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.

Kling on mortgage/financial crisis

Over at EconLog Arnold Kling has written My Fantasy Testimony. It is his "draft testimony" on what caused the mortgage/financial crisis. I have pasted the whole thing below since its worth reading the whole thing. Yes it's long, but read it anyway.

Draft Testimony
Arnold Kling
October 5, 2008

Forty years ago, depository institutions handled mortgage credit risk very differently than they do today. Back then, the depository institution, which was typically a savings and loan association, held mortgages that were underwritten by its own employees, given to borrowers and backed by homes in its own community. These were almost always 30-year, fixed-rate loans, with borrowers having made a significant down payment, often 20 percent of the price of the home. Call this approach to mortgage lending "Method A."

Today, mortgage loans held by depository institutions are often in the form of securities. These securities are backed by loans originated in distant communities by unknown borrowers, underwritten by mortgage brokers or other personnel not employed by the depository institution. The loans are often not 30-year fixed-rate loans, and the borrowers have typically made down payments of 5 percent or less, including loans with no down payment at all. Call this approach to mortgage lending "Method B."

If you compare the two methods using common sense, then Method B does not pass a simple sanity check. In fact, the current financial crisis consists of banks that are up to their necks in Method B.

Method A suffered a breakdown in the 1970's, because inflation was allowed to get out of control. The 6 percent mortgage interest rates that were commonly charged by savings and loans became untenable when inflation and interest rates soared to double-digit levels. The savings and loan industry went out of business. Whether Method B could survive a similar shock is unclear. The right lesson to learn from the 1970's was not that we should use Method B. The right lesson to learn is that we should not let inflation get out of hand.

Many articles have been written by economists from academia and Wall Street extolling the benefits of Method B. They speak of the wonderful innovation of mortgage securities and the supposed efficiency of the secondary mortgage market. In fact, if Method B were to compete fairly with Method A in a market test, Method B would fail. To survive against Method A, Method B requires government favors and subsidies. It always has, and it always will.

The secondary mortgage market began in 1968, when the United States formed the Government National Mortgage Association (GNMA). GNMA pooled loans originated under programs by the Federal Housing Administration (FHA) and the Veterans Administration (VA) and sold these pools to investors. The purpose of this, as with the quasi-privatization of the Federal National Mortgage Association (Fannie Mae) that took place that year, was to take Federally guaranteed mortgage loans off of the books. President Johnson, fighting an unpopular war in Vietnam, wanted to save himself the embarrassment of having to come to Congress to ask for larger and larger increases in the ceiling on the national debt.

Thus, the first steps toward mortgage securitization were taken in order to disguise financial reality using accounting gimmicks. It has been the same ever since.

In the early 1980's, the savings and loan industry was imploding. The savings and loans held many mortgages that had lost value, due to inflation and high interest rates. Under the accounting rules prevailing at the time, they could record the mortgages at their original book values--as long as they did not sell them. The S&L's were stuck. If they did not sell mortgages, they would lack the cash to pay depositors. If they did sell mortgages, they would have to recognize losses, and regulators would shut them down.

The solution was a program called Guarantor at Freddie Mac and Swap at Fannie Mae. Under this program,, an S&L paid Fannie or Freddie a fee to pool loans into securities, which were retained by the S&L. The S&L could then use the securities as collateral to obtain loans. The key to the whole operation was an accounting ruling that allowed the S&L's to maintain the fictional book values of the mortgages held as securities,, even though lenders were using much lower market values when providing the collateralized loans to the S&L's. This accounting ruling came from fierce lobbying by Wall Street, which wanted to broker the loans to the S&L's.

Freddie Mac, Fannie Mae, and Wall Street extracted large fees from this program. Ultimately, most of the S&L's failed, with losses borne by taxpayers. The Guarantor and Swap programs increased the cost, both directly by transferring wealth out of the S&L's and indirectly by allowing defunct S&L's to remain in business and continue gambling with other people's money.

Following the demise of the S&L's, regulators established capital requirements and other rules that made Method A lending very expensive relative to Method B lending. Freddie Mac and Fannie Mae were given freedom to leverage their guarantee at much higher ratios of assets to capital than were Method A lenders. In fact, the capital regulations even told banks that holding private mortgage securities under Method B was less risky and therefore required less capital than Method A lending. The result was that Method B came to dominate the American mortgage market. Had the playing field been level, Method A would have remained in place, and Method B likely would never have gotten started.

The regulations that favored Method B were heavily influenced by the lobbying activities of Freddie Mac, Fannie Mae, and Wall Street investment bankers. The secondary mortgage market lobby made large campaign contributions to key legislators. Their influence tilted regulations to favor Method B. Thanks to the regulatory advantages given to Method B, Freddie, Fannie, and the investment banks earned large profits. It was a triangular trade: contributions for favors for profits.

The recent "rescue plan" can be viewed in this context. It attempts to revive the otherwise moribund mortgage securities market. It is another large favor being granted to Method B.

There has been a flight to safety in credit markets in recent weeks. What is probably a necessary and significant consolidation in the financial sector has turned into a rout.

Under the circumstances, there are two policy imperatives. First, regulators must sort out the banks that are sound from those that are insolvent. The insolvent institutions need to be merged or closed as expeditiously as possible. Sound banks should be encouraged to make loans to qualified borrowers. Some forbearance of capital requirements may be appropriate in order to ensure that good borrowers do not get turned down. Finally, there may be some banks that are neither clearly insolvent nor clearly sound, in part because of questions concerning the values of their mortgage securities. These banks should be allowed to continue operating, under close supervision, perhaps with loans from the Federal Reserve.

Under no circumstances is it justified to attempt to revive the mortgage securities markets. Resumption of active trading in those markets is neither necessary nor sufficient to address tightness in credit markets caused by the flight to safety.

Next, I wish to turn to examine the state of the housing market. One of the characteristics of Method B lending has been loans with low down payments. This caused a wave of speculation, leading to a sharp rise in house prices followed by a sudden decline. In fact, this is to be expected when most homes are bought with little or nothing down. When prices or rising, anyyone can afford a home. When prices are falling, on one can.

