"Ten Days That Changed Capitalism"

I'm sort of surprised at the number of people coming to the conclusion that "something big just happened" that will change how capitalism operates. For example, Martin Wolf and David Wessel both conclude that recent financial instability overturns the idea that markets always function best when government involvement is minimized or absent altogether. They are talking about slightly different topics, Martin Wolf discusses how the regulatory environment must be changed so that financial markets will function better, whereas David Wessel is talking about active and direct government intervention to stabilize prices and markets. The first is about the end of "The Great Deregulation" and the second about the end of the belief that markets always quickly self-correct on their own, but in both cases the conclusion is the same, some markets must be managed using regulatory and/or stabilization tools in order to avoid problems that can negatively affect the entire economy:

Ten Days That Changed Capitalism, by David Wessel, Capital, WSJ (FREE): The past 10 days will be remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse. ...[T]he government's recent actions don't (yet) register at FDR levels. ... But something big just happened. It happened without an explicit vote by Congress. And... billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess. ...

Was this necessary? It's messy, uncomfortable and undoubtedly flawed in many details. Like firefighters rushing to a five-alarm fire, policy makers are making mistakes that will be apparent only in retrospect.

But, regardless of how we got here, the clear and present danger that the virus in the housing, mortgage and credit markets is infecting the overall economy is too great to ignore. The Great Depression was worsened because the initial government reaction was wrong-headed. Federal Reserve Chairman Ben Bernanke spent an academic career learning how to avoid repeating those mistakes.

Is it working? It is helping. One key measure is the gap between interest rates on mortgages and safe Treasury securities. A wide gap means high mortgage rates, which hurt an already sickly housing market. ...

The gap remains enormous by historical standards, but has narrowed. On March 6, according to FTN Financial, 30-year fixed-rate mortgages were trading at 2.92 percentage points above the relevant Treasury rates; Wednesday the gap was down to 2.22. Normal is about 1.5 percentage points. Money markets are still under stress, as banks and others hoard cash and super-safe short-term Treasurys.

Is it enough? Probably not. Although it's hard to know, the downward tug on the overall economy from falling house prices persists. The next step, if one proves necessary, is almost sure to require the explicit use of taxpayer money.

The case for doing more is twofold. One is to cushion the blow to families and communities, even if some are culpable. The other is to disrupt a dangerous downward spiral in which falling prices of houses and mortgage-backed securities lead lenders to pull back, hurting the economy and dragging asset prices down further, and so on.

In ordinary times, a capitalist economy lets prices -- such as those of homes, mortgage-backed securities and stocks -- fall to the point where the big-bucks crowd rushes in, hoping to make a killing. But if the big money remains on the sidelines, unpersuaded that a bottom is near, the wait for bargain hunters to take the plunge could be very long and very painful.

So the next step, no matter how it is dressed up, is likely to involve the government's moving in ways that put a floor under prices, hoping that will limit the downside risks enough so more Americans are willing to buy homes and deeper-pocketed investors are willing, in effect, to lend them the money to do so.

Comments

[Kerry Kirpes]

What if the fundamental issue is affordability? You can prop up the housing market to sustain values but does it help if don't prop up incomes so the houses can be afforded.

[groucho]

"I'm sort of surprised at the number of people coming to the conclusion that "something big just happened"

Mark, something BIG did "just happen". But the "just happened" took place over a generation.

Specifically, the STATE learned how to depreciate the currency while reducing labor's ability to offset loss of purchasing power.

This resulted in much greater household labor participation and finally to household debt as a 3rd cashflow leg.

The current cashflow drivers; tiny rebate checks and household credit defaults(mainly mortgage) with the FED clearly on the path of monetizing said defaults IS still an extremely limited driver.

Households are tapped out. Making sure the coming bailouts don't encourage and reward those who gamed the system so outragrously
has to be priority one.

[save_the_rustbelt]

The mad rush to globalize the economy is a much bigger story than the current flap on Wall Street.

This is a three year blip.

Remember Sarbanes-Oxley? That was supposed to guarantee honest financial reporting - yep.

[anne]

Mark Thoma:

"I'm sort of surprised at the number of people coming to the conclusion that 'something big just happened' that will change how capitalism operates. For example, Martin Wolf and David Wessel both conclude that recent financial instability overturns the idea that markets always function best when government involvement is minimized or absent altogether."

The sense is the surprise is over how naive, how willingly blind, Martin Wolf and David Wessel have been. There has for many years been a determined high-finance campaign to discredit what Teddy Roosevelt let alone Franklin Roosevelt understood about the need for a balance even to impossibly rapacious business interests.

