Marginal Revolution

Still more countercyclical assets

Pretty soon we'll get to the point where almost everything in this economy of ours is booming:

All over sunny San Diego, tough economic times have forced people to cut back on their $4 lattes and sushi dinners. But one new business is booming -- and ka-booming -- precisely because of frustration from the worst financial crisis to hit the United States in decades.  Welcome to Sarah's Smash Shack, where pent-up patrons can relieve stress by hurling dinnerware and bric-a-brac against a wall, as hard as they can, day and night, seven days a week.  San Diego entrepreneur Sarah Lavely charges her clients $10 and up to pulverize plates and glasses during 15-minute intervals. Music blares, clients dress in protective gear and a neon sign urges them to "Break More Stuff."(...)San Diego may boast surf and sunshine year round, but it also has its share of black economic clouds. Its real estate market has been hit hard by the high rate of foreclosures in California, the second highest in the nation, and its unemployment rate has risen to 6.4 percent from 4.8 percent in a year...

Here is the link and I thank John de Palma for the pointer.

Nobel prize odds

You'll find more here, here, and here.  Lots of people favor time series but I'm still picking Oliver Williamson and Jean Tirole.  They gave the prize to theorists last year and now they need to bring it down to earth and also they might wish to choose a Frenchman.  Such a joint prize would in my opinion be well deserved.

Is there any scenario for a break-up of the Euro zone?

Let's say a Eurozone country faces a bank failure and the debt of the failing bank is very large relative to that country's gdp.  This could happen in many countries.  The fiscal authority of that country cannot do the bailout on its own, in part because the resources are not there and in part because the country lacks the political unity for raising taxes.  The other EU countries cannot be persuaded to ante up.  The country in question either loses its major bank, and suffers the concomitant fall out, or it creates "on the spot" monetary policy to save the bank.  That means creating a domestic currency and suddenly announcing that the accounts of the bank will be reimbursed in terms of that currency rather than Euros.

I believe the odds of this outcome are relatively small.

That said, the "easy" option is for the ECB to do the bailout in terms of Euros.  A non-unanimity-requiring procedure for this should be worked out in advance to a greater degree than is currently the case.  And such a procedure may need to be worked out soon, while it is still unclear who would be the winners and losers from such an arrangement.

Unintended consequences

...the financial benefit to Paulson of accepting the call of duty is surely greater than that enjoyed by any other public servant in U.S. history.  Goldman Sachs has long had a policy that all deferred compensation becomes payable promptly to any partner who accepts a senior position in the federal government.  Congress passed a law a quarter-century ago that people taking senior appointed federal position who convert their investments into either an index fund or a blidn trust can do so upon assuming office with zero taxable capital gain until such investments are later sold.  If Paulson took advantage of these provisions, they enabled him to sell his shares in Goldman Sachs without raising any public questions without tax and to diversity his large personal invetments in a single stroke.  For just over two years' service, the saings in Paulson's personal income taxes could have been as large as $200 million.  Paulson had no interest in diversifying his investments and had never sold a share of Goldman Sachs stock.

I wonder what the total benefits for Paulson have turned out to be.  Indeed, it is rare that taking a job in government is such a good business decision (please note: I am not suggesting any conspiracy or evil intentions here).

That passage is from Charles Ellis's The Partnership: The Making of Goldman Sachs.  This book gets better and better, as you keep on reading it.  Definitely recommended.

George Halverson on health care reform

Ah, remember that topic?  Ezra Klein does.  The book is called Health Care Reform Now! and the author is CEO at Kaiser Foundation Health Plan.  That may not sound like an encouraging combination but in fact this is one of the most intelligent health care policy books around.  The analysis of cost inflation, lack of early care, and billing for procedures is perceptive throughout.  The policy proposals involve electronic medical records for everyone, legally required health insurance, enforcing that mandate through the tax system (will he really cut off EITC to kids?), high-deductible plans for the high-income insured, covering some of the uninsured through an expansion of Medicaid (expand SCHIP and cover the single poor), offering primary care-first health insurance plan to the remaining poor uninsured, and finance the whole thing through a health care sales tax.  I like that last part best of all.  Plus he wants to reform the entire infrastructure of health care and institute more pay for performance.

