Category Archive for: Market Failure [Return to Main]

Saturday, June 13, 2009

Climate Plans and Carbon Markets

Jeffrey Sachs says markets alone are not enough to solve the climate change problem, we also need strategic direction from "detailed and coherent" government plans:

Still Needed: A Climate Plan, by Jeffrey Sachs, Scientific American: There is a myth in America that markets, not plans, are the key to success. Markets will supposedly decide our climate future on their own once we institute cap-and-trade legislation to put a market price on carbon emissions. But this is silly: both markets and planning are essential in any successful large-scale undertaking, whether public or private. We need a detailed yet adaptable road map for action that goes far beyond cap and trade. ...

The administration’s climate negotiator has called cap and trade "the centerpiece" of the domestic climate program. A moment’s reflection shows why that cannot be right. Cap and trade will have little effect, for example, on whether the U.S. revives its nuclear power industry, as it should to meet climate objectives. A renaissance for nuclear will depend on regulations, public attitudes, liability laws, and both administration leadership and public education much more than on cap and trade, which would play at most a supporting role.

Continue reading "Climate Plans and Carbon Markets" »

Thursday, May 28, 2009

"Crazy Compensation and the Crisis"

Alan Blinder urges "corporate boards of directors and, in particular, of their compensation committees" to create compensation plans for financial firms that discourage excessive risk taking:

Crazy Compensation and the Crisis, by Alan Blinder, Commentary, WSJ: Despite the vast outpouring of commentary and outrage over the financial crisis, one of its most fundamental causes has received surprisingly little attention. I refer to the perverse incentives built into the compensation plans of many financial firms, incentives that encourage excessive risk-taking with OPM -- Other People's Money.

What, you say, hasn't huge attention been paid to executive compensation...? Yes. But the ruckus has been over the generous levels of compensation,... not over the dysfunctional incentives...

Take a typical trader at a bank, investment bank, hedge fund or whatever. ... Unfortunately, their compensation schemes ... offer.. them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. ...

[L]et's consider the incentives facing the CEO and other top executives... For them, it's often: Heads, you become richer than Croesus ever imagined; tails, you receive a golden parachute that still leaves you richer than Croesus. So they want to flip those big coins, too.

From the point of view of the companies' shareholders -- the people who provide the OPM -- this is madness. ... Traders and managers both want to flip more coins -- and at higher stakes -- than shareholders would if they had any control, which they don't.

The source of the problem is really quite simple: Give smart people go-for-broke incentives and they will go for broke. Duh.

Amazingly, despite the devastating losses, these perverse pay incentives remain the rule on Wall Street today, though exceptions are growing. ... These wacky compensation schemes have puzzled me for nearly 20 years. ... But the issue could be considered an intellectual puzzle until the bottom fell out. ... after an orgy of irresponsible risk taking... [T]he consequences for the real economy have been devastating. ...

What to do? It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices.... But the ... executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won't beat them at this game.

Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. These boards, ... are supposed to represent the interests of stockholders, not those of managers. ... The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. ... For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.

Comprehensive reform of the financial system will probably take years. The problems are many and complex, and the government's to-do list is not only long but also a political minefield. Yet fixing compensation incentives does not require any government action. It can be done by financial companies, tomorrow. Too bad they didn't do it yesterday.

But how is the board of directors chosen? See also:

The SEC's Proxy Access Proposal, by Lucian Bebchuk: The Securities and Exchange Commission voted last week to ask the public to comment on a proposal to let shareholders place director candidates on the corporate ballot. The adoption of such a rule would be a useful step toward the necessary reform of corporate elections. ...

Saturday, May 23, 2009

The Decline of Merit Pay in Journalism

David Cay Johnston on the job market for journalists:

Welcome to the Jungle, by David Cay Johnston, CJR: Reporter Dan Browning’s piece on coming newsroom cuts at the St. Paul Pioneer-Press contains a curious detail that perhaps will encourage rigorous thinking in articles covering compensation. “The company said it wants… the elimination of merit pay….” Browning wrote... The term “merit pay” usually means that management rewards superior performance with superior compensation. ...

There is an adage among business owners ... that properly priced labor pays for itself. Workers whose pay equals their economic value-added receive just what they contribute and, in effect, cost the employer nothing. Those who are underpaid, however, damage profits through inefficiency, because when you underpay you attract less efficient workers. On the other end, those ... who are overpaid rob the owners of part of their profits.

So what does it say that Pioneer Press ... wants to stop rewarding superior performance with appropriately superior pay?

In theory, the best workers will go elsewhere. After all, the highest performers will be in demand and others will bid for their talent. The theory of market economics says that ... the quality of the labor ... will diminish, with appropriate damage to ... equity.

Continue reading "The Decline of Merit Pay in Journalism" »

Monday, May 11, 2009

Antitrust Enforcement

This is a welcome change. I've long been an advocate of stepped up enforcement of antitrust law, mostly because of the economic consequences of monopoly power. But the financial crisis has caused me to realize how much political power comes with dominance in the marketplace, and that is another reason to take a more aggressive approach to antitrust enforcement:

Administration Plans to Strengthen Antitrust Rules, by Stephen Labaton, NY Times: President Obama’s top antitrust official this week plans to restore an aggressive enforcement policy against corporations that use their market dominance to elbow out competitors or to keep them from gaining market share. The new enforcement policy would reverse the Bush administration’s approach, which strongly favored defendants against antitrust claims. ...

The head of the Justice Department’s antitrust division, Christine A. Varney, is to announce the policy reversal in a speech she will give on Monday... The administration is hoping to encourage smaller companies in an array of industries to bring their complaints to the Justice Department about potentially improper business practices by their larger rivals. Some of the biggest antitrust cases were initiated by complaints taken to the Justice Department.

Ms. Varney is expected to say that the administration rejects the impulse to go easy on antitrust enforcement during weak economic times. She will assert instead that severe recessions can provide dangerous incentives for large and dominating companies to engage in predatory behavior that harms consumers and weakens competition.

The announcement is aimed at making sure that no court or party to a lawsuit can cite the Bush administration policy as the government’s official view in any pending cases. ... Ms. Varney is expected to explicitly warn judges and litigants in antitrust lawsuits not involving the government to ignore the Bush administration’s policies...

During the Bush administration, the Justice Department did not file a single case against a dominant firm for violating the antimonopoly law. Many smaller companies complaining of abusive practices by their larger rivals were so frustrated by the Bush administration’s antitrust policy that they went to the European Commission and to Asian authorities. ...

Ms. Varney is expected to say that the Obama administration will be guided by the view that it was a major mistake during the outset of the Great Depression to relax antitrust enforcement, only to try to catch up and become more vigorous later. She will say the mistake enabled many large companies to engage in pricing, wage and collusive practices that harmed consumers and took years to reverse.

While Ms. Varney is not expected to mention any specific companies or industries..., she is aiming at agriculture, energy, health care, technology and telecommunications companies. She may also be reviewing the conduct of some in the financial services industry...

Signaling her intent to revive a moribund antitrust program, she has recruited a collection of senior aides, many of whom are seasoned antitrust litigators or worked in the Clinton administration and the Federal Trade Commission and were involved in many prominent cases, including the one against Microsoft. ...

Sunday, May 03, 2009

"Troubled Banks Must be Allowed a Way to Fail"

Kansas City Fed president Thomas Hoenig has a plan for allowing large and systemically important banks to fail. If we prevent financial institutions from becoming so large and systemically important in the first place, the plans below wouldn't be needed. But if we going to allow such institutions to exist - not my first choice but for now we have what we have - then this is a reasonable approach to take. One difference I have, though, is that I think that stronger form of guarantee for depositors, a key component of the Swedish plan, is needed. That changes the equity calculations when you look solely at the flow of money to depositors, and the politics of that aren't great, but the improved overall outcome can more than compensate for the cost of the government guarantees:

Troubled banks must be allowed a way to fail, by Thomas Hoenig, Commentary, Financial Times: When the financial crisis began ... in 2007, US policymakers reacted quickly out of fear that ... events would lead to a global economic collapse. In my view, the policy response ... has been ad hoc, resulting in inequitable outcomes among firms, creditors, and investors. Despite taking a number of actions..., uncertainty continues and markets remain stressed.

I believe there is an alternative method for addressing this crisis...: the implementation of a systematic plan to resolve large, problem financial institutions. ... Boiled down..., the plan would require those firms seeking government assistance to make the taxpayer senior to all shareholders, with the government determining the circumstances for managers and directors. ...

Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is ... re-privatised as soon as is feasible. ...

This plan has ... management and shareholders bear the costs for their actions before taxpayer funds are committed. This process also is equitable across all firms; is similar to what is currently done with smaller banks; and provides a definitive process that should reduce market uncertainty. ...

In contrast..., the current policy raises a host of issues:

● Certain companies have not been allowed to fail and, as a result, the moral hazard problem has substantially worsened. ...

● So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable..., they have actually been subsidised in becoming more economically and politically powerful.

The US government has poured billions of dollars into these firms without a defined resolution process... The longer resolution is postponed, the greater the losses and the larger the debt burden.

● ...[T]he Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role. This ... may compromise ... independence ... and make it more difficult to contain inflation in the years to come.

● ...We have entrenched these even larger, systemically important, “too big to fail” institutions into the economic system, assuring that past mistakes will be repeated.

Certainly, the approach I suggest for resolving these large firms also is not without substantial cost, but it looks to both the short and long run. ... While I agree that central banks must sometimes take actions affecting the short run, they must keep the long run in focus or risk failing their mission.

The fact that Citibank can negotiate the outcome of the stress tests is, I think, pretty good evidence that banks have become too big and too politically powerful for our collective good. (See here too.)

Monday, April 27, 2009

Paul Krugman: Money for Nothing

Will bankers escape new regulation and get off with "nothing more than a few stern speeches"?:

Money for Nothing, by Paul Krugman, Commentary, NY Times: ...Sanford Weill, the former chairman of Citigroup,... insisted that he and his peers in the financial sector had earned their immense wealth through their contributions to society.

Soon after..., the financial edifice Mr. Weill took credit for helping to build collapsed, inflicting immense collateral damage in the process. ... All of which explains why we should be disturbed by an article ... reporting that pay at investment banks ... is soaring again — right back up to 2007 levels.

Why is this disturbing?... First, there’s no longer any reason to believe that the wizards of Wall Street actually contribute anything positive to society, let alone enough to justify those humongous paychecks. ...

So why did some bankers suddenly begin making vast fortunes? It was, we were told, a reward for their creativity — for financial innovation. At this point, however, it’s hard to think of any major recent financial innovations that actually aided society, as opposed to being new, improved ways to blow bubbles, evade regulations and implement de facto Ponzi schemes.

Consider a recent speech by Ben Bernanke ... in which he tried to defend financial innovation. His examples ... were (1) credit cards — not exactly a new idea; (2) overdraft protection; and (3) subprime mortgages. (I am not making this up.) These were the things for which bankers got paid the big bucks?

Still, you might argue that ... it’s up to the private sector to decide how much its employees are worth. But this brings me to my second point: Wall Street is no longer, in any real sense, part of the private sector. It’s a ward of the state, every bit as dependent on government aid as recipients of Temporary Assistance for Needy Families, a k a “welfare.” ...[G]iven all that taxpayer money on the line, financial firms should be acting like public utilities, not returning to the practices and paychecks of 2007.

Furthermore, paying vast sums to wheeler-dealers isn’t just outrageous; it’s dangerous. Why, after all, did bankers take such huge risks? Because success — or even the temporary appearance of success — offered such gigantic rewards: even executives who blew up their companies could and did walk away with hundreds of millions. Now we’re seeing similar rewards offered to people who can play their risky games with federal backing. ...

Why are paychecks heading for the stratosphere again? Claims that firms have to pay these salaries to retain their best people aren’t plausible: with employment in the financial sector plunging, where are those people going to go?

No, the real reason financial firms are paying big again is simply because they can. They’re making money again (although not as much as they claim), and why not? After all, they can borrow cheaply, thanks to all those federal guarantees, and lend at much higher rates. So it’s eat, drink and be merry, for tomorrow you may be regulated.

Or maybe not. There’s a palpable sense in the financial press that the storm has passed: stocks are up, the economy’s nose-dive may be leveling off, and the Obama administration will probably let the bankers off with nothing more than a few stern speeches. Rightly or wrongly, the bankers seem to believe that a return to business as usual is just around the corner.

We can only hope that our leaders prove them wrong, and carry through with real reform. In 2008, overpaid bankers taking big risks with other people’s money brought the world economy to its knees. The last thing we need is to give them a chance to do it all over again.

Saturday, April 25, 2009

"Good Government and Animal Spirits"

Akerlof and Shiller say it's up to government to set animal spirits free, only then will they be maximally creative":

Good Government and Animal Spirits, by George A, Akerlof and Robert J. Shiller, Commentary, WSJ: The principal long-term result of the current financial crisis should be improved financial regulation. ...

An understanding of animal spirits -- the human psychology and culture at the heart of economic activity -- confirms the need for restoring the role of regulators... History -- including recent history -- shows that without regulation, animal spirits will drive economic activity to extremes. ...

At the end of the 1980s, our economic system was remarkably well-adapted to weather any storm. For example, massive numbers of S&Ls failed during the decade. But government protections isolated this collapse into a microeconomic event that, while it cost taxpayers quite a bit of money, only rarely cost them their jobs.

Then the economy changed -- as it always does -- challenging the regulations that were in place. ... And regulation did not adapt to reflect this change in the financial structure. The regulatory failure led to a profound systemic instability in our economy...

Public antipathy toward regulation supplied the underlying reason for this failure. The U.S. was deep into a new view of capitalism. Americans believed in a no-holds-barred interpretation of the game. We had forgotten the hard-earned lesson of the 1930s: Capitalism can give us real prosperity, but it does so only on a playing field where the government sets the rules and acts as a referee.

Contrary to a widespread impression the current situation is not really a crisis of capitalism. Rather we must recognize that capitalism must live within certain rules. ... It may be true that in the classical economic paradigm there is full employment. But with animal spirits, waves of optimism and pessimism cause large-scale changes in aggregate demand... When demand goes down, unemployment rises. It is the role of the government to mute those changes.

Moreover, entrepreneurs and companies do not just sell people what they really want. They also sell people what they think they want, and not infrequently what they think they want turns out to be snake oil. Especially in financial markets... All of these processes are driven by stories. The stories that people tell to themselves -- about themselves, about how others behave, and even about how the economy as a whole behaves -- all influence what they do. These stories vary over time.

Such a world of animal spirits justifies the economic intervention of government. Its role is not to harness animal spirits but really to set them free, to allow them to be maximally creative. A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents. ...American financial regulation hasn't had an overhaul in 70 years. The challenge for the Obama administration, along with the U.S. Congress and our SROs, is to invent a new and better American version of the capitalist game.

Wednesday, April 22, 2009

Using Anti-Trust Law to Break Up Banks that are Too Big to Fail

Simon Johnson wants to apply anti-trust laws to financial markets and use it to break up banks that are too big too fail. More vigorous enforcement of anti-trust laws is something I've been pushing here for a long time, and as I explain below I agree with this idea, but as I understand it, current anti-trust law is inadequate for this task (particularly on dimensions such as connectedness and systemic risk). So it will likely take Congressional action before we can proceed.

The reason for bringing this up is that I want to amend remarks I made in the past. I have said that there is no single villain in this crisis, no one person, not one change in the law, etc., that caused this. It was a combination of things. But as I think about it more and more, I'm not so sure. The reason? According to the story I've been telling about why the crisis happened, there were incentive failures at just about every step in  the process. Homeowners had no recourse loans giving them one way bets on home values, real estate agents are paid in a way that causes them to maximize the value of sales, mortgage brokers faced no long-run consequences from bad loans, real estate appraisers had incentives to validate sales, ratings agencies were paid by the people whose assets were being rated, CEOs and upper level management had incentives to maximize something other than shareholder value, there was a lack of transparency giving insiders an advantage, it goes on and on.There is not a single step in the process that wasn't compromised by an incentive or market failure of some type.

Looking at this at first, I concluded that it was all of these things, and more, that caused the crisis, and that it could have been stopped at any one of these steps. Had anyone at any one of the steps from the sale of the house to the complex securities traded in the shadow banking system said no, we're not doing that, the money could not have kept flowing through the system and blowing up the bubble. For example, if the mortgage brokers would have taken personal losses on mortgages that later went bad, they might have refused to finance them, and the money could not have been passed upwards to the shadow banking system where it caused such big problems. But instead, the brokers simply passed the contracts along, sliced and diced as necessary, to the next person in the finance chain.

But what should we make of the fact that every singe step in the process is compromised? Every market that was supposed to self-regulate failed? Does every single market in the chain fail at the same time through some highly unlikely coincidence? What are the chances that, on their own, independently, each and every step in the chain would have been subject to a market failure that just happened to let the bubble keep inflating? Whatever it took to keep the money flowing through the system seems to have come to pass.

So more and more I'm starting to thing there may be a single explanation after all, that the regulators of these markets were captured by powerful forces that wanted the game to continue. The power of regulators, and the will to enforce the regulations, must match - in fact exceed - the will and power of those being regulated to resist having constraints placed on their behavior. I've talked about why ideology may have eroded the will of regulators, but their will is partly a function of their power. So long as we allow huge, clearly over-sized financial institutions to exist, this problem will potentially be present.

Therefore, if the current anti-trust legislation is adequate to the task, then yes, let's give regulators the power to enforce it, and ensure we have people in place with the will to do so. But as I said above, I think current law may have glaring legal holes that need to be closed before we can use this section of the law effectively. If so, then it's time to get started crafting new legislation that is up to the task, and I hope Simon Johnson is successful in getting movement in this direction. He has my support.

Sachs: Paying for Government's Expanded Economic Role

Jeff Sachs says the government will need to find new sources of tax revenue:

The Costs of Expanding the Government's Economic Role [Extended version], by Jeffrey D. Sachs, Scientific American: The 10-year budget framework that President Barack Obama released ... is as much a philosophy of government as a fiscal action plan. Gone is the Ronald Reagan view that “government is not a solution to our problem; government is the problem.” Obama rightly sees an expanded role for government in allocating society’s resources as vital to meeting the 21st century challenge of sustainable development. 

The scientific discipline known as public economics describes why government is needed alongside markets to allocate resources. These reasons include: the protection of the poor through a social safety net; the correction of externalities...; the provision of “merit goods” such as health care and education that society deems to be essential for all of its members; and the financing of scientific and technological research that cannot be efficiently captured by private investors. In all these circumstances, the free-market system tends to underprovide the resource in question...

