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Assorted links
2. Johnny Cash and Louis Armstrong (YouTube).
3. Models of correlations among risks, by Robert Engel, and here.
4. What really caused the crisis? A good short piece.
5. Brad Delong lists the cuts in the stimulus plan.
6. Should the IMF create more SDRs?
Posted by Tyler Cowen on February 7, 2009 at 09:25 PM in Web/Tech | Permalink
Comments
The people who cut aid to states don't understand basic economics. Due to the recession, states and cities are slashing programs, halting half-completed construction, and hiking taxes and fees. Of course, this only worsens the recession, but they have to do it to balance their budgets.
It's CRAZY for the Federal gov't to prioritize new projects and programs ahead of maintaining existing projects at the state level that already passed the cost-benefit test.
It's a case of putting (mistaken) ideology and politics ahead of standard economics.
Posted by: a student of economics at Feb 7, 2009 10:36:17 PM
Tyler, I swear at this rate I'm going to burst my bucket. Your "good short piece" on the crisis is indeed short, but not at all good. My strong impression is that your ideology is getting in the way of your truth seeking, as it is with the authors of this article you cite.
Let's walk thru this slowly. Basel II was published in June 2004. Meanwhile US authorities didn't reach agreement on implementation of Basel II until July 2007.
Thea article you cite says "But the way securitisation was achieved – especially from 2003 to the second quarter of 2007 – was more for arbitraging regulation" and then goes on to involve Basel.
Wait! So in 2003 the practical use of securitization was to avoid a rule that wasn't even published until 2004?
It is true global financial firms were supposed to be ready for Basel by January 2007, altho' US compliance wasn't expected until January 2008. That still doesn't explain adequately so much craziness that happened in 2005 and 2006. US implementation wasn't even decided until July 2007!
Why would I go to great expense to structure deals for a rule that doesn't exist yet and whose implementation was still uncertain and incomplete? Since the implementation wasn't known, how could I be sure my expensive and dangerous efforts would actually work as an escape hatch when the government came up with the rules? So why would I do that? To whom does this make sense?
Derivatives Dribble took this whole argument apart months ago from another perspective as well.
Do you honestly Tyler - I mean this sincerely - expect us to swallow such ideology whole?
Posted by: StreetWalker at Feb 7, 2009 10:53:13 PM
Streetwalker, just for a start there was Basel I not just Basel II, but mostly I think you are imagining demons in the piece, which is largely about *market* failure.
Posted by: Tyler Cowen at Feb 7, 2009 11:11:20 PM
I wonder if they can prove the following line:
"The integration of global financial markets has certainly delivered large welfare gains through improvements in static and dynamic efficiency – the allocation of real resources and the rate of economic growth."
Has there been any attempt at quantifying the supposed benefits? Because right now it looks like any benefits are dwarfed by the costs of fragility.
Posted by: travis at Feb 7, 2009 11:47:00 PM
To Tyler and Streewalker,
Indeed Acharya and Richardson are referring to Basel I not to Basel II. Their argument, however, is not about "market" failure; it is about arbitraging regulation. Their argument is consistent with a point made by Peter Wallison in his article The True Origins of This Financial Crisis (the American Spectator February 2009) when writes:
"Bank regulatory policies should also shoulder some of the blame for the financial crisis. Basel I, a 1988 international protocol developed by bank regulators in most of the world’s developed countries, devised a system for ensuring that banks are adequately capitalized. Bank assets are assigned to different risk categories, and the amount of capital that a bank holds for each asset is pegged to the asset’s perceived riskiness. Under Basel I’s tiered risk-weighting system, AAA asset-backed securities are less than half as risky as residential mortgages, which are themselves half as risky as commercial loans. These rules provided an incentive for banks to hold mortgages in preference to commercial loans or to convert their portfolios of whole mortgages into an MBS portfolio rated AAA, because doing so would substantially reduce their capital requirements.
