Time for “Plan B” to deal with the financial crisis

Previously I have commented on the article by University of Chicago economist Luigi Zingales on Why Paulson is wrong? Now Zingales says it's time for "Plan B" to attack the current financial crisis.

Zingales opens his "Plan B" by saying

After pointing a gun to the head of Congress, threatening a financial meltdown in case his plan was not approved, Treasury Secretary Hank Paulson has finally arrived at the only logical conclusion: his plan will not work.

He goes on to say

Desperate for a Plan B, Paulson is slowly warming to the suggestion of many economists: inject some equity into the banking system. Unfortunately, it is too little and too late. The confidence crisis currently affecting the financial system is so severe that only a massive infusion of equity capital can reassure the market that the major banks will not fail, recreating the confidence for banks to lend to each other. The piecemeal approach of 100 billion today, 100 billion tomorrow used with AIG will not work. It will only eat up the money, without achieving the desired effect—without reassuring the market that the worst is over. Simply stated, nothing short of a 5% increase in the equity capital of the banking system will do the trick. We are talking about 600 billion.

But, according to Zingales, that even if the government is willing to spend this kind of money, there are still three problems.

• First, to restore the necessary confidence, a capital infusion needs to reduce a financial institutions’ risk of default to trivial levels.
• Second, a capital infusion does not address the root of the problem, which stems from the housing market. If homeowners continue to default and walk away from their houses, the banking sector will continue to bleed and additional equity infusions will be needed.
• [T]he third and most important problem. If we bail out Wall Street, why not bail out Detroit (probably another 150 billion) and Main Street? In fact, Senator McCain has already talked about buying out the defaulted mortgages to keep people in their homes. Even if we limit ourselves only to the subprime mortgages, we are talking about $1.3 trillion. Where do we stop?
  

Because of this we need a Plan B, which Zingales outlines here (pdf).

Krugman's Nobel

Many people have many reasons for not liking the awarding of the Nobel Prize to Paul Krugman and to be honest I share many of them. But I also have to admit that there are also good reasons why he got the prize.

The Royal Swedish Academy of Sciences gave the award to Krugman for "for his analysis of trade patterns and location of economic activity", that is, for his work on strategic trade theory and the new economic geography.

What is important about Krugman's trade theory? The standard theory of international trade stated in the early 1800s, when the English economist David Ricardo launched the theory of "comparative advantage" to explain the range and composition of trade. This theory, which was extended during the 1920s and 1930s by the Swedish economists Eli Heckscher and Bertil Ohlin, implies that foreign trade is based on differences among countries. Ricardo studied countries which differ in terms of technology. Heckscher-Ohlin considered countries which differ in terms of access to factors of production; some countries have a relatively abundant supply of labour but a scarcity of capital, whereas the opposite prevails in other countries. The result is that some countries should specialize in and export, for example, industrial products and import agricultural products – and vice versa.

Since its inception, this theory seemed capable of explaining the much of international trade. But over the last 50 years or so researchers found increasingly large deviations from the trade patterns predicted by Ricardo and Heckscher-Ohlin. This is what is now called intra-industry trade. Over recent decades it has expanded, in particular between rich countries. Such trade implies that a country both exports and imports more or less the same goods. New Zealand and Australia both import and export wine, for example. This would not be compatible with the theory of comparative advantage unless the production of New Zealand wine required a wholly unique technology, or a completely different combination of labour and capital than, for instance, the production of Australian wine. But this seems somewhat unlikely.

Around 30 years ago, Krugman introduced an new theory of international trade. It was intended to deal the occurrence of intra-industry trade and was based on an assumption of economies of scale whereby mass production diminishes the cost per unit produced. The car industry would be one where such economies of scale would exist. In addition to economies of scale in production, Krugman's new theory was based on an assumption that consumers appreciate diversity in their consumption. We like lots of different wines rather than just one. After our basic needs for food and housing have been satisfied, it seems as if we opt for diversity and variation in our consumption. In 1977, Avinash Dixit and Joseph Stiglitz had published a model for analysing consumers’ preferences for product diversity. According to this model, each producer, working under increasing returns to scale, becomes more or less a "monopolist" in terms of his own brand, even though he is subject to sharp competition from other brands.

Such a model can be used to show that foreign trade will arise not only between countries which are different (as in the traditional theory noted above), but also between countries which are identical in terms of access to technology and factor endowments. Moreover, it can be demonstrated that extensive intra-industry trade will occur. In fact, it becomes advantageous for a country to specialize in manufacturing a specific car, and to produce it for the world market, while another country specializes in a different brand of car. This allows each country to take effective advantage of economies of scale, thereby implying that consumers worldwide will benefit from greater welfare due to lower prices and greater product diversity, as compared to a situation where each country produces solely for its own domestic market, without international trade.

Today, I would guess that the general view is that the basic mechanisms specified by Krugman complement the traditional Riccardo-Heckscher-Ohlin theory. The truth is that reality encompasses features of both theories.

Economic geography deals not just with what goods are produced where, but also with the distribution of labour and capital between countries and regions. Krugman's approach used in his trade theory – in particular the assumption of economies of scale in production and a preference for diversity in consumption – has also was also found to be useful for analysing geographical issues. Thus Krugman was able to integrate two disparate fields in a cohesive model.

The ideas which would form the building blocks of the "new economic geography" had already appeared in Krugman's trade work. In one paper he asks what would happen if foreign trade became impossible, for instance due to excessively high transport costs or other obstacles. His line of reasoning is as follows. If two countries are exactly alike, then welfare will be the same in both countries. But if the countries are alike in all respects except that one of them has a slightly larger population than the other, then the real wages of labour will be somewhat higher in the country with more inhabitants. The reason is that firms in the more highly populated country can make better use of economies of scale, which implies lower prices to consumers and/or greater diversity in the supply of goods. This, in turn, enhances the welfare of consumers. As a result, labour, i.e., consumers, will tend to move to the country with more inhabitants, thereby increasing its population. Real wages and the supply of goods will then continue to increase even more in that country, thereby giving rise to further migration, and so on.

