Below is Boettke's talk in nine parts.
Saturday, 18 October 2008
Austrian economics and the present crisis
On October 6, 2008 at the inaugural lecture for The Future of Freedom Foundation’s “Economic Liberty Lecture Series,” Peter Boettke analysed the current credit crisis in the US from an Austrian perspective. Peter J. Boettke is the BB&T Professor for the Study of Capitalism, Mercatus Center at George Mason University, and University professor in the economics department at George Mason University.
Below is Boettke's talk in nine parts.
Below is Boettke's talk in nine parts.
Worldwide financial crisis largely bypasses Canada
Just for EC, this article from the Washington Post looks at why the US financial crisis has had little impact on Canada. One interesting point is
According to the Canadian Banking Association, one reason for the system's solidity is that banks are national in scope. Each of the largest five institutions has branches in all 10 Canadian provinces, meaning they are less susceptible to regional downturns and they can move capital from region to region, as needed. "As far as I am aware, no American bank has branches in all 50 states," banking association spokesman Andrew Addison wrote in an e-mail.and
Another difference is that in Canada, mortgage interest is not tax-deductible, making it harder to buy a house. [...] People do not take out mortgages just for the tax break. In Canada, "a mortgage is seen as something you want to get rid of as fast as possible," said Peter Dungan, an economist with the Rotman School of Management at the University of Toronto.But it's not just today that the Canadian bank system has looked good. Consider this graph from Mark Perry at the Carpe Diem blog
The McFadden Act of 1927 specifically prohibited interstate branch banking in the U.S., and only allowed banks to open branches within the single state in which it was chartered. Therefore, U.S. banks were forced to be small and local, with an undiversified loan portfolio tied to the local economy of a single state, or a specific region of a single state. The strict regulatory framework of the McFadden Act created a delicate and fragile banking system that could not easily withstand the shock of the Great Depression. Exhibit A: 9,000 banks failed in the U.S. in the early 1930s (see chart above).Perry goes on to quote from an article from the San Francisco Federal Reserve,
During the Great Depression years—1930 through 1933—5.6%, 10.5%, 7.8%, and 12.9% of U.S. banks failed in each year; by the end of that four-year stretch, almost half of U.S. banks had either closed or merged. Bernanke (1983) argues that this banking crisis worsened the magnitude of the downturn because credit supply fell as banks failed. Thus, many firms were unable to finance potential investments. Most of the failed banks were small and operated out of just a single office. In Canada, where not a single bank failed, branching was the rule; in fact, Canada had only ten large banks during the 1930s. The Canadian economy fared much better than did the United States economy, in large part because of its better diversified and integrated banking system. (emphasis added)Perry's bottomline
Strict banking regulations are not always the answer to creating a sound and stable banking system. Exhibit A: The McFadden Act and The Great Depression, and the fact that 0 banks failed in Canada (due to a more sensible regulatory system) vs. 9,000 bank failures in the U.S. largely due to the repressive regulatory framework of the McFadden Act.Score one for Canada!
George Ayittey: cheetahs vs. hippos for Africa's future
In this TEDTalks video, recorded in June 2007, economist George Ayittey unleashes a torrent of controlled anger toward corrupt leaders in Africa. He sees Africa's future as a fight between Hippos -- complacent, greedy bureaucrats wallowing in the muck -- and Cheetahs, the fast-moving, entrepreneurial leaders and citizens who will rebuild Africa.
Friday, 17 October 2008
Walter Williams on the US financial crisis
Walter E. Williams, professor of economics at George Mason University, talks about the the solution to the US's financial crisis. See the video here.
What's new in econ?
At the Austrian Economists blog Peter Boettke asks an interesting question, interesting to other economists at least. He asks What is New in Economics? Boettke explains his question,
Since 1990, what do you consider to be the best economic theory innovations? In my opinion, most of the developments since then that have captured our professional imagination are empirical questions and techniques, not theoretical innovations --- but perhaps I am wrong. Give your nominations --- but don't just list a name, but lets discuss the core insight the name is supposed to capture.I'm not 100 percent sure it would exactly fit Boettke's time frame, but for me one of the most interesting recent developments is incomplete contracts theory. In particular its use in the theory of the firm and the related area of the theory of privatisation.
Wilkinson on Smith on Key
At the businessday.co.nz blog Nick Smith has a strange posting on Key dons his Muldoon mask in tweaking KiwiSaver. Smith writes
A current account deficit doesn't mean we are dis-saving it means we are investing more than we are saving. Our savings are still positive. And that could be optimal. We may be better off by saving what we are and "importing" any additional funds need for the investment we want to do rather than trying to fund all investment out of our own saving and thereby reducing our consumption. As Noland notes
If compulsory super had proceeded, New Zealand Inc would now have huge sums of cash with which to fund future growth rather than borrowing offshore and paying a premium for the privilege.He goes on to say
Conceivably the country would have posted a series of current account surpluses rather than the dismal succession of deficits.
