.  Have you seen the price of oil for the past 6 years?  Does it look like its fluctuating wildly, or just staying high?  So whereas the CPI shows prices overall have risen, the CPI "ex food and energy" incorrectly shows prices relatively stable, because it omits the two main sectors that show inflation.

The rich don't "see" increased energy prices.  (Are their fewer SUVs on the road?)  They see credit tightening.   They see their asset prices falling.  They see "growth" declining.  That's recessionary. They want a rate cut. But if you get a rate cut, prices go up.

What do you do if you're poor, and you have less money, but prices are on the rise? You go see a psychiatrist, that's what. 

It's a tricky situation, so I'll summarize it here: prices have been rising, if you look at all prices.  So rates should have been higher.  Had they been higher, people-- everyone-- would not have borrowed so much, so poor wouldn't be seduced by low rate mortgages, and rich wouldn't have leveraged credit to bid up asset prices (including real estate.)

But at this second, everyone needs a rate cut, because everyone "sees" a serious deflationary pressure.  (If your biggest asset is your house, and its worth 3/4 what it was a year ago, that's deflationary.)  The result of this rate cut will be that the existing inflation, heretofore ignored by everyone, will be magnified.  So while the poor will not have more money (they'll simply not have less), the rich will get much richer.  Inflationary pressures will be much better handled by the rich, for obvious reasons.

And so the Moral Hazard. The Moral Hazard for the Fed is that by bailing us out-- and they will-- easy credit and the Bernanke put will worsen the cycle.  And so the Fed plays a game, a stupid game but what else can it do?  It orders rate cuts on key market days (options expirations) only days after it pretends it is worried about inflation; random Fed robots utter conflicting statements about the health or malaise of the economy-- all in an attempt to make it appear as though the inevitable rate cut is going to be canceled.  It's all about the Moral Hazard. 

But the game can backfire: if markets anticipate this is a game-- if they are sure there will be a rate cut, and they rise (Bank of America bought a stake in Countrywide, that's how sure of a bailout they are) then there's no need for a rate cut after all.   Which causes markets to fall...

But it's the wealth gap that we should be worried about, soon to be greatly increased.  Wealth gaps mean feudalism.  They mean, on the one hand, universal healthcare-- everyone gets the same; on the other hand, flow chart medicine-- since everyone gets the same, let's just make a flowchart. 

It also means mental health parity, which is really a way to funnel the poor into the only outlet we have to deal with their rage: psychiatry. 

(Part 4 tomorrow)

(Long BAC) 






Wealth gaps m... (Below threshold)

August 24, 2007 3:14 PM | Posted by Matt Platte: | Reply

Wealth gaps mean feudalism. They mean, on the one hand, universal healthcare-- everyone gets the same; on the other hand, flow chart medicine-- since everyone gets the same, let's just make a flowchart.

I don't understand these two sentences. Wouldn't a feudal arrangement provide healthcare for the ruling class few and not the many workers?

Vote up Vote down Report this comment Score: -1 (1 votes cast)
Good posts so far. Here's s... (Below threshold)

August 24, 2007 3:33 PM | Posted by Chui Tey: | Reply

Good posts so far. Here's some other examples of narcissm.

A guy borrowed a thousand bucks from his neighbour and has been losing sleep because he could't figure out how to pay the neighbour back. When he explained his predicament to his wife, she suggested that he talk with the neighbour about it. Upon hearing this, he pulled out of bed, opened his window, and shouted out in the middle of the night: "You know the grand you lent me? I can't pay you back!". Now he was able to sleep soundly.

But the neighbour wasn't.


With respect to U.S.'s debt to China. When you owe the bank a billion dollars, the bank owns you. When you owe the bank a trillion dollars, you own the bank.


Vote up Vote down Report this comment Score: 3 (3 votes cast)
Exactly. This article is... (Below threshold)

August 24, 2007 4:08 PM | Posted by Stephany: | Reply

Exactly. This article is on target with psychiatry, homelessness, debt, parity and society. Let's say for example, my lender gets my home via a foreclosure auction off of their books.They lose.I lose. I become homeless.I apply for state or Federal assistance, and still need psychiatric care, adding in medicaid and state or federal programs to support my need.As a result of using easy to gain credit cards, I paid out of pocket expenses for years for psychiatric care for a family member, which in fact is the reason I have nothing left but debt, and several ER hospital bills that remain unpaid due to insurance not covering it, and those were psychiatric visits. Now, I've applied for uncompensated care to pay those. If I survive all of this, I hope one simple outcome happens: sleeping at night with a roof over my head and not using psych meds to achieve that peaceful rest. Lenders will make more money from my ability to keep my mortgage current if I had flexible people working with me in my temporary crisis, when I am in between paychecks as a teacher's assistant. It behooves everyone to create a win/win situation. Keep us off the streets, off medicaid, and in our houses. Cheers.

