Anna J. Schwartz on the crisis and the Fed

“In the 1930s, as Ms. Schwartz and Mr. [Milton] Friedman argued in "A Monetary History," the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they'd lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing: "If the borrowers hadn't withdrawn cash, they [the banks] would have been in good shape. But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress," deepening the crisis and causing still more failures.

But "that's not what's going on in the market now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement." The only way to "get rid of them" is to sell them, which is why Ms. Schwartz thought that Treasury Secretary Hank Paulson's original proposal to buy these assets from the banks was "a step in the right direction."

The problem with that idea was, and is, how to price "toxic" assets that nobody wants. And lurking beneath that problem is another, stickier problem: If they are priced at current market levels, selling them would be a recipe for instant insolvency at many institutions. The fears that are locking up the credit markets would be realized, and a number of banks would probably fail.

Ms. Schwartz won't say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."”

Brian M. Carney, “Bernanke Is Fighting the Last War: An interview with Anna J. Schwartz”, The Wall Street Journal (18 October 2008).

http://online.wsj.com/article/SB122428279231046053.html


Brian M. Carney is an editor, journalist and member of the Wall Street Journal Editorial Board.

As mentioned in an earlier Tdj, at the age of 92, Professor Anna Jacobson Schwartz (1915 - ) is still an economist at the National Bureau of Economic Research in New York City, where she has worked since 1941. She jointed with Milton Friedman to publish in 1965 A Monetary History of the United States, a book that changed the understanding of how the world works for economists as well as politicians, policy makers, and journalists. The book blamed the Fed for causing the slump and in doing so it revolutionized thinking on the causes of the Great Depression. "The book was a bombshell," says British monetarist Tim Congdon. "Until then almost everybody thought the free-market system itself had failed in the 1930s. What Friedman-Schwartz say was that incompetent government bureaucrats at the Fed had caused the Depression." In 2002, in a speech in honor of Mr. Friedman's 90th birthday, Mr. Ben Bernanke, then a Federal Reserve Board governor, said "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

But in Dr. Schwartz’s view they are about to do it again, that is, misunderstand the situation and rather than taking measures that would ameliorate the crisis, the Fed insists instead on making things worse. The “credit market disturbance”, as she puts it, is not, as the Fed believes, caused by a lack of money to lend but by “all these exotic securities the market does not know how to value”. Why are these exotic securities 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of [the bad securities], that would be an improvement." She initially thought Secretary Paulson’s idea to buy these assets from the banks was a good one but then realized it would not work because the low prices for the doggy securities would leave the banks insolvent.

She believe that market participants should be allowed to flourish or fail on their own, with as little government intervention as possible. She argues the government should not be recapitalizing firms that should be shut down." Rather, she bluntly says "firms that made wrong decisions should fail." Referring to the government, she says “I think if you have some principles and know what you're doing, the market responds. They see that you have some structure to your actions, that it isn't just ad hoc -- you'll do this today but you'll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what's going on. So I think if you're tough about firms that have invested unwisely, the market won't blame you. They'll say, 'Well, yeah, it's your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you're stuck with assets you can't sell and liabilities you can't pay off?”

With regard to the Fed’s efforts to deal with the financial crisis she concludes "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."

Anna J. Schwartz on the crisis and the Fed

“In the 1930s, as Ms. Schwartz and Mr. [Milton] Friedman argued in "A Monetary History," the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they'd lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing: "If the borrowers hadn't withdrawn cash, they [the banks] would have been in good shape. But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress," deepening the crisis and causing still more failures.

But "that's not what's going on in the market now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement." The only way to "get rid of them" is to sell them, which is why Ms. Schwartz thought that Treasury Secretary Hank Paulson's original proposal to buy these assets from the banks was "a step in the right direction."

The problem with that idea was, and is, how to price "toxic" assets that nobody wants. And lurking beneath that problem is another, stickier problem: If they are priced at current market levels, selling them would be a recipe for instant insolvency at many institutions. The fears that are locking up the credit markets would be realized, and a number of banks would probably fail.