I'm puzzled as to how he avoids destructive "notches" (implicit high marginal tax rates) across different individual margins and what private insurance companies will do with perfect access to everyone's electronic health care records.  And he doesn't focus enough on encouraging innovation or dismantling bureaucracy and barriers to entry.  Still, this is one of the most substantive books out there on health care economics.  Recommended to anyone who might be tempted.

Addendum: I've now read through the comments and I have to admit I am a little disappointed.  I don't favor Halverson's solutions overall though I do favor a much greater role for integrated HMOs.  The more important point is that I should be able to cover a book, and discuss its virtues, without having to come down on it, or for it, in a partisan way.

Plan B, from Luigi Zingales

Find it here.  In a nutshell:

Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property.

Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level.  Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property.

...In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder.

Zingales also stresses that half-hearted attempts at bank recapitalization are unlikely to work at this time; he thinks that at least $600 billion would be needed.

This piece has many interesting points throughout, it is worth a full read.  Here is a concordance of writings of Luigi Zingales on the credit crisis.

Do researchers suffer from winner's curse?

OH NY GOD...READ THIS!!!!!!!!!!!!!!!!!

From The Economist:

In economic theory the winner’s curse refers to the idea that someone who places the winning bid in an auction may have paid too much...The same thing may be happening in scientific publishing, according to a new analysis. With so many scientific papers chasing so few pages in the most prestigious journals, the winners could be the ones most likely to oversell themselves—to trumpet dramatic or important results that later turn out to be false. This would produce a distorted picture of scientific knowledge, with less dramatic (but more accurate) results either relegated to obscure journals or left unpublished.

My colleague Omar Al-Ubaydli was part of this work.  Fortunately, it is mentioned on the very cover of the magazine.  Nonetheless I believe it is true and it is most true for "hot" fields.  The original paper is here.

Hypotheses which are too simple to be true as stated

We need a new banking system.  A new banking system takes years to build.  We will be in an economic downturn for years and because this crisis is global it will not be better than Japan in the 1990s.  It is hard to build a new banking system through the current, old, nearly insolvent banking system.  Maybe some smart person has a plan to build a new banking system through the old system, while avoiding toxic contamination through the problems of low-solvency institutions.  That smart person remains silent.  I have not given up hope.  The Great Depression had bank failures, we have bank zombies.

Humpty-Dumpty theories

One version of pessimism is to wonder how easily a banking system can be put back together again.  Just as a physical bubble is an asymmetric process (it is easier to pop one than to rebuild it), maybe a banking system is similar.  It's built up over time by lots of lattice work and investment in complementary processes and assets.  Once it pops away it can't be easily reconstructed, even if the reconstruction plan targets the initial cause of the problem (low capitalization).  One implication of this view is that initial recapitalization of banks -- say about a year ago --was a much more urgent matter than we realized at the time.

A more optimistic take is the "bounce" view: things have to fall far enough so that they hit the floor and get a bounce, pushing them back up again.

In the last two days I have started to entertain the possibility that the Humpty-Dumpty view is in fact correct.

A little good news

The DOT will begin to auction off landing slots at airports...well at LaGuardia, Newark and JFK anyway...and "up to 10%" of the slots...and with "mounting opposition."  I did say this was a little good news didn't I?   

Top ten blogs to read during the banking crisis

Here is a list from The Times of London.  I would add Felix Salmon, Paul Krugman, Arnold Kling, calculatedrisk, Dealbreaker, Brad DeLong, Naked Capitalist, and others.

I thank Mark Brady for the pointer.

How will a capitalization plan actually work?

I'm all for bank capitalization but the problem is this: the Fed has been lending hundreds of billions to banks for many moons.  Right now the banks are just sitting on the money, for the most part. 

