Resolving the Financial Market Crisis

In thinking about how to resolve the financial market crisis, I've said that we should do two things, pursue some version of a mortgage repurchase plan, and pursue some means of removing risky assets from financial markets:

[T]he Fed [can] remove risk from the market by purchasing risky mortgage backed securities... I think purchasing mortgages would [also] help to stabilize the mortgage market, so I ... favor ... the mortgage purchase plan, particularly since it helps homeowners directly. I am just not sure that it will be enough by itself to get credit flowing again. ... Because of the uncertainty about whether purchasing mortgages will be enough to stabilize markets, I would advocate doing a combination of both policies, purchase troubled mortgages and purchase troubled financial assets at the same time... (and other measures, e.g. regulatory change, could also be put into place so his is not all that can be done).

In a follow-up, I added that:

I believe a combination of both plans - the Treasury intervening to purchase mortgages and reissue them on more attractive terms, and the Fed intervening to purchase mortgage backed securities (MBS) - is the safest bet. Even if one of the measures isn't enough on its own, hopefully the combination will prove sufficient.

The analytics of proposals such as this are starting to come together. Brad DeLong has done us a favor and provided the latest step in the analytical process. Here's a fragment of a much longer post he has provided. Notice that he has also added recapitalization to the list of policies, an important innovation since this is one of the keys helping financial markets to move forward:

What do we do now? That is the subject of Larry Summers's column. We do two things. First, we have the Federal government reduce the supply of risky financial assets by having the government buy or guarantee (thus making the assets no longer risky, you see) or support the purchase of mortgages (and other things) and so push the private financial-sector supply of financial assets to the left. Second, we have the Federal government "encourage" the financial sector to recapitalize itself, thus pushing the supply up and to the right, like so:

And so pushing up the prices and reducing the interest rates charged on financial assets, making the good equilibrium reappear, and keeping us out of depression, like so:

That, in a nutshell with simple graphs, is what Larry is saying, with the addition that he thinks that we now have in motion enough policy moves to resolve the crisis and save the world economy from depression. But there are four additional points that don't fit easily on the graphs. We need to make sure that we also:

• do smart things to try to keep this from happening again
• assign blame and try as hard as we can--without causing a depression--to make sure that those who bear responsibility don't make out like bandits by looting the Treasury as this is accomplished.
• make sure that others--even if they are still largely innocent bystanders at the moment--do not earn unjustified windfall fortunes in the process.
• make sure that the upward-and-to-the-right orange-arrow movement of the supply curve does in fact take place: make sure that financial intermediaries that survive and profit because of government intervention become not just part of the problem but part of the solution: that because "much is being given to financial institution shareholders and management, [it is only fair that much] action to help the economy and protect the taxpayer... be expected in return."

Now there are three objections to this analysis and this plan of action, roughly: (1) it's immoral, (2) it's unfair, and (3) it can't work in the long run. To expand a bit ... [...Brad's post...]

Comments

says...

Brad wrote; "Later on we can talk about the corollary to the refutation of objective (1)--the fact that the existence of a safety net for the rich since 1844 makes it an obvious matter of simple justice that there be a safety net for the poor and the middle class as well,"

This is the best part as it reveals so much of what is wrong with the economics profession.

Brad accepts there should be two societies with two different safety nets and accepts that this is built into the system. Why not argue we should have a single net with equal access?

[James]

Brad et al. can try an push this through prior to the 2008 elections, and doing it through the Fed avoids the nasty political policy discussion surrounding this.

However, I think the risk is much more than Brad realizes, and the backlash is just as liable to sink the Fed as anything else.

His handwave concession to doing some things later on to address the political issues is nice, but I'm afraid he's poltically tone deaf in this instance.

Perhaps it can be managed in a 'crisis mode' like the Patriot Act, but that route is a bit well-trodden.

What to do? What to do? Tapping public monies is not going to fly, guys. The mood is getting ugly and heads are going to start rolling. It will be interesting to see if the current Dem leadership can remain in power into 2009.

Well, we'll have to wait and see how this one breaks. But I am convinced Brad is breathing in a rarified atmosphere.

[James]

Here is a 'model' that helps to frame up the discussion.

Its easy to see where the country is now on the continuum chart of political and economic thinking. Its in the Bush category and heading away from it.

Where would we put Brad's proposal? It looks like a 'Clinton' fit on this. Is this where we think the country is going? Are they looking just get the reverse of what they have now? Perhaps, but I suspect that Obama is trying to position himself nearer to the front and center, and this is the impetus behind his 'phenomenon.'

But as Tommmy Franks pointed out, anything can happen.

http://tinyurl.com/2cl9kv

[Andrew]

"Financialization is a process whereby financial markets, financial institutions, and financial elites gain greater influence over economic policy and economic outcomes. Financialization transforms the functioning of economic systems at both the macro and micro levels.

Its principal impacts are to (1) elevate the significance of the financial sector relative to the real sector, (2) transfer income from the real sector to the financial sector, and (3) increase income inequality and contribute to wage stagnation. Additionally, there are reasons to believe that financialization may put the economy at risk of debt deflation and prolonged recession.