I wish to emphasize that I support the effort to increase the rate of home ownership among minorities and people with low incomes. The problem with Method B lending is not the color of anyone's skin or the content of anyone's credit report. The problem is the absence of a reasonable down payment. In my view, assistance with saving for a down payment would be better than a system that subsidizes indebtedness. I think of buying a home with little or no money down as home borrowership, not home ownership.

The housing market today is distorted and out of balance. The slogan "Let's keep borrowers in their homes" is rather useless, considering that many borrowers never occupied their homes to begin with. The Washington Post of December 10, 2007, contained a very illuminating story of people with very modest incomes who bought two and three homes during the speculative frenzy. (http://www.washingtonpost.com/wp-dyn/content/article/2007/12/09/AR2007120901197.html)

The plural of anecdote is data. In an article published in the Federal Reserve Bulletin of December 2007, economists Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner reported that the share of mortgage loans going for non-owner-occupied housing went from 6.4 percent in 1996 to 17.3 percent and 16.5 percent in 2005 and 2006, respectively. (http://www.federalreserve.gov/pubs/bulletin/2007/articles/hmda/default.htm)


The United States today has an unusually large inventory of unoccupied housing units, which speculators have been unable to sell or rent. Given the unoccupied housing glut, attempts by policymakers to try to boost house prices are likely to prove futile. As long as the housing market remains out of balance, the valuation of mortgage securities will be problematic. As difficult and painful it may seem in the short run, it probably would be better to work through the foreclosure process and let prices adjust to levels that bring supply and demand into balance in the housing market than to prolong the state of imbalance and uncertainty by trying to prevent foreclosures. This is particularly true for the many homes that were bought for speculation, not as primary residences.

Finally, I wish to call your attention to a communication gap that exists between the financial engineers who design and value mortgage securities and the executives and regulators who make important decisions about how they are used. I call this the problem of the "suits" (the executives) and the "geeks" (the financial engineers). In many cases, the suits at banks and other financial institutions are putting these securities in their portfolios without appreciating their risk characteristics. Regulators, too, seem unaware of the threats posed by these complex instruments.

Charles Duhigg of the New York Times has written two stories, one about Freddie Mac on August 5th (http://www.nytimes.com/2008/08/05/business/05freddie.html?hp) and one about Fannie Mae on October 4th (http://www.nytimes.com/2008/10/05/business/05fannie.html?hp), that illustrate the suits vs. geeks divide. Each story cites former mid-level executives of the companies who issued warnings about risk, mis-pricing, and under-capitalization. But the geeks were ignored by the suits.

Robert Merton, a Professor of finance at Harvard and a Nobel Laureate, suggests that the decisionmakers who I call "suits" need better training in modern mathematical finance. That is one solution. Another solution would be to try to limit the ways in which under-educated "suits" can expose their firms and our economy to risk. As I indicated earlier, I do not believe that the mortgage securities market would have emerged without regulatory favoritism. If such favoritism were taken away, and the mortgage securities market were to fade away as a result, then the communication gap between the suits and the geeks would cease to be a problem.

When citizens should not vote

Given we have an election coming up, as they do in the US, all publicly-minded people out there should register to vote and be ready to head off to the polls on election day, right? Well, maybe not.

On Free Will this week, Will Wilkinson interviews Brown philosopher Jason Brennan, about his forthcoming paper, “Polluting the Polls: When Citizens Should Not Vote” [rtf]. Wilkinson notes that Brennan's argument is simple and compelling. Wilkinson writes

People should be public-spirited, and act with the common good in mind. When enough people vote badly–from ignorance or bias, for example–the result is often bad policy. The quality of policy matters to the public good. Higher-quality democratic decisions, and better policy, can be secured if bad voters choose to abstain. Because the personal cost of not voting badly is so low, a public-spirited person shouldn’t do it. And it seems that a lot of people are quite likely to vote badly. So there are many people who, if they care about the common good, ought to choose not to vote.

Buffett on regulation

The following comes, via Marginal Revolution via Craig Newmark, from a three hour interview of Warren Buffett by CNBC's Becky Quick recorded in August 2008.

QUICK: If you imagine where things will go with Fannie and Freddie, and you think about the regulators, where were the regulators for what was happening, and can something like this be prevented from happening again?

Mr. BUFFETT: Well, it's really an incredible case study in regulation
because something called OFHEO was set up in 1992 by Congress, and the sole job of OFHEO was to watch over Fannie and Freddie, someone to watch over them. And they were there to evaluate the soundness and the accounting and all of that. Two companies were all they had to regulate. OFHEO has over 200 employees now. They have a budget now that's $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies.

QUICK: Mm-hmm.

Mr. BUFFETT: And they sat there, made reports to the Congress, you can get them on the Internet, every year. And, in fact, they reported to Sarbanes and Oxley every year. And they went--wrote 100 page reports, and they said, 'We've looked at these people and their standards are fine and their directors are fine and everything was fine.' And then all of a sudden you had two of the greatest accounting misstatements in history. You had all kinds of management malfeasance, and it all came out. And, of course, the classic thing was that after it all came out, OFHEO wrote a 350--340 page report examining what went wrong, and they blamed the management, they blamed the directors, they blamed the audit committee. They didn't have a word in there about themselves, and they're the ones that 200 people were going to work every day with just two companies to think about. It just shows the problems of regulation.

QUICK: That sounds like an argument against regulation, though. Is that what you're saying?

Mr. BUFFETT: It's an argument explaining--it's an argument that managing complex financial institutions where the management wants to deceive you can be very, very difficult.

Capitalism vs. socialism in a just one picture

Mark Perry at Carpe Diem gives us the difference between capitalism and socialism in a single picture.

North Korea vs. South Korea at night. I'll let you workout which is which!

Perry adds that

According to the CIA World Factbook, 2007 GDP per capita (PPP) was $25,000 in S. Korea vs. $1,700 in N. Korea.

But on the bright side North Korea will have a much smaller carbon footprint than the South. And not much in the way of greenhouse gas emissions.

Bailout advice

Joel Stein of the LA Times has advice for those in congress with regard to the bailout plan,

If I were in Congress, I'd hold out. Every representative who voted no on the bailout got something totally sweet in the bill that passed the Senate. Jim Ramstad (R-Minn.) changed his mind once he got the health insurance for mental illness he's been fighting for. The Senate is trying to bribe Gabrielle Giffords (D-Ariz.) with tax breaks for Arizona solar companies. Earl Blumenauer (D-Ore.), who rides a bicycle, is supposed to be tempted by a tax deduction for bike commuters, as Democrats Adam Schiff of Burbank and Brad Sherman of Sherman Oaks are by tax breaks for movie producers.

