The Markets could use some Pepto Bismol

As the stock market continues another whipsaw reversal of recent gains, counter intuitively 90 minutes after the largest deposit institution in the country reported double the profit from a year ago – I have one question: how is it possible that the markets, particularly financials, will not recover? Even disregarding the across the board strong profits of the remaining major financials in the last quarter, I defy anyone to explain how the fundamentals will not lead to a strong rebound in the mid-term (becoming shorter every day). Another interesting question is how much of the major bankruptcy and wealth destruction we’ve seen is a result of the bubble bursting versus people reacting to the bubble bursting? Washington Mutual for instance had significant write-downs on mortgages, but it also had $16b in withdrawals in its final week and a 90% drop in common share value over just 6 months. A situation like this will throw any company into trouble, whether it has a toxic or fortress balance sheet.

This is an especially interesting question because writedowns on assets are not losses. One, they are not realized, they don’t represent an actual outflow of cash, just a revised downward multi-year estimate which effects the current valuation, and two, they only really effect cash flow to the extent the market reacts adversely. Write-downs are serious and hurt balance sheets, but it is generally a very long-term signal with a lot of noise. Long-term because mortgages and bonds typically have a maturity lasting decades, and noisy because the characteristics of these securities as a whole is always changing based on the current underwriting standards of newly issued assets. But the market (read herd) takes this rather broad signal and immediately forces a translation into very short-term price signals. And I’m not sure the conversion factor is always spot on. To date the banks have written off several hundred billion in mortgages from their balance sheets, a significant shock no doubt, while the stock market has shed over $2 trillion in wealth. In other words, the market capitalization losses sustained is something like six times the actual writedowns. This is an even stronger shock when there is a run on existing contracts, from deposits to insurance product. The government realized in the 20s the unnecessary and preventable impact such reactions could have, and the FDIC has largely prevented it in commercial banks. That no such authority existed for multi-unit banking corporations like AIG or Lehman was rather remarkable considering how central to the financial system they had become.

Rather ironically, the only long term threat I see to robust bank recovery is the federal government. Unless people suddenly break a 10,000 year tradition, people will need shelters, likely, I know this is a stretch, in the form of houses. The rate of population growth and replacement dictates that about 1.3 million new homes need to be built in the U.S. as an annual baseline. In the last 12 months something like 400,000 were built. So the actual housing recovery timeframe is just a function of how big one thinks the bubble is, how big the surplus inventory is. I don’t think it’s much above 1 million, and we’ve already burned off about 900,000 of it. The rubber should finally hit the road soon. And once we get back to a supply-demand driven housing market, it’s hard to imagine that all these homes won’t require financing. In fact, 99.9% of them will. Pretty much everyone who doesn’t have a Louis-V with a milli in it like Lil Wayne will need the services of Bank of America or Citi or Wells Fargo. Thus, their first quarter earnings don’t seem to be mirage at all, more like a harbinger.

So there is more recovery in the pipeline, particularly when most of the recent earnings came from fixed-income arbitrage in a historically robust bond market. I have yet to hear anything close to a lucid argument that explains how housing and finance will not recover. And because prices have been falling for 16 months now, when it does turn it will likely have some strong inflection points. Balance sheets could reinflate relatively quickly as sideline homebuyers finally get on the field. The only potential long-term complicating factor here (assuming underwriting standards improve) then is the little issue of either servicing the government’s preferred stock loans, or worse selling off their common stock should they choose to convert it. The government should only consider converting their shares to equity if the stress tests show huge gaps that can absolutely not be filled any other way. And considering Citi, BoFa, JP Morgan, Wells all have 10% plus Tier I capital, and Treasury has $100 billion in the vault from TARP, and Goldman and Morgan already want to payback, I think the extent to which this has already been considered and bantered about as a serious idea is borderline irresponsible. We already know the market’s response to this rhetoric will dwarf the actual effects of any such real action. In fact, if the current sell-off continues investors can literally do whatever they want.

GM/White House need to think outside the box

The auto industry bailout should be a coordinated framework to re-imagine personal transportation in this country- including electricity providers and boutique next generation auto startups, not just two imperiled giants. Focusing simply on making GM and Chrysler cash flow positive with newly innovated offerings and lower debt burdens might do the job, but it ignores how integrated and market-infrastructure dependent the auto industry is. After this perfect economic storm, there will very likely be little space in the future for the government to intervene wholesale across the financial and auto landscape as they have in the last 6 months, and little opportunity to bridge the auto manufacturers and electricity producers’ interests.

