Nick Rowe: What Caused the Financial Crisis?

On Steven Gordon's blog, Nick Rowe of Carleton University offers his thoughts on what caused the financial crisis/es along with the economics behind his thinking:

Some thoughts on the bubble/s and financial crisis/es, by Stephen Gordon: Nick Rowe provides us with some talking points on how we all got into this mess:

I am taking part in a roundtable on the financial crisis next week at Carleton (Wednesday 8 October 5.30-7.00 in 360 Tory, just in case anyone is interested in attending). The audience and other panel members will be mostly political scientists. I only get 10 minutes. This is what I am currently planning to say:

Opening Salvo: Could better regulation have prevented the financial crisis? Yes; restricting mortgages to less than 70% of the value of the home could have prevented the house price bubble and prevented the crisis. No; because that regulation could only have passed, in a democracy, if a majority of people had been convinced that disaster would happen if people borrowed more; and if a majority had been convinced of that, a bubble would never have happened anyway, and so regulation would not have been needed.

Politics: The left blames Bush, the Republicans, and deregulation. The right blames Obama, the Democrats, and the Community Reinvestment Act. Both sides sound convincing. But both sides are obviously wrong. The housing bubble is global; the financial crisis is global. Russia has a financial crisis, but the Republicans do not regulate Russian financial markets. England had a housing bubble, but does not have a CRA. The US bubble burst first, but other countries are following closely. Canadians watch too much US news. This is a global phenomenon, and needs a global explanation.

What is a bubble? Everybody talks about the house price bubble, but nobody defines what it means. Let me define it:

The amount you should rationally pay for a house, if you sell it one year later is:

1.    P = Annual Rent + [P one year later]/(1+r)

And if you (or the people you sell it to) sell it infinity years later, it is:

2.    P = Present Value of Rents to infinity + [P infinity years later]/[(1+r)^∞]

The second term on the right hand side is the bubble. If everybody expects, and expects future buyers to expect, that future prices will stay finite, the bubble term is zero, and they will not rationally pay bubble prices.

So why do bubbles happen, and why in so many countries at once?

Irrational herd instinct maybe? I don’t know, but I can say something about when they are more likely to happen:
If rents and house prices are growing at rate g, and g<r, then:

3.    P = Rent/(r-g) + P[(1+g)/(1+r)]^∞

If g gets close to r, very small changes in any of the terms have very big consequences for the price you should rationally pay for a house. The ratio between today’s prices and today’s rents becomes very fragile, and very sensitive to expectations about the future. It gets very hard to distinguish between prices that are high because of a bubble, and prices that are high because other people expect slightly higher growth rates. Maybe other people are right? Maybe houses really are worth that much? (And if g ever exceeds r, we enter the financial twilight zone of pure bubbles, where chain letters are stable, and Ponzi schemes really can make everybody rich.)

So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation), but because world savings were high. And world savings were high because the world’s population is getting older, and when people get older they save more for their retirement (note China). And second, because world GDP growth was high (note China and India), Ricardian rents on inelastically supplied land (for houses or oil) had a high growth rate too. So g was close to r. Which made it easier for bubbles to form, in many countries.

So why did bursting bubbles cause a global financial crisis? Why are financial markets so fragile? Because financial markets try to do the impossible. Ultimate savers/lenders want financial assets to be Short, Safe, and Simple. Ultimate investors/borrowers have projects which are Long, Risky, and Complex. Financial markets and financial institutions try to give both sides what they want. In normal times the magic works. Without that magic, people would only save gold or canned food, and there would be no investment, and we would still be in the Stone Age. But the price of that magic is an inherent instability. Each individual can liquidate his savings at any time, but we can’t all liquidate at once. Beliefs become self-fulfilling, and we can also get a second, bad equilibrium, with a bank run or stock market crash. Most people can hold safe assets, if uncorrelated risks are pooled, but some people must always hold the remaining, correlated risks. And if those people go bankrupt, the safe assets too become risky. Many people can hold simple assets, provided some other people do the complicated research. But if their research turns out to be wrong, the simple assets become complicated too.

Efficient financial markets give both sides what they want, but are inherently fragile. There is an inherent trade-off between efficiency and stability. Changes in regulation can move you along that trade-off. Good regulation might improve the trade-off. But it cannot be eliminated. Government bailouts are just the government acting as one more financial institution. Governments too can become illiquid, or insolvent, or get their research wrong.

What should Canada do? Our housing bubble is perhaps smaller than in other countries, and our financial institutions are perhaps more stable. But nevertheless this is a global crisis, and we ought to share in the global rescue. The Canadian government should borrow several hundred billion dollars, and use it to buy risky assets at fire-sale prices. Swap T-bills for toxic waste. We might also make a profit!

Hmmm. I don’t know if I can say all that in 10 minutes.

Comments? Criticisms? Useful advice? What did I get wrong?

Comments

[Benoit]

premise one: In the long term, a well diversified global portfolio always has positive growth.

premise two: Maximizing returns is achieved by leveraging as much as possible those investments in sectors that are guaranteed to grow.

conclusion: profit!