You may well ask what has any of this got to do with dealing with the financial problems the US faces right now. The answer has to be nothing, but it is good politics if you have an upcoming election. Michael Giberson at Knowledge Problem writes, with regard to the tax deduction for bike commuters, that

It is kind of hard to find the provision, since it is embedded in Title III, Section 303, which is described as "Extension of Exclusion of Income From Discharge of Qualified Principal Residence Indebtedness." Scan down to Division B, Title II, SEC. 211: "TRANSPORTATION FRINGE BENEFIT TO BICYCLE COMMUTERS." I don't quite see the connection between bicycle commuting and the discharge of qualified principal residence indebtedness, but no matter.

Giberson also points out that

This is a bigger deal than even Title III, Section 303, Division C, SEC. 503: "EXEMPTION FROM EXCISE TAX FOR CERTAIN WOODEN ARROWS DESIGNED FOR USE BY CHILDREN."

Wooden arrows, financial crisis, an obvious connection. But the best point Stein makes in his article is at the end,

Any representative who voted against the world's largest economic bailout last week but votes for this bigger, uglier, more dangerous version has been bought. Whether you think this bailout is good or not, the people who changed their minds on such a monumental matter for such flimsy, unrelated reasons do not deserve to be trusted with your vote this November

Stein is right but this kind of dishonesty work with voters. Not just in the US but in New Zealand, and all other democracies. We really do get the politicians we deserve.

Reconsidering the international trading system

In this short audio from VoxEU.org, Patrick Messerlin of Sciences Po in Paris spoke to Romesh Vaitilingam about the key challenges facing the World Trade Organisation and potential solutions.

Development doesn't require big government

Bill Easterly tells us that Development Doesn't Require Big Government. He writes in the Wall Street Journal,

Development economics still bears the scars of the Depression. A prominent World Bank Growth Commission concluded in May that "fast, sustained growth does not happen spontaneously. It requires a long-term commitment by a country's political leaders," and "each country has specific characteristics and historical experiences that must be reflected" in the leaders' "growth strategy." Some at the U.N. still recommend the discredited Big Push strategy of state-planned investment.

How much poverty has endured because individual entrepreneurs were shunned in favor of the likes of the $5 billion state-owned Ajaokuta Steel Mill in Nigeria, which never produced a bar of steel? Or because African governments spend their time preparing World Bank-required national Poverty Reduction Strategy Reports instead of freeing space for innovators?

We will never know. But we do know that the free market has a long-run track record of creating prosperity -- even with the occasional crash. The Depression's deceptive intellectual legacy is that development flows from all-knowing states rather than creative individuals. Here's hoping that the backlash to today's crash will not spawn another round of bad economics for the poor.

That's the ending to the Easterly piece, the whole thing is well worth reading.

Mankiw wants a good Bernanke speech

Greg Mankiw wants a good Bernanke speech. Mankiw writes that

My sense is that the Washington economics establishment (that is, Paulson and Bernanke and the teams they lead) is losing the intellectual debate. Many, perhaps most, serious thinkers about financial matters are opposed to, or at least skeptical of, the plans the Treasury and Fed are pursuing.

Mankiw argues one reason that they are losing the debate is simply that they are not fully engaged in it. Mankiw goes on to say,

There appears to be a sense in Treasury and the Fed that they needed to convince Congress, which could be done behind closed doors, and that there was no need to address the legions of economics professors out there.

In one sense this has to be right, it's Congress who gets to vote, not the general economics profession. But as Mankiw also notes,

But as a longer-term strategy, the case for this new Washington consensus needs to be made. The general public is largely opposed to recent moves to rescue the financial system. If Washington crowd cannot bring along the intellectual elite as a first step toward convincing a broader audience, they will end up pretty much alone, which does not seem sustainable.

To deal with this Mankiw wants Bernanke to come out and make a serious, academic case for the path the Washington establishment has chosen.

Of course another possible reason the "Washington crowd" are losing the debate is that their critics are right. The Paulson plan may be the wrong move, which will ultimately fail. There may not be a serious, academic case to support what the Washington has done. But it would be good to see Bernanke at least attempt to justify path that has been taken.

Experts can be bad for your economy

This point is made by David M. Levy and Sandra J. Peart in an article at reasononline. Levy and Peart call their piece An Expert-Induced Bubble: The nasty role of ratings agencies in the busted housing market.

They open their article by asking a question many people are asking given the current financial crisis,

How is it that assets built out of mortgages which just yesterday were worth so much are worth so little today?

Levy and Peart explain,

Experts are constantly telling investors what to buy. Sometimes they give us good advice and sometimes not. So surely the fact that there are experts who give investment advice can't explain the trillion-dollar bubble and subsequent meltdown we're now witnessing. The key additional fact is that experts were selling advice about mortgage-backed assets as if those assets were independent when, in reality, they weren't at all independent assets. Only once investors realized that the housing market is a national market—not a local one—did it become clear that these securities were extraordinarily risky. Hence the collapse.

They then go on to note an important point about housing markets in the US,

Until very recently it was widely believed that all housing markets were local. If this were so, then assets constructed by pooling mortgages across different localities would consist of pooled independent assets. And these new assets would be dramatically less risky to hold than a single mortgage of similar worth: Combine a bunch of diverse mortgages and sell shares of the new security and those shares represent much less risk than holding a single mortgage of the same value as the share. Or so the story went.

But all of this depended on housing markets being local. Critically it was thought that housing markets being local meant that the assets in the pooled security didn't move together. Even Alan Greenspan argued this.

[He] testified to this effect before Congress in 2005, when the housing bubble was well under way: "The housing market in the United States is quite heterogeneous, and it does not have the capacity to move excesses easily from one area to another. Instead, we have a collection of only loosely connected local markets."

Why does this matter? Levy and Peart explain,

... following Greenspan's advice, a firm could build highly rated investment portfolios of purportedly uncorrelated assets out of nothing but mortgages from different parts of the country. Once these portfolios were built, it would become easier to finance houses even for buyers of dubious credit. The problem was that these new securities, and the money which flowed into all housing markets, were sufficient to generate correlation in housing values across the country. As everyone followed the experts' advice—and invested in these new mortgage-backed assets—we began to observe correlated behavior in the housing market, nationwide.

