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A Simple Theory of the Financial Crisis, link
A working link to my paper on the financial crisis, discussed below, seems to be here.
Posted by Tyler Cowen on June 8, 2009 at 02:18 PM in Economics | Permalink
Comments
Learning of Fischer Black's objections, I'm beginning to realize that nobody who helped create the models really misunderstood their limits or approximations. It was the slavish imitation that came after those models produced good results.
It's actually hard to think of a more unrealistic assumption to base a model on than that valuations are independent measurements of the same underlying distribution. Model picking up to now has been driven by tractability. Perhaps the largest social benefit to emerge from this crisis will be the realization that models must be picked (or avoided) on the basis of their possible social consequences, regardless of their tractability.
Shannon and Mandelbrot stocks are up.
Posted by: Michael F. Martin at Jun 8, 2009 3:08:23 PM
Thank you!
Posted by: Neal at Jun 8, 2009 4:26:16 PM
"But consumption was highly robust during
the boom, especially in the United States. This fact
implies that the resources behind the real estate and
financial asset boom came from the real economy
and that the Fed is largely not to blame for the
current crisis. The presence of major financial problems in “tight money” Europe is consistent with
this interpretation."
These are all central bank economies. And just because the ECB brought rates down to 2% rather than 1% doesn't preclude blaming central banks. Free banks actively suppress bubbles by offsetting increased velocity with a decreased money supply. Central banks did not do this, even while it became, as you say, common knowledge that we were in a housing bubble.
Posted by: Will McBride at Jun 8, 2009 7:57:24 PM
Otherwise, I agree with your behavioral explanation. Of course investors are not independent of each other, and herd behavior is very real. But the question is which factor is more important, central banks or behavioral biases, and which one do we have control of as policy makers? What if free banking worked to mitigate behavioral biases and hence bubbles?
Posted by: Will McBride at Jun 8, 2009 8:03:42 PM
Will, you'll get no where with the Fed worshipping cultist.
Posted by: Gabe at Jun 8, 2009 8:04:44 PM
One last thing: how is that consumption must go down if fed induced investment goes up? Rather, the fed pumps up asset values and thus perceived wealth, and thus investment and consumption can, and do, both go up.
Posted by: Will McBride at Jun 8, 2009 8:10:59 PM
I don't understand why Neoclassical economists don't want to use the price mechanism to set prices for interest rates? Its really odd to me, they want to use the price mechanism for everything else. The federal reserve however seems immune to this, they set the rate based on political and economic considerations instead of using the price mechanism.
Posted by: Doc Merlin at Jun 9, 2009 1:36:21 AM
I thought one problem with free banking was that money supply would be pro-cyclical. Will seems to be arguing the opposite. What is the mechanism that would make banks reduce the money supply during booms and increase it during busts? Or are we talking gold standard here? Thanks in advance.
Posted by: myself at Jun 9, 2009 1:45:00 AM
Statistical mechanics posits that lakes don't up and move to the left because the molecules movement averages to zero. Now, drastically reduce the number of decision-making molecules, give them all the same aspirations, and dump a big regulatory whale in the pond and soon enough your beach front will be underwater.
Posted by: Andrew at Jun 9, 2009 6:50:47 AM
"how is that consumption must go down if fed induced investment goes up? Rather, the fed pumps up asset values and thus perceived wealth, and thus investment and consumption can, and do, both go up."
Scarcity. There are limited resources, which results in limitions on total production. Real consumption and real investment cannot both increase at the same time when confronted by a capacity constraint.
Posted by: Bill Woolsey at Jun 9, 2009 7:35:26 AM
"how is that consumption must go down if fed induced investment goes up? Rather, the fed pumps up asset values and thus perceived wealth, and thus investment and consumption can, and do, both go up."
Scarcity. There are limited resources, which results in limitions on total production. Real consumption and real investment cannot both increase at the same time when confronted by a capacity constraint.