[anne]

http://www.palemale.com/december272006.html

Mark Thoma is surprised at the supposed surprise of analysts who never suspected that when the chemical industry was vilifying Rachael Carson the industry might not have been only interested in saving Americans from attacks by dread bald eagles.

[anne]

Not even bothering to think much, we are this very day fining that there was abuse in private military contracting for Afghanistan. Abraham Lincoln would have been shocked. We are this very day finding auditors who are barely beyond failing to audit Enron, were failing to audit mortgage lenders and packagers. We are this very day learning that tobacco companies secretly financing lung cancer research might not have really been interested in having us smoke less to prevent cancer.

That's just this day; balance is needed as Tedy Roosevelt understood but which surprises Martin Wolf and David Wessel.

[bakho]

"overturns the idea that markets always function best when government involvement is minimized or absent altogether."

This was an empty slogan at best. No study has EVER supported this idea.

Market function has everything to do with the quality of the rules and little to do with who makes the rules. Greedheads are just as capable of producing FUBAR rules as government.

[dd]

The issue isn't what went wrong with capitalism; but the deep seated cronyism. Losers pay twice: on the way up and the way down. Anointed "winners" who created the chaos for profit scheme reap the rewards at both ends.
The JPM/Bear/Fed/BlackRock/Penny Mac deal illustrates the cronyism. Prime connected players that unleashed this mess are rewarded on the way up and now: Dimon is a NY Fed Class A BD member; JP Morgan is the major derivatives player; Bear Stearns is its major counter-party; the MBS savior Fink "invented" securitzation and the whole lot of them run hedge funds aka the shadow banking system.
So for all of regulatory hype there will be no investigation because the same contractors who overcharged for shabby houses are now doing the repair at double the cost. It's so very Bush; but then only fools would be suckered for what must be the 100th time by this administration and its band of happy cronyists.

[anne]

Remember kiddies before these 10 days, 11 days before these 10 days even, no one ever never suspected that Bear Stearns might be an investor's best friend however many bodies alreay been strewn along the road even 12 or 13 days before.

[anne]

http://www.nytimes.com/2008/03/27/business/27account.html?hp&pagewanted=print

March 26, 2008

Report Takes Aim at Mortgage Lender's Auditor
By VIKAS BAJAJ

"Improper" practices by New Century Financial were condoned and enabled by KPMG, according to an independent investigation.

[Surprise.]

[anne]

http://www.nytimes.com/2008/03/27/world/asia/27ammo.html?hppagewanted=print

March 27, 2008

Supplier Under Scrutiny on Aging Arms for Afghans
By C. J. CHIVERS

Since 2006, when the insurgency in Afghanistan sharply intensified, the Afghan government has been dependent on American logistics and military support in the war against Al Qaeda and the Taliban.

But to arm the Afghan forces that it hopes will lead this fight, the American military has relied since early last year on a fledgling company led by a 22-year-old man whose vice president was a licensed masseur.

With the award last January of a federal contract worth as much as nearly $300 million, the company, AEY Inc., which operates out of an unmarked office in Miami Beach, became the main supplier of munitions to Afghanistan's army and police forces.

Since then, the company has provided ammunition that is more than 40 years old and in decomposing packaging, according to an examination of the munitions by The New York Times and interviews with American and Afghan officials. Much of the ammunition comes from the aging stockpiles of the old Communist bloc, including stockpiles that the State Department and NATO have determined to be unreliable and obsolete, and have spent millions of dollars to have destroyed.

[surprise.]

[anne]

http://www.nytimes.com/2008/03/26/health/research/26lung.html?hppagewanted=print

March 26, 2008

Cigarette Company Paid for Lung Cancer Study
By GARDINER HARRIS

In October 2006, Dr. Claudia Henschke of Weill Cornell Medical College jolted the cancer world with a study saying that 80 percent of lung cancer deaths could be prevented through widespread use of CT scans.

Small print at the end of the study, published in The New England Journal of Medicine, noted that it had been financed in part by a little-known charity called the Foundation for Lung Cancer: Early Detection, Prevention & Treatment. A review of tax records by The New York Times shows that the foundation was underwritten almost entirely by $3.6 million in grants from the parent company of the Liggett Group, maker of Liggett Select, Eve, Grand Prix, Quest and Pyramid cigarette brands.

[surprise.]

[anne]

We now even have a Supreme Court majority that is bent on turning what limited balance there is between industry and workers and consumers more decidedly in favor of industry, and by industry even ownership is less meant than corporate management which is so often unchecked by shareholding owners.