To be sure, Treasury equity is not the same as debt to the Fed, but are they so different?  Keep in mind the Fed has been a softie to A.I.G. ($30 billion more), so the Fed is hardly a loan shark and in some ways the Fed's I-can't-just-stop-rolling-it-over-when-I-want contribution is a bit like preferred equity.

To put it another way, will partial government ownership so much change bank incentives for the better?

Which is it?

1. Treasury capitalization will matter to the extent that Treasury equity has some different properties than from-the-Fed debt, but this isn't nearly as much of an effect as any published sum for a Treasury capital inflow would indicate.

2. Treasury equity will work because of some legal or regulatory difference between equity and debt which we are otherwise unwilling to abolish.

3. Treasury equity will work because it is a hidden giveaway to bad banks (by the way, this is arguably what happened in Sweden).  But of course we could do the giveaway more directly if not for bad PR.

Inquiring minds wish to know.

Three other points:

4. Capitalization might have a bigger marginal oomph in Europe than here, because the ECB hasn't been going crazy lending out reserves as the Fed has.

5. If the key is to get banks up and running again, we want bank CEO contracts with lots of bonus compensation on the profit upside and those contracts are more important the "worse" is the bank.  Ouch.

6. If such a plan will raise the value of lots of banks, by a lot, none of the shareholders will wish to sell early at low prices, a'la Grossman and Hart 1980, and the Treasury will be back in a bind.

That is what Alex and I talked about over dinner.  I conclude that the crisis will not end anytime soon.

How will partially nationalized banks behave?

This is a question about models, not a question about the real world. 

We are used to invoking shareholder unanimity theorems, whether they are justified or not.  But say the U.S. government owns twenty percent of each major bank.  Exactly what instructions do they give the management?  ("Hey, guys, just get stuff going again!"?)  Presumably the twenty percent shareholder wants something different, and more in line with the public interest, than the desires of the remaining eighty percent.  Are we to assume that the twenty percent wins out?  Can managers be sued for violating their fiduciary responsibilities?  Does the twenty percent explicitly tell the managers to do something other than maximize profit?  What if the eighty percent votes to override them?

What are control rights worth in these situations?

You might argue that the mere fact of recapitalizing the bank will cause the eighty percent to want what the government shareholder wants.  That is not in general true, especially if the government is pulling its capital back out at some point.

You might argue that the government involvement is a kind of insurance and it makes the older equity claims more like debt (insurance on the downside but loss of some potential upside gains).  The newly neutered "debtholders" still might not want the bank to be very active, as evidenced by the stagnant nature of some explicit current debt markets. 

I hear this recurring voice: "Hey, you guys, just get stuff going again!"  It's an odd basis for corporate governance.

I am not sure what is the proper way to model this set-up.

Addendum: Greg Mankiw proposes non-voting shares.

The countercyclical asset, a continuing series

It is getting worse: home vaults.  The Times of London reports:

Sales of household safes have surged as wealthy savers concerned about the health of banks opt to keep cash at home.

Leading safe manufacturers contacted by The Times said that they had seen a big increase in demand. Many predicted that fears of meltdown in the banking sector would mean a further rush before Christmas.

One company said that sales had increased by a quarter, while another said that its staff had received calls from panicking investors who now wanted to keep their savings locked away at home.

Here are previous installments in the series.

Nobel predictions

I used to always predict Fama but I can't this year.  Thomas Sargent is worthy and he has done much more than "rational expectations" but that moniker will hurt his chances for now.  Shiller is a possibility but maybe that looks like pandering to current events.  And I don't think they will pick anyone who was on the board of A.I.G., at least not this year.

Here are my old picks.  This still wouldn't be a bad year for Tirole, Williamson, or anyone else who worked on agency problems.  It seems those problems matter.  And there is still environmental economics.  Or the "surprising European who is undervalued by Americans" pick, a'la Maurice Allais or Trygve Haavelmo.

What do you predict?  Please tell us in the comments.

Houses for Sale! Houses for Sale!