Obama’s budget plan properly focuses on areas that public economics identifies as priorities and where the U.S. discernibly lags behind many parts of Europe: health..., education..., public infrastructure... and research and development... The emphasis is on public-private partnerships (PPP), combining public financing and private sector delivery. ...

Obama’s vision of an expanded federal role is on-target and transformative, but the financing will be tricky. This year’s deficit will reach an astounding $1.75 trillion, or 12 percent of GDP...

Obama’s budget plan aims to reduce the deficit to 3 percent of GNP by 2013, and to level off till 2019..., but ... that target will be very difficult to achieve and sustain as planned. ...[T]he plan is to cut the deficit mainly through higher taxes on the rich, reduced military outlays for Iraq and Afghanistan, new revenues from auctioning carbon-emission permits and, finally, a squeeze on non-defense discretionary spending... Such a squeeze on non-defense spending seems unlikely—and indeed undesirable—at a time when government is launching several much-needed programs in education, health, energy and infrastructure.

The truth is that the U.S. ... will probably have to raise new revenues ... to carry out its vital roles in protecting the poor, promoting health and education and building a modern infrastructure with ... sustainable technology. Ending the Bush-era tax cuts on the rich certainly is merited, but further taxing the rich much beyond that will come up against political and practical limits. Within a few years, we’ll probably see the need for new broader-based taxes, perhaps a national sales or value-added tax such as those widely used in other high-income countries. If we continue to assume that we can have the expanded government that we need but without the tax revenues to pay for it, the unacceptable build-up of public debt will threaten the well-being of our children and our children’s children. ...

I doubt will see any major changes in the tax structure anytime soon, but if we do, value added taxes are regressive, but in countries where they are used, they're an important source of revenue for highly progressive tax-and-transfer systems (but not without problems). So the characteristic of these taxes overall depends upon their implementation, i.e. how the extra revenue from the tax is used.

Tuesday, April 21, 2009

"A Crisis of Ethic Proportions"

John Bogle says "self-interest got out of hand":

A Crisis of Ethic Proportions, by John Bogle, Commentary, WSJ: I recently received a letter from a Vanguard shareholder who described the global financial crisis as "a crisis of ethic proportions." Substituting "ethic" for "epic" is a fine turn of phrase, and it accurately places a heavy responsibility for the meltdown on a broad deterioration in traditional ethical standards. ... Relying on [the] "invisible hand," through which our self-interest advances the interests of society, we have depended on the marketplace and competition to create prosperity and well-being.

But self-interest got out of hand. ... Dollars became the coin of the new realm. Unchecked market forces overwhelmed traditional standards of professional conduct, developed over centuries. ... We've moved from a society in which "there are some things that one simply does not do" to one in which "if everyone else is doing it, I can too." Business ethics and professional standards were lost in the shuffle. ... The old notion of trusting and being trusted ... came to be seen as a quaint relic of an era long gone.

The proximate causes of the crisis are usually said to be easy credit, bankers' cavalier attitudes toward risk, "securitization"..., the extraordinary leverage built into the financial system by complex derivatives, and the failure of our regulators to do their job.

But the larger cause was our failure to recognize the sea change in the nature of capitalism that was occurring right before our eyes. That change was the growth of giant business corporations and giant financial institutions controlled not by their owners in the "ownership society" of yore, but by agents of the owners, which created an "agency society."

The managers of our public corporations came to place their interests ahead of the interests of their company's owners. ... The malfeasance and misjudgments by our corporate, financial and government leaders, declining ethical standards, and the failure of our new agency society reflect a failure of capitalism. ...

What's to be done? We must work to establish a "fiduciary society," where manager/agents entrusted with managing other people's money are required -- by federal statute -- to place front and center the interests of the owners they are duty-bound to serve. The focus needs to be on long-term investment (rather than short-term speculation), appropriate due diligence in security selection, and ensuring that corporations are run in the interest of their owners. ... Making that happen will be no easy task.

Rules will never cover everything, so ethics is part of the problem. But the solution to the agency problem has to come in large part from changing incentives so that the self-interest of the managers coincides with the interests of the people they represent. [Kahneman also talks about agency problems in a section I left out of the next post.]

Wednesday, April 08, 2009

Public Goods and Stimulus Packages

Two from Richard Green. First:

Adam Smith on Roads, by Richard Green: From Chapter 11 of the Wealth of Nations:

Good roads, canals, and navigable rivers, by diminishing the expense of carriage, put the remote parts of the country more nearly upon a level with those in the neighbourhood of the town. They are upon that account the greatest of all improvements. They encourage the cultivation of the remote, which must always be the most extensive circle of the country. They are advantageous to the town, by breaking down the monopoly of the country in its neighbourhood. They are advantageous even to that part of the country. Though they introduce some rival commodities into the old market, they open many new markets to its produce. Monopoly, besides, is a great enemy to good management, which can never be universally established but in consequence of that free and universal competition which forces everybody to have recourse to it for the sake of self-defence. It is not more than fifty years ago that some of the counties in the neighbourhood of London petitioned the Parliament against the extension of the turnpike roads into the remoter counties. Those remoter counties, they pretended, from the cheapness of labour, would be able to sell their grass and corn cheaper in the London market than themselves, and would thereby reduce their rents, and ruin their cultivation. Their rents, however, have risen, and their cultivation has been improved since that time.

Second, in response to Robert Lucas:

Two Questions about Macroeconomics, by Richard Green: I am not a macroeconomist. One of the reasons for this, I suppose, is that I was taught a lot of rational expectations overlapping generations stuff in graduate school and while I found it elegant, I did not believe it. The reason I didn't believe it is because the models are rejected by data: for instance, when households get short term changes in income, they seem to change their consumption behavior somewhat.

Nevertheless, there are ... macro issues that puzzle me. ...Ricardian equivalence types seem to have an underlying assumption that government can't invest in positive NPV opportunities. For instance, Robert Lucas argues that if the government borrows $100 million to build a bridge, household will know they have a future tax liability of $100 million, reduce their spending accordingly, and therefore offset the stimulative impact of the bridge.

But what if the cost to borrow for the bridge is 3 percent and the bridge's IRR is 5%? Then doesn't the bridge stimulate spending for the simple reason that it is a good investment? The federal government has made, it seems to me, some very good investments. Hoover Dam is one. Rural electrification is another. The interstate highway system. The Golden Gate Bridge. The New York City subway system. I could continue...

I do worry about bridges to nowhere. But many macroeconomists seem to believe in the hearts that public goods don't exist, and that there is nothing government can do better than the private sector. I think it is here that macro takes its cues more from religion than science.

[See also: Tax Cuts, Government Spending, Public Goods, and the Stimulus Package and Lucas: Monetary Policy Can Still be Effective.]

“Cap-and-Trade is a Tax"

Thomas Friedman says that opponents of policies to reduce the accumulation of greenhouse gases are going to point out that cap and trade is equivalent to a carbon tax, and make a political issue out of it, so why not go for the real thing?

Show Us the Ball, by Thomas Friedman, Commentary, NY Times: ...Last week, House Democrats, with administration support, introduced a 600-page draft bill ... to reduce greenhouse-gas emissions through a complicated cap-and-trade system. These people have the very best of intentions, but I wish they would step back and ask again: Can cap-and-trade pass? Will it really work? And is it the best strategy, with all the bureaucracy it will require to monitor, auction emissions permits and manage the trading?

Advocates of cap-and-trade argue that it is preferable to a simple carbon tax because it ... “hides the ball” — it doesn’t use the word “tax” — even though it amounts to one. ...

That was true as long as no one thought cap-and-trade could ever pass, but ... opponents are not playing hide the ball anymore. In the past two weeks, you could hear a chorus of Republicans, coal-state Democrats, right-wing think tanks and enviro-skeptics all singing the same tune: “Cap-and-trade is a tax. Obama is going to raise your taxes and sacrifice U.S. jobs to combat this global-warming charade... Worse, cap-and-trade will be managed by Wall Street. If you liked credit-default swaps, you’re going to love carbon-offset swaps.” ...

They could easily kill this effort. So, if the Obama team cares about ... a stronger America and a more livable planet,... I hope it will consider an alternative strategy, message and messenger.

STRATEGY Since the opponents of cap-and-trade are going to pillory it as a tax anyway, why not go for the real thing — a simple, transparent, economy-wide carbon tax? ...

People get that — and simplicity matters. Americans will be willing to pay a tax for their children to be less threatened, breathe cleaner air and live in a more sustainable world with a stronger America. They are much less likely to support a firm in London trading offsets from an electric bill in Boston with a derivatives firm in New York in order to help fund an aluminum smelter in Beijing, which is what cap-and-trade is all about. People won’t support what they can’t explain.

MESSAGE Climate change is a real threat to a healthy planet... But because the worst effects are in the future, many Americans have more immediate concerns. That is why our energy policy should be focused around “American renewal,” not mitigating climate change.

We need a price on carbon because it will stimulate massive innovation in ... energy technology. ... I.T. could be the foundation for a second American industrial revolution, plus it would tip the whole planet onto a greener path. So American economic renewal is the goal, but mitigating climate change would be the great byproduct.

MESSENGER The Obama administration’s carbon tax spokesman — the one who should sell this to the country — should be the president’s national security adviser, Gen. James Jones, not the environmentalists. The imposing former head of the Marine Corps could make a powerful case that ... the country with the most powerful clean-technology industry in the 21st century will have the most energy security, national security, economic security, healthy environment, innovative companies and global respect. That country must be America. So let’s stop hiding the ball and have a strategy, message and messenger that tell it like it is — and make it so.

The tax changes can be made revenue neutral so that there is a change in the incentive to consume goods with high carbon content, but no change (implicit or explicit) in the overall tax burden (e.g. see here for a carbon tax example - a cap and trade equivalent exists). In addition, such rebates, if properly distributed, could help with the political problem Friedman is worried about.

Thursday, April 02, 2009

Using Markets to Fix Markets

Robert Stavins on the "enlightened use of markets" to make fisheries sustainable:

Using Markets to Make Fisheries Sustainable, Robert Stavins: Around the world, over-fishing is leading to severe depletion of valuable fisheries. ... According to the United Nations Environment Program, fully 25 percent of fisheries worldwide are in jeopardy of collapse due to over-fishing. Clearly, something needs to be done. Yet, what has long been considered the obvious answer - restrictions on fishing - has been shown time and time again to be the wrong answer. The right answer is enlightened use of markets.

The fundamental cause of the depletion of fish stocks is well known to economists: virtually all ocean fisheries are “open-access,” that is, fishermen - small operations or large corporations - can fish all they want. ... Each fisherman receives the full benefit of aggressive fishing (that is, a larger catch), but none pay the full cost (an imperiled fishery for everyone). One fisherman’s choices have an effect on other fishermen (of this generation and the next), but in an open-access fishery ... these impacts are not taken into account. What is individually rational adds up to collective foolishness, as the shared resource is over-exploited. This is the “tragedy of the commons.” What to do?

Government intervention is, alas, required. Fishermen don’t welcome such regulation in their economic sphere any more than anyone else does. And they have a point. Conventional regulatory approaches have driven up costs, but not solved the problem. And we know why. If the government limits the season, fishermen put out more boats. If the government limits net size, fishermen use more labor or buy more costly sonar. Economists call this over-capitalization. Costs go up for fishermen (as resources are squandered), but pressure on fish stocks is not relieved.

The answer is to adopt in fisheries management the same type of innovative policy that has been used for decades in the realm of pollution control - tradeable permits, called “Individual Transferable Quotas” ( ITQs) in the fisheries realm. Sixteen countries - some with economies much more dependent than ours on fishing - have adopted such systems with great success. New Zealand regulates virtually its entire commercial fishery this way. It’s had the system in place since 1986, and it’s been a great success, putting a brake on over-fishing and restoring stocks to sustainable levels ­- while increasing fishermen’s profitability!

There are several ITQ systems already in operation in the United States, including for Alaska’s pacific halibut and Virginia’s striped-bass fisheries. More important, the time is ripe for broader adoption of this innovative approach, because a short-sighted ban imposed by the U.S. Congress on the establishment of new ITQ systems has expired.

The first step in establishing an ITQ system is to establish the “total allowable catch.” The next step - and a crucial one - is to allocate shares of that total limit to fishermen in individual quotas that are theirs and theirs alone (read: well-defined property rights). Setting the individual quotas will not be easy. The guiding principle should be simple pragmatism - using the allocations to build political support for the system. Making the quotas transferable eliminates the problem of overcapitalization and increases efficiency, because the least efficient fishing operations find it more profitable to sell their quotas than to exploit them through continued fishing. If you can’t catch your whole share, you can sell part of your quota to someone else, instead of buying a bigger boat.

In addition, these systems improve safety by reducing incentives for fishermen to go out (or stay out) when weather conditions are dangerous. ... Further, because ITQ systems eliminate the motivation for government to limit the duration of the fishing season, supplies available to consumers improve in quality. Prior to the establishment of an ITQ system for Alaskan halibut, for example, the government had reduced the fishing season to just two days, but subsequent to the introduction of the system, the season length grew to more than 200 days.

A decade ago, environmental advocates - led by the Environmental Defense Fund - played a central role in the adoption of the sulfur dioxide allowance trading program that’s cut acid rain by half and saved electricity generators and rate-payers nearly $1 billion annually, compared with conventional approaches. The time has come for environmentalists to join forces with progressive voices in the fishing industry and in government to set up ITQ systems that can keep fishermen in business while moving fisheries onto sustainable paths.

The allocation of individual shares is, as noted above, crucial, and the danger in having the government set the individual quotas is that "pragmatism" and the desire to "build political support" will lead to political favoritism in the allocations, that large firms will have an advantage in capturing the quota regulators, etc. For these reasons, and others, it seems like an auction mechanism would work better, at least for the initial allocation, but perhaps there are political objections to auctions that preclude this option (though the fact that such strong political forces exist would argue for a market based allocation mechanism even though those same forces would prevent such a mechanism from being implemented).

Friday, March 27, 2009

Why Did Ratings Agencies Fail?

The failure of ratings agencies to properly price the risky securities at the heart of the financial crisis has been attributed to conflict of interest (being paid by the issuers of the assets they are rating) and shopping for the best rating (get more than one rating, then only make public the highest one). However, an objection to these explanations is that these incentives have always existed, yet the problems did not emerge until recently. Thus, any explanation relying upon these incentives must explain why they did not cause problems until recently.

This article says the answer can be found in the complexity of the assets that are being rated. When the assets are very simple, risk assessment is not very complicated and the dispersion of ratings across agencies is very low. Thus, there is no incentive to shop around. In addition, it is hard for the agencies to become beholden to asset issuers and inflate ratings because such behavior would be transparent enough so as to risk losing credibility. That is, people outside the agencies can independently check and verify the ratings easily so any manipulation of the ratings would be easy to discover, and the revelation that their ratings are inflated would damage their credibility and hence their business.

But all of this changes when the assets become more complex. First, because of the complexity the dispersion of ratings across agencies will increase. Thus, even if the mean rating does not change, the variance of the ratings make it worthwhile to pay for more than one rating and cherry pick the best of the lot, i.e. to shop around. (In numerical terms, suppose assets are rated from 1, which is the highest risk category, to 10 which is the safest. A non-complex asset might have a dispersion of, say, 7.95 to 8.05 among a fixed number of ratings agencies, while a complex asset might have ratings running from 6.50 to 9.50. In both cases, assuming a symmetric distribution, the mean is 8, but the rewards to shopping around are quite different).

Second, it is easier for the issuer to capture the rating agency, i.e. for the agency to produce the ratings the company is looking for, because the complexity makes such behavior harder to uncover. The ability of outside observers to uncover such behavior diminishes when the variance of the ratings goes up.

To be more precise about the incentive to shop around, there is a cost to obtaining one more rating, the fee the firm must pay (though the article below implies the firm can escape the fee it if doesn't like the rating it gets). The benefit is the chance that the new, incremental rating will be higher than the ratings already in hand, and this diminishes as more ratings are collected, i.e. there is a declining marginal benefit. If the fee is relatively low, it will be worthwhile to collect many ratings, and the expected rating outcome - the maximum of the ratings - will be higher as more ratings are collected. However, issuers do not necessarily collect ratings from every ratings firm since the expected benefit of an additional rating may not cover the cost. But if the fees are sufficiently low, if the assets are sufficiently complex, and if the number of firms is sufficiently small - a case that may describe the recent market fairly well - a corner solution will emerge, i.e. it always pays - in expected terms - to collect all the ratings available and then make only the best rating public.

The other side of this, though, is that the degree of distortion falls when the number of ratings agencies is small. That is, the expected maximum rating is increasing in the number of ratings collected (though the increase comes at a decreasing rate, that's why there is a declining marginal benefit to collecting another rating). It depends upon the nature of the underlying distributions, but it's possible - and I think likely - that the distortion from this factor was low due to the fact that there were only, effectively, Moody and Standard & Poor operating in these markets (do we count Fitch too?). If so, if the shopping around distortion is relatively minor because the number of firms is small (and that is highly speculative on my part, and based upon the quick reactions scribbled out above rather than days of careful thought), then the alternative explanation that the ratings agencies were beholden to asset issuers should be given more weight as the likely, predominant explanation for the problems in these markets.

In any case, here's the article:

The origin of bias in credit ratings, by Vasiliki Skreta and Laura Veldkamp, voxeu.org: Most market observers attribute the recent credit crunch to a confluence of factors – excess leverage, opacity, improperly estimated correlation between bundled assets, lax screening by mortgage originators, and market-distorting regulations. Credit rating agencies were supposed to create transparency, provide the basis for risk-management regulation, and discipline mortgage lenders and the creators of structured financial products by rating their assets. Understanding the origins of the crisis requires, at least in part, understanding the failures of the market for ratings. Proposed explanations for ratings bias have broadly fallen into three categories.

Continue reading "Why Did Ratings Agencies Fail?" »

Monday, March 23, 2009

"Toxic Car" Follow-Up: Pricing Toxic Assets

Sandro Brusco at noiseFromAmeriKa, a blog with other Italian economists Alberto Bisin, Michele Boldrin, Gianluca Clementi, Andrea Moro and Giorgio Topa, sent this to me in response to the post on toxic cars. One of the key problems in the example, and in the toxic asset problem more generally, is finding the right price for the assets when there is no market for them. Sandro uses an example similar to the "toxic car" example to show how mechanism design theory can be applied to the problem of evaluating toxic assets:

Mechanism Desing and the Bailout: Introduction Since the explosion of the banking crisis we have seen many analyses and many proposals for solution; hardly a day seems to pass by without the appearance of a new plan to save the banks. So, you may ask, why do we need plan n+1? Well, I am not going to propose a full-fledged plan. Rather, I would like to make a partial proposal related to one aspect of the problem, the evaluation of the so-called ''toxic assets''. The theoretical underpinnings of many of the existing proposals are often quite opaque: I would like to do the opposite, so I will try to explain in some detail the theoretical basis of my proposal.