Nothing can go wrong right?... right???

[Zipf]

I like your equation 1 - however (unless I am greatly mistaken) it neglects the cost of capital to finance the acquisition.

Should valuations be determined in light of the cost of capital?

Finally, is r the risk free rate? Or the expected market return? (If houses appreciated at about 7% per year - then I guess r is my "broker's r" of 11%).

[a]

It's pretty good, until the end:

"We might also make a profit!"

We might also grow wings and fly.

[robertdfeinman]

I don't know anything about Rowe's political leanings, but Canada has a fairly poor record when it comes to economic development. For its entire history it has depended upon the extractive industries (lumber, fossil fuels, mining) for its wealth. This has been pursued with even less interest in environmental consequences than the US.

This has made Canada the equivalent of a Petro state, only more diversified. The current election campaign is filled with the Canadian version of Reaganesque economic nostrums as well.

So, perhaps instead of preaching to the US on how to fix its mess, he should look at conditions in his own back yard. I'd start with the current rape of the land over the tar sands.

If you don't know what I'm talking about try a few sample pictures:

http://image.guardian.co.uk/sys-images/Environment/Pix/pictures/2008/02/05/tar_sands_ft_mcmurray_345.jpg

http://www.peopleandplanet.net/thumbnail.php?id=1753&max=1000

[Jim K]

You say:

"So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation), but because world savings were high. And world savings were high because the world’s population is getting older, and when people get older they save more for their retirement (note China). And second, because world GDP growth was high (note China and India), Ricardian rents on inelastically supplied land (for houses or oil) had a high growth rate too. So g was close to r. Which made it easier for bubbles to form, in many countries."

This paragraph I think gets to you to the point, but it is really a list of interesting research questions that require empirical evidence not yet provided more than a definitive answer. A competing hypothesis (Jeffrey Frankel using the Dornbusch model, though heavily disputed by Krugman)would hold that inflation WAS evident and it occurred in ASSET price inflation -- first stocks, then housing prices fed by demand for MBS assets, then, when that collapsed, real commodities -- oil, gas, gold, and food. Only if you assume, a priori, that there is, in fact, an sudden expected supply constraint on oil, gas, gold, and food that caused the increase in prices can you conclude that asset-price inflation in commodities never occured. Likewise for housing -- was there ever a shortage of housing units for use as homes, or was there just a shortage if additional demand as financial assets is taken into account?

Why could inflation not show up in wages and consumer prices? Well, that's more interesting research questions, but a hypothesis is that higher unemployment since 2001 coupled with price competition from China can keep some prices low while investors seeking to park paper assets search for other things, driving homes, and then even rice (for which there simply is NO demonstrable shortage and does not compete with bio-fuels) prices higher.

Personally, I think for an explanation of a calamity this big, particularly for a Carleton audience, you need to break out Karl Polyani, and question whether political support for financial markets has just reached such a critically low level in this country -- and hence worldwide because such markets are entirely a policy framework devised by and imposed on the world largely by Americans.

[Benoit Essiambre]

Seriously, what if there was this value, based on a global expectation of future growth. A value that has been reflected in the price of credit, the price of equity and of investments in general ( pension funds etc), especially the more complex investments. And what if given, high oil and commodity prices and high global population, the market is suddenly realizing that we simply can't sustain this kind of growth, especially in terms of real growth per person. Wouldn't that mean the value that all these investments and salaries were based on isn't there anymore or that it simply has never existed?
No amount of government intervention, bailouts or movements of money is going to change the fact that we can't make real value appear by magic. Globally the market seems to be noticing that there is a oversupply of humans and an under supply of natural resources. The average value of human labor has to go down as does the average value of investments based on the product of human labor. Government bailouts may help deleverage banks and struggling institutions, but only while leveraging the government by an equal amount! Bailouts are probably still marginally useful since there is a certain urgency in the problems with banks. The banking system poses immediate dangers and it is probably less critical for governments to deleverage quikly. However in the long run, the lack of value is going to have to be distributed to people. Either through government taxes, inflation, or by a significant amount of people moving towards lower pay jobs. I think the government will never be able to fill this kind of void. The best the it can do is try to help it be distributed more fairly and more efficiently.

[lark]

So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation), but because world savings were high. And world savings were high because the world’s population is getting older, and when people get older they save more for their retirement (note China). And second, because world GDP growth was high (note China and India), Ricardian rents on inelastically supplied land (for houses or oil) had a high growth rate too. So g was close to r. Which made it easier for bubbles to form, in many countries.

World savings are high because the pop is getting older? Ha, ha. "Note China." ? Absurd.

The ideological free traders have shoved Chinese mercantilism down our throats. The currency peg kept the Chinese economy overwhelmingly dominated by an export machine, and the Chinese swamped the world with their resulting 'savings'. The Chinese govt chose to not fund a pension plan or health care for their wage slave citizens, and the share of consumer spending in the Chinese economy continues to shrink.