The Administration only has so much credibility in lecturing the private sector how to make a buck, and only so much room to leverage the benefits of examining the sector in totality. By focusing on the manufacturers in isolation, the government risks supporting fuel efficient vehicles while leaving electric infrastructure developers on the sidelines. The Energy Department has $100 billion in new loan/grant authority, and could indirectly support the automakers by investing in companies like Better Place and Coulomb that develop the electric fueling stations that are a prerequisite for any true Detroit game-changers. The plug-in electric gas hybrid Chevy Volt will be substantially more expensive than an average car to begin with, curtailing sales and lengthening innovation cycles while stalling recovery. Costs will come down only with significant volume, which is a mere pipedream absent a national charging network. And in a world poised to add a billion new cars in China and India in the next 20 years, this is no longer just a matter of pristine design, but self-preservation. Making sure the market infrastructure is there when the new Volt rolls off the line is just as important as making sure they have competitive compensation agreements or streamlined supply lines.

Similarly, private startups operating today at the forefront of auto development, like Tesla Motors, could benefit from the breadth and relative financial depth of the big automakers, while the big automakers could benefit from their new platforms and next generation technology. Joint operating agreements or tech for equity swaps could speed up the bigs’ innovation while giving struggling and investment heavy startups (Tesla is asking for government cash) the market exposure they need to drive costs down. A note of caution however, this is not to say the government should impose anything. The big prize that awaits in the coming years and decades for clean energy winners, and the fierce competition among private actors it will engender, is a catalyst that should not be muted. However, the government and its auto task force is the perfect forum and moderator for getting these parties in a room to talk and see what pencils out. At a minimum they could talk about the non-exclusive aspects and infrastructure they will all need and brainstorm a general strategy, and at most cut some very lucrative deals.

It’s always the time for bold thinking, but very rarely is there the opportunity to actually implement it. The current public appetite for grand new economic architectures (whether TARP or TALF or the Legacy private-public partnership or the auto bailout or the Housing Plan or the Stimulus) is fast dissipating. Ad hoc investments in whatever the market would bare got the industry to this point, and ad hoc government negotiations and a spattering of tiny grants all over the place will just be further death by a thousand cuts.

A Simmer Down Now

Nobel winning economist and liberal zeitgeist Paul Krugman suggested today with a straight face that we return to a financial system, as he put it “like the 60s” - pure depository institutions saving and lending with little to no securitization or hedging. He also seemed to half-heartedly pick a fight with Larry Summers. I hope Larry will put down his 17th diet Coke of the day for a moment and take 20 minutes to draft a response for next week’s Financial Times. It would be a debate we would all benefit from. But then again maybe Summers thinks Krugman’s argument is too much of a straw man, too weak and unthreatening to solicit a response.

Krugman’s general sentiment is dead on, in that the financial system of the future cannot replicate the one we’ve just had. But this does not mean we have to roll back all financial innovation in extremus. This doesn’t mean we need to purge Wall Street or banks of anything that is a little complicated. I think more than anything else it means we just need more checks and balances, or in some places the creation of them, like over the counter trading. And it means we need to “keep it simple stupid.” The experiences of the last 6 months are not so much about the creation of new or wildly complicated financial products, as it is a reminder that firms need at least 5% or so cash on hand and need to verify the information their loans are based on (e.g. mortgage applicants). If these two things had been in place we wouldn’t be here today, and Krugman would not have the bully pulpit to adopt his pseudo neo-Ludite financial perspective.