Continue reading ""Toxic Car" Follow-Up: Pricing Toxic Assets" »

Sunday, March 22, 2009

Government Intervention in the Market for Toxic Cars

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars - the engines blow up and the cars are then worthless - and this will happen just after purchase. The other half are perfectly fine. Unfortunately, there is no way to tell prior to purchase which type of car you will get no matter how hard you try. Thus, half of the assets on the car dealer's "balance sheet" - the cars on its lot - are toxic, and lack of transparency makes it impossible to tell which ones are bad prior to purchase.

If all the cars were in perfect shape, they would sell for $20,000 each. Thus, there are (50)*($20,000) = $1,000,000 in assets on the books according to one way of doing the accounting, but that doesn't necessarily represent the true value of the cars on the lot.

The town where this dealership is located relies upon this business for jobs, it is essential, but, unfortunately, business has fallen off to nothing. Nobody is willing to risk losing $20,000 by purchasing a car that might die just after purchase, so the price has fallen. The expected value of a car is $10,000, but it's an all or nothing proposition, the car runs or it dies, and since people are risk averse nobody is wiling to pay the $10,000 expected value. In fact, the highest price they are willing to pay, $6,000, is lower than the minimum price the dealer is willing to accept (I've assumed a reservation price of $7,500 for illustration, and a horizontal supply curve to make the illustration easier):

Toxic.cars

So how could the government fix the problem?

1. Government purchases of toxic cars

The government could buy the cars itself, say at $7,500 per car, or $750,000 total for the lot, drive them around a bit (stress test them), wait for the bad ones to blow up, then sell the 50 good cars back to the public (who will no longer be fearful since the bad cars are out of the mix). If they can get anything more than $15,000 for each good car, they will make money on the deal (well, there would be overhead and other costs to cover, but let's abstract from minor details). But if cars end up selling for less than $15,000, they will take a loss.

(In the graph, the government intervention shifts the demand curve outward until it intersects at the kink in the supply curve at Q=100).

The problem with this option is knowing what price to offer for the cars. There is no market, and the firm's reservation price may be too high, i.e. paying the reservation price will eventually lead to a loss. And it's worse. In this example the percentage of bad cars is known, but the percentage of bad cars would also be unknown in a more realistic example, so there's no way to know how many good cars there are for sure, and what price they will sell for after the defective cars have been culled out of the herd. If the government pays $7,500 per car, and more than 62.5% of them go bad (not that much more than the 50% estimate), then taxpayers will lose money even if they sell for $20,000. With the percentage unknown, there's no way to know for sure what the breakeven price will be.

This is, in essence, the original Paulson plan. The only twist is that the price - the $7,500 in the example above, would be determined by an auction among many dealers with the government accepting the lowest bid (which could be $7,500 in this example since that is the price the firm is willing to accept). As you can see by thinking this through, there are questions about what price such an auction would reveal.

One danger in this plan is that if you overpay for the cars, e.g. give $7,500 when the breakeven price was, say, actually $5,000, then you have given the owner of the car lot $250,000 more than the cars were actually worth (this will be the loss to taxpayers). The dealer may need this money to stay solvent and stay in business, but, nevertheless, it is a windfall.

There are a lot of uncertainties here, and lots of ways to lose money. But it's possible to make money too.

2. Subsidies and Public-Private partnerships

Here, the government offers a subsidy to private sector buyers. Suppose that the demand curve intersects the vertical line in the graph (at Q=100) at a price of $4,000. Then in order to sell 100 cars, the government must subsidize buyers by $3,500 so that the $4,000 offer is raised to the $7,500 the firm is willing to accept (notice that the buyer willing to pay $6,000 gets a $2,000 windfall, so, except at the margin, this plan gives surplus to people purchasing the assets - as with the first plan, this shifts the demand curve out until it intersects at the kink in the supply curve).

Toxic.cars1

However, once again, the government will not know if it is getting this right or not. Suppose it offers a $1,000 subsidy thinking that is generous enough. In this example, that won't bridge the gap between the highest offer of $6,000, and the reservation price of $7,500. Thus, the subsidy would be too small to restart the market and the plan would fail. So the answer is to make the subsidy large enough to encourage buyers, but the problem is that if it is too large, the government will be giving money away unnecessarily.

And there's another problem. If there's a large gap between what people are willing to pay and what dealers are willing to accept(the gap between $6,000 and $7,500 in the example), this would be problematic politically since it would require subsidies that are unacceptably large.

And I should note that it doesn't have to be a subsidy. That's one way to do this - as a giveaway - but another way is through a no recourse loan (what is being called a partnership). Suppose that the government gives (up to) a $3,500 loan to a private sector buyer to purchase the car for $7,500. If it's a good car and the value rises above $7,500, say to $15,000, then government will get paid back (with interest) since the asset can be sold profitably (another option is for the government to demand a share of this profit through warrants or other means). But if it's a bad car, the price falls to zero and the loan is forgiven - it does not need to be repaid. So the private sector agents only have to put up a fraction of the price to control the asset, and their losses are limited to the amount they put up while the gains are potentially large.

This is, in essence, the Geithner Plan. If many of the loans are not repaid, or if the subsidy is too large, it could lose a lot of money, but it could also make money too.

3. Nationalization

Now for the Saab story. Another option is for the government to simply take over the car dealership. The dealership is essential to the economy of the town, without it people will struggle, and the government - for that reason - might consider temporarily taking over the dealership to prevent failure. In doing so, it would make an evaluation of the company's assets, pay off the people who loaned the business money up to this amount, which may require having them take a haircut, i.e. accept some percentage of what they are owed on the bad loans they made, and the owner would simply be wiped out (which is a benefit since the business is insolvent and this allows the owner to escape the loans that cannot be paid through liquidation).

After taking over, the government would stress test the cars it now owns, put the bad ones in the junk pile, and sell the rest back to the public. So long as it didn't pay the creditors too much when it took over, i.e. the haircut is sufficiently large, it ought to make money on the deal. But it could lose money here too.

The Point

But, and I want to stress this, the point of these plans is not to make money, the point is to keep the economy of the town going, to keep people employed. If people place a large value on security, then even if the government takes a loss on paper, it may not be an economic loss. That is, we must put a value on the jobs that are saved and the security it brings (simply imagine that the utility function has risk as one of its arguments - by lowering the risk of job loss and the associated household disruption, you have made the agent better off, and this must be counted against any loss from any of the programs above). There is value in economic stability and security over and above whatever the government makes (or loses) on the actual financial transactions, and this must be factored into the evaluation of the policy.

Thursday, March 19, 2009

"The Judgments of the Market are True and Righteous Altogether"

Christopher Carroll with an evidence based rebuttal to the "risk-is-holy view" advocating a free market, hands off approach to the financial crisis, and a call for the Fed to do what it always does in a crisis, manage the price of risk (which means going beyond measures such as the purchase of long-term government securities and taking risky assets onto the Fed's balance sheet):

Punter of last resort, Christopher D. Carroll, Vox EU: The financial meltdown that shifted into high gear last September has flushed into public view many surprising facts. One of the strangest is the existence, in the economics profession, of a bizarre religious cult. This cult adheres to the dogma that the “price of risk” is the Holy of Holies that can properly be set only by the immaculate invisible hand of the financial marketplace; and cult members seem to believe, to paraphrase President Lincoln from a rather different context, that “If the Market wills that the economic crisis continue until every dollar of economic activity created by the taking of risk shall be repaid by another dollar destroyed by a newfound fear of risk, so it still must be said that the judgments of the Market are true and righteous altogether.”

The deep origins of the cult, as always, are obscure; presumably they lie properly in the field of psychoanalysis. But to the extent that overt origins can be traced, the wellspring is the literature that attempts to explain the Mehra and Prescott (1985) ‘equity premium puzzle.’ The ‘puzzle,’ in a nutshell, is that asset prices have not, historically, exhibited a relationship between risk and return that is easy to reconcile with the rational behavior of a representative agent facing perfect markets. Many of the responses to this challenge start with the assumption that asset prices must be always and everywhere rational, and then proceed to work out the kind of preferences or environment that can rationalize observed prices. This game brings to mind Joan Robinson’s comment that “utility maximization is a metaphysical concept of impregnable circularity,” and Larry Summers’s remark (quoted by Robert Waldmann) that the day when economists first started to think that asset prices should be explained by the characteristics of a representative agent’s utility function was not a particularly good day for economic science. Oddly, even the failure of this literature to produce a widely agreed solution to the ‘puzzle’ does not seem to have weakened participants’ belief in the soundness of the intellectual framework within which asset prices are a puzzle.

Nor does the assumption that asset prices are always and everywhere perfect reflect the actual past practice of economic policymaking during crises. As DeLong (2008) has recently reminded those of us who are susceptible to the lessons of history (see also Kindleberger (2005)), the “lender of last resort” role of the central bank has always been, during a panic, to short-circuit the catastrophic economic effects of a collapse of financial confidence (in today’s terminology, ‘an increase in the price of risk’).1

Some economists, of course, view narrative history in the DeLong and Kindleberger mode as irrelevant to the practice of their science; they prefer hard numbers to mere narrative. For the numerically inclined, however, Figures 1a and 1b should be persuasive; they show that controlling a market price of risk is something the Federal Reserve has done since it first opened up shop. The top figure depicts a measure of what we are now pleased to call the ‘risk-free’ rate of interest in the United States – essentially, the shortest-term interbank lending rate for which data are available (on a consistent basis) from before and after the founding of the Fed.2 Figure 1b shows the month-to-month changes in this interest rate. The only reason this rate is now viewed as ‘risk-free’ is that the Fed takes away the risk.3

Figure 1a
Carroll1

Figure 1b
Carroll2

Do the advocates of the risk-is-holy view really believe that we were better off in a real free-market era when interbank rates could move from 4 percent to 60 percent from one month to the next (as happened in 1873)? And how long do they think such a system would last? It was, after all, the intolerable stresses caused by financial panics that ultimately led to the founding of the Federal Reserve, in the face of adamant opposition from people holding financial-markets-are-perfect, believe-me-not-your-lying-eyes views that are eerily similar to dogmas that continue to be propounded today. The panic of 1907, in which J.P. Morgan effectively stepped in as a private lender of last resort, constituted the last straw for the unregulated financial system that preceded the managing of risky rates that we have had since the creation of the Fed.

A less extreme version of essentially the same dogma states that while it is acceptable for the central bank to suppress the aggregate risk that would otherwise roil short-term interest rates, the Fed should ignore all other manifestations of financial risk. It is, if anything, harder to construct a coherent economic justification of this point of view than of the strict destructionist view that says the Fed should not exist at all. But there is, at least, a perception that this way of operating is hallowed by time and practice: Since the Fed, the story goes, has spent most of its history ignoring risk, it shouldn’t change that now.

But even this milder dogma does not match the facts. Recent work by Robert Barbera, Charles Weise, and David Krisch,4 shows that over the “Taylor Rule” era of systematic monetary policy (roughly since 1984), the Federal Reserve’s choice of the short run interest rate has been powerfully correlated to market-based measures of risk such as the difference between the interest rates on corporate bonds and corresponding maturity Treasuries. When risk has been high, the Fed has felt the need to stimulate the economy by cutting short-term rates, and vice-versa.

Given the Fed’s pattern of past responses to risk and economic conditions (as embodied in risk-augmented Taylor rules), the implied value of the short term interest rate right now should be somewhere below negative 3.3 percent (actually even lower, since these projections do not reflect the dire recent news). Since interest rates cannot go below zero, the Fed must do something else to boost the economy. The obvious answer is to do everything possible to rekindle the appetite for risk – even if that means taking some of that risk onto the Fed’s balance sheet. This could be accomplished under some interpretations of the still-evolving Term Asset Lending Facility and has already happened in the case of some other, bolder, Fed actions that have been properly viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of the commercial paper market). How much to buy, and which assets to buy, and how to minimize the political risks, are all difficult questions. But the danger of doing too little is far greater, at present, than the danger of doing too much.

The voices that say the Fed should do nothing at all, or nothing beyond perhaps some purchases of longer-dated Treasury securities, are not the voices of reason; they represent a howling dogma that was discredited in 1844 (when the Bank of England received its first implicit authority to intervene during panics; see DeLong (2008)), was discredited again in the panic of 1907, and again during the Great Depression (by being adopted in an extreme form), and is in the process of being discredited yet again today. (In fairness, during ordinary times it is probably wise for the authorities to avoid attempting systematic manipulation of the price of risk, for all the reasons Kindleberger (2005) and Robert Peel (1844) articulated. But this is no ordinary time).

Let’s put it this way: Simple calculations show that the current price of risk as measured by corporate bond spreads amounts to a forecast that about 40 percent of corporate America will be in bond default in the near future.5 The only circumstance under which this is remotely plausible is if government officials turn these dire forecasts into a self-fulfilling prophecy by failing to intervene forcefully in a way that quells the existential terror currently afflicting the markets. While I realize that some economists (and some politicians) might be willing even to undergo another Great Depression as the steep price of clinging to their faith, those of us who do not share that faith should not have to suffer such appalling consequences.

As the Economist magazine might put it, the problem is that the ‘punters’ (investors) who normally populate the financial marketplace and risk their fortunes for the prospect of return, have fled from the field in terror. Back when the financial system was almost entirely based on banks, the solution to such a problem was that the Federal Reserve would act as the ‘lender of last resort’ to quell the panic. In the new financial system where banks are a much smaller share of the financial marketplace than they once were, the Fed’s appropriate new role seems clear: It needs to intervene more broadly than before, in public markets (as has already been done for the commercial paper market) as well as for banks; it needs, in other words, to step up to the plate and become the punter of last resort.

References

Continue reading ""The Judgments of the Market are True and Righteous Altogether"" »

Wednesday, March 11, 2009

Greenspan: The Fed Didn't Do It

Alan Greenspan takes on John Taylor's claim that the Fed caused the housing bubble, and he warns against "micromanagement by government" regulators. Greenspan says the Fed couldn't have caused the housing bubble because it lost control over long-term interest rates once financial markets became globalized, and those were the rates that caused the problem:

The Fed Didn't Cause the Housing Bubble, by Alan Greenspan, Commentary, WSJ: ...The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier...

[T]he presumptive cause of the world-wide decline in long-term rates was the ... surge in growth in China and a large number of other emerging market economies that led to an excess of global ... savings... That ... propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of ... the global housing price bubble. ... I would have thought that ... such evidence would lead to wide support for ... a global explanation of the current crisis.

However, starting in mid-2007, history began to be rewritten, in large part by ... John Taylor... Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust." This notion has ... taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical ... analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover,... the "Taylor Rule" ... parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight. Given the decoupling of monetary policy from long-term mortgage rates,... the Fed ... could not have "prevented" the housing bubble. ...

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

However, the appropriate policy response is not ... heavy regulation. That would stifle important advances in finance that enhance standards of living. ... The solutions for the financial-market failures ... are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities. ... Adequate capital and collateral requirements ... will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management..., while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

We seem to have a disagreement on the scope of regulation. Ben Bernanke:

Bernanke Calls for Broader Regulations, WSJ: Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets... Among his recommendations were tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily. ...

The recommendations were largely consistent with measures being pushed by House Financial Services Committee Chairman Barney Frank (D., Mass.), who is expected to be a key architect of the new financial regulation. ...

Mr. Bernanke ... also pushed for much tougher policies over ... big companies. "Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards," Mr. Bernanke said. ...

I'm in agreement with Greenspan's response to Taylor to the extent that following the Taylor rule wouldn't have stopped the crisis, but I think the low interest rate policy pursued by the Fed is part of the story and served to magnify other factors. As for regulation, relying mainly upon enhanced capital requirements as Greenspan proposes isn't enough, so I'm at least where Bernanke with respect to close supervisory oversight of firms who pose a systemic risk. But I'd go even further and - to the extent possible - break up the firms into smaller entities and sever their interconnections until they no longer posed a threat to begin with. This is harder than it sounds, or so I'm told, but I'd still pursue the option.

Tuesday, February 24, 2009

The Big Break-Up

Simon Johnson:

Privatize The Banks Already, by Simon Johnson: ...In some important and not good ways, we have already nationalized the financial system.

There’s the direct ownership that the government received through TARP and the reupping with Citi, BoA and some others.  These stakes are obviously not (yet) voting stock, but the taxpayer certainly has capital at considerable risk.

Then we have the lines of credit provided by the Federal Reserve which, without a doubt, were instrumental to the survival of almost all major banks during the fall - and arguably remain critical today.  The taxpayer has further downside risk here.

And, most importantly perhaps, we have the expansion of the Fed’s balance...  In effect, the Fed is becoming a commercial bank as well as a central bank. 

The government is essentially taking over the role of intermediation - take funds in and lend them out - for the US economy. This is a form of nationalization, and it will lead to all the lobbying and politically directed credits we have seen in other nationalized financial systems; taking away this credit once the economy starts to recover will not be easy. We have state control of finance without, well, much control over banks or anything else - we can limit executive compensation (maybe) but we don’t get to appoint directors (or replace entire boards) and we have no say in who really runs anything.  Responsibility without power sounds accurate. ...

How then do we really privatize?  By exercising leadership: take over insolvent banks and immediately reprivatize them. ... The taxpayer retains a significant number of shares (or the option to buy common stock) as a way to ensure upside participation...

Above all, we need to encourage or, most likely, force the large insolvent banks to break up.  Their political power needs to be broken, and the only way to do that is to pull apart their economic empires. It doesn’t have to be done immediately, but it needs to be a clearly stated goal and metric for the entire reprivatization process.

No argument here. If there are good reasons to have banks so large their failure could bring down the entire system, a situation that gives them quite a bit of political leverage, I haven't heard them. There are questions about whether having many small banks as opposed to a few big banks reduces systemic risk, and if not, whether having lots of small banks makes policy intervention to stabilize and clean up the system more difficult when problems do arise - having just a few banks might be easier. But breaking up the banks does reduce political and economic power and I see no reason not to make this "a clearly stated goal and metric for the entire reprivatization process."

"The Myth of Simple Market Solutions"

Macroeconomics gets the headlines, especially lately, but there's a lot more to economics than the study of abstract aggregates used as barometers of economic performance. Robert Stavins follows up on his post arguing that market failure is common in the environmental domain with an explanation of why simple solutions to these problems are often inadequate:

The Myth of Simple Market Solutions, by Robert Stavins: I introduced my previous post by noting that there are several prevalent myths regarding how economists think about the environment, and I addressed the “myth of the universal market” ­– the notion that economists believe that the market solves all problems. In response, I noted that economists recognize that in the environmental domain, perfectly functioning markets are the exception, not the rule. Governments can try to correct such market failures, for example by restricting pollutant emissions. It is to these government interventions that I turn this time.

