When Government Is Like A Box Of Chocolates ...

By: Michael Ashton | Tue, Jan 12, 2010
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I don't know if it was Reagan who said it first, but he was the first person I am aware of who said that government's approach to a problem is often "If it moves, tax it; if it keeps moving, regulate it; if it stops moving, subsidize it."

This appears to be exactly what has happened in a number of cases recently, but we have discovered that the cycle doesn't stop there but actually repeats. Financial companies have long been taxed and extensively regulated, but despite all of that earnest oversight, it turned out to be necessary to move to the "subsidization" round. Now, after extensive mollycoddling to rejuvenate the industry, the Obama Administration wants to tax the surviving and thriving companies - including those who have paid back TARP funds by issuing stock and borrowing heavily - to reimburse the country for all those recipients who are highly unlikely to ever repay the government (AIG, GM, etc).

The TARP recipients may not have taken the money originally if they knew that part of the terms included having to pay back not just their own loans, but everybody's loans. Although, come to think of it, most of the TARP banks had no choice as the Treasury and Fed forced them to take money (to avoid "tainting" the ones who really did need it). The reasoning appears to be that some nebulous banking collective is what benefited from TARP, not just the specific banks in question, and now we must take "from each according to their needs," as someone once said.

To boot, Vermont Congressman Peter Welch proposed today to copy the 50% tax on bonuses that the British and French are levying. So, rather than accepting the exodus of talent from those countries to our shores, we figure we'll squeeze our guys too. Clever.

What is really damaging in all this, though, are not the policies in question but the increasing tendency for stochastic/spastic changes in rules.

I recently read a very good book, The Forgotten Man: A New History of the Great Depression, by Amity Shlaes. It is the most unique treatment of that historical period that I have ever read. One of Ms. Shlaes' implied theses is that overwhelming government intervention during the Depression was partly responsible for extending the duration of the Depression even if it also (perhaps) lessened its depth. She shows how FDR's Administration's celebrated progressiveness unsettled the predictability of business relationships and the regulatory structure; this prodded entrepreneurs to be more timid - which is hardly what the economy needed! It is a good book and I recommend it.

This is, of course, what happens when smart people are trying to steer the economy instead of letting the economy steer itself. There must be lots of mid-course corrections because no matter how smart Obama, Geithner, Bernanke, and friends are, they aren't smart enough to understand the totality of the economy in all its dynamism. When they move this lever here, they realize that it creates a need to turn that knob over there, which further necessitates a button-push way over there. The economy naturally handles many of these things if left along, because businesses have financial incentives (if allowed to keep their gains for their shareholders) to handle those levers, knobs, and buttons that are their own specialty.

Now, whenever I think about volatility in any form I can't help but think of options, as readers of my book will already know first-hand. One of the best non-financial uses of options theory I can remember hearing was when an old boss of mine, who was otherwise an ogre, explained why New York Knicks guard John Starks was a good player for a bad team but a bad player for a good team. Starks was a streak shooter, which is another way of saying his output in terms of points-per-shot was highly volatile. When he was on, he lit up the scoreboard; when he was off, as Knicks fans recollect to their sorrow, he could drag a team down in Game 7 of the NBA Finals. My former boss observed that on a bad team, this volatility was good because a "win" was an out-of-the-money option and an increase in volatility increases the delta of such an option. In other words, if you were unlikely to win anyway then Starks' cold periods wouldn't hurt, but his hot periods would cause you to win some games you wouldn't have otherwise. However, on a good team that expected to win, a "win" was an in-the-money option and an increase in volatility decreases the delta. So the hot hand doesn't often help (you were likely to win anyway), but the manos de hielo sometimes sinks you.

This is the key point to be drawn from options theory: if an option is in the money, then an increase in volatility lowers the delta (and the delta can be thought of roughly as the probability of winning); if the option is out of the money, then an increase in volatility raises the delta.

The extension of the option analogy to business may be clear. If the economy is collapsing (I mean, really collapsing), then trying a whole mess of things to stop the implosion of the financial system is arguably warranted, because survival is an out-of-the-money option. But in most cases, the financial/economic system works pretty well, and adding a lot of regulatory volatility to the mix runs the risk of taking that in-the-money option out of the money!

It occurs to me that I am make a presumption here, and that is that the financial/economic system works pretty well if left alone. That laissez-faire philosophy is typical of Republican (old style) or Libertarian thought - the system naturally works. But there are plenty of people who believe that the system doesn't work if left alone; for example, it doesn't distribute income "properly." I suppose if you don't grant my presumption, then it doesn't necessarily follow that adding regulatory volatility is bad because even the economy of the mid-80s to mid-90s wasn't doing what you wanted it to. If a rising tide does not in fact lift all boats, then it is necessary to erect boat lifts.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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