KiwiSaver is important because it is beginning to reverse the trend of New Zealanders spending more than they earn.and
But taking an axe to savings inflows, as Key’s KiwiSaver policy effectively will, is dreadfully disappointing and will harm the economy. And for what?Later Smith refers to comments by David Skilling
“Skilling dismisses this argument. The nation’s well-documented rate of dis-saving - spending more than it earns - means we’re not saving enough. The sheer popularity of the scheme (800,000-plus members) makes claims of an existing savings shift “wildly implausible”, he says.I have to ask a very basic economic question, does Smith know what a current account deficit is? Even if we had a current account surplus, so what? This just means we are saving more than we are investing. Why do we care? Matt Nolan give a quick summary of why we may not care here.
A current account deficit doesn't mean we are dis-saving it means we are investing more than we are saving. Our savings are still positive. And that could be optimal. We may be better off by saving what we are and "importing" any additional funds need for the investment we want to do rather than trying to fund all investment out of our own saving and thereby reducing our consumption. As Noland notes
The current account deficit is merely the result of the borrowing, consumption, and investment decisions of every household and firm in the economy. As long as these households and firms are fully informed of the risk and return associated with their borrowing decisions, is there really any reason to fear the spectre of a current account deficit? To answer my own rhetorical question – it appears not.In a comment on the Smith article economist Bryce Wilkinson responds, sensibly, to Smith's posting. Wilkinson writes
“If compulsory super had proceeded, New Zealand Inc would now have huge sums of cash with which to fund future growth rather than borrowing offshore and paying a premium for the privilege.”
Does anyone know of any substantive support in the mainstream economic literature on the sources of economic growth for the proposition that economic growth is generated from spending huge ‘cookie jar’ funds controlled by politicians? I don’t. Regardless, the Crown’s ‘cookie jar’ is already $200 billion (total Crown assets at 30 June 2008) and government in all its forms is spending annually more than 40 percent of national income, without bothering to rigorously assess whether that spending is doing more good than harm. Does this proposition have anything more to back it up but the belief that politicians can spend New Zealanders’ money better than they can spend it themselves?
“KiwiSaver is important because it is beginning to reverse the trend of New Zealanders spending more than they earn. ”
Where is the evidence that it is reversing any trend? Which of the major macro-economic forecasters are projecting the reversing of a savings trend due to KiwiSaver? More importantly, New Zealanders are not spending more than they earn. (See below) National savings have long been positive and measured household net worth (which excludes the net assets the Crown owns on behalf of households) has been rising.
“But taking an axe to savings inflows, as Key’s KiwiSaver policy effectively will, is dreadfully disappointing and will harm the economy. And for what?”
What is the evidence that KiwiSaver is helping the economy? Stuffing a fund full of tax incentives raises tax rates at the margin, distorts the alloaction of funds, and adds to transaction costs. Many individuals would be better off reducing their debts. Governments should not be inducing people to borrow in order to invest in risky things like shares. Does the bald unqualified assertion that cutting it will harm the economy have any factual basis?
“Skilling dismisses this argument. The nation’s well-documented rate of dis-saving - spending more than it earns - means we’re not saving enough. The sheer popularity of the scheme (800,000-plus members) makes claims of an existing savings shift “wildly implausible”, he says.”
If Skilling actually said this it would be disgraceful. New Zealand is not dis-saving. (A balance of payments deficit does not mean that savings are negative; it typically means that investment is greater than savings. This, in itself, is not a bad thing.) In fact, measured national savings have been positive, not negative, for 35 of the last 36 years for which Statistics NZ has data (see SNCA.S2NB08Z). Are statisical facts simply irrelevant? ‘His’ other arm-waving comment is also a red herring. The issue is not whether there is no effect on total saving, it is whether there is any basis for claiming material effects.
Perhaps the worst thing about all this is that it is so one-eyed. There are a host of respected economists, academics and commentators who have drawn attention to research questioning this sort of one-sided propoganda. Why not use their contributions to promote better-informed public debate. Even just a bit of attention to relevant facts would be better than this.
Thursday, 16 October 2008
Key's super idea woeful and irresponsible (updated)
In this case I think Rodney Hide has it right when he says,
Update: Save the Humans comments on Key or Keynes?
There are two possibilities behind John Key’s announcement that $40 billion of the $100 billion Cullen Fund is to be directed into New Zealand assets.And it is a truly appalling idea. Having the government buy up assets will do nothing to help improve New Zealand's economic performance. As Matt Nolan says
The first is that he knows it’s a dumb idea but thinks it smart politics. That would be bad.
The second is that he thinks it’s a good idea – now that would be truly appalling.
If capital at home made the highest return, then we wouldn’t need to legislate a 40% investment - as the Cullen Fund would put all its dosh there anyway. As a result, by “forcing” the fund to keep 40% onshore, we are reducing the return on our investment plain and simple.To this you can add the idea that this extra government investment could just crowd out private investment, both from within New Zealand and from overseas. So the total amount of investment in New Zealand may not change much at all. And then there is the issue of what happens if politicians start to take an even more hands on approach to the fund. The last thing we need is for investment decisions to be made, not for good economic reasons, but purely for party political reasons.