A second common myth is that economists always recommend simple market solutions for market problems. Indeed, in a variety of contexts, economists tend to search for instruments of public policy that can fix one market by introducing another. If pollution imposes large external costs, the government can establish a market for rights to emit a limited amount of that pollutant under a so-called cap-and-trade system. Such a market for tradable allowances can be expected to work well if there are many buyers and sellers, all are well informed, and the other conditions I discussed in my last posting are met.

The government’s role is then to enforce the rights and responsibilities of permit ownership, so that each unit of emissions is matched by the ownership of one permit. Equivalently, producers can be required to pay a tax on their emissions. Either way, the result — in theory — will be cost-effective pollution abatement, that is, overall abatement achieved at minimum aggregate cost.

The cap-and-trade approach has much to recommend it, and can be just the right solution in some cases, but it is still a market. Therefore the outcome will be efficient only if certain conditions are met. Sometimes these conditions are met, and sometimes they are not. Could the sale of permits be monopolized by a small number of buyers or sellers? Do problems arise from inadequate information or significant transactions costs? Will the government find it too costly to measure emissions? If the answer to any of these questions is yes, then the permit market may work less than optimally. The environmental goal may still be met, but at more than minimum cost. In other words, cost effectiveness will not be achieved.

To reduce acid rain in the United States, the Clean Air Act Amendments of 1990 require electricity generators to hold a permit for each ton of sulfur dioxide (SO2) they emit. A robust permit market exists, in which well-defined prices are broadly known to many potential buyers and sellers. Through continuous emissions monitoring, the government tracks emissions from each plant. Equally important, penalties are significantly greater than incremental abatement costs, and hence are sufficient to ensure compliance. Overall, this market works very well; acid rain is being cut by 50 percent, and at a savings of about $1 billion per year in abatement costs, compared with a conventional approach.

A permit market achieves this cost effectiveness through trades because any company with high abatement costs can buy permits from another with low abatement costs, thus reducing the total cost of reducing pollution. These trades also switch the source of the pollution from one company to another, which is not important when any emissions equally affect the whole trading area. This “uniform mixing” assumption is certainly valid for global problems such as greenhouse gases or the effect of chlorofluorocarbons on the stratospheric ozone layer. It may also work reasonably well for a regional problem such as acid rain, because acid deposition in downwind states of New England is about equally affected by sulfur dioxide emissions traded among upwind sources in Ohio, Indiana, and Illinois. But it does not work perfectly, since acid rain in New England may increase if a plant there sells permits to a plant in the mid-west, for example.

At the other extreme, some environmental problems might not be addressed appropriately by a simple, unconstrained cap-and-trade system. A hazardous air pollutant such as benzene that does not mix in the airshed can cause localized “hot spots.” Because a company can buy permits and increase local emissions, permit trading does not ensure that each location will meet a specific standard. Moreover, the damages caused by local concentrations may increase nonlinearly. If so, then even a permit system that reduces total emissions might allow trades that move those emissions to a high-impact location and thus increase total damages. An appropriately constrained permit trading system can address the hot-spot problem, for example by combining emissions trading with a parallel system of non-tradable ambient standards.

The bottom line is that no particular form of government intervention, no individual policy instrument – whether market-based or conventional – is appropriate for all environmental problems. There is no simple policy panacea. The simplest market instruments do not always provide the best solutions, and sometimes not even satisfactory ones. If a cost-effective policy instrument is used to achieve an inefficient environmental target — one that does not make the world better off, that is, one which fails a benefit-cost test – then we have succeeded only in “designing a fast train to the wrong station.” Nevertheless, market-based instruments are now part of the available environmental policy portfolio, and ultimately that is good news both for environmental protection and economic well-being.

Tuesday, February 17, 2009

"The Myth of the Universal Market"

Robert Stavins discusses the conditions required for markets to produce an optimal allocation of resources, and he notes that that "in the environmental domain, perfectly functioning markets are the exception, rather than the rule":

The Myth of the Universal Market, by Robert Stavins: Communication among economists, other social scientists, natural scientists, and lawyers is far from perfect. When the topic is the environment, discourse across disciplines is both important and difficult. Economists themselves have likely contributed to some misunderstandings about how they think about the environment, perhaps through enthusiasm for market solutions, perhaps by neglecting to make explicit all of the necessary qualifications, and perhaps simply by the use of technical jargon.

So it shouldn’t come as a surprise that there are several prevalent and very striking myths about how economists think about the environment. Because of this, my colleague Don Fullerton, a professor of economics at the University of Illinois, and I posed the following question in an article in Nature:  how do economists really think about the environment? In this and several succeeding postings, I’m going to answer this question, by examining — in turn — several of the most prevalent myths.

One myth is that economists believe that the market solves all problems. Indeed, the “first theorem of welfare economics” states that private markets are perfectly efficient on their own, with no interference from government, so long as certain conditions are met. This theorem, easily proven, is exceptionally powerful, because it means that no one needs to tell producers of goods and services what to sell to which consumers. Instead, self-interested producers and self-interested consumers meet in the market place, engage in trade, and thereby achieve the greatest good for the greatest number... This notion of maximum general welfare is what economists mean by the “efficiency” of competitive markets.

Economists in business schools may be particularly fond of identifying markets where the necessary conditions are met, where many buyers and many sellers operate with very good information and very low transactions costs to trade well-defined commodities with enforced rights of ownership. These economists regularly produce studies demonstrating the efficiency of such markets (although even in this sphere, problems can obviously arise).

For other economists, especially those in public policy schools, the whole point of the first welfare theorem is very different. By clarifying the conditions under which markets are efficient, the theorem also identifies the conditions under which they are not. Private markets are perfectly efficient only if there are no public goods, no externalities, no monopoly buyers or sellers, no increasing returns to scale, no information problems, no transactions costs, no taxes, no common property, and no other distortions that come between the costs paid by buyers and the benefits received by sellers.

Those conditions are obviously very restrictive, and they are usually not all satisfied simultaneously. When a market thus “fails,” this same theorem offers us guidance on how to “round up the usual suspects.” For any particular market, the interesting questions are whether the number of sellers is sufficiently small to warrant antitrust action, whether the returns to scale are great enough to justify tolerating a single producer in a regulated market, or whether the benefits from the good are “public” in a way that might justify outright government provision of it. A public good, like the light from a light house, is one that can benefit additional users at no cost to society, or that benefits those who “free ride” without paying for it.

Environmental economists, of course, are interested in pollution and other externalities, where some consequences of producing or consuming a good or service are external to the market, that is, not considered by producers or consumers. With a negative externality, such as environmental pollution, the total social cost of production may thus exceed the value to consumers. If the market is left to itself, too many pollution-generating products get produced. There’s too much pollution, and not enough clean air, for example, to provide maximum general welfare. In this case, laissez-faire markets — because of the market failure, the externalities — are not efficient.

Similarly, natural resource economists are particularly interested in common property, or open-access resources, where anyone can extract or harvest the resource freely. In this case, no one recognizes the full cost of using the resource; extractors consider only their own direct and immediate costs, not the costs to others of increased scarcity (called “user cost” or “scarcity rent” by economists). The result, of course, is that the resource is depleted too quickly. These markets are also inefficient.

So, the market by itself demonstrably does not solve all problems. Indeed, in the environmental domain, perfectly functioning markets are the exception, rather than the rule. Governments can try to correct these market failures, for example by restricting pollutant emissions or limiting access to open-access resources. Such government interventions will not necessarily make the world better off; that is, not all public policies will pass an efficiency test. But if undertaken wisely, government interventions can improve welfare, that is, lead to greater efficiency. I will turn to such interventions in a subsequent posting.

Of course, this point applies generally to all markets, not just those examined by environmental economists. I don't want the government heavily involved in regulating everything, or even most things, but as I have stated here many times, I think we have moved too far toward the "markets can fix everything" attitude, and more could be done and should be done to correct markets that do not satisfy the conditions required to produce optimal outcomes. Despite claims to the contrary, these markets won't fix themselves, at least not within an acceptable time-frame (this is true at the macro level as well), and intervention to push them in the right direction can improve the market's performance and make us better off.

Monday, February 09, 2009

"Countervailing Power Vacuum"

This is my first entry in TPMCafe Book Club's discussion of Eric Rauchway's book, The Great Depression and the New Deal: A Very Short Introduction. Eric's post to start the discussion asked two questions, (1) why was there a Great Depression in the first place?, and (2) what happened to the principle of countervailing power after the New Deal?

Here's the post:

Countervailing Power Vacuum: I want to come back to Eric's first question in a later post, the question of how depressions come about, and turn to his second question, "what happened to the principle of countervailing power after the New Deal? Did it remain a core concept of American politics, and if so, for how long?"

The idea that countervailing power is needed to balance labor markets has faded over time, and I think the movement toward deregulation in the 1970s is part of the reason for this, and that economists were one of the driving forces behind this change. We hear a lot about the role that Nixon and the Republicans played in bringing about a push for deregulation, a push that found success, but we hear less about the role that the economics profession played in setting the stage for the deregulatory phase that began in the 1970s, a phase that continued for decades and has only recently been muted - perhaps - by the present crisis in the US and world economies. Thus, I'd like to focus on changes within economics that set the stage for the anti-union movement and gave intellectual credence to this movement.

Two changes within the profession that provided the intellectual foundation for the deregulatory movement come to mind (and I'll be interested to hear other takes on this). The first big event was the failure of the Keynesian model to provide an adequate framework for understanding and responding to the economic events and turmoil of the 1970s. The model did not have an adequate theory of supply, it had a relatively naive view of expectations, and it did not have much to say about inflation, a key question in the 1970s.

The failure of the Keynesian model left a void in the profession, and it was quickly filled by the Chicago School's New Classical model, a model that dragged a good deal of ideology about government intervention into the public discourse. The model was hailed as a great intellectual and scientific leap forward. It was claimed to have microfoundations unlike it's ad hoc Keynesian predecessor, i.e. it was based upon optimizing behavior of households and firms. In addition, unlike the Keynesian model which simply imposed things like rigid wages without thinking through whether such arrangements were consistent with optimizing behavior, the model was built from the ground up and hence was based upon defensible economic principles. The Keynesian model could not make such a claim (not so for the New Keynesian model used today, microfoundations are one thing that separates the New Keynesian model from the Traditional Keynesian model). And finally, the Keynesian model had a very naive model of expectations that was no match for the rational expectations embedded in the New Classical structure. So Keynesianism, and it's belief that government intervention could make things better, gave way to a new paradigm.

A key element of the New Classical model was its ability to explain why money and output appeared to be correlated in the data without admitting that government intervention could be useful in stabilizing the economy. The ability to explain this correlation was one of the Keynesian model's triumphs over the older Classical model that existed before the New Classical revolution. In the old classical model, money is neutral - it does not change real variables such as output and employment - so prior to the New Classical model, classical economists had a difficult time explaining why money and output appeared correlated (and causal) in the data. The New Classical argument was that any policy that can be anticipated in advance will be offset by private sector responses to the policy - it will be completely ineffective - unless the policy is unexpected. So policy rules that move money in predictable ways - up in recessions, down when there is inflation - will be useless. But if the policy is unexpected, in which case it is non-neutral and does change real output and employment, it makes people worse off rather than better off because it drives us away from the optimal full information solution.

The result of this was the idea that government intervention always makes us worse off. Policy rules don't work, and unexpected random policy is counterproductive. The best thing the government can do is to provide transparent, certain policy so that nothing unexpected ever happens. Best to just let the money supply grow at a fixed, known rate than try to manage the economy by manipulating the money supply. To buttress the result that government intervention was counterproductive, the New Classical economists also began to challenge the idea that fiscal policy could be used as a stabilization tool in place of monetary policy. The government, in this way of thinking, has no business whatsoever intervening in markets. It always makes us worse off, never better off, so the best thing to do is to simply get out of the way and leave it to the private sector to take care of itself.

The other factor was an assault on the idea of monopoly power in markets. For example, one idea that emerged was the idea was that markets, even markets that looked relatively concentrated, were actually quite competitive, i.e. they were contestable. That is, as soon as a firm in a top heavy industry begins trying to exploit its monopoly power, even when it is the sole or one of the few producers in markets, another firm waiting in the wings will quickly enter and contest the market (the nature of capital is important here, it needs to be able to move into these markets quickly). This discipline by the firms waiting to pounce at the first opportunity, it was believed, was sufficient to ensure that markets that appeared highly concentrated would in fact be competitive in terms of pricing and other behavior. (Globalization of markets was another factor that led people to discount market power at the firm level.)

I don't want to oversell the contestable markets story, it was but one of many developments, but the point I am making is that there was widespread belief that markets that appeared to be quite top heavy were, in fact, quite competitive. And, importantly, if they weren't competitive, an automatic self-correction mechanism would take care of the problem, there was no need for government to do anything, natural forces would intervene as needed and solve the problem.

The point, then, is that economists by and large began to believe that markets were self-correcting, even with respect to monopoly power, and anything governments do, from intervening to break up monopolies to supporting union power, gets in the way of this natural, self-correction process. Thus, unions were not needed as a countervailing force, markets would take care of the problem until there was nothing left to countervail, i.e. markets would naturally produce a competitive marketplace. All government had to do was step aside and watch the magic happen. Market power was bad, whether it be in the hands of firms or workers, and since firms operated in competitive markets, there was no need for unions to balance power. They would just make things worse by causing departures from competitive ideals and making it harder for business to compete in world markets.

We have now observed how well the idea of self-correction and self-regulation worked in financial markets - it didn't work well at all - and I see no reason why it should work any better in bringing about a competitive labor market where one does not exist previously. I don't think the self-correction ideas lived up to their promise, there was and still is an imbalance of power in labor markets with firms surely having the upper hand, and some means of balancing the negotiations between laborers and firms is needed. The only question for me, and it's one I don't have the answer to, is whether the old institutional structure supporting unions is the best possible institutional structure going forward in a highly globalized, interdependent, and flexible world economy. I'm not sure that it is, but I do believe that more balance is needed in labor markets, and until we have something better, unions will certainly more than suffice.

[Note: I'm not sure this is the main reason behind the change, so please feel free to offer other theories for the decline of the principle of countervailing power.]

Tuesday, January 27, 2009

Woodard and Hall: What to do about Fannie Mae and Freddie Mac?

Susan Woodard and Robert Hall on what should happen to Fannie and Freddie:

What to do about Fannie Mae and Freddie Mac?, by Woodard and Hall: Here are our recommendations. A discussion follows.

  1. The GSEs should be preserved, mainly because they are the most effective institutions for providing liquidity to the mortgage market.  Most mortgage investors, including depositories, prefer to hold liquid securities rather than illiquid whole loans. Wall Street securitization is not a substitute.
  2. Fannie and Freddie should be chartered as special-purpose banks, playing their historical roles of securitizing mortgages and holding some portfolio of loans.  Their debt should be federally insured or guaranteed, as are the deposits of banks, and as with banks, the equity of the institutions should be the first backup to bondholders as the capital (or equity) of banks is the first backup to deposits. Their insured or guaranteed debt should not be counted as part of federal debt, as the insured deposits of banks are not. They should be subject to capital standards and supervision of their activities, and subject to restrictions on their activities, like banks.  The capital standards, activity restrictions, and supervision need not be identical to those of banks.
  3. It is important to have two GSEs to assure competitive pricing of the guarantees on mortgages which go into MBS pools.  Guarantee fees are not posted prices, but negotiated in secret.  As a result, the pricing of guarantee fees is not collusive but  close to perfect (Bertrand) competition with two GSEs. In the trade-off of standardization and homogeneity to promote liquidity (which calls for fewer GSEs) vs. competition to assure competitive pricing (which calls for more), two gets an excellent result, likely the best result.
  4. There are three choices for F&F ownership:  1) owned by the government, like FHA and Ginnie Mae; 2) owned as a cooperative, by member institutions, as both once were, and 3) owned by the general public. Fannie and Freddie should be owned by public shareholders, as banks are.  We advocate ownership as public companies, but with explicit and priced federal backing, like banks.

[full analysis]

[Update: Arnold Kling comments on Woodard and Hall's analysis (agrees) and policy proposals (disagrees).]

[Update: See also On the GSEs (again), by Richard Green.]

Saturday, January 24, 2009

"How Cronyism and Rent-Seeking Replaced 'Creative Destruction'"

Eliot Spitzer:

America's Fear of Competition, by Eliot Spitzer, Commentary, Slate: Although everybody claims to love the market, nobody really likes the rough-and-tumble of competition that produces the essential "creative destruction" of capitalism. At bottom, this abhorrence of competition and change are the common theme that binds together the near death of the American car industry, the collapse of the credit market, the implosion of the housing market, the SEC's disastrous negligence, the Madoff Ponzi scheme, and the other economic catastrophes of recent months.

Consider the examples of the SEC and GM, which would appear to have nothing to do with each other. The traditional critiques of the SEC have been that it was underfunded and didn't have up-to-date laws needed to regulate sophisticated financial transactions in evolving markets. That's not accurate. The SEC is a gargantuan bureaucracy of 3,500 employees and a budget of $900 million... And the ... powers of the SEC are so broad that it needs no additional statutory power to delve into virtually any market activity that it suspects is improper, fraudulent, or deceptive. ... The SEC has all the money and people and laws it needs. For ideological reasons, it just didn't want to do its job, and on the rare occasions when it did, it didn't know how.

GM's excuses—that its UAW contract and health care costs make it too top heavy to compete—are partially true but ignore a simple reality: These are the self-inflicted wounds of a company that chose a path of least resistance rather than confront the need for dynamism and innovation. ... The auto industry preferred protection to competition. And when it had to compete, it wasn't up to the task.

Both the SEC and GM refused to adapt from the world of the last century to the more dynamic new millennium. Each reacted the same way to competition: Instead of improving its product, it played defense. ... No one at the SEC seemed to ask the most important question: Given how the market is changing, what should we change to insure the integrity of the capital markets?

Instead, the SEC spent its energy preventing others from doing the work it should have done. Using the rather arcane doctrine of pre-emption, the SEC fought in the courts and on Capitol Hill to keep other enforcers at bay: Apparently, worse than having fraud in the marketplace was the possibility that an entity other than the SEC would appear to be more effective than the SEC at finding it.

For both the SEC and the auto industry, Congress was a place to find protection from meaningful competition. Each used its bureaucratic clout to insulate itself from the pressures of capitalism. ...

