Wednesday, April 29, 2009

Visualizing Big Numbers

Fiatch has posted a great video clip that helps to illustrate what a $100 million budget cut looks like relative to a $3.5 trillion budget.

Tuesday, April 28, 2009


Lots of good blogs to read these days. The Rational Capitalist has one on the moral and logical contradictions of socialism and the welfare state: An Injustice of Injustice: Bossnapping vs. Capitalist Logic

So just what is"bossnapping"?
"Bossnapping” has become a popular technique in French labour disputes. Striking workers take their bosses hostage until they agree to demands

In regards to protesters and vigilante who are attacking businessmen, in particular bankers, he has this to say:

But, the expropriation of wealth is not the object of protest - it is the particular recipient of the loot that is being protested. Rather than fighting for the principle of individual rights or the trader principle, which would entail opposing government welfare both to businessmen and to the poor, these militants only attack the businessmen.

Capitalism simply requires the respect of all individual rights. I continue to be astounded by my well-meaning, hard-working friends who advocate the expropriation of honestly obtained wealth--for whatever reason--and who view themselves as fair and compassionate.

Coercion is neither fair nor compassionate--and neither are those who advocate it's use.

When do you call it torture?

The matter of torture is interesting, difficult and important. Some worthwhile thoughts on this topic are posted over at Back Talk.

Be Brave (And Be Serious): Draw the Torture Line


Monday, April 27, 2009

It's clearly time to use the "F" word

Fascism, also known as corporatism.

Where socialism sought totalitarian control of a society’s economic processes through direct state operation of the means of production, fascism sought that control indirectly, through domination of nominally private owners. Where socialism nationalized property explicitly, fascism did so implicitly, by requiring owners to use their property in the “national interest”—that is, as the autocratic authority conceived it. (Nevertheless, a few industries were operated by the state.) Where socialism abolished all market relations outright, fascism left the appearance of market relations while planning all economic activities. Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically.--The Concise Encyclopedia of Economics

Read this article from today's Wall Street Journal and see if you don't agree that our government is employing fascist tactics.

Busting Bank of America


Saturday, April 25, 2009

"They do not value human life."

Many of you already subscribe to the TIA Daily, but many of you don't. There are days I wish I could just cut and paste an entire issue of Robert's into this blog--and although he has given me permission to occasionally do just that, I don't want to abuse his kind offer. Yesterday he touched on a subject near and dear to my heart, both as a patient and as a physician: our current trend toward the further socialization of medicine.

Why further socialization? Because if you add everyone on Medicare and Medicaid to all the government workers and retirees (civilian and military) who receive insurance or health care though public means, our government has been supplying over 50% of this country's medical care for more than 30 years. Medicare and Medicaid were established in 1965, pushing the percentage up dramatically, but it took a few more years for the numbers to achieve a majority. As our citizens grow older, and a greater and greater proportion of jobs are subsumed by the government, this figure will continue to increase.

Robert's essay yesterday centered around his conversation with a Russian physician who immigrated to the US in order to protect his son from the destructiveness of the Russian system--not just its economic inefficiencies, but the racism and corruption that authoritarian collectivism injects into daily life and into the character of those not strong or savvy enough to resist.

Robert asked about Russia's socialized medical care system. Here is his description of the physician's reply:

His overall summary of Russia's culture of authoritarianism is that "They do not value human life." This was his introduction to the subject on which he was most passionate: socialized medicine. A major part of the reason he left Russia was because socialized medicine is just as intolerable for doctors as it is for patients.

Socialized medicine, he stated flatly, "doesn't work." Why doesn't it work? He explained that a doctor works for the state—not for his patients. So he spends much of his time filling out forms. "As long as the forms are filled out, no one cares what the patient says," how he is doing, or whether he survives.

He then went out of his way to point out that the current administration wants to move us toward socialized medicine. (He did not know my political views, so he had no idea how much I would agree with him on this issue.) "If they move us just a little bit, it will not be so bad. But if they move us a lot, it will be a disaster."

Keep that in mind during the coming debates over President Obama's plans for the de facto nationalization of our medical system.

With this horrifying description in mind, please read in full this latest report on the congressinal Democrats' plan to implement President Obama's massive restructuring of health care by using the budget reconciliation mechanism to circumvent Republican filibuster.

If we desire a system which values each individual human life, we must do all we can to halt and reverse this trend toward implementing socialized health care.

To my friends who are concerned about unequal access to medical services in this country, please keep in mind that government coercion is never compassionate.

Friday, April 24, 2009

A pollution to worry about

One of the greatest tragedies of the environmental movement is the political pollution of science. In the article below, two atmospheric scientists decry the deleterious effect that global warming alarmism has had on our ability to discover and understand the complex truths about the real workings of earth's climate.

