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What went wrong with the economy?
On Wednesday David Leonhardt posed the question, here is part of my answer:
To understand the depths of the current crisis, let’s go back to an apparently unrelated episode in economic thought: the socialist calculation debate. Starting in the 1920s, Ludwig von Mises, the leader of the so-called Austrian School of Economics, charged that socialism was unable to engage in rational economic calculation. Without market prices, he reasoned, no one knows how much economic resources are worth.
The subsequent poor performance of planned economies bore out his point...The irony is that the supercharged capital markets of the American economy are now — at least temporarily — in a somewhat comparable position. Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.
Market prices have been drained of their informational value and thus don’t much reflect the “wisdom of crowds,” as they would under normal circumstances. Investors are instead flocking to the safest of assets, like Treasury bills.
The absence of trading is a big problem. Financial institutions have been stuck holding illiquid assets, whose value cannot be easily determined. Who wants to lend to the institutions holding them? No wonder there is a credit crisis and a general attitude of wait and see.
And here is another problem, namely the relationship between Mises's argument and the degree of leverage. When leverage is high the needs for exact calculation are much greater:
This gridlock is especially harmful because leverage is so high, and financial institutions are so interconnected through swaps and loans. Institutions that rely so heavily on debt are precarious and need up-to-date information about valuations. When they don’t have it, markets freeze up. This is what has taken policymakers by surprise and turned a real estate crash into a much bigger financial problem.
Do read the whole thing; I also consider why price declines don't necessarily restore asset liquidity.
Posted by Tyler Cowen on March 23, 2008 at 07:41 AM in Economics | Permalink
Comments
I'm surprised to hear you argue for more regulation. However, I'm more interested in your response to Fred Block's comment that one major problem was the reduced taxes on the rich, which lead them to invest more money in risky areas like hedge funds.
Posted by: Finnsense at Mar 23, 2008 8:08:21 AM
In the NYT piece you write:
"So what now? Regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions."
I wonder if you can unpack that in a way I might understand it. Can you give an example of something the regulators (would that be the Fed?) are doing now different from your advice, and then spell out what doing it according to your advice would be? Thanks.
Posted by: Daniel Klein at Mar 23, 2008 8:18:18 AM
The libertarian solution is to abolish the Fed, and to arrest Greenspan and Bernanke (even before Cheney and Bush).
When the Fed expands the monetary base by lowering the discount and/or fed-funds rate or by other means, the resulting interest rates are inconsistent with the unfettered time preferences of of all market participants, including margined and cash buyers of securities and derivatives and the institutional lenders to the former. When the loan rate of interest is forced down far enough, demand for loanable funds (or investible resources as Roger Garrison would say) exceeds their supply. To the extent that more of these funds enter capital markets than would otherwise be the case, they help inflate asset prices.
The calculation problem comes into play because the discount rate used to value cash flows of these assets is lower than would be the case under free banking, which causes the bubbles to appear. When rates rise toward their market levels, the bubbles are deflated.
Posted by: Bill Stepp at Mar 23, 2008 8:25:55 AM
Btw, if Jamie Dimon is really clever, he'll require his traders and analysts to have a seminar on ABCT. I'd start with Garrison and Selgin.
Garrison's homepage has some terrific power points.
At least they'll be forewarned somewhat when the next bubble inflates.
They shouldn't let James Grant's readers be the only ones to have fair warning.
Posted by: Bill Stepp at Mar 23, 2008 8:48:28 AM
I have two questions for Tyler.
I'm not much of a judge, but I recall hearing that one of the reasons for the crash in the 20's was excessive leveraging making the financial institution unstable. Thus, regulations were created to restrict buying on margins and other leveraging strategies. Have we simply circumvented these regulations with a new set of leveraging strategies and thus reinvented the same instability?
It seems to me that it would be possible to create assets which can be accurately valued at first, lending themselves well to market calculation. But if these assets then are prone to becoming uncertainly valued as time passes, they would foil market calculation, right? Have we created such hot potatoes with the housing bubble and highly leveraged instruments? Or is it more simply fraud, as in Ponzi schemes? Or neither?
