Apparently the SEC believes in magic, too.

Their top economist is stepping down after the agency rejected his staff’s study and adopted short-selling restrictions. In spite of there being no evidence that short sales can take down otherwise healthy companies, the SEC restricted them because, as they said, they “undermines confidence.”

I’ll tell you what undermines confidence: having politicians artificially support stock prices. If I can only buy a stock at a price that some bureaucrat determines is fair, I’ll just keep my (and my clients’) money at home. Short-selling is the free speech of the financial markets. It allows participants to express a negative opinion. And just like free speech, it’s most unpopular when things really stink.

But it’s not black magic. You can’t cheat an honest man and you can’t undermine a sound balance sheet. In time, the truth of every business comes out. If you short a solid company and they keep on reporting growing stable and growing earnings, you’re going to lose money.

That’s why sound companies never fear shorts. And a free market doesn’t fear the Dark Arts.
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 Do You Believe In Magic (Part 2)? [1:30m]: Play Now | Play in Popup | Download

Do you believe in magic?

That’s what some folks are asking. Take Germany’s Angela Merkel: she has sharply criticized those who might profit from Greece’s distress. I assume she’s talking about hedge funds buying default insurance, driving up borrowing costs. Through the sorcery of derivatives, these dark wizards are brewing up a potion of fiscal pain.

Then there’s Gretchen Morgenson, the New York Times financial reporter, who breathlessly pointed out Sunday that cities and towns that lowered their expenses years ago through the charms of interest rate swaps were actually bewitched by a coven of advisers and brokers. Now they’re bound by unbreakable chains to the rock of negative cash flow. Unless they pay a break-fee.

Across the financial landscape, the white magic of financial innovation has morphed into the dark art of derivative alchemy. But nothing really has changed. Derivatives are a contractual tool for transferring risk from one party to another. Pretty boring, really. They weren’t a miracle when the economy was good. They’re not evil now that times are tough.

So when politicians or news folks try to convince you that finance is magic, there’s really only one response. Blow them off like so much pixie dust.
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 Do You Believe In Magic? [1:30m]: Play Now | Play in Popup | Download

There’s no free lunch. Even with free trade.

Ever since David Ricardo published the Principles of Political Economy, economists have recognized the benefits of trade, even if your trading partner can do everything cheaper than you can. It may seem illogical, but it works. It’s like a lawyer who can type 120 words-per-minute hiring a slower-typing secretary. Even if the lawyer’s faster, it’s better for them both for the secretary to do the filing.

So when global trade exploded after the fall of the Wall in 1989, economists rejoiced. All that comparative trading meant global output could grow faster. Restrictions fell, and billions of consumers entered the market. The only thing to worry about, according to many, was the transition to this trade nirvana.

But the law of unintended consequences asserted itself. Since trade expanded, networks are much more complex, and problems with fuel prices, piracy, and border control are huge. Disruptions in one area can affect the whole globe. So with an increase in global growth comes an increase in volatility.

It’s as if the world’s portfolio went from a blue-chip index to a group of small-cap stocks. The long-term returns are better, but at the price of more volatility. So Milton Friedman is proven right again: there’s no free lunch.
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 Trading Places Redux [1:31m]: Play Now | Play in Popup | Download

So what are the Credit Cops telling us?

First, most countries are perfectly safe. It costs .15% to insure Norwegian debt for five years—the most creditworthy country on the planet. They have annual oil revenue equal to about 20% of their economy. By comparison, the US costs .40%, Switzerland .50%, England .80%, Spain 1%, and Greece 3%. The real global basket cases are Venezuela and Argentina, at 10%

Second, Greece has issues, but they’re related to funding, not solvency. It costs more to insure short-term Greek debt than long-term debt. That’s unusual. It means that investors are concerned that Greece may have trouble in the next six months, but if they clear those hurdles, their debt is no riskier than, say, Egypt.

Finally, there’s no comparable situation here. The most exposed sovereign issuer here is the State of California, with its yawning $20 billion budget gap and default swaps at 2.8%. But the State has a massive, diversified economy to draw upon, and a history of muddling through. It’s highly unlikely that they will default on their general obligations.

The world has gone through a difficult time. But its good to know that the Credit Cops are on the beat. They can tell us a lot, if we listen.
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 The New Vigilantes (Part 2) [1:30m]: Play Now | Play in Popup | Download

In the ‘80s and ‘90s, a new term was coined: bond vigilantes.

Bond vigilantes were traders who would sell out of government debt at the least hint of inflation. They pushed Treasury yields up from 7% to 10% in 1987, when the stock market crash brought yields back down. They attacked the Clinton stimulus program, concerned that the government’s deficits would crowd out other borrowings.

Tom Wolfe dubbed these folks the “Masters of the Universe.” What happened to them?

US bond markets seem positively docile even though the Treasury is borrowing a cool $100 billion a month. Short yields are almost zero, and longer yields are around 3 ½ percent.  So where did they go?

One place is into the credit markets. They pushed the cost of Bear Stearns debt up 4% before the Bear was bailed out. The same thing happened to Lehman before they failed, and is happening to Greece and Iceland now. It seems that the bond vigilantes have become credit cops, spanking companies and governments when their fiscal policies seem irresponsible.

They may not be elected, and their only loyalty may be to their profits. But they can tell us something about a country’s or company’s finances. We would do well to listen.
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 The New Vigilantes [1:31m]: Play Now | Play in Popup | Download

Don Kohn has resigned from the Fed. With him goes a lot of memory.

The Obama administration is now going to be busy finding a successor. While most will focus on whether new Fed members will be interest rate hawks or doves, what’s really interesting can’t be so easily labeled.

Dr. Kohn brought an unparalleled sense of history to his job. He joined the Kansas City Fed in 1970, and moved to Washington in 1975. He saw double-digit inflation, market panics, insolvent banks, and financial contagion well before the latest crisis developed. When the sub-prime fiasco hit, he provided the Chairman with valuable insight about how the Fed had dealt with these challenges.

He served tirelessly, sometimes making politically unpopular calls, like maintaining confidentiality about bank transactions. And he knew how to get things done. During the height of the panic, he had a daily conference call with Bernanke, Geithner, and Governor Warsh. Together, they were the “Four Musketeers.”

Prior to Kohn’s elevation to the Board in 2002, staff economists had never moved up to a policy chair. But we’re lucky he was. By bringing institutional memory to the Fed’s inner circle, he helped us avoid a second Great Depression. He is one of the many unsung heroes of the crisis.
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 Thanks for the Memories [1:31m]: Play Now | Play in Popup | Download