Archive for the 'Economics' Category

A taxonomy of bank failures

Published on 22 May 2012 at 10:57 am in Economics, Finance and Welfare. Tags: , , , , , , .

I hereby present John’s Not Particularly Innovative Taxonomy Of Bank Failures ™.  In increasing order of severity:

Category 1) A pure liquidity crunch — traditionally a bank run — when, by any measure, the bank remains entirely solvent and cash-flow positive;

Category 2) A liquidity crunch and insolvent (assets minus liabilities excluding shareholder equity is negative) according to market prices, but solvent according to hold-to-maturity modeling and cash-flow positive;

Category 3) A liquidity crunch and insolvent according to both market prices and hold-to-maturity modeling, but still cash-flow positive;

Category 4) A liquidity crunch, insolvent and cash-flow negative, but likely to be cash-flow positive in the near future and remain so thereafter; and, finally,

Category 5) A liquidity crunch, insolvent and permanently cash-flow negative.

A category 1 failure is easily contained by a lender of last resort and should be contained: the bank, after all, remains solvent and profitable. Furthermore, a pure liquidity crunch, left unchecked, will eventually push a bank through each category in turn and, more broadly, can spill over to other banks. There need be no cost to society of bailing out a category 1 failure. Indeed, the lender of last resort can make a profit by offering that liquidity at Bagehot‘s famous penalty rate.

A category 2 failure occurs when the market is panicking and prices are not reflecting fundamentals. A calm head and temporarily deep pockets should be enough to save the day. A bank suffering a category 2 failure should probably be bailed out and that bailout should again be profitable for whoever is providing it, but the authority doing to bailing needs be very, very careful about that modeling.

For category 1 and 2 failures, the ideal would be for a calm-headed and deep-pocketed private individual or institution to do the bailing out. In principle, they ought to want to anyway as there is profit to be made and a private-sector bailout is a strong signal of confidence in the bank (recall Warren Buffett’s assistance to Goldman Sachs and Bank of America), but there are not many Buffetts in the world.

Categories 3, 4 and 5 are zombie banks. Absent government support, the private sector would kill them, swallow the juicy bits and let the junior creditors cry. If the bank is small enough and isolated enough, the social optimum is still to have an authority step in, but only to coordinate the feast so the scavengers don’t hurt each other in the scramble. On the other hand, if the bank is sufficiently important to the economy as a whole, it may be socially optimal to keep them up and running.

Holding up a zombie bank should optimally involve hosing the bank’s stakeholders, the shareholders and the recipients of big bonuses. Whether you hose them a little (by restricting dividends and limiting bonuses) or a lot (by nationalising the bank and demonising the bonus recipients) will depend on your politics and how long the bank is likely to need the support.

For a category 3 failure, assuming that you hold them up, it’s just a matter of time before they can stand on their own feet again. Being cash-flow positive, they can service all their debts and still increase their assets. Eventually, those assets will grow back above their liabilities and they’ll be fine.

For a category 4 failure, holding them up is taking a real risk, because you don’t know for certain that they’ll be cash-flow positive in the future, you’re only assuming it. At first, it’s going to look and feel like you’re throwing good money after bad.

A category 5 failure is beyond redemption, even by the most optimistic of central authorities. Propping this bank up really *is* throwing good money after bad, but it may theoretically be necessary for a short period while you organise a replacement if they are truly indispensable to the economy.

Note that a steep yield curve (surface) will improve the cash-flow position of all banks in the economy, potentially pushing a category 5 bank failure to a category 4 or a 4 back to a 3, and lowering the time a bank suffering a category 3 failure will take to recover to category 2.

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Monetary policy for 10 year olds

Published on 14 May 2012 at 3:58 pm in Economics. Tags: , , , , , , , , .

A very smart three year old asked me what would happen if we gave everybody 20 dollars.  Now, this is a deep and difficult question and no less important for having come from a three year old.  Anybody who tells you it’s easy has not thought about it properly.  As it turns out, I am not smart enough to explain this to a three year old, so I instead decided to give my answer to their parents and trust them to translate for me.  I also decided to pretend the question was:

What would happen if we gave every 10-year-old kid on the planet 20 dollars (or its local equivalent)?

