Friday, 31 October 2008

Zimbabwe's inflation rate

According to Steve H. Hanke's new Hyperinflation Index (HHIZ) at the Cato Institute, Zimbabwe's annual inflation is 10.2 quadrillion percent!

The index was set at 1.00 on the 5th of January 2007. As at the 24th October 2008 the index is at 48,500,000,000,000,000.00 which gives an annual inflation rate of 10,200,000,000,000,000%.


Walter E. Williams takes on the job of explaining Wackonomics. Williams writes
For the U.S. Congress, news media, pundits and much of the American public, a lot of economic phenomena can be explained by what people want, human greed and what seems plausible. I'm going to name this branch of economic "science" wackonomics and apply it to some of today's observations and issues.
His best example is
Wackonomics isn't just practiced by the uninitiated. This year's Nobel Laureate, Princeton University Professor Paul Krugman, after the terrorist attack on the World Trade Center, gave one rendition of wackonomics in his column "After the Horror," New York Times (9/14/01). Krugman wrote, "Ghastly as it may seem to say this, the terror attack -- like the original day of infamy, which brought an end to the Great Depression -- could do some economic good." He went on to point out how rebuilding the destruction in New York and Washington, D. C., would stimulate the economy through business investment and job creation. For practitioners of non-wackonomics, this reasoning doesn't even pass the smell test. If Professor Krugman's vision is correct, and extending his logic, the terrorists would have made an even larger contribution to our economic well-being had they been able to fly a plane into the White House and destroyed buildings in other cities.
Broken window fallacy anyone? Such thinking is not just found in the US, how often here have you seen someone here write that greed is to blame for high oil prices or high CEOs salaries or that things like earthquakes are good for the economy? But Williams also points out that wackonomics isn't all bad,
Wackonomics isn't all bad. There's an upside to it. It spares people the bother of having to understand the complexities of the world.

Thursday, 30 October 2008

Our next government? (updated x2)

Eric Crampton has an interesting piece on the iPredict blog discussing Our next government? Eric writes
The markets today are saying 70% National, 30% Labour as next PM. Let's have a look at the underlying numbers.

At high bid for each party, assuming that Peters does not return to Parliament, Hide takes Epsom, Dunne and Anderton return to Parliament and the Maori Party take 6 electorates, we're looking at a 123 seat Parliament arrayed as follows:

GRN: 9
PRG: 1
LAB: 45
MAO: 6
UF: 1
NAT: 57
ACT: 4

62 seats are needed for a majority. National + Act + UF are at 62; Labour + Green + Progressive + Maori are at 61.
He goes on to look at bit deeper,
The markets also are saying there's a 17% chance that National's true vote share will be above 50%. If National's price is normally distributed around the true mean, though, that means there's also a 17% chance that National's true vote share will be below 43.3%. Again, we can take the combination of the prices in VOTE.NATIONAL and MAJORITY.NAT to work out the standard deviation of VOTE.NATIONAL: it's currently at 3.5. Let's assume that the standard deviation of VOTE.LABOUR is the same. We'll benchmark minor party vote share standard deviation by that of NZ First, which we can work out from the combination of VOTE.NZFIRST, TAURANGA.PETERS and MP.PETERS. At current prices, that suggests that the minor party standard deviation is 1.15.

Ok. National's coalition's expected vote share is 50.65%, getting it 61 seats plus Dunne. While the vote share point estimate is 50.65, the standard deviation will be the sum of the standard deviations of the underlying components: 3.5 + 1.15 = 4.65. National's seat share is then expected to be 62, with standard deviation 5.58 seats (as 1% of the vote gets you 1.2 seats).

Labour's coalition's expected vote share is 49.37%, getting it 59 seats plus 1 Maori overhang plus 1 Anderton. The standard deviation will be (as a rough cut) the same as that for National's coalition because we don't need to worry as much about the variance of the Maori party vote if they're set anyway for overhang, so we're really only worried about variance in Green and Labour. So, 4.65. Labour's seat share is then expected to be 61, with standard deviation 5.58 seats.

Now, what's the probability that the realized seat share for the National coalition really lies above the realized seat share for the Labour coalition? A cheap way of checking this is just to check the probability that National lies at 61 seats or less. Our standard normal table tells us the chances of this are 42.86% as only 7.14% of the distribution lies between 62 and 61 seats.

So, National's chances of getting more seats than Labour look more like 57% than like 70%. And those chances get much worse in the 26% probability case that Peters returns to Parliament. I'm not going to bother working them out at this point though.
Don't you just love economists and statisitics?! But what this says is that either Eric has gotten his calculation very wrong or the iPredict market has gotten something wrong. If it is the latter then there is money to be made. Go to it!

Update: Eric has added the following post to the iPredict blog,
Our next government redux

One of the advantages of being at Canterbury in October is that Sir Clive [Granger]comes to visit. Sir Clive won the Nobel a couple of years back for his work in economic forecasting and economic statistics. So I asked him if I'd screwed up anything major in the post below. He said the overall technique should be reasonable for what we're trying to do here, but that I'd made a minor error: the correct probability of National forming the next government, at the current prices in the vote share market, is 60.6%, not 57%. I'd made the rather silly error of adding up the standard deviations rather than adding up the variances.

So we have four options.
1. The prices in the PM markets are wrong
2. The prices in the VS markets are wrong
3. The underlying distributions are highly skewed rather than symmetrical.
4. The Maori party is more likely to go with National than NZ First is likely to make it into Parliament.

We've eliminated 3a, which was the "Eric's completely screwed this up" option as I now have the Sir Clive seal of approval. And you're not going to do better than that in New Zealand currently.

I'm complementing my positions in the PM markets with the appropriate inverse positions in the VS markets as a quasi-arbitrage.
Update 2: Eric comments on And so is solved the mystery of the inconsistent prices

Beware political saviours

Economist Stephen Kirchner writing in The Australian tells us to Beware political saviours. He makes a nice point that I'm sure most public choice economists would also make,
Scottish Enlightenment philosopher David Hume noted as long ago as 1741: "Avarice, or the desire of gain, is a universal passion which operates at all times, in all places and upon all persons." One cannot explain episodic phenomena such as financial crises with reference to a constant such as human nature or rationality.

The principal mistake the critics of free markets make is to assume that self-interest, greed and irrationality affect only private sector decision-makers. Politicians and regulators are just as prone to self-interested behaviour and do not become saints by virtue of elected or unelected office. The public sector and regulators are populated by the same species that is found in the private sector and financial markets. We should always be suspicious of claims to superior moral virtue coming from politicians.
Well said that man.

Norman Barry

This posting by Peter Boettke at the Austrian Economists blog alerted me to the sad news of the death of the political philosopher Norman Barry on the 21 October 2008.

Barry had been Professor of Social and Political Theory at Buckingham since 1984. He was a graduate of the University of Exeter. Professor Barry lectured in Politics at Queen's University of Belfast and at Birmingham Polytechnic (now the University of Central England) before being appointed as a Reader in Politics at the University of Buckingham in 1982. His books include Hayek's Social and Economic Philosophy (1979), An Introduction to Modern Political Theory (1981), The Morality of Business Enterprise (1991), Classical Liberalism in an Age of Post-Communism (1996) and Business Ethics (1998). He was also a visiting scholar at the Centre for Social Philosophy and Policy, Bowling Green State University, Ohio, and at the Liberty Fund, Indianapolis. He was a member of the Advisory Council of the Institute of Economic Affairs, London; the Institute for the Study of Civil Society, London; and the David Hume Institute, Edinburgh.

He came to New Zealand in 1997 to give the Sir Ronald Trotter Lecture on the topic of Business, Ethics and the Modern Economy. See here for a copy. He was a great defender of the classical liberal view of politics and of Austrian Economics.

You can watch a 40-minute video interview with Barry below.

See a nifty 1982 review essay on the history of the idea of spontaneous order from Barry here.

(HT: Reason Magazine)

Tuesday, 28 October 2008

Energy independence

"Energy independence" is one of those ideas that just doesn't go away, no matter how long you send explaining to people why it's crazy. Just look at the current US presidential campaign where both McCain and Obama think it's a good idea. To see why it's not such a good idea read David Henderson at the EconLog blog. He writes
One issue that has arisen in this campaign is the issue of "energy independence." Both McCain and Obama believe that moving towards energy independence is a good idea. But, as I pointed out in this month's The Freeman, it's not. Energy independence is no more desirable than coffee independence, banana independence, or car independence. The case for free trade does not break down just because the good being exchanged is important, as oil is. It doesn't generally make sense, if your goal is the wellbeing of country A's citizens, for country A's government to impose tariffs or import quotas on a product from other countries. Even if we put the moral arguments against coercion aside, and even if we nationalistically care only about Americans (I don't care only about Americans), the gains to the domestic producers from reducing trade are less than the losses to domestic consumers. I won't repeat that argument here because you can go to The Freeman to read it.
The Freeman article he refers to above is available here. Read it and the rest of Henderson's blog posting.

Effects of minimum wages

The Economic Logician comments on work by Natalya Y. Shelkova of the University of Connecticut on the effects of the minimum wage.

A controversy has been raging for many years about whether minimum wages increase or decrease employment of the low waged. But the effects of the minimum wage on other wages has not been so well studied. The idea behind the minimum wage is, I would assume, to raise the lowest wages to a level that makes them "living wages". What about the other wages? The Economic Logician writes
Natalya Shelkova suggests that the workers with productivities not much higher that the minimum wages get their wage depressed to the minimum wage. The reason is that the minimum wage acts like a coordination device for employers who thus implicitly collude to offer lower wages. Empirically, she shows that this happens more in states that follow the federal minimum wage, as well as at times where the minimum wages has not been changed for a long time. This implies that introducing a minimum wage reduces wages, at least for those who had wages reasonably close to this new minimum. However, increasing an existing minimum wage raises wages.

EconTalk this week

Mike Munger of Duke University talks with Russ Roberts at EconTalk about the often-vilified middleman--someone who buys cheap, sells dear and does nothing to improve the product. Munger explains the economic function of arbitrage using a classic article about how prices emerged in a POW camp during World War II. Munger then applies the analysis to the financial crisis.

Monday, 27 October 2008

The great escape

Having outlined Greg Mankiw's view, see here, of what got us into the 1930s depression, I now take a look at Robert Higg's view of what got us out. Higgs writes in a column, Our Economic Past ~ The Great Escape from the Great Depression, in "The Freeman: Ideas on Liberty" - October 2008, Vol. 58 No. 8, that
With regard to the Great Escape, economists have also reached substantial agreement, but unfortunately they have come to agree on an interpretation that is almost completely wrong.