Add in the petro dollars and you have a huge pool of liquidity cascading into real estate.

Yes the damage could have been limited if regulators and ratings agencies not been captured by the financial industry. Why were the grown ups so captured? The reason is largely the ideological machine of the neoliberals and their crew of Chicago influenced economists. That plus the Republican party created a perfect storm intended to enrich economic elites and dismantle the regulatory regime.

This Nick Rowe is providing nothing more than an apologia.

Sorry, apologies not accepted1

[uhoh]

I dunno.
NPR says the big problem is the unknown amount of credit default "insurance" in unknown hands - secret contracts with no reserve funds - causing bankers to mistrust one another

Seems reasonable:
http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_default_swaps/index.html?inline=nyt-classifier

http://www.google.com/search?q=credit+default+swap+gambling

eh?
-- People who don't _own_ a bond can buy a credit default "insurance" and collect the full value if the bond fails.
-- Many people can buy the same kind of "insurance"
-- There's no public record of who has this "insurance"
-- There's no public record of who will pay if the bond fails
-- Internet gambling is illegal since the Port Act passed

So you have a huge number of gamblers and the only game left to play is the credit default swap game, eh?

And, what can push bonds into default? All it took was Lehman Brothers as the first domino -- how many different default "insurance" policies are going to be (or supposed to be) paid, how many times the actual Lehman dollar amount?

[acerimusdux]

Excellent summary of the problem.

As an aside:

"restricting mortgages to less than 70% of the value of the home could have prevented the house price bubble and prevented the crisis."

I would say that 30% down seems more than needed. Though it certainly would have prevented the crisis. I would think that 15%-20% down would normally be a sufficient limit, though.

[craig tindale]

Folks need to start channeling their inner Austrians

Fisher, Minksy, Schumpeter all have perfectly rational explanations

going back further Hayek and Mises have allot to say as well

I remember when i read a Princeton paper in 99 by Bernanke about transmitting money or conduccting money rains through the RE asset channel via low rates and folks through the "wealth effect" feeling richer and consuming through equity withdrawal, thinking, geeeze neo classical has become a cult, full of false beliefs and snake oil

no where in those papers was any thought of risk assessment to such policies, so contrived proof that inflation was always preferable to deflation and statements like "therefore a determined central banks can always causse inflation" , which is absolute nonsense of course

the problem with allot of you folk is that your so narrowly educated that you will never understand

folks dont need to research why it happened they just have to get out grandads books and read them

[Felix Lopez]

A bubble is the easiest thing to spot. When is there a bubble? Easy... when a lot o people say a bubble is occurring. There is not a single bubble that was clearly identified beforehand by many different people that turned out not beeing a bubble. Central Bank rhetoric that says that is not possible to identified bubbles is just not true. Bubbles on the making are the most easily identified phenomena on the economic sphere. Is there a real state bubble in Germany? Nobody says so now, so there is not bubble. Easy.

[donna]

Meh. I call shenanigans.

US Savings at record lows, we still got a bubble.

[Dave]

If you're asked to discuss the origins of the current financial crisis and instead you simply shower your audience with equations that supposedly describe human behaviour at these times, you'll (1) lose your audience, and (2) lose an important opportunity to discuss the real origins of the current situation.

The best economist (IMHO) would make a short set of cogent arguments about how the crisis came to pass without having to resort to the obscurity of equations. This kind of thing reminds me of all the quants on Wall St who resort to ever more esoteric models for pricing derivatives and securities -- and where that has led is now plain for all to see.

You have 10 minutes. May I suggest that you focus on the important messages that you really want to try to get across. Can you imagine J. K. Galbraith or Keynes reaching for power series math to make a simple point that assets were in bubble?! I think not.

[baileyman]

How about if houses trade above replacement value then it's a bubble?

Land. Land is the thing that goes up in price. How do we convince ourselves that it's ok to capitalize rent into the value of the land under a house structure?

[acerimusdux]

"A competing hypothesis (Jeffrey Frankel using the Dornbusch model, though heavily disputed by Krugman)would hold that inflation WAS evident and it occurred in ASSET price inflation -- first stocks, then housing prices fed by demand for MBS assets, then, when that collapsed, real commodities -- oil, gas, gold, and food. Only if you assume, a priori, that there is, in fact, an sudden expected supply constraint on oil, gas, gold, and food that caused the increase in prices can you conclude that asset-price inflation in commodities never occured."

Commodities can be used as stores of value, when there is a loss of faith in currencies. In addition, there are inevitably supply contraints in such limited resources. Obviously, the popultation is growing, and the supply of oil, or food, is likely not going to keep up. Also, it is noted that older populations save more, but note also that they don't tend to cut back so much on things like food.

I think a key point here is that much of the faith that may have been lost in currency and financial system stability had nothing to do with excessive expansion of currency. A lack of regulation, and excessive expansion of credit, are other matters. A bubble in credit may well cause increases in these asset prices, as well as some commodities. If currency were expanded instead, that would go more to "core" inflation (note that "core" inflation deliberately EXCLUDES things like oils and food precisely because they aren't related to currency inflation).