I am not surprised, nor was Mark Thoma.

[Turbo]

Free markets can only produce the optimal outcome if participants do not have the power to individually influence market outcomes. Clearly in today's world of crony capitalism this is not the case, so greater regulation is required. If losses are going to be socialized, then business might as well all operate like regulated utilities. I don't think the problem is with free markets per se, but that markets have been allowed to devolve into murky oligopolies, and that standards, ethics and even rule of law appear to be largely absent, so free market outcomes can no longer be expected.

[kharris]

bakho, as is often the case, has his finger on something important. Everybody gives lip-service to the importance of the "rule of law" in advancing economic welfare. When it comes down to figuring out what that grand label means, though, there is real slippage. Contracts are sacrosanct, unless you have the wherewithall to defend a breach of contract in court. Then, you are simply making a business calculation. Property rights are sacrosanct, unless you are a developer who can get some level of government to condemn a private holding so that you can buy it. The "rule of law" is important to those at the top as a way to control the rest.

When you hear calls for tort reform, ask the speaker whether individuals or businesses use more court resources in pursuing tort claims. I'm pretty sure the answer is that businesses do. Do individuals or businesses rake in the most cash from court actions? Does anybody try to limit tort actions between businesses? If Microsoft wants to bring an intellectual property rights case, does anybody propose reform to stop them? Not so much. Tort reform is generally intented to limit individual recourse against businesses, not business recourse. In fact, our government attempts to internationalize recourse in every round of trade negotiations. US firms should be able to sue Indian firms for intellectual property rights infringements. You should not be able to impose punitive sanctions on a firm that profited from selling unsafe products. Businesses should be able, however, to sue each other and to sue you. They should be able to utterly ruin you for minor damage to their cash flow. You should be unable to impose damage on them sufficient to compel safer behavior on their part.

Read your credit card contract if you doubt there is an imbalance. Who decided it was OK for your mortgage payment date to be changed at will by the service who bought the loan?

Rule of law is a really big deal for economic performance. It's also a really cynical joke.

[robertdfeinman]

I'm back with the language police. In this case the key word is "regulate".

When free marketeers say they are against government regulation, what do they actually mean? They aren't against patent or copyright protection. They aren't against enforcement of contract law. They aren't against anti-dumping rules.

So, it's only some regulation that they are against. So far I only see two types that are consistently attacked: the "regulations" having to do with paying taxes, and those having to do with enforcement of health, safety, environmental and fraud laws.

If we could only go back to the days of Jay Gould, I guess everything would be OK again. While we're at it lets burn all the copies of Upton Sinclair's books, lest anyone get the idea that "unregulated" firms will sell dangerous or tainted products.

A close study of PR disasters in the past will show that it is the firms themselves that demand standards so that they can assure customers that their products are safe.

Government regulations are needed not only to prevent fraud and monopolistic practices, but to assure consumers about what they are buying. Why the free marketeers have such an irrational view of taxes is beyond me.

I just added an essay on my web site where I suggested that instead of comparing policies between countries to see which ones work best, we just use US states. They have no tariffs, language barriers, or migration restrictions to cloud the picture.

It turns out that those states which have consistently had the highest tax rates and the highest levels of government support for services have performed the best over the past 200 years: Massachusetts, New York, New Jersey, etc.

Those that have had the lowest tax rates and the least state participation have done the worst: Mississippi, Alabama, etc.

Those that got complacent and allowed heavy industry to avoid paying adequate taxes to fund change are now in a development hole: the rust belt.

California is a special case, it used to collect adequate taxes and build infrastructure, but the Norquist type tax revolt has crippled the state and it is now slipping into the "former" leading state category.

Have I missed any other "regulations" which the right thinks are hampering their businesses?

says...

A little early....

FOR IMMEDIATE RELEASE 4/1/2008 IRS RESTRUCTURES

The IRS announced a major restructuring today. The IRS says it will now model itself after the Federal Reserve.

Paulson is quoted as saying, “This is a new day in America with the quasi-privatization of fiscal policy”.

The new IRS reserve system will be modeled after the current Federal Reserve system with new taxing entities (Tanks) based on a fractional taxation system. Tank of America and Tankgroup will be the first of many new private tanks that will gather and distribute revenue for the U.S. government. International Tanks are expected to be partly owned by various foreign sovereign wealth funds.

Paul Krugman was heard to be upset, “I'll have to rewrite all 250 chapters of my book, I just don't understand what is going on.”, he lamented.