It is wrong factually because it places the Great Escape in the early 1940s, around the time the United States became a declared belligerent in World War II, whereas the economy did not return to what we may properly describe as prosperity until after the war. Economists have misconstrued the specious “wartime prosperity” as the real thing, but diverting nearly 40 percent of the total labor force into military-related employment and producing mountains of guns and ammunition do not create genuine, sustainable prosperity, as people would discover if they tried to operate an economy on this basis for more than a brief period. The true Great Escape did not occur until 1946.
He goes on to say
After the war most of the wartime economic controls were discontinued, more than 10 million men were mustered out of the armed forces, and the released warriors and civilian war workers quickly found private employment or left the labor force for home or school. The unemployment rate in 1947, when the transition was nearly complete, was less than 4 percent.

The standard interpretation of the transition after 1945 emphasizes that during the war people had accumulated enormous amounts of bonds and bank deposits, and afterward these financial holdings were “released” to finance consumer spending, especially for durable goods whose production had been prohibited or greatly diminished during the war. This interpretation, however, makes no sense: the bonds one man sold another bought, leaving the economy’s overall holdings unchanged. Similarly, the money one man spent by drawing down his bank account reappeared in the sellers’ bank accounts, leaving the economy’s overall bank deposits unchanged. In fact, holdings of liquid assets did not decline at all after the war. People financed their spending for consumer goods by reducing their saving rate.

Nor did people attempt to reduce their holdings of liquid assets by decreasing their demand for cash balances—equivalently, by increasing the average dollar’s “velocity of expenditure.” Velocity actually fell slightly during the immediate postwar years (because, some economists have conjectured, people still expected postwar deflation).

Nor did consumers reduce their holdings of government bonds. Although the amount of outstanding government debt declined between 1945 and 1948, this occurred almost entirely because of reductions in the holdings of commercial banks and corporations other than banks and insurance companies.
What then drove the postwar business expansion?
While consumers were financing their postwar spending binge simply by reducing their saving rate, which had risen to extraordinary heights during the war, businesses financed their postwar investment surge by selling government securities acquired during the war; by retaining more of their current earnings, in part because business taxes were reduced substantially after 1945; and by entering the capital markets, where stocks and bonds could be sold on very attractive terms. Even greater business expansion was prevented mainly by lack of materials, rather than by lack of desire to invest or lack of financial resources—to the great astonishment of the elite Keynesian economists, who had forecast that a severe postwar depression would occur when the government reduced its purchases of war-related goods and services.
Higgs goes on to argue here, as he has before, that the Keynesians policy makers of the time had failed completely to understand that the prewar depression had persisted for so long in large part because of "regime uncertainty". During the Second New Deal, the period 1935 to 1938, the Roosevelt administration had created extreme apprehension in the minds of investors and businessmen about the security of their private property rights, and thus had discouraged these people from making the large volume of long-term investments necessary for the economy's full recovery and for its sustained long-run growth. By the time that World War 2 ended, Roosevelt was dead and the most zealous advisers and administrators of the Second New Deal had left government service altogether or had been placed in less influential positions. This resulted in a considerably more auspicious view being taken of the future security of private property rights than had been true before the war. This change in outlook was sufficient to induce a great deal of long-term private investment for the first time since 1929. Higgs writes
Because “regime uncertainty,” which had dominated the later 1930s, no longer cast such a dark shadow over business and investment, the economy finally recovered from the Great Depression and the economic hardships of the war years, even as it simultaneously reallocated about 40 percent of the labor force from war-related uses to civilian uses.
Higgs ends by noting
The year 1946, when civilian output increased by about 30 percent, was the most glorious single year in the entire history of the U.S. economy. By 1948, real output was back on its long-run growth trend, and during the decades that followed, the economy was spared the sort of deep and long debacle that a congeries of wrongheaded government policies had caused during the 1930s.

Sunday, 26 October 2008

Mankiw on what caused the depression of the 1930s

In his latest article in the New York Times, But Have We Learned Enough?, Gregory Mankiw gives us an outline of his view of what caused the depression of the 1930s. He writes,
The Depression began, to a large extent, as a garden-variety downturn. The 1920s were a boom decade, and as it came to a close the Federal Reserve tried to rein in what might have been called the irrational exuberance of the era.

In 1928, the Fed maneuvered to drive up interest rates. So interest-sensitive sectors like construction slowed.

But things took a bad turn after the crash of October 1929. Lower stock prices made households poorer and discouraged consumer spending, which then made up three-quarters of the economy. (Today it’s about two-thirds.)

According to the economic historian Christina D. Romer, a professor at the University of California, Berkeley, the great volatility of stock prices at the time also increased consumers’ feelings of uncertainty, inducing them to put off purchases until the uncertainty was resolved. Spending on consumer durable goods like autos dropped precipitously in 1930.

Next came a series of bank panics. From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today.

The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks.

As they withdrew their funds, the banking system’s normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households’ debts.

Second, the disappearance of so many banks made credit hard to come by. Small businesses often rely on established relationships with local bankers when they need loans, either to tide them over in tough times or for business expansion. With so many of those relationships interrupted at the same time, the economy’s ability to channel financial resources toward their best use was seriously impaired.
But the big question is What does this have to do with the situation we face today? Mankiw sees parallels. But Anna Schwartz, co-author with Milton Friedman of "A Monetary History of the United States" thinks not much. In a recent interview she said
Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."
Schwartz and Friedman argued in "A Monetary History," that in the 1930s the US was faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they'd lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing. If borrowers had left their money in the banks, the banks would have been fine. But they didn't and importantly the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress. This just deepened the crisis and causing still more failures. But
"that's not what's going on in the market now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."
So the history of the Great Depression may not be a good guide to what needs to be done today. The problems of the two time periods are different and thus the solutions need to be different. The government's justification for the current activism in terms of monetary policy just doesn't meet the historical test.

OECD ladder too steep for NZ to climb

Dr Trinh Le of the New Zealand Institute of Economic Research has an interesting piece in the National Business Review of October 24 2008. Her article is entitled OECD ladder too steep for NZ to climb, a title which right now seems all too true.

Le points out that
In 2007, New Zealand’s GDP averaged $US26,600 per capita in purchasing power parity terms, ranking 22 out of 30 OECD countries.
Over 2000-2007, New Zealand’s real GDP per capita grew at 2.1% per year, while the average growth rate for the rest of the OECD was 2.4% (or 1.8% if weighted by population).

If each country continued to grow at its average growth rate for the period 2000-2007, New Zealand would only reach the middle rung of the OECD ladder in 2170.

In the last three years, New Zealand’s growth performance was poorer than the rest of the OECD (1.5% vs 3.0% per year). If these growth rates were sustained, New Zealand would drop to 24th place in 2010 and continue to fall further later on.

Assuming that other countries maintain their average performance of the period 2000-2007, New Zealand’s GDP per capita will need to grow at 4.6% per year in the next decade to reach the top half of the OECD. That would mean an average growth rate of 5.9% in total GDP, assuming a population growth rate of 1.27% (average rate for 2000-2007).

A growth rate in GDP per capita of 7.4% is required for the goal to be achieved in five years. Since 1970, there has not been a single year when New Zealand recorded growth of at least 7.4%, let alone five years in a row. The highest average rates over 5- and 10-year periods were respectively 2.9% (1992-1997) and 2.6% (1992-2000).
But may be the worst thing that Le points out in our growth in labour productivity. The graph below comes from the NBR article.With labour productivity heading in that direction we are very unlikely to be able to improve our growth rate to the level required to move up the OECD ladder.

Why is growth so bad? A number of policies have contributed to this outcome.
Interest-free student loans, raising the top marginal tax rate and not indexing tax brackets to inflation, high effective marginal tax rates (through Working for Families), the Employment Relations Act, KiwiSaver, re-nationalisation of ACC and the railways, the Emissions Trading Scheme, and increasing government spending and regulation are some of the many growth-retarding policies that have been introduced in the last nine years.
Le ends her article by noting
Getting back to the top half of the OECD is a commendable goal, but its achievement is highly unlikely under current policy settings. It would be a good thing if the need for substantial changes to policy settings informed public debate during this general election period.
Looking at the election campaign so far I don't see any evidence that such debate is taking place. I have yet to see what I would call pro-growth policies have any of the parties.

Saturday, 25 October 2008

Don Boudreaux on changing times

Donald J. Boudreaux writes in the Pittsburgh Tribune-Review on Changing times. He says,
All in all, the past 30 years have been satisfying ones for friends of free markets.

Has this period suddenly come to a close? Is the subprime-market meltdown sparking another era of intervention along the lines of the New Deal?

Newspapers, magazines, and the broadcast media are full of pundits predicting this outcome (and eager to applaud it when it happens). These pundits might well prove to be prescient. Conventional wisdom already holds that this financial mess is a result of unfettered free markets. The fact that markets have become freer over the past 30 years is now distorted into the myth that these years were marked by the reign of laissez-faire capitalism.

Joe Six-Pack can be forgiven if he now thinks that, for the past few decades, commissioners and staff at the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Department of Justice, along with bank regulators at the Fed, have all been on permanent administrative leave -- vacationing on some far-off island with every last tax collector.

Of course, the economy hasn't been remotely close to laissez faire. Yet the belief that it has been -- the belief that government intervention cannot possibly have played a role in this mess because there's been no government intervention -- is fast discrediting markets. With equal speed, this mistaken belief is rejuvenating Americans' faith in command-and-control regulations.

One lesson I draw from this frightening state of affairs is that even the most obvious falsehood stands a good chance of being widely believed if it is repeated often enough. The claim that the U.S. economy of late has been one of laissez faire has become a mantra. And it's now taken as fact.

Another lesson is that we champions of free markets and individual liberty became too complacent. "Of course the virtues of markets are widely appreciated," we proclaimed confidently. "Airlines are deregulated and the Iron Curtain lies in rubble!"

Well, now that the Dow has shed 40 percent of its peak value and people who expected to retire at the age of 55 fear that they must wait until they're 60 or 65, the virtues of markets are lost amid the panic of market adjustments.

"Enough already with laissez faire!" people cry.

"Give us regulations that will protect us from bankers offering exceptionally attractive credit terms. Spend lots of money buying up worthless assets so that their prices make them appear to be the equal of gold. Create new bureaucracies. Have government set CEOs' pay and buy the banks!"