Vote up Vote down Report this comment Score: 1 (1 votes cast)
I'm sorry if this sounds la... (Below threshold)

August 25, 2007 4:21 PM | Posted by Common Reader: | Reply

I'm sorry if this sounds lame and hippie, but I'm really disturbed by what it says about our society that people don't see the wealth gap.

Real world example: I live in a small town in the South that is stuffed to the gills with people who are pissed off that they can't afford to live someplace else, so they throw their disposable income and other people's tax money into cultural stuff - yoga studios, a community art center, film festivals - to pretend like it's just as good as Manhattan or San Francisco (but BETTER, cause there's better produce). Outside of the tiny area where there are people who can afford this stuff, it's pretty bleak. There's nice stuff for rich people - horses, fishing, that kind of thing - but ordinary people? There's church, tv, and drinking in smoky bars while listening to crunk. That's it. If you want anything else in your life but your grim, culturally desolate small town surroundings, you have to drive to it, and NO ONE CAN AFFORD IT ANYMORE. I think the mental health implications here are obvious.

How is this any way to run a society? Put some goddamn trains in so people can get away from their hard lives and do something wholesome one night a week, how hard is that? But that isn't going to happen because the people with the ability to put the trains in can't even see lower-income people anymore.

I recently spent some time in Singapore and one of the things that struck me was that while the income disparities are just as large (and in a way, in real terms they're larger since poor people in Singapore are way less comfortable than poor people here) because of the way the city is physically structured, 1)everyone has access to the benefits of the immense wealth being generated and 2) it's impossible to be ignorant about how the poorer people live. I'm not talking about taxing the rich here, either - I'm talking about how the beautiful Christmas displays were available to everyone, how for the cost of a cup of coffee any teenager can sit in a Starbucks and look at the bright shiny world of business and excitement, while here in my small town neighborhood, 30 miles away from Raleigh, I have neighbor with children who have never seen a skyscraper. I believe the industry term for this is "crazy."

Vote up Vote down Report this comment Score: 6 (6 votes cast)
Perhaps my confusion is sim... (Below threshold)

August 27, 2007 5:40 AM | Posted by Eric: | Reply

Perhaps my confusion is simplistic, but I fail to see the connection between universal health care and an expanded wealth gap.

At the very least, there's no pattern of wider income inequality than what the U.S. already has among countries with universal healthcare. Keeping in mind that Russia and Brazil supposedly have 'universal healthcare', I would still risk saying that one could draw rather the opposite conclusion: that functional universal healthcare is associated with countries with LESS income inequality. I'm not intending to draw a causal relation--I'm not sure comparisons can even be made (i.e. the Swiss model of 'universal healthcare' is not the same as the British model of 'universal healthcare' is certainly not the same as the Brazilian model of 'universal healthcare'). Nonetheless, I fail to see the line of causation that implies "wealth gap means feudalism means universal healthcare." Except that you consider all three to be bad.

For example, maybe you can say Finland is a 'feudalistic' country because its citizens are dependent on the government. And you can certainly say it has universal healthcare. But I don't know what standard of 'wealth gap' one could use that would make Finland a worse case of wealth gaps than the U.S.

Vote up Vote down Report this comment Score: 1 (1 votes cast)
Brilliant. OMG. Brilliant. ... (Below threshold)

September 3, 2007 11:47 PM | Posted by Common Reader #2: | Reply

Brilliant. OMG. Brilliant.

Narcissistic econometrics.

Can we have more posts on this?

"when you owe the bank a trillion, you own the bank" heh, good one.

Vote up Vote down Report this comment Score: 1 (1 votes cast)
Hi. I find your blog provo... (Below threshold)

September 15, 2007 11:00 PM | Posted by Stephen: | Reply

Hi. I find your blog provocative and entertaining. I could never do what you do, but I feel compelled to nag about one issue: please learn to use the subjunctive. Your otherwise excellent writing is like nails to a chalkboard when I see 'was' instead of 'were'. Thanks.

Vote up Vote down Report this comment Score: 0 (2 votes cast)
Great article. Where is pa... (Below threshold)

May 4, 2011 5:39 PM | Posted by Bonnie Butler: | Reply

Great article. Where is part IV? Thank you!

Vote up Vote down Report this comment Score: 1 (1 votes cast)