Krugman's work evolved into the so-called core-periphery model, which shows that the relation between economies of scale and transport costs can result in either concentration or decentralization of communities. Under some circumstances, the forces which contribute to concentration tend to dominate. Regional imbalances arise and most of the population will be concentrated in a high-technology core, whereas a small minority will inhabit the periphery and live off agriculture. Such a mechanism could underlie the explosive urbanization witnessed around the world, with rapidly growing megacities surrounded by increasingly depopulated rural areas. Such an outcomes is not, however, the only possibility. Under a different set of conditions, the forces which give rise to decentralization will dominate. This promotes somewhat more balanced development. Krugman's model can be used to account for the mechanisms at work in both directions. For example, his model indicates that declining transport costs easily generate concentration and urbanization – which seems particularly noteworthy since transport costs have exhibited a declining trend throughout the twentieth century.

This work does justify the award of the Nobel. I do however share the surprise of Mark Koyama at Oxonomics over the award.

I always envisioned Krugman winning jointly with Dixit or perhaps with Bhagwati or another trade theorist.

A joint prize between two or all three of Krugman, Dixit and Bhagwati would have made a lot of sense. Koyama also says

This is also surprising because Krugman is relatively young (is he the youngest winner?) and because the new economic geography is a youthful subfield of economics. I would have imagined a nobel prize going to endogenous growth theory or to incomplete contracts and the theory of the firm before it went to the new economic geography.

I must agree, endogenous growth theory, incomplete contracts and the theory of the firm seem to me to be areas with a longer history which are richly deserving of the prize. And there are others.

Why are some other economists not that happy with the award? As Peter Boettke has written

Krugman is far more politically partisan than any of the recent award winners. Joe Stiglitz became more ideological and partisan after he won the prize, Ned Phelps used the platform of the prize to think "big" thoughts about the capitalist system, but Krugman became ideological and partisan more than a decade prior to the announcement of his prize. And he has not really written serious academic papers or books in economics during that time span. Krugman more or less abandoned scientific economics when he decided to start writing for a broader audience in the 1990s.

Note that the work that got Krugman the prize was done before this time. Boettke goes on to say

Unfortunately, and unlike both [Milton] Friedman and [John Kenneth] Galbraith, Krugman's work devolved from science to ideology and finally to political partisanship. Friedman and Galbraith had always kept (though from differing perspectives) on the scientific to ideological spectrum, but neither became overtly partisan in their writings. This cannot be said for Krugman and the way he has used his platform as an economist and as a columnist for the New York Times for his Democratic partisanship purposes.

This would be innocent enough if Krugman were just another political pundit, but now the prize has given him an enhanced platform from which to pronounce his partisan positions as if they are grounded in economic science. The casualty of this in the public imagination will be the subtle and fine points of the economic way of thinking that we inherited from a long line of political economists from David Hume and Adam Smith to James Mill, Ricardo, J. B. Say and John Stuart Mill to Frank Knight, Ludwig von Mises, F. A. Hayek, Milton Friedman and James Buchanan.

I share Boettke's concerns.

Bryan Caplan makes an interesting prediction,

When Obama wins, Krugman will quickly drop his partisan hackery. He's unfair to his enemies, but he does not suffer fools gladly. And it's safe to say that a year into Obama's presidency, there will be plenty of folly for Krugman to decry.

We just have to wait and see.

EconTalk this week

Patri Friedman, Executive Director of the Seasteading Institute, talks with Russ Roberts at EconTalk about seasteading, the creation of autonomous ocean communities as an alternative to existing political and cultural forms. Topics discussed include the political and economic viability of seasteading, risks of piracy, the aesthetics of living on the ocean, and the potential impact of seasteading on conventional governments.

World food prices

Peter Timmer of Stanford University and the Centre for Global Development talks to Romesh Vaitilingam in this audio from VoxEU.org about the causes of high food prices – including the growth of China and India, dollar depreciation, biofuels and speculation – and the consequences – notably the renewed incentives for investment in raising agricultural productivity.

In another audio from VoxEU.org, Nora Lustig of George Washington University talks to Romesh Vaitilingam about rising food prices – causes of the recent increases and how developing countries and international institutions should respond.

2008 Nobel Prize in Economics (updated x2)

The Royal Swedish Academy of Sciences

has decided to award the

Bank of Sweden Prize in Economic Sciences in

Memory of Alfred Nobel

2008

to

Paul Krugman
Princeton University
Princeton, NJ, USA

"for his analysis of trade patterns and location of economic activity"

More later.

The Undercover Economist covers Krugman here, Marginal Revolution here, Greg Mankiw here, the Mises Economics Blog here, Peter Boettke here, Oxonomics here.

Update: More comments: from Russ Roberts here, Peter J. Boettke again here, Robert Higgs here, Justin Fox here, Justin Wolfers here, Peter Klein here, Arnold Kling here and here, Bryan Caplan here, Johan Norberg here, Will Wilkinson here, Edward L. Glaeser here.

More updates: More comments by Michael F. Cannon here, Sallie James here. James makes a good point

I have my concerns with Prof. Krugman’s later work and his tendency to allow his political views to trump economic good sense. As the Economist [$] wrote in 2003 “A glance through his past columns reveals a growing tendency to attribute all the world’s ills to George Bush…Even his economics is sometimes stretched…” He is generally considered to be a big-government liberal. But the prize was not awarded for his NYT columns or his opinions on economic or foreign policy.