That people so readily indict the market and plead for government intervention is a sure sign that those of us whose job it is to make a compelling case for free markets have failed.

It's tempting to blame the general public for their economic ignorance. But succumbing to this temptation solves nothing. If public understanding of the market is shallow (as it certainly is), the fault lies first and foremost with people like me [Boudreaux is chairman of the Department of Economics at George Mason University] -- people who accept the responsibility for explaining the many merits of markets to a general audience.

We must do better. Making the invisible hand of the market visible -- and showing that, even when it's a bit unsteady, the invisible hand is always more reliable and less bossy than is the visible fist of government -- must become an even higher priority for people who care about the kind of society we will bequeath to our children.
Boudreaux is right that the public understanding of the market, and economics, in general is shallow but I'm not sure how much difference even the likes of Don Boudreaux can make. Bryan Caplan in his book The Myth of the Rational Voter: Why Democracies Choose Bad Policies lists an "antimarket bias" as one of the four systematic biases about economics that people hold. Such a basis is common place and long held in face of all the effects of economists to educate the general audience. As Caplan writes
Antimarket bias is not a temporary, culturally specific aberration. It is deeply rooted patten of human thinking that has frustrated economists for generation."
You only have to look at the standard of economic debate in either the US or New Zealand election campaigns to see the very low standard it meets. Politicians play to beliefs like the "antimarket bias" to get votes. Voters could demand more from their elected representatives, but they don't. As Caplan's book makes clear, Boudreaux has a hell of a battle on his hands to change this, but I do wish him luck.

Public policies against global warming: don’t forget the supply side

In this audio from, Hans-Werner Sinn talks to Romesh Vaitilingam about Public policies against global warming: don’t forget the supply side. Sinn argues that public policy discussion of climate change has focused only on the reduction of demand for fossil fuel, neglecting the supply side.

Hans-Werner Sinn is Professor of Economics and Public Finance at the University of Munich, President of Ifo Institute for Economic Research and Director of CES.

Friday, 24 October 2008

Four myths about the financial crisis

At the Federal Reserve Bank of Minneapolis three economists - V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe - set out to look at Four Myths about the Financial Crisis of 2008.

The myths
  1. Bank lending to nonfinancial corporations and individuals has declined sharply.
  2. Interbank lending is essentially nonexistent.
  3. Commercial paper issuance by nonfinancial corporations has declined sharply and rates have risen to unprecedented levels.
  4. Banks play a large role in channeling funds from savers to borrowers.
What do they find? Basically that each of these myths is refuted by financial data, that is available to those who want it, from the Federal Reserve. Its a short paper, so it doesn't take long to read the whole thing. The abstract reads
The United States is indisputably undergoing a financial crisis. Here we examine four claims about the way the financial crisis is affecting the economy as a whole and argue that all four claims are myths. Conventional analyses of the financial crisis focus on interest rate spreads. We argue that such analyses may lead to mistaken inferences about the real costs of borrowing and argue that, during financial crises, variations in the levels of nominal interest rates might lead to better inferences about variations in the real costs of borrowing.
The Free Exchange blog attacks this piece here and Mark Thomas attacks it here. Alex Tabarrok attacks the attackers here.

Why are hedge funds not blowing up all over the place?

At Freakonomics Steven D. Levitt asks Why Are Hedge Funds Not Blowing Up All Over the Place? He writes
There are many things I do not understand about the financial crisis, but the one thing that currently puzzles me the most is how there have not been dozens of huge hedge-fund failures over the last few months.
Levitt goes on to give two reasons why we have not yet seen massive hedge-fund failures,
The first is that most hedge funds have “lock up” periods, so that investors can only get their money out with a lag of a few months or maybe up to a year.

The second reason that hedge funds might not yet be blowing up is that they are nearly unregulated, so they don’t face “mark to market” rules or required capital ratios. So these hedge funds could be in terrible shape, but might be able to hide that fact — at least until the redemptions hit.
From this he makes a prediction that,
the next few months will see a string of huge hedge-fund failures, which will lead hedge-fund investors to pull their cash out of hedge funds en masse, triggering further hedge-fund blow ups.
A testable hypothesis. Time will gives us the answer.

Thursday, 23 October 2008

The State of Macro (updated)

Over at the visible hand in economics we are referred to a posting at EconLog in which Arnold Kling rips into economists. Kling is unhappy with the state of current macro but not everyone argees. Olivier J. Blanchard in a recent NBER working paper looks at The State of Macro.

Blanchard argues that for a long while after the explosion of macroeconomics in the 1970s, the field looked like a battlefield (still does to me!). He goes on to say that over time however, largely because facts do not go away, a largely shared vision both of fluctuations and of methodology has emerged. But he adds not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism and herding. In his view, however, none of this deadly. The general state of macro is good.

The first section of his paper sets the stage with a brief review of the past. The second section argues that there has been broad convergence in vision, and the third reviews the specifics. The fourth focuses on convergence in methodology. The last looks at current challenges.

Update: Arnold Kling responds to Blanchard here. He opens by saying
I'll excerpt more below, and try not to get personal about an economist who for thirty years has embodied everything I despise about macro. Back then, he was insufferably smug and I was childishly rebellious. Not much has changed.

New iPredict stocks

I'm a bit late on this, but better late than never I guess. iPredict has nine new stocks on offer to do with results in three electorate races.
  1. Epsom: Hide vs Worth
  2. Mangere: Field vs Sio
  3. Tauranga: Bridges vs Peters
EPSOM.WORTH - This contract pays $1.00 if Richard Worth wins the Epsom electorate in the 2008 New Zealand General Election, $0 otherwise.

EPSOM.HIDE - This stock pays $1.00 if Rodney Hide wins the Epsom electorate in the 2008 New Zealand General Election, $0 otherwise.

EPSOM.OTHER - This contract pays $1.00 if both EPSOM.HIDE and EPSOM.WORTH contracts close at $0. Otherwise this contract closes at $0.
MANGERE.SIO - This stock pays $1.00 if Su'a William Sio wins the Mangere electorate in the 2008 New Zealand General Election, $0 otherwise.

MANGERE.FIELD - This stock pays $1.00 if Taito Phillip Field wins the Mangere electorate in the 2008 New Zealand General Election, $0 otherwise.

MANGERE.OTHER - This contract pays $1.00 if both MANGERE.FIELD and MANGERE.SIO contracts close at $0. Otherwise this contract closes at $0.
TAURANGA.PETERS - This stock pays $1.00 if Winston Peters wins the Tauranga electorate in the 2008 New Zealand General Election, $0 otherwise.

TAURANGA.BRIDGES - This stock pays $1.00 if Simon Bridges wins the Tauranga electorate in the 2008 New Zealand General Election, $0 otherwise.

TAURANGA.OTHER - This contract pays $1.00 if both TAURANGA.PETERS and TAURANGA.BRIDGES contracts close at $0. Otherwise this contract closes at $0.

Wednesday, 22 October 2008

Politicians v's faith-healers

At Cafe Hayek Don Boudreaux gives us his view of politicians,
The general lesson here is that politicians are akin to faith-healers. Both pose as wizards; they use enchanting words to push crackpot potions. The faith-healer dupes his customers into believing that he will suspend medical reality; the politician dupes voters into believing that he will suspend economic reality. Both are frauds.
If only voters realised this fact.

Kling on banking

Arnold Kling writes about his Thoughts on Banking and Thoughts on Banking: An Example. With regard to the first posting he writes
This post returns to the deep topic of banking theory. I am very unhappy with the state of banking theory in economics. People make very strong empirical claims about what they call the risk-taking process based on shallow thinking about that process. I think that Mencius Moldbug is giving the wrong answer, but at least he is asking the right question, which is more than I can say for, well, just about the entire economics profession.
This stuff is for the macro geeks among us.

Myron Scholes on financial innovation and failure

When debating the notion that more regulation would repair the finance industry and keep us out of trouble in the future Nobel laureate Myron Scholes, one of the fathers of modern finance, makes an interesting point:
Economic theory suggests that financial innovation must lead to failures. And, in particular, since successful innovations are hard to predict, the infrastructure necessary to support innovation needs to lag the innovations themselves, which increases the probability that controls will be insufficient at times to prevent breakdowns in governance mechanisms. Failures, however, do not lead to the conclusion that re-regulation will succeed in stemming future failures. Or that society will be better off with fewer freedoms. Although governments are able to regulate organisational forms, they are unable to regulate the services provided by competing entities, many yet to be born. Organisational forms change with financial innovations. Although functions of finance remain static and are similar in Africa, Asia, Europe and the United States, their provision is dynamic as entities attempt to profit by providing services at lower cost and greater benefit than competing alternatives.
At the Free Exchange blog they comment
Looking at the recent and explosive growth of some financial derivatives, I wonder if something Schumpeterian occurred in financial innovation. Perhaps too much was invested in these products, thanks to an incomplete understanding of them and the risks they posed. Schumpeter predicts that such investment, in any industry, inevitably leads to a contraction. On the other hand, innovation is ultimately the only sustainable driver of long-term growth. It also, by definition, causes market fluctuations. Policies aimed at undermining innovation hinder an industry's ability to compete globally.
May be more regulation could help prevent another crisis, but it may also kill the goose that lays the golden egg.

Tuesday, 21 October 2008

Butler on Adam Smith

In this short video from the Institute of Economic Affairs in London, Eamonn Butler, author of Adam Smith: A Primer, talks about Adam Smith and the nature and importance of his ideas.

Butler on the finanical crisis

Eamonn Butler writing in the The Australian, on the 21 October, points out that there is No such thing as a free lunch. He writes
WITH turmoil in the world's markets, politicians and commentators have been demanding more regulation and control of the financial sector. Kevin Rudd even says it was caused by extreme capitalism. Their reaction is predictable, but entirely wrong.

This crisis was not caused by capitalism being fatally flawed. It was caused by politicians forcing the banks to give out bad loans, monetary authorities flooding the West with cheap credit and regulators being asleep at the wheel.

Indeed, one can date its origin precisely, to October 12, 1977, when US president Jimmy Carter signed the anti-redlining law. Before then, lenders generally denied loans to people in poor neighbourhoods, believing that the local mix of low incomes and a weak housing market would lead to many people defaulting. But the politicians - with good intent - wanted to make home ownership available to all Americans. So lenders were forced into giving out risky mortgages, what we call sub-prime loans.

By 1985, this torrent of bad business had nearly bankrupted the US's savings and loan institutions. So the government took on their bad debt and encouraged them to consolidate, unwittingly making them too big to be allowed to fail.