Update: Save the Humans comments on Key or Keynes?
Boudreaux on Friedman
Don Boudreaux alerts us to an essay at Forbes.com which unfortunately describes Milton Friedman as a "champion of unfettered markets." This description, as Boudreaux rightly points out, reflects a common but unfortunate misunderstanding. Boudreaux goes on to write
Milton Friedman championed not unfettered markets, but markets fettered by competition and consumer sovereignty rather than by political diktats. Friedman understood that fetters imposed by government are neither the only nor the best means of keeping markets working well. Indeed, far too often - as Friedman knew - fetters imposed by government turn in practice into crowbars that businesses use to break free of the competitive shackles that oblige them to behave prudently and fairly.
Knowledge and power (updated)
When discussing The Political Economy of the Bailout Arnold Kling writes
Update: The Free Exchange blog attacks Kling here.
Whether the economy needs a "plan," or whether the plan will help the markets, is beside the point. The plan serves to consolidate power. Four weeks ago, the Fed and the Treasury had far more power than anyone can intelligently use. Still, they came to Congress requesting more power. Then, when the bill was passed, Paulson [whom Kling refers to as the "American Mussolini"] took even more power than what it sounded like the legislation was givingThen Kling makes the important point
We got into this crisis because power was overly concentrated relative to knowledge. What has been going on for the past several months is more consolidation of power. This is bound to make things worse. Just as Nixon's bureaucrats did not have the knowledge to go along with the power they took when they instituted wage and price controls, the Fed and the Treasury cannot possibly have knowledge that is proportional to the power they currently exercise in financial markets.The discrepancy between knowledge and power is what Kling has called the "suits vs. geeks divide". One group has the knowledge while the other the power. In today's economy knowledge is increasingly dispersed but power is increasingly concentrated, even in the private sector, with some CEO's not understanding their own businesses. But compare this with the public sector, do politicians understand the budgets and the laws that they vote on? What do the regulators understand about the consequences of their rulings? The divide between government geeks and government suits is much greater and more dangerous. Add to this the fact that the incentives not to understand are greater in the public arena and you get, at least part of, the reason for bad outcomes in the state sector.
Update: The Free Exchange blog attacks Kling here.
Wednesday, 15 October 2008
Drug approval denationalization
The Davos Question is "What one thing do you think that countries, companies or individuals must do to make the world a better place in 2008?" The answer given by economist Professor Daniel Klein is drug approval denationalization. He explains in this video,
Interesting blog bits
- Stuff.co.nz report on Nats want more local investment
- NZ Herald report on National to direct 40pc of Super Fund to NZ.
- The visible hand in economics on "More" local investment may lead to less.
- Kiwiblog on National to legislate for at least 40% of NZ Super Fund to be invested in NZ.
- Video by Bernard Hickey on John Key plans to fiddle with Cullen fund.
- Not PC on No indeed, Minister
- Not PC on National Socialism
New iPredict stocks
iPredict has three new stocks on offer to do with residential property values.
- QV.AUCK.DEC08 - This contract pays $1 if the percentage annual change in the QV estimated residential property values index for the Auckland Region falls by more than the Wellington Region or Christchurch in the year ending December 2008, otherwise $0.
- QV.WGTN.DEC08 - This contract pays $1 if the annual change in the QV property values index for the Wellington Region falls by more than the Auckland Region or Christchurch in the year ending December 2008, otherwise $0.
- QV.CHCH.DEC08 - This contract pays $1 if the annual change in the QV property values index for Christchurch falls by more than the Auckland Region or Wellington Region in the year ending December 2008, otherwise $0.
UC has new VC
Jade Software CEO Dr Rod Carr has been appointed to the position of vice-chancellor at the University of Canterbury, effective from 1 February 2009.
Prior to joining Jade in 2003, Carr was Deputy Governor and Director of the Reserve Bank of New Zealand. He has also held senior positions within the Bank of New Zealand and the National Australia Bank.
Carr has a PhD in Risk Management and Insurance, and an MA in Applied Economics and Managerial Science from the Wharton School at the University of Pennsylvania, an MBA in Money and Financial Markets from the Columbia Graduate School of Business in New York, and a LLB (Hons) and BCom (Hons) in Economics from the University of Otago.
He is a long involvement with the University. He currently chairs the advisory board of NZi3 - the national ICT Innovation Institute based at UC. He is also a director of the Geospatial Research Centre and a member of the College of Business and Economics Advisory Board.
Prior to joining Jade in 2003, Carr was Deputy Governor and Director of the Reserve Bank of New Zealand. He has also held senior positions within the Bank of New Zealand and the National Australia Bank.
Carr has a PhD in Risk Management and Insurance, and an MA in Applied Economics and Managerial Science from the Wharton School at the University of Pennsylvania, an MBA in Money and Financial Markets from the Columbia Graduate School of Business in New York, and a LLB (Hons) and BCom (Hons) in Economics from the University of Otago.