Look at it from the perspective of a newly graduated college student with a decent job, who wants to buy her first house. The ability of this person to get a loan, and the interest charged on it is directly related to the willingness of banks to provide it. A typical bank will have 90% of their portfolio seeking a return in some respect. A good deal of these will be wrapped in recourse debt instruments to provide diversity, and often produce a margin via selling. This diversity represents more risk control for the banks and thus confidence to lend, and this margin represents more money the bank can lend, and thus more favorable credit terms for our post-collegiate house owning aspirant. And the security is only unsustainable, only contributes to a bubble, if the face value is below the current value of the future cash flows – e.g. if significant numbers of those who borrowed the consumer debt that stands behind the security will not actually pay up. This risk can be prevented quite easily with accurate information about the borrowers. This is widely applied today in the government’s new housing plan, which won’t deal with potential borrowers above a 38% debt/income ratio. Of course, to determine this you have to actually record this information. A greasy-haired condo pusher in El Paso wasn’t always accurately reporting this information to banks, surprise surprise! and banks were eager to make the deal anyway to push it up the chain. But this little scheme does not mean securities cannot be properly valued. In fact it just means the Fed needs to require actual records of income to be reported, as they did in February. So, securities can actually be worth more than their market price, and it’s good for the investor who sees a profit, good for the banks who generate more financing, and good for our college grad who can afford a slightly better house on better terms. Krugman would have us, in one radical fell swoop, nix this whole concept. Dangerous idea.

The other part of his argument attacks the big spooky market of derivates, e.g. futures, options and swaps- concepts that have only been around for hundreds of years- from farmers wanting to protect their crops from future unpredictable weather to British spice traders who didn’t want their global deals to be subject to the volatility of foreign exchange currencies. Derivatives just allow risk control, and if you happen to control this risk yourself, an incentive to do so in the form of profit. And yes, rules need to be in place. Like the degree of leveraging and collateral, or who’s trading where- tracking all this is in the works. Yet high finance is not the only place where Lord of the Flies will play out if there aren’t basic rules, and this caveat is no reason to pick on Wall Street. The credit default swaps (you will swap money for my asset if it turns out to totally suck) fiasco with AIG was not a result of the derivatives or futures system, but because they invested in a bubble (quite happily) and didn’t have nearly enough cash on hand to meet their obligations. Options and swaps are banks’ insurance, and without them they will understandably lend a lot less. Which means Krugman’s argument hurts just about everyone who wants to ever use money for anything. We require insurance for a $2,000 Datsun with 270,000 miles, it's the law, why would we not have insurance on $1 billion in mortgage loans? Or 20 million barrels a day of crude that we import? Or pensions? Or… Risk control is paramount and lowers the costs of financing and increases the availability of productivity enhancing capital. Keep it simple stupid.

Cap n’ Trade = Tax n’ Trade = Tax n’ (Bubble + Windfall)

There has been a lot of talk about a market-based cap and trade system as the ticket to a clean energy future. It’s a good solution. It could work. But it also carries significant risk, risk that a revenue neutral price signal (tax) would not. A recent MIT report highlights the expediency involved in getting climate policy right the first time. This 2009 study projects a median increase of 5.1 C (9.2 F) by 2100, up from a 2003 projection of 2.3 C. This kind of warming will have serious implications on everything from biodiversity to agricultural and forestry production to sea levels on a scale of meters. Any policy the United States seriously puts in place will take years. The EPA for instance has just completed a draft mandatory reporting rule for every producer that emits more than 25,000 pounds of GHGs a year, about 13,000 in the U.S. It has taken years of dialogue to get to this point. The rule still has to be finalized, then a registry set up ands tested, and then the actual cap would have to be developed, and then a tidal wave of litigation resolved. The point is, after all of this is sorted through, the system we get better work. Because of the potential for bubbles, price manipulation and windfall profits in a cap system, there is an elevated risk that it might not. The resultant public pushback and backlash in Washington could very well cause significant modifications if not outright repeal of such a system.

There are three basic issues with a cap system: 1) it’s just a nicer word for a tax because a cap creates scarcity which increases prices 2) even if the permits are auctioned off at the outset if can still result in huge windfall profits that can distort markets and create bubbles and 3) there is an implicit trade-off between price volatility and emissions reductions. This last point is because there is either a price ceiling or there isn’t. Without one, prices can be as high as the market will allow. In the case of the acid rain market, permits got above $1,000/ton and last year showed 75% year over year price volatility. This is far from good for businesses, investors or consumers. And this is in a market where there are readily available technological substitutes. Low sulfur coal is abundant. Scrubbers that capture SO2 and NO2 exist and are cheap. The same is not true for GHG reductions, so there is every reason to think that without a ceiling the price in the GHG market would be higher not lower than the already very high-priced and volatile acid rain market. However, if there is a ceiling, it is maintained in the same way the Federal Reserve targets interest rates, by open market operations with a reserve of credits. In the Fed’s case, reserves in cash, in the GHG market the reserves would be GHG credits. But what happens if you run out of these credits held in reserve? In other words, what happens if it takes more credits than have been set aside to deflate the price to the level prescribed in law? Well then you just create more permits, oh and there goes the whole point of the system – because you’re above the cap, e.g. you’re not reducing emissions which is a primary purpose of the system.