COMMENTARY: Global-warming politics

Pure science victim of an empirical meltdown

In our combined 50 years of professional atmospheric and environmental science experience in government, academia, activism and consulting, we have observed a dichotomy between the real and the academic-bureaucratic worlds of environmental science.

Scientists and engineers who work hands-on in the trenches with real-world environmental-science challenges on a daily basis are skeptical of claims of a substantial influence on global climate from human activity.

Academicians who view the world from their computer screens, theories, limited field investigations and well-read published reports are not only true believers but avid promoters of the theory of anthropogenic global warming (AGW)...

Our serious interest in the environment, however, is not unreasonable concern. Much personal, professional and academic experience tells us there's much more to be learned about the hugely complex climate system. And simple, politically motivated declarations of supposed climate facts and proposed solutions to dubious anthropogenic contributions to global warming will only abridge a full understanding of the biosphere and humans' limited interference with its natural operation.

Already Shrugging


By Dick Morris And Eileen McGann


Wednesday, April 22, 2009

Wealth Day --an Earth Day Alternative

Good reads for Earth Day:

The Earth is Mankind's Gardenby Nicolas Provenso

Alternative Fuel Folly by Kimberly A. Strassel

The Anti-Industrial Coup by Robert Tracinski

James Hansen’s Former NASA Supervisor Declares Himself a Skeptic
by Anthony Watt

On Climate and Health, Beware of Easy Formulas by Michael Barone

As Keith Lockitch points out:

Regardless of one’s views on global warming--and there is ample scientific evidence to reject the claim that manmade carbon emissions are causing catastrophe--the fact is that kneecapping the fossil fuel industry while diverting tax dollars into expensive, impractical forms of energy will not be an economic boon, but an economic disaster.We in developed countries take industrial-scale energy for granted and often fail to appreciate its crucial value to our lives--including its indispensable role in enabling us to deal with drought, storms, temperature extremes, and other climate challenges we are told to fear by global-warming alarmists. If we want to restore economic growth and reduce our vulnerability to the elements, what we need is not “green energy” forced upon us by government coercion but real energy delivered on a free market.

Wayne Dunn sums it up nicely:
Clearly, a viable, cleaner form of energy...will not be created by some snarling rock-hurler, nor some land-confiscating government official, nor some loafer who nests with squirrels. A material value isn't going to spring from those who tell us to renounce material things. Innovations stem from capitalists pursuing self-interest, not naturalists preaching self-sacrifice.

Wealth is not the problem. Wealth is the solution.


Cutting out the Middle Man

Another post for today, once again over at simply Capitalism.

Other good articles to check out:

"Fiscal Nanosurgery," Investor's Business Daily, April 21

On the Urgency of Restructuring Bank and Mortgage Debt, and of Abandoning Toxic Asset Purchases by John Hussman


Saturday, April 18, 2009

Predicting from Principles

My latest post is over at simply Capitalism.

In it I discuss Henry Hazlitt's book, Economics in One Lesson, stating, "Written for the intelligent layman, this book can be read by an interested high-schooler" to which I'd like to add, "and possibly even a motivated middle-schooler (Andrew - you might give it a try.)"

Thursday, April 16, 2009

How much is too much?

Unfortunately, this list is incomplete.

"The government taxes you when you bring home a paycheck.
It taxes you when you make a phone call.

It taxes you when you turn on a light.

It taxes you when you sell a stock.

It taxes you when you fill your car with gas.

It taxes you when you ride a plane.

It taxes you when you get married.

Then it taxes you when you die.

This is taxual insanity and it must end."

-- J. C. Watts, Jr. (1957- ) US Congressman from Oklahoma (R), former quarterback in the Canadian Football League

(HT Liberty Quotes)

Wednesday, April 15, 2009

Happy Anniversary

Why my in-laws chose to get married on Tax Day I will never understand---although it's nice having a positive to balance out the negatives of today. I'm filing my return electronically and hoping that Gov. Schwarzenegger can find enough money to send me my refund.

Off to a Tea Party in front of the San Jose IRS building so no time today for an essay. I must admit I am feeling a bit odd about protesting. I don't think it's enough just to go wave a sign (mine will say "Liberty--the only stimulus we need")--but for the first time in my life, I think waving the sign is important too. I have done much more than stomp my feet and complain so it's far more than a simply having Tea Tantrum.

Here's some good reading for you to enjoy while I am off putting my body where my mind has been, so to speak.

Taxpayers Get Really Tea-ed Off Investor's Business Daily Editorial

Tax Day becomes Protest Day Glenn H Reynolds WSJ

Tax Injustice Day: Altruism vs. Americanism
by Ed Locke

Tax Cuts and the "Trickle Down" Economics Straw Man
by Thomas Sowell

Taxes and Prosperity Lost
by Walter Williams

A Wage Earner Against the Estate Tax
by George Reisman

Politicians Love the Tax Code We Hate by Steven Malanga

And for your viewing pleasure:

(HT Carpe Diem for several of these links.)