Tyler and I have both suggested that increased immigration would help to increase the demand for housing and relieve some of the financial crisis.  Writing in the WSJ Lee Ohanian concurs:

We should encourage the immigration of prime-age individuals. Beginning in 2007, net immigration fell to half of its level over the previous five years. Increasing immigration would increase the demand for housing and raise home prices. And note that the benefit would be immediate. Home prices -- and the value of subprime obligations -- would rise in anticipation of a higher population base. The U.S. particularly needs highly skilled workers. These workers not only would purchase homes, but would generate higher living standards for all Americans.

More generally, Ohanian warns that what made the Great Depression great was the misguided policies that Hoover and Roosevelt adopted to fight the depression.  Ohanian has an ill-considered swipe at Obama on this score but the general point is valid and worth remembering as we rush onwards. 

Caplan: 10/10 at 10 on 20/20

That's Bryan Caplan appearing on 20/20 this Friday (10 pm EST).  Who better to put this election in perspective?

I've never traveled with Alex before

Until now, that is.  We're even in a country with a partially nationalized banking system.

The headline from yesterday's Daily Mail is scary: "It's outrageous that banks demand taxpayers' money yet impose 15 pc interest rates on small businesses."  The article then outlines the high interest rates that borrowers have to pay.

I guess more easy credit is what we need and nationalization is the way to get there.  If I can believe this morning's headline, the United States may be headed to the same place.  Remember all that junk -- like the subsidy for small arrows -- that they ended up sticking into the Paulson plan?

What I've been reading

1. The Sacred Book of the Werewolf, by Victor Pelevin.  A fun Russian weird novel; here is a good review of it.  It's one of the few works of fiction I've finished lately.

2. The Patron's Payoff: Conspicuous Commissions in Italian Renaissance Art, by Jonathan K. Nelson and Richard J. Zeckhauser.  Put together a collaborating art historian, a first-rate microeconomist, an interest in signaling and a preface by A. Michael Spence and this is what you get.

3. White Heat: The Friendship Between Emily Dicksinson and Thomas Wentworth Higginson, by Brenda Wineapple.  Yes, this is a very good book.  But it has the same problem that most other Emily Dickinson books have.  Her poems are so short you can fit them into a narrative and they are so strong they tend to overwhelm any non-fiction context they are put in.

4. Geoffrey Heal, When Principles Pay:Corporate Social Responsibility and the Bottom Line.  The main point is that socially responsible behavior is often profitable for business in the long run.  I know that doesn't sound like such a compelling message right now, but this is a highly intelligent and now a sadly neglected book.

5. Samuel Johnson: A Biography, by Peter Martin.  This is only the third best biography of Johnson (Walter Jackson Bate is #2) and it is still one of the best books of the year.  What does that say?

Tyler Cowen on ethnic dining

Currently, what are you favorite places to eat in the D.C. metro area?

I love Thai X-ing (DC), Meaza (Baileys Crossroad), Nava Thai (Wheaton), Hong Kong Palace (Falls Church), China Star (Fairfax), Bombay Indian (Silver Spring) and Angeethi (Herndon), plus just about everything Vietnamese in Eden Center (Falls Church). The 9th Street Ethiopian row is very good as well, and also Zenenbech, up on Florida/U/5th or so. Those places are very good and I can eat at them more or less without limit. There aren't many places around as good as those.

Here is much more.

Libertarian perspectives on the bail-out

Veronique de Rugy and Philippe Lacoude.

Stan Liebowitz.

Please feel free to leave other references in the comments; there is a greater rush of material coming out than I can keep track of.

Addendum: Here is a (non-libertarian) dose of optimism.

Assorted links

1. Filipino food is better than you think.

2. Real life mast tying from Google.

3. Betting market on the economics Nobel Prize.

4. Markets in everything: a lego doppelganger of your beloved.  Only $60K.

5. What is an economist worth?

6. Heroes of capitalism, a new blog.

I thank a variety of MR readers for the pointers.

