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It's monetary policy, not a morality play
Here is my now-on-Sundays NYT column, on the recent subprime crisis. Excerpt:
Nonetheless, Fed watchers should resist the tendency to put all events into a simple or a morally plausible narrative. Monetary policy is a largely technical subject, and its ups and downs don’t usually fit into the kinds of emotion-laden stories that human beings apply to daily life. The “us versus them” tag registers in human memory, but monetary policy is not always or even usually about moral issues. As Freud famously noted, sometimes a cigar is just a cigar.
Financial market news, which is by nature unpredictable, suffers from distortion when it is crammed into the form of a simple story. Unlike most well-structured narratives, the zigs and zags of daily profit and loss defy simple categorization in terms of moral precepts.
In the case of subprime mortgages, many investors did not foresee the risk of collateralized debt securities. In response to this crisis, the Fed has been trying to keep a steady hand and prevent a credit crunch. We don’t yet know how well the Fed has succeeded, or how well it could have done in the first place. And the storm has not yet fully passed.
Of course, such an account of recent financial history sounds mundane and offers less human conflict. It’s less like the stories that people have gossiped about for thousands of years and thus will have less traction, even if it is a better guide to monetary policy issues.
Here is commentary from Mark Thoma; he believes I should embrace government bail-outs more, without moralizing against them or citing moral hazard so much.
I might add that this desire to fit everything into a story lies behind recent blogosphere discussions of supply-side economics. Many Democrats need a story of the following form: "The Republican Party makes decisions in a systematically worse way -- much worse way -- than do the Democrats." (Otherwise they might be led to favor restrictions on state power, because Republican rule has not been pretty.) While I don't assign p = 0 to this possibility (e.g., Clinton did govern better than Bush has), I think most of the Democratic bloggers give it a far higher p than it deserves, and they retreat into moral strictures to "be more progressive" when faced with contrary evidence. So a description like "the Republicans have complex motives, not all of which are noble, and end up making lots of mistakes" doesn't, for them, sound different enough from the Democrats (whom they know) for comfort.
Posted by Tyler Cowen on September 9, 2007 at 08:02 AM in Economics | Permalink
Comments
I am Marginal Revolution fan but ...
If I can summarize the last paragraph, Democratic are biased against Republicans. I am sure that's true, and of course libertarians might be biased in favor of tax cuts. On the topic of long-term, widespread deceit in the promotion of tax cuts, libertarians might retreat into discussions of the biases of Democrats.
In general, I don't think bias arguments are fruitiful. Better, to demonstrate the bias through showing the "contrary evidence" and demolishing the argument than asserting the evidence and maligning the opponent.
Tom
Posted by: Tom G. at Sep 9, 2007 8:31:40 AM
I agree with Tom G above but........
that is exactly the blogoshere is supposed to be about. Intelligent, well-infomred people duking it out over the thorny issues of teh day. But as an MR fan for 4 years now I can see that no matter how hard Prof Cowen/Prof THoma/Prof Delong/Prof Rodrik try the vast majority of the people simply won't change their biases. I can fill an entire book with examples of such wilful ignorance of hard evidence in the blogospher itself but I'll save that effort for my publisher.
The bottom line: The blogoshere is becoming a victim of it's own success, making it easier for people to build their own echo chambers, ignore contrary evidence, nod in agreement at the supporting agreement and in general refusing to acknowledge that the world has many shades of grey.
For relatively politically centrist people like me the marginal value of blogoshere will drop sharply just as internet chat forums about anarcho-capitalism.
Posted by: sa at Sep 9, 2007 9:07:59 AM
"I might add that this desire to fit everything into a story lies behind recent blogosphere discussions of supply-side economics. Many Democrats need a story of the following form: "The Republican Party makes decisions in a systematically worse way -- much worse way -- than do the Democrats." (Otherwise they might be led to favor restrictions on state power, because Republican rule has not been pretty.) While I don't assign p = 0 to this possibility, I think most of the Democratic bloggers give it a far higher p than it deserves, and they retreat into moral strictures to "be more progressive" when faced with contrary evidence. So a description like "the Republicans have complex motives, not all of which are noble, and end up making lots of mistakes" doesn't, for them, sound different enough from the Democrats (whom they know) for comfort."
You should write more on this.