Tuesday, April 14, 2009

Yesterday was Tax Freedom Day- sort of

What is Tax Freedom Day?

Below is the brief explanation from the Tax Foundation, the organization which calculates it. (A more detailed explanation can be found here.)

How Tax Freedom Day Is Calculated

Tax Freedom Day answers the basic question, "What price is the nation paying for government?" An official government figure for total tax collections is divided by the nation's total income. The answer this year is that taxes will amount to 28.2 percent of our income, and the stretch of 103 days from January 1 to April 13 is 28.2 percent of the year. Income and tax data are then parsed out to the states, yielding 50 state-specific Tax Freedom Days.

This year's Tax Freedom Day comes a little earlier than last few years, but only because of the downturn in the economy. Not all states are equal however. I happen to live in the state with the 4th highest tax rate, so my Tax Freedom Day doesn't come until April 20th.

A more complete view of the tax burden government places on us is the Tax Freedom Day which includes the budget deficit----which is in fact simply a deferred tax burden and should be figured in. With the new deficit projections, we won't stop working for government and start working for ourselves until May 29. This is the latest date for "tax freedom" since similar levels were achieved at the height of WWII. The graph below only goes back to 1967, but the current trend is still impressive.

I found it interesting to note that the above dates are set by counting 103 days from January 1st, including weekends and holidays. If you just count Monday through Friday, the days you actually spend working, we don't starting working for ourselves until May 28th-- or if you include the deficit, not until July 28th!

Another very important aspect of these calculations is that these figures reflect the average tax burden. Since 40% of Americans don't pay income taxes, your individual tax freedom day will come much later. As Ari Fletcher points out, "A very small number of taxpayers -- the 10% of the country that makes more than $92,400 a year -- pay 72.4% of the nation's income taxes." As we approach the day when over 50% of the population do not pay income taxes, we come ever closer to the majority of voters receiving benefits from the government for which they do not pay. Talk about moral hazards!

"A government which robs Peter to pay Paul can always depend on the support of Paul."
-- George Bernard Shaw


Monday, April 13, 2009

Markets work--Use markets

Another good find by Kendall posted at simply Capitalism: Austrian Economists on the Crisis.

On, Arnold Kling and Russ Roberts, two economists with approaches heavily influenced by the Austrian School of economics, discuss key contributing factors to the current economic crisis along with the rationale behind many of the responses by government.

I have thoroughly enjoyed Russ Robert and Arnold Kling's contributions to the discussion on EconTalk and elsewhere. Both are informed, appear to be honestly curious and critical, and make attempts to engage the other side in a respectful manner.

This clip has many worthwhile take-home points, but perhaps my favorite is Kling's summary of the various approaches to government's role in the economy. As he put it:

The Chicago School (monetarists) say: "Markets work--use markets."

Keynesians say: "Markets fail--use government."

Economists from George Mason University (heavy Austrian influence) say "Markets fail--use markets."

Pithy, but not quite accurate. First off, monetarists are only partial advocates of the free market. Milton Friedman (and many others) believe in the market for goods and services, but support the government's role in the market for money through Federal Reserve manipulation of the money supply. Some in the Austrian School might say that markets fail, but that is because of how they are defining failure. If "failure" means that mistakes will occur, then all human activities (not just markets) are failures because humans are neither omniscient nor infallible--and never will be. Such a definition equates human life with failure!

I think the following formulation is more accurate and more helpful:

Markets work (as a discovery process.)
Governments fail in markets (by disrupting market discovery.)
Use markets.

None of the above formulations, however, address the other crucial aspect of markets vs. government. Free markets are based on voluntary exchange; government is based on coercion. Not only does government intervention into the market disrupt proper market functioning, but the way that it does so is to violate its primary raison d'etre: the protection of individual rights. One more, and perhaps the primary, reason to "use markets."


Friday, April 10, 2009

Tyranny vs. The Rule of Law

Great post at simply Capitalism on the current trend of increasing arbitrary use of government power. The author aptly points out that following the "forms of law" is not equivalent to "the rule of law." The essence of tyranny is unrestrained, arbitrary power. In passing a law which unilaterally changes the terms of a contract crosses the line from rule of law into the "rule by men." In so doing, Congress has violated its constitutionally limited mandate.

No Bill of Attainder or ex post facto Law shall be passed.

