Melvyn Krauss: Don't Crucify Labor on a "Cross of Moral Hazard and No-Bailouts"

I like this, perhaps because it echoes and provides a foundation for some of the points I've been making. It's from Melvyn Krauss, a senior fellow at the Hoover Institution:

Sub-Prime Economic Theory, by Melvyn Krauss, Project Syndicate: The possibility that the European Central Bank may raise interest rates in the midst of a financial crisis recalls the great American orator William Jennings Bryan’s famous “cross of gold” speech in 1896. Referring to the international gold standard’s deflationary bias, Bryan railed: “You shall not press down upon the brow of labor a crown of thorns. You shall not crucify mankind upon a cross of gold.”

In other words, ordinary people should not be made to suffer for the foibles of policymakers enthralled by some defunct economic theory.

Today, the defunct economic theory is that a rapid shift in preferences – colorfully called a “reduced appetite for risk” – is the key reason behind the current sub-prime mortgage and financial crisis. To avoid future increases in this appetite, policymakers and pundits have focused on the so-called “moral hazard problem”: the “bad guys” must pay for their mistakes, lest they make them again.

One would have expected the modern-day William Jennings Bryan to be warning central bankers not to crucify mankind on a “cross of moral hazard and no-bailouts.” But, surprisingly, the opposite is occurring.

Some on the left, motivated in part by revulsion against financial types who are thought to reap unjustified incomes, have joined forces with conventional economists, whose almost religious belief in their models has blinded them to the harm their dubious economic theory can do to the real economy and the interests of ordinary people. No bailouts can mean no college for the kids – or, for many, no house.

The key question economists should now be asking is why financial markets are “seizing up” when banks and other financial institutions are flush with liquidity.

The conventional explanation – a reduced appetite for risk – is not convincing. The sub-prime market seems too small to have caused such a broad-based change in risk preference.

A more convincing explanation is that the current crisis, with its unknown dimensions and scope, has so clouded the economic landscape as to freeze market participants in their tracks, so to speak, until things clear up.

That is the fundamental lesson of an important new book, Imperfect Knowledge Economics: Exchange Rates and Risk, by Roman Frydman and Michael Goldberg. The key to understanding financial markets, especially when they are as unsettled as they have been in recent weeks, is not a change in preferences, but inherent imperfection of knowledge and altered expectations concerning the future course of macroeconomic fundamentals.

What policy prescriptions does the “imperfect knowledge” approach imply for the current crisis? The most important one for central bankers is that they should cut interest rates – and cut them fast – to re-assure market participants that turmoil in financial markets will not be allowed to affect the real economy.

Judging by its recent policy reversal, the US Federal Reserve acts as if it were a late convert to the imperfect knowledge hypothesis. ... It matters little that the Fed could have ... cut the federal funds rate ... at its emergency meeting – indeed, that may have to be done. The important thing is that the Fed’s policy crossed the bridge from indifference to re-assurance. Could it be that Bernanke obtained an advanced copy of the Frydman-Goldberg book during those pregnant ten days in August?

Bernanke certainly had time to reflect upon how his legendary predecessor, Alan Greenspan, handled the Long Term Capital financial crisis in 1998. Greenspan was not the kind of economist who would crucify mankind on either a cross of moral hazard or the mechanistic models of conventional economic theory. He cut interest rates to re-assure markets that the financial crisis caused by the hedge fund’s collapse would not affect the real economy. The markets and economy responded with vigor and enthusiasm.

After an initial stumble – a rookie mistake, as one commentator put it – Bernanke appears to be following in the master’s footsteps. ...

Comments

[David]

The problem is imperfect information. So rather than trying to increase transparency, the solution is to provide more easy credit (inflation be damned) to induce more debt and encourage a new asset bubble? This doesn't make sense to me. The reason we are going to have a recession is that so much of the consumer spending has been financed by debt (credit card and mortgage). Now that people don't have an appreciating asset to borrow against, they are going to have to pay down their debt and spend less. We can't avoid this. We can put it off for a while longer, but that will only make the ultimate price debt bigger. Personally, I'd rather suffer the consequences now when the economy is going reasonably well than suffer in a few years when inflation has taken off.

[mayo]

The national home average must be around 210.000, and the cap on freddy and sally is around 450.000. So labor's cross must be to carry the financial burden for those who sinned and bought more Mac-house than they could afford. -nice

[Jason]

It seems that Krauss is hammering this notion of "preferences for risk" because it appears to him to be a reference to a primitive. I do not think that is a correct understanding of how most people use the term - you can blame them for bad use of economics language, that's about it.