Alex Tabarrok here.

Is there too much competition in English football?

This is the somewhat strange sounding question asked over at Oxonomics. In a posting, Is there too much competition in English Football?, Mark Koyama summaries work by Stefan Szymanski. The Szymanski argument is that it would be more socially efficient if the Premiership was less rather than more competitive. Koyama writes

The reason for this is that in order to compete with one another teams have to spend resources investing in talent in order to compete. Szymanski shows that the Nash equilibrium of this game is inefficient because teams invest too much in the transfer market. In particular weak teams invest too much relative to stronger teams in an attempt to improve their relative position. This result arises like the excessive entry argument in IO because when each team invests in the transfer market it not only improves its own position but it also makes it harder for other teams to compete. There is a business stealing effect. This is an externality each team imposes on its rivals.

The social planner in contrast only cares about maximising the total gate receipts of all clubs taken together. This requires equating the marginal revenue of higher gate receipts to the marginal cost of acquiring players. Under the market solution clubs invest more than this in the transfer market because they equate marginal costs not only with higher total gate receipts but also with the gate receipts that they will gain at the expense of other teams.

But why do we care about cares about maximising the total gate receipts of all clubs taken together? As Adam Smith pointed out more than 240 years ago, "Consumption is the sole end and purpose of all production". So surely we should want to maximise the total utility of fans, the consumers, rather than the revenues of the producers. And if fans get utility from competition, then more is preferred to less.

More fantasy testimony

Earlier I commented on Arnold Kling's Fantasy Testimony on the US financial problems. Now over at EconLog Kling give us More Fantasy Testimony. He calls these comments his "oral remarks." I have posted the whole of the remarks below, again this long but well worth the read.

Thank you for the opportunity to provide the first clear, accurate explanation of the way that mortgage securitization produced a financial crisis. I am not a prognosticator. I did not predict this crisis. I am uncertain how best to try to get out of it. My training is as an economist, and my background includes experience at Freddie Mac in the late 1980's and early 1990's developing measures of mortgage credit risk.

When I left the mortgage industry, more than ten years ago, this sort of crisis was unthinkable. In the meantime, a number of developments took place that produced the crisis. It is a phenomenon that I believe I now understand, but only in hindsight.

I reject the two main partisan narratives of this crisis. The Left wants to blame deregulation motivated by free-market ideology. It is true that poorly-conceived regulation was a major factor. However, the blindness of key regulators reflected not ideology but ordinary bureaucratic information loss. The knowledge that existed inside Freddie Mac, Fannie Mae, Treasury, and the Federal Reserve did not flow up to the leaders of those organizations.

The Right wants to blame overly-aggressive lending to minorities and low-quality borrowers, promoted by Congress and regulators. While it is true that many loans were made that should not have been made, the problem was not the color of the borrowers' skins or the content of their credit reports. The problem was low down payments and a large proportion of mortgages for what the industry calls non-owner-occupied homes or investor loans, and what ordinary people would think of as speculators.

The crisis had three main causes. First, securitization got out of hand, approaching three-fourths of total mortgage debt outstanding. Second, housing speculation got out of hand. Third, the gap in executive understanding of financial innovation, what I call the "suits vs. geeks divide," got out of hand.

Cause #1: Securitization

Contrary to popular myth, the growth of securitization did not reflect the genius of Wall Street. Instead, it was both the intended and unintended consequence of regulatory decisions that penalized traditional mortgage lending. Had the competition between securitizers and traditional depository institutions been free and fair, I believe that the securitizers would have lost.

Whatever its theoretical merits, mortgage securitization in practice is a tool for hiding risk and exploiting regulatory loopholes. These loopholes often were pried open by lobbyists. It was an unhealthy triangular trade in which campaign contributions from securitizers were exchanged for Congressional influence of regulations which in turn created profits for the securitizers. I sketch some of this history in my written remarks.

Recently, the main force driving mortgage securitization has been bank capital requirements. These penalize banks for holding loans that they originate themselves. Perversely, the FDIC requires banks to hold less capital against securities backed by low-down-payment mortgages originated by strangers than against high-down-payment mortgages originated by staff under the bank's supervision and control. If the risk-based capital metrics had been tied to the true risk of the underlying assets, then I am confident that banks would have driven Fannie, Freddie, and the private securitizers of Wall Street out of business. Without the distortion of misguided capital requirements, we would have seen old-fashioned loans, originated by old-fashioned prudent underwriting standards, and held in old-fashioned bank portfolios financed by deposits and debt instruments, not by exotic derivatives. Again, this will be explained in more detail in my written remarks.

Cause #2: Speculation

The second main cause was the speculative frenzy in houses. It is my conjecture that roughly 50 percent of troubled mortgages today are loans that were made not to owner-occupants but to speculators. This is a rough estimate--I would rather say that between 30 and 70 percent of troubled loans were made to speculators. I will explain this conjecture in my written remarks. Regardless of the exact figure that prevails, the significant proportion of speculative buyers must be taken into account in devising public policy.

--It is futile to demand that we keep borrowers in their homes when so many borrowers never occupied these homes in the first place.

--It is unfair to ask taxpayers to pay the mortgages of speculators.

--It is unfair to ask mortgage lenders to reduce the interest rate or otherwise modify the loan terms of speculators.

--It is not practical to bail out the housing market "from the bottom up" when so much of the marginal stock of housing is in the hands of speculators.

Cause #3: Suits vs. Geeks

Another factor in the crisis has been executives who misunderstood financial innovations. Financial executives seem to deal with financial innovation in three stages. First comes resistance. Next comes acceptance. Next comes blind faith and hubris. At the latter stage, the financial engineers, who I refer to as "geeks'" sometimes throw up caution flags at the executives, who I refer to as "suits." All too often, the suits run past the caution flags of the geeks.