What we are left with here is a debate over semantics. It really depends on what you define as "money" and what you define as "inflation". But too loose usage of these terms can obscure a critical point; that a primary cause of one type of "inflation" being too high may be the other type of "inflation" being too low.

Keep in mind too, the primary direct economic impact of inflation. Inflation (of the core PCE, currency induced sort), is in effect a tax on wealth. The lower this "tax", the more the inclination to hoard wealth and commodities, and the less the inclination to invest in long term capital invesments which will pay off instead in future goods.

In the long run, Capitalism depends on some redistributive component, or one ends up with increasing inequality which eventually will put a limit on future growth (and begin to lead instead to hoarding of value, rather than long term capital investment, which often is justified only by expectations of more broadbased future growth). At the one extreme, nations which attempt to perform this redistribution through outright seizures of property will tend to disuade capital from entering the country to invest. At the other, nations which offer the lowest rates of both currency inflation and direct taxation of wealth will attract plenty of funds, but offer little incentive for long term capital investment (and here we get bubble economies).

What we end up with here is a kind of global prisoners dilemna, where optimal global growth and prosperity likely depends on countries agreeing on a higher level of currency inflation (or else direct wealth taxation) and stronger government involvement in long term investment (infrastructure, education, social saftey nets), than preferred in some wealthy nations, but stronger property protections, personal liberties, and more open economies than prefered in some poorer ones.

[Ryberg]

This is not anywhere near as difficult as you are making it.

Understand first what a Ponzi scheme is. It is like a chain letter (which the US Postal Service made illegal many years ago). A schemer assures you positive returns if you "invest" today. Tomorrow the schemer gets 10 more "investors" and pays you off. You are now convinced that the schemer has a great "investment" so you plow your money back in along with 100 more "investors". The 10 "investors" are paid off so handsomely that they "reinvest" with a 1000 more "investors". It works wonderfully as long as more "investors" enter than are being paid off. And with "reinvestments", that can happen for a long time. Even decades and whole generations. Eventually, however, there will not be enough new "investors" to cover the promised returns to existing "investors". When word gets out that the promised returns can't be paid, at least some "investors" will want their money back, making it even harder for the scheme to work. This is when the Ponzi scheme can collapse.

Note there are no goods or services that need to be exchanged and there is no requirement for capital investment capable of producing future goods so principles of economics do not apply. Forget about g and r. We are talking about gullible people getting duped by unprincipled people.

So who are these gullible and unprincipled people? Look in the mirror.

Why did real estate prices rise? Because people could borrow money to buy it. We didn't ask if it was worth the money because we knew its price would continue rising so we could always get our money back. We were told that real estate always increased in value so this was a safe "investment". If we bought just like the thousands of others who were buying we could make money without having to produce anything. Capital gains without real capital is the essence of a Ponzi scheme.

Now let the financial engineers from Wall Street Investment Management banks enter into the game and we have a Ponzi scheme on steroids. They introduced financial derivatives and derivatives on derivatives. They didn't produce anything tangible but they did grow exponentially. Now that is one heck of a balloon. A bank might take $1 of capital and lend it out 10 times in mortgages. But a hedge fund could borrow a million dollars of Treasury Bonds and buy $25-50 million of mortgages from the banks, thus increasing their capital and enabling them to issue another 100 mortgages each. Hedge funds make huge amounts of money on the spread between the short term Treasurys and the long term mortgages. Banks make large (not huge) amounts of money on the origination of mortgages. And "investors" have proof that rising real estate prices will always reward them so they take to flipping real estate.

Unfortunately, all Ponzi schemes end badly. Some "investors" find that even their minimal payments are more than they can sustain in the real economy so they default. When enough default, the prices of the real estate stop rising. More importantly, mortgages get written down to at least the falling price of the underlying property. But the mortages were leveraged several times by the hedge funds and banks. So a small decrease in loan asset prices causes large decreases in financial institution capital.

This is how leverage works. Ponzi on the upside and crash on the down side.

There is no need for any real economic growth. Unfortunately, if there is some economic growth, financial engineers can persuade us (and our government) that all we need to do is restore confidence (in this scheme) and create another $700 billion in debt. The hair of the dog that bit you... And economists can mask the Ponzi balloon by talking about g and r.

The United States has become a giant Ponzi scheme driven by exponentially growing debt, especially debt dreivatives, that is disconnected from any real economy. The sooner this cancer is removed, the sooner real economic forces can operate properly.

[jamzo]

am i dumb?

as i understand what happened in the world this seemed to be what happened

greenspan ran a low low low interest rate policy

which reduced payment on mortgages

which created more demand for housing

which caused rise in housing prices

which made housing a good investment and shelter

whihc made it look like a safe and profitable investment for one and all

[RW]

What Ryburg and jamzo said: By all means read your grandparents books, your parents books too (show some respect), but don't skip Hyman Minsky whatever you do.

