Nostradoofus

Solutions suggest themselves when you state a problem precisely.

The phrase “credit crisis” is unusably general.  The precise problem is that no one trusts their own estimates of default risk, so they’re afraid to lend.  It’s that simple.

Here are some key tools used to estimate default rate, and why they are no longer trusted.

1. Credit rating.  In 2007, it emerged that thousands of AAA ratings granted by the three rating agencies (Moody’s, Standard & Poor’s, and Fitch) were completely wrong.  
2. Extrapolation.  The economic environment has changed so abruptly, and so many unregulated financial instruments have been introduced in such a short time, that extrapolation of past default rates is increasingly recognized as a fallacy.  As an easy example, exotic mortgages mostly didn’t exist 10 years ago, so there is no historical basis to estimate default rates.
3. Financial statement transparency.  Previously, you could estimate the default risk of a company by looking at its books.  Today, increasing use of complex derivatives and off-balance-sheet liabilities make this more difficult.  For example, since many derivatives are illiquid, their market value cannot be estimated from current prices;  derivatives face their own counterparty risk (aka clearing risk) that is hard to estimate;  etc.  Worst, everyone knows the big financial institutions are holding out on us — whatever their books say, everyone knows they still have yet to write off all the junk.  As long as everyone believes that, they will be afraid to lend.

Note we have not mentioned monetary policy at all.  That’s because it doesn’t help.  As written here in January, short-term rates could go to zero, and lenders would still be afraid to lend, because they cannot estimate default risk from credit rating, nor balance sheets, nor extrapolation from the past.

The solution — the only solution — is to restore confidence through transparency.  At minimum, this would require:

• Major central banks to agree on disclosure standards, and force all banks to air the dirty laundry.  
• A very noisy, very public government oversight campaign to restore confidence in bond rating agencies.
• FASB standards to require public disclosure of the maximum exposure of a company’s derivative instruments, rather than just the market value of those instruments.

These and other steps would begin to restore a rational basis for estimating default risk, which in turn would permit rational pricing of bonds, which in turn would restore the bond market, which would cause bond yields to fall, which would restore the stock market.

The financial press and powers that be are weirdly silent on all these issues, exactly those required to mitigate the damage.  How strange that some civilian in southern California would even find it necessary to write a post like this one.

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Flying cars are cool. Let’s pass a law to require 25,000 of them by 2015. If GM resists, they must just be hiding their secret flying car technology.

I’m not actually talking about flying cars, but zero-emission vehicles (ZEVs) mandated by the state of California.

ZEVs are a cool idea, and a hard problem. In particular, the battery-electric solution is much more expensive than internal combustion, uses more energy (considering the entire generation value chain), and creates new environmental problems (how to recycle tens of millions of lead-acid batteries?)

Mandates define the problem too narrowly. We want less carbon, pollution and fossil fuel use. ZEV is one way. So is bicycling. Why mandate only one of these?

California’s ZEV mandates are a cheap shortcut, an easy path to political points. If we really had guts, we’d just add a huge tax on gasoline.

At $7 a gallon, we’ll get a much broader solution set, more market-based, and much earlier than 2015.

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The Wall Street Journal reports — as news, not opinion — that Obama’s pledge to talk to unfriendly foreign powers is somehow controversial.

Are there any historical examples in which talking with a sovereign head of state weakened American power? or in which refusing to talk successfully weakened an enemy?

There are certainly many cases in which poor communication with an unfriendly power resulted in avoidable wars or close calls. And there are even more cases in which refusing to talk accomplished nothing at all.

Saddam Hussein’s 1991 Kuwait gambit could probably have been avoided if the US had clearly communicated its willingness to use force.

We haven’t spoken to Cuba for 49 years. Absolutely no effect.

The entire Pacific theater of World War II was probably avoidable by better communication with Imperial Japan in the months before Pearl Harbor.

Ignoring North Korea accomplished nothing. Engaging North Korea accomplished something greater than or equal to zero, but certainly no worse than before.