The result has been unfortunate: Over and over, we supplied the protection from needed change that these entities desired. Then, when the going got tough, neither the SEC nor GM was up to the task. By preventing the stern taskmaster of competition from forcing adaptation, we became complicit in their becoming dinosaurs. ... Both GM and the SEC need to see a change in market conditions as an opportunity—not a challenge to market share.

We must rebuild these two institutions. If we don't infuse them with a culture of change and love of competition, they will fail once again. ... This is a unique opportunity for President Obama and the Congress to take two seemingly different entities and force them to play by the real rules of capitalism...

Congress and the executive branch have, to a considerable extent, been devoted to business interests in recent years. In essence the argument is that what's good for business is good not just for America, but for the whole world. The ideological basis for this approach is that the interests of business and of greater society always coincide so that maximizing business interests maximizes social benefits at the same time, and that a hands off approach from government is the best way to allow those coincident interests to express themselves.

Unfortunately, however, this ideological foundation incorporated a flawed understanding of the interaction between market structure and social benefits, particularly the ability of markets to self-correct when the market structures deviate from the socially optimal structure. The result of this, particularly as it came to be applied in the political arena, contributed to the existence of cronyism, rent-seeking, institutions that became too big, interconnected, and too powerful to fail, and other problems. Political power combined with rigid ideology built upon a false premise - the doctrine of immediate self-correction by markets - gave us a result that was far from the competitive ideal presented in textbooks, a world that was far from the ideal competitive model that produces such large benefits for society.

I think there is some understanding that the approach of the past did not work, with the current state of the economy it's hard to argue that it did, and that we need to go in a new direction. And I'm sure we will try. But I wonder, when all is said and done, will anything really change?

Thursday, January 22, 2009

Tax Cuts, Government Spending, Public Goods, and the Stimulus Package

Tax cuts won't build schools, or any other public good.

And right now, with so much of our infrastructure in need of attention, we need public goods.

We tried the tax cut approach to stimulating the economy once, we had no choice since Bush and the Republicans would not have passed any other type of stimulus package.

Guess what? It didn't work very well, and we have little to show for it. Had we, say, rebuilt water systems instead, at the very worst we'd have better water. That's not so bad in any case.

And it's been interesting, if that's the right word, to watch the same people who delayed fiscal policy for months and months and months as they insisted that we try tax cuts first now tell us that it will take too long to put the spending in place. They don't seem to realized that's because of their insistence on the use of tax cuts rather than spending. If we had started on these projects a year ago instead of enacting the tax cut package to appease the right, timeliness would not be such an issue - we might already be repairing sewage systems, rebuilding roads, and so on. I've even heard some who ought to know better argue that because forecasts say the recession will end soon, we can't possibly get the spending in place soon enough. That is, they argue that by the time the spending hits the economy, the economy will have already recovered (these are often the same people who reassured us that there was no housing bubble, and there was not worry anyway because the recession, if it hit at all, would be very mild and easily absorbed by our dynamic, flexible economy). Never mind that forecasts beyond around six months ahead are not much better than a coin flip, and they know it, some forecast somewhere says that the recession will end before spending is in place, and that's enough for them to take the argument public. What if the forecast is wrong?

It's not completely clear to me that the fact that the recession might end soon undercuts the case for government spending anyway. If the money is spent on large, socially beneficial projects - and lots of infrastructure comes under this heading - then so what if the economy recovers? These are things we very much need, and that won't change just because the economy is doing better. There will be net benefits no matter the state of the economy, but the net benefits will be higher if we pursue these projects when the costs are low. If we are lucky, and the economy recovers very fast, much faster than expected, then there will still be benefits, they just won't be as large.

We need to do these things, and right now, with so many idle resources in the economy, the opportunity cost of employing resources is low. For this reason, this is an opportune time to meet the challenges that we face in repairing the infrastructure and in meeting other needs that are critical to maintaining robust economic growth, and in maintaining our health and welfare.

The tax cuts are better than spending proponents generally ignore public goods when they argue that the private sector is always better at spending money, but it seems to me that leaves out an important part of the argument.

If the argument that the private sector is more efficient than government always prevailed, we wouldn't have any public goods at all, and that's not an economy I'd want to live in. Obviously, there are times when spending on public goods is justified economically, and I'd argue strongly that this is one of those times, i.e. that there are lots of places the government can spend money that have large social returns. Why would we want to wait until the opportunity cost is very high to reap these returns instead of pursuing these projects now when the cost is lower? If we are going to have to make these expenditures anyway, it doesn't make any sense to wait.

And one last question. The tax cuts are best crowd argues that government makes poor spending decisions, and this is one of their key objections to spending measures. But doesn't government make bad tax decisions too? The tax cut advocates like to promote some tax they've designed that has wonderful properties on paper, and sounds great on the editorial page, but it's just as easy to do that with fiscal policy. If you don't have to confront the reality of the legislative process, and you are free to argue from a theoretical perspective instead, not a dollar will get wasted. But as we saw during the first fiscal stimulus attempt, the one where the "it has to be tax cuts or nothing" types prevailed, the tax cuts that were actually enacted were far from optimal, and there was quite a bit of disappointment in the actual tax cut package that was put into place. And perhaps because of that, the tax cuts had less effect than hoped. I know that the tax cut advocates say that this time government needs to do it right, and they have lots of advice about what "right" is, but, really, given the realities in congress, what makes them think this time will be any different?

Tax cuts won't build schools.

Update:

War and non-remembrance, by Paul Krugman: As I’ve already pointed out,the prospect of a Keynesian stimulus is having a weird effect on conservative economists, as first-rate economists keep making truly boneheaded arguments against the effort.

The latest entry: Robert Barro argues that the multiplier on government spending is low because real GDP during World War II rose by less than military spending.

Actually, I’ve already taken that one on. But just to say it again: there was a war on. Consumer goods were rationed; people were urged to restrain their spending to make resources available for the war effort.

Oh, and the economy was at full employment — and then some. Rosie the Riveter, anyone?

I can’t quite imagine the mindset that leads someone to forget all this, and think that you can use World War II to estimate the multiplier that might prevail in an underemployed, rationing-free economy.

Tuesday, January 20, 2009

"Models of Bounded Rationality and the Credit Environment"

When I talk about the need for government intervention in the marketplace, the justification for the intervention usually relies upon the presence of substantial market failures of one sort or another. However, as Robert Waldmann often points out in comments to those posts, government intervention can be justified in other ways besides the traditional list of market failures, e.g. the presence of dynamically inconsistent preferences can be used to justify forced saving for retirement. The discussion below looks at how governments ought to respond to the current problems in the economy if a key assumption of economic models, rationality, is dropped and replaced with an assumption that agents have bounded rationality:

Models of bounded rationality and the credit environment, by Leigh Caldwell, voxeu.org: Responses to the recession should not be based on unrealistic expectations of rational behaviour. We now know enough about real, flawed human psychology to be able to take some account of it in policy setting.

The “homo economicus” model of rational agents, acting to maximise utility in the possession of all available information, is not realistic. It is hardly a credible way to look at human beings – but we tolerate it because it is simple enough to allow equilibrium analysis which often gives reasonable predictions.

However, these equilibrium models are not serving very well in today’s situation. Standard monetary policy and (to a lesser extent) Keynesian theories are based on rational-actor assumptions. They give broad recommendations about monetary loosening and fiscal expansion – which central banks and governments are rightly trying out. But growth is not resuming.

Bounded rationality is the broad term for behavioural models that do not follow the rational-maximiser formula. There is not yet a generally accepted alternative model. Lots of individual non-rational behaviours have been discovered, but they are grafted onto a rather clunky ‘rational actor with bits’ instead of forming a coherent behavioural model.

However, the best place to test a new theory is often at the edges of the old one, where the existing model breaks down. So the current troubles in the financial and real economy may be a good opportunity to try out some alternative models and see which give a reasonable description of what we see.

Models of bounded rationality

Different models of bounded rationality vary basic assumptions of the rational agent model in different ways. Some of those assumptions are:

Continue reading ""Models of Bounded Rationality and the Credit Environment"" »

Sunday, January 18, 2009

Shiller: A Stimulus for Financial Advice?

Robert Shiller says we need to provide subsidized financial advice:

How About a Stimulus for Financial Advice?, by Robert Shiller, Economic view, NY Times: In evaluating the causes of the financial crisis, don’t forget the countless fundamental mistakes made by millions of people who were caught up in the excitement of the real estate bubble, taking on debt they could ill afford.

Many errors in personal finance can be prevented. But first, people need to understand what they ought to do. The government’s various bailout plans need to take this into account — by starting a major program to subsidize personal financial advice for everyone.

A number of government agencies already have begun small-scale financial literacy programs. ... But a much more ambitious effort is needed.

Continue reading "Shiller: A Stimulus for Financial Advice?" »

Wednesday, January 14, 2009

Too Big Not To Break Up

I'm just catching up with this news:

Here We Go Again..., by James Kwak: The Wall Street Journal (...shorter Bloomberg article here) is reporting that Bank of America will receive billions of dollars more in government aid, probably in a deal that looks something like the second Citigroup bailout, ostensibly to help absorb losses incurred by Merrill Lynch since the acquisition was negotiated in September but more generally to shore up B of A’s increasingly shaky balance sheet. At least someone involved knows how this looks: the reports say the deal will be announced on January 20 - yes, the day of Barack Obama’s inauguration - thereby keeping it from being the main story of the day.

It looks bad for all sorts of reasons:

  • Wasn’t B of A supposed to be a healthy bank? Isn’t Ken Lewis (CEO) the person who told Henry Paulson he didn’t need the first round of TARP money, but he would take it to show solidarity and for the public good?
  • The money is going to finance an acquisition? Isn’t that the thing that (according to most people) banks aren’t supposed to be doing with their bailout money?
  • The B of A-Merrill deal closed on January 1. So it looks like - as the WSJ is reporting - the deal only closed because Treasury gave B of A a verbal commitment to supply the needed bailout money later.
  • Isn’t this more policy by deal?

That said, I think some sort of deal has to be done. Even Yves Smith at naked capitalism (one of the most consistent and sharp critics of the way TARP has been implemented), who says this deal “stinks to high heaven,” says that “Merrill is a systemically important player” and “letting the deal with BofA ‘fail’ is a non-starter.” But I predict that when the terms are announced I will think they are too generous...

[O]ne price we are paying in these bailouts is the creation of a new tier of mega-banks that, because they are Too Big To Fail, have the competitive advantage of being essentially government-guaranteed. What we really need as a condition on TARP money is a new regulatory structure to make sure that these mega-banks do not abuse the oligopolistic position we have just handed them, and perhaps a commitment to break them up when economic circumstances allow. That would be considerably more valuable than a cap on executive salaries and corporate jets. But it will also be a lot more difficult to define and to agree on.

One thing, I would take the word "perhaps" of "What we really need as a condition on TARP money is ... perhaps a commitment to break them up when economic circumstances allow." These banks are too big not to break up, so unless there are very good reasons to allow them to remain so large, and I haven't heard them, then they need to be downsized. (And if such arguments do exist, these institutions need to be regulated much more than they have been in the past, much as we do - or ought to do - with other non-competitive markets.)

Tuesday, January 06, 2009

"Adding a Trillion Dollars in Debt is Quite Manageable"

This is from an interview of Kenneth Rogoff:

...The Long-Term Consequences of Debt
Region:
Well, let's talk about the U.S. debt and its long-term consequences, in the context of the current economic crisis. The Stabilization Act authorizes $700 billion, some of which will contribute to the growth of national debt. Economists such as NYU Professor Nouriel Roubini suggest $2 trillion …

Rogoff: I have, as well, suggested $1 trillion to $2 trillion.

Region: Yes, I think up to $2 trillion "to fix the system" are your words.

Rogoff: That is because the bailout process is just at the beginning. Look at history. Carmen and I have a paper coming out ... looking at the aftermath of banking crises. We argue that it is highly misleading to look at reported ex post fiscal costs because these are subject to a great deal of accounting manipulation and typically do not reflect true economic costs. If, instead, one looks at things that are less manipulable, like the run-up in public debt, it's clear that the costs of a financial crisis are just staggering.

For example, even though this interview won't be published for a couple of months, I think it's safe to say there'll be a huge stimulus package, some of it surely dissipative. We'll probably bail out the mortgage holders before this is over, some large class of them. Auto companies, municipalities and so on.

Perhaps the costs will be less. But I doubt it.

Region: And the long-term growth consequences of that additional debt?

Continue reading ""Adding a Trillion Dollars in Debt is Quite Manageable"" »

Saturday, January 03, 2009

Should Executive Pay be Capped?

Robert Frank argues against capping executive pay (with one exception). He says that a high marginal tax rate is a better option:

Should Congress Put a Cap on Executive Pay? , by Robert Frank, Commentary, NY Times: It's no wonder that voters’ outrage over exorbitant executive pay is mounting. After all, the government just had to bail out financial firms that paid big bonuses last year to many ... executives who helped precipitate the current financial crisis.

Nor is it any wonder that Congress is considering measures to limit executive pay... One popular proposal would cap the chief executive’s pay ... at 20 times its average worker’s salary. But while Congress may well have compelling reasons to limit executive pay in companies seeking bailout money, voter anger is not a good reason to extend pay caps more generally.

To be sure, executive pay in the United States is vastly higher than necessary. Executives in other countries, whose pay is often less than one-fifth that of their American counterparts, seem to work just as hard and perform just as well. ...

So why not limit executive pay? The problem is that although every company wants a talented chief executive, there are only so many to go around. Relative salaries guide job choices. If salaries were capped at, say, $2 million annually, the most talented candidates would have less reason to seek the positions that make best use of their talents.

More troubling, if C.E.O. pay were capped and pay for other jobs was not, the most talented potential managers would be more likely to become lawyers or hedge fund operators. Can anyone think that would be a good thing?

In large companies, even small differences in managerial talent can make an enormous difference. Consider a company with $10 billion in annual earnings that has narrowed its C.E.O. search to two finalists. If one would make just a handful of better decisions each year than the other, the company’s annual earnings might easily be 3 percent — or $30 million — higher...

Critics complain that executive labor markets are not really competitive — that chief executives appoint friends to their boards who approve unjustifiably large pay packages. But C.E.O.’s have always appointed friends, so that can’t explain recent trends.

One reason for these trends is that companies themselves have become bigger. ... Beyond growth in company size, executive mobility has also increased. In past decades, about the only way to become a C.E.O. was to have spent one’s entire career with the company. ... Increasingly, however, hiring committees believe that a talented executive from one industry can also deliver top performance in another. ... This new spot market for talent has affected executive salaries in much the same way that free agency affected the salaries of professional athletes.

If the market for executive talent is competitive, critics ask, why are C.E.O.’s in an industry paid about the same, regardless of performance? That’s because no one knows with certainty how a particular executive will perform. ... Executives whose record predicts good performance command a high rate. Their leash, however, has grown shorter. In the past, a C.E.O. could often stay in the job for many years despite lackluster performance. Today, a C.E.O. who fails to deliver is often dismissed after a year or two.

In short, evidence suggests that the link between pay and performance is tighter than proponents of pay caps seem to think. Since the fall of the former Soviet Union, no one has seriously challenged the wisdom of relegating a high proportion of society’s most important tasks to private markets. And the market-determined salary of a job generally offers the best — if imperfect — measure of its importance.

The financial industry, however, may be an exception. A money manager’s pay depends ... on the fund’s rate of return relative to other funds. This provides strong incentives to invest in highly leveraged risky assets, which yield higher average returns. But as recent events have shown, these complex assets also expose the rest of us to considerable systemic risk.

On balance, then, the high pay that lures talent to the financial industry may actually cause harm. So if Congress wants to cap executive pay in financial institutions receiving bailout money, well and good.

Elsewhere, however, the more prudent response to runaway salaries at the top is to raise marginal tax rates on the highest earners, irrespective of occupation. Again, relative salaries drive job choices. The jobs with the highest pretax salaries will still offer the highest post-tax salaries, just as before, so this step will not compromise the price signals that steer talented performers to the most important jobs. ...

When I look at these markets and ask if the conditions for competitive markets are satisfied, conditions like free entry, homogeneous products (as opposed to "small differences in managerial talent [that] can make an enormous difference"), perfect information about product quality (as opposed to "no one knows with certainty how a particular executive will perform"), it doesn't seem to me like they are. So even with "free agency," I don't think the market necessarily provides the correct economic incentives, i.e. the correct relative prices (of, say, executive salaries relative to the salaries of painters). If this is true across the board for high salaries whether or not they are executives, for the most part anyway, then differential treatment of high incomes is not warranted. But the fact that these salaries are "vastly higher than necessary" does mean that a high marginal tax rate can be used to overcome the distortions that the higher than necessary salaries bring about. So in this case the tax would not be creating a distortion, it would be correcting one.

Since part of the column talks about the growth in executive salaries in recent years, it's probably also useful to note that much of the change in the distribution of income recently has been driven by high salaries in the financial services industry (and the vaunted spot market spread this huge distortion to other markets by raising compensation generally). Saying that these salaries - which were based upon bubble values rather than underlying fundamentals, and which put upward pressure on executive pay generally - provide the correct economic incentives is, it seems to me, hard to defend.

Saturday, December 20, 2008

"A Solution to the Principal-Agent Problem"

How to solve the moral hazard problem involved in body swapping:

The Bible Meets Science Fiction: A Solution to the Principal-Agent Problem, Suggested by Lawrence H. Officer, JPE Back Cover, vol. 110, no. 1: “Next, you and the Martian Gentleman will both sign a Reciprocal Damage Clause. This states that any damage to your host body, whether by omission or commission, and including Acts of God, will, one, be recompensed at the rate established by interstellar convention, and, two, that such damage will be visited reciprocally upon your own body in accordance with the lex talionis.

“Huh?” Marvin said.

“Eye for eye, tooth for tooth,” Mr. Blanders explained. “It's really quite simple enough. Suppose you, in the Martian corpus, break a leg on the last day of Occupancy. You suffer the pain, to be sure, but not the subsequent inconvenience, which you avoid by returning to your own undamaged body. But this is not equitable. Why should you escape the consequences of your own accident? Why should someone else suffer those consequences for you? So, in the interests of justice, interstellar law requires that, upon reoccupying your own body, your own leg be broken in as scientific and painless a manner as possible.”

“Even if the first broken leg was an accident?”

Especially if it were an accident. We have found that the Reciprocal Damage Clause has cut down the number of such accidents quite considerably.” [Robert Sheckley, Mindswap (New York: Dell, 1966), p. 17.]