"Though the banks may have been adequately capitalized if the mortgages were of high quality or if the AAA rating correctly predicted the risk of default, the gradual decline in underwriting standards meant that the mortgages in any pool of prime mortgages often had high loan-to-value ratios, low FICO scores, or other indicators of low quality. In other words, the Basel bank capital standards, applicable throughout the world’s developed economies, encouraged commercial banks to hold only a small amount of capital against the risks associated with residential mortgages. As these risks increased because of the decline in lending standards and the ballooning of home prices, the Basel capital requirements became increasingly inadequate for the risks banks were assuming in holding both mortgages and MBS portfolios."
You should read Wallison's article to put those two paragraphs in the context of his explanation. His article is a truly good short piece.
Posted by: E. Barandiaran at Feb 8, 2009 1:13:34 AM
In my mind the "market failure" is a result of a massive failure of efficient market theory. "Eliminate risk by spreading it around," "If people are buying it then it must be valuable," "Mark these things to market because that is their true vale," etc. EMT is not a free market ideology when it is built into the regulations.
Posted by: Andrew at Feb 8, 2009 3:36:01 AM
"There is almost universal agreement that the fundamental cause of the crisis was the combination of a credit boom and a housing bubble."
So, I'm not appealing to the authority of the piece. I'm pointing out that they are either right or wrong about "universal agreement" regarding a credit boom. The investment banks collapsed in rough correlation to their leverage rates.
Okay, so these highly regulated institutions didn't have to put all the bananas on their roof, but calling banana-induced roof collapse a "market failure" sounds like it is ignoring the necessity of an accompanying government/policy failure. If the government is going to regulate the financial institutions, then I am reminded of Bastiat's assertion that if the government claims to control the weather, then they make themselves responsible for weather problems.
These things happen because people follow the market-share leader in a pro-cyclical fashion. Calling it market-failure seems to imply that there is a government solution. However, this is perhaps the one sense in which the "we are the government" mantra is actually true. How is a democratic government going to take the punch bowl away from the party when everyone wants more punch?
Posted by: Andrew at Feb 8, 2009 3:45:27 AM
Okay, so these highly regulated institutions didn't have to put all the bananas on their roof, but calling banana-induced roof collapse a "market failure" sounds like it is ignoring the necessity of an accompanying government/policy failure.
But the article concerns investment banks, hedge funds, and special investment vehicles, not the highly regulated "on-balance-sheet" portion of commercial banks you seem to have in mind.
Regulations concerning investment banks are often informal -- of the "play a clean game so the refs don't have to get involved" variety -- and limited more to stopping broker-dealers from trading on inside information or disappearing with all of your money. The government does not generally tell investment banks (or other non-commercial bank and non-insurance company entities) what kinds of risk they can take on.
Posted by: Ricardo at Feb 8, 2009 3:56:28 AM
I'm not an economist so I don't understand fully but the big problem seems to be the failure of the banks to correctly assess risk. This was manifested in giving loans to people who couldn't pay them back and then chopping them up to hide how risky they were. Now, if this is correct (and it might well not be) then government regulation could easily have prevented the crisis. Making sure the credit-rating agencies were doing their job properly could have been enforced. Making sure the quants were not allowed to dupe everyone with overly complex financial instruments could have been enforced. Lastly, setting limits on the kinds of credit risks the banks could lend to could have been enforced. I worked in mortgages when I was at university years ago and we weren't allowed to lend over 3x income. Looser banks lent 4x income. Recently, banks were lending 7 or 8x income. It's just crazy.
Of course it's possible that with totally unregulated everything, markets would have performed better but that's a) unrealistic and b)a huge and unnecessary gamble. It's not news that people don't always behave rationally. What's so dangerous about some genuine oversight?
Posted by: Finnsense at Feb 8, 2009 4:13:41 AM
Hmmm...there's no relation between the regulated parts of the finance industry and the "unregulated" parts? When the government helps control the money and credit supply? That's my main complaint with the terminology. "Market failure" sounds like these things are independent. And, "Market failure" also sets up an unachievable standard for the market, that the market is expected to be flawless. This is basically the efficient market theory writ large, which is that failed, and those who believed in it, in my opinion.