--Constitution of the United States, Article I, Section 9.3

Government: The ex post facto “Investor”

by Kendall Justiniano


Thursday, April 9, 2009

Blogging is not enough

The daily assaults to our freedoms have become almost overwhelming. My response has been to stay abreast of events as best I can, to study the history and functioning of our banks and the Federal Reserve, and to spend what time I can communicating what I learn to others. I've written to my congressmen---and received back mass-produced form letters, which make it painfully obvious no one actually read what I wrote. But to do nothing is to stand on the track with the train headed toward me. Here are two projects I am supporting to help counter the attacks on capitalism, the only system which will provide us with lasting peace and prosperity.

Speaking Up through Books

Atlas Shrugged is a story of high drama, depicting the consequences of a society that consistently acts on the anti-life premises of altruism and collectivism. One law and regulation at a time progressively denies individuals the fruits of their labor, simultaneously strangling and exploiting the ability of the productive to create wealth and value. The evolving economic dictatorship is both actively and passively enabled by the productive themselves as long as they continue to accept the moral premises which deny a man the right to exist for his own sake.

This story is today writ large. For a chilling example, watch this clip of bankers statements following a meeting with President Obama in which he warned them:

“Be careful how you make those statements, gentlemen. The public isn’t buying that.”
“My administration,” the president added, “is the only thing between you and the pitchforks.”

These are the kind of comments I would expect from a Mafioso, not my country's president--and yet they are completely consistent with the premise that individuals and the businesses they create must purchase from others their right to exist. Our politicians are all too willing to act as the "Public's" henchmen, demanding and accepting sacrifices under the auspices of The Greater Good. Originally written to restrain government intrusion into the private affairs of men, our Constitution has been reinterpreted in ways that severely weaken its ability to protect our inalienable individual rights. The story of Atlas Shrugged can help alert critical thinkers to the dangers we face right now as all three branches of our government steadily increase statist controls of both the socialist and fascist variety.* The trend toward bigger government and greater controls will not reverse until the consequences of the loss of liberty are grasped by the general population and that understanding is clearly communicated to our elected officials.

The second project I would like to showcase is an example of the kind of action which is open to us all.

From what I can tell, the originator took an idea, created a website and a means to collect contributions in order to fund his idea, and now is spreading the ideas of liberty one kit at a time. Here is his mission in his own words:

The Lucidicus Project is an independent educational initiative designed to encourage medical students to think about the foundations of individual rights, and consider what a social system built on the consistent defense of such rights would mean for medicine and healthcare.

Our mission is to provide the Medical Intellectual's Self-Defense Kit to medical students in the United States and around the world. The kit contains books and other resources that define and clarify the meaning of important concepts such as rights and capitalism, and demonstrate how they relate to medicine and healthcare. Every few weeks, we also publish editorials that comment on current issues.

This project exists and grows thanks to the voluntary donations of its supporters. Kits are distributed free to qualified medical students, and there are no membership fees or registration. If the preservation of individual rights is important to you, and if you support the work we do, then please consider contributing to The Lucidicus Project today.

The website also allows contributors to see where their money is going. Beginning with the first recipient in 2005, a brief paragraph introduces each student who has received the kit, dispelling the anonymity which helps preserve a disconnect between our ideas their real-life consequences. Each law and regulation passed that restricts or controls the ability of physicians to offer their best advice and judgment to their private patients (a.k.a. us) acts as a damper on the minds and spirits you see depicted in these bright, young and optimistic faces.

There is much to admire in this project. It's grassroots nature. It's promotion of exposure to ideas. The inclusion of recipients who agree, disagree and are not quite sure. The demonstration of the effectiveness possible by targeting a specific audience with a clearly delimited and focused goal. The example of benevolence in action, both in the tone of its text, as well as through its coordination of voluntary interactions on multiple levels: the contributors, the recipients, and the creators of the materials.

I hope you will help these projects grow.


*"Where socialism sought totalitarian control of a society’s economic processes through direct state operation of the means of production, fascism sought that control indirectly, through domination of nominally private owners. Where socialism nationalized property explicitly, fascism did so implicitly, by requiring owners to use their property in the “national interest”—that is, as the autocratic authority conceived it. (Nevertheless, a few industries were operated by the state.) Where socialism abolished all market relations outright, fascism left the appearance of market relations while planning all economic activities. Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically."--The Concise Encyclopedia of Economics

Wednesday, April 8, 2009

Perverse incentives

If you tax something, you will get less of it.
If you subsidize something, you will get more of it.

Keep this in mind while contemplating the following:

When businesses are taxed, production is taxed at least twice, and frequently more often: first, as corporate income tax, and then again when individuals are taxed on investment returns (dividend income and capital gains) --and the investments themselves were bought with previously-taxed personal income! Postmortem estate taxes add yet another layer of wealth expropriation by the government.

Then consider that interest expense and business losses are tax deductible. Multiple government programs exist to make "home ownership" (i.e. mortgages) more affordable. Failing businesses are (repeatedly) subsidized through government bailouts.

