:LPE:

Sometime in the early 1970s, Milton Friedman formed the opinion that freer markets produced more freedom and more democracy. I believe he was taken to task over his conceptions of freedom (perhaps democracy) by CB Macpherson, in a tussle I think most agree Macpherson won. I had a discussion with a friend a few days ago, on the subject of the prospects for democracy in single-resource economies. We were talking of course about Venezuela, Iran, Iraq, Mexico, Nigeria, and so-on. The hypothesis is, if I understand it, that governments can more safely ignore the majority of the population if they can derive their finaces from the resource base, either through exploiting it themselves or cutting a deal with some unscupulous mulit-national. The rest of the government’s job is crowd control. This led to a discussion of colonial histories and the new hypothesis, do democracy and freedom (whatever they are) tend to spring up where we hve the opposite situation, namely, a diversity of revenue sources for governments? Put another way, where the tax base is wide and progressive, would we expect to see freedom and democracy? Since freedom and democracy are difficult to operationalize (Bush II alone seems to have the power to do so), other “democratic outputs” could be used, like quality of life, various participation rates in employment and civil society, and so-on.

I was getting geared up to start looking for rough statistics when, bingo, the CCPA beat me to it: Link.

This is an attempt to correlate tax regimes with social outcomes. Some highlights: high tax countries have:

+ lower poverty rates
+ more equalk income distribution
+ higher pension and disability incomes
+ greater gender equality
+ greater economic security
+ better health outcomes
+ better educational outcomes
+ lower crime rates
+ more trust in public institutions
+ more leisure time, less drug use, more likelihood of political participation
+ better environmental outcomes
+ higher GDP per hour worked and per capita
+ lower labour unit costs and lower inflation
+ higher rates of household savings
+ higher labour participation
+ more innovation by standard measures
+ higher rankings on “competitiveness” scales

High-tax jurisdictions do not lead in all categories, and some are close or insignificant differences. But it makes interesting reading in light of the hypothesis above.

There are plenty of narratives shooting around about the recent credit market ‘jitters’. Most analyses have it originating in default rates in sub-prime lending market in the US, and depending on what you read, having those defaults cause lenders to stop lending in the sub-prime market, then the commercial paper market, then commercial lending period, then stocks based on some of the commercial lending behaviour, then broader economic (read: productive economy) effects. Some labour economists have noted that the pressure that causes defaults in subprime loans (mortgages becoming worth more than the property securing them, and eventually, rising rates causing bigger payments) is equally true of the broader housing market, not just the sub-prime market, and so the effects may yet have a second “wave”.

Sometimes, these narratives mention the “irresponsible lending” practices of the sub-prime loan companies, which is probably true; making loans to people who you know can’t afford them is predatory. One of the interesting features of this lending is how the risk of making those loans - the default risk - is moved around. This is the role of asset-backed securities. I first read about them in Frank Partnoy’s books in the early ’00s, and so they were notorious then, it was just a matter of time before they ran their cycle. The interesting feature is that the people who traditionally measured and absorbed the risk of home loans, banks, no longer had to do so: they merely repackaged the loans as bonds or other similar securities in different combinations, got a credit agency to rate them (highly as possible), and sell them to investors at a slight premium. Effect: banks no longer hold onto the risk of loans, investors do, those investors being hedge funds, mutual funds (maybe), pension funds (sometimes) and, bizzarely, other banks through what are known as “conduit investments”.

So, the people with the history and expertise to manage the risk - the mortgators - no longer have an incentive to do so, because they just sell the risk to someone else. With lots of borrowed money floating around looking for returns greater than the cost of borrowing, this kind of financial innovation is nearly inevitable.

The second group of players needed to pull off this scheme are credit rating agencies: institutional investors are prohibited from buying debt below a certain quality, which is what sub-prime loans are, junk debt, so there is pressure on credit rating agencies to give them an unrealitically good credit rating. Many of the repackaged sub-prime loan based securities had AA or above ratings — nearly the same as US Treasuries. That seems a little much. Sometimes the securities were repackaged so that they looked less scary, in which case, we have a failure of the credit rating agencies to understand what they were pricing (that in itself is scary); in other situations, there are conflicts of interest, because if credit rating agencies want more work, they have to cooperate with their banking clients. Either way, one of the main gatekeepers between institutional investors (who themselves should know better) and these risky securities really failed to perform its function. So, the combination becomes, banks that want to unload risk (for a fee) and credit rating agencies that want more business from a bank (for a fee), and insurance and pension funds who really really want better returns to improve their balance sheets. Voila, a credit bubble.

Two sets of data about activity in the Canadian capital markets, from the Canadian Economic Observer Historical Tables. The first, net new issues of bonds and equity in Canada.

Equity was preferred to debt in the recession of the early 90s, but note that even in the end of the long bull (’97-’00) debt was preferred to equity, and there has been a significant drop in net new issues since 2002. Note that in 2001-2002, with interest rates at historic lows, much new debt was issued. This compares relatively closely to the pattern of debt issue in the US.

However, the pattern in equities is quite different. There are less but still positive net issue of equities (mainly common shares) in Canada, until 2006, when there are net retirements of common shares. Query whether this last moment reflects the taking private spree or redemptions or both. The second shart shows new issues and retirements a little more clearly. In the US, only once in the past 20 or so years has there been a net new issue of shares, where in fact, US capital markets have been shedding dispersed shareholders.