The plan calls for the Tax Reserve to set a tax rate by which member banks will be required to pay a small fraction of the taxes they collect to the government. It is the equivalent of the Fed's current system of borrowing and lending being replaced by taxing and spending. Tanks would make spending decisions just as Banks make lending decisions. Tanks would take their place among the private institutions that have a 'special relationship' with our government.

Mark Thoma is quoted as saying, “ I'm not sure it this is efficient or optimal, perhaps a few new regulations and enforcement of old ones would be sufficient along with a new election”.

Many have complained that the IRS is just too cumbersome and overbearing, inserting itself into the lives of every economic participant. The new system claims to avoid these issues, but as some have pointed out, the Federal Reserve has also inserted itself into the lives of every economic participant through its private Banks.

“I spend way more time balancing my check book than I do working on my taxes”, said Jane Public. “I never understood how Banks work, and now there are Tanks?”

Some are concerned we are replacing a old public entity with a new private entity that will allow economic returns to be captured by those that control these new Tanks. Given the new fractional taxation system, funds to government will be greatly reduced, shrinking it to where it fits nicely in a bathtub. Abu Dhabi has joint ownership in the new Tankgroup and will begin helping to make taxing and spending decisions across America.

Details are emerging, but it looks like the new Tax Chairman will be former Citigroup Chairman, Charles Prince. “I'll do my best to serve the institutions that come under my jurisdiction.” the new Prince was quoted as saying.

Some have argued that monetary policy should be implemented more like fiscal policy but they may as well be April's Fool.

[Winslow R.]

That last post was mine :)

[ken melvin]

Hee Hee

[JRossi]

Prof. Thoma, You state you are surprised about the number of people coming to the conclusion that something big just happened. I assume your comment was tongue-in-cheek. Groupthink is ubiquitous among our species. What did Keynes say about world wisdom? I make no comment on the merits of these observers' opinions.

[William Smith]

Prof Thoma,
A good article except for the last paragraph, where he links, almost without realizing it, the financial bailouts to protecting ordinary Americans, rather than New York investors.

[Leverage]

"...some markets must be managed using regulatory and/or stabilization tools in order to avoid problems that can negatively affect the entire economy..."

Yes. Highly leveraged items that are widely held must not be allowed to rise to unsustainable price levels. The high leverage can collapse the credit markets when prices fall back to affordable levels. Among other measures, passing a law at the national level that eliminates all non safety zoning regulations would help. Supply could then more efficiently expand to meet demand, preventing prices from rising beyond the ability of the median person to afford. Texas did not have the afford-ability problems that California did. Zero/low down payment loans should also be abolished, as they frequently are not repaid.

The bad loans on the books are another matter. They will not be solved by attempting to artificially keep home prices rising, because homes are already too expensive to interest buyers. Foreign savers will not buy them at full price, because they are not worth that. This pretty much leaves the taxpayer on the hook, like in the S&L bailout.

[SGC]

Agree with Anne: "we are this very day finding that there was abuse in private military contracting for Afghanistan. Abraham Lincoln would have been shocked."

In previous wars, the assumption was that business would profit from the war effort and so government imposed something called an "excess profit tax". The name is pretty accurate: if a business made more profits during wartime, than in normal times, the government would take as much as 95% of the excess. This tax was imposed during the Civil War, WWI, WWII and the Korean War.

It seems to me that (the abuse of?) economic theory has in fact degraded our society's ability to understand economic behavior.

[tac]

"But, regardless of how we got here, the clear and present danger that the virus in the housing, mortgage and credit markets is infecting the overall economy is too great to ignore. The Great Depression was worsened because the initial government reaction was wrong-headed."

"The case for doing more is twofold. One is to cushion the blow to families and communities, even if some are culpable. The other is to disrupt a dangerous downward spiral in which falling prices of houses and mortgage-backed securities lead lenders to pull back, hurting the economy and dragging asset prices down further, and so on."

Is there some contest that I am unaware of to produce the most self contradictory articles possible? The actions that were taken under Hoover (which the author credits as worsening the depression) were all aimed at building floors.