And it is often said that the issue of windfall profits, assigning private rights to a previously non-exclusive public good (like atmospheric emissions) that enriches the recipient of the now newly minted asset class, can be solved with a 100% auction system. Why is this an issue? Say the auction sells credits to the market at $5/ton CO2. The EU and Chicago Climate exchange (the largest U.S. exchange for GHG emissions) have historically traded CO2 at around $4 ton, so in all likelihood $5 is a very high initial assumption and it’ll be more like $2. But even if it’s $5, these permits will be held onto by the market until they appreciate. And the anxiety alone of a new energy scarce world will probably lead to significant appreciation right away. Not to mention that when a firm needs to buy these credits they have few short terms options and so it’s not hard to imagine them being bid up. Now if the price in the market is $20/ton, then there is a 300% windfall, the asset netted 3x what it cost, equivalent to a 75% subsidy. If there was no auction, the windfall would be infinite (something for nothing) – so it’s less windfall than without an auction, but still a windfall. Windfalls are basically strong subsidies, and subsidies distort price signals, create artificial value and expands the size of the market because of the elasticity of demand. So there is value creation absent new productivity, and absent new wealth creation these prices can not be supported indefinitely, they will have to fall. E.g. a classic boom and bust cycle – originating in windfall profits. In short, if firms get assets that trade at $20 for $5 they have a $15 profit margin, which is a good thing for the firm, but that $15 now has to be put somewhere. And because it was created simply by an actuarial identity, because the government said the credits will be sold for that price, and not because of $15 productivity gain, this $15 will contribute towards inflation and asset appreciation that is not sustainable in the mid-run.

Cap and trade can work, it is just that we must be sober about the risk it carries and think hard about getting it right. One approach would be to design a system that is entirely revenue neutral – so all that new money out there is offset by government spending. Another approach might be to smooth out price volatility by creating larger margin calls or position limits. Or, here’s another idea.

10 Things I Want to Do in No Particular Order and I’m not Sure Why (and maybe I don’t want to do all of them)

-Enter a hot tub from a rolling start, perhaps office chair.

-Play bass guitar to the moon with no shirt.

- Get a tattoo of a giant V on my shoulder, it would stand for many different things.

- Shoot a music video. I tried this a few years ago and had three police encounters.

-Take a company public- fuck this is nearly impossible.

-Shake Merritt Paulson’s hand.

-Bravely lose an eating contest.

-Ask someone reading a newspaper in the subway to name one thing they remember from the paper they read last week.

-Jazzercise.

-You know, that one thing we did that was really sweet.

Squeezing the Triggers

Former Treasury Secretary Paul O’Neil talks in his book about how in 2001-2 he and Fed Chairman Greenspan preferred a “trigger” approach to the then proposed Bush tax cuts. They wanted to cut taxes in phases depending on the future growth of revenues relative to budget needs. There was a current account surplus at the time, and so they had no problem cutting revenues, but they wanted to do it in parts so that if a budget deficit opened again they could achieve some balance between future needs and tax reductions, by not pulling the trigger on the rest of the cuts. It was a good idea because it was extremely policy neutral. It did not oppose tax cuts at all, and would have let trillions of dollars of them go forward, just so long as they were real cuts, not just an intergenerational transfer. I think the same idea of triggers could have been useful with the American Recovery and Reinvestment Act.

Congress could have developed three $250 billion segments, with only the contents of the first chunk really spelled out in the legislation. The first segment would be spent immediately, and the President and his advisers would submit a plan to spend the other two when they needed them, allowing them to adapt as the economic situation evolves. This would have focused funds on the areas where they can be spent the fastest, made passing the bill even quicker, allowed an opportunity for “lessons learned” in the remaining two sections, allowed the nation to essentially test how well the stimulus worked (for instance by comparing White House job creation estimates to reality), given control over the amount added to the deficit by not spending the whole amount if the economy began significantly rebounding, and essentially improved the package over time by seeing where the most jobs are created for the least amount of money and where investments enhance productivity the greatest.