Instead of borrowing somebody's body, Wall Street borrows their money. But when they do the equivalent of breaking your leg - when they damage the deposits they are holding - they don't always suffer any consequences. In fact, many of them get to keep the large bonuses they earned for managing the money so poorly, e.g. see Krugman's latest column. A broken leg clause is a bit on the thuggish side, of course, financial penalties are more acceptable, but this does make clear the need for money managers to "feel your pain" in order to get the incentives correct.

Thursday, December 11, 2008

Is a Bonus Culture Ruining Africa and Our Financial System?

Paul Collier says high compensation doesn't necessarily bring out the best in those receiving it:

A bonus culture that ruined the City is also ruining Africa, by Paul Collier, Comment is Free: The financial crisis in the developed world and the long, slow crisis of African governance have one feature in common: what economists coyly term "high-powered incentives". The financial crisis was the consequence of management decisions... For decades people in these positions had behaved prudently, which is why their businesses built up good reputations. Why was the behaviour of the present vintage so different? The answer is the introduction of high-powered incentives - or, more intelligibly expressed, obscenely large payments tied to some specified performance. The theory is that such incentives overcome problems of managerial shirking and niceties such as putting the workforce's interests before those of shareholders.

This simple theory provided the intellectual veneer for grotesque greed: high-powered incentives are, in reality, very damaging. And I have watched them wreak havoc in the apparently very different context of African politics. The bonuses Africa's leaders pay themselves are sizable even by the breathtaking standards of the developed world; like financial managers, the politicians have a massive incentive to achieve the performance benchmark. In the financial sector the benchmark has been quarterly measured profits; in Africa it has been winning an election.

Continue reading "Is a Bonus Culture Ruining Africa and Our Financial System?" »

Wednesday, November 26, 2008

Fed Intervention: Managing Moral Hazard in Financial Crises

"Moral hazard has its costs, but it also has its benefits":

Fed Intervention: Managing Moral Hazard in Financial Crises, by Harvey Rosenblum, Danielle DiMartino, Jessica J. Renier and Richard Alm, Economic Letter, FRB Dallas: Editor’s note: Federal agencies and regulators have taken decisive steps to combat the financial crisis that began in the summer of 2007 and continued into the fall of this year. This Economic Letter focuses on key Federal Reserve actions through early October.

At the end of September 2008, U.S. policymakers had been working for more than a year to contain the shock waves from plunging home prices and the subsequent financial market turmoil. For the Federal Reserve, the crisis has given new meaning to the adage that extraordinary times call for extraordinary measures. The central bank has dusted off Depression-era powers and rewritten old rules to address serious risks to the global financial system.

The spreading financial crisis has led the Fed to pump liquidity into the economy and expand its lending beyond the commercial banking sector. In March, it assisted with J.P. Morgan Chase’s buyout of Bear Stearns, a cash-strapped investment bank and brokerage. Six months later, the Fed took direct action again, with an $85 billion bridge loan to prevent the disorderly failure of American International Group (AIG), a giant global company heavily involved in insuring against debt defaults.[1]

These Fed actions—part of a broader U.S. government effort to contain the financial crisis—call to mind two earlier financial interventions: in the case of Long-Term Capital Management (LTCM) in 1998 and in the aftermath of the Sept. 11, 2001, terrorist attacks.

In both episodes, the Fed felt compelled to protect the financial system from severe shocks and the overall economy from spillovers that might produce serious downturns. Inherent in the Fed’s moves was a natural by-product of intervention—moral hazard and the controversy that flows from it.

Concern about moral hazard helps explain why the Fed has traditionally intervened only rarely and reluctantly, trying to do what’s necessary, but as little as necessary, to achieve financial stability. Markets generally should and do self-correct. When potential financial problems arise, the Fed’s default reaction has usually been to do nothing and let the markets work their way through the difficulties.

On rare occasions, however, the markets themselves are at risk of failure. In such cases, the Fed can’t fulfill its obligation to promote financial stability without direct action. Two factors have strengthened the case for central bank intervention in the past decade—the financial system’s increased globalization and the untested nature of the new and complex financial instruments that have come under stress.

The escalation of what’s now recognized as a global financial crisis has changed the modus operandi of Fed interventions. The guiding principle of do what is necessary, but as little as necessary, has been replaced by the recognition—reinforced by actions—of the importance of doing whatever it takes to break the downward spiral in the financial and credit markets that has contaminated the overall economy. With a broad understanding of the consequences of inaction, the Fed has taken a hard turn toward intervention in an atmosphere in which fear of moral hazard has been displaced by the reality of systemic risk’s unacceptable consequences.

Continue reading "Fed Intervention: Managing Moral Hazard in Financial Crises" »

Sunday, November 23, 2008

"The Moral Dimension of Boom and Bust"

"This monstrous conceit of contemporary economics has brought the world to the edge of disaster":

The moral dimension of boom and bust, by Robert Skidelsky, Project Syndicate: After the first world war, HG Wells wrote that a race was on between morality and destruction. Humanity had to abandon its warlike ways, Wells said, or technology would decimate it.

Economic writing, however, conveyed a completely different world. Here, technology was deservedly king. ... In the economists' world, morality should not seek to control technology, but should adapt to its demands. Only by doing so could economic growth be assured and poverty eliminated.

We have clung to this faith in technological salvation as the old faiths waned and technology became ever more inventive. Our belief in the market – the midwife of technological invention – was the result. We have embraced globalisation, the widest possible extension of the market economy.

For the sake of globalisation, communities are denatured, jobs offshored, and skills continually reconfigured. We are told by its apostles that the wholesale impairment of most of what gave meaning to life is necessary to achieve an "efficient allocation of capital" and a "reduction in transaction costs". Moralities that resist this logic are branded "obstacles to progress". ...

That today's global financial meltdown is the direct consequence of the west's worship of false gods is a proposition that cannot be discussed, much less acknowledged. One of its leading deities is the efficient market hypothesis – the belief that the market accurately prices all trades at each moment in time, ruling out booms and slumps, manias and panics. Theological language that might have decried the credit crunch as the "wages of sin", a comeuppance for prodigious profligacy, has become unusable. ...

Mathematical whizzkids developed new financial instruments, which, by promising to rob debt of its sting, broke down the barriers of prudence and self-restraint. The great economist Hyman Minsky's "merchants of debt" sold their toxic products not only to the credulous and ignorant, but also to greedy corporations and supposedly savvy individuals.

The result was a global explosion of Ponzi finance ... which purported to make such paper as safe and valuable as houses. ...

The key theoretical point in the transition to a debt-fuelled economy was the redefinition of uncertainty as risk. Whereas guarding against uncertainty had traditionally been a moral issue, hedging against risk is a purely technical question.

Continue reading ""The Moral Dimension of Boom and Bust"" »

Wednesday, November 12, 2008

"The Only Politically Feasible Approach"

A call for "a comprehensive, upstream cap-and-trade system" to combat climate change:

Inspiration for climate change, by Robert N. Stavins, Commentary, Boston Globe: ...Will the environment and energy team of President-elect Obama respond effectively to the serious challenges that lie ahead? ... Ultimately, will Obama work with Congress to develop climate strategies that are scientifically sound, economically sensible, and thereby politically pragmatic? Will he take on the difficult task of crafting meaningful climate legislation?

The only politically feasible approach that can make a real dent in the problem is a comprehensive, upstream cap-and-trade system to reduce carbon dioxide emissions 50 to 80 percent below 1990 levels by 2050. The declining cap will increase the cost of polluting, thereby discouraging the use of the most carbon-intensive fossil fuels and providing powerful incentives for energy conservation and technology innovation.

The system could start with a 50-50 split of auctioned and free allowances, gradually moving to 100 percent auction over 25 years. To establish political support in the short term, free allowances should be targeted to sectors that are most burdened by the policy. And the auction revenue which will increase over time can be used to compensate low-income consumers...

The best option may be to make the program revenue-neutral by returning all auction revenue to citizens through direct cash dividends or annual tax credits. This can go a long way toward making the legislation palatable to Republicans and Democrats alike who are reticent to take any actions that even resemble a tax increase.

By making the overall emissions cap gradually become more stringent over time, costs can be greatly reduced by avoiding premature retirement of existing capital stock, reducing vulnerability to siting bottlenecks, and ensuring that long-lived capital investments incorporate appropriate advanced technology.

Still, the costs of meaningful action will be significant, with impacts on gross domestic product eventually reaching up to 1 percent per year. ...

The bottom line is that getting serious about global climate change will not be cheap or easy. Beware of claims to the contrary. But if the current state-of-the-science predictions about the consequences of another few decades of inaction are correct, this defining moment provides an important opportunity for serious and sensible action.

Is a carbon tax out of the question?

"Reluctance to Invest in Long-Lived Plant and Equipment"

Michael Perelman:

Why Markets Fail, by Michael Perelman: Markets fail for many reasons. With all the attention to the current financial crisis, the time has come to look at another part of market failure -- the reluctance to invest in long-lived plant and equipment. I'm not merely thinking about the deindustrialization of the US economy, but a more general reluctance. The commitment of funds for fixed capital entails taking a risk. In the words of John Hicks, one of the earliest economists to win a so-called Nobel Prize, pointed to the obvious problem: "an entrepreneur by investing in fixed capital gives hostages to the future" (Hicks 1932, p. 183). Unfortunately, neither Hicks nor virtually any other economist has explored this fear of investment.

The most popular response to this reluctance to invest came from a very conservative Austrian economist, who once served as a socialist minister of finance, before landing at Harvard. Joseph Schumpeter was indeed one of the giants of 20th century economics. Here his reputation to his personal brilliance, as well as a willingness to learn from Karl Marx.

Schumpeter was no Marxist. In fact, he boasted that he was going to turn Marx on his head, just as Marx had done to the German philosopher Hegel. During the dot.com era, Schumpeter may have been the most commonly mentioned economist, not among the living. What won the affection of those who saw the Internet as completely revising the nature of capitalism was a single phrase coined by Schumpeter -- creative destruction.

The idea was that when the economy became sluggish, new innovations would be so profitable that investors would rush in and build up whole new industries. In doing so, they would destroy existing industry, but the net effect was to enliven enliven the entire economy. For Schumpeter, this creative destruction was the lifeblood of capitalism.

Schumpeter liked to use transportation as a dramatic example of creative destruction. In the 19th century, an important German economist, Johann Heinrich von Thuenen loaded a standard wagon with a standard load of grain, hitched up 2 horses, and had 2 farm workers drive the wagon as far as they could go, feeding themselves and the horses on the grain. Theoretically, the wagon could go about 230 miles on a road running through a flat plain before the humans and animals consumed all the grain, which was their only source of energy. In practice, the limit was 20 miles.

Canals slashed the cost of transportation, while setting off an economic boom. Railroads followed with another revolution in transportation, setting off another boom. Finally, the internal combustion engine allowed trucks to haul freight with even more savings, creating still another boom.

But wait! Where are the entrepreneurs? Government, not entrepreneurs, provided the wherewithal for these transportation revolutions. Governments built the canals. Governments finance the railroads with land grants and other subsidies. Governments built the highways that made possible freight hauling by trucks. Schumpeter could not have chosen a more perfect example. Entrepreneurs have good reason not to make such investments. Industries that depend on capital-intensive plant and equipment have difficulty withstanding strong competition, which forces prices down near the cost of production. But, as any introductory economics text explains, previous investments are not part of the cost of production. Unless prices are far in excess of the cost of production, businesses with long-lived capital will be unable to recoup the cost of its investment.

Just as Microsoft would not recover its cost of developing its software code if it sold its software for little more than it costs to embed it on a CD, railroads fold under intensive competition. Indeed, during the 19th century, railroads went bankrupt with some regularity, much like the airlines today. But investment creates jobs that create the demand they keep the rest of the economy going. Spurts of sound investment occur after wars or depressions wipe out large swaths of capital. The period following World War II, known as the Golden Age, was a perfect example. Business can hope to pull in huge profits before the market becomes saturated.

The dot.com boom seemed to be a counter example, but in fact the physical investment for much of that period relatively small. Once the boom was underway, then irrational euphoria brought unprofitable investment online, which ultimately could not be supported.

This reluctance to invest extends to replacement of capital goods. The steel industry near where I grew up was working with factories that were built before World War I. The Great Depression forced more competitive industries to modernize, but, once the crisis passed, they too left their productive capacity age. No wonder deindustrialization swept across the United States, beginning in the 1970s.

Eventually, Schumpeter proposed that capitalism had reached a new stage, where only to large corporations could muster the resources required to develop the new technology, which could drive creative destruction. Yet, Schumpeter's earlier concept of the entrepreneur still has some relevance. New ideas often need new people, outside of the higher echelon of the corporate sector.

For example, Chester Carlsson started Xerox after Kodak rejected his new idea to produce a copy machine, telling him that his copy machine would not earn very much money, and in any case, Kodak was in a different line of business. Steve Wozniak could not interest Hewlett Packard in his idea for a personal computer. Even more ironically, researchers at Xerox developed revolutionary new computer technology, including a graphical interface and a mouse. Yet, the company never showed much interest in the technology. Instead, Stephen Jobs copied the technology for Apple Computer.

In short, the evidence that markets are sufficient to generate investment is lacking -- at least until the business cycle reaches the stage of euphoria. At that point, much of the investment will be irrational.

As business stagnates and profits fall, money will seek higher profits and finance, which will become riskier and riskier. Eventually, the house of cards falls, irrational and outdated investment becomes scrapped, and one of two things will happen. After a painful depression, bankruptcies will wipe out a good deal of debt. New investment opportunities present themselves. Eventually, the economy will be reinvigorated for a while until the cycle begins again. Alternatively, the dislocation of the depression to a different way of organizing production.

Tuesday, October 21, 2008

What Didn't Cause the Crisis?

Tyler Cowen, contradicting Anna Schwartz, says it was private sector imperfections, not government policy that caused the imperfection. In particular, the Fed's decision to kep interest rates low is no the culprit:

Is the low Fed Funds rate to blame?, by Tyler Cowen: ...I don't side with Austrian Business Cycle Theory in citing loose monetary policy as the main factor in the artificial boom which preceded the crash. I view the boom as having been fueled by new global wealth, most of all in Asia, and the liquification of that wealth through credit and the desire for additional risk.

Note that if an increase in real wealth fuels the investment boom, consumption can be robust or even go up at the same time as the rise in investment. Now, in the boom preceding the current bust, was American consumption robust? Sure. If the investment boom had been driven mainly by monetary factors, investment would have gone up and consumption would have gone down, as explained here. (Try a rebuttal here.)

Loose monetary policy did contribute to the bubble. In that sense I would defend a modified Austrian theory. But other reasons also suggest that monetary policy was not the main driver. Money has a much bigger effect on short-term rates than long-term rates. Even long-term real rates have only mixed predictive power over real economic activity, including investment. The Austrians have never developed much of a theory of bubbles. Ideally you would have a good bubble theory, with Austrian-like monetary factors stirring up the bubble even more. But you can't get away with pinning so much of the blame on the government, as modern Austrians are wont to do. "Bubbliness" is a private sector imperfection and relabeling it as "government distorting price signals through monetary policy" doesn't much change that.

Speaking of trying to reassign the blame to government, Menzie Chinn says it wasn't Fannie and Freddie, and it wasn't the Community Reinvestment act, two of the three main points of attack for the 'government caused the problems' crowd (the Fed is the third target for those who want to blame government policy rather that the private sector) I will focus on the second part of Menzie's post - there's more in the original:

CRA and Fannie and Freddie as betes noire, by Menzie Chinn: There is so much chaff floating around about the roles of Fannie and Freddie and of the Community Reinvestment Act in the current crisis, despite the best efforts of economists like Jim Hamilton [0] [1], Mark Thoma and Janet Yellen, that it seems worthwhile to once again go through some of the arguments that have been forwarded. ...

What about the charge that Fannie and Freddie "made" the market so that all these subprime loans could be securitized? There's a grain of truth in there, but I think keeping in mind which loans are going bad is useful, when reading this excerpt.

This much is true. In an effort to promote affordable home ownership for minorities and rural whites, the Department of Housing and Urban Development set targets for Fannie and Freddie in 1992 to purchase low-income loans for sale into the secondary market that eventually reached this number: 52 percent of loans given to low-to moderate-income families.

To be sure, encouraging lower-income Americans to become homeowners gave unsophisticated borrowers and unscrupulous lenders and mortgage brokers more chances to turn dreams of homeownership in nightmares.

But these loans, and those to low- and moderate-income families represent a small portion of overall lending. ... Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.

During those same explosive three years, private investment banks -- not Fannie and Freddie -- dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data. [Emphasis added -- mdc]

Now, again, consider which subprime loans, in the graph below, went bad...

Ffcrajazz21

Figure 1.8 from IMF, Global Financial Stability Report, Oct. 2008.

Notice that the delinquency rate is highest in the years after Fannie and Freddie are constrained in terms of their subprime holdings. So, more regulation of F&F was a good thing, I'll say, with the benefit of hindsight.

Now, there are more sophisticated, game-theoretic based arguments. In particular, Jim has observed that the mere existence of GSEs with substantial portfolios of MBS's meant that the government -- by insuring Fannie and Freddie -- would implicitly insure the private firms as they expanded their operations, supplanting F&F's market share:

what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

This is by far the most intelligent and plausible interpretations of how F&F could have contributed in a significant way to the current housing crisis (as separate from the overall crisis, which would have been triggered by some other market given the mixture of securitization, credit default swaps and high leverage [2]). In fact, Mike Dooley and I have made similar arguments about the expansion of contingent liabilities, in the run-up to the East Asian crises [3]. The challenge here is how to test this hypothesis against others; we need to measure the implicit insurance that these private firms felt they had directly from the Fed's intent keep the monetary policy sufficiently expansionary to keep housing prices going up, separate from the insurance committed directly by the Treasury to prevent individual banks from going under. (By the way, this is a separate issue from whether F&F made sense economically in their circa 2006 form; see the analysis by Frame and White. I tend to think the answer is no.)

Interestingly, one of the corollaries of this argument is that it would be hard to disentangle the balance of blame of F&F and the "Greenspan put".

One question I do (or will) have is the following: if the credit card or auto loan securitized markets blow up [4], who are the equivalents to the GSE's?

I think all of this leads to a more nuanced view of the role of CRA and the two GSE's in the crisis. If I had to identify the central factors, I wouldn't point to F&F alone, or CRA alone (if at all). Rather, I'd look to (i) monetary policy (including whether it was lax, and the implications of the "Greenspan put"), (ii) what drove down the returns at the long end of the maturity spectrum ("the conundrum") thus inducing the desperate search for yield, (iii) securitization in the absence of countervailing regulation and (iv) the development of a completely non-transparent and unregulated over-the-counter credit default swap market.

