Felix Salmon

Today brings dueling stories in the NYT and the WSJ on the status of the bank foreclosure-settlement talks. At issue is the question of whether the banks should be given immunity with respect to lawsuits surrounding their securitization shenanigans. Here’s the WSJ, saying quite clearly that they won’t:

U.S. and state officials dismissed the push for broad immunity as a “nonstarter,” according to a federal official involved in the talks, but they have countered with a narrower offer. It would cover robo-signing and other servicer-related conduct but leave banks open to potential legal action for wrongdoing in fair lending and securitization, according to people familiar with the situation. Attorneys general in California, Delaware, Massachusetts and New York have said they are investigating mortgage-securitization practices.

In the NYT, by contrast, Gretchen Morgenson says that New York’s Eric Schneiderman is pushing back against a federal attempt to give banks immunity on such matters:

Mr. Schneiderman and top prosecutors in some other states have objected to the proposed settlement with major banks, saying it would restrict their ability to investigate and prosecute wrongdoing in a variety of areas, including the bundling of loans in mortgage securities.

So, is immunity with respect to mortgage securitization a nonstarter, or is it the whole reason why banks would dream of signing the settlement in the first place? I suspect it might be both. If I was a bank, I wouldn’t dream of paying billions of dollars in return for a narrow settlement precluding further prosecution about robo-signing and the like: it just wouldn’t make economic sense to do so. At the same time, if I were Schneiderman, in the middle of a detailed investigation into what banks’ mortgage departments got up to in the run-up to the crisis, I certainly wouldn’t want that investigation rendered moot and toothless before it had even been concluded.

If you’re expecting this settlement to be announced any time soon, then, prepare for disappointment: these are the kind of talks which often fall apart at the final hurdle. The Justice Department is on the record as wanting to “bring billions of dollars of relief to struggling homeowners”, but it’s not obvious that this settlement is the best way to do that, or even that any kind of mechanism for delivering that relief is credibly in place. So my expectation is that the talks are going to drag on, yet another contingent liability hanging over the head of America’s largest banks. It’s an outcome that no one really wants, which weirdly makes it the kind of outcome most likely to happen.

I’m very late to Jeremy Groves‘s wonderful little paper where, using himself as a subject, he timed his bike commute on a heavy steel bike and on a much lighter carbon bike. After riding 1,520 miles back and forth from Sheffield to Chesterfield Royal Hospital and carefully timing every journey, he came to an inescapable conclusion: the lighter bike wasn’t any faster than the heavier one. And this on a long journey where small differences would, you would think, add up: the round-trip commute was 27 miles long, with 2,766 feet of total ascent. That’s the kind of uphills where saving 9lbs of bike makes a real difference.

So, what’s going on here? Groves has his own theories, mainly surrounding the idea that big factors, like the weight of the rider and the amount of drag, completely obliterate smaller factors like the weight of the bike and the resistance of the tires. But I think there might be something else going on, too. Here’s Joshua Foer on what he calls the “OK plateau”:

In the 1960s, the psychologists Paul Fitts and Michael Posner described the three stages of acquiring a new skill. During the first phase, known as the cognitive phase, we intellectualize the task and discover new strategies to accomplish it more proficiently. During the second, the associative phase, we concentrate less, making fewer major errors, and become more efficient. Finally we reach what Fitts and Posner called the autonomous phase, when we’re as good as we need to be at the task and we basically run on autopilot. Most of the time that’s a good thing. The less we have to focus on the repetitive tasks of everyday life, the more we can concentrate on the stuff that really matters. You can actually see this phase shift take place in f.M.R.I.’s of subjects as they learn new tasks: the parts of the brain involved in conscious reasoning become less active, and other parts of the brain take over. You could call it the O.K. plateau.

The skill of riding a bike fits perfectly into this scheme. It’s not easy to learn at first, but over time we get better at it, until we’re so good at it that we basically stop thinking about it, and stop trying to get any better than we are. I’m sure that a doctor like Groves has much better things to think about on his commute than his bicycling technique.

When I switched from a heavier bike to a lighter one, I felt as though I was going faster, but I have no idea whether that’s empirically true. Certainly the lighter bike is much more maneuverable, which is very handy on New York’s potholed streets. And it’s easier to get up hills, even if I’m not getting up them any faster.

As Kent Peterson notes, a lighter bike can make your journey more comfortable. That doesn’t mean it will make your journey more comfortable: ultra-light racing bikes in fact tend to be rather uncomfortable things. But when you’re riding up a hill at your normal speed, you’re generally happier when you weigh less. That’s why people buy lighter bikes: at the margin, they’re likely to make any given bike ride a little more pleasant. Which is not the same thing as saying it’ll be faster. Leave the racing to the racers: the rest of us are just happy being happy.

(Via Vanderbilt)

James Stewart, on Saturday, looked at the narrow issue of how to tax carried interest, and made the very good point that it’s really just a small part of the much broader issue raised by the fact that we tax capital gains at a much lower rate than earned income:

The root of the problem highlighted by Mr. Buffett is the disparity between tax rates on capital gains and ordinary income. Were these rates the same, the debate over how to treat carried interest would vanish, along with much of the disparity between tax rates for the rich and people like Mr. Buffett’s secretary.

Is that so unthinkable? … Even some hedge fund and private equity officials concede that the argument for lower capital gains rates rests more on faith than science. “I’ve seen study after study that says lower capital gains rates have no impact on behavior,” the hedge fund official told me.

That view is also backed by a growing amount of academic research questioning the premise that lower capital gains rates promote growth. The evidence “is murky, at best,” said Leonard E. Burman… author of “The Labyrinth of Capital Gains Tax Policy.”

“It’s not the panacea for economic growth that advocates make it out to be,” he said. Mr. Buffett himself lent empirical support to this view in his column. “I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off,” he said.