He is a long involvement with the University. He currently chairs the advisory board of NZi3 - the national ICT Innovation Institute based at UC. He is also a director of the Geospatial Research Centre and a member of the College of Business and Economics Advisory Board.
Kling: written remarks
Earlier I commented on both Arnold Kling's Fantasy Testimony on the US financial problems and later on his posting More Fantasy Testimony. These comments he called his "oral remarks." I also noted in that posting that Kling said he was working on some support material which he refers to as his "written remarks." Now over at EconLog Kling give us these "written remarks". Again posted in full below. They are even longer than his two previous messages but as usual they are well worth reading.
Kling has added this update to this messageWritten Remarks
1.The History of Mortgage Securitization
Arnold Kling
Suppose that you were a bank executive and were offered a choice between two methods for holding mortgage loans. Call them Method A and Method B.
Under Method A, you employ the mortgage originators. You give them rules and instructions. You set their incentives. You can choose whether to pay them only for accepting loans or to also pay them for reviewing and rejecting loan applications where appropriate. They originate loans in your local community. The loan terms are set by your policies. You receive the borrowers' payments and deal with loan delinquencies according to your procedures. Sometimes, your procedures call for rapid foreclosure. In other instances, they dictate some sort of loan workout.
Under Method B, you hold a security interest in a pool of mortgages. These loans were originated by people unknown to you, whose only incentive is to maximize "production," without regard to quality or risk. They are paid when they originate a loan, never for rejecting a loan application. The loans come from far and wide, including many places with which you are not familiar. If borrowers are delinquent in their payments, you have no control over how this delinquency is addressed.
Most executives, if offered this choice, would prefer method A. Compared with Method A, Method B does not pass a simple sanity check. Using economic jargon, method B has much higher "agency costs." Under Method A, the people acting as the agents of the executive work for the bank. The executive has the power to align the incentives of the agents with those of the shareholders of the bank. Under Method B, the agents who originate home mortgages are working against you, not for you. They are trying to slip as many bad loans through the door as they can. It is up to someone else, not you, to stop them--assuming that they care..
Today, three-fourths of mortgage debt in the United States is held using Method B, also known as securitization. How did this happen?
Method B has some potential advantages. A pool of loans from different regions has more geographic diversity than a set of loans from a single community. Also, a highly specialized mortgage intermediary, such as Freddie Mac or Fannie Mae, can develop risk management and quality control procedures to manage third-party originators, and with economies of scale they can hold down agency costs. Securities markets make it possible to place mortgage debt with mutual funds, pension funds, and insurance companies, thus broadening the market.
However, with a level regulatory playing field, depository institutions could obtain all of the advantages of Method B with none of the disadvantages. A multi-state bank holding company could have a portfolio of mortgage loans that is geographically diversified. A well-known bank holding company could issue debt instruments that could be held by any investor who now holds mortgage securities.
The mortgage securities market exists because of regulations that prevent depository institutions from using Method A economically at sufficient scale. The balance of advantages shifts to securitization only because of the way that government puts its thumb on the scale.
The secondary mortgage market began in 1968. In that year, President Lyndon Johnson was besieged. His war in Vietnam was unpopular. Along with his cherished War on Poverty, it was raising the need for government borrowing. Each time the President came to Congress to request an increase in the ceiling of the national debt, he faced embarrassment and attacks. To forestall this, his Administration looked for ways to get government housing programs off the books.
One solution was to sell the Federal National Mortgage Association (Fannie Mae) to private investors. Fannie Mae had been set up in 1938 as a national purchaser of mortgage loans originated by third parties, called mortgage bankers. Fannie Mae did not securitize loans, at least to this point. Instead, it held mortgage loans in its portfolio, like a giant Method A lender with the mortgage bankers as its agents. Selling Fannie Mae took Fannie Mae's debt off the government books, which made the national debt appear smaller.
Another tactic for controlling the national debt was the introduction of the Government National Mortgage Association, GNMA, which introduced the first mortgage-backed securities. GNMA created and sold securities backed by loans guaranteed under programs of the Federal Housing Administration (FHA) and the Veterans' Administration (VA). The risk of mortgage defaults still rested entirely with taxpayers under FHA/VA. However, selling the GNMA pools took the loans off the government's books for accounting purposes.
The secondary mortgage market thus began as an accounting gimmick to hide liabilities. It has been the same ever since. The economic costs and benefits of securitization are beside the point. Over time, various accounting gimmicks and regulatory anomalies have driven securitization forward.
The Federal Home Loan Mortgage Corporation, Freddie Mac, was chartered in 1970 as an agency under the Federal Home Loan Bank Board. in order to promote Method B lending in conventional mortgage loans, meaning loans that fund middle-class home ownership. An individual mortgage that is above a certain ceiling, which is indexed to house prices unless altered by Congress, is not eligible for purchase by Freddie Mac or Fannie Mae. Freddie Mac also was chartered to stick to "investment-quality" mortgage loans, meaning that it was not to deal in loans with low down payments or what we would now call the sub-prime market.