Charles Duhigg of the New York Times has written two stories, on August 5th and October 5th, respectively, about the executive hubris at Freddie Mac and Fannie Mae. At both companies, the CEO was warned by the firm's own employees about the threat to safety and soundness posed by taking on high-risk loans without adequate capital protection. In both cases, the CEO brushed aside the warnings.

In my written remarks, I will comment further on Freddie Mac, based on my experience with its credit risk culture and contacts with people still at the company. In addition, I will describe how in the private securitization market, the stage of blind faith and hubris was reached with credit scoring as an underwriting tool and with credit defaults swaps as an overall risk management tool.

The suits vs. geeks divide also affects regulators. Ben Bernanke and Henry Paulson are as misinformed about these phenomena as the typical financial CEO. My conjecture would be that much lower down within the Federal Reserve staff and at the Treasury, there are career civil servants who understand the mortgage crisis at least as well as I do. Unlike me, perhaps some of them put together the pieces before it even happened. And yet Mr. Bernanke and Mr. Paulson lack this knowledge. This is not because they personally are defective, but because they are human. Atop an agency such as the Fed or Treasury, the leader sits like an ancient potentate, with advisers underneath him competing for power by manipulating the information he sees.

For a variety of reasons, critical information often fails to make it to the top of large organizations. I call this phenomenon bureaucratic information loss. My guess is that business schools have another name for it. I am sure that there are entire courses dedicated to the treatment of this organizational disease, but there is no cure.

What Next?

I am not a prognosticator. I am not as confident about what I am about to say as about what I have just said.

It appears to me that the Paulson plan, of trying to have the Treasury join the Liar's Poker game of mortgage security trading, is not the answer. Even its proponents seem to be backing away from it, after having bullied, shamed and bribed Congress into passing the ill-conceived plan.

Instead, the solution du jour appears to be bank recapitalization. This may be closer to the right answer, but I think it is worth pausing and thinking a bit before rallying to that banner.

My instinct in this situation is to abandon the things that are broken and instead to reinforce the things that work. In terms of the old saying, when you're in a hole, stop digging.

We are in a hole with respect to mortgage indebtedness. We have too much indebtedness and too little equity. Home ownership is a fine thing, but the emphasis should be on ownership, which means having a reasonable equity stake in the home. People who cannot afford a twenty percent down payment, or even a ten percent down payment, should not be unnaturally encouraged to purchase homes. A housing policy that induces people to save for a down payment rather than subsidizing mortgage indebtedness would lead to a more stable housing market.

We are in a hole with respect to excess housing units relative to households. The slowdown in housing construction is a natural response that should not be resisted. The foreclosure process on houses owned by speculators should be accelerated, not delayed. We need to get to a point where housing units are either deployed profitably as rental units or as economically viable owner-occupied homes. How far prices have to fall to reach that point is not clear, but we should not try to fight the inevitable.

We are in a hole where we have too many lenders doing too little lending. Banks that the FDIC considers undercapitalized need to be separated out from those that are sound. The worst banks need to be shut down. Others, which are neither clearly sound nor clearly insolvent, might be placed in a separate category, where they are able to sustain some operations on the basis of loans from the Federal Reserve but are otherwise restricted in their lending and insulated from being able to damage any healthy banks.

With the marginal banks isolated, the healthy banks perhaps will be able to reconstitute the banking system, including interbank lending and mortgage origination. Capital regulations should be modified in order to encourage sound lending by sound banks. For example, mortgage loans with down payments of at least 20 percent should be assigned a very low risk weight.

Looking further ahead, we need to ask what it is about financial markets that makes them subject to manias and panics. We always know how to prevent the last crisis, but can we ever know how to prevent the next one? Are government institutions the solution, or are they the problem? Taking bureaucratic information loss into account, can regulation ever be relied upon? These are difficult questions. For the most part, the economics profession has not been asking them over the past thirty years. My guess is that over the next thirty years, research priorities will change.

Kling adds that he is working on some support material which he refers to as his "written remarks." It will be interesting to see these when he has finished.

Robert Higgs on the current crisis

In a couple of recent posts I have referred to the work of economic historian Robert Higgs. Now Eric Crampton has sent me this link to an audio, from the Ludwig von Mises Institute, of an interview with Robert Higgs. Higgs is interviewed by Jeffrey Tucker and they start by talking about the parallels between the current financial problems in the US and the Great Depression. The interview, which was recorded on 6/10/08, lasts about 25 minutes.

FDR's policies prolonged the depression

In two recent posts, here and here, I made comment on the idea that "regime uncertainty" was one factor which prolonged the depression in the US. The basic idea being that private investors held back on investing since they were unsure as to whether or not they would receive the returns on any such investment. I have now came across a paper in which two economists at UCLA blame the delay in recovery on specific anti-competition and pro-labour measures that Roosevelt promoted and signed into law June 16, 1933. So New Deal policies could have delayed recovery via at least two routes, private investment and industrial policy.

After spending four years scrutinizing Franklin D. Roosevelt's record, the economists Harold L. Cole and Lee E. Ohanian conclude in their study that New Deal policies signed into law 75 years ago thwarted economic recovery for seven years. The study, "New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis", appeared in the Journal of Political Economy, 2004, vol. 112, no. 4, p.779-816.

In a news release on the paper Cole is quoted as saying

"President Roosevelt believed that excessive competition was responsible for the Depression by reducing prices and wages, and by extension reducing employment and demand for goods and services," [...] "So he came up with a recovery package that would be unimaginable today, allowing businesses in every industry to collude without the threat of antitrust prosecution and workers to demand salaries about 25 percent above where they ought to have been, given market forces. The economy was poised for a beautiful recovery, but that recovery was stalled by these misguided policies."