Add Georg Soros' "The New Paradigm for Financial Markets" to supplement Minsky and you'll probably understand this catastrophe a lot better than Nick Rowe and most members of his audience.

[dd]

The wrong end of the stick yet again. Just like Hank's bazooka. Yeesh. This was not a bottom up "mortgage" crisis but a top down "innovation" crisis. Trickle Down, trickling down on the masses produces a river of profits.

[dd]

Nice Chart here:
http://www.thedeal.com/newsweekly/features/chain-of-fools.php

Notice the trickle up profits and the trickle down debt.

says...

robertdfeinman

In defence of my countryman, he neither preached, nor took a partisan stance on who is to blame. In any case, considering the global impact of the mess that originated in the US it is most certainly legitimate to weigh in.

You make a good point that the Canadian economy is heavily weighted in natural resources, but that's because we have them the US and the rest of the world wants them. You also have to understand that Canada is a huge country with a very small population. This has all sorts of implication that I'm sure you can work out for yourself.

I live in Alberta, and believe me that there is enormous concern here about the tar sands exploitation here too - at least in some quarters. After all we have to live with it. It wrecks the environment, it causes enormous social problems (like 40% of kids dropping out of hight school to go work on the rigs), inflation is a big problem, and the list goes on. Unfortunately, there's so much money flying around, and the Provicial government, which hasn't changed in over 30 years, is bought and paid for by the oil companies. To top it off, the Federal government relies on tax revenue derived from the oil sands to make up for the revenue that used to come from southern Ontario before the auto and manufacturing sectors there collapsed completely. It's a form of Dutch disease I guess, only it's in a modern economy and there's no appetite for the Norwegian solution. At least not yet.

[Ciphernerd]

definitely a giant Ponzi scheme. Lending people money so they can consume is not investment.

[Greg]

While some of your readers have touched on the problem, I have not really seen the entire picture described well anywhere. Granted, it is very, very complicated, but I have yet to see a discussion of the CDO market that accurately described how this web holds the entire worlds financial system on the brink. If there were no credit default swaps, Bearn Stearns and AIG could have gone bankrupt without government help. Also, Lehman's bankruptcy wouldn't have caused the problems that it did. Deregulation of the swaps market in 2000 and exemptions for i-banks in 2004 were the last straws that put us over the edge.

[prem kumar]

Your explanation of the boom bust phenomenon for the house prices is logical. What you miss out is that the financial sector shouldn't have collapsed with the house prices. The scandal is about the greed and hubris of the financial sector in general and the big banks in particular to have used high leverage with wrong risk models. And of course the failure of the regulators on lending standards (Ninja loan is not the alternative to 70% LTV) and more importantly the non regulation of CDS.

[btg]

let me also weigh in here against the comments made by robertdfeinman...

yes, the canadian economy is different than that of other industrilised nations because of our dependence on resources (as well as high levels of foreign ownership, and over-reliance on just the US for our exports) - and yes, the oil sands are a disaster and those of us who want to do something about it have yet to have any real influence over the matter - but frankly, i would hear howls here from Americans if any of us Canadians were to similarly make blanket statements that saying to NO Americans have the right to comment on things such as human rights in China (Tibet, prison labour, etc.) or the Middle East, or World Peace given the policies of the Bush administration (Gitmo, Invading countries on specious grounds, racism, etc.), or previous administrations.

The Canadian economy is integrated in with that of the US to a large extent - it just has different proportions of the same things. The US actually produces more oil than Canada - both are major agricultural producers. Alberta is part Texas, part Alaska, part Montana and part Nebraska. Southern Ontario has an economy that is similar to that of neighbouring great lakes states - part Ohio, part Michigan, part Illinois (in terms of Toronto being like a Chicago in many ways).

Our failure to to become more of an industrialised nation is due to many things - a quasi-colonial mentality being foremost, as well as the fact that we have adopted Anglo-american economic theory about free markets - even when Canada was highly protectionist, we didn't just have an open door to US and other foreign ownerhsip, we actively encouraged it - wanting a branch plant economy using imprted technology and tooling, instead of creating our own companies and products - unlike, say, Japan or South Korea and the Asian model - or Sweden.

Unfortunately, iti s very hard for us to break away and create the type of country I would like to see - because of the ways in which our society and political system work against such changes (Quebec separatism, other regional identities and distrust of Ontareio, etc.)

[Winslow R.]

Nick wrote: "Could better regulation have prevented the financial crisis? Yes; restricting mortgages to less than 70% of the value of the home could have prevented the house price bubble and prevented the crisis."

Not true, though it would have been harder to create.

First barrier to collapse
With a 30% downpayment the homeowner takes the first 30% loss if asset prices decline.

Second barrier to collapse
With 3%-10% capital requirement the bank takes the next 3-10% loss if asset prices decline.

If the government is willing to stand by while asset prices decline by more than 40% we have wiped out the capital cushion and if regulation is in place, deleveraging eats its way through the system.

[Sumi]

Thanks for highlighting that it's the Nick Rowe from Carleton. I was worried for a second, because here in Japan Nick Rowe is the guy who sang "Cruel to be Kind."