As of 1970, mortgage lending in the United States was predominantly Method A, conducted mostly by the savings and loan industry (S&Ls). However, inflation and interest rate regulations were soon to wreak havoc on the S&Ls. At that time, interest rates on deposits were limited by government edict, known as regulation Q. As inflation soared, market interest rates rose above regulation Q ceilings. Competitors, notably money market funds, lured consumers away from S&L's, limiting their ability to serve the needs of mortgage borrowers. Furthermore, restrictions on interstate activity created a shortage of mortgage funds in California even though there were ample savings deposits in the East.
By securitizing loans with Freddie Mac, the S&L's, particularly in California, were able to expand their mortgage lending beyond the limits of their deposit base. However, it is important to recognize that S&L's only needed securitization because of the regulatory constraints that prevented them from taking other steps to obtain funds, such as raising interest rates on deposits or issuing debt collateralized by mortgage assets.
In the latter part of the 1970's, Robert Dall and Lew Ranieri, two executives at the bond-trading investment banker Salomon Brothers, decided that it was time to take the mortgage market away from Method A and the S&L industry. They saw the potential for huge trading profits if America's mortgage debt could be securitized. With the S&L industry weakened by the combination of higher inflation and interest rates and stifling regulation, Salomon Brothers heavily promoted mortgage securitization, primarily through Freddie Mac and Fannie Mae. In the process, they learned how to manipulate Congress and government regulators to help implement their vision.
For example, in the early 1980's Freddie Mac introduced a program called Guarantor. Fannie Mae soon followed with a program called Swap. The purpose of these programs was to perpetrate an accounting hoax on behalf of insolvent S&Ls.
At that point in history, the S&L's had issued fixed-rate mortgage loans which had declined in market value because interest rates had risen during the interim. Had they marked their assets down to their true market values, they would have had to go out of business. As long as they hung onto the loans, the accounting standards then in force allowed them to postpone recognizing any losses.
At the same time, the S&L's needed to raise cash, and the only assets they had to sell were the underwater mortgage loans. Not selling the mortgages meant running out of cash. On the other hand, selling the loans meant having to recognize losses.
What Guarantor and Swap did was allow the S&L's to exchange their mortgages for securities backed by those same mortgages. They could use the securities as collateral for borrowing, in order to raise cash. The key to the whole transaction was an accounting treatment that allowed the S&L's to defer recognizing losses on the securities in the same way that they could defer losses on the underlying mortgages. This accounting ruling was granted by the Federal Home Loan Bank Board, thanks in large part to heavy lobbying by Wall Street and S&L executives.
The result of Guarantor and Swap was to worsen the bleeding of the S&L's, with large fees collected by Freddie, Fannie, and Wall Street firms. Meanwhile, securitization allowed the S&L's to avoid recognizing insolvency, so that they could keep gambling even when they had negative net worth. When the S&L's finally went out of business, the taxpayers took the loss.
By the 1990's, the depository institutions that had been the mainstays of Method A lending were defunct. The FDIC and the Federal Reserve Board issued new risk-based capital regulations that were intended to prevent a repeat of the S&L debacle. Meanwhile, Freddie and Fannie received their own special regulator, who issued different capital regulations.
The bank capital regulations were crude, creating different classes of assets with different risk weights. For example, low-risk mortgages (with down payments of 20 to 40 percent) were given a risk weight of 0.35, on a scale that essentially goes from 0 at the lowest to 1.0 at the highest.
The Freddie/Fannie capital regulations were based on a stress test that simulated a pattern of declining house prices. The stress test penalized mortgages with low down payments, which historically had been outside of the two companies' charters all along. However, for low-risk mortgages, Freddie and Fannie were required to hold much less capital than banks. This gave Freddie and Fannie a significant cost advantage, and over the decade of the 1990's the two firms essentially took over the market for conforming mortgage loans (loans falling underneath the loan-limit ceiling and with sufficient down payment and borrower credit history to meet the "investment quality" standard.)
Early in the 21st century, private securitization (meaning mortgages securitized by Wall Street firms, not by Freddie or Fannie) emerged as a major force in the mortgage market. This phenomenon developed for a variety of reasons.
First, credit scoring had emerged as a way of assessing a borrower's credit history. This in turn lowered some of the agency costs associated with Method B lending. Instead of having to trust the mortgage broker to examine the credit report by hand, an investor could treat the credit score as hard data.
Second, Wall Street needed to find a substitute for the guarantee supplied by Freddie Mac or Fannie Mae. If you buy a Freddie Mac mortgage security and one of the borrowers defaults, that loan is pulled from the pool by Freddie Mac. Freddie Mac immediately pays into the pool the unpaid principal balance on the defaulted loan, and then tries to recover for itself what it can from selling the house. The investor is insulated from the default loss. (Fannie Mae offers the same protection.)
