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May 11, 2010

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Posted: 10 May 2010 11:03 PM PDT

"Antipathy Toward Government was at All-Time Highs"

Posted: 10 May 2010 06:39 PM PDT

Edmund Andrews reinforces the point about "degradation of effective government by anti-government ideology" under the Bush administration that Paul Krugman made this morning:

Reflections on the oil spill, by Edmund Andrews: Executives from BP and its partners in the Gulf oil spill will endure a heavy round of indignant and righteous grilling at Senate hearings on Tuesday, and they deserve it.

But it's also obvious that Congress and the Interior Department failed in all sorts of ways over the years. ...

The Interior Department's hapless Minerals Management Service failed miserably as well. As the Wash Post reported a week ago, MMS exempted BP's ill-fated rig last April from a rigorous environmental analysis after concluding that a big spill was extremely unlikely.

Less than a year ago, it gave BP's partner, Transocean a "Safety Award for Excellence" ("SAFE," get it?) for its work in the Gulf. Randall Luthi, the MMS's last director under President Bush, is now president of the National Oceans Industries Association. The Bush-Cheney, Texas-Wyoming crowd passionately wanted to ramp up drilling logging and mountain-top mining. It had a zero-tolerance policy toward objections of any kind.

I have a personal take on the MMS. Back in 2006, I wrote a long series of stories about how the agency was losing tens of billions of dollars in royalties on oil and gas being pumped in the Gulf of Mexico. (They still are, by the way.) The MMS's accounting was disastrously muddled; political hacks under Bush were blocking the agency's own auditors; and the Interior Department had fouled up leases going back to the Clinton administration. My stories unleashed a slew of investigations, which not only confirmed jaw-dropping incompetence and subservience to industry but also the famous sex-and-drugs scandal in which MMS employees in Denver partied hardy with oil execs.

Now, it's true that the Interior Department and the MMS were in some ways uniquely awful -- especially under the Bush administration. ...

But there was a broader lesson here: antipathy toward government -- any kind of government -- was at all-time highs. Republicans, and to a lesser extent Democrats, were hitting the peak of a 25-year rise in anti-government skepticism. If nobody thinks government can do anything good, then you attract mostly cynics and losers who are mainly interested in leveraging their jobs into lucrative deals with industry.

This wasn't unique to Interior and MMS. The SEC, which was a feared and prestigious enforcement agency back in the 80's (under Reagan, btw), became a laughingstock. The bank regulators competed with each other to make life easy for the banks, on whom most depended for their fees. It was the same deal almost everywhere else: consumer protection, food and drug regulation, occupational safety, the Justice Department.

By the end of the Bush administration, they were all emaciated, hollowed-out shells. Now we're discovering, a little late, that those gray government civil servants and those musty federal buildings might actually be good for something after all.

When appointments to these agencies become a way of rewarding people for their political support and to impose an anti-interventionist government ideology (but only where government might get in the way of profit, the view toward intervention in social issues was different) rather than as an opportunity to provide the best possible government service to the nation, we should expect a bad outcome. These appointments have always served political ends to some degree, but under Bush service became secondary and this was taken to extremes.

"Virginia AG Cuccinelli Out To Kill Academic Freedom"

Posted: 10 May 2010 03:51 PM PDT

This is in today's daily links, but I think it deserves a bit more notice:

Virginia AG Cuccinelli Out To Kill Academic Freedom, by Barkley Rosser: Friday's WaPo reports that Virginia Attorney General Ken Cuccinelli, following up on his efforts to end efforts by state universities and colleges to avoid discriminating against GLBT folks, has decided to interfere directly in scientific research in a criminal way. In particular, Cuccinelli is claiming that climate scientist, Michael Mann of hockey stick fame, engaged in billing fraud with the state while working on this subject while a professor of environmental sciences at the University of Virginia, where he has not been located for some years (now at Penn State). Cuccinelli is demanding all kinds of emails and other materials from the university, apparently attempting to imitate the climategate gang that did this over at East Anglia, only to end up with no fraud being discovered.

I think that some of the critics of Mann's work were correct, but this is an outrage. There is no evidence at all of fraud (and those claiming the email in which he spoke of using a "trick" as evidence for this do not understand or are willfully misrepresenting how this term is used in these situations) on his part, whatever errors he may have made in his study of the hockey stick (and it really does not matter exactly what the temperature was 1000 years ago; I have posted on this here previously). ...