What if credit cards blow up?:

Credit Cards Follow Mortgages Into Delinquency, RTE: Credit cards are increasingly going the way of home mortgages — into delinquency.

cardelinquencies_art_257_20081021162427.jpg

Four quarter change in credit-card delinquencies. Red = Conditions have worsened; Green = Conditions have improved; White = No change (Source: NY Fed)

The Federal Reserve Bank of New York today released data showing that roughly 73% of U.S. counties had year-over-year increases in their mortgage delinquency rates in the first quarter (the latest period with full data available). A slightly smaller share of counties — about 71% — had higher delinquency rates for credit cards issued by banks than a year earlier. ... Delinquency rates for mortgages and credit cards are likely to continue rising into next year. ...

Monday, October 13, 2008

Informational Cascades and the Financial Crisis

Was the financial crisis caused by an informational cascade?:

Wall Street's Lemmings, by Cass R. Sunstein, TNR: ...It is impossible to understand the ... current financial crisis ... without exploring the dynamics of informational cascades. ...

To get a sense of how cascades work, imagine that a group of people is deciding whether to invest in real estate or instead the stock market. Assume that group members are announcing their views in sequence. From his own knowledge and experience, each member has some private information about what should be done. But each member also attends, reasonably enough, to the judgments of others.

Andrews is the first to speak. He suggests that real estate is the way to go. Barnes now knows Andrews's judgment;... if her independent judgment is otherwise, she would--if she trusts Andrews no more and no less than she trusts herself--be indifferent..., and she might simply flip a coin.

Now turn to a third person, Carlton. Suppose that both Andrews and Barnes have favored investing real estate, but that Carlton's own information, though not conclusive, suggests that this is a definite mistake. Even in that event, Carlton might ... follow Andrews and Barnes. ... If he does, Carlton is in a cascade.

Now suppose that Davis, Eagleton, and Franklin know what Andrews, Barnes, and Carlton said. On reasonable assumptions, they will do exactly what Carlton did ... regardless of their private information... And all this will happen even if Andrews initially blundered. ... That initial blunder can start a process by which a number of people end up making really terrible decisions. Human beings ... can lead one another to disaster. ...

Continue reading "Informational Cascades and the Financial Crisis" »

Sunday, October 12, 2008

Regulation and Competitive Markets

I want to rerun an old post, then add something to it:

Markets Are Not Magic, by Mark Thoma: To listen to some commentators is to believe that markets are the solution to all of our problems. Health care not working? Bring in the private sector. Need to rebuild a war-torn country? Send in the private contractors. Emergency relief after earthquakes, hurricanes, and tornadoes? Wal-Mart with a contract is the answer.

Whatever the problem, the private sector - markets and their magic - beats government every time. Or so we are told. But this is misplaced faith in markets. There is nothing special about markets per se - they can perform very badly in some circumstances. It is competitive markets that are magic (though even then we have to remember that markets have no concern whatsoever with equity, only efficiency, and sometimes equity can be an overriding concern).

In order to work their magical efficiency, markets need very special conditions to be present. There must be full information available to all participants. Product quality, locations and prices of alternative suppliers, every relevant piece of information must be known. Not quite sure if the wine is good or not? That's an information problem. Not sure if the used car has problems? Don't know where any gas stations are except the ones beside the freeway in a strange town? No way to be sure if consultants are worth the amount they are being paid? Information problems are common and they can cause substantial departures from the perfectly competitive, ideal outcome.

There also must be numerous buyers and sellers, enough so that no single buyer or seller's decisions can affect the market price. For example, if a firm can affect the market price by threatening to limit supply, the market does not satisfy this condition. If, as some claim, CEOs are in such short supply that they can individually negotiate their compensation, then the market is not producing an efficient outcome. Whenever there are a small number of participants on either side of the market - suppliers or demanders - this is potentially problematic.

In order for markets to work their magic, the product must be homogeneous. That is, the product or input to production sold by all firms in the market must be perfectly substitutable so that as far as the buyer is concerned, one is as good as the other. If some buyers favor one brand over another, if CEOs are perceived to have different and unique talents, if government favors one contractor over another due to political contributions, this condition does not hold. In many cases the variety may be worth the inefficiency, not many of us would want just one style and color of shirt to be available in stores, but the inefficiency is there nonetheless.

In order for markets to work their magic there must be free entry and exit. Most people understand free entry, but free exit is sometimes less evident, so let me try to give an example. Starting a blog on Blogger or TypePad is easy. Entry is a snap and you can be up and running in no time at all. It's easy to join the competition and start supplying posts. But suppose that later you decide you want to switch, say, from TypePad to Blogger. That is not so easy. There is no way, at least no simple and convenient way, to export all of your old posts from TypePad and import them into Blogger, a significant barrier to exit if a large number of posts must be moved. Whenever barriers exist in markets that prevent free movement into and out of the marketplace or between firms within a market (on either side - there are sometimes barriers to purchasing as well), markets will underperform.

The list goes on and on. In order for markets to work their magic, there can be no externalities, no public goods, no false market signals, no moral hazard, no principal agent problems, and, importantly, property rights must be well-defined (and I probably missed a few). In general, the incentives that the market provides must be consistent with perfect competition, or nearly so in practical applications. When the incentives present in the marketplace are inconsistent with a competitive outcome, there is no reason to expect the private sector to be efficient.

Continue reading "Regulation and Competitive Markets" »

Saturday, October 04, 2008

What Caused the Financial Crisis?

An article in the NY Times, "Pressured to Take on Risk, Fannie Hit a Tipping Point," is causing many people to wonder if Fannie and Freddie caused the financial crisis.

First, let me clarify the question. We are asking what caused the housing bubble, and, by definition, the cause cannot be explained by changes in an underlying market fundamental. I don't mean that we can't point to, say, a rumor that led to a rapid increase in the price of some good as speculators rush in, just that bubbles - by definition - are divorced from market fundamentals.

I think a more interesting question is what sets the stage for a bubble to emerge - what allows the rumor, irrational exuberance, etc., to express itself as a bubble? One thing that is needed is liquidity and credit, some way of substantially increasing demand. This is the air that inflates the bubble. Even if all the other conditions for a bubble to emerge are present, if there is no way to inflate the bubble - no way for speculators to rush in and drive up the price - then it won't inflate.

We already know that there was enough available liquidity to inflate a housing bubble. So something went wrong in these markets that allowed the bubble to emerge and then pop, and this is causing us immense problems right now, but what was it?

I think the most important factors are agency problems, the mis-pricing of risk, and the failure of securitization to distribute risks across the financial system.

With respect to the agency issues, there is a long chain between the home buyer, the mortgage broker, and, ultimately, the sliced and diced complex securities that nobody fully understands. Let's take one step in the chain, that of a a bank or mortgage broker, either one. Suppose they are paid a fee, i.e. by the number of mortgages that pass through their hands each month (as, essentially, they were). The more mortgages they can push through, the higher their income. They are required to meet certain guidelines as they do this, but so long as their income depends upon the number of mortgages passing through their hands and not what happens to the mortgages later on - so long as it is a fee-based system - they have every incentive to push the guidelines as hard as they can and to find a way around them whenever possible.

If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis. So right away, in nearly the first step of the chain, we have to ask what went wrong, why they were willing to take so many questionable loans. The problem is what economists call an agency issue. The brokers had no stake in the outcome once the mortgages left their hands. The same with banks, all they had to do was process the mortgages, package them up, then sell them and collect their fee.

Think about the incentives here. Suppose you are a mortgage broker and you begin to suspect that the bubble will pop soon, that all this lucrative business might end. To protect the business, should you get worried and start checking mortgages more carefully to make sure that things don't get further out of hand? No, you should accelerate what you are doing, write even more mortgages - nothing you can do can stop the bubble from popping, you are just one of many, many brokers far down the chain - so why not collect as many fees as possible before the gravy train ends? What if everyone thinks this way, and they all rush to sell as many of these things as they can? Mania.

A solution to this is to give each person in the chain a stake in the future outcome of the mortgage. If mortgage brokers' income had been connected to a financial instrument that pays off according to the future performance of the mortgages they write, would they have behaved differently? Probably. (What about homeowners, why didn't they say no? Don't they have a stake in the future price of the home? Homeowners in non-recourse states - and more generally - were basically granted cheap options on their homes. The downside was protected and they had no reason to effectively monitor risk. If prices fell, they could just walk away and know that their other assets remained safe and that their credit reputations could be restored with time. Of course, if everyone walks away other assets such as retirement savings don't remain safe, but that doesn't change the incentive on an individual level.)

Ah, you say, but as you go up the chain why didn't people refuse to take the financial paper, why didn't they conclude it was too risky? The risky mortgages don't have to be stopped at the bottom, this is a linked chain, so why weren't they stopped higher up in the chain where the stakes are higher? Isn't that where Fannie, Freddie, and moral hazard rear their ugly heads? Did they encourage and allow this risky paper to pass through the system?

The mis-pricing and mal-distribution of risk played a key role here (along with poor management decisions in cases where alarms were raised). The agency issues above, and the consequences of the failure to predict and distribute risk are much more important than any moral hazard issues arising from the implicit government guarantee granted to Fannie and Freddie.

Institutions in the shadow banking sector were willing to take large volumes of risky loans as they came up through the system. Why?

The people at the top of this complex chain did not fully understand the risks the were assuming when they took on the subprime business, or, rather, when they took on the complex securities derived from the subprime business. When the bubble popped, it shouldn't have been a big problem if the risk assessment models they relied upon had been correct, and if securitization had distributed the risk as promised. As Brad DeLong notes:

  • There is $11T if U.S. mortgages
  • There is $60T of global financial assets
  • Even if we had $2T of losses on mortgage-backed securities that shouldn't pose a big problem for Wall Street--actually 48th and Park Avenue

So if the risks had been distributed fairly evenly, it's much less likely that we'd be in this mess (the losses of 2T - an intentionally high-balled number - are only 1/30th of global financial assets). It wasn't the misprediction of the level of risk that was the biggest problem, the losses could have been absorbed, it was the (unintended) concentration of risk through the failure of securitization that was the most problematic.

Fundamentally, then, it was the agency problems and the failure of risk prediction and distribution models that allowed the bubble to inflate and then cause big problems after it popped. But back to Fannie and Freddie. The willingness of the non-traditional banking sector - the shadow banking system - to take on these risky assets and still pay investors a relatively high return put tremendous pressure on Fannie and Freddie to follow suit. And their response was unwise - Fannie and Freddie followed the shadow banking sector downward. There is lots to fault in the behavior of Fannie and Freddie and in government oversight of them - the decisions of management, the lobbying efforts that were funded by their ability to extract a premium from the implicit government guarantee - all of this was a big problem. The bubble, and later the financial crisis expressed itself in these institutions, and they may have also contributed to it to some extent as they took on more risky securities when their business began to go elsewhere. But the agency issues and the failures of risk models and securitization would have created problems in the largely unregulated shadow banking sector even if these two institutions had taken on nothing but the safest of mortgages. The bubble still would have inflated in the shadow banking system - maybe it's a little smaller, I don't know - but it still would have been large enough to cause big problems when it burst. The best behavior of Fannie and Freddie would not have been enough to stop the bubble from inflating in other parts of the financial sector, and then turning into a full fledged financial crisis as housing prices plunged.

The problems we are having were caused when lots of available liquidity rushed past the checks and balances that proper agency provides in pursuit of promises that risk models and complex securities did not deliver. The unexpected losses alone might not have caused a crisis had the losses been widely distributed, but, the losses were concentrated and hidden in ways that created widespread fear and threatened the entire system. Getting rid of that fear is not going to be easy.

[Update: Given some of the responses elsewhere to this post and others like it, let me add one more thing. Asking the question "what caused the financial crisis," thinking about it, and then arguing that Fannie and Freddie were not the primary driving forces behind the financial meltdown (though they could have affected the size of the problem as noted above) is not the same as defending Fannie and Freddie. Whether are not Fannie and Freddie are performing a useful function, and if they are performing a useful function how they should be structured going forward is not a question I've fully resolved. The market failure they are addressing is not entirely evident to me, and until I understand how they improve the efficiency of these markets, I won't take a position. They certainly should not operate as private entities with an implicit government guarantee as before - that's what set up the situation where the implicit guarantee could be exploited profitably and used to fund lobbyists and ad campaigns to make sure the golden goose kept laying eggs. However, I have posted arguments from other people arguing for their existence, and I am thinking about those as well as arguments against their continuation. In any case, something to guard against, I think, is to inappropriately blame Fannie and Freddie for the financial crisis and then use that as a reason to shut them down irrespective of any useful function they might serve. So when I see those with an agenda against government intervention trying to do just that - arguing honestly in some cases and dishonestly in others that Fannie and Freddie were a big factor in the crisis so they can use them as an example of government intervention gone awry and also shut them down - a double bonus in their eyes - I have tried to present evidence and arguments that the cause lies elsewhere. But as I said, that is not the same as defending their existence. My interest is in understanding the true cause of the financial crisis and in stopping it from happening again - and to avoid getting stuck on wrong arguments along the way - not in using the crisis to argue about whether Fannie and Freddie ought to continue as government supported institutions. That can wait for another day.]

Wednesday, October 01, 2008

It Wasn't Fannie and Freddie

More evidence:

Coleman, Lacour-Little and Vandell argue that house prices made sense until 2004, by Richard Green: The abstract of their new paper:

The cause of the "housing bubble" associated with the sharp rise and then drop in home prices over the period 1998-2008 has been the focus of significant policy and research attention. The dramatic increase in subprime lending during this period has been broadly blamed for these market dynamics. In this paper we empirically investigate the validity of this hypothesis vs. several other alternative explanations. A model of house price dynamics over the period 1998-2006 is specified and estimated using a cross-sectional time-series data base across 20 metropolitan areas over the period 1998-2006. Results suggest that prior to early 2004, economic fundamentals provide the primary explanation for house price dynamics. Subprime credit activity does not seem to have had much impact on subsequent house price returns at any time during the observation period, although there is strong evidence of a price-boosting effect by investor loans. However, we do find strong evidence that a credit regime shift took place in late 2003, as the GSE's were displaced in the market by private issuers of new mortgage products. Market fundamentals became insignificant in affecting house price returns, and the price-momentum conditions characteristic of a "bubble" were created. Thus, rather than causing the run-up in house prices, the subprime market may well have been a joint product, along with house price increases, (i.e., the "tail") of the changing institutional, political, and regulatory environment characteristic of the period after late 2003 (the "dog").

This result is hardly consistent with the charge that the GSEs were the principal source of the problem. It also says something about having a purely private mortgage market.

Saturday, September 27, 2008

"The Opposite of Moral Hazard"

John Hempton is upset over the the seizure of Washington Mutual. Justin Fox explains:

Australian money manager John Hempton owned Washington Mutual preferred shares and was thus wiped out when the bank was seized and flipped to JP Morgan Chase last week. But he's not mad about that. He's mad about what happened to owners of Wamu bonds. By also wiping out senior debt holders at Wamu, he argues, the government has now botched things in a profoundly serious way...

Hempton thinks that if the FDIC had simply liquidated Wamu, some money would have been left for the senior creditors. By choosing not to do that--presumably because it would have meant a big hit to the FDIC insurance fund--it has discouraged anybody else from providing that kind of credit to U.S. banks.

Here's (a short version of) John Hempton :

The reckless, irresponsible seizure of Washington Mutual: please read in Washington DC, by John Hempton: I lost money on this – so you can take my analysis with the caveat of a slightly angry grain of salt.

But I still think the seizure of Washington Mutual is the most capricious government action of this cycle and possibly the worst thing that has happened to American Capitalism this cycle. ...

Now what has the Government done here. It has confiscated the institution and sold everything except the liabilities marked equity, preferred, junior and senior. It confiscated the liquidation rights of the senior and junior debt. [It confiscated the liquidation rights of the preferreds too but that is an understood risk in owning preferreds. And whilst I lost money here I am far more angry about the other…]

If WaMu had been placed in liquidation I am pretty sure the seniors would have got something. If the senior debtors had been allowed to conduct an auction for WaMu (compromising all the junior stuff including the prefs I owned) then they would have got something.

Except that the liquation rights – well established order-of-creditor rights – were denied by a swift US Government action.

Now I understand that there is a strong policy presumption in favour of a quick government disposal of a failing institution – and that policy presumption might at some stage trump the rights of some holders of paper. However a pretty strong case must be made....

It would of course be more acceptable if there was a large body of evidence that the government put forward to justify their complete disregard for quite senior rights here. ... But in this case the Feds did very little to justify their decision. ...

The OTS/FDIC carried a risk – the risk being that the losses would be so large that would wind up costing the government money.

The government solved its problem – and it did it by taking away the rights of the senior debt holders to an orderly liquidation – when on the numbers given by the ultimate acquirer the senior debt was likely to be whole or near to whole.

The Government did this seemingly capriciously. It changed the order of creditors and the basis on which banks all across America raise wholesale funds.

Now there is not much raising of wholesale funds by banks at the moment. But after this deal there is likely to be less. It is simply the case that there is now a new risk for people who provide wholesale funding – and that risk is that the government will unilaterally abrogate their rights – without appeal, without due process and without accountability.

In the process the OTS and the FDIC have effectively removed the main low-cost source of funds of pretty well all banks in America. They will have put the fear-of-Government into such people globally. This is the opposite of moral hazard. In the Moral hazard case people take too many risks because they believe the government will reimburse their losses. But in this case people are going to take too few risks because they know that government might unilaterally remove their rights and property.

This was – by far – the least justified government action of this credit cycle. And it spells doom for any bank in America that is ultimately reliant senior (and hence well protected) but unsecured financing because it is so capricious.

Those banks are many – but we can start with Wachovia whose destiny (failure) is now nearly certain – and for whom the precedent is set. But after that we can go for all the banks including the champions such as Bank of America and Citigroup. Creditors now face confiscation of their rights by the US Government without oversight or audit or even process.

At that point there is no creditors and the economy collapses. The trust needed to make capitalism worked has been removed. I am not a conservative - but I will argue - along with many conservatives - that the most important function of government in a capitalist society is provision of a framework by which property rights can be defined and enforced as this is the key to making a capitalist society function. The Government is now acting as if the framework does not apply to them. That is bad whatever your political persuasion.

What next

The FDIC and OTS have won the battle with respect to WaMu. They got rid of WaMu without any cost to the taxpayer. The WSJ lauded that achievement. They really did get out of their WaMu risk quite neatly – and I will be the heads of those organisations went to bed feeling pretty pleased with themselves.

But in the process they have doomed about two thirds of the US banking system.

I am still a believer that government – whilst not stuck with great incentives will grope for right solutions. But that belief of this former (competent) public servant is being shaken to the core.

And whilst Wachovia and dozens of others will eventually hit the wall because of this decision, the Government will work out that it has a bad process before Bank of America fails.