Meanwhile, several other problems worried the monetary authorities. In 1987, the US stock market plummeted, fearing that other lenders could collapse. There have been other successive crises. Asia's markets sank. Mexico, Argentina and even Russia defaulted on their loans. Over-valued dotcom stocks crashed. Then there was 9/11. Each time, Western authorities responded by flooding the markets with cash.

After 9/11, the Federal Reserve took US interest rates down from 6.25 per cent to just 1 per cent, fearing this blow to investor confidence could sink the markets. But, again, its action boosted the wrong market by sustaining the credit bubble.

With loans six times cheaper, mortgage applications soared.

Lenders, awash with the Fed's cash, happily issued more sub-prime loans. With more people buying homes, house prices soared. Buying a house seemed a certain money-maker, so more people got more loans and bought more houses, continuing the spiral.

In London, that other great financial centre, a decade of government overspending saw public debt soaring. Private debt and house prices soared even faster.

So for 10 years, economies boomed, the champagne flowed and everyone had a great party. But it was financed by fake money, printed by the authorities solely to keep the party going. When the realisation broke, the long party turned into the inevitable hangover we suffer today.

The regulators, meanwhile, were unconscious on the floor. The US mortgage institutions, Fannie Mae and Freddie Mac, had 200 regulators on their case but still went bust for $US5 trillion. These semi-governmental companies allowed investors to believe the bad mortgages were guaranteed by government, causing credit rating agencies to give their dodgy bonds high scores.

Mortgage lenders repackaged these bad debts across the world, but nobody cried foul. Institutions were lending 30 times their asset base. Though the Bank of England knew that the huge mortgage lender Northern Rock was failing, the 2500 staff of Britain's financial regulator seemed to do nothing until it collapsed six months later. Even then, they had no coherent plan.

When the government is persuading the casino to hand out free chips and the regulators are standing drinks at the bar, you shouldn't be surprised if the customers place a few risky bets. It's the management, not the system, that deserves our scorn for breaking the basic rules of economics: there ain't no such thing as a free lunch.

Any sustainable solution has to get finance back to those basics. But the bailout package includes so many treats for special interests that it could save the culprits without helping the victims.

But it's a big world out there. China, the world's fourth biggest economy, continues to grow at nearly 10 per cent. India and other emerging economies are expanding, too. Even with the West in recession, world growth next year will probably be near 4 per cent. That's pretty good.

Western capitalism has been dealt a severe blow by inept politicians and officials. But global capitalism continues to pull hundreds of millions of people out of poverty. It's a great system. Let's not break it.
Eamonn Butler is director of the Adam Smith Institute, a free market think tank in London, and author of the excellent Adam Smith: A Primer (2007, IEA, London).

EconTalk this week

Clay Shirky, author of Here Comes Everybody: The Power of Organizing Without Organizations, talks about the economics of organizations with EconTalk host Russ Roberts. The conversation centers on Shirky's book. Topics include Coase on the theory of the firm, the power of sharing information on the internet, the economics of altruism, and the creation of Wikipedia.

Monday, 20 October 2008

An international perspective on the US bailout

The current credit crisis in the US has prompted many calls for some form of regulation to prevent such an event from ever happening again. In a new column at Romain Rancière, Aaron Tornell and Frank Westermann defend a financial system that engenders systemic risk. Economies that risk occasional credit crises enjoy higher long-run growth, and the cost of the US bailout is well within historical norms. Not your standard view of the situation.

The column, An international perspective on the US bailout, opens by noting
As the US economy is hit by the financial crisis and associated bailout costs, it is useful to take an international perspective on current events. In the last three decades, many developing countries have also experienced financial crises and large bailouts. Yet, the growth gains brought by financial liberalisation and deregulation have, in most cases, far more than offset the output and bailout costs of crises. Importantly, financial liberalisation by itself did not generate crises – government meddling and implicit bailout guarantees were often involved. In many ways, the US story is not so different.
Rancière, Tornell and Westermann go on to point out that many commentators point to financial deregulation as a key cause of the crisis. In Rancière, Tornell and Westermann's view the facts suggest otherwise.
  • First, the size of the bailout is within historical and international norms.
  • Second, financial liberalisation and deregulation policies along with financial innovation have largely contributed to the impressive growth performance of the US economy relatively to EU countries. The development of new financial instruments has helped finance the IT revolution and the large-scale increase in home ownership. Both factors have been powerful engines of US growth.
  • Third, policy interventions, such as the effort by some in the administration and Congress to induce Fannie Mae and Freddie Mac to move into the subprime mortgage market, have largely paved the road to the financial crisis the US faces today.
One question to ask is How big is the bailout compared to others? Rancière, Tornell and Westermann note
The $700 billion bailout bill is equivalent to 5% of GDP. Adding to it the cost of other rescues – Bear Stearns, Freddie Mac and Fannie Mae, AIG – the total bailout costs could go up to $1,400 billion, which is around 10% of GDP.
But they put this into perspective by pointing out that
  • Mexico incurred bailout costs of 18% of GDP following the 1994 Tequila crisis.
  • In the aftermath of the 1997-98 Asian crisis, the bailout price tag was 18% of GDP in Thailand and a whopping 27% in South Korea.
  • Somewhat lower costs, although of the same order of magnitude, were incurred by Scandinavian countries in the banking crises of the late 1980s. 11% in Finland (1991), 8% in Norway (1987), and 4% in Sweden (1990).
  • Lastly, the 1980s savings and loans debacle in the US had a cumulative fiscal cost for the taxpayer of 2.6% of GDP.
They also explain the costs of the bailout that taxpayers are now facing can be seen as an ex post payback for years of easy access to finance in the US economy.
The implicit bailout guarantees against systemic crises have supported a high growth path for the economy – albeit a risky one. In effect, the guarantees act as an investment subsidy that leads investors to (1) lend more and (2) at cheaper interest rates. This results in greater investment and growth in financially constrained sectors – such as housing, small businesses, internet infrastructure, and so on. Investors are willing to do so because they know that if a systemic crisis were to take place, the government will make sure they get repaid (at least partially).
Such effects from a bailout scheme only occur when there is a systemic insolvency risk. This is simply because a bailout is not forthcoming if an isolated default occurs, it will only be granted when a systemic crisis hits because it is only under the threat of generalised bankruptcies and a financial meltdown that would the US Congress would agree to a bailout plan.
Thus, an investor will be willing to take on insolvency risk only if many others do the same. When a majority of investors load on insolvency risk, they feel safe (because of the bailout guarantee). No wonder many financial firms end up with huge leverage and loaded with risky assets. In the Tequila and Asian crises the risky bet was the so-called currency mismatch, in which banks funded themselves in dollars and lent in domestic currency. In the US, it took the form of toxic mortgage-related assets. There are no innocent souls here. Borrowers, intermediaries, investors and regulators understood the bargain. At the end, the bailout guarantee scheme has succeeded in inducing more investment by financially constrained agents in real estate and small businesses.
Now what of the positive side of risk-taking in the long run. Rancière, Tornell and Westermann say
Perhaps the financial sector lent excessively, leading to overinvestment in the housing sector today and the IT sector in the late 1990s. But the bottom line remains that risk-taking has positive consequences in the long run even if it implies that crises will happen from time to time. Over history, the countries that have experienced (rare) crises are the ones that have grown the fastest. In those countries, investors and businesses take on more risks and as a result have greater investment and growth. Compare Thailand's high-but-jumpy growth path with India's slow-but-steady growth path before it implemented liberalisation a few years ago. Over the last 25 years, Thailand grew 32% more than India in terms of per-capita income despite a major financial crisis. Similarly, easier access to finance and risk-taking explains, in part, why the US economy has strongly outperformed those of France and Germany in the last decades.
Many people are arguing for a rolling back of financial liberalisation and for a return of the "good old days" of strict regulation. But if Rancière, Tornell and Westermann are right then maybe this is not the right response to the current situation.

Rancière, Tornell and Westermann conclude
Today's bailout price seems high. But is it that much relative to the higher growth the US has enjoyed in specific sectors and overall? Let's wait for the final price tag. Other countries' experiences tell us that financial liberalisation – and some of its consequences – is not such a bad idea after all. They also teach us the importance of quickly jump-starting the lending engine so as to avoid a growth collapse and for the regulatory agencies to refrain from killing the natural risk-taking process that accompanies the resumption of credit growth.

White on Krugman

The latest issue of the The Freeman: Ideas on Liberty (October 2008, Vol. 58 No. 8) has an interesting article in which Lawrence H. White rebuts Paul Krugman's view that the subprime crisis is the result of too little regulation. See The Subprime Crisis Shows That Government Intervenes Too Little in Financial Markets? It Just Ain’t So! (pdf). White is the F.A. Hayek Professor of Economic History at University of Missouri - St. Louis.

Sunday, 19 October 2008

More on the current financial problems

Brian M. Carney of the Wall Street Journal has report of a recent interview he did with Anna Schwartz. As Carney points out
Most people now living have never seen a credit crunch like the one we are currently enduring. Ms. Schwartz, 92 years old, is one of the exceptions. She's not only old enough to remember the period from 1929 to 1933, she may know more about monetary history and banking than anyone alive. She co-authored, with Milton Friedman, "A Monetary History of the United States" (1963). It's the definitive account of how misguided monetary policy turned the stock-market crash of 1929 into the Great Depression.
In addition there is a nice piece by Jeff Miron at on Why this bailout is as bad as the last one. Warren E. Buffett says Buy American. I Am. Kenneth Arrow comments on a Risky business
The root of this financial crisis is the tension between wanting to spread risk and not understanding its consequences

Cool heads needed

In a recent piece in the Dominion Post Roger Kerr makes the point that Cool Heads Needed in Economic Turmoil. Kerr writes that there are some things that are clear about the current crisis,
First, it will pass. Defensive actions by governments and market adjustments will pave the way for recovery, probably within a year or two. A repeat of the 1930s Great Depression is highly unlikely.

Second, market-based economic systems will not be abandoned. They involve risk and can be volatile, but their wealth-creating abilities are unsurpassed.