Here's a bit more from the article:
As ammunition for this chilling assault, Mr. Cuccinelli twists beyond recognition a statute designed to punish government contractors who use fake receipts to claim taxpayer funds and those who commit other such frauds. For Mr. Cuccinelli's "investigation" to have any merit, the attorney general must suppose that Mr. Mann "knowingly" presented "a false or fraudulent claim for payment or approval." Mr. Cuccinelli's justification for this suspicion seems to be a series of e-mails that surfaced last year in which Mr. Mann wrote of a "trick" he used in one of his analyses, a term that referred to a method of presenting data to non-experts, not an effort to falsify results. ...

And:

By equating controversial results with legal fraud, Mr. Cuccinelli demonstrates a dangerous disregard for scientific method and academic freedom. The remedy for unsatisfactory data or analysis is public criticism from peers and more data, not a politically tinged witch hunt or, worse, a civil penalty. ... For the commonwealth to persecute scientists because one official or another dislikes their findings is the fastest way to cripple not only its stellar flagship university, but also its entire public higher education system.

Tenure is supposed to offer some protection against these attempts to curtail academic freedom, but If the right people come after you, tenure won't help. There are always ways to bypass the protection tenure offers, e.g. through trumped up charges of fraud as is being attempted in this case. Fortunately, however, though this is not yet fully resolved, Ken Cuccinelli does not appear to be one of the right people, and, in fact, is very obviously wrong.

Should "Erroneous" Algorithmic Trades be Canceled?

Posted: 10 May 2010 11:43 AM PDT

Rajiv Sethi doesn't understand the logic behind the decision by Nasdaq and the New York Stock Exchange to cancel some trades that were made during last week's plunge in the stock market:

Algorithmic Trading and Price Volatility, by Rajiv Sethi: Yesterday's dramatic decline and rapid recovery in stock prices may have been triggered by an erroneous trade, but could not have occurred on this scale if it were not for the increasingly widespread use of high frequency algorithmic trading.

Algorithmic trading can be based on a variety of different strategies but they all share one common feature: by using market data as an input, they seek to exploit failures of (weak form) market efficiency. Such strategies are necessarily technical and, for reasons discussed in an earlier post, are most effective when they are rare. But they have become increasingly common recently, and now account for three-fifths of total volume in US equities... This is a recipe for disaster:

[In] a market dominated by technical analysis, changes in prices and other market data will be less reliable indicators of changes in information regarding underlying asset values. The possibility then arises of market instability, as individuals respond to price changes as if they were informative when in fact they arise from mutually amplifying responses to noise. 

Under such conditions, algorithmic strategies can suffer heavy losses. They do so not because of "computer error" but because of the faithful execution of programs that are responding mechanically to market data. The decision by Nasdaq to "cancel trades of 286 securities that fell or rose more than 60 percent from their prices at 2:40 p.m." might therefore be a mistake: it protects such strategies from their own flaws and allows them to proliferate further. Canceling trades can be justified in response to genuine human or machine error, but not in response to the implementation of flawed algorithms.

I don't know how the losses and gains from yesterday's turmoil were distributed among algorithmic traders and other market participants, but it is conceivable that part of the bounce back was driven by individuals who were alert to fundamental values and recognized a buying opportunity. ...

I would be very interested to know whether the transfer of wealth that took place yesterday as prices plunged and then recovered resulted in major losses or gains for the funds using algorithmic trading strategies. I expect that those engaged in cross-market or spot-futures arbitrage would have profited handsomely, at the expense of those relying on some form of momentum based strategies. If so, then the cancellation of trades will simply set the stage for a recurrence of these events sooner rather than later. ...

I agree - I don't understand the logic behind the decision to cancel the trades either. However, Donald Marron says there's merit to both sides of the argument, and attempts to find a compromise:

Advice to Nasdaq and the NYSE: Cancel Only 90% of the "Erroneous" Trades, by Donald Marron: Nasdaq and the New York Stock Exchange have both announced that they will cancel many trades made during the temporary market meltdown between 2:40 and 3:00 last Thursday afternoon (see, for example, this story from Reuters). These "erroneous" trades include any that were executed at a price more than 60% away from their last trade as of 2:40.

The motivation for these cancellations is clear: a sudden absence of liquidity meant that many stocks (and exchange-traded funds) temporarily traded at anomalous prices that no rational investor would have accepted.

As several analysts have noted, however, canceling these trades creates perverse incentives. It rewards the careless and stupid, while penalizing the careful and smart. It protects market participants who naively expected that deep liquidity would always be there for them, while eliminating any benefits for the market participants who actually were willing to provide that liquidity in the midst of the turmoil. ...

I see merit in both sides of this argument. My economist side thinks people should be responsible for their actions and bear the costs and benefits accordingly. But my, er, human side sees merit in protecting people from trades that seem obviously erroneous.