Has our foreign policy has become so sclerotic that simply talking to other sovereign heads of state is controversial? What is this position based on? There is no supporting evidence, and much contravening evidence.

Only the weak fear appearing weak. Does America’s leadership have so little self-confidence that it cannot risk even speaking to an enemy?

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Americans — and especially English-language media — commonly confuse wealth with prosperity. A primer:

• Prosperity is how much you make. Wealth is how much you have.
• Prosperity is revenue. Wealth is assets minus liabilities.
• Prosperity is what America has (high GDP per capita). Wealth is what America doesn’t have (we’re a net debtor, i.e. negative equity).

Once you make this distinction clearly in your mind, you see the error everywhere. For example, consider this Reuters article about subprime lending in expensive neighborhoods. Reuters mistakenly refers to overleveraged owners of expensive homes as “wealthy.” This is obviously wrong, since the source of their problem is insufficient equity, i.e. insufficient wealth. They are prosperous, but spendy, and hence not wealthy enough to stay in their homes.

Discovering a reasoning error is often enough to change behavior. If the wealth/prosperity distinction were clearly understood by more Americans, we would grow rapidly wealthier. China’s government and citizenry understand the distinction, which is a big reason they are advancing so fast.

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Long-term real median productivity growth per capita is the perfect economic objective. It creates a simple objective function to measure all policy options.

Yes, growth should be distributed relatively evenly. Yes, there should be equality of opportunity. But all of that is contained in the above definition.

Median is used instead of average, because it makes the middle class a mathematical necessity. Equality of opportunity is similarly necessary to increase the median (though not necessarily the average).

“Long term” is a required qualification, because it prevents dumb short-term stimuli, such as fighting foreign wars to increase domestic employment.

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Few but Mr. Bush’s dogged 29% now believe spreading democracy by force was a good stabilization strategy.

Can we find any useful insight at all, lost in the neoconservative disaster that is Iraq? Well… almost. OK, they were wrong about democracy, and wrong about using force, so their wrongness is at least 99.7% pure. But there is something rich countries can spread, by policy and by example, that automatically creates stability.

Trade and investment.

Why is this stabilizing? Because economic interdependency complicates projection of military power. Governments and citizens (particularly merchants) depend upon stability of input supplies and investments, and don’t want to rock the boat.

It’s no accident that the “axis of evil” happens to be a group of relative outcasts from the global trading system. In a confrontation between one of them and the U.S., both sides have less money to lose in a confrontation, and thus war becomes more likely.

Among the three, Iran is the most economically integrated, and thus least likely to be a threat. Look at Iran’s incentives. They are one of the more economically isolated countries in the world, and yet are absolutely dependent upon the price of oil. Could they use a proxy army (aka terrorist) to plant nukes in U.S. cities right now? Yes. Will they? No. Why? The price of oil would collapse, and with it their own economy. Even Iran’s hands are tied by its limited participation in the global trading system.

Viewed this way, it looks mistaken to economically isolate countries whose policies we don’t like. Yet this is consistently what we do. The right answer is the opposite: kill them with kindness, by throwing the trading and investment doors wide open.

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The goal of government is to maximize quality of life for its citizens. The functional requirements for achieving this are covered pretty well in the Constitution: basically justice, domestic safety and economic opportunity.

Serving those requirements are an infinite variety of potential actions, so it makes sense to prioritize based on return on investment to the nation collectively. This provides the greatest good, for the greatest number, in the shortest time. High-ROI policies should be done immediately, and low-ROI policies should be delayed. Extreme examples:

HIGH ROI – Teach people to read, write, and use the Internet.

LOW OR NEGATIVE ROI – Pay farmers not to grow things.