Third, just as in the 1930s depression, the stagflation of the 1970s and the Asian economic crises of the 1990s, many of the current problems are government-made. Governments and businesses need to learn from their mistakes.
He goes on the explain that many acts of folly precipitated the meltdown in the US financial sector,
Prime exhibits include the easy money policies of the Federal Reserve after the dotcom crash, which helped fuel the house price boom; the government sponsorship of Freddie Mac and Fannie Mac, the giant mortgage underwriters that failed; the legislation and political pressure that encouraged banks to lend to unqualified borrowers in the name of ‘affordable housing’; land supply restrictions; mark-to-market accounting rules; non-recourse lending regulations; and more.
Later he notes that
Once the default avalanche was triggered, authorities in the United States, Europe and elsewhere had little option other than to act to protect their financial systems, [...]
This is not so clear to me. As Jeff Miron has recently put it
It is time for the government to do the one thing it does well: nothing at all.
Or as Miron entitled a previous column on the US financial problems, Bankruptcy, not bailout, is the right answer.

When looking at the US governments approach to protect their financial system Miron argues that the government bailouts of banks will hide problems and spread inefficiency. He writes
If banks were fundamentally sound but temporarily in need of cash, they could sell stock on their own to private investors. Few investors now want bank stock, however, because they cannot tell which banks are merely illiquid -- short of cash for new loans because their assets are temporarily sellable only at fire-sale prices -- and which are fundamentally insolvent -- short of cash and holding assets whose fundamental values are less than the bank's liabilities.

This lack of transparency is a crucial impediment to new investment, and therefore to new lending.

Government injection of cash, however, does little to improve transparency. A bank with complicated, depreciated assets is in much the same position after the government gives it cash as it was before, since outside investors will still have limited information about the solvency of any individual bank.

Perhaps the new cash will spur the sale of bad assets, or nudge banks to reveal their balance sheets, but that is far from obvious. Banks, moreover, might remain cautious even with this increased liquidity simply because of uncertainty about the economy. Thus it is hard to know whether cash injections will actually spur bank lending.
The great Anna Schwartz also sees the problem as one of lack of transparency. This from a recent report of an interview with Schwartz by Brian M. Carney in the Wall Street Journal,
This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."
Miron goes on to say
In any event, government ownership of banks has frightening long-term implications, whether or not it alleviates the credit crunch.

Government ownership means that political forces will determine who wins and who loses in the banking sector. The government, for example, will push banks to aid borrowers with poor credit histories, to subsidize politically connected industries, and to lend in the districts of powerful members of Congress. All of this is horrible for economic efficiency.

Government pressure will be difficult for banks to resist, since the government can both threaten to withdraw its ownership stake or promise further injections whenever it wants to modify bank behavior. Banks will respond by accommodating government objectives in exchange for continued financial support. This is crony capitalism, pure and simple.

Government ownership of banks will not be a temporary expedient. Politicians can swear they will unwind the government's position once "economic conditions improve," but no one can enforce this promise. The temptation to use banks as a political tool will be permanent, not temporary, so government ownership will continue for decades, or forever.

Worse yet, government ownership of banks sets a precedent for ownership in every industry that suffers economic hardship. Some might argue that banking is "essential," but many industries -- autos, steel, computers or agriculture -- will make similar claims when it is their turn to demand a bailout. Thus banking will be only the first victim in an enormous expansion of the government's role. This again will have disastrous consequences for economic efficiency.
But in Miron's view this is not the worst of it,
The injection means that banks get cash, and they get it now. This benefits current stockholders and bondholders, which is why stocks have jumped on news of the injections.

The government, however, gets stock that might end up being worthless, since some banks will fail anyway. The government gets stock that may never trade in a market or have its value determined by fundamentals. The government gets stock that it cannot sell for years, if ever, without generating turbulence in asset markets as investors interpret the government's decisions or position themselves to profit from them.

Government purchase of bank stock, therefore, is a transfer from taxpayers to people who took huge risks and lost. The United States, and the world, got into the current mess by trying to insure away risk, which everyone should have known was a fool's errand. Thus bailing out risk-taking -- or providing new guarantees for loans and deposits -- will generate even greater problems down the line.
Thus the US efforts to protect their financial system may well not work and similar efforts in many other countries share at least some of the problems of the US approach. But more importantly, doing nothing at all, as Miron puts it, was an option and if the actions countries have taken don't work hindsight may make it seem the optimal action (or inaction!).

Should this surprise us? I would argue no. As I tried to argue here and here the history of the Great Depression tells us that government efforts to deal with a crisis do, by and large, little good and in fact can make matters worse.

So Roger Kerr is correct to say cool heads are need right now, but I would argue that such heads may be saying, do nothing.

Saturday, 18 October 2008

Dixit: why Paul Krugman got the Nobel Prize

In this article, Why Krugman got the Nobel Prize: Economics, not polemics, at Avinash Dixit, University Professor of Economics at Princeton University and the 2008 President of the American Economic Association argues that economics got Krugman the prize. He notes that Paul Krugman the columnist offers strong views, attracting adulation and hatred. His newspaper-reading fans delight in his Nobel Prize; his foes are shocked and dismayed. Both are mistaken. His prize has nothing to do with his popular writing. In this piece Dixit explains that the prize celebrates Krugman’s achievements in science, not in the policy arena. This column clarifies exactly what those achievements are.

Austrian economics and the present crisis

On October 6, 2008 at the inaugural lecture for The Future of Freedom Foundation’s “Economic Liberty Lecture Series,” Peter Boettke analysed the current credit crisis in the US from an Austrian perspective. Peter J. Boettke is the BB&T Professor for the Study of Capitalism, Mercatus Center at George Mason University, and University professor in the economics department at George Mason University.

Below is Boettke's talk in nine parts.

Worldwide financial crisis largely bypasses Canada

Just for EC, this article from the Washington Post looks at why the US financial crisis has had little impact on Canada. One interesting point is
According to the Canadian Banking Association, one reason for the system's solidity is that banks are national in scope. Each of the largest five institutions has branches in all 10 Canadian provinces, meaning they are less susceptible to regional downturns and they can move capital from region to region, as needed. "As far as I am aware, no American bank has branches in all 50 states," banking association spokesman Andrew Addison wrote in an e-mail.
Another difference is that in Canada, mortgage interest is not tax-deductible, making it harder to buy a house. [...] People do not take out mortgages just for the tax break. In Canada, "a mortgage is seen as something you want to get rid of as fast as possible," said Peter Dungan, an economist with the Rotman School of Management at the University of Toronto.
But it's not just today that the Canadian bank system has looked good. Consider this graph from Mark Perry at the Carpe Diem blog

Perry writes
The McFadden Act of 1927 specifically prohibited interstate branch banking in the U.S., and only allowed banks to open branches within the single state in which it was chartered. Therefore, U.S. banks were forced to be small and local, with an undiversified loan portfolio tied to the local economy of a single state, or a specific region of a single state. The strict regulatory framework of the McFadden Act created a delicate and fragile banking system that could not easily withstand the shock of the Great Depression. Exhibit A: 9,000 banks failed in the U.S. in the early 1930s (see chart above).
Perry goes on to quote from an article from the San Francisco Federal Reserve,
During the Great Depression years—1930 through 1933—5.6%, 10.5%, 7.8%, and 12.9% of U.S. banks failed in each year; by the end of that four-year stretch, almost half of U.S. banks had either closed or merged. Bernanke (1983) argues that this banking crisis worsened the magnitude of the downturn because credit supply fell as banks failed. Thus, many firms were unable to finance potential investments. Most of the failed banks were small and operated out of just a single office. In Canada, where not a single bank failed, branching was the rule; in fact, Canada had only ten large banks during the 1930s. The Canadian economy fared much better than did the United States economy, in large part because of its better diversified and integrated banking system. (emphasis added)
Perry's bottomline
Strict banking regulations are not always the answer to creating a sound and stable banking system. Exhibit A: The McFadden Act and The Great Depression, and the fact that 0 banks failed in Canada (due to a more sensible regulatory system) vs. 9,000 bank failures in the U.S. largely due to the repressive regulatory framework of the McFadden Act.
Score one for Canada!

George Ayittey: cheetahs vs. hippos for Africa's future

In this TEDTalks video, recorded in June 2007, economist George Ayittey unleashes a torrent of controlled anger toward corrupt leaders in Africa. He sees Africa's future as a fight between Hippos -- complacent, greedy bureaucrats wallowing in the muck -- and Cheetahs, the fast-moving, entrepreneurial leaders and citizens who will rebuild Africa.

Friday, 17 October 2008

Walter Williams on the US financial crisis

Walter E. Williams, professor of economics at George Mason University, talks about the the solution to the US's financial crisis. See the video here.

What's new in econ?

At the Austrian Economists blog Peter Boettke asks an interesting question, interesting to other economists at least. He asks What is New in Economics? Boettke explains his question,
Since 1990, what do you consider to be the best economic theory innovations? In my opinion, most of the developments since then that have captured our professional imagination are empirical questions and techniques, not theoretical innovations --- but perhaps I am wrong. Give your nominations --- but don't just list a name, but lets discuss the core insight the name is supposed to capture.
I'm not 100 percent sure it would exactly fit Boettke's time frame, but for me one of the most interesting recent developments is incomplete contracts theory. In particular its use in the theory of the firm and the related area of the theory of privatisation.

Wilkinson on Smith on Key

At the blog Nick Smith has a strange posting on Key dons his Muldoon mask in tweaking KiwiSaver. Smith writes
If compulsory super had proceeded, New Zealand Inc would now have huge sums of cash with which to fund future growth rather than borrowing offshore and paying a premium for the privilege.

Conceivably the country would have posted a series of current account surpluses rather than the dismal succession of deficits.
He goes on to say
KiwiSaver is important because it is beginning to reverse the trend of New Zealanders spending more than they earn.
But taking an axe to savings inflows, as Key’s KiwiSaver policy effectively will, is dreadfully disappointing and will harm the economy. And for what?
Later Smith refers to comments by David Skilling
“Skilling dismisses this argument. The nation’s well-documented rate of dis-saving - spending more than it earns - means we’re not saving enough. The sheer popularity of the scheme (800,000-plus members) makes claims of an existing savings shift “wildly implausible”, he says.
I have to ask a very basic economic question, does Smith know what a current account deficit is? Even if we had a current account surplus, so what? This just means we are saving more than we are investing. Why do we care? Matt Nolan give a quick summary of why we may not care here.

A current account deficit doesn't mean we are dis-saving it means we are investing more than we are saving. Our savings are still positive. And that could be optimal. We may be better off by saving what we are and "importing" any additional funds need for the investment we want to do rather than trying to fund all investment out of our own saving and thereby reducing our consumption. As Noland notes
The current account deficit is merely the result of the borrowing, consumption, and investment decisions of every household and firm in the economy. As long as these households and firms are fully informed of the risk and return associated with their borrowing decisions, is there really any reason to fear the spectre of a current account deficit? To answer my own rhetorical question – it appears not.
In a comment on the Smith article economist Bryce Wilkinson responds, sensibly, to Smith's posting. Wilkinson writes
“If compulsory super had proceeded, New Zealand Inc would now have huge sums of cash with which to fund future growth rather than borrowing offshore and paying a premium for the privilege.”