This raises another question, So how did the securities maintain their high investment grades? Once these correlations were observed, once people realised that there were interconnections between housing markets nationwide, why didn't another set of experts, the rating agencies, step in and downgrade the securities? Clearly these securities were not as safe as was being assumed.

The answer, like so much of economics, has to do with incentives.

In this case, the incentives weren't there to obtaining unbiased estimates of security values. Instead, incentives favored "rating shopping" and so, unsurprisingly, rating shopping became the norm. The Securities and Exchange Commission's 1994 report, Concept Release: The Nationally Recognized Statistical Ratings Organization (NRSRO), contained the following sentences:"A mortgage related security must, among other things, be rated in one of the two highest rating categories by at least one NRSRO." The phrase "one of the two highest rating categories" authorized the firm holding a mortgage backed security to shop for ratings. If one rating agency failed to produce a desirable rating, the firm could look for another, more favorable rating.

So the firms could get the ratings they needed, without the buyer of the securities knowing about any other lower rating. This meant that the buyer didn't have the ability to average out different ratings to help remove the bias caused by the rate shopping. Levy and Peart note,

As long as experts were trusted and the market didn't know the difference between unbiased and biased estimates, the trick worked marvelously. The collapse followed suddenly as we have all come to understand that the ratings were miserably biased.

Upshot, don't necessarily trust the experts, or at least don't trust just one expert.

Incentives matter: moral hazard file

This is from the Undercover Economist. Tim Harford reminds us that moral hazard can at times take rather extreme forms

According to the Florida newspaper The St Petersburg Times, in the late 1950s and early 1960s, more than two-thirds of insurance claims for the loss of a limb originated in the Florida Panhandle. At the epicentre, “Nub City” – the tiny town of Vernon, Florida – almost 10 per cent of the adult population had lost a limb. One man was said to be insured by dozens of companies when he lost his foot; fortunately he had been carrying a tourniquet at the time of the accident. He pocketed a million dollars. Another man shot his foot off – “while aiming at a squirrel” – just 12 hours after buying insurance. Now that’s careless – and that’s moral hazard in spades.

The Economic Consensus

Alex Tabarrok at Marginal Revolution argues there is now a consensus among economists that the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization. He notes that economists as diverse as Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan, along with Tabarrok and Tyler Cowen, and many others, are of this view. Tabarrok goes on to say

Krugman would prefer a recapitalization in the form of nationalization. In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.) In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways.

The consensus policy of economists would put most of the burden of adjustment on politically powerful holders of equity and bonds.

Importantly Tabarrok also notes that economists have arrived at a consensus that the bailout bill is not the right policy. Looking at the economists noted above, none is enthusiastic about the bailout. Most would properly think that the bailout has a good chance of failing. But as Tabarrok also points out

Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.

Lynne Kiesling at the Knowledge Problem blog notes

Fast recapitalization, removing the signaling penalty by having the government require banks to stop giving dividends in the short run ... those are the kind of policies that economists have been discussing, fleshing out, and encouraging over the past two weeks. Of course, the challenge to those proposals is that the parties who end up paying are precisely those firms and industries that are politically powerful.

The public choice economics lesson in this? Mancur Olson was right about concentrated benefits and diffuse costs:

... large groups will face relatively high costs when attempting to organize for collective action while small groups will face relatively low costs. Furthermore, individuals in large groups will gain relatively less per capita of successful collective action; individuals in small groups will gain relatively more per capita through successful collective action. Hence, in the absence of collective incentives, the incentive for group action diminishes as group size increases, so that large groups are less able to act in their common interest than small ones.

The book concludes that, not only will collective action by large groups be difficult to achieve even when they have interests in common, but situations could also occur where the minority (bound together by concentrated selective incentives) can dominate the majority.

Sadly, if not unexpectedly, politics trumps economics yet again. But this time it could be very costly. Steve Horwitz points out, over at the Austrian Economists blog, that this is The Triumph of Politics over Economics. He writes

Not much more to be said about the bailout bill going into law. Load it up with lots of goodies and you can buy lots of votes. Keep stoking the fires of "crisis" while you do to make sure the public is sufficiently confused. End result? De facto nationalization of a huge hunk of the credit markets. To use Pete's terms, this was a major victory for the "forces of stupidity." Let's hope the "forces of innovation" can make a comeback.

Concise encyclopedia of economics

The second edition of the Concise Encyclopedia of Economics is now available online. The CCE has both search and browse functions available. Contributors include Armen Alchian, Gary Becker, Avinash Dixit, Claudia Goldin, Greg Mankiw, Paul Romer, Pete Boettke, Tyler Cowen, Bryan Caplan, Russ Roberts and many others. If you ever need to look up an term or idea in economics, chances are that you will find it discussed in the encyclopedia.

Boudreaux on Stiglitz

In a recent article in Vanity Fair Joe Stiglitz asserts that greater purchases of foreign oil by Americans would put upward pressure on the U.S. trade deficit and thereby "force the U.S. to continue borrowing gargantuan sums from abroad, making us even more indebted."

Don Boudreaux begs to differ. At Cafe Hayek Boudreaux writes that Stiglitz is wrong on two counts.

First, if Americans increase their imports of oil, this fact does not necessarily increase the size of the U.S. trade deficit. If the foreign suppliers of this oil spend all of their dollar earnings buying American exports, then there's no increase in the size of the U.S. trade deficit.

Second, even if we assume that foreigners who sell more oil to Americans will spend none of their resulting earnings on American export during the current period, not a single dollar earned by these foreigners need be borrowed back from these foreigners by Americans. Americans can borrow these dollars from foreigners, of course. But John Doe in Denver or Jane Roe in Roanoke (or Uncle Sam in Washington) is no more "forced" to borrow back the dollars they spend buying oil from Sheik Faisal in the middle east than they are "forced" to borrow back the dollars they spend buying mutton from shepherd Frank in the Midwest.