Take a look at Matt Y.s most recent posts on Charles Krauthammer, and it becomes hard to think that liberal bloggers are overestimating p. Essentially every major decision of the last decade made by republicans has turned out to be a disaster. If you recall the age of young Mister Y, the liberal blogger p value becomes much more understandable, because given their data set, it is correct.
Posted by: mickslam at Sep 9, 2007 9:14:30 AM
It seems like every decade there is a problem in the financial markets that requires action by the FED to keep the whole economy from melting down. In the post mortem it is explained that investors or banks or hedge funds etc indulged in over risky behavior on a massive scale. Given this evidence why do economist think rewarding risk taking is a good idea that should be rewarded with tax breaks on capital gains while return on safe investments like CDs or bonds should not have any tax breaks. There may have been a time when the world was less dependable so risk taking needed to be encouraged but perhaps the economy would be better off if investors took fewer risks.
Posted by: joan at Sep 9, 2007 9:53:04 AM
The irony of Mark Thoma exhorting someone to not moralize is too much. I remember beginning to read Thoma as an economist, but quickly realized it was not economic reasoning that was at the center of his posts, but moralizing. Any time someone uses the term "should" with respect to government policy, they have abandoned the realm of economics and entered the realm of morality.
Posted by: M. Hodak at Sep 9, 2007 10:21:59 AM
I might add that this desire to fit everything into a story lies behind recent blogosphere discussions of supply-side economics. Many Democrats need a story of the following form: "The Republican Party makes decisions in a systematically worse way -- much worse way -- than do the Democrats."
This is outrageous. The "recent blogosphere discussions of supply-side economics" were started by a patently false post by Megan McArdle, and much of the response was simply pointing out how inaccurate it was. Now we have Tyler, who put a weak defense of McArdle, delving into psychology to claim that her critics simply "need a story." What nonsense. The criticism was largely straightforward and factual.
Do Democrats like to point out Republican foolishness? Yes, of course. And Republicans like to point out Democratic foolishness. And both sides sometimes exaggerate. But that's not what's going on here. This is just a case of a clearly inaccurate post coming under well-deserved fire.
Posted by: Bernard Yomtov at Sep 9, 2007 12:18:11 PM
I had the same reaction as M. Hodak (having been on the receiving end of Thoma's moralizing).
Anyway, 'Clinton did govern better than Bush has', was just dumb luck on Clinton's part. He inherited an economic expansion almost two years along, then lost congress to the Republicans. People like Dick Armey and Phil Gramm checked Clinton's (and his wife's) worst instincts.
Take a hard look at the last half century (1958-2007). We had a lot better governance in the last twenty five years with its three to one ratio of Republican presidents to Democrat than in the quarter century that preceded it.
Posted by: Patrick R. Sullivan at Sep 9, 2007 12:23:19 PM
What BY said, and I'll additionally point out that the NYT piece is a classic of the form where if you don't have the facts on your side, start impugning the motives. I mean, don't you know how young Yglesias is?
It's also quite amusing that an apologia for the complexity of banking is launched by the same people who pompously disdain "credit snobs". Are all libertarians just more subtle boosters of the kleptocracy? It sure looks like it.
Posted by: Russell L. Carter at Sep 9, 2007 12:24:42 PM
The "recent blogosphere discussions of supply-side economics" were started by a patently false post by Megan McArdle...
She was replying to a silly argument by Jonathan Chait, iirc. But, your reaction confirms Tyler's point.
Posted by: Patrick R. Sullivan at Sep 9, 2007 12:26:45 PM
She was replying to a silly argument by Jonathan Chait, iirc.
Even if Chait's article were silly (and it wasn't) that's no reason to respond to it with a bunch of nonsense.
You may want to argue that Chait, not McArdle, started the discussion. That's plausible. But it was McArdle's response that really kicked things into motion.
Posted by: Bernard Yomtov at Sep 9, 2007 1:16:46 PM
In every movement there are "true believers" (if there weren't there wouldn't be a movement).
So let's take the members of a movement and divide them into several categories:
1. The followers - not well informed, but they "know it when they see it".
2. The discerning followers - better informed, sometimes critical, but, in general, they buy the positions of the movement.
3. The cheerleaders - these can be further divided into the "true believers" and the shills. Sometimes they are one and the same, but not always.