Here’s my answer:

If we were to give every 10 year old on the planet the equivalent of 20 dollars in their local currency, they’d immediately spend all of it, because 10-year-old kids do not care about savings and have no debts to pay down.

***

If this all came as a complete surprise, the shops would immediately be emptied of all lollies (candy if you’re American, sweets if you’re British) before the shop owners knew what was happening. Some of them might have put up their prices part-way through the day, but not many. If it’s a small one-person shop it’s hard to go around changing the price on everything when you’ve got a queue 20 people long that you need to serve. If it’s a big shop, the owner probably isn’t on site and flunkies aren’t paid to think, they’re paid to just take the customers’ money. It’s a bit more complicated through, because each shop selling out of their lollies would happen in a cascade through the day. The kids would first swarm to the shop that everybody knows about and when it sold out, they’d move on to to more obscure shops. They’d repeat the process until every shop sold out of stock or the kids ran out of money.

At the end of the day, faced with empty shops and tills overflowing with money, the shop owners would then order more lollies and put up their prices for next week when those lollies actually arrive. They’d also go home and celebrate with their family over the windfall profits. They’d order new cars, book holidays and increase the pocket money they give to their own 10-year-old kids. So as well as clearing out existing inventory, the shower of money will lead to more demand for new stuff and a future increase in prices. Eventually, once everything had settled down, the price of everything (including cars and holidays) would have gone up, but along the way they will have collectively produced and consumed more stuff than they would have otherwise.

***

Alternatively, if all the purveyors of lollies had one day’s advance warning that this avalanche of disease and bad manners was going to descend on their shops, they would face a problem (the good kind of problem). If they’re a popular and well-known shop, they would know they were going to sell out. Ideally, they’d have ordered more stock to sell in advance, but it’s not going to come in time (it takes a week). So instead, they order more lollies (and beg their supplier to be quick about it) and put up their prices immediately to suck some more money out of the kids. When the shop opens, the flood of kids turn up and buys all the lollies at the higher prices and swarms on to the next shop. But because of the higher prices, the kids will run out of money sooner and so the really obscure shops may not get much extra business at all. Knowing that this is going to happen, the obscure shops may not increase their prices, hoping to tempt some of the kids to come to them.

At the end of the day, the owner of the popular shop is positively giddy with excitement. They’ve sold all their lollies and gotten even more money than they would have if they’d sold them all last week. When they go home and celebrate, they order two new cars, one of them a Lexus, and the holiday they book is at a 5 star resort. Their kid doesn’t just get an increase in pocket money, they get sent to a private school. The owners of the obscure shops are also happy, because they’ve had a really profitable day, but it’s not been as good as it would have been without the advance notice. They just get their existing car repaired and buy a book about travelling through interesting countries. Their kid gets an extra scoop of ice cream for dessert. In the end, prices have generally gone up, although not necessarily everywhere (more popular and more fancy stuff will have increased their prices more) and, in aggregate, we will have produced and consumed more stuff.

***

If the whole thing was announced two weeks in advance, then some really interesting stuff would happen. The most popular shop would place an advance order for extra lollies so as to have more stock on the day and they’d increase their prices. They’d need to judge it carefully to decide how much of each to do, but their goal would be to make even more profit than they would with just one day’s notice. But that order for extra lollies will need to be placed and delivered and paid for before the kids ever get their 20 dollars. That means that the popular shop will need to borrow against the upcoming profit. On top of that, with all that advance notice, it’s not only the popular shop owner that will change their plans. The lolly manufacturers themselves would be putting up their prices, so the cost of ordering those extra lollies is higher. The normally obscure shops might try to do something to remind kids that they’re there. The really smart kids might even spend the two weeks looking for obscure shops that are less likely to put their prices up. Because the obscure shops might therefore be more likely to be visited on the big day, they’ll generally be able to put up their prices a little bit. But on the other hand, that will be offset by the fact that kids will know that the popular shop will have twice as many lollies as usual, so even knowing about the obscure shop, maybe they’re better off just going to the popular one.