If foreign oil suppliers to the U.S. lend the dollars they earn to Uncle Sam or to the likes of General Electric, then Americans' oil imports do indeed cause the U.S. trade deficit and Americans' indebtedness to rise. But if these same foreign suppliers instead hold on to their dollars, or buy equity in General Electric or real-estate in Rhode Island, or if they use these dollars to fund foreign direct investments in the U.S., then even though the U.S. trade deficit rises, it does not increase Americans' indebtedness.

Yet more views on the US bailout plan

Here is the transcript of a PBS News Hour programme on the US financial crisis and what to do about it. Guests on the programme include: Scheherazade Rehman, who has written about financial crises and advised a number of institutions, including the World Bank and central banks. She's a professor of international finance and business at the George Washington University. John Cochrane who is a professor of finance at the University of Chicago. He helped organize a letter signed by 200 economists questioning the design of the Paulson plan and Ken Rogoff who is a former chief economist for the IMF. He's now a professor of public policy and economics at Harvard University.

There are also links to a mp3 and a Streaming Video version of the programme.

Arnold Kling discusses the programme at EconLog in a posting entitled Cochrane and Rogoff on the PBS News Hour.

The monster returns

The following piece is by John H. Cochrane, Myron S. Scholes Professor of Finance in the Graduate School of Business at the University of Chicago, in which he explains his ideas on what the Government should do, instead of the Treasury plan, to deal with the current financial crisis in the US. The original can be found on the research section of his his website. The article is dated 1st October 2008.

The monster returns

John H. Cochrane

Like a monster from an old horror movie, the Treasury plan keeps coming back from the dead. Yes, we are in a financial crisis that needs urgent, determined, and clear-eyed help from the Government. But this plan is fundamentally flawed. It won’t even work, leaving aside its horrendous cost and long-lasting damage to the financial system. The additions and sweeteners in the Senate version, and those on the table in the house, make it even less likely to work.

A workable plan has to be based on fundamentally different principles: recapitalizing banks that are in trouble, including allowing orderly failures, and providing liquidity to short – term credit markets. These are not new and untested ideas; these are the tools that governments have used for a hundred years to get through financial turmoil. However, they have to be used in forceful and decisive ways that will step on a lot of powerful toes.

The problem

The heart of the problem now, as best as anyone I know can understand it (we are all remarkably long on stories and remarkably short on numbers), is that many banks hold a lot of mortgages and mortgage-backed securities whose value has fallen below the value of money the banks have borrowed. The banks are, by that measure, insolvent. Credit market problems are a symptom of this underlying problem. Nobody knows really which banks are in trouble and how badly, nor when these troubles will lead to a sudden failure. Obviously, they don’t want to lend more money.

A “credit crunch” is the danger for the economy from this situation. Banks need capital to operate. In order to borrow another dollar and make a new loan, a bank needs an extra (say) 10 cents of its own money (capital), so that if the loan declines in value by 10 cents the bank can still pay back the dollar it borrowed. If a bank doesn’t have enough capital – because declines in asset values wiped out the 10 cents from the last loan -- it can’t make new loans, even to credit-worthy customers. If all banks are in this position (a much less likely event) we have a “credit crunch.” People want to save and earn interest; other people want to borrow to finance houses and businesses, but the banking system is not able to do its match-maker job.

Solving the problem

Ok, if this is the problem, then banks need more capital. Then the people, computers, buildings, knowledge, and so forth that represent the real business can borrow money again and start lending it out. The core of any plan must be to recapitalize the banking system. How?

Issue stock, either in offerings, in big chunks as Goldman Sachs famously did with Warren Buffet last week, or by merging or selling the whole company. There are trillions of dollars of investment capital floating around the world, happy to buy banks so long as the price is good enough. Banks don’t want to issue stock, because it seems to “dilute” current stockholders, and might “send bad signals.” Lots of sensible proposals amount to twisting their arms to do so. In many previous “bailouts” the Government has added small (relative to $700 billion!) sweeteners to get deals like this to work.

Let banks fail, in an orderly fashion. When a bank “fails,” we do not leave a huge crater in the ground. The people, knowledge, computers, buildings and so forth are sold to new owners – who provide new capital – and business goes on as usual. A new sign goes on the window, new capital comes in the back door, and new loans go out the front door. Current shareholders are wiped out, and some of the senior debt holders don’t get all their money back. They complain loudly to Congress and the Administration – nobody likes losing money – but their loss does not imperil the financial system. They earned great returns on the way up in return for bearing this risk. Now they get to bear the risk.

We saw this process in action last week. On Monday, we heard many predictions that the financial system would implode in a matter of days. At the end of the week, JP Morgan took over Washington Mutual. Depositors and loan customers didn’t even notice. As someone who argued publicly against the Treasury plan on Monday, I felt vindicated.

This process does need government intervention – “in an orderly fashion” is an important qualifier. Our bankruptcy system is not well set up to handle complex financial institutions with lots of short-term debt and with complex derivative and swap transactions overhanging. Until that gets fixed, we have to muddle through. An important long-run project will be to redesign bankruptcy, delineate which classes of creditors get protected (depositors, brokerage customers, some kinds of short term creditors), and how much regulation that protection implies, and to design a system in which shareholders and debt holders can lose the money they put at risk without creating “systemic risk.” But not now.

What is simple to describe economically –wipe out shareholders, write-down debt, marry the operations to new capital – is not straightforward legally and institutionally. If we just throw everyone into bankruptcy court, the lawyers will fight it out for years and the operations really will grind to a halt. In the heat of the crisis, we need the same kind of greasing of wheels and twisting of arms that went into the last few bank failures.

Fancy ideas. The main point of any successful plan is to marry new capital with bank operations. There are lots of creative ways to do this, including forced debt-equity swaps, and various government purchases of equity. (My colleagues at the University of Chicago are particularly good at coming up with clever schemes. See http://research.chicagogsb.edu/igm/.)

The second part of the solution is to maintain liquidity of short-term credit markets. The Fed is very good at this. Its whole purpose is to be “lender of last resort.” We are told that “banks won’t borrow and lend to each other.” But banks can borrow from the Fed. The Fed is practically begging them to do so. Even if interbank lending comes to a halt, there need not be a credit crunch. If banks are not making new loans, it is because they either do not have capital, or they don’t want to – not because they can’t borrow overnight from other banks. (And the “other banks” are still there with excess deposits.) If the Fed is worried about commercial paper rates, it can support those.