Hedge funds are the least regulated part, right? While they and the financial innovations have represented surprisingly little of the problem.
The article discusses the roundabout ways these folks worked to get around the regulations. What good is regulation that doesn't acknowledge circumvention?
Free marketers such as myself don't believe in dis-regulation or a priori market perfection. We believe in the regulations that arise through spontaneous organization, trial-and-error, proliferating what works rather than what we want to work. We believe solutions of this kind arise painfully, but are more robust. Likewise, what works going forward will result from individuals who got their fingers burned, not elegantly crafted regulation. Rather, government efforts usually make sure the culprits yield little of the repercussions.
But government regulation didn't prevent the crisis. It wasn't libertarians who fought for Glass-Steagull repeal, it was Democrats and Republicans. But, even that simply directed the flow of the credit bubble. I would assert that many libertarians would approach PARTIAL de-regulation in a regulated business very carefully.
Posted by: Andrew at Feb 8, 2009 5:25:04 AM
The Robert Engle piece is the one that annoys me, personally. He talks about VaR working because if you ran it every day it would show you that you were increasingly in trouble. Too bad that you were too late to unwind your positions, eh?
It's like navigating a boat with the depth finder. Usually it will work. You can feel your way along the cost using the 200ft line ... until you get to a dangerous place where you should be no where near.
Posted by: odogaph at Feb 8, 2009 7:57:30 AM
So should I buy the Engle book or just think about buying it?
Posted by: Robert Bell at Feb 8, 2009 9:21:04 AM
They are right about the problems caused by regulatory arbitrage; but, contrary to their proffered solution, the only way to avoid this problem is to get rid of regulation, or rather, to "regulate" by the rule of law and the discipline of capital markets.
They also fail to understand that the boom and bust was caused by central banks. In the U.S. the Fed kept interest rates too low too long, and in Europe, the Bank of England and the ECB did the same. These led to housing bubbles, which spilled over into banks, then commodities, private equity, stocks, etc.
The Economist of Feb. 7 points out that when the euro started trading, euro-denominted interest rates were lower than rates denominted in defunct currencies, leading to housing bubbles.
Talk about bankers who broke the world!
Easy Al and the Helicopter Pilot ought to be on trial, and if found guilty frog marched to the nearest jail cell. We'll let European libertarians extract their own justice.
Posted by: enemy of the state at Feb 8, 2009 9:36:41 AM
it's really depressing that the cuts involve so many things like modernizing federal building, preventive health care, etc., which will only increase long run govt spending. IMHO the first targets for stimulus should be to move spending from tomorrow to today, e.g. more scientific research, improving energy efficiency, vaccinations, speeding up pentagon procurement (whose costs are often increased by delaying spending to make the single-year budget impact small while reducing economies of scale).
Posted by: DK at Feb 8, 2009 10:19:26 AM
odograph you are right, but, as a boater, there are a lot of times when you really, really want a depth finder, since a lot of sandbars like to move away from their charted position. VaR isn't everything but CVaR is an essential piece of the toolbox.
Posted by: DK at Feb 8, 2009 10:20:52 AM
Jeez, let's get our priorities straight. The only link in that group that mattered was the one to Armstrong-Cash!
Almost enough, on Sunday morning, to make this atheist come to Jesus/Allah/Whoever.
Posted by: Maureen Ogle at Feb 8, 2009 11:20:03 AM
This deserves a prize for opacity - "the ratio of debt to national income went up 100% from 3.75 to 4.75 to one".
Posted by: dearieme at Feb 8, 2009 11:49:22 AM
The best short explanation of what "really" happened was by a Wall Street economist who said that all of the models on MBS assumed that geographical diversification was an adequate proxy for risk diversification (i.e., the old real estate maxim that it's all location, location, location). We've had localized real estate busts before (e.g., Los Angeles in the early 90's), but not a nationwide real estate bust. The interesting question is what caused a nationwide real estate bust. Is it a matter of unprecedented access to leverage? Did the MBS market itself cause the correlation?
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