[riathareja]

Lehman Brothers is not more. Merrill Lynch has gone down the Bank of America jaw. AIG too could go belly up. With a doubt, these developments in America are the most shocking events to have hit global financial markets. So where did it all begin? And what does it mean for the Indian stock markets? Find out. . .http://realtydigest.blogspot.com/2008/09/why-lehman-brothers-went-bust-whats.html

[acerimusdux]

Jamzo:

"greenspan ran a low low low interest rate policy

which reduced payment on mortgages"

This is where I disagree. In general, what Greenspan, and now Bernanke, have run is a low "inflation" policy (in terms of the core PCE target). So, short term rates most often weren't low enough. Lower short term rates would have sparked more inflation and eventually raised long term rates; inflation also would have made existing loans less profitable and thus perhaps better reminded banks and investors of the inherent risks.

If Greenspan for a time pushed short term rates very low, this wouldn't have caused or contributed to a bubble, it would have lessened it. Because pushing short term rates low enough becomes inflationary.

Look at the sharp drop in currency growth during the time period the bubble was inflating. Look at the falling growth of the monetary base. Look at M1, where growth declined to zero by late 2005, and was below zero over the second half of 2006.

The "liquidity" that inflated this market came from loans, not dollars.

Insufficient regulation and oversight played a significant role in allowing these ponzi schemes to develop, but ultimately, we also had both fiscal and monetary policies which created an incentive to lend, but not invest.

[swells]

This is the best explanation I've seen to date of how we got into the position we are in with CDSs. It's at:

http://www.slate.com/id/2201428/

It's titled We're Down 700 Billion Let's Go Double or Nothing; How the Financial Markets Fell for a 400 Year Old Sucker's Bet.

It's a really good explanation of the weakness that was inherent in all the complex derivatives that were created. The nexus is that risk was squeezed into events that were deemed highly improbable but nonetheless occurred.

[ddt]

IMO, this article is pretty much junk. (what can you expect from Carleton... the guy probably wrote it while doing a keg-stand)

The mythical savings glut??? come on. that's so 2003-era-Greenspan. try telling Brad Setser that the treasury purchases from China are all for the retirement accounts of aging Chinese people.. yeah right. Gee, petrodollars, the chinese dirty float and a 1% interest rate on the global reserve currency couldn't possibly have anything to do with the global housing bubble, could they? Of course not, it was all because of thrifty Chinese grandpas stuffing their bank accounts. that's the ticket

and why in God's name would it be a good idea for the Canadian government to start purchasing toxic foreign assets? That makes no sense at all.

[acerimusdux]

"The mythical savings glut??? come on. that's so 2003-era-Greenspan."

Nothing mythical at all about it. From my point of view, it could as easily (and I think more appropriately) be decribed as an investment deficit, but there is no question that an excess of savings over intended investment is at the root of the problem.

And as Rowe correctly points out, "central banks cannot set interest rates below the natural rate without causing accelerating inflation". I've already provided the evidence above that Greenspan (and now Bernanke) were not directly causing low rates, the markets were. When it comes to currency, the Fed was quite tight. The Fed's primary contribution to low rates was reduced inflation expectations.

What Rowe seems to miss (as did Greenspan) is that accelerating inflation would have helped to correct the imbalance which was causing the disincentive to invest. They seem to think it would have been a bad thing.

There are only two obvious ways to persuade more of those private funds to move into capital investmet, raising those low rates:

1.> Direct public investment, thus increasing government spending on capital investment, things like infrastructure, which help improve future productivity.

2.> increasing the supply of currency, thus increasing inflation, thus creating more incentive for capital investment, and less incentive for "investment" in financial assets (like loans - which promise returns only in future payments of dollars).

Thus, monetary and fiscal policy, bringing the economy near to full emplyment, finally seeing workers get real wage increases, etc. The simplest thing the Fed could do to help correct the underlying imbalance might be to raise the PCE target.

[Ciphernerd]

"There are only two obvious ways to persuade more of those private funds to move into capital investment, raising those low rates:

"1.> Direct public investment, thus increasing government spending on capital investment, things like infrastructure, which help improve future productivity.

"2.> increasing the supply of currency, thus increasing inflation, thus creating more incentive for capital investment, and less incentive for "investment" in financial assets (like loans - which promise returns only in future payments of dollars).

"Thus, monetary and fiscal policy, bringing the economy near to full emplyment, finally seeing workers get real wage increases, etc."

That's what I was thinking, but...

"The simplest thing the Fed could do to help correct the underlying imbalance might be to raise the PCE target.

...why inflate with monetary policy? Wouldn't banks catch on, as you mentioned earlier? And why would bank loans for houses and cars be the best places for new money in the economy anyway? It seems like you're trying to temporarily trick banks into injecting money into the economy. Why not simply print money (i.e., without government borrowing or taxation) and spend it on the infrastructure you mentioned? Then we could tighten up monetary policy and hopefully keep default rates low at the same time.