--------------------

the Hoover program was tailor-made to fit the very doctrine that union leaders had been long proclaiming. There was no chance of wage increases in an unhampered market. The point is that unions did not have the power to enforce wage
floors throughout industry (unions in this era being weak, constituting only about 7 percent of the labor force, and concentrated in a few industries), and so the federal government was proposing to do it for them. pg 212
---------------------

From Hoover's own mouth December 3rd 1929

I have instituted . . . systematic . . . cooperation with
business . . . that wages and therefore earning power
shall not be reduced and that a special effort shall be
made to expand construction . . . a very large degree of
individual suffering and unemployment has been prevented.
---------------------

From Rothbard's "America's Great Depression"

[Winston]

So the next step, no matter how it is dressed up, is likely to involve the government's moving in ways that put a floor under prices, hoping that will limit the downside risks enough so more Americans are willing to buy homes and deeper-pocketed investors are willing, in effect, to lend them the money to do so.
I live in an area where the median house price is 10X the median family income which is a huge aberration from the historic norm of 4X. Exactly why should I see the government working hard to keep the market distorted as a good thing? People didn't regard the rapid run-up in house prices or the "innovative" products that made it possible a bad thing, nor should they see a drop that is just as rapid as a bad thing. Let asset prices fall. It's the only way.

[Bruce Wilder]

Groupthink, indeed, JRossi.

And, well-managed Groupthink, when it comes to such organs as the WSJ. David Wessel knows his job. Commenters like Groucho and Leverage are happy helpers.

[Fall Already]

"Let asset prices fall. It's the only way."

Yes, I agree. Home prices must fall, regardless of how powerful the homeowner SIG is. The average consumer will not accept a 400% rise in the CPI just so homeowners can pretend their over zoned lots have magically enabled them to get rich quick, with no effort.

The sooner home prices fall to affordable levels, the sooner people will buy homes again. They will buy furnishings for their homes. The economy will expand. The big problem is stubborn homeowners trying to get peak prices for far too long. Homes are not a magic lamp that lets people get rich quick with no effort. Get over it already.

[CJ]

I couldn't agree more.

[Patricia Shannon]

Amen.

[Icarus]

I don't think the core issue is about free markets here...it is about regulation.

We had so many home loans which were fraudulent. False information abounded. False incomes, false documents supporting the informaiton...even poor understanding of the loans from the consumer.
This is the root cause.

All these contracts fueled a ficticious bubble economy, which seemed ok as long as home prices were rising.

What would have happened if such corruption were ironed out? We have new debt instruments, so the price of housing assets may experience a structural shift. However, the 'real' economy should be the baseline, and nothing too much changed during 2003-2007...not enough to warrant a doubling of housing costs.

[Real Person from the Real World]

Balloon Mortgages sold with bloated fees to naive home buyers who could not afford the homes, then "packaged" into securities sold abroad to foreigners while the great US mortgage binge falls apart. A US contracting company sells decrepit surplus to the Afganis to fight the Taliban. Gas company Enron's executives laughing on the phone as they fleece Californians. Gas hitting $3.50 at the pump while some people work for less than $10 an hour, and car insurance is mandated, and speed traps abound. Companies cannot afford to hire people, just contractors provided by vendors at the going rate, basically at good size markup for a middle man who got in as a vendor. Health Insurance companies that hire people to refuse payment to insurance holders who get too sick, while fewer and fewer people have insurance, since most can only get it thru an employer, and the employers are either cutting back or hiring independent contractors. Student loans sold by school financial advisers to struggling, financially strapped students, while the executives of the companies live the yatching life on their profits. Ah, the privatized, self serving and individualistic world of contracting. and segmented business models, where middlemen fleece the unwary.

Meanwhile, we fight a pointless war that costs trillions, and Dubbyah wants to cut taxes and social security. Is Bear Stearns the biggest story, or just part of a chain of market failures of loose cannon capitalism?

[Real Person from the Real World]

Balloon Mortgages sold with bloated fees to naive home buyers who could not afford the homes, then "packaged" into securities sold abroad to foreigners while the great US mortgage binge falls apart. A US contracting company sells decrepit surplus to the Afganis to fight the Taliban. Gas company Enron's executives laughing on the phone as they fleece Californians. Gas hitting $3.50 at the pump while some people work for less than $10 an hour, and car insurance is mandated, and speed traps abound. Companies cannot afford to hire people, just contractors provided by vendors at the going rate, basically at good size markup for a middle man who got in as a vendor. Health Insurance companies that hire people to refuse payment to insurance holders who get too sick, while fewer and fewer people have insurance, since most can only get it thru an employer, and the employers are either cutting back or hiring independent contractors. Student loans sold by school financial advisers to struggling, financially strapped students, while the executives of the companies live the yatching life on their profits. Ah, the privatized, self serving and individualistic world of contracting. and segmented business models, where middlemen fleece the unwary.

Meanwhile, we fight a pointless war that costs trillions, and Dubbyah wants to cut taxes and social security. Is Bear Stearns the biggest story, or just part of a chain of market failures of loose cannon capitalism?