Posted by: Mike Huben at Mar 23, 2008 9:52:01 AM
I'm not much of a judge, but I recall hearing that one of the reasons for the crash in the 20's was excessive leveraging making the financial institution unstable. Thus, regulations were created to restrict buying on margins and other leveraging strategies. Have we simply circumvented these regulations with a new set of leveraging strategies and thus reinvented the same instability?
If excessive leverage was a factor in causing the crash of '29, what was the cause of the excessive leverage?
Can you spell F E D E R A L _ R E S E R V E?
The Fed can't manage stock bubbles by dictating margin requirements, which should be determined by the market.
Previous attemtps to do so have failed, and traders can circumvent the requirements by gaining additional leverage in futures and options. The margin rules are also more liberal for institutional investors.
Fed actions are the only cause of "excessive" leverage. The Fed's tinkering with margin requirements to deflate stock bubbles makes as much sense as using price controls to stop inflation.
Does anyone have an extra "Arrest Greenspan First" button?
Posted by: Bill Stepp at Mar 23, 2008 10:49:24 AM
I liked your article. But I have two questions: (1) Aren't asset values always uncertain? Fischer Black in one of his papers argues that speculation exists only when asset values are uncertain, and speculation is always with us. (2) If speculation is always with us, aren't markets inherently unstable-- i.e. bubbles, followed by collapses, severe doubts about the value of assets: liquidity crises!
Posted by: PeterE at Mar 23, 2008 12:05:10 PM
When I looked at the profile of Bernanke on this week's cover of Business Week, at first I thought it was Lenin. But then I remembered that Lenin only spoke of the consequences of debauching the currency, whereas Bernanke is actually doing it.
Lenin's tomb for Bernanke.
Posted by: Bill Stepp at Mar 23, 2008 12:36:02 PM
Hmm, not a word about consumer fraud. I guess that narrative franchise is defunct. Doesn't reflect well on the supposed "insights" that were produced by that franchise though.
However, this column is really pretty good. The psychologizing seems eminently sensible, rather than the previously banal and condescending ideological tone, and it admits that the set of likely outcomes is rapidly reducing, for good reasons. We do have to thank Republicans and faux libertarian collaborationists like Tyler for enabling this rather large experiment in free market exuberance, and especially to thank them for the backlash that's coming. Your time in the woods probably extends for a decade so, that will be a good time to do some thinking on other minor trifles, such as when is it right to go to war.
Posted by: Russell L. Carter at Mar 23, 2008 1:15:47 PM
A question for Tyler about the market for MBS. My understanding is that when JP Morgan bought Bear, Stearns, that the accountants over the weekend had to come up with some value for the firm in the absence of a market. One interesting factoid overlooked is that at the last minute of the deal, JP Morgan concluded that the value was much less than previously thought, in the end about $2.30 a share. No firm other than Morgan had a chance to look at the books so much, but some others had already passed, so maybe there was some market for the company. The value of the building on Madison Avenue was thought to be four times that amount. So evidently the market for financial securities firms that hold MBS had some means of price discovery. Are MBS essentially worthless? But since nobody has to open the books we have no real good picture what the valuation of components of the company are, such as MBS, we can only guess. However, my question would be, isn't the proxy market and price discovery working in a way here to value mortgage-backed securities? And instead of opening the books and making firms mark to market their holdings, isn't the Fed really just preventing the market from working and price discovery to happen, hoping everyone will keep on listening to the Great Pretender? So I think there is a 4th policy alternative: follow von Mises and abolish the Fed, don't have regulation either by politicians or by unaccountable bankers, except to prevent force or fraud like what has been going on legally. In the meantime, can we expect to see other investors take note of what happened in the price discovery of MBS for Bear, Stearns, and assume that other firms holding similar securities have the same value, and so until they crash the market for MBS is not going to be liquid?
Posted by: John2 at Mar 23, 2008 1:36:44 PM
I find the following Hayek quote very useful here :
"before we can explain why people commit mistakes, we must first explain why they should ever be right"
Economics and knowledge (1937)
Subprime mortgages were used to trick poor people into huge loans? Greedy investors leveraged themselves to the eyeballs? A sudden epidemics of dumbness and greediness is probably not the answer. People are usually quite good at coping with these flaws in there fellow partners. There is no reason to believe that these preventions suddenly vanished.