[RW]

Hoover Institution? Beware the Greeks bearing gifts.

[Bruce Wilder]

Melvyn Krauss is no friend of ordinary people.

I suspect what worries him, and his patron most, is something he doesn't mention: that somebody might notice the foundation of the subprime mortgage market is predatory lending, and might want to regulate it.

[gordon]

If this piece "echoes and provides a foundation" for some of Prof. Thoma's previous posts, it seems a pretty distant echo and a pretty insubstantial foundation: "A more convincing explanation is that the current crisis, with its unknown dimensions and scope, has so clouded the economic landscape as to freeze market participants in their tracks, so to speak, until things clear up".

Which means what, exactly? "We don't know what's going on, so keep smiling and hand out more ice cream"? "Duck and Cover"?

In a couple of previous posts here and here, Prof. Thoma indicated first that the regulatory environment needs fixing, and later that moral hazard problems need fixing. Now I am at a loss to know what (if anything) he thinks needs fixing.

[Mark Thoma]

It would have been better expressed as

"echoes and provides a [separate] foundation"

The foundation is the work of Frydman and Goldberg - which I happened to have an advance copy of - it's based upon a presumption of imperfect information. e.g. knowing the direction but not the magnitude of change. That is an example of the kind of uncertainty Krauss is referring to that cause markets to "freeze" (and his references to the text take him out of a strict neoclassical framework).

My mind is open, not closed, to new explanations of why markets might fail to perform as expected, and I was fortunate to be able to exchange a few emails over the last several days with R. Frydman about the ideas in the book. When you know the full class of models that might explain a result, and you know from empirical evidence something about their relative plausibility (this is ongoing), you can design policies that are robust across the potential explanations. That way, policy will work relatively well no matter which of the models turns out to be correct. Thus, understanding the full theoretical range of explanations is an important step in designing good policy when, as is of course the case, knowledge of the world is less than perfect.

[dirge]

Avoiding the Moral Hazard problem isn't about punishing anyone. It's about discipline, trying to prevent this from happening again by showing institutional investors that worst case scenarios have to be planned for and that the Fed isn't always going to be there to bail them out. If the S&L's and LTCM hadn't been bailed out then we might not have had quite the problem we have today.
Cutting interest rates now is akin to handing out kerosene to juvenile pyromaniacs.

[dug]

The problem has little to do with moral hazard beliefs that the Fed would bail people out because they did it before. It has everything to do with poor regulation, lack of regulation, unenforced regulation, of the business of credit provision.

The mortgage brokers and originators who pushed people into these ridiculous loans weren't doing it secure in the knowledge that the Fed would bail them out. They are already going bust. They peddled and pushed these loans because that was where the lucrative fees were, and because there was no regulation making them responsible for the probity of their actions. Who cares if they are selling exploding ARMs to senior citizens who don't understand the forms? Who cares if they're pushing subprime loans onto prime borrowers and stating fake "stated-incomes"? All the credit risk gets securitised and repackaged and sliced into CDOs, to be held by who-knows-who -- probably some unsuspecting foreigner.

Take your eyes away from that subprime economy, the United States, for a moment and compare it with other countries where household debt and housing prices also rose a lot, like the UK or Australia. Do they have the same credit problems? Do they have predatory lending to the same extent? Of course not. In these countries, the originator remains legally responsible for lending responsibly, even after securitisation. So the subprime loans aren't low-doc and the low-docs aren't nothing-down.

Yet again, we would all be better off if the US stopped believing in American Exceptionalism and actually tried to learn something from the rest of the world.

[reason]

I second dug in that. Why is the debt problem so much more severe in the US than elsewhere (so severe that the US has been running 5-6% BOT deficits for years).

[ilsm]

Moral hazard.

More medicine show con.

Predatory loans, preyed on greedy hedge funders.

The Federalist No. 10. The Utility of the Union as a Safeguard Against ..... A rage for paper money, for an abolition of debts, for an equal division of ...

Trash the constitution and the money supply to save the likes of these.

I say crucify them!

[Matt]

Whether or not Krauss is a "friend of ordinary people", his analysis isn't at all convincing. Confidence only provides a temporary solution to the imperfect knowledge problem. Greater transparency and more careful accounting are the ultimate solutions, and advances in transparency and accounting are almost always driven by government (or sometimes professional) regulation, not by investors.

It is true that most people will be hurt in a no-bailout credit crisis, but what helps ordinary people in the long term is STABILITY in the economy. As other comments have noted, it seems like Krauss is really trying to promote short-term monetary loosening as a means to avoid regulation, which is the main source of stability (transparency and fair accounting) in the economy. This will benefit investors in the next bubble, but not ordinary people.