What Wall Street came up with to back private mortgage securities was the idea of a credit risk tranche. If you bought a senior tranche, then it was guaranteed to absorb no losses until at least, say, 10 percent of borrowers defaulted. Since this was a rare event, the senior tranche was considered safe. Junior tranches, which absorbed a disproportionately large share of losses, could be protected with credit default swaps, in which a large insurance company or other intermediary agreed to absorb the losses.
The market in private mortgage securities expanded during a period of rising home prices. In this environment, it was profitable to reach into segments of the market where it was not possible to make investment-quality loans. This included borrowers with blemished credit histories and borrowers who could not afford even a 5 percent down payment. The private securitizers made riskier and riskier loans, but as long as home prices kept increasing, defaults were rare and market participants enjoyed nice profits.
The securitization process so bamboozled the regulators that banks were holding securities backed by high-risk, low-down-payment mortgages that had been rated AAA, and thus had a risk capital weight of 0.20, which is significantly less than the 0.35 risk weight given to a low-risk mortgage with a 40 percent down payment originated using Method A. The regulators were telling banks to treat Method B mortgage loans with low down payments as safer than Method A loans with high down payments.
As home prices rose, it became more and more difficult for borrowers to come up with 20 percent down payments, causing the proportion of conventional mortgages to shrink. As private securitization increased in importance, Freddie and Fannie saw their market shares, which had peaked at 50 percent in 2003, start to decline. Moreover, the segment of the market they were left with was increasingly upscale, so that political leaders began to berate Freddie and Fannie over their lack of support for "affordable housing." The pressure built on Freddie and Fannie to join in the high-risk lending frenzy, and they caved into that pressure.
News reports show that at both Freddie and Fannie, warnings were issued by staff about high-risk lending. The stress test methodology required the firms to dedicate large amounts of capital for these loans in order to protect the firms in case of a downturn. Not wishing to abandon the high-risk market or to dilute earnings by raising the capital called for by the stress tests, the CEO's at the two firms simply over-rode staff objections and dove into the market, without raising the requisite capital.
Freddie and Fannie were never the dominant high-risk lenders. Nonetheless, they took on more risk than they should have, with less capital than was prudent. Had they maintained a focus on safety and soundness and stayed out of high-risk lending, the firms would done less to inflate the house price bubble. Freddie and Fannie would be in good shape now to pick up the pieces of the faltering private securitization market. Instead, the two firms themselves required a taxpayer bailout.
Finally, it is important to bear in mind that Freddie Mac and Fannie Mae were part of the Method B mortgage lending process. If capital requirements had been rationally tied to risk and applied equally to all institutions, Method A lending would have driven method B lending out of the market. Freddie and Fannie would not have grown to dominate the market. Instead, my conjecture is that they would not have been able to gain even a toehold in a free and fair market. Mortgage securitization is entirely a product of regulatory distortions.
The regulatory distortions were by no means accidental. Often, the regulatory loopholes were pried open by lobbyists working for Freddie Mac, Fannie Mae, or Wall Street firms that profited from securitization. Key members of Congress were generously plied with campaign contributions, in return for which they championed securitization and emasculated the regulators who oversaw Freddie Mac and Fannie Mae.
2.Speculation and the Housing Market
I credit other economists with warning early and strongly about a speculative bubble in housing. Prominent examples include Dean Baker, Paul Krugman, and Robert Shiller. Shiller, in particular, has given a very eloquent description of the bubble in the housing market in his recent book, The Subprime Solution.
As of 2004, I was one of those who thought that high home prices reflected unsustainably low interest rates. Today, some people continue to blame the run-up in home prices on Federal Reserve policy and low interest rates. However, I have changed my position on that, and I now believe that the bubble was speculative.
A major contributing factor to the speculative bubble was the explosion in lending for home purchase with little or no money down. When the down payment is small, the buyer's equity consists almost entirely of price appreciation. When prices are rising, anyone can buy a home with a low down payment, and any mortgage loan is safe. Low-down-payment lending helps foster a speculative frenzy on the way up. Of course, prices cannot go up forever. Once prices stop rising, the low-down-payment loans tend to go sour rather quickly.
There is considerable evidence that many homes were bought purely for speculative purposes. William Wheaton, a professor of urban economics at MIT, estimates that in recent years the growth of housing units exceeded the increase of household formation by six percentage points. These excess houses were bought by speculators.
Further evidence of speculative excess can be seen from an article that appeared in the December 2007 issue of the Federal Reserve Bulletin. It showed that loans for non-owner-occupied homes (also known as investor loans) grew from roughly 5 percent of total mortgage originations a decade ago to more than 15 percent of originations in 2005 and 2006. This may in fact understate the amount of speculative buying, because it is common for speculators to lie on their loan applications by claiming that they intend to occupy the home.
When I was looking at mortgage credit risk, we expected investor loans to default at three to ten times the rate of normal loans. If 85 percent of loans ((the ones issued to real homeowners) default at rate X, and 15 percent of loans (issued to speculators) default at rate 3X, then loans to speculators would account for about 35 percent of all defaults. If you use 10X, then speculators would account for about 85 percent of all defaults. Thus, it seems reasonable to suppose that between 35 percent and 85 percent of troubled loans are for non-owner-occupied housing. This makes attempts to "protect homeowners" or do a "bailout from the bottom" highly problematic.