What's needed is a compromise–one that maintains good incentives for stock buyers and sellers, but provides protection against truly perverse outcomes.

Happily, the world of insurance has already taught us how to design such compromises: what we need is coinsurance. People have to have some skin in the game, otherwise they become too cavalier about costs and risks. ... Even a little skin in the game gets people to pay attention to what they are doing.

So here is my proposal:  NYSE and Nasdaq should cancel only 90% of each erroneous trade. The other 10% should still stand.

If Jack the Algorithmic Trader sold 100,000 shares of Accenture for $1.00 last Thursday, he should be allowed to cancel 90,000 shares of that order. But the other 10,000 shares should stand–as a reminder to Jack (and his boss) of his error and as a reward to Jill the Better Algorithmic Trader who was willing to buy stocks in the midst of the confusion.

When you lose money in the stock market, even for trades that are obviously based upon and erroneous strategy after the fact, do you get a Mulligan? I must be missing something here, can someone explain why these trades should be canceled?

"Checks and Balances at the Fed"

Posted: 10 May 2010 09:09 AM PDT

Jon Faust is worried that the Dodd proposal to change the selection process for members of the FOMC (the committee that sets monetary policy) will lead to too much political control of the Fed and all the problems that come with it:

Checks and Balances at the Fed, by Jon Faust, RTE: The financial crisis has provided, among other things, a civics lesson about the Federal Reserve. Some people have been surprised to learn that 5 of 12 votes on the Fed's main policy committee–the Federal Open Market Committee (FOMC)–are cast people who are not politically appointed. The 7 politically appointed Fed Governors vote on the FOMC, but the remaining 5 votes rotate among the Reserve Bank Presidents, who are chosen by the Board's of the Reserve Banks. People on those Boards are, themselves, mainly chosen by the member banks of the Federal Reserve System. Senator Dodd's reform bill attempts to fix this problem.
This supposed fix is dangerously naïve and ignores the lessons of the last great financial crisis.
The bill as reported states: "To eliminate potential conflicts of interest at Federal Reserve Banks, the Federal Reserve Act is amended to state that no company, or subsidiary or affiliate of a company that is supervised by the Board of Governors can vote for Federal Reserve Bank directors…"
The current arrangement of the FOMC was framed as a response to the Great Depression. The framers viewed the conflicts of interest over Fed policy as fundamental and saw no way to eliminate them. Historical precedent suggested (and still suggests) that political control of a central bank leads to lack of discipline and inflation. But complete absence of political influence is also inappropriate in a Democracy.
Thus, the FOMC's framers looked to the uniquely American solution of checks and balances. In particular, they called upon two widely despised groups during the depression—bankers and politicians—to balance each other's worst impulses.
Representative Glass and Senator Steagall, of Glass-Steagall fame, fought tenaciously over the balance. Steagall proposed that only the politically-appointed governors would vote on the FOMC. Glass responded that Steagall was "without peer in his advocacy of inflation." After heated debate, Congress arrived at the 7 to 5 split we have today. Senator Glass summarized the reasoning, "[The vote on the FOMC] will stand 5 to 7 giving the people of the country, as contradistinguished from private banking interest, control by a vote of 7 to 5…" There can be no doubt that the Congress sought to achieve a balance of fundamentally conflicting interests.
I am not arguing that Congress got the balance right, and the recent crisis is certainly reason enough to re-visit what the correct balance would be. But naively fiddling with the balance in the name of eliminating conflicts of interest misses the real civics lesson from the founding of the Fed's FOMC.

I've written about this topic as well. This is from a post at Maximum Utility, my blog at CBS MoneyWatch:

What's Wrong With the Dodd Proposal to Restructure the Fed?: A proposal from Senate Banking Committee Chairman Christopher Dodd changes the selection process for key positions within the Federal Reserve system. Unfortunately, this proposal makes the selection process worse, not better. If this proposal is passed into law, it would further concentrate power within the Federal Reserve system, and it would politicize the selection process, both of which are the opposite of where reform should take the system.
The Current Structure of the Federal Reserve System
The Federal Reserve System consists of a Central Bank in Washington and twelve Federal Reserve District (or regional) Banks. The Central Bank's authority resides with the seven member Board of Governors, one of which serves as chair (currently Ben Bernanke). Each of the District Banks has a nine member Board of Directors along with a bank President. It is the selection of the Board of Directors that is at issue.
Currently, the nine member Board of Directors at each of the District Banks consist of three Class A directors, three Class B directors, and three Class C directors. Class A directors are elected by member banks within the district and are professional bankers. Class B directors are also elected by member banks in the district, but these are business leaders, not bankers. Finally, Class C directors are appointed by the Board of Governors and are intended to represent the public interest.
Class B and Class C directors cannot be officers, directors, or employees of any bank, and Class C directors may not be stockholders of any bank. One Class C director is selected by the Board of Governors to serve as Chair of the Board of Directors. The Board of Directors selects the President of each District Bank, but the President must be approved by the Central Bank's Board of Governors.
What is the reasoning behind this structure? When the Fed was created in 1913, there was a concerted attempt to distribute power across geographic regions; between the public and private sectors; and across business, banking, and the public interests. The geographic distinctions were important because it's not unusual for economic conditions to differ regionally -- conditions can be booming in some places and depressed in others -- and the regions would favor different monetary policies. Thus, it's important to bring these different preferences to the table when policy is being determined so that the best overall strategy can be implemented.
Changes in the Distribution of Power over Time
In the early days of the Fed, power over monetary policy -- which at that time was mainly discount rate policy within each Federal Reserve District -- was shared between Washington and the District Banks, so the intent of the system was largely realized.
However, the shared power arrangement within the Federal Reserve system changed after the Great Depression. The Fed did not perform well during the great Depression and one of the problems, it seemed, was that the deliberative, democratic nature of the institution prevented it from taking quick, decisive action when it was most needed. Furthermore, the Fed did not have the tools it needed to deal with system-wide disturbances rather than problems with individual banks (the discount window is well-suited to help individual banks, but it's not an effective tool to combat system wide disruptions; on the other hand, open-market operations -- a policy tool the Fed obtained after the Great Depression -- can inject reserves system-wide and are much more useful to deal with system-wide problems).
The result was that after the Great Depression, power was concentrated in the Central Bank's Board of Governors in Washington D.C., and increasingly over time, in the hands of one person -- the Chair of the Federal Reserve. Thus, over time the Fed has evolved from a democratic, shared power arrangement at its inception to a system that functions, for all intents an purposes, as a single bank in Washington, D.C,. with twelve branches spread across the U.S.
The Dodd Proposal
How would the Dodd proposal change this? Under the proposal, the Board of Directors for each District Bank would be chosen by the Central Bank's Board of Governors (who are themselves chosen by the President with the advice and consent of the Senate). The chair of the Board of Directors at each District Bank would be chosen by the President and confirmed by the Senate.
This means that the key figures within each District Bank would be chosen by Washington, and unlike the present system, there is no attempt at all to represent geographic, business, banking, and public interests explicitly in this arrangement. In addition, it no longer has the explicit safeguards contained in the current rules to prevent bankers from dominating the directorships (e.g. under the new rules the Chair of the Board of Directors could be a banker, currently that can't happen). Given that the appointments are coming from Washington (as opposed to a vote of banks within the District for six of the nine positions on the Board like we have now), there is no guarantee that the District bank Boards won't be stacked with one special interest or another. Thus one of the main reasons given by Dodd for the change in the selection process -- to remove the influence of bankers -- is actually undermined by his proposal because it removes the safeguards against the Board being dominated by banking interests.
I believe that the current structure of the Fed already gives too much power to Washington and not enough to the District Banks, and this has helped to feed the perception that the Fed does not represent the interests of the typical person. Unfortunately, the Dodd proposal further concentrates power in Washington and adds more political elements to the selection process thereby making these problems even worse.
Thus, I agree with this:
Bullard, 48, the St. Louis Fed's president since April 2008, said ... the Fed is ultimately controlled by political appointees as it stands... "We don't want to put all the power into Washington and New York," Bullard said. "That's just the opposite of what this crisis is teaching us. So you want the input from around the country, and I think it's really important for informing monetary policy."
Richmond Fed President Jeffrey Lacker said ... "I wouldn't want to see the reserve bank governance mechanism politicized in any way,"... Asked if Dodd's plan would politicize the process, Lacker said: "I think it could."
Finally, while the proposal claims to insulate the Fed's monetary policy decision from political pressure, this quote from the same article illustrates the dangers of political interference. The quote is in response to another part of the Dodd proposal that would take away some of the power the District Bank Presidents have in setting monetary policy (which is already much less than the power of the Board of Governors):
"I doubt very much that by a year from now Fed presidents are going to have as big a role as they now have," Financial Services Committee Chairman Barney Frank told reporters... He has said the presidents too often vote in favor of higher interest rates.
That last sentence means he believes the Fed has favored low inflation over low unemployment as it has set interest rate policy. That may or may not be true, but do we really want members of the House setting interest rate policy or changing the structure of the Fed whenever they disagree? I don't.
I fully agree that the selection process for the Directors and the District Bank Presidents could and should be changed (that includes redrawing geographic districts). It's not clear that the present system does the best possible job of representing the array of interests that have a stake in the outcome of policy decisions. But concentrating power in Washington is not the way to solve this problem. Instead we need to redistribute power over a wider range of interests, including geographic interests, and make sure the selection process for key positions within the Federal Reserve system brings those interests to the table when policy is determined.
[Update: See also Alan Blinder's "Threatening the Fed's Independence".]