The system we have right now — where we tax earnings from capital at much lower rates than we tax earnings from labor — is counterintuitive. If you have money, you really have no choice but to invest it somehow, and when you invest it you’re generally going to try to maximize the return you get on that investment. That’s true whatever the capital gains tax might be. On the other hand, people really do have a choice whether or not — and how much — to work. Taxing labor will, at the margin, mean less of it.

Meanwhile, the way that the capital gains tax is structured, it actually encourages bad investment. Here’s Alan Blinder, writing when the same debate came up four years ago:

Why do we have a preference for capital gains in the first place? The main argument is that lower taxes on capital gains boost investment. But the evidence on that point is iffy at best…

A far more important objection is that the tax preference for capital gains undermines capitalism — a system in which capitalists, not the state, are supposed to make the investment decisions. When I discuss this issue with my Economics 101 students, I show them an example of a proposed investment that loses money before tax (and which, therefore, should be rejected) but which actually turns a profit after tax because of the preferentially low capital gains rate. (Accountants and tax lawyers live this example every day.) The government thus induces people to make bad investments, which is a good way to run an economy into the ground. Come to think of it, that’s just what the old Soviet Union did. It invested copiously, but badly.

BUT would taxing capital gains like other types of income imperil our economy? No. The Tax Reform Act of 1986 did exactly that, and it did not end capitalism as we know it. In fact, the gross domestic product in 1987 and 1988 grew at about the same rate as in 1985 and 1986, and the investment share of G.D.P. barely budged.

Here’s a simple suggestion, then, for the super-committee taking the latest long hard look at US fiscal policy. Rationalize the tax code, pick a number for any given annual income, and declare that number to be the tax rate — no matter whether it’s for personal income or corporate income, income from labor or income from capital gains. It would probably put a significant number of tax lawyers and accountants out of work, but I’m sure they could find productive employ elsewhere.

If you did this while abolishing all the corporate tax loopholes and individual tax deductions, you could even sell the whole thing as a tax cut, keeping everybody happy.

But it’s not going to happen, because of the incentives facing politicians. If the tax code is complicated, and if politician are permanently fiddling with loopholes and deductions, then there are always monied interests throwing large amounts of money at those politicians in an attempt to move the tax code to their advantage. Simplify the tax code, and all that money goes away. No elected politician is ever likely to vote for that.

It appears Muammar Gaddafi’s regime in Libya has more or less fallen. Right now, I’m thinking about Mahdi Ziu (from this great April Times article on the Libyan revolution), and wishing that Tim Hetherington and Chris Hondros were taking pictures in Tripoli today.

Manhattan District Attorney Cy Vance, Jr. will apparently ask a judge to dismiss all charges against former IMF head Dominique Strauss-Kahn.

“Groupon is the invisible hand of capitalism sucker punching good restaurants that deserve to succeed and helping out mediocre venues that deserve to fail.” – Bloomberg critic Ryan Sutton on his new crusade against bad restaurant deals.

Representatives from the Obama administration are said to be pressuring New York Attorney General Eric Schneiderman into settling with major banks over “dubious foreclosure practices.” And Bloomberg reports that the largest banks have received as much as $1.2 trillion in loans from the Fed.

Skype will acquire group messaging startup GroupMe for a reported $85 million. GroupMe’s been around less than eighteen months; angel investors like Lerer Ventures have made quite a bit of money, while Series B leader Khosla has almost tripled its investment in barely nine months. One expects founders Jared Hecht and Steve Martocchi also came out nicely, though still a far cry from Zuckerberg money.

The boy was 13 when a dawn immigration raid abruptly ended his father’s four-year quest for political asylum in Britain. By nightfall of that day in 2005, father and son were hundreds of miles from home, locked in the privately run Yarl’s Wood Immigration Removal Center here, scheduled for deportation to their native Angola in the morning.

Instead, shortly after midnight, the despondent father, Manuel Bravo, 35, walked to a stairwell with a bed sheet and hanged himself. The note he left said why: so that his orphaned boy could stay in Britain.

-Yesterday’s incredible, front page NYT piece on a particularly awful British asylum situation is like a cross between Charles Dickens and Zadie Smith. If you haven’t already, please, please read it.

This chart comes from Eric Burroughs, who calls it “one of the best gauges for showing the extreme nervousness over what the endgame really is in Europe”. But I’m assuming here that you’re not the kind of person who looks at FX volatility surfaces on an everyday basis, so it might be worth a little bit of explanation.

The chart is showing how expensive it is to buy options on the EUR/CHF exchange rate — that is, the number of Swiss francs per euro. When the Swiss franc strengthens, as it has been doing of late, the exchange rate goes down. The current exchange rate can be seen in the middle the “Delta” axis, where it says “ATM” — that stands for “at the money”. So everything to the left of that line — the PUT contracts — shows the price of a bet that the Swiss franc is going to strengthen. And everything to the right of the line — the CALL contracts — shows the price of a bet that the Swiss franc is going to weaken.

Now the Swiss franc has appreciated a lot against the euro of late — you could get more than 1.5 Swiss francs to the euro this time two years ago, while a couple of weeks ago the exchange rate dropped to as low as 1.03, and it’s still at 1.12 right now. To put it another way, a 100 Swiss franc meal in Zurich would have cost you €65 two years ago, €76 one year ago, and €89 today. At this point, the Swiss franc is so strong that the Swiss National Bank is doing everything in its power to try to weaken it. So the time to bet on a strengthening Swiss franc was clearly in the past.

But just look at the chart — it’s much higher on the left-hand side, the PUT side, than it is on the right-hand side. That’s known as “skew”, and it means that the market is decidedly bearish on EUR/CHF. If you want to bet that the exchange rate is going to go back up, that will cost you quite a lot of money. But if you want to bet that the exchange rate is going to continue to decline, that’s going to cost you an absolute fortune.