[anne]

There was of course no bailing out of Saving and Loan companies, or of Long Term Credit Management. What was done was to protect the economy against economic disruptions threatening to be quite severe. The idea that there were bailouts in either instance pays no attention to history. The only instance of a fairly recent domestic bailout was altogether different and never mentioned, this was the bailout of the commercial banking system as a whole from 1990 and was a result of the Federal Reserve folling the mandate of protecting the banking system.

[anne]

Liquidity provision, to protect market functioning as in October 1987, is a normal function of the Federal Reserve and complained about since 1929 by Austrian economists who are always wishing pain on others for reasons that are a bizarre mystery.

folling is really following....

[robertdfeinman]

I thought the point of the article was to extol the virtues of the great god Greenspan once again and to point out that Bernanke is no Greenspan.

Greenspan always knew what his mission was, to protect the rentier class. Now the super wealthy and their toady's at Hoover are worried that their interests won't be protected automatically and that they will have to lobby for the policies they prefer.

Just for the record (third time just this morning):
The Hoover Institution is an arm of the plutocracy (why do the same names keep coming up over and over again?).

Here are the details:
Media Transparency

The right pundit class is like kudzu, you chop it down in one place and it comes back even stronger somewhere else.

[wjd123]

It would be nice if the lawyers could find some legal reason to take on those who practiced predatory lending. Sending in the lawyers in 21 century America is equivalent to sending in the furies of Greek mythology. Lawyers are punishment in themselves no matter the crime, guilty or innocent. If there are no laws predators have broken than shame on Congress.

If there are laws that lawyers can find, fear not, it won't be a feast for the legal profession because many of those they will be feasting upon are other lawyers who were charged at the time of real estate closings to represent the interests of both parties. As for the financial institutions that avoided their fiduciary responsibilities, let the lawyers feast.

[ndd]

First of all, good catch rdf.
As usual, the wolves are coming dressed in sheep's clothing. One might call it "rancid populism" to make a nod to another post.

The nub of the article for me though is this:

A more convincing explanation is that the current crisis, with its unknown dimensions and scope, has so clouded the economic landscape as to freeze market participants in their tracks, so to speak, until things clear up.

.... The key to understanding financial markets, especially when they are as unsettled as they have been in recent weeks, is ... imperfection of knowledge....

What policy prescriptions does the “imperfect knowledge” approach imply for the current crisis? The most important one for central bankers is that they should cut interest rates – and cut them fast – to re-assure market participants that turmoil in financial markets will not be allowed to affect the real economy.

My rebuttal: in the first place, the author is conflating "subprime mortgage crisis" which afflects mortgage holders and borrowers, with the related but separate "liquidity crisis." The first has to do with insolvency, not illiquidity. The second has everything to do with illiquidity due to lack of knowledge. Which leads us to the second point, which is;

The cure for lack of knowledge isn't easy money, but -- wait for it -- knowledge! Fancy that! And how do we get knowledge? In this case, mandatory disclosure. Let all public market participants (e.g., hedge funds) be forced to disclose their direct investments in non-traditional mortgages, and their leverage therin. Once they disclose, investors in those market participants (e.g., endowments investing in hedge funds) must disclose their own exposure w/in 7 days thereafter.

With disclosure comes the solution, without the need for rate cuts.

[Bruce Webb]

"There was of course no bailing out of Saving and Loan companies, or of Long Term Credit Management."

Anne you might want to expand on that. My memory more parallels the summary here, I see an injection of $300 billion in taxpayer money that allowed operators of these S&Ls to reorganize their profoundly mismanaged industry, an industry which ended up looking more like a Ponzi scheme than anything.

The Greatest Savings Crisis in History

Sure enough, when the real estate markets experienced a normal business cycle slump, the SLAs were disproportionately affected. Regional economic shocks (such as down spiralling commodity prices) rocked the value of real estate and the stability of these lending institutions. The coup de grace was delivered through the inordinately volatile interest rates. SLAs had to pay short term depositors high interest - while collecting lower income, in the form of interest payments on their old loans. This negative spread between the cost of funds and the assets' yield - eroded the operating margins of the SLAs. When they discovered that the securities that they were holding were much less valuable than the loans that they were intended to secure - panic ensued.

Hundreds of thousands of depositors crowded to draw their funds. Hundreds of SLAs (out of a total of more than 3,000) were rendered insolvent, unable to pay their depositors. They had to shut up their gates and were put to siege by angry - at times, violent - clients who lost their life savings.