Ohanian and Cole use data collected in 1929 by the Conference Board and the Bureau of Labor Statistics. Using this they were able to calculate average prices and wages across a number of industries just prior to the start of the Great Depression. Then they worked out a counter factual of what would have happened if Roosevelt's policies not been put in place. By adjusting for annual increases in productivity, they were able to use the 1929 benchmark to work out what prices and wages would have been during every year of the Depression without Roosevelt's interventions. They then compared those figures with actual prices and wages as reflected in the Conference Board data.

One result they found was that in the three years following the implementation of Roosevelt's policies, wages in 11 key industries averaged 25 percent higher than they otherwise would have done. But unemployment was also 25 percent higher than it should have been, given gains in productivity.

Meanwhile, prices across 19 industries averaged 23 percent above where they should have been, given the state of the economy. With goods and services that much harder for consumers to afford, demand stalled and the gross national product floundered at 27 percent below where it otherwise might have been.

The news release quotes Ohanian as pointing out that

"High wages and high prices in an economic slump run contrary to everything we know about market forces in economic downturns." [...] "As we've seen in the past several years, salaries and prices fall when unemployment is high. By artificially inflating both, the New Deal policies short-circuited the market's self-correcting forces."

An important point noted by Cole and Ohanian is that under the National Industrial Recovery Act (NIRA), industries were exempted from antitrust prosecution if they agreed to enter into collective bargaining agreements that significantly raised wages. Because protection from antitrust prosecution all but ensured higher prices for goods and services, a wide range of industries agreed. In fact by 1934 more than 500 industries, which accounted for nearly 80 percent of private, non-agricultural employment, had entered into the collective bargaining agreements called for under NIRA.

According to Cole and Ohanian the NIRA and its aftermath account for 60 percent of the weak recovery. Without the policies, they contend that the Depression would have ended in 1936 instead of the year when they believe the slump actually ended: 1943.

Bail-out: lessons from Japan

From the Free Exchange blog comes a link to this NBER working paper, Will the TARP succeed? Lessons from Japan by Takeo Hoshi (University of California-San Diego) and Anil Kashyap (University of Chicago).

The paper compares the current situation in the US with that of Japan during its decade-long banking crisis. Hoshi and Kashyap argue that the US bail-out plan, as originally envisioned, risks repeating the many errors made in Japan.

The U.S. government is hiring asset managers to purchase up to $700 billion of toxic real estate securities that are the center of the current credit crisis. Buying up assets, if done properly, might address the collective under-capitalization that is the fundamental problem plaguing the financial system. But, experience with financial crises in other countries suggests that success is by no means guaranteed. Japan was the largest other country where the banks were seriously undercapitalized and where asset purchases were a critical part of the government's response to the problem. The U.S. bailout plan is similar to the Japanese approach in that it does not clearly identify the capital problem as critical and instead proposes using AMCs to remove distressed assets from bank balance sheets. When Japan used AMCs, their effectiveness was limited in part because they did not purchase enough assets. AMCs did not help recapitalization, either, and Japan had to come up with different mechanisms to use public funds for recapitalization. Both these risks are also present for the U.S. plan.

The TARP is Troubled Assets Relief Program and AMCs are asset management companies. The Free Exchange notes

Japan created no fewer than four AMCs between 1992 and 2003. The first were funded by the private sector because of “vigorous public resistance” to the use of taxpayer funds. The amount of assets they purchased was small and more importantly, because they were designed not to overpay for bad loans, they did little to boost bank capital. Not until 1997 did Japan create a mechanism to inject capital into banks, and that was initially shunned because of stigma and because public claims would be senior to common stock holders. The government recapitalised two major banks in 1998 and in 1999 created a larger $238 billion recapitalisation plan. All the major banks except one applied, and the government ultimately injected $71 billion in the form of preferred shares and subordinated debt.

The Free Exchange also notes that the US TARP differs form the approach taken in Japan in that

... there are no insolvent debtor companies that need to be restructured, and the Treasury is explicitly authorised to modify the loans of homeowners. But it shares, with the Japanese, the problem that it does not explicitly deal with the capital inadequacy of the banking system.

Limerick for the greater depression?

Eric Crampton sent me the following Limerick due to Samuel Bostaph,

There was a Fed head named Bernanke
Whose money supply hanky panky
Created inflation
And beggered the nation
All for the love of his banke.

Cartoon of the day

This cartoon comes via Mark Perry at the Carpe Diem blog,

Basics of property rights

Roger Kerr's latest piece in the Otago Daily Times, Back to Basics on Property Rights (pdf), relates to my posting yesterday on Regime uncertainty.

Kerr writes

Business New Zealand, Federated Farmers, the New Zealand Business Roundtable, and the New Zealand Chambers of Commerce joined forces in commissioning the report because of their growing concerns about continuing ill-justified confiscations of private property rights, be they foresters’ cutting rights, landowners’ and developers’ rights, investors’ rights to the infrastructure they own and even their right to freely buy and
sell shares.

It is concerns like this that lie at the base of regime uncertainty. Higgs in his paper lists some of the Acts of Congress in the US that weakened property rights between 1933-40. See below for Table 1, from page 571 of Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War.

Yesterday I mentioned the Bill of Rights Act and the Resource Management Act as two examples of acts of parliament that undermine property rights in New Zealand. But Roger Kerr makes the point that New Zealand's bad history of property rights abuses goes back much further, and continues today,

New Zealand has a poor record in this area. The country is still divided because of Maori land confiscations almost 150 years ago. But such actions continue today, with the foreshore and seabed issue, the forced unbundling of Telecom and consequent massive loss of shareholder value, and the blocking of the sale of shares in Auckland International Airport Limited (AIAL).