As it turns out, both parties are losing money : the lender and the borrower. They were both unable to even roughly guess the future value of houses. And few others were, or we would have expected better informed people to jump in as contrarians. By doing so, they would have involuntarily shared their information so the rest of us could benefit. That's how people and markets can be right.
The current lack of liquidity seems to be a side-effect. If anyone knew where housing prices were headed, they could use that information to do arbitrage, and the bid-ask spreads would soon be back to normal.
So whatever caused people and bankers to be wrong about housing prices must be the answer to the post's title. This brings us back to the usual suspects : Federal deficit and inflation of the money supply.
Posted by: Stephane at Mar 23, 2008 1:39:06 PM
"So what now? Regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions. This will limit dangerous leverage, contain contagion effects and make the system less dependent on the steady flow of good information."
Nothing like barring the gate after the horse has bolted.
The fundamental problem with using regulation to control financial risk taking is the government's inability to anticipate and control financial innovation.
You have to remember that Wall Street is staffed by thousands of highly motivated financial wiz-kids putting in 80 hour weeks to invent new ways to take and manage risk. By contrast, the government has a somewhat smaller number of 9 to 5 guys who couldn't get jobs on Wall Street. In this particular arms race the government is both out-manned and out-gunned.
For this reason financial regulation always lags financial innovation. The only thing we know for certain about the next speculative blow-up is that it will be different from the current one.
In fact, regulation can be part of the problem. Financial regulation that fails to keep up with the markets simply creates more speculative opportunities. Consider the role that obsolete banking regulation had in creating the S&L crisis.
Interestingly, the Fed and the Treasury have shown us the way forward. Over the long term, the only people with any ability to control management risk taking are shareholders. The problem is ensuring that they posses the motivation.
In the past the shareholders in major institutions have been able to gamble that their companies are simply too big to fail and will thus be the recipients of a government bailout if things go pear shaped. High risk strategies aren't much of a concern if you are playing with house money.
The non-bailout bailout of Bear Sterns was the first step in breaking this assumption. By whacking Bear Sterns shareholders in process of addressing the potential systematic risks arising from a Bear collapse the government sent a message to shareholders throughout Wall Street. The only problem is this brilliant on-the-fly improvisation may end up being overturned in court.
A really effective regulatory response to this crisis would be to grant the Fed the right to force sale or dissolution of an insolvent financial institution that it considered to pose systematic risk on irrevocable terms. The idea is to permanently remove the comforting assumption of a Fed bailout then sit back and watch shareholders in financial institutions take a renewed and vigorous interest in risk management.
Posted by: Deepish Thinker at Mar 23, 2008 1:51:51 PM
Bear Stearns is worth more than $2.30 a share.
One reason JPM made a low-ball offer is the $5-6 billion in retention and severance pay they'd have to pay to keep Bear's more productive employees from defecting to competitors.
Posted by: Bill Stepp at Mar 23, 2008 2:18:35 PM
About Ponzi, I think his currency arbitrage operation in Boston was not leveraged at all, not like a fractional reserve bank, although what happened was like a bank run. The banks are the openly real frauds, not homeowners. Also his arbitrage operation was legal and a somewhat useful economic function. He actually did pay off a lot of fearful customers who demanded their money back. It is true that the overhead made his business always run at a loss, as he didn't charge for his service from old customers, only essentially took it from new customers, but surely there are other forms of such pyramid operations that are legal. I'm not sure how much real fraud there was with Ponzi's operation or the mortgage market, a lot of the accusations might be more because of the humiliation and feelings of betrayal factor.
But the real problem was that Ponzi's business was not as big as a fractional reserve bank or Bear, Stearns, so the government arrested him like Al Capone instead of taking the business over and selling it like they do with strip clubs that don't pay taxes.