The Partnership

For the proud Sachs family, the failure of Goldman Sachs Trading Corporation became a very public humiliation.  In 1932, Eddie Cantor, the popular comedian and one of forty-two thousand investors in Goldman Sachs trading Corporation, sued Goldman Sachs for one hundred million dollars while regularly including in his vaudeville routine bitter jokes about the firm.  One: "They told me to buy the stock for my old age...and it worked perfectly...Within six months, I felt like a very old man!"

That is from the new Charles D. Ellis book The Partnership: The Making of Goldman Sachs.  So far this book is a very good history and it has more economic and historic substance than The Snowball.

What happened to the carry trade?

Remember when investors would borrow in Japanese yen, at low interest rates, to invest in higher-yielding currencies such as the Australian and Kiwi dollars?  For a long time it seemed like free money was just sitting there on the table.

Well, two days ago the Australian dollar dropped 12 percent against the yen and the Kiwi dollar dropped ten percent, both in a single day.  Calculate that return on a yearly basis and you can see the problem; toss in leverage if you wish.

Here is one article on the destruction of the carry trade.  I suspect they are not planning on awarding the Nobel Prize this year to Eugene Fama (is Bob Shiller a better bet?), but in fact the selection of Fama, despite his association with the "efficient markets" idea, would be quite timely.

Paragraphs to ponder

The pursuit of “risk sensitivity” led to a re-organisation of bank assets away from lending on the basis of the banker’s private views about the borrower - regulators considered this hard to quantify and a little suspect – towards lending on the basis of an external credit rating. The higher the rating, the lower the capital banks had to set aside against the loan. Regulators saw this as not only risk-sensitive but transparent and quantifiable. Banking by numbers was oh so modern.

Here is much more, interesting throughout.

David Murphy makes me weep

He is a loyal MR reader, but that doesn't mean he always carries good news:

My question:

When the Fed backstops the Commercial Paper market by entering it and offering a "risk free" counterparty to companies, is it crowding out private lending?  I also feel like the same could be true of the Treasury.  If the Treasury offers to buy the toxic MBS on the books of private companies, they lose all incentive to deal with private counterparties that are not risk free...

I know that the government is trying to encourage credit to flow. In some way it seems like they are impairing the flow by making markets on risk free capital.

Boo hoo!  The ideal, of course, is that the people who need riskless assets can hold riskless assets and pass their funds along to those who can profitably lend funds out to riskier borrowers.  That's not where we are right now.  To put this more concretely, if the Fed is not buying or backstopping your commercial paper (and they're not touching mine), maybe now it's harder to make your way in the marketplace.

David, by the way, poses the thought experiment of ceasing to issue T-Bills but suggests that might bring Armageddon. 

Russian foreign aid, circa 2008

A E4bn loan from Russia might make financial sense – although Russians might think otherwise given Moscow’s shaky finances. But it would create strategic ructions. Iceland is a NATO member, but Russia would want something in return for a loan equal to almost a third of the tiny state’s GDP. The US would fret this could eventually mean a Russian military presence in the North Atlantic.

Here is the story.  It seems that Iceland may prefer Russia to the IMF, but Russia does not yet seem on board.  I can only wonder what Bobby Fischer would have said...

Reverse auctions: a defense

The US is embarking on the greatest public intervention into financial markets since the Great Depression. The ultimate success or failure of the intervention will depend, in part, on the fine details of the auction design.

The basic auction approach suggested here is neither new nor untested. It has been used successfully in many countries in recent years to auction tens of billions of dollars in electricity and natural gas contracts, as detailed in Section 8. Moreover, it is quite similar to the approach that has been used to auction more than $100 billion in mobile telephone spectrum worldwide. It is a dynamic version of the approach that financial markets use for share repurchases. If implemented correctly, each auction can be completed in less than one day. And the same software used for implementing electricity and gas auctions could be used to initiate these auctions in October.