4. The leaders - their motivations vary: power hungry, self assured and self righteous, and/or hypocrites.
It is easy to point out the foibles of groups 1-3, Mencken made a career out of this, for example. But this is just criticizing human nature.
The real issue comes with the leaders. We have seen enough examples of madmen running nations that there is a whole science devoted to understanding why people follow them: Adorno, Arendt, and more recent people like Robert Altemeyer have written about this.
Now to the issue at hand. There is ample evidence that things have not gone well for the past decade, at least for a large sector of the country. Some blame this on fundamental problems with the guiding philosophy, some with just the implementation.
Those who have been on the outside looking in are now enthusiastic about a chance to have their turn. Many of these people are young enough so that they have never experienced a time with a functional Democratic majority, in my opinion that would be LBJ. So, many of them imbue the Dems with better motives than they might deserve - they are bound to be disappointed to a lesser or greater extent.
Criticizing their enthusiasm or naiveté may be fun, but it's a cheap shot. The real discussions aren't taking place. To my mind they are:
1. The degree that militarism controls priorities in this country
2. The level of social services to be provided by government (or as I like to say, government-administered)
3. The level of social inequality that will be permitted, both in terms of opportunity and wealth
4. The degree that private firms will be allowed to set priorities and the degree of regulation that is needed
Other areas that get a lot of attention, such as tax policy and actions by the Fed, are actually implementation details, not the issues themselves.
So what we get is lots of discussion about implementation, but not much discussion of the goals. One reason that this may be so, is that the goals of those on both sides of the political spectrum don't differ by that much. Neither group is willing to scale back on militarism. Both sides support robust economic growth via a capitalistic, free-market model and both sides expect that it is a "national interest" that we have access to raw materials and finished goods at favorable terms.
There are no socialists, communists, anarchists, Georgists or any of a large number of similar philosophies in the public space. There certainly aren't any in government.
So the big endians fight with the little endians and the world spins along. When people will wake up to the fact that this time is not just like the past is the big question. Resource constraints, over population and climate change may be of concern, but actually addressing the issues seems not on anyone's agenda.
Posted by: robertdfeinman at Sep 9, 2007 1:52:48 PM
Didn't the Fed's low interest rates help create the sub-prime housing mess?
The value of a dollar is half what it was before 9/11 (see the price of gold http://goldprice.org/gold-price-history.html#10_year_gold_price) and the prices for real assets, like real estate and oil, had to rise accordingly.
So housing looked like a better investment than it really was, at least to the dumb money.
Hopefully the Fed will just stop inflating. Unfortunately, the fictitious measure they use to decide whether prices are rising, the so called core rate of inflation, is more of a trailing indicator, so they will probably over correct and end up deflating.
If that's the case, the problems with real estate are just beginning.
Posted by: Alan Brown at Sep 9, 2007 1:57:28 PM
I know next to nothing about monetary policy, and I'm prepared to take Tyler's word for it that the policies that the Fed is pursuing really are the right ones, and are not just a way to transfer wealth to the super-rich. But we are living in a time when a huge amount of what the government does *really is* just a way to transfer wealth to the super-rich. It is highly rational to have strong priors that any particular policy that benefits the rich is really just upward wealth redistribution. Since it is very difficult for most people to tell the policies where this is true from those where it is false, they can be forgiven their suspicions. This doesn't mean giving in to the cruder versions of populism, which can be very ugly and illiberal, but it does mean fitting an argument like Tyler's in the proper context.
Posted by: David J. Balan at Sep 9, 2007 2:44:22 PM
Was Freud saying:
A cigar is sometimes just a nicotine high?
And is that what Kipling meant when he said:
"A woman is only a woman, but a good cigar is a smoke."
Posted by: Shakespeare's Fool at Sep 9, 2007 4:28:41 PM
Something bugged me about Tyler's article. In the midst of his good points, he says next to nothing about how guilty the Fed is in all this...and...goes a step further to somehow insinuate that they've done a decent and justified job in all the aftermath of the subprime crisis and thereby validating the role they assume.
He also obscures the word "indpendent" when referring to central banks and how much better independent central banks handle monetary policy. When "indpendent" means "do whatever they feel is necessary", I don't think that's greatest or most important point to take from all this. Independent should mean "independent of the whims of the Fed". And that's a good point to take from this.
Of course, I don't know how "Austrian" Cowen is on this matter...so I can't say for sure that he would agree.