When the big day comes, the popular shop will have a huge day. They’ll sell squillions of lollies at higher prices, but the really obscure shops will make more money, too. But they can’t all get more money than they would under the one-day-notice or no-notice scenarios. Exactly who will win and who will lose relative to the first two scenarios will depend on who managed to convince the kids to come to them on the day. At the end of the day, the popular shop will pay off their loan to the bank and will almost certainly have made an excellent profit. The owner of the popular shop and the owners of the obscure shops that made good profits will go home and celebrate, buy cars and holidays and try to figure out how to better compete with each other next time.

Overall, this case leads to an increase in demand and production of stuff before the money gets given to people (it temporarily sits in the popular shop’s inventory). The lolly manufacturer gets their money before the new money is even printed. In the end, prices are a bit higher and real quantities were higher than they would have been, but the distribution of that demand is once again different. Some of the extra money will go first (before it even exists!) to the manufacturer. Some of it will go on the big day to shop owners and some of it will go on the big day to the bank owner.

***

Now we start to get sneaky.  If it’s announced two weeks in advance, but then cancelled the day before the big day, then the popular shop will have already ordered, received and paid for their extra lollies with a loan they took out from the bank.  The manufacturer will already have started spending their share of the money. Obscure shops will already have put effort into reminding kids that they’re there, and smart kids would already have spent time looking for really obscure shops.  In this case, the manufacturer is happy; they got their money and so still celebrate with their family, but they’ll put their price back down because everything has gone back to normal.  The obscure shop owners are a little bit annoyed but don’t really mind because at least now more kids know about them.  The bank owner is sort-of happy, but worried about getting their money back so instead of celebrating they go to see the popular shop owner and have a difficult conversation about complicated stuff like loan covenants.

The popular shop owner is the only person who’s really annoyed, because they’re the only one that’s out of pocket.  They’ve got twice their normal inventory and a big loan to pay off.  Now, if the lollies will last for a while and the bank is patient, they might be able to just go about their normal business, selling them to the kids as they get their weekly pocket money and paying off the loan bit by bit.  But if the lollies are going to go bad if they’re not sold quickly, the popular shop may have to lower their prices temporarily to tempt kids to buy them even without the extra 20 dollars.  If that’s the case, the popular shop will make a loss and just be trying to minimise it.  They’ll hope they make enough money to at least pay back the bank.

Overall, real things happened and real stuff was produced and consumed, a fair bit of it before the big day was ever meant to happen.  While prices jumped around a little bit — some up, some down — they generally returned to where they were beforehand.

***

Finally, we get to the scenario where it’s announced two weeks in advance, but people think it’s going to be cancelled before the big day.  In this case, the obscure shops probably won’t bother to remind kids that they exist and only the most bored of the smart kids will ride around looking for obscure shops that they probably won’t have a chance to spend money in anyway.  The popular shop, worried that they’ll be stuck with a big loan and inventory they can’t sell without making a loss, either won’t order anything in advance at all or will only make a small order.  The manufacturer won’t blame the popular shop for only making such a small order and won’t bother to put up their price.

If the big day does get cancelled as people suspect, then nobody gets hurt and nothing happens, while if it really does happen, it’ll be a fantastic surprise and everybody will be happy (well, at least the kids and the shop owners).  But, importantly, nothing much will happen at all until people believe the big day is really going to go ahead.

***

This last scenario is a bit like America and the UK today.  The central banks have engaged in tremendous efforts to stimulate their economies, but for a bunch of boring reasons, the benefits of those efforts will only appear in most people’s pockets at some point in the future.  On top of that, every time the shops start to think the shower of money will actually come through and place orders with the manufacturers, the manufacturers get excited and raise their prices a little.  But because that means some prices are going up even before people get the new money, some central bankers worry that they’re planning to give away too much of the stuff and so talk very loudly about how they’re going to cancel most of the stimulus before it gets into people’s hands.  That makes the shops worried again and so they cancel their orders.