Posted by: John2 at Mar 23, 2008 2:21:10 PM
If there is no market for a thing, is it worth anything? Of course you are talking about a point in time. 6 months from now, everyone will be writing up those supposedly worthless assets. People like Jamie Diamond know this.
As asset price begin to fall, somewhere we will reach a market price. The sooner the better.
Posted by: jorod at Mar 23, 2008 3:00:35 PM
The buying frenzy of the 1920s ran unabated even when it was obvious that the economy was slowing down. Raising rates in the late 20s had no effect on the buying public. People were convinced the market could only go up. They kept borrowing and borrowing. Sound familiar?
The coup de gras came when the government raised taxes and instituted restrictive trade policies.
Posted by: jorod at Mar 23, 2008 3:07:53 PM
The banks are the openly real frauds, not homeowners.
There is nothing fraudulent about banks and the fiduciary media they issue. They are bailors performing a warehousing operation only in Rothbard's incorrect, a priori (!) history.
The development of assignable and negotiable bank instruments, bank notes and clearing facilities, proceeded in accordance with the rule of law and didn't involve fraud or coercion.
But the real problem was that Ponzi's business was not as big as a fractional reserve bank or Bear, Stearns, so the government arrested him like Al Capone instead of taking the business over and selling it like they do with strip clubs that don't pay taxes.
Strip clubs that don't pay taxes are being shaken down and robbed by the State. Al Capone was busted for income tax evasion, a natural right. Taxation of Capone or of strip clubs is theft.
Posted by: Bill Stepp at Mar 23, 2008 3:42:18 PM
Tyler,
Don't you think that the uncertainty in the markets is reflecting information? That is, the market prices are conveying uncertainty about the future (not the least of which is probably uncertainty about what the government will do)? It seems to me that when market prices break down, they do so for good reasons we might do well to take seriously.
Posted by: Grant at Mar 23, 2008 5:36:10 PM
People who want to pin the entire blame for the current crisis on the Fed are ignoring a pretty important fact: the yield curve was inverted for most of 2006 and 2007. The Fed influences short-term rates very heavily through open-market operations but has a much smaller and more muted influence over long-term rates. The inverted yield curve squeezed profit margins of banks which depend on long rates being higher than short rates and enticed them to seek out higher-yield, higher-risk investments.
If you want to pin blame on someone for low long-term rates, start with sovereign wealth funds and foreign central banks. There is no reason why Fed monetary policy alone would have caused the yield curve to flip.
Posted by: Ricardo at Mar 23, 2008 5:36:23 PM
One quote that struck me in particular was:
...only so many financial institutions have the size and expertise to buy up low-quality assets in large quantities
In fact, it is worse than that as even high-quality commercial paper and high-quality auction-rate securities have been unable to find buyers in recent times. Auction-rate munis issued by The Port Authority of New York and New Jersey famously climbed to a yield of 20% when the auction-rate security market collapsed. The reason is that the major investment banks withdrew their promise to buy up all securities being sold off in the auction-rate market when yields hit a certain ceiling. This promise previously lent stability and liquidity to a relatively new market (traditional munis have always had very little liquidity). Without the big banks involved, no one else wanted to take on liquidity risk even if it meant earning an easy profit.
Finance is still very much an economies of scale business even with hedge funds entering the picture. When big banks get into trouble, very few people are willing to stake large amounts of money even on high-quality assets like high-grade commercial paper or high-grade auction-rate munis.
Posted by: Ricardo at Mar 23, 2008 6:05:33 PM
I'll say it again, just because: I don't think it is a "fundamentalist" position to insist that contracts are honored, and that taxpayers don't bail people out for their bad investment decisions. I am shocked that Professor Cowen seems to be saying that the best thing to do now is to let government relieve investors of their mistakes, while increasing its oversight of their decisions. I would prefer a move in the other direction, where people can do whatever they want with their money, but then don't cry to the government if they lose it.
Posted by: Bob Murphy at Mar 23, 2008 6:40:58 PM
I am shocked that Professor Cowen seems to be saying that the best thing to do now is to let government relieve investors of their mistakes, while increasing its oversight of their decisions. I would prefer a move in the other direction, where people can do whatever they want with their money, but then don't cry to the government if they lose it.