Financialization operates through three different conduits: changes in the structure and operation of financial markets, changes in the behavior of nonfinancial corporations, and changes in economic policy.

Countering financialization calls for a multifaceted agenda that (1) restores policy control over financial markets, (2) challenges the neoliberal economic policy paradigm encouraged by financialization, (3) makes corporations responsive to interests of stakeholders other than just financial markets, and (4) reforms the political process so as to diminish the influence of corporations and wealthy elites."

Abstract: Financialization: What it is and Why it Matters, Thomas Palley

[Bruce Wilder]

"the government buy or guarantee (thus making the assets no longer risky, you see) or support the purchase of mortgage"

at a price to be determined how?

[Winslow R.]

'Andrew' I read the Palley paper and continue to be struck by the difficult path progressives seem inclined to take to rebalance power in America.

We need a simple change that will have a profound impact on the structure of society.

Fed Direct could allow every American citizen to borrow directly from the Fed.

The idea is not so far fetched...

Treasury Direct allows every American to purchase bonds directly from the Treasury.

Fed Direct would bring about everything Palley is looking for and far more though it may not be readily apparent to the casual observer, making it all the easier to implement politically.

Now is the time for an economist to advocate such a plan as the financial industry is in a weakened bargaining position with regards to the U.S. taxpayer.

[gordon]

Winslow R., what is the difference between Fed Direct and my proposal for a Commonwealth Bank of the United States?

[Winslow R.]

"Winslow R., what is the difference between Fed Direct and my proposal for a Commonwealth Bank of the United States?"

Looks like we are in agreement.

The difference between me and you seems to be in our ability to tweak Mark's sense of amiability :)

[hari]

Brad deftly considers Robert Nozick's, "Anarchy, State, and Utopia" as a relevant part of the discussion on hi fi markets meltdown under Libertarian economic modelling.

Rationalization of the defects of current regulatory system, with a view to bridge the intellectual abysss of free-market economics, cannot be adequate to come to grips with the decadence of the management of hi fi market system. For tenured Profs to rationalize, as Summers and Brad are invariably doing, is untenable. It won't do in a globalized world.

The decadence of the capitalist system must be attacked from top down and reformed before it becomes a fatal disaster - bringing down the global financial markets with it.

[Risk and Reward]

"...thus making the assets no longer risky..."

Yes. High risk requires high potential reward. Low potential reward necessitates low risk. If we want foreign savers to buy our securitized bonds at low interest rates, the risk must remain very low. Sort of an FDIC type guarantee for securitized bond buyers.

Realistically, this guarantee cannot be removed in the near future. Trust can take a long time to restore, once it is lost. GSE guarantees of most future mortgages will probably be necessary for a long time to come, if low mortgage rates are the desired causatum. To keep risk to the fisc within a tolerable range, regulations must weed out potential borrowers who are unlikely to repay.

[Farrar]

Damn, I keep forgetting -

There is a limit on what economist can do or reasonably recommend. That limit might be defined by the intersection of two curves, one representing the political constraints imposed by the party in power and their ideology, and the other by (un)favorableness (could that be a word?) of the economic situation.

At this time, the political constraints are more or less a straight line, vertical or horizontal - sorry I forgot to attribute the axes to either factor - in any case, we know that with leadhead, it's pretty inelastic.

Thus, as long as the (un)favorableness curve remains potentially manageable, (this is getting too difficult- I have no idea how to draw that curve) any conscientious economist such as our host is restricted to making suggestions within the feasible, given that immovable hard line of ideology.

Apparently Hari forgot that too, saying
"For tenured Profs to rationalize, as Summers and Brad are invariably doing, is untenable. It won't do in a globalized world."

Wild eyed non-economists like me and a few others forget that limit, and often go overboard in proposing such commonsensical, too-easy solutions like nationalizing the banks, or having HUD take over foreclosed MacMansions, turn them into duplexes and rent them out (to paraphrase only a few commonsensical solutions put forth by others on this blog.) But I wouldn't have thought that of Hari, who is used to dealing with the real world, which is, of course governed by ideology rather than common sense.

Now, do you suppose that responsible economists like Mark Thoma or Brad Delong, progressive as they may be, could even acknowledge such ideas on their blogs, given the rigid straight line described above? Such moving outside the politically possible could be considered tantamount to revolution -- unless, of course an interdepartmental committee (Econ/PolySci) were set up to coordinate.

Furthermore, I believe that some commenters are being much too hard on Brad Delong. I see a delicious tongue-in-cheekiness in his blogs, which suggests to me that he is very much aware of the futility of recent pronouncements by his cohorts, and is either -
- resigned to the collapse of the system in a not too distant future, or
- resigned to waiting nervously for a new administration to change the paradigm.

The important question is, Can we count on any of the candidates to change the paradigm?

[hari]

Yes! But the fundamental paradigm shift must inevitably make them also consider their point-of-view *outside* the Libertarian box. Don't you think intelligent academics with tenure must also contribute to finding ways and means to go forward in this globalized world - rather than returning to their *home base* and forgetting the market may be not only fraudulently de-masked but fatally cornered - southward.
Summers is thinking outside the box - but still prentending that we may not be facing a rcession or whatnot. His pedegree is of course Samuelson....