Now anyone in favor of the stimulus would surely point out that it was so big because the challenges are so big, and two, passing it once was no sure thing, so why repeat it. On the first point, in all actuality there are very real constraints on how fast that volume of money can be spent. Infrastructure grants typically take 5 years to administer, any job in an emerging field (like green energy) by definition has a scarce labor market and so there needs to be new technical training and certification, which can take years. Even just obligating the money, e.g. signing contracts to spend it, is subject to either a formulaic application process, competitive bidding, or the state legislative process – all of which takes time. And then often there is design work or studies that have to be done before people can even be hired. That’s why the White House estimates about 75% of the funds will be spent within 18 months. That’s quick, and about as quick as it could be reliably done, but it’s by no means particularly streamlined. So long as the three triggers are pulled within a year or longer, the funds will get out the door at the same rate as the consolidated version, and because of learning and technology, it might even become more efficient. Right now Energy Secretary Chu, a brilliant Nobel chemist, has over $150 billion in credit authority that he can place basically anywhere he thinks will advance green technology and create jobs. And understandably, he’s still trying to figure out the best way to do it. This inevitably involves wading through thousands of applications from mainly promising sounding companies who applied via their states for a piece of the action. Figuring out which ones to give money is tough. Figuring out how to make all those loans into a cohesive system is tougher. And knowing if you spent the money as well as could be done, for instance that you didn’t deny the next Google of energy, is probably impossible. If the money was spent in waves, and appropriated in triggers, they could adapt their lending based on real results in the field and be surer that they’re making the best investments for the economy and for the future. The worst situation would be to invest in an idea or project that becomes obsolete, then people are unemployed all the same once it’s built, but then are stuck with a less productive economy because of antiquated technology, and now will have to pay higher taxes to pay off the debt from the stimulus. A triggered approach would provide real-time information to make the soundest investments.

On the issue of passing three parts, one has to look no further than the Troubled Asset Relief Program. It had two parts, where the President had to request to use the second half of the funds and get a majority vote to receive the funds. Now I think the TARP has been very successful given its point. There was a clear and present risk of systemic failure of the credit markets in early October. In the course of a week there was a string of huge financial institutions failing, and each one lost weakened the remaining. Since TARP passed and the banks recapitalized, there have been no major failures and now that basically seems out of the question. The point wasn’t to create a boom or solve every firm’s problems (in fact you don't want to do that because it deflates the important value of risk appreciation), it was to ensure the continued operation of the capital markets, and it did. Secretary Paulson and Chairman Bernanke had essentially a weekend to come up with a plan, and I think they did a brilliant job. And they structured it in a way that taxpayers will almost certainly see every dime back. So the stimulus could have been done in the same way, where the President has to submit a plan for spending the remaining section when he wants it, and then a 51% vote is required in Congress. Given the majority’s comfortable cushion, the request could be passed in an afternoon. Only the bill itself authorizing this structure would require 60%.

I also think that the stimulus bill could have been more creative, and not cheesy idealistic creative, but 21st century creative. Basic infrastructure is important. We need bridges and wastewater plants and sidewalks. States and localities already spend enormous sums on this every year and there are large revolving funds provided by the federal government annually in these areas. The stimulus needed $100 billion immediately going to the states to cover current deficits, and it needed money for basic infrastructure and schools and transportation. But how about incentives for new investments? What about a venture fund to invest in new research and companies? In a hyper-competitive and growing (on net over the 21st century the world will almost assuredly see the largest creation of wealth in history, China and India alone are on pace to pull almost half the world into the middle class) we must make long-term investments. As Friedman recently wrote, what about recruiting the best Ph.D’s from around the world by issuing more skilled worker visas, so they can build companies here and create new demand via buying surplus houses and supporting American businesses? The world becomes less brick and mortar every day, yet this bill seems to lay a lot of bricks. This stimulus is probably one of the greatest domestic policy achievements of a President in the first month in office ever. There is no perfect policy, yet this one is quite good. How good is very hard to know, unless you waited for some of the smoke to clear before pulling the trigger again.