Posted by: Bill Woolsey at Jun 9, 2009 7:35:55 AM
Bill, tell me what's wrong with this story: Bob the renter currently saves half his income in a savings account and spends the rest. The Fed engages in a prolonged loose money policy, causing Bob to think it's cheaper to own than to rent. Bob buys a house, and later a second house as an investment. Bob's income has not changed, nor has his share of that income devoted to consumption and savings. However, his savings is now devoted to down payments and mortgage payments and maintenance on his houses. In addition, the market value of his houses has increased 20% every year for now 5 years straight, more than doubling his investment. Bob takes out a home equity loan and uses that to increase his consumption. Bob avoided the bounds of his scarce income by getting the banks to loan him additional money.
Posted by: Will McBride at Jun 9, 2009 5:36:54 PM
myself, George Selgin is the guy to read on this, especially his book The Theory of Free Banking. In it he describes why the profit motive causes free banks to lend out a high percentage of their deposits. They balance the benefits of more loan interest payments with the costs of insolvency or a liquidity crisis. Historically, they kept 1% to 2% in reserves, so they were very sensitive to changes in net clearings, i.e. velocity. An increase in net clearings raises the risk of a liquidity crisis, and knowledge of this may lead to a run, so to avoid this free banks will reduce their loans to the extent they can, thus reducing the money supply to offset increased velocity. The Fed would love to do this, but lacks the local and timely knowledge, and perhaps the incentive, to do it efficiently.
Posted by: Will McBride at Jun 9, 2009 5:49:17 PM
McBride:
Sorry I didn't respond for so long.
I think you are confusiong the concept of scarcity of resources with "limited funds."
Resources are factors of production like land, labor and capital. Scarcity of resources is that there is only limited amounts of these things. That means that production is limited. And so, producing more of one good requires the that less of some other good be produced. That is opportunity cost.
Anyway, more production of capital goods requires less production of consumer goods because resources are scarce.
Credit shifts funds between and among firms and households. It doesn't create land, labor, or capital out of nothing.
Bob, who borrows to fund consumption, can spend more than his income. That is because someone spends less than their income instead.
In the U.S., personal saving has been positive. That doesn't mean that there aren't lots of Bob's who have been dissaving and going into debt. But there are Mary's and Dave's who have been accumulating assets--stocks, bonds, CDs, and balances in bank accounts.
Banks can lend money into existence, and central banks can do this in spades, however, this is just a small part of the credit markets. More importantly, the other side of any disequilibrium between saving and lending created by this is temporary. The other side of someone spending newly created funds is people accepting funds in payment with the intention of spending them.
Anyway, while debt (with or without a loose monetary policy) allows some people to consume more than there income, not everyone can do this at once. Generally, people consumer less than income, allowing for investment, the use of resources to produce capital goods.
Posted by: Bill Woolsey at Jun 10, 2009 2:24:10 PM
Bill, I disagree with your statement:
"Credit shifts funds between and among firms and households. It doesn't create land, labor, or capital out of nothing."
During a credit boom, employment goes up because wages go up. In this sense it "creates" labor by pulling it off the sidelines. The labor in turn is used to create capital. Labor is not fixed in the short term, and capital is not fixed in the long term. Only land is fixed. I think our disagreement is about dynamics. Technically, you are right that an instantaneous money supply shock has no immediate effect on anything, but go out a few days, weeks, or months and it changes both labor and capital.
And again, here in this statement you are using a static analysis:
"Bob, who borrows to fund consumption, can spend more than his income. That is because someone spends less than their income instead."
We know banks leveraged up over time, increasing the money supply out of thin air and unrelated to anyone's income.
Posted by: Will McBride at Jun 10, 2009 4:55:25 PM
We know banks leveraged up over time, increasing the money supply out of thin air and unrelated to anyone's income.
The leveraging up of the banks did not increase the money supply out of thin air. The banks got the borrowed money because there were investors willing to lend it to them. Its just that these investors weren't located in the US, but rather were usually foreign funds looking for more return than offered by treasury bonds.