The problem is one of commitment and credibility.  Some people think that when the central banks talk about their exit strategies they’re doing it to defend their hard-won credibility in controlling inflation.  That’s all well and good as a long-run strategy, but it also erodes a different type of credibility because, from the perspective of the public at large, they’re committing to do something and then going back on that commitment.  It’s the boy who cried wolf in reverse.  Imagine trying this strategy with your own kid:

  • First, offer to give them $20 for lollies if they do their homework every night for a week
  • They will immediately sit down and do tonight’s homework
  • Tomorrow morning, tell them it’s actually only going to be $5 and, maybe, nothing at all
  • Do you really expect them to do their homework on that second night?
  • Do you really expect the trick to work again next month?

Yes, on the face of it, this whole essay goes against my previous thoughts on monetary policy at the moment.  What?  A guy can’t have multiple, contradictory opinions at once?

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Peak Oil (again)

Published on 20 April 2012 at 12:13 pm in Economics, The Environment and USA. Tags: , , , .

The Economist has a piece on it:   Feeling peaky

FT Alphaville discusses it:  Peak oil goes mainstream (again)

From 2005, when oil was US$60/barrel, James Hamilton wrote:  How to talk to an economist about peak oil

In a related point, I’ve also put together two charts looking at the number of miles driven in America.  The first gives a rolling 12-month total of the number of miles driven per capita in America, while the second looks at deviations from previous peaks in the same.  Both are from 1971 onwards.  A few things to note:

  • The current dip started well before the recession (peak was in June 2005); it’s been going for 79 months so far.
  • The current level was last seen in February 1999.
  • The current level (January 2012) is 6.34% below the most recent peak; the low point in the current dip was at 6.45% below (November 2011).
  • The dip at the end of the ’70s and start of the ’80s (i.e. the second oil crisis and the Volker recession) reached 4.99% below the previous peak after 21 months and was back above that peak after 54 months.

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HFT and frontrunning

Published on 11 April 2012 at 7:10 pm in Economics and Finance. Tags: , , , .

I am not a finance guy and I almost certainly don’t know what I’m talking about when it comes to high-frequency trading (HFT), but if ignorance stopped people giving their opinions on the internet, all we’d have left would be pornography and we don’t want that, do we?

A friend sent me to this opinion piece by Alan Kohler, a journalist at the ABC (that’s the Australian Broadcasting Corporation, for any Americans in the audience).  He’s terribly worried about HFT in general and front-running in particular.  I can’t be bothered quoting him — you can click through and read it for yourself if you like.  Go on, I’ll wait.

At first, I couldn’t see how anybody could legally front-run me.  I wrote this in reply to my friend:

Suppose that I’m a buyer.  My order is:

* I want to buy up to W shares

* The last transaction price was X per share

* I will pay no more than Y per share

* If there are any shares on offer for a price lower than or equal to Y, the following applies:

* Take the lowest asking price that is less than Y.  If the quantity available for sale at that price is greater than X, I’m done.  If the quantity available at that price is less than W, then look for the next-lowest asking price that is less than or equal to Y.  Repeat as necessary.

* If I end up buying everything on offer for asking prices less than Y and I still haven’t filled my order, the remainder is left as a bid at price Y.

So the “normal” way of buying shares — walking up to your broker and saying “10 shares, please”, is just a way of saying “W=10, Y=infinity”. It’ll get you 10 shares at the current prevailing price.

I can see how my broker could front-run me:  After getting my order, they could buy up everything with an asking price lower than my Y and then sell it to me at Y.  But (a) it’s illegal for brokers to do this; and (b) the whole point of my saying that I’m happy to buy them at price Y is that I’m happy to buy them at price Y.

I cannot see how an entirely separate company can front-run me.

Then a second friend pointed out that the front-running is really against institutional players in the market.  In reply to him, I described it like this:

1) I’m an institutional buyer (presumably an institutional seller would just have everything in reverse). The current price of the stock (i.e. the last transaction price) is X. I think that it’s worth at least Y now and that it will, over time, eventually be worth Z, with Z > Y > X. I want to buy 1 million shares at as low a price as possible but no higher than Y. There are more than a million shares available in existing quotes with asking prices between X and Y.

2) Rather than spook the market, I send in a stream of buy orders. Say, 100 orders for 10,000 shares, with the bid price for each gradually rising with whatever ask quotes are available.