And in fact the market seems to think that even if the Swiss National Bank manages to weaken the Swiss franc in the short term, over the long term its efforts won’t count for much. The lowest parts of the chart — the cheapest bets of all — are the ones saying that the Swiss franc is going to weaken over the long term of 18 months to 2 years. Meanwhile, the highest parts of the chart — the most expensive bets you can make — are the ones saying that the Swiss franc is going to strengthen a lot over the long term of 18 months to 2 years.

Some of this activity is hedging, of course, rather than speculation. Let’s say you’re one of those corporate chieftains attending Davos in January as a Strategic Partner. That’ll cost you 590,000 Swiss francs. In 2011, that was €457,000. But as of right now your Davos membership fee has already risen to €523,000; you might well want to lock it in right there before it goes any higher. (If you’re unfortunate enough to be paying in dollars, it’s even worse.)

But the main message of the chart is that people are almost irrationally worried right now. The Swiss franc is a classic flight-to-safety play, a bit like gold or Treasury bills. That’s why it has appreciated so much of late. But the markets are saying that its recent appreciation might only be the beginning, and that the Swiss franc might well end up being worth more than the euro pretty soon. Here’s how Burroughs puts it:

When the skew starts to normalize, then the market may be convinced that Europe is getting a handle on this crisis. We are far from that point.

I’ll trust Eric to keep an eye on this chart — I wouldn’t know where to start even trying to build such a thing. But it seems clear to me that he’s right: we’re going to wait a long time before this chart stops sloping down and to the right. Which is another way of saying that we’re going to continue to have a crisis in Europe for the foreseeable future.

While watching another Arab government get toppled on Sunday evening — this time that of Muammar Gaddafi, in Libya — I was also reading George Magnus’s excellent note for UBS, entitled “The Convulsions of Political Economy”; you can find it chez Zero Hedge.

Convulsions is right — not only in the Arab world, of course, but also in Europe and the US. And the result is arguably the most uncertain outlook, in terms of the global political economy, since World War II ended and the era of the welfare state began.

As Magnus says:

It seems that we are having sometimes esoteric tiffs between Keynesians and Austrians about if and how governments should sustain jobs and growth. But, deep down, we are having a much more significant debate as we are being forced to redefine what we think about the rights and obligations of citizens and the State.

Most fundamentally, what I’m seeing as I look around the world is a massive decrease of trust in the institutions of government. Where those institutions are oppressive and totalitarian, the ability of popular uprisings to bring them down is a joyous and welcome sight. But on the other side of the coin, when I look at rioters in England, I see a huge middle finger being waved at basic norms of lawfulness and civilized society, and an enthusiastic embrace of “going on the rob” as some kind of hugely enjoyable participation sport. The glue holding society together is dissolving, whether it’s made of fear or whether it’s made of enlightened self-interest.

In Europe, the speed with which the transmission has been thrown violently into reverse is nothing short of astonishing. The whole second half of the 20th Century was devoted to building strong European institutions which would maximize cooperation and minimize mistrust and finger-pointing between member states. Great statesmen put European unity on a par with narrow national self-interest, and the resulting institutions — the euro, of course, but also things like the Schengen Agreement and the European Convention on Human Rights — transformed the blood-soaked continent of the 1940s into a peaceful and prosperous model for how disparate countries could successfully work together to the benefit of them all.

And the US, of course, the global hegemon, a continent unto itself, stood as a beacon for the rest of the world: 300 million disparate people coming together to create something unprecedented — an economic, political, and military colossus built on solidly democratic principles. E pluribus unum.

But countries and institutions can ultimately survive only with the will and consent of those they govern — and that consent is evaporating around the world. Europeans have no love for Europe’s institutions, be they the euro or the ECB or the EFSF. Unemployment, in much of Europe, has reached the point of no return — the point at which it becomes endemic, stubbornly immune to attempts to tackle it. In turn, that results in broad-based cynicism and disillusionment when it comes to politics and politicians generally.

And then on this side of the pond we have Rick Perry — harbinger and prime example of the way in which mistrust in federal institutions has moved from the fringe to the mainstream. Indeed, what we see with Perry is far more than mistrust — he actually denies most federal institutions their existential legitimacy, and has written a book explaining at length how everything from Social Security to federal bank regulation is in fact unconstitutional.

When Perry accuses Ben Bernanke of treachery and treason, his violent rhetoric (“we would treat him pretty ugly down in Texas”) is scary in itself. But we shouldn’t let that obscure Perry’s substantive message — that neither Bernanke nor the Fed really deserve to exist, to control the US money supply, and to work towards a dual mandate of price stability and full employment.

For the first time in living memory, someone with a non-negligible chance of winning the US presidency is arguing not over who should head the Fed, but whether the Fed should even exist in the first place.

Looked at against this backdrop, the recent volatility in the stock market, not to mention the downgrade of the US from triple-A status, makes perfect sense. Global corporations are actually weirdly absent from the list of institutions in which the public has lost its trust, but the way in which they’ve quietly grown their earnings back above pre-crisis levels has definitely not been ratified by broad-based economic recovery, and therefore feels rather unsustainable. Meanwhile, the USA itself has undoubtedly been weakened by a shrinking tax base, a soaring national debt, a stretched military, and a legislature which has consistently demonstrated an inability to tackle the great tasks asked of it.

It looks increasingly as though we’re entering Phase 2 of the global crisis, with 2008-9 merely acting as the appetizer. In Phase 1, national and super-national treasuries and central banks managed to come to the rescue and stave off catastrophe. But in doing so, they weakened themselves to the point at which they’re unable to rise to the occasion this time round. Our hearts want government to come through and save the economy. But our heads know that it’s not going to happen. And that failure, in turn, is only going to further weaken institutional legitimacy across the US and the world. It’s a vicious cycle, and I can’t see how we’re going to break out of it.

Update: emptywheel responds.

Update 2: as does Ezra.

One of the problems with the news cycle is that perennial issues — problems and solutions both — tend to get ignored in favor of things which have changed in the last few hours or days or weeks. As a result, when it comes to the global economic crisis — the thing which came to the world’s attention in 2008 and which no amount of Panglossian dreaming of V-shaped recoveries can wish away — one of the key potential solutions has been left all but ignored from the outset of the crisis through the present day.