The illiquidity spread like fire. One stedilnica after the other collapsed, leaving in their wake major financial crises, ruined businesses and homeowners, devastated communities. The crisis reached gigantic proportions and threatened the stability of the whole banking system all over the USA.

The Federal Savings and Loans Insurance Corporation (FSLIC) - which insured the deposits in SLAs - could no longer pay the claims and, in effect, went bankrupt. This single event had a chilling effect on the Federal government. True, the government did not guarantee the obligations of the FSLIC. Still, it was perceived to be an arm of the Federal Government and the public shock and outrage were beyond description.

So, the Federal Government was forced to step in. A hasty $300 billion (!) package was put in place to save what could still be saved. This was the first step, a right and proper reflex: the injection of liquidity through a special agency, the FHFB. Everyone involved postponed the mutual accusations, the criminal charges, the resignations and recriminations to a later stage. First and foremost the system had to be stabilized and it could be stabilized only through the restoration of public trust. Public trust could be restored only with money - and with a lot of it. The visible, unambiguous involvement of the top level authorities had a positive, long term effect. The "full faith and credit of the USA" was now behind the SLAs and that was good enough for everyone.

Wealthy depositors were getting ridiculous levels of returns on uninsured deposits. Which in a rational economic world would have been accompanied by risk of loss. Yet everyone was made whole at taxpayer expense. Now if they had limited this injection of cash to only insured deposits then only the wealthy would have incurred any loss at all, well the wealthy and the S&L operators. If 'bailout' isn't the word for an injection of $300 billion into the system what is?

[Bruce Webb]

And this looks remarkably like a Fed organized bailout. Basically you are looking at a $3.65 billion dollar unsecured loan. I doubt these banks acted without some private assurances from the Fed that they would be made whole if and when necessary. And the organizers of LCTM walked away with plenty.

Long Term Capital Management

With losses of capital by LTCM its bank lenders became worried about the security of their loans. In the fall of 1998 when LTCM was on the brink of failure the Federal Reserve Bank of New York brought the lenders together and brokered a bailout. Some fourteen or so banks contributed about $300 million each to raise a $3.65 billion loan fund. That fund along with the equity still held by LTCM enabled it to withstand the turmoil in the markets. Another financial crisis occured in the form of unusually high spreads on swaps. LTCM was reorganized and continued to operate. By the next year it paid off its loans and was effectively liquidated by early 2000.

It if walks like a bailout, and talks like a bailout, I am willing to call a duck a duck.

[Monkey In Chief]

The pro-bailout crowd acts like the bailout would be free and the anti-bailout crowd is just mean and wants to take away people's houses. A bailout is going to impose real costs on the rest of the country.

Somebody has to pay for the mistakes of the reckless. The only question is whether the reckless borrowers will pay or everybody else.

[Insurance Guy]

It seems to me that if debt is rising faster than income, as I believe has been the case in the United States for decades, then the effectiveness of monetary policy must have a limit.

Am I out to lunch on this? When the Fed spurs economic growth through easing of interest rates, isn’t debt creating the result? Obviously I am a layman. I would appreciate any feedback.

[mrrunangun]

I don't have precise figures at hand, but isn't it so that the prices of gold and oil have each roughly tripled since the 1998 LTCM bailout? (They are each roughly twenty-fold what they were in 1968.) Does that fact, if it is a fact, constrain the freedom of action of the central banks?

[Lafayette]

IG: When the Fed spurs economic growth through easing of interest rates, isn’t debt creating the result?

If lower interest rates will help those to better pay off their variable interest rate (by mitigating the cost) debt, then lower interest rates certainly helps to maintain disposable income..

But, some models apparently suggest that a rate decrease will not be sufficient to spur further growth. The US economy is bound to contract from here on out, and there is a chance it could go into recession. People do not incur further debt in an economic decline, they reduce spending.

It is clear that housing prices in the US are likely to undergo serious devaluations - as much as 15% according to one model being employed. So, there wont be much unlocking of capital gains for further spending there either.

As Americans danced up the credit lending hill along with rising realty prices, they unlocked value that enhanced disposable income. The opposite will now happen. Spending can no longer depend upon asset revaluations to maintain consumer demand.

The economy will not improve. That will affect equity valuations as well. So, it appears that it will have to get worse before either markets get better.

The only question unanswered is by how much the economy will contract.

Note also the credit card repayment defaults are on the rise. It's time to pay the piper for past profligacy.

Btw, the contagion is not restricted to the US. If world economic growth cannot continue without the US motor, then it will suffer as well. If it does grow, however, with the lower dollar, American exports could help mitigate reduced domestic demand. But, that's a BIG little "if".