Kerr goes on to point out at least as far as the AIAL case is concerned the government's action breached rule of law principles and in doing so pushed up the cost of capital and therefore we would assume had a negative effect on investment.

The report adds weight to last week’s ruling by the Regulations Review Committee of parliament regarding the way the government intervened in the Canadian bid for shares in AIAL. The Committee upheld the complaint of the Business Roundtable and the Wellington Regional Chamber of Commerce that the government’s action breached rule of law principles and risked deterring investment and pushing up the cost of capital to the detriment of all New Zealanders.

Later Kerr notes the unfortunate role of Treasury in the AIAL affair,

An extraordinary aspect of the exercise – and an alarming one for shareholders in any potentially ‘strategic’ asset – was the Treasury’s role in it. Although the Treasury had initially advised the government against intervention, it subsequently advised the Committee that “no taking of property arises from the regulations” and led it to agree that “share value fluctuation due to authorised regulatory intervention is something that shareholders simply have to accept”.

Kerr goes on to say

Based on the arguments presented by the Treasury, parliament might as well take the compensation provisions out of the Public Works Act and simply declare that when land is taken under it, the loss in value “is something landowners simply have to accept”.

Tell that to farmers and other landowners who report a steady flow of new proposals to ‘protect’ some piece of private land in the guise of the national good, generally without any reference to the rights of the landowner or consideration of compensation.

Such actions by a leading government department do nothing to assure investors that the returns to their investments are safe and this can have a chilling effect on the amount of investment undertaken.

Another point noted by Kerr is the incoherent nature of legislation impacting on private property rights in New Zealand. He writes

One of the issues highlighted in the report and reflected in the AIAL case is that legislation impacting on private property rights is fundamentally incoherent. On the one hand we have the Public Works Act 1981 which sets out to ensure that citizens are secure in their property rights. It embodies the longstanding common-law position that the Crown should only take private land for an essential public work, and only if voluntary negotiations fail, in which case compensation should be paid.

On the other hand we have the New Zealand Bill of Rights Act 1990, which does not even acknowledge any right to the quiet enjoyment of one’s possessions, let alone to private property in general. Then there is the Resource Management Act 1991, which allows political majorities on councils to dictate the use to which private land can be put without landowners’ consent and without compensation.

The same issues arise in the case of regulatory takings such as proposals to ‘protect’ a piece of private land or heritage building, where a government may allow the owner to retain possession of the property but regulate it in such a way as to diminish its value or use, again without compensation.

Kerr ends his article by saying

A Primer on Property Rights (which can be found at www.nzbr.org.nz) argues that clearly defined and respected property rights are the foundation of a peaceful, cohesive and prosperous society and, ultimately, the democratic system. Achieving recognition of this view and agreement on the proper role of the state in this area should be a high priority of any government. It is to be hoped the report will promote constructive debate on how this goal can be achieved.

I would phrase the issue as one where "regime uncertainty" and its impact on private investment, and thus productivity, is important and needs to be addressed. If New Zealand's investors are not convinced that their investments are secure then they will reduce investment and we will continue to see our standard of living fall.

Executive compensation in widelyheld US firms

The European Society for New Institutional Economics runs a yearly School on New Institutional Economics. This paper comes from the 2007 school. It is by Jesse Fried of U.C. Berkeley and is on "Executive Compensation in Widely-Held US Firms". The abstract reads

Over 70 years ago, Berle and Means described the problems that arise because of the separation of ownership and control in widely-held U.S. companies. These companies are owned by dispersed public shareholders, but controlled by their managers who have substantial discretion under state corporate law. My lecture will focus on how managers have used their power to obtain pay arrangements that do not serve shareholders’ interests. I will also discuss and evaluate the various efforts made by shareholders and the federal government to address this problem.

The powerpoint version of the presentation can be download here.

An addition and useful article to read on this topic is Lucian Arye Bebchuk and Jesse M. Fried "Executive Compensation as an Agency Problem"

Regime uncertainty

In some of the recent commentaries on the current financial problems in the US an idea that is being mentioned is that of "regime uncertainty". For example at Cafe Hayek Don Boudreaux writes

What I find most scary about the current market turmoil are the shenanigans it fuels on Capitol Hill and its immediate environs.

Uncle Sam is, I worry, on the verge of creating the same kind of "regime uncertainty" that Bob HIggs effectively argues deepened and prolonged the Great Depression.

while Peter Boettke at The Austrian Economists blog says,

To my mind, one of the most important economic concepts to be developed in the past decade is Bob Higgs's idea of "regime uncertainty" and the application to which he has put that concept to use to explain the deepth and length of the Great Depression. Given the earlier application, the relevance of the concept of "regime uncertainty" to our current situation should be evident.

As pointed out by both Boudreaux and Boettke the notion of regime uncertainty is due to the economic historian Robert Higgs. Higgs introduced the idea in a paper Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War. His purpose was to explain why the depression lasted so long in the US. Higgs writes,

I shall argue here that the economy remained in the depression as late as 1940 because private investment had never recovered sufficiently after its collapse during the Great Contraction. (p.563)

The Great Contraction refers to the macroeconomic collapse that occurred between 1929 and 1933. Higgs goes on to say,

I shall argue further that the insufficiency of private investment from 1935 through 1940 reflected a pervasive uncertainty among investors about the security of their property rights in their capital and its prospective returns. (p.563)

If businesspeople are uncertain as to whether or not they will capture the returns to their investments they will be reluctant to invest. Later Higgs explains,