So it’s worth taking a big step back, and looking at the global economy from 30,000 feet. When you do that, you see a lot of wasted resources — in food, in energy, in water, and of course in war. But add them all together and they still don’t come close to the human resources that are wasted every day. This is the 21st Century — the age of information technology and service-sector value-addition. The two most valuable companies in the world, Apple, and Exxon Mobil, both have fewer employees than the population of Moses Lake, WA. The right people in the right place are worth more now than at any point in history — even as the total population of the planet, and therefore its gross human potential, has never been higher.

At the same time, however, the universe of people with the potential to really change the world is vastly smaller than it ought to be. Silicon Valley entrepreneur Marc Andreessen, writing in the WSJ on Saturday, complains with good reason:

Many people in the U.S. and around the world lack the education and skills required to participate in the great new companies coming out of the software revolution. This is a tragedy since every company I work with is absolutely starved for talent. Qualified software engineers, managers, marketers and salespeople in Silicon Valley can rack up dozens of high-paying, high-upside job offers any time they want, while national unemployment and underemployment is sky high.

Does the world have a shortage of good software engineers? Yes. Does Silicon Valley have an artificial shortage of good software engineers? Yes. There are lots of highly-qualified software engineers from India, Russia, and elsewhere — even Canada — who would love to work in Silicon Valley but can’t, for visa reasons. Even if you got your qualification at Stanford University, right in the heart of Silicon Valley, it’s decidedly non-trivial to get a job in Palo Alto or Cupertino upon graduation. You know the companies, you know the people, they know you, they would love to hire you — but the Bureau of Citizenship and Immigration Services gets in the way, and forces you out of the country instead.

If you’re more ambitious than that, of course, the situation gets even worse. There are at least ways of getting a work visa in the US; they’re far too onerous, and leave far too much to chance, but it’s possible. If you want to become an entrepreneur, on the other hand, there’s really no point in even trying. Recent graduates are perfectly positioned to build the great companies of the future: they’re bright, they’re hard-working, they’re up to speed on the state of the art, and they generally don’t yet have families which require job security and a steady income. But if they’re not US citizens, it’s almost impossible for them to build the economy of the future in this way.

And Silicon Valley has historically been a very good place for immigrants — think Intel’s Andy Grove, or Google’s Sergei Brin. It’s no coincidence that the most vibrant areas of the economy are also the places with the highest immigration. Immigrants — especially rich and well-educated immigrants — work hard, create jobs, pay much more in taxes than they take out in benefits, and tend to have overachieving children: they’re a recipe for economic growth and prosperity. The US is a nation of immigrants; from the Statue of Liberty’s beaconed hand glows world-wide welcome, at least in theory. In practice, the US has shot itself in the foot in this regard, especially when compared to its Anglophone competitors like Canada and England. America would have an all but insurmountable competitive advantage in the fight for talented immigrants, were it only to bother competing.

Take another step back, and the lack of mobility of the skilled global elite is a microcosm of a much larger problem, which is the lack of labor mobility more generally, both between and also within countries. Detroit, for instance, has painfully high levels of unemployment just because there aren’t nearly enough jobs in the city, any more, to support its population. The solution is for people in Detroit to move to where jobs are more plentiful. Similarly across the US: one of the reasons why a single currency works well across 50 disparate states is precisely because there’s a decent amount of labor mobility between those states. But as a rule, the more labor mobility the better, and one way of ensuring that jobs get filled by the best-qualified people is to maximize the ease of moving geographically from one job to another.

Moving is always painful, of course, especially for families, but this is one area where homeownership is very much a bad thing. Selling a house is difficult, expensive, and time-consuming — all the more so in today’s depressed market, when millions of homeowners are underwater on their mortgages. In the short term, the government should be doing everything it can to bring liquidity back to the real-estate market — and that means forcing banks to do principal reductions on underwater mortgages. In the long term, it should phase out the mortgage-interest tax deduction, which artificially increases homeownership and decreases labor mobility.

Improving labor mobility is not easy. Italy, for instance, has been a unified country with a single language and a single currency for 150 years, but it still has minimal labor mobility from the south to the north. The lack of labor mobility has been one of the biggest macroeconomic problems facing the Eurozone; again, the millions of unemployed people in the south are not filling jobs in the north. (There’s a bit more mobility from east to west, but not much more.) And globally, discrimination on the basis of one’s country of nationality is the one universally-condoned form of discrimination still in existence: every country in the world puts up significant barriers to prevent foreign nationals from living and working within its borders.

This is not a problem which can or even should be fixed overnight. But it’s a huge problem all the same, and the world’s policymakers should be working on it rather than ignoring or exacerbating it, as they’re doing at the moment. If we want to maximize long-term growth, eradicate global poverty, and give everybody in the world the opportunity to achieve their potential, then a vast improvement in global labor mobility is top of the list of prescriptions.

The death of the M&A scoop is going to happen slowly, but frankly it should happen as quickly as possible — and the past 24 hours in the history of Hewlett-Packard is an excellent indicator of why.

Yesterday, just after noon, Bloomberg found itself in possession of some market-moving news about HP: it was engaging in a major strategic shakeup, closing its WebOS division, buying UK company Autonomy for about $10 billion, and putting its PC business up for sale. (Bloomberg has since updated its story to reflect HP’s formal announcement, so I can’t link to the scoop itself.)

The markets, suffering through a massive down day, loved the news, in its leaked-to-Bloomberg form. HP shares were trading about $29.85 before the news came out; a few minutes later they were as high as $34. That’s a rise of 14%, or, to put it another way, an increase in market capitalization of some $8.5 billion.