3) The HFT dude is sitting right next to (or even inside) the exchange and sees this stream of orders coming in and being filled sooner than regular market players.

4) He doesn’t know it’s me sending them in and he doesn’t know my cut-off quantity or my cut-off price, but simple logic says if I’ve just sent in 9 orders for 10,000 shares each, I’m probably going to send in a 10th, too.

5) Making an intelligent guess that I will, he (very) quickly throws an order into the exchange to buy (say) 10,000 shares at the current asking prices and then once he’s got them, puts them up for sale again a fraction of a cent per share higher. He can do this offer to buy, complete the transaction and offer to sell before I get around to submitting my 10th order precisely because he’s so close to the exchange.

6) My 10th order comes in and since the (new, higher) asking price is still below my cut-off price, I happily buy them off the HFT dude.

7) Repeat until I finish buying 1 million shares or the price rises to Y, in which case I stop early.

I might still have that wrong (and if anybody with actual knowledge sees any mistakes, please do correct me), but for the moment I’ll suppose that I’ve got the basics down.  Here are my thoughts, in handy bullet-point form:

  • Recognising the presence of the HFT dude, the rational thing for the institutional buyer to do would be to randomise the size and timing of each order they send in to mimic a bunch of smaller players. I assume this happens.
  • To the HFT dude, a sequence of buy orders from a single purchaser and a sequence of buy orders from a collection of different purchasers would therefore be observationally equivalent. The HFT dude is therefore just a momentum trader.
  • At worst, the HFT dude is unmasking the institutional buyer’s desire to stay hidden.
  • Let’s say that the institutional buyer’s current valuation of Y is correct. Absent the HFT dude, the original sellers lose (because they sold at prices below Y) and the buyer gains (because they bought at prices below Y). With the HFT dude, the original sellers lose the same amount for the same reason and the buyer is forced to split their gain with the HFT dude.
  • But if the true value of the stock really is Y, the presence of the HFT dude simply moves the price towards Y more quickly. The market is indeed made more efficient.
  • If the institutional buyer was looking to buy for the long term, I see no problem here. Their primary goal was always to profit from the Z-Y margin and if they managed to purchase at something less than Y, that was just gravy.
  • If they were only intending to hold on to the shares for a couple of seconds anyway because they were trying to do exactly the same thing to even slower and larger buyers up the food chain (i.e. they are only interested in the Y-X margin), then frankly, they had it coming and the world should not feel sorry for them.
  • On the face of it, it seems to me that institutional players complaining about HFT outfits doing front-running amounts to complaining that they’re being forced to do their real job (of actually analysing the long-term profitability of a business) instead of just day trading.
  • Other aspects of HFT, like quote stuffing, may still be harmful; I don’t know.
  • I can see why regular, retail day traders (i.e. guys sitting in their bedrooms) would hate HFT frontrunning: they’re the slowest form of momentum traders. I do not see why I should care about them.
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Two awesome links

Published on 29 March 2012 at 12:19 pm in Economics, Europe, The Environment and USA. Tags: , , .

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Output gaps, inflation and totally awesome blogosphere debates

Published on 18 February 2012 at 6:27 pm in Academia, Economics, Finance and USA. Tags: , , , , , , , , , , , , .

I love the blogosphere.  It lets all sorts of debates happen that just can’t happen face to face in the real world.  Here’s one that happened lately:

James Bullard, of the St. Louis Fed, gave a speech in which (I believe) he argued that wealth effects meant that potential output was discretely lower now after the crash of 2006-2008.  David Andolfato and Tyler Cowen both liked his argument.

Scott Sumner, Noah Smith, Paul Krugman, Matt Yglesias, Mark Thoma and Tim Duy (apologies if I missed anyone) all disagreed with it for largely the same reason:  A bubble is a price movement and prices don’t affect potential output, if for no other reason then because potential output is defined as the output that would occur if prices didn’t matter.

Brad DeLong also disagreed on the same grounds, but was willing to grant that a second-order effect through labour-force participation may be occurring, although that was not the argument that Bullard appeared to be making.