[paine]

ozonomics

" Present Value of Rents to infinity "

imagine the roll call of assumptions here ??

but forget that
note this

" [P infinity years later]/[(1+r)∞] "

formal economics as april fools joke

[moo]

Well duh. As Mason Gaffney said in a much better article (The Great Crash of 2008, see link): “Rise of land prices cannot simply flatten out at a high plateau, because the increment has become part of the expected return that buyers are paying for, and lenders are relying on. So prices that cannot rise further have to drop: there is no equilibrium level.”

Land Value Taxation can prevent future housing bubbles.

[paine]

if by gazing at the infinite horizon
we like herb stein notice
all bubbles must pop

then what accounts or their florishing so readily
surely its not the non recognition of the players
of bubble as bubble
even as it expands

to the contaray knowing its a bubble
guides the play itself

successful fraud
and
looting
are ever and always
the only reliable source
of rational trust
in the existence of a bigger fool

another variety of bigger fool
( or knave in fool's clothing)
writes stuf like this

"central banks cannot set interest rates below the natural rate without causing accelerating inflation"

btw
belief in natural rates (faked or otherwise)
is just the sort
of mind twister that lands you in oz

[paine]

moo
i like your policy
even if your source's 'umble analytics :

"...prices that cannot rise further have to drop.."

shakes me some

[paine]

"Most people can hold safe assets, if uncorrelated risks are pooled,"

worthy of brad delong

"but some people must always hold the remaining, correlated risks"

the whole people ought to hold such risk thru its lender of
last resort and unlimited capacity
the state

of course till we have a global state
open macro create
even in the best of state systems
a zig zag of sub optimal second best patterns

[paine]

"Governments too can become illiquid, or insolvent..."
only if they hold foreign money debts

"... get their research wrong "
it ain't the risk bub
its the uncertainty of the risk
that hurts

any risk uncertainty that is created
by the system itself
not by the unknowably unknown
can be
avoided or over come by regulations
or at least off set
by whole people backed compensations
ie
thru the actions of the state

[Elastic Supply]

"So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low...And second, because world GDP growth was high (note China and India), Ricardian rents on inelastically supplied land (for houses or oil) had a high growth rate too."

Interesting. So an elastic supply of homes would have avoided the bubble trouble. The supply of land is finite, but in the US, there is still plenty of build-able land. China has 4 times our population, with less land. Land area was not the problem, restrictions on land were.

"...interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation)..."

When supply is increasing, the natural state is deflation. Keeping prices rising during this period was a mistake. Interest rates were below the natural rate, which causes debt financed bubble during boom times. Negative real short interest rates contributed to excessive leveraging. Institutions borrowed far too much short money at 1/2%, and loaned long at 5%. This left them vulnerable, and caused the current mess.

[paine]

"Land area was not the problem, restrictions on land were"

true
but the lot boom was not about ground rent capitalization

where zoning restricts density
it incresaes average ground rent
but as ground rent
is a function of lease revenue from
location and improvements
valued per square foot of lot
the bubble was irrational
since lease rates (rentals) never kept pace
with lot value prices

ie we got problems atop problems

artificially high lot values
but sustainable thru restrictive zoning
and then credit flow induced speculative spiral
unsustainable lot bubbles

[paine]

"When supply is increasing, the natural state is deflation"

money nearly as fixed in supply as land
requires a velocity stability
that is not spontaneously present
even putting that aside
you're a hard guy mr natural
in fact natural might be removed
to good effect given associative dangers
you might just say
explicitly ....given a stable money stock
which is an assumption hard to defend
on its own grounds alone
and btw
why worry
when your money stock
like ours is costless to expand ????

at any rate
secular deflation as optimal ???

assuming stable prices
as optimal is bad enough
even if you didn't have to deflate now and again
just to maintain long run zero price level change

-----------------
yes all this expanded leveraging is naughty
but its not just about rates
the leveraging couldn't happen
without
a necessary credit flow that required
either fraud or tacit regulatory approval

and its the flow rate itself
not that flow's price per period per unit
that is decisive here
a flow controled ultimatley
with total independence from the interest rate
which may determine margins but not amounts
if as in our present system
credit sector by sector even if guided by relative profitability
is none he less still rationed

-------
spontaneous unpumped
hyrdaulic models of "flow" fail here
despite easy scaling and intricationing

the planned character of it all
is lost
without a notion of intentional pumpings
and tap turnings
and
these volitional operations
are not just at the level of the fed's open market ops
profit max is not like a pressure law

[acerimusdux]

Ciphernerd says...

"Why not simply print money (i.e., without government borrowing or taxation) and spend it on the infrastructure you mentioned? Then we could tighten up monetary policy and hopefully keep default rates low at the same time."

That would have exactly the same effect. You lower rates by printing money to buy up Treasuries. You spend by issuing new Treasuries. No real difference from if you just print money and spent it. If we did it that way, it would still end up showing up in banks as increased cash deposits, and thus higher reserves. And it would end up having the same impact on interest rates.