One blogger, at least, was unimpressed. Zero Hedge, in an astonishingly prescient post entitled “Hewlett Packard Leaks Good News Early, To Mask Bad News Later,” explained exactly what was going on:

With less than 5 hours until the company’s official earnings release, Hewlett Packard just leaked to by Bloomberg that it would spin off its PC business and purchase British software developer Autonomy PLC. This is the oldest trick in the book to get a stock to drop from a higher level in the hopes that staggered releases of news, first good, then bad offsets each other, instead of having the good news be overwhelmed by the bad… We very much doubt this surge will sustain itself for more than a few minutes after the scam is understood. We also very much doubt that today’s earnings release will have anything good to say about the future.

By the end of the day, HP was back to its pre-report levels, in anticipation of a weak earnings report. But no one guessed just how weak the earnings would be.

HP was still spinning, though: its official news release was headlined “HP Confirms Discussions with Autonomy Corporation plc Regarding Possible Business Combination; Makes Other Announcements.” Among those “other announcements”:

FY11 GAAP diluted EPS is expected to be in the range of $3.59 to $3.70, down from its previous estimate of at least $4.27.

In English? “We’ve been telling shareholders to expect earnings of at least $4.27 per share this year. But actually we’re not going to come close. In fact, we’re not going to make more than $3.70, and we might make as little as $3.59.”

The drop from $4.27 to $3.59 is a whopping 16% — a huge miss, given that we’re already more than three quarters of the way through Hewlett Packard’s fiscal year. HP didn’t even attempt to guess what 2012 might hold in stock, perhaps because it’s likely to take most of that year to slough off the PC business it poured so much money into back in 2002.

And so when HP shares opened for trading today, they fell sharply — just as Zero Hedge predicted they would. They’re now trading at less than $24 per share — a 20% fall from the closing price yesterday and a whopping 31% fall from the post-leak knee-jerk exuberance levels of about 12:15pm or so yesterday.

We still live in a world, sadly, where it’s considered good journalism to get a scoop like Bloomberg’s and to move the market by publishing it — in the world of financial journalism, moving markets like this is the gold standard of what editors and proprietors are looking for. Even if you move them in what turns out to have been entirely the wrong direction, with a one-sided story which leaves out the most important news of the day.

It’s clear today that HP’s strategy is failing, that the big strategic moves are something of a hail-Mary pass, and that it’s massively overpaying for Autonomy. We got there in the end. But the M&A scoop which kicked off the news cycle looks like an attempt by HP to manage media coverage and to distract attention from its dreadful earnings guidance. And, at least for a few short minutes, it actually worked.

James Macdonald has an extremely valuable way of putting things into stark focus:

The markets have highlighted a fundamental shortcoming in Keynes’s ideas: He assumed that governments would always be able to borrow. If they cannot, then Keynesian economics is dead in the water.

The thesis of Macdonald’s essay is simple and scary — and, I think, correct.

We have been living through, and are now probably witnessing the end of, an era with no historical parallels: what might be described as the “great debt experiment.”

In many ways this is a good thing. We’ve relied far too much, in the developed world, on debt-fueled growth — and that kind of growth rapidly becomes unsustainable in a world where the amount of growth that can be squeezed out of every marginal dollar of debt has been falling steadily for decades.

But deleveraging,which is great from a systemic-stability perspective, has another name in the short term: austerity. And that’s something we’re only starting to get used to, and which is going to get much more painful, especially in Europe, before this cycle has played itself out.

Greece was the first Eurozone country to find itself locked out of public markets; it won’t be the last. And even now, Greece can still borrow: the ECB and Eurozone have enough faith in Keynesian principles that, for the time being, they’re willing to step in as the lender of last resort to troubled sovereigns. But Greece is small enough to save in that matter; Italy, not so much. If the public markets shut out Italy, or if the Eurozone lacks the political will to continue throwing good money after bad, then we’ll immediately enter the most severe crisis of our lifetimes.

Here’s a couple of charts from Spiegel’s excellent slideshow on the subject to put Europe’s sovereign debts in perspective; the second one should be titled “debt”, not “deficit”. But the first one is the scarier one: it just shows the debt coming due by end-2013 in the five crisis countries. We have a serious liquidity issue here, never mind the questions of solvency raised in the second chart.

The Maastricht limit, of course, is the maximum debt that Eurozone countries are allowed to have. So much for that idea. And debt in general, as we saw in 2008-9, is a treacherous and precarious beast — you never want to push it to its limits. The market will roll over a country’s debts happily and indefinitely — until it won’t. Some countries, like Japan, are relatively safe in that regard: “the market”, there, is domestic savers in a country with a high domestic savings rate. But when a country is reliant on foreign investors to buy its debt, and can’t easily fund itself domestically, it’s playing an extremely dangerous game.

Is that the case in the US? Happily, no — as you might suspect, given the 10-year Treasury yielding 2%. But you’d probably be surprised how much of America’s $14 trillion debt is money we’ve lent to ourselves in one form or another.

So the US, by rights, should be the last country onto the austerity train. We’re the happy recipient of the global flight-to-quality trade, we fund in our own currency, and we fund largely domestically. (Yes, the “public debts” includes a lot of foreign investors, and even some foreign sovereigns, but all that money being taken out of our paychecks in the form of social security contributions and the like goes a surprisingly long way — it’s forced lending to the US government, and it’s not going away.) There are serious questions about some countries’ ability to be able to continue to tap the capital markets; there are no questions at all about others. The US is, happily, in the latter category: if the Treasury ever stops borrowing, that will be thanks to Congressional edict, rather than due to any reluctance on the part of the markets to roll over debt.

That said, the US is running into enormous political problems just trying to make up with sovereign borrowing what the economy has lost in private-sector borrowing over the course of the recession. If it can’t rise to the Keynesian challenge domestically, there’s absolutely no way it will let itself be dragged into becoming a lender of last resort globally.