It is gratifying to see that concerted global quasi-government action is still possible; and not only for making war on terrorists, but in order to bailout individuals and firms in credit trouble. If the custodians of the financial system have mastered one thing since the 1990s, it has been the bailout. No longer must turmoil in the financial markets presage a general economic crisis.

What else can be said? Some pretty massive resources have gone into providing liquidity in credit markets, including low-interest loans backed by rapidly-declining CDOs, expanding the forms of permitted collateral for the loans, an interest rate cut by the Federal Reserve, and even pension funds attempting to bail out the market for commercial paper (where in the Caisse’s mandate are the words “stabilize or subsidize private commercial paper markets”?).

Players in the market with some optimistic bets have been given breathing room to unwind them at not-so-massive losses. Marxists and money-system pessimists of all ideological stripes are saying I told you so, someone in the Globe said two days ago that the PE market would be back on pace by September (which deal does she have in the pipe?) and bank economists are cautiously saying not much more than we won’t know how wide-spread the effects of this correction are until we know how wide-spread the effects of this correction are. Jeff Rubin looked a bit like a chump when he said sub-prime woes would not affect Canada.

Correction, yes, it is a “correction”; in this case, as a friend said, a backlash without there having been a revolution. He meant there was no market shock, no ‘exogenous’ factor that caused the animal spirits to panic: no hurricane, no plague among cattle, no (new) war broken out. This correction was, it seems, prompted by a lack of buyers of high-risk debt, which led to questions from existing owners of that debt. Some hedge funds were off 80% in July.

No exogenous event, apparently a growing systemic effect (as the bank economists say, we’ll know how systemic when we know how systemic): is not the naive question, why didn’t everyone see this coming, if the Marxists did? What possible explanation would you have for your client when they ask why you didn’t see the bubble in CDOs, the risks of interest rate hikes to low-income borrowers, and so-on? Is it just the vagaries of the market system? More rigorous neoclassical economists ought to suggest that the market in many of these esoteric securities is finding a new equilibrium as those with bad judgment or imperfect information or whatever, are being priced out. We aren’t hearing a lot about proper repricing of securities in general equilibria right now, because the central banks have coordinated to prop up prices, making it the not-so-free-market. Central bankers are ideologically free marketeers, but practically much more selective in their application of price stability: Delong estimated that the Fed’s intervention last week implied a projected inflation rate of 2,000%, about 1,997.5% more than their target rate the week before, when they considered raising interest rates.

In fact there was plenty of easily available analysis about this particular eventuality - just not about the precise timing - so we might even say the bets were bets against time, and some got caught on the wrong side of the hump. If you unwound your bets or cashed out in June, you were doing pretty well this year. Not so much now. The central banks have tried to generate time for players to get their money out, not much more.

But the explanations are yet to come - just now they are “fear has the market” (where, I suppose, ‘faith’ had it previously) and the implication that a more drastic ‘correction’ is unwarranted, certainly the central banks think so, and the further implication that fear is irrational, and an orderly unwinding of the deals must at least take place. To smooth the way are the central banks whose Greenspanian technique has been to let the bubbles form and wipe up the mess when they burst (with the notable exception of the Bank of England, which has remained remarkably consistent in it’s non-intervention). Bernanke inherited the mess from his predecessor, who knew of the equity bubble in ‘99 but refused to do anything about it, and who knew of the real estate bubble in ‘04, but refused to do anything about it. Until this week, the BoC was ready to raise rates again, and the Fed in the US was considering it, but perhaps waiting until the Spring to do so.

That was then. Today, it is interesting to see how a coordinated global policy to socialize costs can be forged overnight, how capital markets are remarkably dependent upon structured quasi-governmental intervention (and if we extend the analysis, how they are structured public institutions anyway, and ought to be brought under the control of a more accountable and democratic polity than senior financial echelons of a single city), and how free market theory is so rapidly jettisoned when hedge funds have money to lose, how we can barely distinguish between investment banks and pension funds, and how we still don’t know why someone paid 2% of assets under management and 20% of profits can make such a hash of things: no doubt if they were paid 3 and 30 this would not have come to pass.

This will be interesting for your friend who is not a lawyer to watch - the profession’s reaction to Philip Slayton’s book about lawyers-gone-bad. I got an e-mail from the LSUC recently providing a generic disclaimer along the lines that not all lawyers sleep with their clients, overbill (read: steal) and lie in court. An interesting case of preaching to the choir. Let’s see though, last year there was the Treasurer (think: President) of the law society who slept with three clients while sitting on a discipline committee that suspended another lawyer for a year for doing the same thing — and when the Treasurer was busted (he tried to get his lovers to sign releases, ouch), he himself got 4 months. Then there was the prominent Bay St. lawyer having the the least secret affair in the world with a Supreme Court judge’s daughter-in-law. Then there was the guy who laundered money for the mob, a lot of it. And, isn’t Conrad Black a lawyer, Alan Eagleson…anyway, it shouldn’t be hard to drum up material.

I’ve yet to read the book or the Maclean’s scoop on same, but I look forward to it. One of the things to look for is, of all the laywers gone bad, how many are punished by the LSUC - the body that the public has delegated to manage lawyers - and of those who are punished, how many are from large establishment firms, and how many are from small or sole proprietorships.