Does anyone know of any substantive support in the mainstream economic literature on the sources of economic growth for the proposition that economic growth is generated from spending huge ‘cookie jar’ funds controlled by politicians? I don’t. Regardless, the Crown’s ‘cookie jar’ is already $200 billion (total Crown assets at 30 June 2008) and government in all its forms is spending annually more than 40 percent of national income, without bothering to rigorously assess whether that spending is doing more good than harm. Does this proposition have anything more to back it up but the belief that politicians can spend New Zealanders’ money better than they can spend it themselves?

“KiwiSaver is important because it is beginning to reverse the trend of New Zealanders spending more than they earn. ”

Where is the evidence that it is reversing any trend? Which of the major macro-economic forecasters are projecting the reversing of a savings trend due to KiwiSaver? More importantly, New Zealanders are not spending more than they earn. (See below) National savings have long been positive and measured household net worth (which excludes the net assets the Crown owns on behalf of households) has been rising.

“But taking an axe to savings inflows, as Key’s KiwiSaver policy effectively will, is dreadfully disappointing and will harm the economy. And for what?”

What is the evidence that KiwiSaver is helping the economy? Stuffing a fund full of tax incentives raises tax rates at the margin, distorts the alloaction of funds, and adds to transaction costs. Many individuals would be better off reducing their debts. Governments should not be inducing people to borrow in order to invest in risky things like shares. Does the bald unqualified assertion that cutting it will harm the economy have any factual basis?

“Skilling dismisses this argument. The nation’s well-documented rate of dis-saving - spending more than it earns - means we’re not saving enough. The sheer popularity of the scheme (800,000-plus members) makes claims of an existing savings shift “wildly implausible”, he says.”

If Skilling actually said this it would be disgraceful. New Zealand is not dis-saving. (A balance of payments deficit does not mean that savings are negative; it typically means that investment is greater than savings. This, in itself, is not a bad thing.) In fact, measured national savings have been positive, not negative, for 35 of the last 36 years for which Statistics NZ has data (see SNCA.S2NB08Z). Are statisical facts simply irrelevant? ‘His’ other arm-waving comment is also a red herring. The issue is not whether there is no effect on total saving, it is whether there is any basis for claiming material effects.

Perhaps the worst thing about all this is that it is so one-eyed. There are a host of respected economists, academics and commentators who have drawn attention to research questioning this sort of one-sided propoganda. Why not use their contributions to promote better-informed public debate. Even just a bit of attention to relevant facts would be better than this.

Thursday, 16 October 2008

Key's super idea woeful and irresponsible (updated)

In this case I think Rodney Hide has it right when he says,
There are two possibilities behind John Key’s announcement that $40 billion of the $100 billion Cullen Fund is to be directed into New Zealand assets.

The first is that he knows it’s a dumb idea but thinks it smart politics. That would be bad.

The second is that he thinks it’s a good idea – now that would be truly appalling.
And it is a truly appalling idea. Having the government buy up assets will do nothing to help improve New Zealand's economic performance. As Matt Nolan says
If capital at home made the highest return, then we wouldn’t need to legislate a 40% investment - as the Cullen Fund would put all its dosh there anyway. As a result, by “forcing” the fund to keep 40% onshore, we are reducing the return on our investment plain and simple.
To this you can add the idea that this extra government investment could just crowd out private investment, both from within New Zealand and from overseas. So the total amount of investment in New Zealand may not change much at all. And then there is the issue of what happens if politicians start to take an even more hands on approach to the fund. The last thing we need is for investment decisions to be made, not for good economic reasons, but purely for party political reasons.

Update: Save the Humans comments on Key or Keynes?

Boudreaux on Friedman

Don Boudreaux alerts us to an essay at which unfortunately describes Milton Friedman as a "champion of unfettered markets." This description, as Boudreaux rightly points out, reflects a common but unfortunate misunderstanding. Boudreaux goes on to write
Milton Friedman championed not unfettered markets, but markets fettered by competition and consumer sovereignty rather than by political diktats. Friedman understood that fetters imposed by government are neither the only nor the best means of keeping markets working well. Indeed, far too often - as Friedman knew - fetters imposed by government turn in practice into crowbars that businesses use to break free of the competitive shackles that oblige them to behave prudently and fairly.

Knowledge and power (updated)

When discussing The Political Economy of the Bailout Arnold Kling writes
Whether the economy needs a "plan," or whether the plan will help the markets, is beside the point. The plan serves to consolidate power. Four weeks ago, the Fed and the Treasury had far more power than anyone can intelligently use. Still, they came to Congress requesting more power. Then, when the bill was passed, Paulson [whom Kling refers to as the "American Mussolini"] took even more power than what it sounded like the legislation was giving
Then Kling makes the important point
We got into this crisis because power was overly concentrated relative to knowledge. What has been going on for the past several months is more consolidation of power. This is bound to make things worse. Just as Nixon's bureaucrats did not have the knowledge to go along with the power they took when they instituted wage and price controls, the Fed and the Treasury cannot possibly have knowledge that is proportional to the power they currently exercise in financial markets.
The discrepancy between knowledge and power is what Kling has called the "suits vs. geeks divide". One group has the knowledge while the other the power. In today's economy knowledge is increasingly dispersed but power is increasingly concentrated, even in the private sector, with some CEO's not understanding their own businesses. But compare this with the public sector, do politicians understand the budgets and the laws that they vote on? What do the regulators understand about the consequences of their rulings? The divide between government geeks and government suits is much greater and more dangerous. Add to this the fact that the incentives not to understand are greater in the public arena and you get, at least part of, the reason for bad outcomes in the state sector.

Update: The Free Exchange blog attacks Kling here.

Wednesday, 15 October 2008

Drug approval denationalization

The Davos Question is "What one thing do you think that countries, companies or individuals must do to make the world a better place in 2008?" The answer given by economist Professor Daniel Klein is drug approval denationalization. He explains in this video,

Interesting blog bits

  1. report on Nats want more local investment
  2. NZ Herald report on National to direct 40pc of Super Fund to NZ.
  3. The visible hand in economics on "More" local investment may lead to less.
  4. Kiwiblog on National to legislate for at least 40% of NZ Super Fund to be invested in NZ.
  5. Video by Bernard Hickey on John Key plans to fiddle with Cullen fund.
  6. Not PC on No indeed, Minister
  7. Not PC on National Socialism

New iPredict stocks

iPredict has three new stocks on offer to do with residential property values.
  1. QV.AUCK.DEC08 - This contract pays $1 if the percentage annual change in the QV estimated residential property values index for the Auckland Region falls by more than the Wellington Region or Christchurch in the year ending December 2008, otherwise $0.
  2. QV.WGTN.DEC08 - This contract pays $1 if the annual change in the QV property values index for the Wellington Region falls by more than the Auckland Region or Christchurch in the year ending December 2008, otherwise $0.
  3. QV.CHCH.DEC08 - This contract pays $1 if the annual change in the QV property values index for Christchurch falls by more than the Auckland Region or Wellington Region in the year ending December 2008, otherwise $0.

UC has new VC

Jade Software CEO Dr Rod Carr has been appointed to the position of vice-chancellor at the University of Canterbury, effective from 1 February 2009.

Prior to joining Jade in 2003, Carr was Deputy Governor and Director of the Reserve Bank of New Zealand. He has also held senior positions within the Bank of New Zealand and the National Australia Bank.

Carr has a PhD in Risk Management and Insurance, and an MA in Applied Economics and Managerial Science from the Wharton School at the University of Pennsylvania, an MBA in Money and Financial Markets from the Columbia Graduate School of Business in New York, and a LLB (Hons) and BCom (Hons) in Economics from the University of Otago.

He is a long involvement with the University. He currently chairs the advisory board of NZi3 - the national ICT Innovation Institute based at UC. He is also a director of the Geospatial Research Centre and a member of the College of Business and Economics Advisory Board.  

Kling: written remarks

Earlier I commented on both Arnold Kling's Fantasy Testimony on the US financial problems and later on his posting More Fantasy Testimony. These comments he called his "oral remarks." I also noted in that posting that Kling said he was working on some support material which he refers to as his "written remarks." Now over at EconLog Kling give us these "written remarks". Again posted in full below. They are even longer than his two previous messages but as usual they are well worth reading.

Written Remarks
Arnold Kling

1.The History of Mortgage Securitization

Suppose that you were a bank executive and were offered a choice between two methods for holding mortgage loans. Call them Method A and Method B.

Under Method A, you employ the mortgage originators. You give them rules and instructions. You set their incentives. You can choose whether to pay them only for accepting loans or to also pay them for reviewing and rejecting loan applications where appropriate. They originate loans in your local community. The loan terms are set by your policies. You receive the borrowers' payments and deal with loan delinquencies according to your procedures. Sometimes, your procedures call for rapid foreclosure. In other instances, they dictate some sort of loan workout.

Under Method B, you hold a security interest in a pool of mortgages. These loans were originated by people unknown to you, whose only incentive is to maximize "production," without regard to quality or risk. They are paid when they originate a loan, never for rejecting a loan application. The loans come from far and wide, including many places with which you are not familiar. If borrowers are delinquent in their payments, you have no control over how this delinquency is addressed.

Most executives, if offered this choice, would prefer method A. Compared with Method A, Method B does not pass a simple sanity check. Using economic jargon, method B has much higher "agency costs." Under Method A, the people acting as the agents of the executive work for the bank. The executive has the power to align the incentives of the agents with those of the shareholders of the bank. Under Method B, the agents who originate home mortgages are working against you, not for you. They are trying to slip as many bad loans through the door as they can. It is up to someone else, not you, to stop them--assuming that they care..

Today, three-fourths of mortgage debt in the United States is held using Method B, also known as securitization. How did this happen?

Method B has some potential advantages. A pool of loans from different regions has more geographic diversity than a set of loans from a single community. Also, a highly specialized mortgage intermediary, such as Freddie Mac or Fannie Mae, can develop risk management and quality control procedures to manage third-party originators, and with economies of scale they can hold down agency costs. Securities markets make it possible to place mortgage debt with mutual funds, pension funds, and insurance companies, thus broadening the market.