The one good part of the current proposals is a temporary extension of federal deposit insurance. The last thing we need is panicky individuals rushing needlessly to ATM machines.

By analogy, we are in a sort of “run” of short-term debt away from banks. We have learned in this crisis that the whole financial system is relying to an incredible extent on borrowing new money each day to pay off old money, leading quickly to chaos if investors don’t want to roll over. It doesn’t make sense to threaten that overnight debt winds up in bankruptcy court, which is at the heart of the need for Government to smooth failures. In the short run, guaranteeing new short-term credit to banks as a sort of deposit insurance could stop this “run.” If we do that, of course, we will have to limit how much banks and other financial institutions can borrow at such short horizons in the future.

Banks vs. the Banking system

Banks can fail without imperiling the crucial ability of the banking system to make new loans. If a bank fails, wiping out its shareholders, and its operations are quickly married to the capital of new owners, the banking system is fine. Even if one bank shuts down, so long as there are other competing banks around who can make loans, the banking system is fine.

I think many observers, and quite a few policy-makers, do not recognize the robustness that our deregulated competitive banking system conveys. If one bank failed in the 1930s, a big out of state bank could not come in and take it over. Hedge funds, private equity funds, foreign banks, sovereign wealth funds didn’t even exist, and if they did there’s no way they would have been allowed to own a bank or even substantial amounts of bank stock. If a bank failed in the 1930s, a competitive bank could not move in and quickly offer loans, or deposit and other retail services, to the first bank’s customers. JP Morgan could not have taken over WaMu. But all those competitive mechanisms are in place now – at least until a new round of regulation wipes them out. This is, I think, the reason why we’ve had 9 months of historic financial chaos and only now are we starting to see real systemic problems.

There is a temptation for regulators and government officials to hear stories of woe from failing banks, their creditors, and their shareholders and mistakenly believe that these particular people and institutions need to be propped up.

The Treasury Plan

The treasury plan is a nuclear option. The only way it can work to solve the central problem, recapitalizing banks, is if the Treasury buys so many mortgages that we raise mortgage values to the point that banks are obviously solvent again. To work, this plan has to raise the market value of all mortgage-backed securities. We don’t just help bad banks. We bail out good banks (really their shareholders and debt holders), hedge funds, sovereign wealth funds, university and charitable endowments – everyone who made money on mortgage-backed instruments in good times and signed up for the risk in bad times. This is the mother of all bail-outs.

There is a storm out on the lake, and some of the boats are in trouble. Commodore Bernanke has been helping to bail water from some boats until they can patch themselves up, encouraging other sound boats to help, and transferring passengers on sinking boats to others. But it’s getting tough and the storm is still raging. Someone has a great idea: let’s blow up the dam and drain the lake! Ok, it might stop the boats from sinking, but there won’t be a lake left when we’re done. That’s the essence of the Treasury plan.

Short of that, it will not work. Suppose a bank is carrying its mortgages at 80 cents on the dollar, but the market value is 40 cents. If the Treasury buys at 40 cents or even 60 cents on the dollar, the bank is in worse trouble than before, since the bank has to recognize the market value. Unless the Treasury pushes prices all the way past 80 cents on the dollar up to 90 or even 100, we haven’t done any good at all. And $700 billion is a drop in the bucket compared what that would take.

There is a lot of talk about “illiquid markets,” “price discovery,” and the “hold to maturity price;” the hope that by making rather small purchases, the Treasury will be able to raise market prices a lot. This is a vain hope – at least it is completely untested in any historical experience. Never in all of financial history has anyone been able to make a small amount of purchases, establish a “liquid market” and substantially raise the overall market price.

Since the Treasury will not be able to raise overall market prices, it will end up buying from banks that are in trouble, at prices fantastically above market value. This is transparently the same as simply giving the banks free money. Make sure the taxpayers get a thank-you card.

There is other talk (reflected in the Senate bill) of abandoning mark-to-market accounting, i.e. to pretend assets are worth more than they really are. This will not fool lenders who are worried about the true value of the assets. If anything, they will be less likely to lend. Conversely, if prices are truly artificially low, then potential lenders to banks know this and would lend anyway. We might as well just ban all accounting if we don’t like then news accountants bring. No, we need more transparency, not less.

Many of the changes in new versions of the Bill make matters worse, at least for the central task of stabilizing financial markets. The Senate adds language to protect homeowners – “help families to keep their homes and to stabilize communities.” That’s natural; a political system cannot hope to bail out shareholders to the tune of $700 billion dollars without bailing out mortgage holders on the other end. But it makes the bank stabilization problem much worse. Mortgages are worth a lot less if people don’t have to pay them back. This will directly lower the market value of mortgages that we’re trying to raise.

Yes, we need to do something. But “doing something” that will not work, with potentially dire consequences, is not the right course, especially when sensible and well-understood options remain.

Neurofacturing

Edward Leamer, Professor of Management, Professor of Economics and Professor of Statistics at the University of California Los Angeles, talks, in this audio from VoxEU.org, to Romesh Vaitilingam about his concept of ‘neurofacturing’ - creating value through knowledge work rather than physical labour - its rising significance in the world of the personal computer and the internet, the impact on inequality and the implications for our education systems.

New frontiers in free trade

This Cato Daily Podcast is an interview with Razeen Sally, recorded on September 16 2008, author of New Frontiers in Free Trade. Sally is director of the European Centre for International Political Economy, an international economic policy think tank based in Brussels. He is presently on a leave of absence from the London School of Economics and Political Science, where he has taught since 1993.

Inflation record?

Absent current official money supply and inflation data, it is difficult to quantify the depth and breadth of the still-growing economic crisis in Zimbabwe. To overcome this problem, Steve H. Hanke, Professor of Applied Economics at The Johns Hopkins University and Senior Fellow at the Cato Institute, has developed the Hanke Hyperinflation Index for Zimbabwe (HHIZ). This new metric is derived from market-based price data and is available here for the January 2007 to present period. The HHIZ will be updated weekly.

As of 26 September 2008, Zimbabwe's annual inflation rate was 531 billion percent.