The top priority should be for policies that simultaneously decrease spending and increase quality of life. The number of such options is surprisingly large. To name just a few:

• All government document filing should be via Web browser, with no surcharge. This by itself could save a double-digit percentage of all government spending, through decreased staffing. For example, to renew your driver’s license in California, currently the fee is higher over the Internet than in person, even though the latter service costs 10 times more to provide. The latter service should cease to exist — all renewals should be web-based. This should also be true for filing court documents, paying property taxes, and a thousand other government interactions. Billions of hours are wasted on both sides, at public expense, by making you write something down on paper, deliver it to a live person in an office, and having them transcribe the info into a computer. The money saved should be applied to providing public Web access at libraries and government offices, and to educating everyone in how to conduct such business over the Web — a very high-ROI use of funds.
• Phase out services provided in non-English languages. Not that English is superior — on the contrary, Spanish is objectively better, as it’s more grammatically consistent, easier to learn, and easier to pronounce. (Bonus: it’s also better for poetry, because so many words rhyme.) No, the reason is simply that standardization yields huge return on investment, and most people here already speak it. Nearly all other large nations with diverse linguistic heritage — India, Philippines, Indonesia, and many countries in Africa — standardize on a single language for government and commerce. Not to do so here means that we pay money to decrease our own economic output, which is, to be succinct, crazy. The money saved should be applied to providing free English lessons to anyone who can prove legal U.S. resident status — again, a very high-ROI use of funds.
• Derive military vehicles from standard commercial platforms. Currently, army jeeps and trucks are developed as they were in World War II — purely to “effectiveness” specifications, with little regard for return on investment. As a result, in 90% of real-world applications, a Humvee provides less utility than a loaded Chevy Suburban, but costs three times as much because it is produced in low volume. Simply armoring a Suburban saves money, increases reliability, and lets soldiers travel in plush leather comfort. Kidding about the leather.

The point here is that we are missing obvious opportunities to improve output, benefiting the lives of all Americans, for free or even negative cost.

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America’s failure in Iraq stems partly from errors and half-truths in our own cultural narrative, e.g.:

• America is the richest country in the world.
• America is a liberator.
• America exemplifies liberty and justice.
• Guns are a fundamental right.
• Celebrate diversity.
• Vietnam taught that you can’t win a guerrilla war.

To expand on that:

“America is the richest country in the world.” False. The statement confuses prosperity, which we have in abundance, with wealth, which we lack. On an equity basis, America, as the world’s largest net debtor, is actually the poorest country in the world. Support for the invasion was predicated on a mistaken idea that we can afford it. In the short run this is true, in exactly the same way that you could go out right now and buy a car with your credit card. The pain comes later. We are financially overextended, and our top priority is to fix that. We should think locally, focusing on productivity growth, until we fix our trade and budget deficits.

“America is a liberator.” False. What we did during World War II was so amazing that the global halo persists to this day. But it has not really been true since the Marshall Plan (if it was indeed ever true). America is just another nation, with just another set of national interests. This “liberator” concept is hype that confuses people worldwide, especially here, and undermines our reputation for truthfulness. Believing our own hype here led directly to the misapprehension that we would be welcomed as occupiers in Iraq.

“America exemplifies liberty and justice.” This was more or less true from 1965-2001, compared to other nations. Thereafter, ironically, as we have crowed ever louder about our example to the world, liberty and justice have eroded here and abroad — and everyone in the world knows it but us. This has led us to believe mistakenly that our moral authority permits us to take unilateral geopolitical action without consequences. Oops — there were consequences.

“Guns are a fundamental right.” Here, domestic politics caused brain damage to foreign policy. In 2003, the U.S. could easily have disarmed the entire nation of Iraq, making it effortless to tell friend from foe: anyone armed and out of uniform is a foe. Instead, civilians are permitted to run around with Kalashnikovs. Why? Almost certainly because of the imperative back home that we shall not take civilians’ guns away.