However, with a level regulatory playing field, depository institutions could obtain all of the advantages of Method B with none of the disadvantages. A multi-state bank holding company could have a portfolio of mortgage loans that is geographically diversified. A well-known bank holding company could issue debt instruments that could be held by any investor who now holds mortgage securities.

The mortgage securities market exists because of regulations that prevent depository institutions from using Method A economically at sufficient scale. The balance of advantages shifts to securitization only because of the way that government puts its thumb on the scale.

The secondary mortgage market began in 1968. In that year, President Lyndon Johnson was besieged. His war in Vietnam was unpopular. Along with his cherished War on Poverty, it was raising the need for government borrowing. Each time the President came to Congress to request an increase in the ceiling of the national debt, he faced embarrassment and attacks. To forestall this, his Administration looked for ways to get government housing programs off the books.

One solution was to sell the Federal National Mortgage Association (Fannie Mae) to private investors. Fannie Mae had been set up in 1938 as a national purchaser of mortgage loans originated by third parties, called mortgage bankers. Fannie Mae did not securitize loans, at least to this point. Instead, it held mortgage loans in its portfolio, like a giant Method A lender with the mortgage bankers as its agents. Selling Fannie Mae took Fannie Mae's debt off the government books, which made the national debt appear smaller.

Another tactic for controlling the national debt was the introduction of the Government National Mortgage Association, GNMA, which introduced the first mortgage-backed securities. GNMA created and sold securities backed by loans guaranteed under programs of the Federal Housing Administration (FHA) and the Veterans' Administration (VA). The risk of mortgage defaults still rested entirely with taxpayers under FHA/VA. However, selling the GNMA pools took the loans off the government's books for accounting purposes.

The secondary mortgage market thus began as an accounting gimmick to hide liabilities. It has been the same ever since. The economic costs and benefits of securitization are beside the point. Over time, various accounting gimmicks and regulatory anomalies have driven securitization forward.

The Federal Home Loan Mortgage Corporation, Freddie Mac, was chartered in 1970 as an agency under the Federal Home Loan Bank Board. in order to promote Method B lending in conventional mortgage loans, meaning loans that fund middle-class home ownership. An individual mortgage that is above a certain ceiling, which is indexed to house prices unless altered by Congress, is not eligible for purchase by Freddie Mac or Fannie Mae. Freddie Mac also was chartered to stick to "investment-quality" mortgage loans, meaning that it was not to deal in loans with low down payments or what we would now call the sub-prime market.

As of 1970, mortgage lending in the United States was predominantly Method A, conducted mostly by the savings and loan industry (S&Ls). However, inflation and interest rate regulations were soon to wreak havoc on the S&Ls. At that time, interest rates on deposits were limited by government edict, known as regulation Q. As inflation soared, market interest rates rose above regulation Q ceilings. Competitors, notably money market funds, lured consumers away from S&L's, limiting their ability to serve the needs of mortgage borrowers. Furthermore, restrictions on interstate activity created a shortage of mortgage funds in California even though there were ample savings deposits in the East.

By securitizing loans with Freddie Mac, the S&L's, particularly in California, were able to expand their mortgage lending beyond the limits of their deposit base. However, it is important to recognize that S&L's only needed securitization because of the regulatory constraints that prevented them from taking other steps to obtain funds, such as raising interest rates on deposits or issuing debt collateralized by mortgage assets.

In the latter part of the 1970's, Robert Dall and Lew Ranieri, two executives at the bond-trading investment banker Salomon Brothers, decided that it was time to take the mortgage market away from Method A and the S&L industry. They saw the potential for huge trading profits if America's mortgage debt could be securitized. With the S&L industry weakened by the combination of higher inflation and interest rates and stifling regulation, Salomon Brothers heavily promoted mortgage securitization, primarily through Freddie Mac and Fannie Mae. In the process, they learned how to manipulate Congress and government regulators to help implement their vision.

For example, in the early 1980's Freddie Mac introduced a program called Guarantor. Fannie Mae soon followed with a program called Swap. The purpose of these programs was to perpetrate an accounting hoax on behalf of insolvent S&Ls.

At that point in history, the S&L's had issued fixed-rate mortgage loans which had declined in market value because interest rates had risen during the interim. Had they marked their assets down to their true market values, they would have had to go out of business. As long as they hung onto the loans, the accounting standards then in force allowed them to postpone recognizing any losses.

At the same time, the S&L's needed to raise cash, and the only assets they had to sell were the underwater mortgage loans. Not selling the mortgages meant running out of cash. On the other hand, selling the loans meant having to recognize losses.

What Guarantor and Swap did was allow the S&L's to exchange their mortgages for securities backed by those same mortgages. They could use the securities as collateral for borrowing, in order to raise cash. The key to the whole transaction was an accounting treatment that allowed the S&L's to defer recognizing losses on the securities in the same way that they could defer losses on the underlying mortgages. This accounting ruling was granted by the Federal Home Loan Bank Board, thanks in large part to heavy lobbying by Wall Street and S&L executives.

The result of Guarantor and Swap was to worsen the bleeding of the S&L's, with large fees collected by Freddie, Fannie, and Wall Street firms. Meanwhile, securitization allowed the S&L's to avoid recognizing insolvency, so that they could keep gambling even when they had negative net worth. When the S&L's finally went out of business, the taxpayers took the loss.

By the 1990's, the depository institutions that had been the mainstays of Method A lending were defunct. The FDIC and the Federal Reserve Board issued new risk-based capital regulations that were intended to prevent a repeat of the S&L debacle. Meanwhile, Freddie and Fannie received their own special regulator, who issued different capital regulations.

The bank capital regulations were crude, creating different classes of assets with different risk weights. For example, low-risk mortgages (with down payments of 20 to 40 percent) were given a risk weight of 0.35, on a scale that essentially goes from 0 at the lowest to 1.0 at the highest.

The Freddie/Fannie capital regulations were based on a stress test that simulated a pattern of declining house prices. The stress test penalized mortgages with low down payments, which historically had been outside of the two companies' charters all along. However, for low-risk mortgages, Freddie and Fannie were required to hold much less capital than banks. This gave Freddie and Fannie a significant cost advantage, and over the decade of the 1990's the two firms essentially took over the market for conforming mortgage loans (loans falling underneath the loan-limit ceiling and with sufficient down payment and borrower credit history to meet the "investment quality" standard.)

Early in the 21st century, private securitization (meaning mortgages securitized by Wall Street firms, not by Freddie or Fannie) emerged as a major force in the mortgage market. This phenomenon developed for a variety of reasons.

First, credit scoring had emerged as a way of assessing a borrower's credit history. This in turn lowered some of the agency costs associated with Method B lending. Instead of having to trust the mortgage broker to examine the credit report by hand, an investor could treat the credit score as hard data.

Second, Wall Street needed to find a substitute for the guarantee supplied by Freddie Mac or Fannie Mae. If you buy a Freddie Mac mortgage security and one of the borrowers defaults, that loan is pulled from the pool by Freddie Mac. Freddie Mac immediately pays into the pool the unpaid principal balance on the defaulted loan, and then tries to recover for itself what it can from selling the house. The investor is insulated from the default loss. (Fannie Mae offers the same protection.)

What Wall Street came up with to back private mortgage securities was the idea of a credit risk tranche. If you bought a senior tranche, then it was guaranteed to absorb no losses until at least, say, 10 percent of borrowers defaulted. Since this was a rare event, the senior tranche was considered safe. Junior tranches, which absorbed a disproportionately large share of losses, could be protected with credit default swaps, in which a large insurance company or other intermediary agreed to absorb the losses.

The market in private mortgage securities expanded during a period of rising home prices. In this environment, it was profitable to reach into segments of the market where it was not possible to make investment-quality loans. This included borrowers with blemished credit histories and borrowers who could not afford even a 5 percent down payment. The private securitizers made riskier and riskier loans, but as long as home prices kept increasing, defaults were rare and market participants enjoyed nice profits.

The securitization process so bamboozled the regulators that banks were holding securities backed by high-risk, low-down-payment mortgages that had been rated AAA, and thus had a risk capital weight of 0.20, which is significantly less than the 0.35 risk weight given to a low-risk mortgage with a 40 percent down payment originated using Method A. The regulators were telling banks to treat Method B mortgage loans with low down payments as safer than Method A loans with high down payments.

As home prices rose, it became more and more difficult for borrowers to come up with 20 percent down payments, causing the proportion of conventional mortgages to shrink. As private securitization increased in importance, Freddie and Fannie saw their market shares, which had peaked at 50 percent in 2003, start to decline. Moreover, the segment of the market they were left with was increasingly upscale, so that political leaders began to berate Freddie and Fannie over their lack of support for "affordable housing." The pressure built on Freddie and Fannie to join in the high-risk lending frenzy, and they caved into that pressure.

News reports show that at both Freddie and Fannie, warnings were issued by staff about high-risk lending. The stress test methodology required the firms to dedicate large amounts of capital for these loans in order to protect the firms in case of a downturn. Not wishing to abandon the high-risk market or to dilute earnings by raising the capital called for by the stress tests, the CEO's at the two firms simply over-rode staff objections and dove into the market, without raising the requisite capital.

Freddie and Fannie were never the dominant high-risk lenders. Nonetheless, they took on more risk than they should have, with less capital than was prudent. Had they maintained a focus on safety and soundness and stayed out of high-risk lending, the firms would done less to inflate the house price bubble. Freddie and Fannie would be in good shape now to pick up the pieces of the faltering private securitization market. Instead, the two firms themselves required a taxpayer bailout.

Finally, it is important to bear in mind that Freddie Mac and Fannie Mae were part of the Method B mortgage lending process. If capital requirements had been rationally tied to risk and applied equally to all institutions, Method A lending would have driven method B lending out of the market. Freddie and Fannie would not have grown to dominate the market. Instead, my conjecture is that they would not have been able to gain even a toehold in a free and fair market. Mortgage securitization is entirely a product of regulatory distortions.

The regulatory distortions were by no means accidental. Often, the regulatory loopholes were pried open by lobbyists working for Freddie Mac, Fannie Mae, or Wall Street firms that profited from securitization. Key members of Congress were generously plied with campaign contributions, in return for which they championed securitization and emasculated the regulators who oversaw Freddie Mac and Fannie Mae.

2.Speculation and the Housing Market

I credit other economists with warning early and strongly about a speculative bubble in housing. Prominent examples include Dean Baker, Paul Krugman, and Robert Shiller. Shiller, in particular, has given a very eloquent description of the bubble in the housing market in his recent book, The Subprime Solution.