Here is the whole paper, thanks go to Samson in the comments section.  So far this is the best paper I've seen on the topic.  Tim Harford offers other useful links.  Still, I am inclined to agree with Arnold Kling:

The theory that you can fix credit markets by "removing the clog" of mortgage securities is just that--a theory. My guess is that it will not work. I am sure that other things will have to be tried sooner or later--probably sooner. I hope the other moves work. I do not think it is at all realistic to rely on the Paulson plan.

Is there a positive spin to this?

Fed announces commercial paper funding facility.  Here is my post from yesterday.  My best shot at a positive spin, just offered to Alex in my office, is this:

They wouldn't do it unless they had to.  And if they had to do it, that they are doing it is very good news indeed.

I am not sure that Alex was persuaded.  There are some good comments at the first link.

The roots of Chinese pollution

A detailed analysis of powerplants in China by MIT researchers debunks the widespread notion that outmoded energy technology or the utter absence of government regulation is to blame for that country's notorious air-pollution problems. The real issue, the study found, involves complicated interactions between new market forces, new commercial pressures and new types of governmental regulation...

China's power sector has been expanding at a rate roughly equivalent to three to four new coal-fired, 500 megawatt plants coming on line every week...most of the new plants have been built to very high technical standards, using some of the most modern technologies available. The problem has to do with the way that energy infrastructure is being operated and the types of coals being burned.

The good news is that there is a single lever -- coal quality -- that could have an enormous impact on Chinese pollution levels.  Here is the full story.

Why exactly are those mortgage-backed securities so hard to trade?

With emphasis on that word "exactly," here is Gary Gorton's superb paper The Panic of 2007.

Go ahead and read and read and read and the more you feel confused the more, in fact, you are being instructed.  You are confused because it is confusing.  Then I got to p.45 (!) and I almost split a gut (and cried, simultaneously) when I read the sentence:

Now we come to the first information issue.

It then goes like this:

What is the loss of information?  The information problem is that the location and extent of the (2006 and 2007 Q1-2 vintage) subprime risk is unknown to anyone.  It is very hard to determine the location of the risk, partly because of the chain of interlinked securities, which does not allow the final resting place of the risk to be determined.  But also, because of derivatives it is even harder: negative basis trades moved CDO risk and credit derivatives created additional long exposure to subprime mortgages.

His examples show this in detail but I do not know a simple way to blog it.  Scroll to pp.23-30, and p.35 for a dose of how these securities were structured.

Gorton is also highly critical of "mark to market" (p.62) and he pinpoints the collapse of certain parts of the REPO market (p.66) as a critical development.  He ties it all in to Hayek and Grossman and Stiglitz and discusses how we ended up having assets with non-transparent, non-backwards-translatable prices and what that means for economic calculation.  He contrasts a private clearinghouse (and monitoring) vs. rules of accountancy and how we ended up relying too much on the latter.

Starting on p.67, there is a sustained and mostly convincing argument that securitization has not been much at fault.

If you are interested in the nuts and bolts of the current financial crisis, and its origin in 2007, this paper is essential reading. 

Bad news, but good news too

Banks are hoarding cash in expectation of pay-outs on up to $400bn of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and ­dealers.

This added pressure on the frozen financial system comes as authorities prepare to meet participants in the so-far unregulated $54,000bn credit derivatives market to speed up plans for the creation of a central clearing house.

Here is the story.  Here is my earlier post on derivatives and clearinghouses.

How to tell if things are going very badly

If the Fed ends up guaranteeing commercial paper and/or interbank loans.  Too many people are listening to Polonius.

Assorted links

1. The ten highest earning authors; I like only one of them.

2. Chris Blattman and Michael Clemens on the long run.

3.The worst academic jobs around the world?

4. The difference between country music and rap music

5. Is there a need for "speed bankruptcy"? -- an analysis of the major plans

Does the free market erode moral character?