In light how admits that people are poor at understanding monetary policy when they can't even understand simple concepts like free trade, I'm not so sure his article will leave readers very clear on the best lessons to take from all this.
Yes, "forget the narratives, it's not that simple so stop trying to find one" is a good lesson...but I think some clarity on the nature of what really causes these problems deserved a little more attention.
Posted by: John at Sep 9, 2007 4:38:34 PM
All the comments and Cowen's article is very good. But it is all based on the premise that the decision makers -- Fed & govt officials, business leaders, investors, the press -- really understand all that is driving the financial markets and the economy. Our level of uncertainty, or ignorance is obviously much higher then essentially everyone assumes. It seems a requirement that someone writing an article like this or other ones assumes away massive levels of ignorance and uncertainty. What if there really is a long wave and the key difference between what the Japanese experienced in recent decades and what we have experienced is that they had heir two bubbles -- business investment and housing -- concurrently and we are having our serially.
my point is that we do not know and that we are facing an environment of very high uncertainty and ignorance. But Cownen is just as guilty as the typical Wall Street Investment Strategist of not really knowing what he does not know.
Posted by: spencer at Sep 9, 2007 5:03:52 PM
Tyler,
Very nice piece. You mentioned "random luck." Is there another kind of luck? :-)
Best,
David
Posted by: David R. Henderson at Sep 9, 2007 8:49:08 PM
Is a "moral hazard" argument in any way about morality? (consider this a "question from a loyal MR reader.")
My understanding is that it isn't, and that most economists would consider it equally rational and appropriate for sick people to take advantage of insurance companies as for the insurance companies to strive not to be taked advantage of. Ditto for investors taking advantage of the Greenspan Put, and for the fed trying to stop them. Perhaps we should say "adverse incentives" instead of "moral hazard".
Posted by: DK at Sep 9, 2007 9:03:18 PM
yes, this sounds like a critique of Matthew Yglesias.
why don't libertarian/conservative bloggers critique him more? there's something likable about him which I don't get.
Posted by: thehova at Sep 9, 2007 9:19:45 PM
I thought the comparison in the column to cleaning up after a traffic accident was apt. However, everyone wants to know what caused the traffic accident and how to prevent similar accidents in the future. Looking at the human element (reckless or inattentive driving, lax traffic enforcement, a badly designed intersection, and so on) strikes me as a reasonable thing to do. Sifting through data is one way to figure this out, but so is asking people to tell their stories, particularly when story-telling results in testable hypotheses.
To summarize this story by saying that "In the case of subprime mortgages, many investors did not foresee the risk of collateralized debt securities" not only sounds mundane, but implies that nobody could have anticipated a problem. Financial news may be unpredictable, but it's hard to reconcile this with the growing unease about the housing bubble long before it burst.
Here's a hypothesis: market incentives are an efficient motivator for discovering innovative ways to conceal risk from investors. One way to conceal risk is to make the game more complicated. Recently, several large market failures (the dot-com bubble, Enron, and the housing bubble) could be considered as failures caused by sellers responding to incentives by making financial products more complicated until investors could no longer properly assess risk, and therefore overpaid for financial products. Sellers not taking the risks have little incentive to simplify them; they can make money selling risks they themselves don't understand and have no trouble convincing themselves that these risks are low.
Sophisticated investors are particularly vulnerable to this market failure due to their trust in their own ability, their admiration for their colleagues' intelligence, and the observation of genuine benefits that come from the market's increasing sophistication. Meanwhile, more simple-minded folks might more easily see that there's a pattern here: when people start talking too quickly, hold onto your wallet.
Maybe that's just another morality tale. But if the increasing complication of the financial markets itself causes risk to the system as a whole, how do we analyze these risks?
Posted by: Brian Slesinsky at Sep 9, 2007 10:22:00 PM
Brian,
I don't know if I'd call Enron market failure, as it took advantage of loopholes in (non-market) regulation. I also don't know if I'd call the housing bust market failure either, for the same reason. The USA's financial and banking institutions are not market-based. Banks are heavily regulated and run by congress and the Fed. Mortgage securities of course aren't a government creation, but I don't think they were the source of the problem in itself. I believe they served as a vehicle for bad investments to be flipped before the inevitable bust.
If we had severe shortages or excesses in things like IT, wave-runners, or cars, I'd call those market failure (like the dot-com boom-bust).