These foreign funds, in turn got their money from the surplus savings of people. The people got their surplus savings from higher incomes. So, to say that the increase in money supply was unrelated to anyone's income is wrong. The increase in money supply was definitely caused by increases in some peoples' income. The fact that these people were largely outside the USA doesn't change the argument.
Posted by: quanticle at Jun 11, 2009 11:16:43 AM
Maybe you're right, but my understanding is that the global savings glut was greatly exacerbated if not primarily caused by foreign central banks defending their currencies and stock piling reserves.
Posted by: Will McBride at Jun 11, 2009 11:36:20 PM
Credit booms involve a shift in funds between firms and households.
The lenders spend less, the borrowers spend more.
If borrowers are willing to bid up wages and this increases labor supply, and if the those borrowing funds for capital bid resources away from consumption, then this can well increase production because of more labor and capital.
The reversal of this situation, then, is people not wanting to work because people don't want to pay them as much and people purchasing consumer goods because no one wants to compensate them enough to accumulate financial assets.
What we don't observe is a situation where people don't want to buy things. Rather is is an unwillingness to provide resources (labor and saving to fund investment) that results in less production. People want more leisure and more consumption now.
That is where your approach breaks down. While your bust can show less production, it is generated by less desire to earn incomes. Generally, the scenarios we want to explain are where people want to earn income, but they cannot because no one wants to use their resources to produce things because they cannot be sold because people don't want to buy them.
The explanation is an increase in the demand to hold money--necessarily. And it can be solved by lower prices (including nominal incomes like wages.) But if those prices fail to fall rapidly enough, there is a reduction in real income, not because people don't want to work (which would result not in unemployment, but increased quits and early retirements) or because they want to consume rather than save and fund investment) but rather because there is an inadquate demand to purchase what their resources are being used to produce.
Now, most of credit is not associated with money, but some is. And it is a big mistake to treat all credit markets as some kind of inverted pyramid built on money. So, that the credit associated with money creation creates ever expanding pools of other sorts of credit. Nearly all of the credit is of the sort where the lenders spend less and the borrowers spend more. The exception is when credit is created by the issue of new money--a tiny fraction of total credit.
Your notion that it has no effect immediately, but it will effect wages, production, etc., if it continues is exactly backward. For a short time, people hold more money than they want and this funds real lending. But they spend the money, and that raises prices and reduces the real value of money to match what they do hold, and that reduces the purchasing power of the lent funds through this means, so that they fund lending that maches the real money balances people do want to hold.
It isn't that each dollar of money creation funds a vast edifice of credit that is all misallocation of resources. It is the process of creating money can create a termporary misallocation of resrouces. Most of that credit would exist if the quantity of money had not changed at all. And to the degree that all of that credit collapses because all the lenders scramble for a fixed quantity of money--that is the disequilibrium. A vast and growing shortage of money is causing an economic collapse.
Leverage? To say that firms are "too leveraged" must means that they should be funded by equity rather than debt. It isn't that they all have too many resources. A single firm that leverages gets more resources. But they come from somewhere. They come from the lenders who spend less on something to fund the firm. To say there is too much leverage is to say that there these lenders are lending too much. OK.. maybe it would be better if they purchased newly issued stock instead.
Now, to the degree that people save only because they can lend to firms rather than make equity investments because the risk would be too great, then less leverage means less saving and more consumption and less production in the long run.
In my view, a "credit boom," shifts resources between sectors of the economy and a "credit bust" shifts them again. Frankly, I think the impact of leisure and labor is trivial. Spending rises in some parts of the economy, and falls in others. Unless there is shortage of money--an increase in the demand to hold money relative to the amount of money people want to hold. And that means less spending, an inability to sell across the board, and an inability to sell resources and earn incomes.
I would recommend looking at Leland Yeager's work--especially, money and credit confused.
Posted by: Bill Woolsey at Jun 14, 2009 12:01:08 PM
Posted by: 家教 at Aug 17, 2009 12:50:03 AM