Production is taxed multiple times.
The cost of debt and failure is subsidized.

If you tax something, you will get less of it.
If you subsidize something, you will get more of it.

Government policies are the root cause of these artificial, inverted incentives. It is precisely these incentives which encourages excessive debt and risk-taking, and which in turn have led to the instability and eventual collapse of so many financial institutions. The solution is "Separation of Market and State" thus releasing proper market forces to supply the natural incentives of profit and loss with the resultant discovery of the most efficient use for scarce resources.

Wealth is not the problem.
Prosperity depends on production.
We need to let the producers produce, and reward success, not failure.


Tuesday, April 7, 2009

Women's Rights

The world is a little poorer now. Last week, after putting up a good fight against cancer, one of my neighbor's took her last breath. Petite. Gracious. Soft spoken, but very determined. Always with a twinkle in her eye. She was a gentle but persistent advocate of education for girls and women. A 50-year member of the American Association of University Women, she convinced me to attend a few lectures sponsored by the local chapter. The lectures were given by independent accomplished women. Interesting. Informative. Enjoyable.

Mickey had warned me that many in the group support political ideas she did not. (Both she and her husband are staunch believers in limited government.) The national office of AAUW promotes the use of government force to implement their platforms: lobbying for funding and the passage of special interest laws. The local chapter, however, raises money through voluntary donations to provide scholarships for girls. The Local Scholarship program was my neighbor's favorite project and the day before she died, I learned part of the reason why. Visiting with her husband while he kept vigil in the Comfort Care section of the hospital, he told me how Mickey had put herself through college. Her parents had refused to help because they wanted her to simply marry and have children. This was not her vision for herself, so she worked and paid her own way. Quite an accomplishment for anyone, but even more remarkable for a single woman over 60 years ago.

When I read today's TIA Daily, I thought of her. She appreciated the fact that, in this country, she was free to work for giving girls a better chance through higher education because we have already respect and protect women's rights as individuals.

Women's rights and the treatment of women are a profound measure of the progress of a civilization, for a reason that modern feminists will not necessarily acknowledge: because women are the weaker sex. I mean that women are physically weak relative to men, who are on average much larger and stronger, with a far more developed musculature. Thus, the treatment of women in a society is a revealing measure of that society's attitude toward physical force.

In a society where might makes right, where the rule of brute force has been thoroughly unleashed, women are always the first victims. Even the poorest and meanest man, the guy on the lowest rung who is oppressed by others above him who are bigger and stronger—even he can find one person he is still able to dominate and oppress: a woman, whether it is his mother, his wife, or his daughter. And he will oppress her—if the oppression of others by force is the accepted norm of the society he lives in. For examples, look to the Muslim world with its "honor" killings, arranged marriages, sexual segregation, and special restrictions on the travel and attire of women.

This is a complete contrast to the kind of society in which force is subordinated to morality. A society in which a woman can do whatever she wants without fear is a society in which the physically weak can rely on being protected from the physically strong. In fact, in a civilized society the physically weak feel safe because of the physically strong. The mark of such a society is a sense of chivalry—the idea that a man's superior physical strength is properly used to protect rather than to dominate, to serve the cause of justice and freedom rather than to assert arbitrary power over others. -Robert Trasinski, TIA Daily 04-07-09 "Women's Rights as a Measure of Civilization"

Life. Liberty. Property and the pursuit of happiness--for all. Men and women. Weak and strong.
Establish these, and we all can flourish and pursue our dreams.
Thank you, Mickey, for a life well lived. For your spark of light which brightened the world with its determined benevolence. You will be missed.


Monday, April 6, 2009

Too Big to Succeed ( Intro)

I considered summarizing the article in the post below but decided that since the article speaks so well for itself, my time would best be used in other directions. The Freeman generously gives permission to reprint articles accompanied by appropriate credit, and so I am taking advantage of their offer.

In "Too Big To Succeed", from the April 2009 issue of The Freeman, Less Antman provides fascinating context to the ballooning of credit default swaps (CDS) and their contribution to today's financial debacle. The background Antman provides is one more (detailed) illustration that it decidedly is NOT free market forces which brought us today's instability, but rather the effects of government regulation and the failure of central planning. Antman explains how laws and regulations denied public trading in CDS, forcing them into the "shadows," away from public scrutiny and corrective market forces.

The April issue is now posted on The Freeman website. I also recommend you check out a few other articles. "The trouble with Keynes" by Roger Garrison outlines how Keynesian economic theory provides the (false) justification for shifting trade decisions away from the market (and efficient use of scarce resources) to government (and politically-motivated control of scarce resources.) Grennady Stolyarov, in his article "Globalization: Extending the Market and Human Well-Being," discusses the benevolent effects of the free market and the division of labor on promoting improved international relations as well as raising the standard of living for everyone. He concludes his article with an argument for lifting of all trade restrictions--pointing out how even if done unilaterally, the freest country will benefit most.