Interesting blog bits

1. The visible hand in economics asks Are economists allowing us to wander towards the Great Depression II
2. A speech by Roger Kerr on Moral Markets (pdf).
3. Economic Logic on What is a CEO worth?
4. Thomas Sowell on Bailout Politics.
5. Lynne Kiesling on More definitive evidence that property rights improve fishing yields and sustainability.
6. Peter Klein on Teaching Economics through Cinema.
7. Barry Eichengreen on And now the Great Depression.

   The Paulson Plan, whatever its final form, will not end the crisis quickly. Unemployment will rise but will the most serious credit crisis since the Great Depression bring about a new depression? Here one of the world’s leading economic historians identifies the relevant Great-Depression lessons. We won’t see 25% unemployment as in the 1930s, but double digits are not out of the question

Wall St bailout approved by the Senate

The New Zealand Herald website has this report on the US Senate approval of the Wall Street bailout plan. The Herald reports

WASHINGTON - After one spectacular failure, the $700 billion financial industry bailout has found a second life today, winning lopsided passage in the Senate and gaining ground in the House, where Republican opposition softened.

But I thought the most interesting paragraph of the article was this,

Senators loaded the economic rescue bill with tax breaks and other sweeteners before passing it by a wide margin, 74-25, a month before the presidential and congressional elections.

But may be I just have a suspicious mind.

Jeffrey Tucker over at the Mises Economcs Blog has a posting on The Senate at Its Finest. He writes,

That's the claim that these guys are making after having passed what is surely the most ghastly piece of legislation since I don't know when. One after another of these Senators is stepping forwarding the mic to declare just wonderful, how courageous, how inspiring it has been to steal $700 billion from American taxpayers to give it to failed but powerful market players, against the overwhelming opposition of the public and in defiance of every principle of economic logic. Some held out but changed their votes when the legislation was made ever worse with each additional inclusion of pork, control, and moral hazard. Such a hard, indeed, Senatorial, thing to do!

Information on another bailout

James Hamilton at Econbrowaer reports on another bailout, this time to automakers. Hamilton quotes a report from Breitbart reports:

The US Senate Saturday approved 25 billion dollars in loan guarantees for the financially strapped US auto industry, intended to spark a wave of automotive innovation. The loan guarantees were included in a continuing resolution that included funding for the US government and the wars in Iraq and Afghanistan. President George W. Bush has indicated that he intends to sign the bill....

The bill, which was approved by the House of Representatives on Wednesday, are the first loan guarantees for U.S. carmakers since Congress approved a similar 675 million dollar measure for Chrysler Corp. in 1980. Chrysler Chairman Robert Nardelli, however, said this week the loan guarantees should not be considered a rescue package for struggling carmakers. "This is not a bailout," he said.

He then comments

Well, if the loans are repaid, you might argue that it's not a bailout because no federal outlays were involved. And you might argue the same for the $1.7 trillion in Fannie and Freddie's debt that the U.S. Treasury now seems to be guaranteeing, and for the $3.1 trillion in guarantees on agency MBS, and for the $600 billion or so in loans that the Federal Reserve seems to have extended. Not to mention the $700 billion Treasury plan still under debate.

He ends by asking

On the other hand, what's another measly $25 billion among friends?

Indeed, will taxpayers notice another $25 billion going walkabout?

Tyler Cowen's views on the crisis -- a summary statement (updated)

At Marginal Revolution Tyler Cowen gives a 15 point summary of his view of the financial crisis in the US. In a comment to Tyler's posting Alex Tabarrok writes "FYI, my views are very similar to those of Tyler".

The summary is

1. Glass-Steagall repeal was not a major cause of the financial crisis, nor was government-induced "minority lending."

2. We should use regulation to move more of the currently unregulated derivatives markets to the clearinghouse model.

3. The crisis represents a massive conjunction of both market and governmental failure.

4. I would not nationalize banks as ongoing concerns, at least not short of a far more extreme emergency than the current status quo.

5. The modified Paulson plan was better than nothing -- especially after the market had been scared -- but far from my first choice. In any case the plan would have been revised almost immediately. The Paulson and Dodd plans were never that far apart.

6. My first choice is to induce and if need be to force more information revelation, identify the insolvent banks, close them up, and give the battle-tested FDIC a much greater role in the whole process.

7. In the meantime the Fed should not worry much about inflation.

8. The critical deregulatory mistake was allowing excess leverage. Many deregulations get blamed but in fact contributed little to the problem.

9. Everyone says that letting Lehman die was a big mistake but I'm not yet convinced. Maybe a bracingly high TED spread is what we need.

10. Libertarians are overrating the moral hazard argument, as many equity holders have been wiped out.

11. If someone is pushing conclusions and not identifying the potential weak points in his or her arguments, be suspicious. Also beware of anyone pretending to offer you simple answers.

12. I have a long and complicated view on the relevance of Austrian Business Cycle Theory which resists easy summation, but markets could have and should have been more cautious in response to Greenspan's easy money policies.

13. Insolvent hedge funds and the commercial paper market remain outstanding issues which are not easy to address.

14. I agree with Arnold Kling about relaxing capital requirements though at this point I don't expect it to help much.

15. The crisis is complex and has many causes; there won't be a simple or quick solution.

Update: Thanks to Matt Nolan of The visible hand in economics for pointing out this set of notes on the credit crisis by Roger Congleton.

New iPredict stocks

iPredict has three new stocks on offer to do with who will win Wellington Central.

1. WC.Franks - This contract pays $1.00 if Stephen Franks wins the Wellington Central electorate in the 2008 New Zealand General Election, $0 otherwise.
2. WC.Robertson - This stock pays $1.00 if Grant Robertson wins the Wellington Central electorate in the 2008 New Zealand General Election, $0 otherwise.
3. WC.Other - This contract pays $1.00 if neither WC.ROBERTSON and WC.FRANKS contracts close at $1. Otherwise this contract closes at $0.

EconTalk this week

On EconTalk this week Arnold Kling of EconLog talks with host Russ Roberts about the economics of the housing market with a focus on the role of Fannie Mae and Freddie Mac. The conversation closes with a postscript on the current financial crisis.

The four horsemen of the financial panic

This is from the Friends of ATR [Americans for Tax Reform] website: The Four Horsemen of the Financial Panic.