The problem is that the world is complicated. The investors' mistakes threaten to cost a lot of other people money as well. Tell us how you propose to prevent that.
Posted by: Bernard Yomtov at Mar 23, 2008 7:03:56 PM
Bernard,
I don't believe the problem is that some people may loose a lot of money. No matter how many people default on their mortgages, no houses will be "lost". They don't disappear, they just get used by someone else. No justification for a free market I've ever heard of is dependent upon people getting to keep their wealth in times of trouble.
If you want to show that BSC's buyout was necissary, I think you need to show how the buyout would aid people in consuming desired goods and services more than it would hurt the taxpayer. It doesn't matter if the housing market crashes in areas where too many houses were built; that would be a good thing.
If BSC went under, would there be anything preventing sound mortgages from being taken out? I understand there would be temporary disruptions in the mortgage markets as firms toppled, but would there be lasting effects? I do understand that because our nations financial markets are largely centrally-planned, we are unlikely to have a significantly better system emerge from the ashes of the current one. But I still think the moral hazard of a bailout is significant.
Are we in a circumstance of privatized profits and public losses? Given the lack of any significant externalities in the mortgage industry, I wonder how this came about?
Posted by: Grant at Mar 23, 2008 8:21:15 PM
Some random comments:
- One problem is the granularity of the mortgage securities held on the bank's balance sheet. The complexity of these things is staggering. In each pool you want to know such things as: geographic distribution of the mortgages (CA, FL, NV, AZ being the riskiest), how many were no doc, what is the loan-to-value, what is the interest rate for each mortgage, what is the size of the mortgage (with the larger ones being more susceptable to refinancing), etc. Add to this the small size of many of the non-AAA tranches--some probably as little as $10 million. I think this is one of the distinguishing things from the tech meltdown--$40 billion stock of Amazon was the same at the first share and last share--not so in mortgage land. I think it's easy to see why liquidity dried up: it is difficult to value these securities in the first place and no Wall Street firm could afford to add more on its balance sheet.
- Negative convexity of mortgages may be a killer here for firms such as Bear and Countrywide. And those that were creating CDOs magnified their exposure. As the risk premiums on these bonds went up, the value went down exponentially. I have a feeling leverage and negative convexity will be place high up on the list of no-nos in finance from now on.
- I do place a lot blame on Wall Street. I think a lot of firms knew that the quality of the morgages were dropping in 2005 and 2006--but the money was too good. Besides, they always thought that they could get out before the big problems hit. I'm sure a lot of them look back and wish they had sold a part of their books back in August and September instead of even lower prices today.
Wall Street encouraged the sub-prime and alt-A loans by accepting them unquestionably and pooling them into securities that the rating agencies mis-rated.
- I agree with Deepish Thinker: there's no way the regulators could keep up with Wall Street or stop consumers from the buying over-prices housing in 2004, 2005, and 2006. Once someone had a friend or relative that had 20% gain in a house, the stampede started and it was too late to reason with the vast majority of them. Also, isn't that why mortgage brokers exist now, as a way to get around that stodgy savings and loans and all their pesky requirements? Now that mortgage brokers are bad words, they are becoming mortage consultants or real estate consultants.
- I'm surprised that so many are confused by the low yield on Treasuries. To me it's a simple flight to quality. It happens every time there is a financial crisis: a short term rush to buy treasuries and avoid anything with credit risk.
Posted by: Elfin at Mar 23, 2008 9:15:44 PM
--The absence of trading is a big problem. Financial institutions have been stuck holding illiquid assets, whose value cannot be easily determined.
whose problem is this absence of trading? how have they been "Stuck"? They bought various assets, and claimed to have handled the risk for them. Their value WAS determined, they though: by the price.
Sure, there was a lack of interest in working through their risk profiles, or checking the value of the instruments. but the above statement is silly.
They don't trade now because THEY DON'T WANT TO. They don't want to find out that they aren't worth what they paid for them. they don't WANT to cut their losses and take their lumps.
Posted by: mouse at Mar 23, 2008 9:47:57 PM