Several other article are worth reading, but those were my favorites.

Too Big to Succeed (the article)

Too Big to Succeed

by Less Antman, April 2008, The Freeman

One widely cited culprit for the 2008 financial crisis was a supposed decision by the government not to regulate a relatively new type of financial instrument known as a credit default swap (CDS). In fact, this so-called "failure to regulate" refers to regulations that prohibited public trading of these instruments, concentrated risk in a small number of large firms, and massively increased the probability of a financial disaster. To add to the irony, one of the government officials most responsible for these interventions, then-Federal Reserve Chairman Alan Greenspan, recently apologized for having had too much faith in the free market when he should have apologized for not having had enough.

In 1999 Brooksley Born, head of the Commodity Futures Trading Commission (CFTC), tried to bring CDSs under the regulatory umbrella of her agency. Born was stymied by Greenspan, Treasury Secretary Robert Rubin, and Securities and Exchange Commission Chairman Arthur Levitt. She eventually resigned and the dispute was effectively settled in 2000 by the passage of the Commodity Futures Modernization Act(CFMA), which prohibited the CFTC from any further examination of CDSs. Details of the dispute can be found in an October 15, 2008 Washington Post article titled "What Went Wrong," by Anthony Faiola, Ellen Nakashima, and Jill Drew. But the article itself went wrong when it saw only deregulation and free markets in a fiasco caused by regulation and central planning. It failed to consider the full implications of the CFMA itself, nor did it address the disastrous side effects of an international agreement known as the Basel Accord, both of which made credit default swaps anything but a free-market failure.

Who's in Charge?

As neat and tidy as it might be to portray Born as the advocate of regulation and Greenspan, Rubin, and Levitt as opponents, it was actually a dispute among government officials over which of them should be in charge. The confusion derives from the nature of CDSs themselves.When someone borrows money the lender is always concerned about the possibility that the borrower will not repay the loan. There are various ways for the lender to protect against that risk. The lender can sell the loan to someone else, who assumes both the right to collect the payments and the risk that the borrower will fail to make them. The lender can require the borrower to find someone willing to guarantee the loan-that is, someone who agrees to pay if the borrower defaults. Or the lender can make a separate contract with an unrelated third party who, in exchange for a premium paid by the lender, agrees to make the same guarantee to pay the lender if the borrower defaults.

A CDS is an example of the third option. The party paying the premium-the lender in this example-is considered the buyer of the CDS. The seller of the CDS is essentially providing default insurance, so a CDS can be viewed as an insurance contract and might be subject to regulation by government officials who oversee the insurance industry.

It is also, however, a form of derivative-a contract -hat derives its value from another asset or contract (in his case, the actual loan), but which can be settled separately by a payment of cash or some other highly liquid asset. In fact the parties to a CDS don't actually need to have any relation to the loan: You and I can enter into a CDS in which I pay you a premium and you promise to pay me money in the event General Motors defaults on bonds that neither you nor I own. In this case, you and I are both speculating (or gambling) on a possible future event and neither one of us can be described as insuring the other against risk. Thus a CDS may be viewed as a form of futures contract and might be subject to regulation by government officials who oversee the futures industry.

Many of the biggest players in the CDS market turned out to be banks. Only about 40 of the more than 5,000 banks in the United States traded CDS contracts, with three of them-JP. Morgan Chase, Bank of America, and Citigroup-trading more of them than all other banks combined. Commercial banks ended up as major buyers of packages of loans known as mortgage-backed securities that were protected by credit default swaps, and many investment banks were involved in these transactions. Thus a CDS may be viewed as a product supporting banking and lending and might therefore be subject to regulation by government officials who oversee the banking industry.

Finally, since an overwhelming percentage of credit default swaps are associated with either publicly traded bonds or publicly traded mortgage-backed securities, a case could be made for classifying a CDS as a form of investment security, which might be subject to regulation by the government officials who oversee the securities industry.

Despite the Post's portrayal, Born may actually have come the closest to advocating a free-market policy. Although she was never able to get far enough to develop her ideas in detail, as head of the CFTC she likely would have had the authority to regulate CDS contracts that were traded on public commodity futures markets. The three men opposing her prevented these contracts from being publicly traded at all. As a result, credit default swaps could only be traded privately, keeping this market in the hands of a relatively small group of big players whose subsequent missteps might have been prevented or their impact minimized by such public trading.

Private Versus Public Trading

The distinction between private and public trading is important. Private contracts are those resulting from one party directly contacting another and negotiating a mutually acceptable agreement. While government courts claim jurisdiction over the enforcement of these contracts, the content of the contracts is generally up to the two parties.