In response, Bullard wrote a letter to Tim Duy, in which he revised his argument slightly, saying that it’s not that potential output suddenly fell, but that it was never so high to start with.  We were overestimating potential output during the bubble period and are now estimating it more accurately.

The standard reply to this, as provided by by Scott Sumner, Tim Duy, Mark Thoma and Paul Krugman, takes the form of:  If actual output was above potential during the bubble, then where was the resulting inflation?  What is so wrong with the CBO’s estimate of potential output (which shows very little output gap during the bubble period)?

Putting to one side discussions of what the output gap really is and how to properly estimate it (see, for example, Menzie Chinn here, here and here), I’ve always felt a sympathy with the idea that Bullard is advocating here.  Although I do not have a formal model to back it up, here is how I’ve generally thought of it:

  • Positive output gaps (i.e. actual output above potential) do not directly cause final-good inflation.  Instead, they cause wage inflation, which raises firms’ marginal costs, which causes final-good inflation.
  • Globalisation in general, and the rise of China in particular, meant that there was — and remains — strong, competition-induced downward pressure on the price of internationally tradable goods.
  • That competition would induce domestic producers of tradable goods to either refuse wage increases or go out of business.
  • Labour is not (or at least is very poorly) substitutable.  Somebody trained as a mechanic cannot do the work of an accountant.
  • Therefore, the wages of workers in industries producing tradable goods stayed down, while the wages of workers in industries producing non-tradable goods were able to rise.
  • Indeed, we see in the data that both price and wage inflation in non-tradable industries have been consistently higher than those in tradable sectors over the last decade and, in some cases, very much higher.

The inflation was there.  It was just limited to a subset of industries … like the financial sector.

(Note that I’m implicitly assuming fixed, or at least sticky, exchange rates)

As it happens, I also — like Tyler Cowen — have a sneaking suspicion that temporary (nominal) demand shocks can indeed have effects that are observationally equivalent to (highly) persistent (real) supply shocks.  That’s a fairly controversial statement, but backing it up will have to wait for another post …

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Sensible government policy that still makes me twitchy

Published on 9 February 2012 at 6:19 pm in Australia, Economics, Ethics and Politics. Tags: , , , , .

The Australian government is likely to start means testing the private health care rebate (i.e. subsidy).

I think that’s sensible — I generally support means testing of almost all government services — but it still makes me twitchy:

It amounts to saying that high-income households are free to choose how to spend their money, but for middle- and low-income households we’ll change relative prices so they’ll have an extra incentive to buy product X.

It’s analogous to food stamps in America — we don’t trust you to spend this welfare money on what we think you ought to spend it on, so we’re going to force you.

This is a problem of means testing in general, but I think it’s nevertheless worthwhile for three reasons:

(a) It helps minimise government expenditure;
(b) It avoids middle-class welfare, which I find fundamentally distasteful; and
(c) It provides an alternative mechanism of progressivity independent of the tax code, thereby permitting flatter (and, hence, simpler) taxes.
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Get set for more negative interest rates

Published on 1 February 2012 at 7:30 pm in Economics, Finance and USA. Tags: , , .

Via FT Alphaville, I see that the US Treasury Borrowing Advisory Committee wants to allow bids for US treasury issuances that have negative interest rates:

The question was asked if it made sense for Treasury to permit bids and awards at negative interest rates in marketable Treasury bill auctions. DAS Rutherford noted that there were operational issues associated with such a rule change, but that the hurdles were not insurmountable. It was the unanimous view of the committee that Treasury should modify auction regulations to permit negative rate bidding and awards in Treasury bill auctions as soon as feasible. Rutherford noted that any decision on this policy change would likely be made at the May refunding.

Fun times.

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Terrible news from Apple (AAPL)

Published on 25 January 2012 at 3:58 pm in Academia, Economics, Europe, Finance, UK and USA. Tags: , , , , , , , , .

Apple just reported their profits for 2011Q4.  It turns out that they made rather a lot of money.  So much, in fact, that they blew past/crushed/smashed expectations as their profit more than doubled on the back of tremendous growth in sales of iPhones and iPads.  [snark] I’ll bet nobody’s talking about Tim Cook being gay now. [/snark]

It’s an incredible result; stunning, really. I just wish it didn’t make me so depressed.