One issue that is worth studying is the fact that there were price bubbles in real estate markets in some foreign countries, also. It is not likely that those bubbles were the result of monetary policy of the United States, and even less likely that they were the result of regulatory changes in the United States. Did other countries also encourage higher leverage in real estate, or were the bubbles able to inflate without any such encouragement? I wish that I knew the answer to that question.
3. The Foster-Van Order Model of Mortgage Default
When I was at Freddie Mac, we adopted an approach to dealing with mortgage credit risk that was developed by Chet Foster and Robert Van Order, two economists who came to Freddie Mac from the Department of Housing and Urban Development. The idea is that a borrower has trouble making the payments on a loan has two choices. One choice is to sell the house. The other choice is to allow the lender to foreclose on the house.
Allowing the lender to foreclose is what we call the option to default. If the house can be sold for more than the outstanding balance on the loan, the borrower will sell the house. We say that the default option is out of the money. On the other hand, if the value of the outstanding balance on the loan exceeds the market price of the house, the borrower might as well default. We say that the default option is in the money.
Speculators are more likely to exercise the default option than are owner-occupants. The owner-occupant takes into account the cost of relocating his or her family.
When the borrower makes a down payment of 20 percent, the default option is far out of the money. House prices have to fall by 20 percent before the default option begins to make sense. On the other hand, with a down payment of 2 or 3 percent, the default option can be in the money if house prices decline only slightly. That is what makes low-down-payment mortgages dramatically more risky than mortgages with a down payment of 20 percent or more.
4. Credit Default Swaps and Systemic Risk
I will define systemic risk as follows: whenever individuals make contingency plans that can only be executed if others are not trying to execute similar contingency plans, there is systemic risk. For example, suppose that many of us have money in a bank where deposits are not insured. I form a contingency plan which says that if the bank gets into trouble, I will run down to the bank and withdraw my deposit before the bank runs out of money. If everyone else forms the same contingency plan, we cannot execute our plans at the same time. Instead, the result is a bank run.
Another example of systemic risk was involved in the stock market crash of October 19, 1987. At that time, many institutional investors had purchased "portfolio insurance," in order to protect against a downturn. Portfolio insurance was supposed to act like a stop-loss order for a diversified stock portfolio, giving owners a guarantee that the value of their investments would not fall below a given floor. Each company that sold portfolio insurance had a contingency plan that consisted of executing a computer program to sell shares of stock in the event that stock prices started to decline. Collectively, these contingency plans were incompatible, because the computer programs were all trying to sell at the same time.
Finally, we come to credit default swaps. The buyer of a credit default swap pays a fee to a seller, in exchange for which the seller promises to pay a large sum to the buyer in the event of a default on a mortgage security or corporate bond. A seller of a credit default swap is in same position as a property and casualty insurance company. Ordinarily, the insurer simply collects premiums, and only rarely must it pay claims.
Faced with the prospect that they might have to pay significant claims, some sellers of credit default swaps probably had formed contingency plans that involved selling short bonds and stock related to their guarantees. Thus, if you had sold a credit default swap on debt issued by Lehman, you could hedge by shorting Lehman debt, Lehman stock, or by shorting the securities of similar financial institutions.
Of course, these individual contingency plans, when executed collectively, resulted in waves of short-selling. Credit default swaps apparently were another example of systemic risk, in which individual contingency plans were not mutually compatible.
Note that eliminating counterparty risk, by moving credit default swaps from the over-the-counter market to an organized exchange, would not solve the problem. Even when traded on an organized exchange, credit default swaps would have to be hedged using short-selling strategies that create the equivalent of bank runs.
5. Suits vs. Geeks
Financial innovation has outpaced the ability of financial executives and regulatory agency heads to remain current. The financial engineers (the geeks) create products that behave quite unlike ordinary bonds. The executives (the suits) rely on intuition that applies to simpler securities. The results are catastrophic.
When I was at Freddie Mac, there was hardly any gap between the suits and the geeks. The Foster-Van Order model of mortgage default was ingrained in the corporate culture. The CEO, CFO, and other key executives understood this model and its implication that mortgage defaults would be much higher for mortgages with low down payments. Moreover, the suits bought into the idea of using a stress test to set capital requirements. Using a stress test methodology, in which mortgages are evaluated according to how well they would survive a downturn in house prices, the capital required to back mortgages with low down payments is prohibitively high.
When a new CEO came to Freddie Mac in 2003 (several years after I had left), a gap apparently opened up between the suits and the geeks. Warnings issued by the Chief Risk Officer and others about low down payment mortgages were ignored by the CEO.
For decades, Wall Street traders have taken advantage of depository institution executives' inability to keep up with financial innovation. Securities with very unfavorable risk characteristics often are pawned off on unwitting banks or savings and loans. As part of this process, the Wall Street firms obtained crude and misleading risk measures from the credit rating agencies. Industry geeks knew that these ratings were inappropriate, but the suits at banks relied on the ratings, in part because that is what the suits at the regulatory agencies were telling them to do, particularly with regard to capital requirements.