Starting with the Securities Act of 1933, however, the federal government defined certain financial transactions as public matters and claimed the authority to regulate or prohibit them. Any contract that results from advertising or general solicitation, any use of an exchange that makes it possible for buyers and sellers to be matched up without knowing each other, or even the mere fact that one of the parties is an individual with a net worth under $1 million and an annual net income under $200,000 can be sufficient to claim the contract is a public matter.

The Commodity Futures Modernization Act, by prohibiting the CFTC from regulating credit default swaps, prevented it from authorizing public trading of CDSs on futures exchanges. In other words, the CFMA regulated public trading in the severest manner possible: It forbade it.

With only private trading permitted, the general public was effectively excluded. Furthermore, remember that private contracts must result from direct negotiations and that there is a prohibition on providing any public information about them that might be deemed advertising or general solicitation. This provided an overwhelming edge to the biggest players \who traded them the most, as the high costs of concac::i1g potential counterparties, negotiating contracts individually, and compiling private information created enormous economies of scale. Thus the federal government didn't merely declare credit default swaps off-limits to the CFTC; it also effectively created a trading cartel for the largest banks, insurance companies, and hedge funds catering to wealthy investors.

Credit default swaps were invented by a team led by Blythe Masters of J.P Morgan in 1997 as a tool for hedging the risk of default on loans. In a truly free market, regulated exclusively and severely by Messrs. Profit and Loss, she would today be hailed for this great invention. Prices are information, and the cost of a freely traded credit default swap provides a far better estimate of the risk on a debt instrument than the opinion of a credit rating agency that doesn't personally suffer from a default and expresses its opinion in the form of letters. The meaning of a AAA or BB rating is vague and debatable, while a CDS priced at 1.08 percent on an 8 percent bond indicates that it is the equivalent of a risk free 6.92 percent bond.

Furthermore, making the risk tradable would allow virtually all of us to choose, if we wished, to include small amounts of CDSs in our diversified investment portfolios. We could increase our personal investment returns modestly in exchange for sharing in a tiny portion of the total risk associated with lending. We wouldn't all need to become experts in them. Mutual funds could put together diversified portfolios of CDS contracts and develop track records to draw our investments, and asset managers would have the incentive to become more informed in order to serve clients better. As a personal financial adviser, I would love to have that option for the client portfolios I manage.

Finally, the widespread trading of CDS contracts would help minimize counterparty risk-the danger that the party with whom we've contracted will not honor his obligations. With many people able to trade them, the portion held by anyone player could be reduced and those who overexposed themselves to risk would have a ready market to hedge their own activities.

How Government Made the CDS a WMD

Unfortunately, government intervention helped make credit default swaps toxic. The explosion in the use of CDSs was not a free-market phenomenon. In 1988 the Basel Committee on Banking Supervision, an international body made up of representatives from all the major central banks, produced the Basel Accord, which went into effect in 1992 in the United States and most other participating countries. The accord set capital requirements for all banks that weighted assets based on their risk. The Basel II Accord was signed in 2004 to refine the requirements.

Under the Basel Accords the lowest capital requirements for a bank were not for the loans they personally originated and understood best but for AAA-rated securities. The safest direct loans are home mortgage loans to borrowers with excellent credit whose loan amounts don't exceed 80 percent of the property value. These loans to "prime" borrowers have a risk weighting of 35 percent under Basel II. But if such loans are packaged into a mortgage-backed security rated AAA, the risk weighting is only 20 percent, reducing the amount of capital the bank must keep on hand and increasing its profits. Thus a bank has the incentive to sell the loans it has originated and replace them with AAA securities. Indeed, Basel II virtually mandated that banks sell their loans if they wanted to be competitive. The biggest buyers, Fannie Mae and Freddie Mac, two government-sponsored enterprises operating as profit making businesses, benefited enormously from this regulation-inspired activity.

Not all loans are to prime borrowers with large down payments, however. Because of various government mandates, such as the Community Reinvestment Act, incentives were created to lend to less creditworthy borrowers with low or no down payments. Although most of these loans were not made by banks, they too were packaged into mortgage-backed securities, and many of them found their way to banks as AAA-rated securities.

How so? Why would a package of loans to subprime borrowers get the same high rating as a package of loans to prime borrowers? Through the magic of a CDS. Although the loans themselves might have a high risk of default they were protected by credit default swaps sold by entities that were themselves rated AAA, such as AIG Insurance, and CDSs were given AAA ratings as a result. A package of subprime loans might be rated BB (below investment grade), getting a prohibitive 350 percent risk weighting under Basel II, but that would be reduced to 20 percent weighting as a CDS-protected AAA security.