Government-sponsored enterprises (GSEs). Fannie Mae, et al, bears a large share of the responsibility. By purchasing mortgages, repackaging them into securities, and selling them on the open market, mortgage lenders were encouraged to issue riskier and larger mortgages. They could then shift the risk to the GSEs by selling the mortgage to them. As of this year, the GSEs owned or securitized half of the $12 trillion mortgage debt market. Exacerbating the GSE risk is the Clinton-era rule which said that the GSEs only needed to retain capital equal to 2.5% of mortgages assumed (it’s 10% for other financial institutions). When the GSEs had no one to whom they could shift the hot potato, the house of cards came crashing down. According to opensecrets.org, the GSEs have contributed over $1.5 million to federal candidates this year. Nearly 60% of that money went to Democrats.

Easy money from the Federal Reserve. On January 3, 2001, the Federal Reserve cut the federal funds rate by fifty basis points, to 6.00%. They continued to do so until the rate hit a bottom of 1.00% on June 25, 2003. This also had an effect on mortgages. According to Freddie Mac, the average rate for a thirty-year fixed rate mortgage fell from a peak of 8.52% in May 2000 to a nadir of 5.23% in June 2003. As a result, households with less income could afford bigger and more expensive houses.

As an example, someone paying a $2000 per month mortgage in May 2000 would be able to afford a house worth about $282,000. That same $2000 payment in June 2003 would get our homeowner a house worth about $460,000.

Many of these homebuyers, moreover, didn’t get conventional 30-year mortgages. Because lending was so cheap, banks were offering adjustable-rate mortgages, “balloon” options, and no-money-down at closing. The banks shifted their risks to the GSEs. When the Federal Reserve started raising the federal funds rate, mortgage rates climbed back up (they’re currently hovering around 6 percent), some of the ARMs matured, and households found themselves unable to as easily make these payments.

Did the Federal Reserve need to cut rates this low “for the economy?” Not if one believes in low inflation as a necessary precursor of economic growth. The price of gold, which is a good indicator of future inflation trends, has grown from about $250 per oz. in 2001 to $900 per oz. today. That’s a gain of 260% in just over seven years.

Community Reinvestment Act (CRA). This legislation, first passed in 1977, gave federal regulators the power to encourage banks to issue loans to high-risk households and small businesses. It was ramped up in the Clinton Administration, who along with groups like ACORN, jaw-boned banks into issuing riskier and riskier loans to poor households. Efforts by the Bush Administration to rein in CRA bureaucratic zealousness met with charges of racism and elitism by Congressional Democrats and left wing activist groups.

Mark-to-market accounting rules. This refers to an accounting practice that forces a balance sheet to value an asset at its current market price (that is, what it could be sold for at the time). The Federal Accounting Standards Board (FASB) issued Statement 157 on November 15, 2007, which required this accounting practice for all financial firms. Some securities holding devalued mortgages still retained underlying value, but could not be sold because there were no buyers. As a result, mark-to-market required the firms to value the securities at or near $0. If, however, the firms were allowed to value the assets at something closer to book value, their balance sheet positions would improve. Mark-to-market is an arbitrarily-restrictive accounting practice that should be scrapped for assets like securities which generate current income. Doing this alone would solve much of the problem. The SEC relies on FASB in an advisory role, but could overrule it in giving guidance to company accounting practices.

Government officials and economic advice

That great letters to the editor writer Don Boudreaux is at it again. This is a letter he recently sent to the Wall Street Journal.

V. Nagarajan suggests that the financial turmoil on Wall Street combines with the fact that most winners of the Nobel Prize in Economic Science are Americans to reveal that economics is a discipline unworthy of Nobelity (Letters, September 30).

While some laureates are indeed undeserving of such high distinction, Mr. Nagarajan's presumption that Uncle Sam's economic policies are fashioned after the advice of distinguished economists is unwarranted. One of America's greatest economists is my colleague James Buchanan, winner of the 1986 Nobel Prize. Jim's life work shows that government officials seek office, not truth - and that success at their venal endeavor too often requires not merely ignoring sound economics but positively fleeing from it as if it were a fast-expanding cloud of anthrax spores.

Even the briefest of overviews of the public choice literature would make one very suspicious of the idea that governments take any notice of good economic advice. If only they did.

Is deregulation to blame?

Is deregulation to blame for the financial mess in the US? The answer, according to Peter J. Wallison writing at Bloomberg.com, is no. Wallison writes

In the debate on Sept. 26, Democratic presidential nominee Barack Obama argued that the current crisis in the financial markets is the result of Republican deregulation.

Wallison continues

The credibility of the charge depends on ignoring several important facts:

-- There has been a great deal of deregulation in our economy over the last 30 years, but none of it has been in the financial sector or has had anything to do with the current crisis. Almost all financial legislation, such as the Federal Deposit Insurance Corp. Improvement Act of 1991, adopted after the savings and loan collapse in the late 1980s, significantly tightened the regulation of banks.

-- The repeal of portions of the Glass-Steagall Act in 1999 -- often cited by people who know nothing about that law -- has no relevance whatsoever to the financial crisis, with one major exception: it permitted banks to be affiliated with firms that underwrite securities, and thus allowed Bank of America Corp. to acquire Merrill Lynch & Co. and JPMorgan Chase & Co. to buy Bear Stearns Cos. Both transactions saved the government the costs of a rescue and spared the market substantial additional turmoil.

None of the investment banks that got into financial trouble, specifically Bear Stearns, Merrill Lynch, Lehman Brothers Holdings Inc., Morgan Stanley and Goldman Sachs Group Inc., were affiliated with commercial banks, and none were affected in any way by the repeal of Glass-Steagall. [...]

-- Republicans have favored financial regulation where it was necessary, as in the case of Fannie Mae and Freddie Mac, while the Democrats have opposed it. In 2005, the Senate Banking Committee, then under Republican control, adopted a tough regulatory bill for Fannie and Freddie over the unanimous opposition of committee Democrats. The opposition of the Democrats when the bill reached the full Senate made its enactment impossible. [...]

-- The subprime and other junk mortgages that Fannie and Freddie bought -- and the market in these mortgages that their buying spawned -- are the underlying cause of the financial crisis. These are the mortgages that the Treasury Department is asking for congressional authority to buy. If the Democrats had allowed the Fannie and Freddie reform legislation to become law in 2005, the entire financial crisis might have been avoided.