“Celebrate diversity.” Half true. Diversity is good, but celebrating it is often bad. To state this another way, ethnic and religious diversity benefits America economically and culturally, but petty tribalism causes self-segregation. Entrenched over generations, self-segregation destroys nations. Petty tribalism is instinctive. As a result, many people, particularly the uneducated, have a tendency to slip into it in the absence of mitigating forces. Re-instill those mitigating forces, and tribalism fades: note how ethnic civil wars often end when leadership makes it illegal for public institutions to organize by ethnic affiliation, essentially making it impossible to “celebrate” diversity politically. Lee Kuan Yew’s Singapore is a good example: beginning around 1960, you could create any kind of political party you wanted, as long as it was not affiliated with the Malay and Chinese ethnic groups that dominate the country. By institutionalizing the tendency to ignore ethnic affiliation, Lee ended the internecine civil warfare that had dogged post-colonial Singapore. By contrast, in today’s Iraq, it seemed natural for American policymakers — ignorant of history, and accustomed to “celebrating” diversity back home — to permit Sunni, Shia and Kurdish political parties. Combine this with civilian AK-47 ownership, and you have instant civil war.

“Vietnam taught that you can’t win a guerrilla war.” Wrong. Vietnam taught that you can’t win a guerrilla war MILITARILY. It taught that you can’t back a corrupt government and expect popular support. And it taught that you may have to compromise politically to regain peace. Great Britain understood this 150 years ago, and resorted to playing warlords against each other to maintain order. Not pretty, but consider the alternatives in Iraq right now.

Time to stop believing our own hype, stop mindlessly repeating domestic buzz phrases, and instead see things as they are.

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Americans surprised at their global unpopularity might consider how we are performing against this partial list of the most obvious, basic rules of civilized behavior.

1. Justice, not revenge.
2. Lead by example.
3. Treat enemies with decorum.
4. Speak precisely and succinctly.
5. Admit and apologize for mistakes.
6. Avoid condescension.
7. Don’t flaunt prosperity.

(By coincidence, this list has significant overlap with a more complete, more general and more revered list of seven things not to do.)

Each time you read a public statement from our President or his staff, check it against this list, and ask yourself how we are doing.

When our representative on the world stage calls a head of state a “midget,” or a “sawed-off runt,” are we treating enemies with basic decorum and avoiding condescension? Is his dogged mispronunciation of “nucular” precise and clear?

Don’t rush to judgment either way on this. Just memorize the list, and compare it to what you hear America saying in the papers.

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The U.S. Constitution explicitly forbids cruel and unusual punishment. What is cruel? One way to nail it down is to compare alternatives. Here is an instructive thought experiment.

Imagine our judicial system was required to provide nonviolent convicts a choice between two types of sentence. One would be a normal prison term. The other would be an “equivalent” amount of caning (a form of extremely painful whipping currently employed in Singapore, which in turn adopted it from the old British colonial justice system).

For example, say you are convicted of felony drug possession, and sentenced to 6 months in jail. Under this imaginary system, the judge would be required to offer you the option (but not the requirement) to receive, let’s say, 20 lashes instead of prison time.

For those who don’t know, caning is horrifically painful. Brutal. Barbaric.

And yet, which would you choose? Obviously the caning. Why? Less dangerous than jail. No beatings, rape, race riots, corruption, extortion, or threats. Millions of Americans face these things — things nearly anyone would do nearly anything to avoid — in prison every day.

Thus, while we can’t say the prison system is cruel in an absolute sense, we can say that any reasonable person considers it more cruel than a brutal whipping. To me, that sounds pretty cruel.

Now for the irony:

1. Behavioral psychologists will tell you caning deters crime better than prison.
2. Judges will tell you the appeals court logjam would vanish if convicts had an option to accept corporal punishment. The entire justice system would be, faster, fairer and more effective.
3. The prison population would fall by more than half, releasing billions of dollars into the productive economy, helping to balance government budgets, etc.

In short, corporal punishment by choice (not by obligation) is cheaper, more effective, and preferable to both the justice system and to the convicted. The very idea is repugnant, and yet any of us would choose it over our existing prison system. Very strange situation.

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