This was an international phenomenon. In September a report of the Center for European Policy Studies described the bailout of AIG Insurance by the Federal Reserve as a bailout of the European banking system. AIG was exposed to nearly a half-trillion dollars in credit default swaps, $300 billion of it to provide regulatory capital relief to European banks subject to Basel II. On September 15, 2008, the credit-rating agencies Standard & Poor's and Moody's downgraded AIG's debt rating. Ironically, the price of credit default swaps on AIG itself had been rising for months, demonstrate the superiority of CDS pricing to credit ratings in the timely identification of borrower difficulties. This triggered contractual obligations for AIG to post tens of billions in additional collateral to guarantee its own ability perform on the CDS contracts it had sold. There was some evidence that AIG could have arranged financing through various hedge funds or American banks but it apparently didn't like the terms of these loans. It obtained a better deal from the Fed, even though the central bank has no oversight authority with respect to insurance companies. Had AIG not been able to post the additional collateral, the CDS protection it offered would no longer have preserved the AAA ratings of the securities in the European bank portfolios it was insuring, and capital requirements would have increased by as many as 16 ½ times for some of the assets held b\- these banks.

Jury Still Out

So how significant were credit default swaps in the financial meltdown of 2008? For the firms that went bankrupt such as Lehman Brothers, or those that were taken over, such as Bear Stearns, or those that had to cede significant control in exchange for government bailouts, such as AIG. wry. They were big players in the CDS market who made some bad bets and failed to hedge their own risks.

It is not nearly as clear that there is any systemic problem with credit default swaps. In a November 15, 2008 article, "The Meltdown That Wasn't," the Wall Street Journal noted, "Lehman Brothers was supposed to be exhibit A. The firm was on one end of roughly $5 trillion in CDS contracts, according to Moody's, and Lehman was itself the subject of $72 billion in CDS, in which other investors were betting on Lehman's success or failure. Here was the doomsday scenario, with a major player in CDS going bankrupt. It turned out to be the meltdown that never melted."

Lehman failed and the government let it fail. There is no evidence the liquidation had anything to do with problems for any other player. Businesses go bankrupt all the time, and it is best for the long-term health of an economy that incompetent managers cease to manage.

Credit default swaps didn't melt down at all. The market for them continued to function smoothly even as tl1euaditional credit markets were struggling. There were many causes for the housing boom and bust that played me biggest role in the financial panic of 2008, and it is quite plausible to wonder if CDS contracts are being scapegoated to distract from other more likely villains. The role of CDSs in satisfying regulatory capital requirements appears to have been a major reason for the explosion in their use. If there is any failure there, it is in the unforeseen consequences of the regulations that came from the Basel Accords. They should be modified or repealed.

The Born Supremacy

Still, had Born gotten her way in 1999, many good consequences might have come from it:

1) Publicly traded CDS contracts almost certainly would have priced the risk of various debt instruments more accurately than the credit-rating agencies have done. As mentioned, CDS prices showed AIG was in trouble before the rating agencies acknowledged it.

2) Large players in the CDS market would have had a convenient way to hedge excessive risk exposure without being limited to hedge funds, big banks, insurance companies, and the federal government.

3) The inefficiencies in pricing that have allowed players such as J.P

Morgan Chase to make large profits on the basis of superior information would have been replaced with a more efficient market and level playing field.

4) Individual investors would be able to diversify portfolios more and earn some of the returns available in this market instead of being available only as taxpayers to bailout the incompetent.

5) Counterparty risk would be massively reduced by the much greater number of participants in the market.

Born may be getting the last laugh. In October 2008 the Chicago Mercantile Exchange announced plans to establish exchange trading of credit default swaps. In spite of the posturing of some politicians there is enough recognition of the benefits of derivatives to ensure that the markets for them will be expanding rather than disappearing. While we can only hope exchange regulation will be limited to the enforcement of contracts, regulated public trading is better than none at all.

The democratization of credit default swaps has begun. Greenspan, Rubin, and Levitt may have meant well in trying to limit CDS trading to big players, figuring that the public wasn't ready to assume the risks associated with new financial instruments. Unfortunately the massive taxpayer-financed bailouts have shown that the public was going to bear the cost of failure in any event, and the primary result of their elitist attitude was to concentrate risk unnecessarily within a handful of firms whose exposure made them too big to succeed.

Saturday, April 4, 2009

A Crisis of Credit

There is a strange idea abroad, held by all monetary cranks, that credit is something a banker gives to a man. [Or or government gives to a bank, or to an auto company.] Credit, on the contrary, is something a man already has. He has it, perhaps, because he already has marketable assets of a greater cash value than the loan for which he is asking. Or he has it because his character and past record have earned it. He brings it into the bank with him. That is why the banker gives him the loan. The banker is not giving him something for nothing.

--Henry Hazlitt, Economics in One Lesson