I don't buy that investors didn't know the risks. I'm sure some were fooled, but most people knew housing was in a bubble, just like most people knew IT was as well ten years ago. Investors got burned because they were hoping to flip their investments before the bubble burst, and they weren't able to. Markets already produces deals of a complexity which both parties in a trade are comfortable with (although I wouldn't want to suggest that purposefully obfuscated deals shouldn't be treated as fraudulent).
The best explanation I've heard for the housing boom painted the decision of banks to engage in bad lending practices as a prisoner's dilemma (or the plural of which, the "tragedy of the commons"). Because a bank does not bare the full cost of a bad loan it gives out (due to credit crunches effecting the whole lending industry), it is in the self-interest of profit-seeking banks to take advantage of low interest rates and do a lot of lending. The ability for a loan to be flipped as a MBS or whatever helps the process along even more. If a bank does not increase lending with lower rates, it won't make as much money will still suffering much of the harm from a credit-crunch.
Granted, none of this would be a problem if the loans given out were "good" ones. But does anyone really think that the number of wise investments increased just because Greenspan dropped the Federal Funds Rate to 1.0%?
Posted by: G at Sep 10, 2007 6:29:01 AM
A reaction from the Naked Capitalism economics blog: Tyler Cowen's Misguided Morality Play:
I'm late to this item, and I probably should let it go, but it is so disingenuous (I'm tempted to say intellectually dishonest) that I can't let it go by.
Posted by: at Sep 10, 2007 9:55:54 AM
Given how poor most people are at risk assessment, I think it's naive to assume that investors understood the risks. Yes, they "understood" in the sense that we all know there are risks, but there is an all-too-human tendency to discount them.
It also seems fair to say that the original lender should have more information about the customer than is available to third parties and should bear some responsibility for the outcome. Maybe there should be a limit on how much of a loan may be resold, just as there are limits on margin?
The "prisoner's dilemma" of banks making bad loans (where they knew or suspected or didn't care about the ultimate outcome) is only a dilemma if you assume that all decisions must be profit maximizing. Moral decisions do, sometimes, involve forgoing profit. A market that creates incentives to do the wrong thing is a badly designed one, but that doesn't eliminate all responsibility for the people involved.
Posted by: Brian Slesinsky at Sep 10, 2007 12:46:13 PM
Given how poor most people are at risk assessment, I think it's naive to assume that investors understood the risks. Yes, they "understood" in the sense that we all know there are risks, but there is an all-too-human tendency to discount them.I would say the vast majority knew of the risks. Who would be buying mortgage-backed securities who hadn't heard of the housing bubble? Its not like people purchase these things at their grocery store.
It also seems fair to say that the original lender should have more information about the customer than is available to third parties and should bear some responsibility for the outcome. Maybe there should be a limit on how much of a loan may be resold, just as there are limits on margin?If the buyers of mortgage securities wanted more information, they could have requested it. I'm all for holding sellers' feet to the fire for taking advantage of asymmetrical information in consumer goods and the like, but purchasing securities is literally purchasing risk. In a properly functioning market, higher returns mean higher risk. Investors should know this as surely as a grocery shopper knows to thoroughly cook chicken in order to avoid food poisoning.
The "prisoner's dilemma" of banks making bad loans (where they knew or suspected or didn't care about the ultimate outcome) is only a dilemma if you assume that all decisions must be profit maximizing. Moral decisions do, sometimes, involve forgoing profit. A market that creates incentives to do the wrong thing is a badly designed one, but that doesn't eliminate all responsibility for the people involved.This is true, that game theory simplifies the goals of actors into "winning", which in this case is making profits. Its not completely realistic, and probably paints a more pessimistic picture than is reality. But I would say its far simpler to correct the systemic problems than to hold people to a moral standard after the fact. If newly-created credit is a form of "commons", IMO it makes sense to either regulate the use of that common resource, or privatize (i.e. denationalize) it. If the later happened (and I'm not going to hold my breath for that one), the Fed would probably regulate the lending practices of the banks which used its credit via contract, and for its own self-interest.
Posted by: G at Sep 10, 2007 2:08:10 PM
Matthew Yglesias gets slammed from a conservative/libertarian perspective here.
Posted by: TGGP at Sep 10, 2007 2:10:18 PM