And one more post from Maximum Utility:

Why The Federal Reserve Needs To Be Independent, by Mark Thoma: There are several bills that have been proposed in Congress directed at the Federal Reserve. The two most prominent proposals are Senate Banking Committee Chairman Christopher Dodd's bill to take away most of the Fed's regulatory authority, and Congressman Ron Paul's bill to force the Fed to allow its monetary policies to be audited by the Government Accountability Office (GAO).
Many people worry, rightly in my opinion, that if these proposals or others like them are passed into law, then the Fed's independence would be threatened.
Political business cycles and inflation
Why is the Fed's independence so important? One reason is the control of inflation. As former Federal Reserve Governor Frederic Mishkin wrote this week in an op-ed coauthored with Anil Kashyup of the University of Chicago:
Economic theory and massive amounts of empirical evidence make a strong case for maintaining the Fed's independence. When central banks are subjected to political pressure, authorities often pursue excessively expansionary monetary policy in order to lower unemployment in the short run. This produces higher inflation and higher interest rates without lowering unemployment in the long term. This has happened over and over again in the past, not only in the United States but in many other countries throughout the world.
What Mishkin and Kashyup are referring to are "political business cycles." The idea is that monetary policy acts faster on output and employment than it does on inflation. To take a concrete example, suppose that the impact of a change in the money supply on output peaks about six months after the change in policy, and then fades after that. And also suppose that the impact of the change in the money supply on prices is delayed six months and is not fully felt until eighteen months after the policy change (these are roughly consistent with econometric estimates of the impact of changes in money on output and prices).
This situation opens up the possibility for a politician in control of the money supply to manipulate the economy in an attempt to increase the chances of getting reelected. If votes depend upon output growth, as they seem to, then the politician can pump up the money supply around six months before the election so that output will peak just as the election is held. Then, the politician could plan to reduce the money supply just after the election to avoid having inflation problems down the road.
So the politician implements this strategy, gets reelected, and now comes the time to cut back on the money supply. But there's a problem. Output peaked the month of the election, and has been falling ever since. Will the politician actually cut the money supply and raise interest rates to avoid inflation -- which would reduce output and employment growth even further, something that is sure to bring protests -- or decide to live with the inflation? The choice is often to live with inflation, and as the cycle repeats with each election, inflation slowly ratchets upward.
Budget deficits and inflation
But political manipulation of the money supply is not the problem most people are worried about, it's the expected increase in the government debt that is creating the inflation worry.
When the government purchases goods and services, those purchases must be financed in one of three ways--raising taxes, borrowing from the public (i.e., issuing government debt), or printing new money. Thus, if government spending is much larger than taxes, and if raising taxes is political poison, then the deficit must be financed by either printing money or issuing new government debt. However, increasing the government debt is often a bad choice politically, so when faced with this decision politicians often choose to increase the money supply rather than increase the debt, and the result is inflation. The inflation is a hidden tax--in essence the government spending is paid for by inflating away the value of the dollar, but the blame for the inflation can often be displaced onto things like oil and other commodity prices, and thus the political consequences are not as large as for changes in taxes or in the debt.
The hope is that an independent Fed can overcome the temptation to use monetary policy to influence elections, and also overcome the temptation to monetize the debt, and that it will do what's best for the economy in the long-run rather than adopting the policy that maximizes the chances of politicians being reelected.
Independence threatened
Many people are worried that if the US does not get its long-run debt problem under control, a problem driven mainly by escalating health care costs, then politicians worried about their reelection chances will begin pressuring the Fed to finance the debt by printing money. And if the Fed is uncooperative, its independence may be taken away legislatively.
I believe these threats are real, and as noted above, experience shows that once politicians get involved in monetary policy, inflation generally becomes a problem. For that reason, I am very opposed to anything that threatens the Fed's ability to assert its independence and keep the economy on the best long-run path.

(For more discussion of the pros and cons of Fed independence, see here; for more on the degree of the Fed's independence in the U.S., see the bottom of this post.)

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