Here, the ECB and BoE and other CBs are more pessimistic and prepared to intervene (again) in the market, if required.

[hari]

@ Farrar -

You're raising a serious moral question about our academics -whether they are tools of their heirarchy - therefore delimited to mouth *faul* philosophy (like we are able to do when disturbed by their tounge-and-cheek commentary) - or can they really think outside the *box*?

I've a lot of fun with Brad's blog because the bugger is well read and also a bit indisciplined (compared to our Mark) and anarchic - part of his inheritance of knowledge, I suppose.

I recall, the more one gets to know, the less one understands - although (they say) knowledge is power and ignorance bliss!

Mark is not trying to hide his philosophy from us - I find him transparent and honest. He's also trying to come to grips with what Summers and Brad are illustrating with the graphics.

[ddt]

winslow & gordon - Your ideas are really not that farfetched, they are just not easy to sum up in a soundbite that voters can understand, while there are also powerful interests set against them. My grandad ran as an MP for the Social Credit party way back in the day. It is a thankless task to campaign for popular access to government credit. People have spent their whole lives fighting for it to no avail.

[Winslow R.]

ddt wrote: "It is a thankless task to campaign for popular access to government credit. People have spent their whole lives fighting for it to no avail."

Point taken. It would seem if there was a time to fight, it would be now. Times have changed as computer technology make feasible what at one time may have been a paperwork nightmare.

Even the IRS taxation process is becoming computerized.

I posted a 'joke' of a scenario showing what would happen to the national government if we had a fractional reserve taxing system just like we have a fractional reserve banking system. Why both systems aren't fractional is testimony to the ability of citizens to retain some control over national finances.

[Winslow R.]

Again an idea not so far fetched as this is a fractional taxation system in Rome as described by Bruce Bartlett.....

"Tax farmers were often utilized to collect provincial taxes. They would pay in advance for the right to collect taxes in particular areas. Every few years these rights were put out to bid, thus capturing for the Roman treasury any increase in taxable capacity. In effect, tax farmers were loaning money to the state in advance of tax collections. They also had the responsibility of converting provincial taxes, which were often collected in-kind, into hard cash. [6] Thus the collections by tax farmers had to provide sufficient revenues to repay their advance to the state plus enough to cover the opportunity cost of the funds (i.e., interest), the transactions cost of converting collections into cash, and a profit as well. In fact, tax farming was quite profitable and was a major investment vehicle for wealthy citizens of Rome (Levi 1988: 71-94). "

http://www.cato.org/pubs/journal/cjv14n2-7.html

Maybe we could get Bruce Bartlett to lead the fight against a fractional reserve system.

[Winslow R.]

Tax Farming
http://en.wikipedia.org/wiki/Tax_farming

"A modern example of a variation of tax farming is the United States IRS outsourcing of the collection of taxpayers' debts to private debt collection agencies. In September 2006, the IRS began to outsource the collection of taxpayers debts to private debt collection agencies. "

http://en.wikipedia.org/wiki/Privatized_tax_collection

says...

Pimco's Bill Gross agrees,

Well, that’s enough liberal, populist, straight-talking think pieces for one Investment Outlook. Over the past few pages I’ve suggested: 1) home price declines have to be halted in order to revive the U.S. economy, 2) the Bear Stearns crisis and its solution will lead to increased government regulation and a higher probability of inflation, 3) J.P. Morgan (the old man) was right – character, not assets, should form the foundation for lending, although a reversion to this old-fashioned model is not likely anytime soon, and 4) whether you know it or not – whether you like it or not – you are bailing out Wall Street.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+March+2008.htm

[Lord]

3 It can't work in the long run

If prices are out of balance with incomes, the government may absorb the losses, but it can't keep prices where they otherwise must end up.

[gordon]

Thanks, Winslow R. Is there a post/comment which explains the Fed Direct idea?

[Winslow R.]

I've discussed the issue with various people. This is an excerpt of a debate with a banker friend.

A Lender Halts U.S.-Backed Student Loans
http://www.nytimes.com/2008/02/28/business/28loans.html?_r=2&adxnnl=1&oref=slogin&ref=business&adxnnlx=1204229100-BdxLHSC6VMd4GCZeKDA8SQ

*These loans could be created by the student themselves if they had access to the TAF auction.

*No need for loan officers, just a SS#. The Fed would accept a student loan as collateral for Fed funds at the current TAF auction rate.

That's functionally an unsecured loan? Are you suggesting the govt allows all to borrow unsecured?

*Are present student loans any different? Most people's first loan is a credit card and/or a student loan, both unsecured loans. Larger loans could still be secured by assets, but still no need for a bank. Only need the TAF and a functioning market to efficiently value assets. The government should concentrate on creating efficient markets that can 'discover' value as this is one area they have the power to optimize.

*A stronger monetary policy mechanism will have a more direct impact on the economy creating a more powerful Fed.