Which means that we’re in the final innings of the Keynesian game. If you look at the history of sovereign debt, we started with countries borrowing large sums of money from rich private-sector individuals like the Rothschilds. When those sums weren’t enough, the era of big publicly-owned banks began, and borrowing capacity rose sharply. Then we moved into domestic capital markets, and eventually international capital markets. Each move increased the amount of money available for lending to sovereigns. Finally, when sovereigns get tapped out, they can try to appeal to super-sovereigns: the ECB, the EFSF, the IMF and the like. But those funds are limited, and don’t last long. Hence the move to austerity — the only other option. Or, of course, there’s always inflation — the other way that the ECB can bail out overindebted sovereigns. But that doesn’t seem likely any time soon.

Update: Matt at Obsolete Dogma has a really smart response.

Everybody knows that correlations go to 1 during a crisis. But markets and crises move at many speeds. Rodrigo Campos quotes one technical analyst today as saying that during the latest bout of market volatility, “We were moving over a three and a half day period like we were during the flash crash, just more orderly. It was totally irrational.”

Paul Amery today takes a bigger step back, looking at stock-market correlations over the past five years or so. The chart is instructive, I think:

The methodology here is a bit complicated — you start with the implied volatility of stock index futures and then strip out the implied volatility of single-stock options. And towards the end of each contract’s life things can go a bit haywire — especially if the contract is expiring in January 2009, right in the middle of the crisis. But the big picture seems clear: correlations are not only very high, but they’re on a steady uptrend, too. What we’re seeing right now is not some kind of unusual spike: it’s entirely in line with how the stock market has been trading for years now.

JP Morgan, in a research report last year, looked even further back, using a different methodology.

The big thesis of the report was that correlations had overshot, and were likely to come back down; that didn’t happen. Instead, the trend has only continued since then: correlations have been increasing for a good 20 years at this point, and are now at levels exceeding those seen even in the aftermath of the 1987 crash, when portfolio insurance products forced high correlations on the market as a whole.

There are many reasons why correlations are high and rising. The rise of high-frequency trading is one; the rise of ETFs is another. Both of those are here to stay.

And then there’s the broader economy. Here’s how JP Morgan puts it:

A significant driver of correlation between stocks is the prevailing macroeconomic environment. During periods of high macro uncertainty, stocks prices are largely driven by macro factors such as economic growth, unemployment, interest rate changes, inflation expectations, etc. Therefore, during changes in macroeconomic regimes, stock prices tend to move in unison leading to a high level of correlation.

On top of that, macroeconomic uncertainty tends to lead to stock-market volatility, and stock market volatility in turn is associated with higher correlations. So the more uncertain the macro environment, the higher correlations are likely to go. JP Morgan might be right that we’re in a “correlation bubble”, but if we are, I don’t think it’s going to burst any time soon, just because macro uncertainty is going to remain very high for the foreseeable future.

What are the implications of this? For one thing, expect your broad-based S&P 500 index fund to give you much less diversification benefit than it would have done ten years ago; similarly, you can expect it to be much more volatile than it would have been ten years ago, too. Essentially, indices are behaving more and more like risky individual stocks, with the proviso that they can’t go to zero.

On top of that, it’s going to remain very hard to make money as a stock picker in this market. It’s easier than ever to play the indices, thanks to ETFs, which now account for 40% of all exchange-traded activity in equities. And if you want extra risk, that’s easy, too: just play bank stocks instead of the broad index. Because of their inherent leverage, they always fall more than the index when it’s going down, and rise more when it’s going up. But if you’re carefully doing the Graham-and-Dodd thing, poring over balance sheets and trying to find value, make sure you have a long time horizon and aren’t liable to get run over by the correlation steamroller. Your carefully-picked stock will, to a first approximation, do exactly the same thing as all the other stocks are doing, and if you’re planning on waiting for corporate fundamentals to assert themselves, be prepared to wait a long time.

Michele Bachmann has promised to bring back $2 per gallon gas. But I want a chicken in every pot!

Tim Geithner’s 50th birthday cake is about as depressing as this economy. He should have just eaten a “supercookie.” Oh wait, no, that’s actually a new method websites are using to track your browsing history, the WSJ tells us.

British gilt yields fall to their lowest since the 1890s. German guilt’s still really high, otherwise they would have told PIIGS to take a hike by now.

Some great photographs of What They Were Thinking, then and now, in the New York Times Magazine.

AT&T charges you 10,000,000% more for sending data when it’s in a text message. While we’re on the subject of unfair, capricious bureaucracies, here’s an interesting Q & A with Eliot Spitzer on ratings agencies. “The metaphor I used to use is that it’s like getting a speeding ticket. You learn the lesson for some period of time but then 20 miles down the road, 30 miles down the road, your foot starts going back down on the accelerator. It’s a question of for how long we’ve learned the lesson.” Er, should we expect to find some more hookers twenty or thirty miles down the road?

Hundreds of foreign students in the U.S. on a summer work visa program staged a walkout at a Hershey’s plant, alleging heavy exploitation. I wonder: did the Oompa Loompas ever try that?

Ezra Klein says that FDR devaluing the dollar (and some help from Hitler) helped end the Depression. Bit of trivia: that same Executive Order is why Glenn Beck shills gold coins at a hefty markup.

And Anderson Cooper has a very severe case of the giggles.

Peter Rudegeair, who has the memory of an elephant, thought of me when he saw David Swensen’s op-ed in last Sunday’s NYT. Back in March 2009, he recalled, I posted a short blog entry entitled “The Dangers of Listening to David Swensen”. In light of the new piece, Peter asked, what do I think now?

The answer is that Swensen still doesn’t look so good, despite the fact that he’s mainly advocating something perfectly sensible — investing in low-cost index funds. Still, there are two problems with the piece. His argument doesn’t really hold up, and it also looks suspiciously self-serving.