[calmo]

So cute: that's a BIG little "if". (Well here's a little BIG "IF".)
Ok, nuff tickling laffy:

If world economic growth cannot continue without the US motor, then it will suffer as well. If it does grow, however, with the lower dollar, American exports could help mitigate reduced domestic demand.

And there's no denying the importance of the US consumer in the global market (Roach's Imbalanced Global Economy has more than brain washed me, you?)
And no denying the transnational character of what registers as American business and the dismal outlook for American exports in the next wave of global consumption (India and China)...unless we bury all that corn and start planting rice RIGHT NOW.

[Robinia]

Naw, Calmo-- don't trade subsidized corn for subsidized rice. If we want global economic stability, we in the US should stop subsidizing the planting of corn AND rice (and the over-manufacture and give-away of military aircraft and munitions), and let some carbon-sequestering trees grow. We revitalize the housing market and constructiton trades by incentivizing conservation retrofit measures in existing housing, solar and wind energy development, and other carbon-neutral technologies. Simultaneously, we rebuild infrastructure in freight and passenger rail, decrease reliance on the property tax by increasing reliance on a progressive income tax(thus incentivizing farming for the needs of the regional population)and incentivize the redevelopment of distribution and wholesale businesses that reduce the foodmiles in the diet of the average American. And, encourage the development of various forms of telecommuting, in order to reduce the energy used by workers commuting to and from work, one to a car.

Then, we will not feel obligated to go to war to steal the oil under other peoples' sand, or rely on the Indian and Chinese workforces for most of the necessities of life (and some non-necessities, too-- like cheap lead jewelry for tots).

[calmo]

Robinia, what planet are you from again?
Sounds wonderful!
I feel revitalized just reading you...bring on the telecommuter thingie.

[Lafayette]

calmo: And there's no denying the importance of the US consumer in the global market (Roach's Imbalanced Global Economy has more than brain washed me, you?)

No, Reich's rants haven't influenced me. Global trade statistics do.

The American consumer is less and less a "motor" to world economic growth. The past two decades have seen a massive shift in capital to emerging economies, thus allowing the latter to develop an import demand as well as participate in satisfying export demand.

And, as the dollar becomes less and less a reserve currency, as is the case presently, then its impact on world economic growth will lessen. Why?

One must understand what "world reserve currency" means. It means that people hold American dollars, that is, they finance their own exports to America by purchasing T-notes (American debt) with their export earnings. When that little favor has ended, America is going to find itself paying "hard cash" for its imports.

Want to pay Euros for oil imports and buy them on international markets at $1.30 to do so? That's what is bound to happen as export countries no longer want to hold dollars from a import country that continually jolts international financial markets with its speculative frenzies.

Or, let's remember all those PCs that China use to buy from the US ... that are now Made in China ...

Maybe the US will learn, finally, that it is living beyond its means? As has been said before, here; America has been living off borrowed time. It's getting to be time to pay the piper.

[gordon]

I think Bruce Webb is right when he says: "It if walks like a bailout, and talks like a bailout, I am willing to call a duck a duck". Matt is also right when he says: "It is true that most people will be hurt in a no-bailout credit crisis...".

The need for a bailout to prevent worse damage has been the theme of Prof. Thoma's posts over the last couple of days. I can see the logic in that, but (to quote Matt again): "Confidence only provides a temporary solution to the imperfect knowledge problem". The trouble seems to be, as I tried to indicate in my previous comment, that nobody is making any concrete suggestions about how to prevent this happening again. Matt is suspicious about this silence: "...what helps ordinary people in the long term is STABILITY in the economy. As other comments have noted, it seems like Krauss is really trying to promote short-term monetary loosening as a means to avoid regulation...".

If Matt is right, there is a confusion between the immediate reponse and the longer-term response. I hope nobody really thinks that a bailout now will substitute for action to prevent this happening again. Do they?

[run75441]

Gee . . . why do you think the banks and finacial institutions make so many subprime and predatory loans???

"2005 Bankruptcy Abuse Prevention, Consumer Protection Act"

It slams the door on most who would seek Chapter 7 in favor of Chapter 13 which forces payments upon those who are above the state's median income before child support and alimony. The courts now enforce bill collection.

Banks and Financial Institutions have you coming and going.

[Lafayette]

run: "why do you think the banks and finaciail institutions make so many subprime and predatory loans???

No one is forcing anyone to undertake a loan that is potentially hazardous to their financial condition.

Why does anyone actually believe the advertising crap they see on television for "great loans!" at "cheap prices!"? Because they are gullible.

There's a sucker born every minute and there is no one is responsible for protecting people against their own innate gullibility. The Fed was asleep at the wheel.