Executive Compromise: The Contrarian View

There has been much populist celebration over President Obama’s recent freezing of bank executives’ salaries who receive federal money, and before that the freezing of his senior staff’s salaries. I’m not adamantly against this, but I don’t see how it accomplishes much of anything. So I’ll take the contrarian view – the usually more fun view. Firms already have every reason to avoid taking government money - because they’re not getting “bailed out” at all. They’re giving up huge stakes in their companies and the future profits that go with it, and assuming new debt to pay the government back. AIG gave up nearly 80% of its assets in the form of preferred stock and warrants. This means everyone who has parked money with them is now in the back of the line behind the federal government for dividends or shareholder privileges, experienced huge price dilution, and will likely see the government slowly and painfully liquidate their holdings. The shareholders don’t want that, the executives don’t want that, employees don’t want that, no one wants that – it’s a last resort. So the notion that they’re willing to basically give up the entire company so they can get their hands on public money just so they can get their holiday bonuses seems implausible. Also, Wall Street bonuses typically make up about a third of the NYC tax base in a given year. Without these bonuses, the city faces an even bigger budget gap, has to cut more services in a time where government purchases are needed to create demand, and ironically some of the very funds being loaned to banks in the first place.

And then there’s the whole issue of incentives. There are very few people who have the experience or capacity to run large financial institutions, let alone fix them when they are awash in problems, and it’s not like they have nothing better to do. The Jamie Dimons or Lloyd Blankfeins are not short on job opportunities. Cutting compensation 95%+ isn’t exactly the recipe for recruiting the best managers and thinkers in a time when they are most needed to sort through a menagerie of problems. The financial downturn was precipitated by a phenomenal disregard for basic due diligence. Most people put more effort into buying a used car than Citi did buying $100 billion of bonds, as Robert Rubin put it – “it was an afterthought.” Jamie Dimon largely protected JP Morgan in the summer of ’07 just by realizing he couldn’t really explain the slight uptick in defaults, and once they realized that they also realized they had no idea why the bonds were rated so high, so they divested. And diligence, as the word suggests, is not easy or particularly enjoyable. These firms will avoid further trouble only when they have executive committees that take their time and scrutinize their every step. If they’re not rewarded, if incentives are muted, it becomes less clear that they have a motivation to perform this diligence. Misaligned incentives (like in securities bundling or rumor-fueled short selling) got us into this situation; a system capable of preventing it will not emerge until these basic incentives are realigned. And last, the success or failure of these firms does not hinge on the value of their relatively meager salaries. President Obama has about 300 senior staff that earn about $180,000 a year and usually get a 5% annual pay increase. Assuming Obama keeps this freeze in place for 8 years this amounts to $24m in savings. The economic system is facing challenges on the order of millions of jobs and trillions of dollars. And during this time, good policy, and the hard-working men and women behind developing it, are more important than ever. Saving a few million bucks and cutting pay to the people you most rely on doesn’t seem to accomplish much.

What people really care about is “are they doing a good job”. People care about good decisions, good investments and good profits. If the firms were above water today, no one would raise a peep about their compensation. Targeting annual bonuses confuses the issue, which is ultimately one of bottom line performance, something that usually requires more compensation, not less.

Improving, not just saving, Social Security

Yeah, yeah, yeah. You’ve heard it all before. Social security is not looking so secure, but why does it really matter? I think most people would probably say because it would certainly be nice to get that monthly check in the mail once they’ve retired, particularly when 7.5% of every paycheck is taken out for it. Who likes to pay something for nothing? After all, the current system is projected to take in less money than it pays out around 2017, which means it will eat up the budget, which means even tighter capital markets and higher future debt. And then of course it’s projected to go bankrupt in 2040. It’s all very boring.

But the bigger reason we should fix social security - and not just patch it up with a million clever little ideas, say by lowering the inflation index or pushing back the retirement age, which will succeed only in postponing insolvency and making people work harder for less, but not really improve anything - is because of the enormous… opportunity cost! I wish it could cut aluminum cans in half or something, but we’ll have to settle for opportunity cost. Think about the difference between every dollar of your paycheck that goes into the Social Security Trust Fund, and then is subsequently spent immediately and preserved in the form of debt, versus every dollar going going into a well balanced mutual fund and earning interest. And then multiply over, oh, say four decades. Say on average you make a real income of $50,000 a year for the next 40 years, and the standard 7.65% of this is contributed to payroll taxes, this is $153,000 in principal. When that money goes into the Trust Fund, the government at best will nullify the deleterious effects of inflation, and worse yet, may actually lose purchasing power depending on the spread of government bonds versus inflation, or still worse, may decide never to pay it.