As of 2004, I was one of those who thought that high home prices reflected unsustainably low interest rates. Today, some people continue to blame the run-up in home prices on Federal Reserve policy and low interest rates. However, I have changed my position on that, and I now believe that the bubble was speculative.

A major contributing factor to the speculative bubble was the explosion in lending for home purchase with little or no money down. When the down payment is small, the buyer's equity consists almost entirely of price appreciation. When prices are rising, anyone can buy a home with a low down payment, and any mortgage loan is safe. Low-down-payment lending helps foster a speculative frenzy on the way up. Of course, prices cannot go up forever. Once prices stop rising, the low-down-payment loans tend to go sour rather quickly.

There is considerable evidence that many homes were bought purely for speculative purposes. William Wheaton, a professor of urban economics at MIT, estimates that in recent years the growth of housing units exceeded the increase of household formation by six percentage points. These excess houses were bought by speculators.

Further evidence of speculative excess can be seen from an article that appeared in the December 2007 issue of the Federal Reserve Bulletin. It showed that loans for non-owner-occupied homes (also known as investor loans) grew from roughly 5 percent of total mortgage originations a decade ago to more than 15 percent of originations in 2005 and 2006. This may in fact understate the amount of speculative buying, because it is common for speculators to lie on their loan applications by claiming that they intend to occupy the home.

When I was looking at mortgage credit risk, we expected investor loans to default at three to ten times the rate of normal loans. If 85 percent of loans ((the ones issued to real homeowners) default at rate X, and 15 percent of loans (issued to speculators) default at rate 3X, then loans to speculators would account for about 35 percent of all defaults. If you use 10X, then speculators would account for about 85 percent of all defaults. Thus, it seems reasonable to suppose that between 35 percent and 85 percent of troubled loans are for non-owner-occupied housing. This makes attempts to "protect homeowners" or do a "bailout from the bottom" highly problematic.

One issue that is worth studying is the fact that there were price bubbles in real estate markets in some foreign countries, also. It is not likely that those bubbles were the result of monetary policy of the United States, and even less likely that they were the result of regulatory changes in the United States. Did other countries also encourage higher leverage in real estate, or were the bubbles able to inflate without any such encouragement? I wish that I knew the answer to that question.

3. The Foster-Van Order Model of Mortgage Default

When I was at Freddie Mac, we adopted an approach to dealing with mortgage credit risk that was developed by Chet Foster and Robert Van Order, two economists who came to Freddie Mac from the Department of Housing and Urban Development. The idea is that a borrower has trouble making the payments on a loan has two choices. One choice is to sell the house. The other choice is to allow the lender to foreclose on the house.

Allowing the lender to foreclose is what we call the option to default. If the house can be sold for more than the outstanding balance on the loan, the borrower will sell the house. We say that the default option is out of the money. On the other hand, if the value of the outstanding balance on the loan exceeds the market price of the house, the borrower might as well default. We say that the default option is in the money.

Speculators are more likely to exercise the default option than are owner-occupants. The owner-occupant takes into account the cost of relocating his or her family.

When the borrower makes a down payment of 20 percent, the default option is far out of the money. House prices have to fall by 20 percent before the default option begins to make sense. On the other hand, with a down payment of 2 or 3 percent, the default option can be in the money if house prices decline only slightly. That is what makes low-down-payment mortgages dramatically more risky than mortgages with a down payment of 20 percent or more.

4. Credit Default Swaps and Systemic Risk

I will define systemic risk as follows: whenever individuals make contingency plans that can only be executed if others are not trying to execute similar contingency plans, there is systemic risk. For example, suppose that many of us have money in a bank where deposits are not insured. I form a contingency plan which says that if the bank gets into trouble, I will run down to the bank and withdraw my deposit before the bank runs out of money. If everyone else forms the same contingency plan, we cannot execute our plans at the same time. Instead, the result is a bank run.

Another example of systemic risk was involved in the stock market crash of October 19, 1987. At that time, many institutional investors had purchased "portfolio insurance," in order to protect against a downturn. Portfolio insurance was supposed to act like a stop-loss order for a diversified stock portfolio, giving owners a guarantee that the value of their investments would not fall below a given floor. Each company that sold portfolio insurance had a contingency plan that consisted of executing a computer program to sell shares of stock in the event that stock prices started to decline. Collectively, these contingency plans were incompatible, because the computer programs were all trying to sell at the same time.

Finally, we come to credit default swaps. The buyer of a credit default swap pays a fee to a seller, in exchange for which the seller promises to pay a large sum to the buyer in the event of a default on a mortgage security or corporate bond. A seller of a credit default swap is in same position as a property and casualty insurance company. Ordinarily, the insurer simply collects premiums, and only rarely must it pay claims.

Faced with the prospect that they might have to pay significant claims, some sellers of credit default swaps probably had formed contingency plans that involved selling short bonds and stock related to their guarantees. Thus, if you had sold a credit default swap on debt issued by Lehman, you could hedge by shorting Lehman debt, Lehman stock, or by shorting the securities of similar financial institutions.

Of course, these individual contingency plans, when executed collectively, resulted in waves of short-selling. Credit default swaps apparently were another example of systemic risk, in which individual contingency plans were not mutually compatible.

Note that eliminating counterparty risk, by moving credit default swaps from the over-the-counter market to an organized exchange, would not solve the problem. Even when traded on an organized exchange, credit default swaps would have to be hedged using short-selling strategies that create the equivalent of bank runs.

5. Suits vs. Geeks

Financial innovation has outpaced the ability of financial executives and regulatory agency heads to remain current. The financial engineers (the geeks) create products that behave quite unlike ordinary bonds. The executives (the suits) rely on intuition that applies to simpler securities. The results are catastrophic.

When I was at Freddie Mac, there was hardly any gap between the suits and the geeks. The Foster-Van Order model of mortgage default was ingrained in the corporate culture. The CEO, CFO, and other key executives understood this model and its implication that mortgage defaults would be much higher for mortgages with low down payments. Moreover, the suits bought into the idea of using a stress test to set capital requirements. Using a stress test methodology, in which mortgages are evaluated according to how well they would survive a downturn in house prices, the capital required to back mortgages with low down payments is prohibitively high.

When a new CEO came to Freddie Mac in 2003 (several years after I had left), a gap apparently opened up between the suits and the geeks. Warnings issued by the Chief Risk Officer and others about low down payment mortgages were ignored by the CEO.

For decades, Wall Street traders have taken advantage of depository institution executives' inability to keep up with financial innovation. Securities with very unfavorable risk characteristics often are pawned off on unwitting banks or savings and loans. As part of this process, the Wall Street firms obtained crude and misleading risk measures from the credit rating agencies. Industry geeks knew that these ratings were inappropriate, but the suits at banks relied on the ratings, in part because that is what the suits at the regulatory agencies were telling them to do, particularly with regard to capital requirements.

Most recently, the suits vs. geeks divide emerged concerning the issue of whether mortgage securities are undervalued. Many suits, including Henry Paulson and Ben Bernanke, took the view that mortgage securities were artificially undervalued. The original Paulson Plan, in which the Treasury would enter market to buy mortgage securities, was based on the assumption that it would be profitable to hold these securities to maturity.

Geeks tend to believe that the market has correctly reduced the values of mortgage securities. Using the Foster-Van Order model, it would seem that the default option on many mortgages is "in the money," causing a huge loss of value for mortgage-backed securities. The fact that so many loans issued in recent years were investor loans is even more ominous. Finally, the imbalance in the housing market means that prices could fall even more. This would expand the losses on mortgage securities.

From a geek perspective, there is an asymmetry in the possible outcomes from investing in mortgage securities. The likelihood of earning a profit is very high, but the amount of the profit will be small. The profit will come from scenarios in which house prices fall only modestly over the next several years. On the other hand, the likelihood of a severe housing depression is low, but the consequences for mortgage securities would be devastating. The potential for taking a large loss, even with a small probability, would lead a risk-averse investor to be cautious about buying mortgage securities, even though the likelihood of earning a small profit is high.

For an analogy, consider a game in which we role a six-sided die. If the number on the die comes up 1,2,3,4, or 5, I give you one dollar. If the number comes up 6, you give me hundred dollars. You are more likely to win than to lose, but you still would not play that game unless I made it more attractive. The same holds true for investing in mortgage securities.

In other words, the market may be quite rational in pricing mortgage securities. The suits who wish to have Treasury speculate in that market would be forcing American taxpayers to engage in a gamble that professional investors would rather not take.

6.Further Reading

Michael Lewis' book, Liar's Poker, contains an insightful history of the early days of the mortgage securities market. The book is based on Lewis' experience as a trainee and salesman for Salomon Brothers. He portrays the way that Wall Street exploited the weaknesses of the S&L industry to muscle its way into the mortgage market.

The specific details of risk weightings and capital requirements, which are an important part of the story, are not easy to track down. One helpful FDIC document is here:

For an analysis of how risk weightings create regulatory arbitrage and artificially boost mortgage securitization, see the paper "Risk-Based Capital Requirements for Mortgage Loans," by Paul S. Calem and Michael Lacour-Little.

For documentation of the increase in loans for non-owner-occupied housing in recent years, see "The 2006 HMDA Data,: by Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner," Federal Reserve Bulletin, December 2007.

For more on the suits and geeks divide at Freddie Mac and Fannie Mae, see the stories in the New York Times by Charles Duhigg. "At Freddie Mac, Chief Discarded Warning Signs," August 5, 2008.; and "Pressured to Take More Risk, Fannie Reached Tipping Point," October 5th, 2008.

Also, see Susan Woodward, "Rescued by Fannie Mae?" Washington Post, October 14, 2008. She argues that Fannie Mae modelers understand mortgage credit risk, but business executives ignored the modelers.

Three academic webcasts provide useful information and analysis of the crisis. At MIT (, William Wheaton provides information on the housing glut promoted by speculation. At Harvard (, Ken Rogoff describes how the financial sector in the United States is bloated. Also, Robert Merton talks about what I call the suits vs. geeks divide. Finally, at the University of California, San Diego (, James Hamilton has some helpful slides that illuminate the difference between what I call Method A lending and Method B lending, along with a chart showing the evolution over the past decade of the market shares of various forms of mortgage lending.
Kling has added this update to this message
Update: I will have to revise this to take a more conservative view of the proportion of investor loans. A reader sent me data on subprime loans showing that investor loans are only foreclosing at a rate slightly higher than owner-occupied. This still leaves open the possibility that investor loans are doing much worse than owner-occupied in the conventional mortgage category, but in any case I need to re-do my math on that one.