I am honored to share a symposium with Garry Kasparov, among other notables, including Robert Reich, Jagdish Bhagwati, Bernard Henri-Levy, Michael Novak, and others.  My answer to the question is "No, on balance" and here is my opening bit:

In matters of morality, the free market functions like an amplifier. By placing more wealth and resources at our disposal, it tends to boost and accentuate whatever character tendencies we already possess. The net result is usually favorable. Most people want a good life for themselves and for their families and friends, and such desires form a part of positive moral character. Markets make it possible for vast numbers of people, at every level of society, to strive for and achieve these common human ends.

There is much more at the links.

Why is the Fed Paying Interest on Excess Reserves?

Today the Fed starts to pay interest on reserves.  The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax.  Reducing taxes on banks at the present time makes sense and in the long run there are some efficiency gains from paying interest on required reserves, especially to the extent that the previous system could be gamed.  Overall, however, this is small potatoes.

More interesting is why the Fed. will pay interest on excess reserves.  In the long run, there are again efficiency gains but why would the Fed. want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets?  My best guess is that the Fed. wants to play more Operation Twist and in Brad DeLong's terms this gives them an additional tool to do it on the Pan-Galactic scale.  In short, they will buy long bonds and commercial paper or other such asset and use the interest payments on excess reserves to sterilize.  Although paying interest on excess reserves brings this whole operation under the Fed house it's unclear to me, however, how the situation is markedly different than with Fed/Treasury cooperation.

What caused the financial crisis?

Forget about particular details for a moment, in conceptual terms what led so many financial institutions to take so much excess risk?  Bob Frank addresses that question and here is my list of major factors:

1. Collective stupidity: A lot of Greeks believed in Zeus and a lot of people in 1938 thought Hitler would be good for Germany.  They were just plain, flat out wrong.  I'll also put "model error" under this heading.  The relevant stupidity concerned both the fate of home prices and the degree of acceptable leverage.

2. Writing the naked put: This is Bob Frank's main explanation, noting that he uses different terminology and adds a relative status dash to the argument.  If you don't know options theory, just imagine betting against the Washington Wizards to win the NBA title every year.  For a lot of years you'll earn super-normal returns, but one year (not anytime soon, I can assure you) you'll be wiped out.  That is essentially the strategy the banks were playing.  They were going "short on volatility," so to speak.  In the meantime they reaped high returns and some amazing perks for private life.  It's hard to just call the party to an end, even if you have a relatively long time horizon.

3. The neutering of debtors. This is the sophisticated form of the moral hazard argument.  Bailouts mean that debtors and depositors don't have enough incentive to keep safe the firms they give their money to.  Note that #3, as a corollary, suggests that equity holders do not on their provide adequate safeguards against a crash.

Evaluation: You can pin most of the blame on #3 provided you think that a) our government really could let these firms default on their debts ex post and b) society is willing to live with significantly less liquidity transformation up front and also lower returns for depositors.  I reject this mix for reasons of time inconsistency, namely that ex post the bailout is always on its way so this is simply something we have to live with. 

You're left with #1 and #2 but it is hard to assign relative weights because they work together.  The people earning money under #2 won't work terribly hard to disillusion the fools and frauds operating under #1.

At times I am tempted to add #4 to the mix:

4. The increasing value of human capital: Bankruptcy is no longer so painful for the wealthy.  You can always get another high-paying job plus you have $10 million squirreled away somewhere in Switzerland.  You could end up working for the guv'ment for $130K a year and your life still is pretty good once you get over the shock of adjustment.  So why not take lots of risk and try to get ahead of the other guy?

The full story then involves additional resources being put on the table -- for possible risky investment -- as a result of easy monetary policy, pro-housing government policies, the global savings glut, and simple bad luck.  I'll cover those factors in more detail soon.  And I'll also have more to say about some of the details of mortgage-backed securities and accounting practices and regulation; those were factors too, although not at the level of generality I am covering here.

Addendum: Here's Mark Thoma and Barry Ritzholz.  In the comments Robert Feinman is square on, read him.

Second addendum: Megan McArdle adds quite a bit.