On the other hand, pick any ten year period of the stock market, any 10 year performance period of Wall Street, and the average returns will never be below 7%. Not during the Great Depression, not during S & L or dotcom, not now, not ever. Business cycles are real, they happen, but the ups and downs average to a healthy trend. Saying something is reliable because it has never failed is all you can really go on. For instance, people banking on the Social Security Trust Fund paying them out around the middle of this century often cite how much more reliable a Government IOU is because the government has never defaulted on its debt. True, but then the rationale of the safety of Wall Street is no less reliable. The government has never defaulted on its obligations. And Wall Street has never produced less than 7% per decade in returns, let alone a loss. So say over the 40 years you’ve contributed that $153,000 to the government and the market just hits the bottom of that 7% return, you still turn that money into over $600k. Assuming the best, this is a 400% difference from what the government would pay out, a very steep opportunity cost. Now there are no guarantees. And if people would like to play the “more conservative card” of just paying into the fund and getting a government guarantee, they should be able to. But, just like U.S. Senators, people should have the choice to contribute their income into actual funds. The Regular ol’ Person system could be essentially the same design as the Senators’. There would be a pension board that oversees 5 or so broad investment plans, divided by their equity/fixed income ratio, but all diversified and managed by professionals and overseen to regulate leverage and risk (something missing since about 2004 when the SEC removed net capital holding requirements). The point is people couldn’t just invest wherever the mood struck them, there would be a small menu of balanced funds to choose from. And because of the simplicity of the rules - 5 plans, no more than 10:1 or so leveraging, it would be clear whether funds were being abused/Madoffed in any way.

I hope that any future modification to Social Security does not reflexively deny individuals a choice in how their earnings are used. I think this is the compromise that can be struck - people who like the current system (retooled with some painful actuarial adjustments) can stay with it. But not allowing individuals a choice to place their payroll earnings into a balanced fund seems to me to be denying people an awful lot, and for nothing but the concerns of other people who would be unaffected. It would have the added benefits of freeing the government up from a lot of debt and providing much needed private capital injections to our financial institutions. A lot of this could be used to do things like deploy clean energy, build smart grids, in short create good jobs. And of course there are details, there always are. When money from current workers is placed in an investment fund, and not siphoned towards current retirees, there will have to be bridge financing in the form of more debt. Yet so long as much of Asia has a 30% savings rate, and so long as there are sovereign wealth funds, there will be ample capital to absorb a few more government securities. Plus, paying these off in the future will be easier than waiting for the system to slide into debt and paying then, as the pension system will be more sustainable and profitable thanks to new productivity from deeper capital markets and decreased government retirement obligations - meaning a broader economic base. And there will have to be cut off points for when people can make the transition. And there will have to be a little bit of private earnings skimmed by the Board as reserves to provide insurance to people who might pick particularly unlucky times to retire – in this way they would be guaranteed a minimal payment not below the regular system. Bueller?

But the point is, legitimate debate about the system doesn’t have to ruin anything. Those who think the government is the best universal retirement planner and want that legal guarantee can have it. And those who would prefer to fund government managed private investments with their money can do that. Now this is bipartisanship This isn’t a parlor room discussion or a game of gotchya between editorialists (oh how Stiglitz, Krugman, Summers, Brooks et. al. love to seem the smartest guy in the room). It’s a very pragmatic day-to-day kitchen table decision. And I think given the choice, people should be given more opportunity, not less.

On another note, the CBO recently scored the House stimulus bill. It estimates 7% of the energy investments will be spent within 2 years and less than 50% of the transportation dollars spent in 4 years. This is too slow to provide immediate stimulus and generally conforms with what the Council of Economic Adviser's new chair Christina Romer has shown in her work. I think the second half of TARP ($150b to buy up worst assets, $150b for continued recapitalization and $50b for mortgage refinancing, which could save 1m+), combined with a more focused $100b stimulus could have great effect.