Swensen is right, of course, that the mutual fund industry has a conflict between making money for itself and making money for investors. But then he starts getting specific about how the industry takes money from investors and turns it into profit for itself:

Mutual fund companies, retail brokers and financial advisers aggressively market funds awarded four stars and five stars by Morningstar, the Chicago-based arbiter of investment performance…

In 2010, investors redeemed $152 billion from one-star, two-star and three-star funds and placed $304 billion in four-star and five-star funds. In the crisis-scarred year of 2008, even as investors withdrew $174 billion from one-star, two-star and three-star funds, they added $47 billion to four-star and five-star funds. Year in and year out, flows to four-star and five-star funds prove remarkably resilient and overshadow flows to the three bottom categories.

This churning of investor portfolios hurts investor returns. First, brokers and advisers use the pointless buying and selling to increase and to justify their all-too-rich compensation. Second, the mutual fund industry uses the star-rating system to encourage performance-chasing (selling funds that performed poorly and buying funds that performed well). In other words, investors sell low and buy high.

Ill-advised buying and selling of funds costs the investing public a substantial sum. In 2010, Morningstar found that if mutual fund investors in 2000, as a whole, had simply bought and held their funds for 10 years, their investment outcomes would have improved by an average of 1.6 percentage points per year. That 1.6 percent may not sound like much, but it adds up to tens of billions of dollars per year.

Swensen is right that people are more likely to sell underperforming funds, and buy outperforming funds. And he’s also right that there are fund managers out there who recommend precisely that course of action: I wrote about one of them a few weeks ago. But he’s wrong that the tendency to rotate from underperforming funds into outperforming rival funds is responsible for that 160bp of negative alpha. If that was the case, all you’d need to do is trade the opposite way — sell the five-star funds, buy the one-star funds — and you’d make a fortune.

The fact is, as Swensen well knows, that within any given sector, the difference between the best-performing funds and the more mediocre performers is almost always modest. If you look very carefully, over five years or longer, then you might be able to discern a performance differential between, say, five-star and four-star funds. But as a rule, it’s nothing to write home about. So unless you pay massive up-front fees every time you buy and sell funds, being rotated from one value fund to another, or from one emerging-market fund to another, is unlikely to do massive harm to your net worth.

What’s more, investors are actually pretty smart win it comes to picking mutual funds. They’re cost-conscious: the lower the fees, the more popular the fund is likely to be. And if you look back at the funds which investors piled into before Morningstar existed, they tend to be precisely the ones which would have got 4- and 5-star ratings, and which over the long term turned out to be the best bets.

So the 160bp of underperformance — the difference between investor returns and market returns — doesn’t seem to come from the area that Swensen identifies: it’s a lot more complex than that.

A look at the report in question is probably useful at this point; Swensen doesn’t provide a link, but I’m nicer. What we’re looking at here is a gap between investor returns, on the one hand, and the average return of a mutual fund in that sector, on the other. Morningstar’s John Rekenthaler confirmed for me that we’re looking at the unweighted average of all the funds in a sector, regardless of size — so in the smaller sectors, if there were one or two small funds which did extremely well, that could easily throw off the average considerably. What’s more, there’s significant survivorship bias over the course of a decade: the underperforming funds tend to close and not get counted in the figures, while the best performers all live on.

All of which means that Swensen isn’t right when he characterizes the average fund return as the return that investors would have received had they “simply bought and held their funds for 10 years”.

And there’s certainly no evidence to suggest that buying actively-managed funds rather than index funds will cost you anything close to 160bp a year. As I say, mutual fund investors in aggregate are pretty smart: they tend to buy funds which might not be quite as cheap as the cheapest index funds, but which aren’t far off. Even once you take into account the idea that most fund managers underperform the index, you’re still not going to get to that 160bp level.

Instead, Rekenthaler has his own theory for the underperformance, which rings much more true to me. We’re not seeing investors rotate within sectors, we’re seeing them rotate between sectors, something he calls “category chasing”. When tech stocks or real estate or gold are hot, investors pile in; when those sectors crash, the same investors pile out. “Within a category, people are making rational decisions,” says Rekenthaler. “The problem is that they’re chasing categories.”

I hasten to add here that Rekenthaler doesn’t have the empirical data to prove this thesis in an iron-clad manner. But it’s more credible than the Swensen thesis, since it seems as though it’s better at explaining the big differences between stated mutual-fund returns, on the one hand, and the actual returns that investors see, on the other.

And if Rekenthaler is right, then Swensen’s prescription — everybody should just pile into index funds — does no good at all, and in fact might even do harm. As index funds steadily get supplanted by ETFs, the ease of trading in and out of them, from one hot sector to the next, becomes all but irresistible: everybody becomes a market timer. I have a very expensive broker, who performs no useful service for me at all, beyond simply being expensive — and that’s a good thing, because if I know that trading is expensive, then I won’t do it, and if I don’t trade, I’ll make more money over the long term. Fees are bad — but sometimes ease of trading can be bad, too, as Emanuel Derman notes today.

On the other hand, there’s one group which would benefit greatly if Swensen’s advice were taken and the SEC put a lot of effort into pushing all individual investors into index funds. And that’s the kind of hedge-fund managers who Swensen invests in. Because there’s a paradox of index funds: while they make perfect sense for any given individual, it would be disastrous if everybody invested in them. The whole point of having a market is that you need millions of people all competing against each other to allocate capital most efficiently. Investing in an index fund is a way of free-riding on the collective wisdom of active investors, and so you need to have more active investors than index-fund managers in order for the market to continue to work.

The more people that invest in index funds, the easier it becomes, in theory, to beat the index — which is Swensen’s job. And while I’ll continue to recommend that any given individual should invest in index funds, I wouldn’t suggest, as Swensen does, that there’s a public-policy benefit in pushing everybody to do so.

Allan Sloan says that today is “scarier than 2008-09″ — and looking at the markets, he doesn’t seem far off. Yes, stocks are still much higher than they were at the height of the crisis, but relative to earnings the improvement isn’t all that impressive. Meanwhile the 10-year Treasury hit a new all-time low yield of 1.97% today, inflation figures notwithstanding, and gold too is hitting new highs above $1,825 per ounce.