The European collective response

It turns out there won't be one.  In fact we are seeing the opposite:

"We will work cooperatively and in a coordinated way within the European Union and with our international partners," it [the statement] added. "In the spirit of close cooperation within the European Union, we will ensure that potential cross-border effects of national decisions are taken into consideration."

This language was seen as a rebuke to Ireland, which last week decided to offer guarantees to all Irish depositors. The decision, taken unilaterally, irked Brown and his lieutenants in London, who feared it might lead Britons to pull their money out of British banks and put it in Irish banks instead to enjoy the guarantee.

British depositors were already crowding to get into the nationalized Northern Rock but they were turned away at the proverbial door.  Other news is that the German government-led bank consortium to rescue Hypo Bank has fallen apart, not a good sign.  The German government has today moved to guarantee all "private savings deposits" [private Sparanlagen], also not a good sign.  Which other countries will now follow suit?  All of them?  Europe as a whole lacks a safe asset as focal, liquid, and available as T-Bills and now that is becoming a problem.

Wikipedia on reverse auctions

Gartner's keys to success as a supplier in reverse auctions are: (a) Thorough preparation – it's essential to know your costs, your suppliers, and your market to the greatest extent possible – tiny details can make the difference between winning and losing, and between being profitable or not; (b) Reverse auctions should be largely kept to the supply of commodity products rather than proprietary ones; and (c) Having a strong, competent bidder leading your effort at the time of the auction, with clear guidelines on when to bid and when to fold is essential.

Anticipating Hank Paulson, Gartner adds:

"I know most people don't look at reverse auctions positively, but we see them as a process that makes you better,"

Here is the link.  The article will soon be much longer.  Here is a website devoted to summarizing the research against reverse auctions; it appears unrelated to critiques of Paulson and the Paulson plan.  It seems to be fighting a personal war and so I doubt its objectivity:

The bottom line is BUYERS should not use reverse auctions because the amount of savings that can actually be achieved is greatly overstated. In addition, reverse auctions create numerous other problems for buyers.  SELLERS should not participate in reverse auctions because there is nothing in it for them; especially incumbent suppliers. In almost every case, neither buyers nor sellers benefit from this purchasing tool because it is an unhealthy continuation of zero sum power-based bargaining that degrades the competitiveness of both parties. Reverse auctions are undeniably a bad purchasing practice and a wrong approach to spend management.

I hope to soon consider other research on reverse auctions.

Regulation, a dialogue with Warren Buffett

Via Craig Newmark:

QUICK: If you imagine where things will go with Fannie and Freddie, and you think about the regulators, where were the regulators for what was happening, and can something like this be prevented from happening again?

Mr. BUFFETT: Well, it's really an incredible case study in regulation
because something called OFHEO was set up in 1992 by Congress, and the sole job of OFHEO was to watch over Fannie and Freddie, someone to watch over them. And they were there to evaluate the soundness and the accounting and all of that. Two companies were all they had to regulate. OFHEO has over 200 employees now. They have a budget now that's $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies.

QUICK: Mm-hmm.

Mr. BUFFETT: And they sat there, made reports to the Congress, you can get them on the Internet, every year. And, in fact, they reported to Sarbanes and Oxley every year. And they went--wrote 100 page reports, and they said, 'We've looked at these people and their standards are fine and their directors are fine and everything was fine.' And then all of a sudden you had two of the greatest accounting misstatements in history. You had all kinds of management malfeasance, and it all came out. And, of course, the classic thing was that after it all came out, OFHEO wrote a 350--340 page report examining what went wrong, and they blamed the management, they blamed the directors, they blamed the audit committee. They didn't have a word in there about themselves, and they're the ones that 200 people were going to work every day with just two companies to think about. It just shows the problems of regulation.

QUICK: That sounds like an argument against regulation, though. Is that what you're saying?

Mr. BUFFETT: It's an argument explaining--it's an argument that managing complex financial institutions where the management wants to deceive you can be very, very difficult.

Here is a good article on what the mortgage agencies have been up to.