I salute the innovation and cheer on the profits. That is capitalism at its finest and we need more of it.

It’s that f***king mountain of cash (now up to $100 billion) that concerns me, because it’s symptomatic of what is holding America (and Britain) in the economic doldrums.

The return Apple will be getting on that cash will be miniscule, if it’s positive at all, and conceivably negative.  Standing next to that, their return on assets excluding cash is phenomenal.

Why aren’t they doing something with the cash? Are they not able to expand profits still further by expanding quantities sold, even in new markets? Are there no new internal projects to fund? No competitors to buy out? Why not return it to shareholders via dividends or share buybacks?

Logically, a company holds cash for some combination of three reasons: (a) they use it to manage cash flow; (b) they can imagine buying an outside asset (a competitor or some other company that might complement them) in the near future and they want to be able to move quickly (and there’s no M&A deal that’s agreed upon faster than an all cash deal); or (c) they want to demonstrate a degree of security to offset any market perceived risk with their debt.

Apple long ago surpassed all of these benefits.  The net marginal value of Apple holding an extra dollar of cash is negative because it returns nothing and incurs a lost opportunity cost.  So why aren’t their shareholders screaming at them for wasting the opportunity?

The answer, so far as I can see, is because a significant majority of AAPL’s shareholders are idiots with a short-term focus. They have no goddamn clue where else the money should be and they’re just happy to see such a bright spot in their portfolio.  Alternatively, maybe the shareholders aren’t complete idiots — Apple’s P/E ratio has been falling for a while now – but the fundamental point is that they have a mountain of cash that they’re not using.

In 2005 that wouldn’t have been as much of a problem because the shadow banking system was in full swing, doing the risk/liquidity/maturity transformation thing that the financial industry is meant to do and so getting that money out to the rest of the economy.[*] Now, the transformation channel is broken, or at least greatly impaired, and so nobody makes any use of Apple’s billions. They just sit there, useless as f***, while profitable SMEs can’t raise funds to expand and 15% of all Americans are on food stamps.

Don’t believe me?  Here’s a graph from the Bank of England showing year-over-year changes in lending to small- and medium-sized enterprises in the UK.  I can’t be bothered looking for the equivalent data for the USA, but you can rest assured it looks similar.  The report it’s from can be found here (it was published only a few days ago).  The Economist’s Free Exchange has some commentary on it here (summary:  we’re still in trouble).

So what is happening to all that money?  Well, Apple can’t exactly stick it in a bank account, so they repo it, which is a fancy way of saying that they lend it to a bank (or somebody else in the financial industry) and temporarily take some high quality asset like a US government bond to hold as collateral.  They repo it because that’s all they can do now — there are no AAA-rated, actually safe, CDO tranches being created by the shadow banking system any more, they’re too big to make use the FDIC’s guarantee (that’s an excellent paper, btw … highly recommended) and so repo is all they have left.

But the financial industry is stuck in a disgusting mess like some kid’s hair with chewing gum rubbed through it. They’re all just as scared as the next guy (especially of the Euro problems) and so they’re parking it in their own accounts at the Fed and the BoE.  As a result, “excess” reserves remain at astronomical levels and the real economy makes no use of Apple’s billions.

That’s a tragedy.

 

 

 

[*] Yes, the shadow banking industry screwed up. They got caught up in real estate fever and sent (relatively) too much money towards property and too little towards more sustainable investments. They structured things in too opaque a manner, failed to have public price discovery and operated under distorted incentives. But they operated. Otherwise useless cash was transformed into real investment and real jobs. Unless that comes back, America and the UK will stay in their slow, painful household deleveraging cycle for another frickin’ decade.

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Today’s community service announcement …

Published on 16 December 2011 at 2:47 pm in Academia, Economics and Epistemology. Tags: .

… comes from the language of scientific (well, economic) argument.

The phrase “X is consistent with Y” is actually a very, very weak statement.  All it’s saying is that X doesn’t provide evidence against Y.  Here’s a handy flow chart:

X is … Y:    ”consistent with” < “suggestive of” < “evidence for” < “proof of”

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