But I think it is time that the process is short circuited. The heads of the OTS (John Reich) and of the FDIC (Sheila Bair) should be sacked now and for cause. Mr Paulson better get control of this process and let it be known that the US has a process for dealing with senior creditors and making sure that their rights are honoured.

Otherwise heaven help us.

Friday, September 26, 2008

Would the Cantor Plan Solve the Crisis?

From Brad DeLong:

**Sigh:** House Republicans and the Press, Brad DeLong: Hoisted from Comments: anonymiss:

Grasping Reality with Both Hands: You gotta comment on the current House Republican insurance plan. Time Magazine seems to think it's a real plan, not a Potemkin plan. I have no idea, but I think the people at Time are morons, so you MUST let us know if this is real or more nonsense from the guys who brought you "get rid of the capital gains tax! That'll fix everything!" http://www.time-blog.com/swampland/2008/09/the_republican_alternatives.html

Anonymiss is citing Karen Tumulty:

Politically at least, the [Republican Deputy Whip Eric] Cantor plan has a lot of appeal. By insuring these junky mortgage-backed securities, rather than buying them, the government presumably wouldn't be spending nearly as much money. In fact, it would be getting money from Wall Street, in the form of premiums for this insurance. This scheme would function sort of like GNMA. The very process of insuring these assets would help solve one of the biggest problems: Nobody knows what they are worth.

The problem, at least in the eyes of Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, is that, while it would help the situation, it wouldn't work to stabilize the markets as well as their plan would.

Here's how it has been explained to me: Last winter and spring, when Treasury and the Fed analyzed a lot of options out there for what to do, they considered this insurance option. They decided that because the insurance option would leave the bad stuff on the bank balance sheets, it wouldn't give the banks the additional liquidity they need. They also believe it wouldn't create a market price that can stimulate trading, the way a purchase program would.

I'm not any kind of an expert on this stuff, so I don't know who is right here...

Let us see. On the one hand, the Treasury Secretary, the Federal Reserve Chair, and their staffs. On the other hand, an unstaffed Republican Chief Deputy Whip Eric Cantor who has not a plan but a plan to have a plan to ask the Treasury to design a different plan than the plan the Treasury thinks is best.

Cantor calls for "the Treasury to design a system to charge premiums to [mortgage-backed security] holders to finance [government-provided] insurance" against defaults.

The Fed and the Treasury have been looking at these issues since at least last winter. I suspect that the Treasury and Federal Reserve staff have decided that such federal government-provided insurance is indeed something we want to try to work toward as part of our financial system after the crisis is over--the "commitment fee" due in 2010 in the Fannie/Freddie nationalization makes no sense otherwise, for it is such a fee for the insurance on mortgages and mortgage-backed securities that Fannie/Freddie have gotten for free in the past but that Treasury wants to charge them for and also offer to others staring in 2010. But my belief is that Treasury and Federal Reserve staff have also judged that it won't work well enough to be a useful tool in handling the current crisis for speed-of-implementation reasons: we need to move to asset purchases--that banks need liquidity now, and we need functioning markets where securities are priced now, and you can buy assets a lot faster than you can set up insurance schemes.

Confronted with these two sets of opinions--a single unstaffed guy who is an expert in rounding up and feeding Republican House members on the one hand, and the Treasury Secretary, Federal Reserve Chair, and their staffs on the other, Karen Tumulty says "I don't know who is right here" because "I'm not any kind of an expert on this stuff."

So why doesn't she give her space at Time to somebody who is an expert, and does know who is right here? This is he said-she said journalism as self-parody.

Why oh why can't we have a better press corps?

And, beyond the fact that the proposal can't be implemented fast enough, I don't see the big savings either. The losses will still be there (assuming whatever confidence effect that would occur with this proposal wouldn't be substantially different from the confidence effect from a direct purchase of distressed assets, and I don' see why it would be), and there would be revenue from the equity warrants just like there is revenue from the insurance premiums, so where are the big savings? There are also higher administrative costs under the insurance proposal (and all the usual market failure worries such as adverse selection to worry about in the program design).

It can't be accomplished fast enough to help with the current crisis, there are no big cost savings associated with using this program to solve the crisis (even if it worked), so what's so attractive about it as a solution to our immediate problems?

Ah, I just found more from Justin Fox:

More on the Cantor plan to insure everybody's mortgage, Curious Capitalist: I've been doing a little checking around on Eric Cantor's idea to insure everybody's mortgage, which ... is now generating some talk ... of a blended plan that would combine increased insurance with purchases of mortgage securities. ...

The government already insures half the mortgage debt out there, Cantor & Co. argue, so why not just insure the rest?

It turns out that people at Treasury and the Fed actually did discuss expanding mortgage insurance when they were tossing around ideas earlier this year for halting the mortgage meltdown, but decided it wouldn't have nearly the impact on getting markets moving again that buying mortgage securities outright would.

When I emailed Mark Zandi ... of Moody's Economy.com ... he responded with that same worry plus some others:

Seems to me it doesn't address the fundamental problem that there is no market for these securities. How can you write insurance on these securities unless you know the risks you are taking and you can't know that unless you have a market. Reminds of that pink floyd song. Anyway, this is a much less effective way of addressing the problem and would very likely cost taxpayers more than the tarp. Perhaps most importantly most immediately is that since it is not clear how and if it will work it won't stabilize financial markets.

When I emailed back to ask which Pink Floyd song, Zandi was unresponsive. Anybody got any ideas?

Then I talked to Lou Pizante, a veteran of the mortgage-securitization business who now runs Mavent, a maker of compliance software for mortgage lenders. He pointed out the only way for the Cantor plan to work actuarily was for every last one of those $6 trillion in mortgage securities to be insured. Otherwise you'd just get the financial institutions with the crappiest loans on their books choosing to participate--which would amount to a giant bailout of the bad guys by taxpayers. So I'm not sure how you could do a blended plan of insurance and purchases, since you've got to insure everybody.

Finally, even if you do get every last mortgage in the country covered by insurance, there's the issue, mentioned in my earlier post, of figuring out to price it. Too cheap and it's a bailout, too steep and you make banks' problems worse. Which is true of the original Paulson plan as well, of course. But that plan is much more upfront about being a bailout.

Equity Warrants and Asymmetric Information

Jonah Gelbach an Economist for Obama, explains why an argument against including equity warrants as part of the bailout proposal doesn't hold in the presence of the type of asymmetric information present in these markets:

"Smart Friend" vs. Asymmetric Information, Economists for Obama: Earlier today, Greg Maniw posted a three-point defense of the Paulson bailout plan from someone to whom he referred only as "a smart friend".  I want to address point 2 of Mankiw's friend's argument:

2. "Taxpayers will be better off if Treasury gets warrants."

This is essentially the assertion made in David Leonhart's column in the NY Times on Wednesday. And it again illustrates that we would all be better off if high schools taught the Modigliani-Miller theorem. MM implies that the price of the asset (again, assuming the auction gets it right) will adjust to offset the value of any warrants Treasury receives. In this case of a reverse auction, imagine that the price is set at $10. If Treasury instead demands a warrant for future gains of some sort, then the price will rise in the expected amount of the warrant -- say that's $2. Then the price Treasury pays for the asset will be $12. Some people might prefer to get $12 in cash and give up a warrant worth $2 in expected value. Fine, that's a choice to be made. But the assertion that somehow warrants are needed is simply wrong.

For a smart guy, Mankiw's friend is making a pretty dumb argument. Sure, if everyone has the same information, then an asset with a value of $10 will cost $12 if it's required that a $2 warrant comes with it. But that totally misses the point. Based on what I've read, it appears that if everyone understood what these assets were worth, there wouldn't be any need for a bailout: the bailout is necessary because people with capital are scared witless that anything they buy will just be crud. Folks like Mankiw are constantly reminding us (and they're often right) that there's no reason to think government has better information than private parties. So how will Hank Paulson or his agents know any better than folks risking their own money?

Continue reading "Equity Warrants and Asymmetric Information" »

Wednesday, September 17, 2008

"Paradigms of Panic"

Before getting to the main point, "Paradigms of Panic," it will be helpful to start with some definitions. First, not all bank runs are alike:

Bank runs come in two kinds.

In some cases, the bank run is a pure self-fulfilling prophecy: the bank is “fundamentally sound,” but a panic by depositors forces a too-hasty liquidation of its assets, and it goes bust. It’s as if someone calls “fire!” in a crowded theater, provoking a stampede that kills many people, even though there wasn’t actually a fire.

In other cases, the bank is fundamentally unsound — but the bank run magnifies its losses. It’s as if someone calls “Fire!” in a crowded theater, and there really is a fire — but the stampede kills people who would have survived an orderly evacuation.

We also need to distinguish traditional bank runs from their modern counterparts. Traditional bank runs are fairly familiar and are described in more detail below, but what do modern bank runs look like? Here's an example involving hedge funds from something I wrote in the past. (It's slightly edited. The term "bank-like function" in the first sentence means financial intermediation. Most of the discussion of financial intermediation is about temporal intermediation, i.e. borrowing short and lending long, but intermediaries can also aggregate and smooth risk, aggregate small deposits into large loans, and lower transactions costs):

Entities outside the traditional banking sector have been engaged in bank-like functions and are hence subject to bank-like problems such as bank-runs.

For example, hedge funds can be hit with withdrawals even if they are not in trouble themselves, at least initially, due to uncertainties about the future state of the market, rumors, etc.

But like a bank who lends out most of the deposits it receives and only keeps a fraction of the deposits on hand as reserves, a hedge fund uses the deposits it receives to purchase securities and other assets for its portfolio maintaining some as a cash reserve. But unless it has substantial cash reserves on-hand, when investors make withdrawals the fund must begin to liquidate its portfolio to pay them off.

But if nobody will purchase mortgage-backed securities you are offering, who do you sell to? With nobody buying the assets the fund is trying to sell, they are forced to try to raise cash in other ways, and problems mount.

And it can feed on itself, just like a bank run. If investors hear that people are having trouble getting their money out of a particular fund, or from funds generally, they will rush to get their money out before the fund fails, and the problems spread as funds try to sell assets to raise the needed cash.

So it's sort of like a bank run, but without a standing lending facility (i.e. the equivalent of a discount window) available to meet the demand for liquidity, though such institutions could be created.

And they have been created.

Next, the "New World Order" and how to save the free world:

Continue reading ""Paradigms of Panic"" »

Tuesday, September 16, 2008

"Moral Hazard for Corporations"

Yesterday, in his "Third Rant of the Day", knzn argued:

[W]hen the financial system is strained and interest rates on Treasury securities are already quite low, there is an increased risk that a weak economy will turn into a serious recession which the Fed will have little power to combat. If you depend on your job to earn a living, that’s a pretty serious risk.

So instead of putting “taxpayer money” on the line, Secretary Paulson is putting taxpayers on the line.

Today, he argues that moral hazard is misunderstood, and that "the financial system as a whole should be insured":

Moral Hazard for Corporations, by knzn: With all the talk about “moral hazard” lately, I have realized something: there is a basic flaw in the way the subject is typically discussed with respect to financial corporations. I’m not saying that the people discussing it are necessarily misunderstanding, but the terms in which it’s typically discussed will tend to lead the unwary into sloppy thinking or confusion.

Continue reading ""Moral Hazard for Corporations"" »

Sunday, September 14, 2008

Protecting Workers from Discrimination

More on equal pay:

Equal Before Mammon, by James Surowiecki, New Yorker: She was an ordinary middle-class mom who, despite fierce criticism, succeeded in a male-dominated profession. ... She was a woman named Lilly Ledbetter, a former middle manager at a Goodyear plant in Alabama, who appeared at the Democratic Convention to give a human face to the slogan “Equal pay for equal work.”

Ledbetter’s unlikely journey to center stage began in the late nineteen-nineties, when she received an anonymous note revealing the salaries of her fellow-managers, all of whom were men. Although Ledbetter did the same job..., and had more seniority than some of them, they were all being paid considerably more... Ledbetter sued, under the Civil Rights Act, and proved that her lower pay was the result of discrimination... But ... the verdict was overturned on appeal, and then the Supreme Court ruled against her. ...[A]ccording to the Civil Rights Act, Ledbetter’s lawsuit had to be filed within a hundred and eighty days, and the Court ruled that the clock started ticking with the first act of discrimination, almost two decades before Ledbetter found out what was going on.

Ledbetter was out of luck. But the Court did leave open a possibility for others like her: if Congress wanted a more realistic time frame for lawsuits, all it had to do was change the law. And ... that’s precisely what Congress tried to do. Last year, the House passed a bill, named after Ledbetter, that essentially did away with the statute of limitations on pay discrimination, and the Senate was set to do the same until Republicans filibustered it to death.

Protecting workers from discrimination is a fairly uncontroversial idea. So opponents of the bill, who include John McCain, insisted that, while they’re in favor of equal pay, the new law would unleash a flood of frivolous litigation. That’s a familiar excuse, and in this case a threadbare one. There would likely be more lawsuits if the bill was passed—the point, after all, was to allow more people to sue—but there was no reason to expect a deluge, since, before the Court’s decision, it’s probable that most potential litigants had assumed a less stringent interpretation of the time limit anyway. ...

Other opponents of the bill depict it as a stalking horse for the idea of “comparable worth”... But the Lilly Ledbetter bill has nothing to do with comparable worth. ...

Does the Ledbetter bill matter? It’s true that active discrimination is rarer these days than it once was. But ... racial and sex discrimination is still a powerful force in the job market. ...Kerwin Charles and Jonathan Guryan, of the University of Chicago, show... that, under certain reasonable conditions, market competition will not necessarily eradicate discrimination. That may be why, they suggest, the gap between black and white wages is widest in the most prejudiced parts of the U.S.—precisely what you’d expect if businessmen could discriminate and get away with it. ...

[O]pponents of the bill have acted like McCain, proclaiming their support for fair pay while doing their best to insure that workers have a hard time getting it. Maybe it’s time for them to give Americans some straight talk and unveil a new slogan: “Unequal pay for equal work.” It may not be catchy, but at least it’s honest.

Friday, September 12, 2008

"Ownership vs Markets"

I want to think about this more, but this strikes me as a good point:

Ownership vs markets, by Chris Dillow: Sam Brittan and Anatole Kaletsky both worry that the credit crunch is undermining the case for free market capitalism. I fear, however, that they are eliding a crucial distinction - that between free markets and traditional capitalist ownership structures. The credit crunch does more to highlight the failing of the latter than of free markets. I say this for four reasons:

1. Banks lost money on mortgage derivatives because of principal-agent failings. Principals - banks’ bosses - didn’t understand what agents (traders) were doing, and traders had incentives to take on excessive risk, because the gains from doing so - a life-changing bonus - exceeded the benefits of prudence.

2. Banks have been reluctant to lend to each other not so much because each bank fears its counterparty will not repay the money, but because they fear they’ll need the money themselves. This is because banks just don’t know what sort of losses they are sitting on. It’s impossible for managers of such complex organizations to know everything.

3.  Banks are under-capitalized because chief executives have traditionally had incentives to maximize earnings by using leverage. Pressure upon them to be more prudent has been absent partly because when shareholding is dispersed, no individual shareholder has much incentive to rein in management.

4. Good financial innovation - of the sort advocated by Robert Shiller - has been lacking because it’s very difficult for anyone to own its beneficial effects; it’s a public good. By contrast, the gains from “bad” financial innovation - overly complex mortgage derivatives - are more appropriable. So we get more of it.

...What we’re seeing is not a market failure, but an ownership failure. What’s the solution?

Not nationalization - which is a bad way of solving principal agent problems.

Perhaps instead, banks should make more use of internal markets. They should become more like venture capitalists, allocating capital to semi-independent divisions, which put in their own capital. This would restrain traders’ risk-taking, as they can not so easily hide behind the fact that losses are spread over the whole firm. And it would reduce the problem of asymmetric information between banks’ senior managers and trading desks, as there’s a simpler test of how well the latter do - whether they can hand over enough hard cash to cover their required returns.

Now, I’m being deliberately vague here. I just want to stress that ownership is the problem, more than markets. 

Tuesday, September 09, 2008

"There is Still a Very Big Need for Fannie and Freddie"

Dean Baker argues that Fannie and Freddie should be run as public corporations. There are (at least) two ways to support this, one is as a means of promoting home ownership, and the other is to stabilize housing markets. Not everyone agrees with the first justification since it distorts markets (assuming the promotion of home ownership is not correcting a market failure in which case it would be hard to argue against). However, the second justification - stabilization - is, I think, harder to dismiss since volatility in these markets produces large welfare losses:

Freddie's dead, by Dean Baker, Comment is Free: Fannie Mae and Freddie Mac finally kicked the bucket this weekend, with the Treasury department stepping in to take over the companies. The top management is being sent packing (albeit with multi-million dollar severance packages), and the shareholders will stop seeing dividends, probably forever. ...

The big question is what these institutions will look like going forward. There is a strong argument for keeping these institutions publicly run. In effect, both Fannie and Freddie can be operated as public corporations, which was the case with Fannie Mae prior to its privatisation in 1968.

The current disaster should not lead people to forget the benefits that these companies conveyed to homeowners. By creating the secondary mortgage market, they created first a national and then an international market for home mortgages. This had the effect of equalising interest rates across the country and making homeownership affordable to millions of families.

Perhaps the private sector would have created a secondary mortgage market on its own, but it didn't. Furthermore, private issue mortgage backed securities have performed far more poorly in the current crisis than the securities issued by Fannie and Freddie. This is why private issue mortgage backed securities have virtually disappeared over the last year, and Fannie and Freddie are now financing almost 80% of the new mortgages being issued. Those who tout the virtues of the private sector in the secondary mortgage market are arguing based on faith, not evidence.

There is still a very big need for Fannie and Freddie to ensure a well-operating secondary mortgage market. ... Fannie and Freddie can best serve their role of providing the stable anchor of the secondary mortgage market...

Private banks would still be free to be creative and innovative in developing complex new mortgage derivatives, if they can find anyone to buy them. The difference is that the taxpayer would not be standing behind the private sector banks, prepared to absorb any losses even as the stockholders and top executives got rich off the gains.

The federal takeover of Fannie and Freddie will force a debate over their ultimate status. It is clear that many Republicans want to see them broken up and privatised, which has long been their explicit agenda.

The current crisis has shown the failing of Fannie and Freddie in their role as public/private hybrids. We should see that as reason for ending the private side of the equation. The only obvious value added by the private side is the tens of millions of dollars of compensation received by the CEOs. The CEOs can go to Wall Street if they want those salaries.

Friday, August 29, 2008

The Market What?

I am apparently the victim of an insidious force and desperately in need of an exorcism.