The hypothesis is a variant of an old idea: the willingness of businesspeople to invest requires a sufficiently healthy state of “business confidence,” and the Second New Deal ravaged the requisite confidence. (p.568)

and

To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. (p.568)

While Higgs work was to do with the depression of the 1930s in the US, I wonder if the idea can not also be applied to recent New Zealand economic history, perhaps right up to today. As Bryce Wilkinson explains in the preface to his recent report A primer on property rights, takings and compensation,

Yet ill-justified confiscations of property rights continue to abound, be they foresters' cutting rights, developers' and landowners' rights, the foreshore and seabed issue, or investors' rights to the infrastructure they own and even their rights to freely buy and sell shares. Some of these takings have treated individuals unjustly and polarised communities. Investment confidence and potential economic growth have been undermined. (emphasis added)

Higgs makes the point that

Such attenuations [of property rights] can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights. (p.568)

Higgs later notes, with regard to the depression era in the US, that

... during the next two presidential terms, the Roosevelt administration proposed and Congress enacted an unparalleled outpouring of laws that significantly attenuated private property rights. (p.570)

Wilkinson notes in the New Zealand context that

The New Zealand Bill of Rights Act does not acknowledge any human right to the quiet enjoyment of one's possessions, let alone to private property in general. The Resource Management Act allows possibly ephemeral political majorities to dictate, within limits, the use to which private land is put without the consent of landowners and without compensation.

while in the introduction to the Wilkinson report Richard Epstein writes

In order to illustrate this theme, the report details the conflict between two visions of land use regulation: the classical liberal theory on the one hand and, on the other, the more interventionist attitudes embodied in other New Zealand statutes, most notably the New Zealand Bill of Rights Act 1990 and the Resource Management Act 1991. The former statute is noteworthy for its refusal to consider the right to own and retain private property as one of the fundamental freedoms in New Zealand. The latter statute is not directed toward ownership and retention of property but toward limiting its use. And the statute explicitly allows the state through its planning agencies to limit any future use or development of property unless it is done in accordance with some proposed plan on either a district or a regional level.

The governments willingness to interfere with the rights of owners of infrastructure, as in the case of Telecom, or the rights of owners of shares to freely buy and sell those shares, as in the Auckland Airport case, are examples which raise concerns about the security of property rights. But the current period is not the only one in recent New Zealand history in which it could be argued that property rights have been under attack. Under the National governments of Robert Muldoon property right could be seen as being insecure. The economic question this raises in what effects has this regime uncertainty had on private investment in New Zealand and indirectly on our productivity? Have we seen the same chilling effect on investment in New Zealand as Higgs showed for the US during the depression? Is such uncertain a cause of New Zealand's recent poor economic performance?

Russell Roberts talks about the financial mess

George Mason University economist and author Russell Roberts, who blogs at Cafe Hayek, talks with Reason.tv about the problems with the US economy and the US government's bailout plan. Watch this six-minute interview to learn where the problems came from, why the bailout won't address them, and what sort of hurt we're in for over the next several weeks, months, and years. "The real cost of this," warns Roberts, "is that we have said to people, 'Risk taking is not as risky as it used to be.' That's a mistake. It's a horrible mistake and it will lead to a lower standard of living down the road because investment will be more cavalier and less prudent."

Interesting blog bits

1. The Economic Logician on Why is prostitution so well paid?
2. Walter E. Williams on Lessons From the Bailout
3. Stephen J. Dubner reviews The Price of Everything a novel by the economist Russ Roberts.
4. Steven D. Levitt on Martin Feldstein on the Financial Crisis.
5. The Visible hand in economics asks Government investment: Saviour or Villain?
6. Dick Langlois on Monetary Policy and the Housing Crisis.
7. Veronique de Rugy and Philippe Lacoude on Building a Better Bailout: How Washington could have helped the market at no cost to taxpayers. And what it should do if it's hell-bent on spending $700 billion

Fundamentalists versus realists (updated)

Greg Mankiw points us to this posting at the Growth Blog by Paul Romer entitled Fundamentalists versus Realists. In part Romer writes

The financial crisis provoked three open letters to policy makers. Fundamentalists opposed the plan (here.) Realists supported the plan (here) or supported more discretionary powers for dealing with the crisis without endorsing any specific plan (here.)

A quick look through the lists of economists who signed the various letters shows that the camps do not separate cleanly along the familiar lines of left-versus-right or active-versus-limited government. The key difference lies in the relative weight each side gives to formal models as opposed to judgment.

Fundamentalists have an unswerving faith in models. Policies should always be derived from the best available model. Data should be filtered through a model. If an observation does not fit within the context of a model, it should be excluded from consideration.

Realists are more conscious of the limits of models and more comfortable with a division of labor between the researcher who improves the models and the clinician who makes policy decisions. They recognize that the power of models comes precisely from a commitment to abstraction that filters out potentially important complexity. They believe that useful evidence can accumulate with direct experience as well as through the research process of testing and refining models. They believe that researchers should consider the possibility that the fault lies with the model when its predictions diverge from clinical judgment and that policies should draw on both sources of evidence.

Many times, the confidence fundamentalists have had in abstract models turned out to be well founded and the objections raised by realists who were more focused on details were misplaced. The fundamentalists were right that an airline industry could still function even if airlines could set their own fares; that people could still talk to each other even if they purchased phone service from different companies. The realists pointed to all the complicated details that arise in such markets, details that simple models could not capture. Fundamentalists, correctly, ignored the detail and pushed prescriptions based on the textbook model of competition.

Other times, the models are missing something that is too important. In the study of macroeconomic fluctuations, real business cycle theorists and their descendants, the dynamic stochastic general equilibrium modelers, are the quintessential fundamentalists. Their models are a useful way to make research progress, but in macroeconomic policy making, the great depression, which these models cannot explain, is a decisive data point warning us that the models are incomplete and have to be supplemented by clinical judgment.