Most recently, the suits vs. geeks divide emerged concerning the issue of whether mortgage securities are undervalued. Many suits, including Henry Paulson and Ben Bernanke, took the view that mortgage securities were artificially undervalued. The original Paulson Plan, in which the Treasury would enter market to buy mortgage securities, was based on the assumption that it would be profitable to hold these securities to maturity.
Geeks tend to believe that the market has correctly reduced the values of mortgage securities. Using the Foster-Van Order model, it would seem that the default option on many mortgages is "in the money," causing a huge loss of value for mortgage-backed securities. The fact that so many loans issued in recent years were investor loans is even more ominous. Finally, the imbalance in the housing market means that prices could fall even more. This would expand the losses on mortgage securities.
From a geek perspective, there is an asymmetry in the possible outcomes from investing in mortgage securities. The likelihood of earning a profit is very high, but the amount of the profit will be small. The profit will come from scenarios in which house prices fall only modestly over the next several years. On the other hand, the likelihood of a severe housing depression is low, but the consequences for mortgage securities would be devastating. The potential for taking a large loss, even with a small probability, would lead a risk-averse investor to be cautious about buying mortgage securities, even though the likelihood of earning a small profit is high.
For an analogy, consider a game in which we role a six-sided die. If the number on the die comes up 1,2,3,4, or 5, I give you one dollar. If the number comes up 6, you give me hundred dollars. You are more likely to win than to lose, but you still would not play that game unless I made it more attractive. The same holds true for investing in mortgage securities.
In other words, the market may be quite rational in pricing mortgage securities. The suits who wish to have Treasury speculate in that market would be forcing American taxpayers to engage in a gamble that professional investors would rather not take.
6.Further Reading
Michael Lewis' book, Liar's Poker, contains an insightful history of the early days of the mortgage securities market. The book is based on Lewis' experience as a trainee and salesman for Salomon Brothers. He portrays the way that Wall Street exploited the weaknesses of the S&L industry to muscle its way into the mortgage market.
The specific details of risk weightings and capital requirements, which are an important part of the story, are not easy to track down. One helpful FDIC document is here: http://www.fdic.gov/news/news/financial/2008/fil08069a.html
For an analysis of how risk weightings create regulatory arbitrage and artificially boost mortgage securitization, see the paper "Risk-Based Capital Requirements for Mortgage Loans," by Paul S. Calem and Michael Lacour-Little. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=295633
For documentation of the increase in loans for non-owner-occupied housing in recent years, see "The 2006 HMDA Data,: by Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner," Federal Reserve Bulletin, December 2007. http://www.federalreserve.gov/pubs/bulletin/2007/pdf/hmda06final.pdf
For more on the suits and geeks divide at Freddie Mac and Fannie Mae, see the stories in the New York Times by Charles Duhigg. "At Freddie Mac, Chief Discarded Warning Signs," August 5, 2008. http://www.nytimes.com/2008/08/05/business/05freddie.html?hp; and "Pressured to Take More Risk, Fannie Reached Tipping Point," October 5th, 2008. http://www.nytimes.com/2008/10/05/business/05fannie.html?hp
Also, see Susan Woodward, "Rescued by Fannie Mae?" Washington Post, October 14, 2008. http://www.nytimes.com/2008/10/05/business/05fannie.html?hp. She argues that Fannie Mae modelers understand mortgage credit risk, but business executives ignored the modelers.
Three academic webcasts provide useful information and analysis of the crisis. At MIT (http://events.mit.edu/event.html?id=9303415&date=2008/10/08), William Wheaton provides information on the housing glut promoted by speculation. At Harvard (http://video2.harvard.edu:8080/ramgen/AAD-PAN/FinMktsPanel.rm), Ken Rogoff describes how the financial sector in the United States is bloated. Also, Robert Merton talks about what I call the suits vs. geeks divide. Finally, at the University of California, San Diego (http://www.econbrowser.com/archives/2008/10/roundtable_disc.html), James Hamilton has some helpful slides that illuminate the difference between what I call Method A lending and Method B lending, along with a chart showing the evolution over the past decade of the market shares of various forms of mortgage lending.
Update: I will have to revise this to take a more conservative view of the proportion of investor loans. A reader sent me data on subprime loans showing that investor loans are only foreclosing at a rate slightly higher than owner-occupied. This still leaves open the possibility that investor loans are doing much worse than owner-occupied in the conventional mortgage category, but in any case I need to re-do my math on that one.
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
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?
Tuesday, 14 October 2008
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.
Why are some other economists not that happy with the award? As Peter Boettke has written
Bryan Caplan makes an interesting prediction,
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.I share Boettke's concerns.
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.
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.
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"
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.
Monday, 13 October 2008
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.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.
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.
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.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.
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.
Sunday, 12 October 2008
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
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
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.
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.
Saturday, 11 October 2008
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 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.
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