To be honest, though, I’m not seeing fear or panic right here. For one thing, we’re in the middle of August — the time of year when traders and institutional investors go on vacation, volumes tend to dry up, and market moves can get magnified for no good reason. Today stocks fell as much as 5% and the VIX broke above 40 — moves which are indeed reminiscent of what was happening in those panicked days of 2008-9. But having experienced those days and come out the other side, I feel that the investing public as a whole has been toughened up a bit, inured to volatility in a way they weren’t back then. Plus, of course, they’re much richer, on a mark-to-market basis, than they were when the S&P 500 was below 700.

What I’m not seeing here is deep-seated existential fear — the idea that certain companies might well wind up seeing their stocks go all the way to zero, and then defaulting on their debts. During the crisis, we had the worst possible flavor of that fear — that it was banks which were insolvent. Now, by contrast, bank stocks are low, but the famous TED spread, for instance — one of the best indicators of the degree of faith that financial institutions have in each other — is still less than 30 basis points. It spiked to more than 400bp at the height of the crisis.

If we were genuinely in a period of panic and turmoil, we wouldn’t see multi-billion-dollar deals being done for companies like Morotola and Autonomy; we certainly wouldn’t be seeing extreme equity capital markets deals being mooted like the idea that Manchester United might list its shares on the Singapore stock exchange. The markets are clearly finding it difficult, this August, to determine what the right and proper price is for various financial assets. But that’s not panic. In fact, it might just be a perfectly rational response to an increasingly uncertain world.

Matt Taibbi’s 5,000-word exposé of the SEC’s document-shredding is a magnificent piece of journalism, and is the first and last place that you should look to understand what’s going on here. After the piece came out, Senator Chuck Grassley — who’s quoted in the article — made growling noises in the general direction of the SEC, which is now very much on the back foot. But all the news and background that you need can and should be found in Taibbi’s article, rather than Grassley’s 325-word press release.

So how well is the mainstream media reporting this news? Everybody’s reporting Grassley’s statement, of course, as they should be. But the WSJ, Bloomberg, FT newspaper, and even Reuters make no mention of Taibbi or his article at all. The NYT is better, providing a link to the article and saying that the document disposal was “first reported by Rolling Stone magazine on Wednesday”, but the link feels grudging and there’s nothing which indicates that if you follow the link you’ll get a much fuller and richer version of the story than you’ll get from the NYT. Only FT Alphaville draws a direct connection between Taibbi’s article and Grassley’s statement and really encourages you to read the piece.

Blogs and Twitter, of course, are much better. Zero Hedge, Dealbreaker, Naked Capitalism, Daily Intelligencer, Clusterstock, Atlantic Wire, and many others took Taibbi’s article seriously, linked to it prominently, devoted entire posts to it, and mentioned him by name rather than just referencing the name of his publication. The Huffington Post gave the article its standard aggregation treatment, and Arianna tweeted it personally.

As for the substance of the article, Taibbi makes a very strong case. Only Matt Levine has attempted a defense of the SEC, and he says that the agency’s policy of destroying files was “publicly announced”, when in fact it was a secret internal policy which the SEC wouldn’t even admit to when asked point-blank by the National Archives and Records Administration, the agency in charge of all federal document-disposal decisions. Levine says that “the trouble with Big Brother was too much all-pervading surveillance, not too little”; the financial crisis, I think, proves him clearly wrong on that front. The SEC in particular was toothless and ineffective for the entire Bush Administration, effectively giving banks and other fraudsters a green light to do anything they wanted. And its response to these latest allegations has been distressingly defensive and obfuscatory.

I hope this turns into a big scandal and causes significant changes at the SEC — although I’m not holding my breath. But if it does, Taibbi will deserve a huge amount of the credit. And judging by today’s coverage, he won’t get it from the mainstream financial press.

The much larger than expected 0.5% inflation figure today is certainly worrying, even if I wouldn’t go as far as Joe Weisenthal, who says that it “screams stagflation”. For one thing, we had negative inflation in June, of -0.2%, so there might be an element of mean-reversion here. But if you look at the 12-month inflation figures, they’re all pretty high, with a headline number of 3.6% — significantly higher than anybody at the Fed would normally feel comfortable with.

The problem is separating the signal from the noise. The Fed has one time-tested way of doing this, which is to strip out food and energy prices: if you do that, inflation was just 0.2% last month, and 1.8% over the past year. Meanwhile, energy costs have gone haywire:

It’s very hard to know what to make of a series like this, where you can have 37.2% annual inflation in fuel oil even when it’s fallen in price for three successive months, and where price volatility in fuel is closely connected to price volatility in the markets generally. Gasoline alone, with its 4.7% rise in July, accounts for fully half the headline 0.5% inflation rate — and although no one can know where gas prices are going to head going forwards, it seems improbable that they’re going to continue to rise at that kind of pace. In that sense, gas-price inflation, although certainly painful now, is not something self-perpetuating which the Fed can or should worry about when setting monetary policy.

It’s also worth remembering that the heavily-indebted US economy could do with a little bit of inflation right now, to help deflate real debts and chivvy along growth: an annual core inflation rate of 1.8%, although the highest we’ve seen since 2009, is much closer to optimal than the 0.6% number we saw last October.

So my feeling is that inflation figures, like stock-market prices, should be treated as less than gospel during this summer of volatility. Food and energy prices are crucially important parts of America’s household budgets: they can’t and shouldn’t be ignored. But there are very strong linkages between the two: 97% of the fertilizer applied to crops is manufactured from natural gas, a lot of energy is expended trucking food to supermarkets, and then of course there’s this:

If I were the Fed, I’d be looking very closely at the dynamics of food and energy prices, to work out the degree to which we’re just seeing normal market-based volatility, and the degree to which we’re seeing a secular upwards trend here which is going to have a nasty effect on inflation for the foreseeable future. That said, even if it’s the latter, it’s hard to see what the Fed can do about it. Marginally higher short-term interest rates aren’t going to have much effect on oil prices or refineries.