At EconLog Arnold Kling disagrees with Romer. He asks Who is a Realist? Kling writes,

I did not care for Paul Romer's claim that realists support the Paulson plan, while model-addicted fundamentalists oppose it. In my view, there are realistic reasons to oppose the Paulson plan.

First, many "realists" say that we need to boost home prices. But Ed Glaeser argues persuasively that trying to boost home prices is unrealistic. And if home prices have much farther to fall, then the premise that mortgage securities are undervalued is unrealistic.

I do not think it is realistic to say, "Credit markets are seizing up. Therefore, we must support the Paulson plan." In fact, if credit markets are seizing up, then something like what the Fed is doing today, as discussed by Tyler Cowen and Alex Tabarrok, makes more sense.

The theory that you can fix credit markets by "removing the clog" of mortgage securities is just that--a theory. My guess is that it will not work. I am sure that other things will have to be tried sooner or later--probably sooner. I hope the other moves work. I do not think it is at all realistic to rely on the Paulson plan. Trying to revive the mortgage securities market is not a realistic solution--it is a very unfortunate distraction.

It may well be that "the models are incomplete and have to be supplemented by clinical judgment". But you then have to ask on what basis do we pick the "clinical judgment" we are to use? Do we need a theory of clinical judgment? It seems to me that Romer's model-addicted fundamentalist economist is, at best, a caricature. As Keynes said of Alfred Marshall

...the master-economist must possess a rare combination of gifts. He must be mathematician, historian, statesman, philosopher–in some degree. he must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.

So a good economist has both a good understanding of theory and a good dose of realism. Those economists opposing the Paulson plan have a large measure of both.

Update: The visible hand in economists comments on the Romer piece here.

Anatomy of a Train Wreck

Stan J. Liebowitz looks at the Anatomy of a Train Wreck: Causes of the Mortgage Meltdown. Liebowitz is Research Fellow at The Independent Institute, Ashbel Smith Professor of Economics and Director of the Center for the Analysis of Property Rights and Innovation at the University of Texas at Dallas.

In his report Liebowitz asks a number of questions: Why did the mortgage market melt down so badly? Why were there so many defaults when the economy was not particularly weak? Why were the securities based upon these mortgages not considered anywhere as risky as they actually turned out to be?

In the executive summary of his report the key paragraph is

This report concludes that, in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the government undertook an attack on underwriting standards starting in the early 1990s. Regulators, academic specialists, GSEs, and housing activists universally praised the decline in mortgage-underwriting standards as an “innovation” in mortgage lending. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. The price bubble, along with relaxed lending standards, allowed speculators to purchase homes without putting their own money at risk.

In his conclusion Liebowitz writes

We are experiencing one of the worst financial panics in the post-WWII era. Everyone knows that the increase in mortgage defaults has been the primary driver for these financial difficulties. The mortgages with outrageously lax underwriting standards that have been justifiably ridiculed in the press are not unusual outliers but unfortunately are representative of a great many mortgages that have been made in the last few years.

The question that is being asked is the correct question: how did it come about that our financial system allowed such loans to be made, condoned such loans, and even celebrated such loans? The answers that are being given are not yet the correct ones, however. The main answer that is being given, that unscrupulous lenders were taking advantage of poorly informed borrowers, does not fit the evidence nor does it dig deep enough.

The “mortgage innovations” that are largely the federal government’s responsibility are almost completely ignored. These “innovations,” heralded as such by regulators, politicians, GSEs, and academics, are the true culprits responsible for the mortgage meltdown. [...]

The political housing establishment, by which I mean the federal government and all the agencies involved with regulating housing and mortgages, is proud of its mortgage innovations because they increased home ownership. The housing establishment refuses, however, to take the blame for the flip side of its focus on increasing home ownership—first, the bubble in home prices caused by lowering underwriting standards and then the bursting of the bubble with the almost catastrophic consequences to the economy as a whole and the financial difficulties being faced by some of the very homeowners the housing establishment claims to be trying to benefit.

Later in the executive summary Liebowitz says

The recent rise in foreclosures is not related empirically to the distinction between subprime and prime loans since both sustained the same percentage increase of foreclosures and at the same time. Nor is it consistent with the “nasty subprime lender” hypothesis currently considered to be the cause of the mortgage meltdown. Instead, the important factor is the distinction between adjustable-rate and fixed-rate mortgages. This evidence is consistent with speculators turning and running when housing prices stopped rising.

In his conclusion he goes on to say,

But let’s not blame the speculators here. There is nothing wrong with speculation or speculators. At fault is a mortgage system run by flexible underwriting standards, which allowed these speculators to make bets on the housing market with other people’s money. It was a system that invited the applicant to lie about income. It was a system that induced applicants to watch a video instead of providing solid evidence about their financial condition.

Even that would not be so bad if the people making the money available were aware of its use and knew that they would have recourse to getting their money back. But the money for the speculation was made available by lenders who believed the housing and regulatory establishment when this housing and regulatory establishment said that such loans were safe. Since the housing and regulatory establishment consisted of mighty government agencies and highly educated academics, it was not unreasonable for the lenders to assume that the claims made for flexible underwriting standards were correct. Unfortunately, the claims were not correct although most of the housing and regulatory establishment continue to argue otherwise.

EconTalk this week

William Bernstein, author of A Splendid Exchange, talks about inequality with EconTalk host Russ Roberts. Bernstein is worried about it; Roberts is not. Bernstein argues that inequality is damaging to the health of low-status people and hurts the health of the economy. Roberts challenges Bernstein's empirical evidence. It's a lively conversation on the economics of status, productivity and the progressivity of taxes.