And, first part of the question:

"Wouldn't banks catch on, as you mentioned earlier? And why would bank loans for houses and cars be the best places for new money in the economy anyway? It seems like you're trying to temporarily trick banks into injecting money into the economy."

I suppose the biggest problem with banks catching on is that they mostly control the Federal Reserve to begin with, and thus might not let me get away with it. :)

As for houses and cars, I don't see that they would necessarily be more attractive. Especially as a large percentage of cars are imports, they might see prices rise. And houses depend on long term consumer financing, where costs could also rise in response to more long term funds being consumed by capital investment, as long term interest rates would likely rise from increased inflation expectations.

Also, I should point out that I would not neglect much needed regulation to prevent excessive expansion of credit, either. Loan markets do need to be regulated to prevent excessive risk. Set an upper cap on interest rates. Require reasonable reserves (including for CDs, money market accounts, etc.) Do away with the unregulated shadow banking stuff. This is meant in addition to all that.

And, I should seperate the monetary and fiscal policy aspects. I believe the long term PCE target should be raised regardless of where we are right now. If the economy were humming along near full employment, and there were danger of it over heating, you would just skip the fiscal spending side and instead allow it all to go to deficit reduction.

For where we are right now, though, yes we need stimulus. And yes, it is a bit of a "trick"; short term monetary stimulus depends in part on the inherent inefficiency of markets in adjusting. Eventually everyone adjusts, but in the short run, it gives the illusion of greater spending power. In a downslide, where people are losing confidence, this can be beneficial. By the time inflation expectations catch up, we could be well into recovery.

Finally, as to my view of a higher inflation target as a tax on wealth. It would be possible to simply keep a very low target, and tax wealth directly. With about $58 Trillion in net household wealth in the US, you could concievably raise about $870 billion a year with a 1.5% annual tax.

Now, suppose instead you raise the long term PCE target by 1.5%. In effect, you are imposing a tax which will have 100% compliance and no administrative and collection costs.

[Ciphernerd]

"'Why not simply print money (i.e., without government borrowing or taxation) and spend it on the infrastructure you mentioned? Then we could tighten up monetary policy and hopefully keep default rates low at the same time.'

"That would have exactly the same effect. You lower rates by printing money to buy up Treasuries. You spend by issuing new Treasuries. No real difference from if you just print money and spent it. If we did it that way, it would still end up showing up in banks as increased cash deposits, and thus higher reserves. And it would end up having the same impact on interest rates."

Okay, maybe I'm not understanding something. Instead of swapping treasuries for federal reserve notes, I'm suggesting that the Fed would simply give money to the U.S. to spend. We wouldn't make any commitment to tax the money back out. In other words, given the fact that we seem to be in a liquidity trap, we distribute helicopter money using fiscal policy. (Maybe the above paragraph reveals some confusion on my part--I think it makes sense, though.)

Furthermore, why wait for a crisis to distribute helicopter money? It seems to me that every dollar in circulation is there for one of two reasons:

1. The government taxed or borrowed the money, in which case it will be taxed back out.
2. Someone borrowed the money from a bank, in which case it will be paid back out with interest.

Both taxation and interest on debt have a deflationary effect, while the money supply needs to grow with an economy. The solution is to lower interest rates to encourage lending and engage in deficit spending, which creates an opposing inflationary force. However, these tactics increase the rate of deflation, which in turn requires even more loaning and deficit spending, etc. I'm suggesting that economic growth cannot keep up with the mounting debt, making a liquidity trap inevitable. The only solution for a sustainable economy is a low-level steady supply of helicopter money, and it ought to be distributed in the same way that all public revenue is distributed.

Then all the regulations you mentioned (increased capital requirements--and don't forget insurers!) could be implemented, along with a _higher short-term rate_ created by selling treasuries to banks.

I think that's different from what you've proposed, which is to buy up treasuries from banks. Isn't it? Or am I confused?

[acerimusdux]

What I mean is, suppose the following steps occur:

1. You want to increase spenging by $100 billion
2. The Treasury issues bonds to borrow the $100 billion.
3. The government spends it on a new $100 billion door knob for the pentagon.
4. Now, the Fed buys that same $100 billion in bonds, replacing it with reserve notes.

My point is that this is exactly the same impact as if they just took the reserve notes and directly bought the door knob. The two bond market trasactions cancel out.

Either way, I think it is the fiscal spending itself which would potentially increase rates. The increased competition for capital, the resulting economic growth, and the increase in inflation expectations are what would begin to increase rates.

Now if you mean by helicopter money, just give it to people, along the lines of the $500 stimlus checks, one problem there is that a lot of it will just go to pay down debt, and end up in the banks (increasing their reserves) before it increses any economic activity. So you would get a bit more punch from direct spending in a way that actually encourages work.

[sam]

30% downpayment would have prevented the crisis? Who can afford 30% cash of the value of a house? Small houses of 200,000 dollars would need a 60,000 dollar downpayment. How many years saving is that for someone that makes 25,000 a year? If they'd imposed that regulation homevalues would have collapsed earlier than this year.