Ms. Schwartz won't say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."”

Brian M. Carney, “Bernanke Is Fighting the Last War: An interview with Anna J. Schwartz”, The Wall Street Journal (18 October 2008).

http://online.wsj.com/article/SB122428279231046053.html


Brian M. Carney is an editor, journalist and member of the Wall Street Journal Editorial Board.

As mentioned in an earlier Tdj, at the age of 92, Professor Anna Jacobson Schwartz (1915 - ) is still an economist at the National Bureau of Economic Research in New York City, where she has worked since 1941. She jointed with Milton Friedman to publish in 1965 A Monetary History of the United States, a book that changed the understanding of how the world works for economists as well as politicians, policy makers, and journalists. The book blamed the Fed for causing the slump and in doing so it revolutionized thinking on the causes of the Great Depression. "The book was a bombshell," says British monetarist Tim Congdon. "Until then almost everybody thought the free-market system itself had failed in the 1930s. What Friedman-Schwartz say was that incompetent government bureaucrats at the Fed had caused the Depression." In 2002, in a speech in honor of Mr. Friedman's 90th birthday, Mr. Ben Bernanke, then a Federal Reserve Board governor, said "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

But in Dr. Schwartz’s view they are about to do it again, that is, misunderstand the situation and rather than taking measures that would ameliorate the crisis, the Fed insists instead on making things worse. The “credit market disturbance”, as she puts it, is not, as the Fed believes, caused by a lack of money to lend but by “all these exotic securities the market does not know how to value”. Why are these exotic securities 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of [the bad securities], that would be an improvement." She initially thought Secretary Paulson’s idea to buy these assets from the banks was a good one but then realized it would not work because the low prices for the doggy securities would leave the banks insolvent.

She believe that market participants should be allowed to flourish or fail on their own, with as little government intervention as possible. She argues the government should not be recapitalizing firms that should be shut down." Rather, she bluntly says "firms that made wrong decisions should fail." Referring to the government, she says “I think if you have some principles and know what you're doing, the market responds. They see that you have some structure to your actions, that it isn't just ad hoc -- you'll do this today but you'll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what's going on. So I think if you're tough about firms that have invested unwisely, the market won't blame you. They'll say, 'Well, yeah, it's your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you're stuck with assets you can't sell and liabilities you can't pay off?”

With regard to the Fed’s efforts to deal with the financial crisis she concludes "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."

Tax cuts to "starve-the-beast"

“David Romer: [A] major motivation that people have put forward for cutting taxes is their concern that government is too large. ....

This is something that Ronald Reagan was very explicit about. It was one of the motivations for his tax cuts, and it goes under the name of the "starve-the-beast" hypothesis. The "beast" is government and its "food" is the revenues. Despite its importance, there's been very little empirical work on this ....

In the paper ..., we go through the history of tax changes and take out the ones that are motivated by decisions that had already been made to increase spending, take out ones that are coming not from policy at all but from developments in the economy, and the like. We try to isolate changes in taxes that seem truly legitimate for testing the starve-the-beast hypothesis.

And what we find is no evidence for starve-the-beast. There's no systematic tendency for spending to fall after tax cuts relative to what it otherwise would have been.

Region: I was quite surprised by that.

Christina Romer: We didn't know what we were going to find. .... But ... we thought the results would be interesting whichever way they came out.

Region: But you did find that tax cuts were followed by something else.

Christina Romer: Right. Tax cuts led, eventually, to tax increases. Basically, something has to give; there is a government budget constraint. What we thought gave when you cut taxes was spending, but we seem to find that in postwar U.S. history what actually gives is the tax cut itself. A substantial fraction of a tax cut is typically undone in the subsequent five years.”

"Christina and David Romer Interview", The Region, Federal Reserve Bank of Minneapolis (September 2008).

http://www.minneapolisfed.org/pubs/region/08-09/romers.pdf

http://www.minneapolisfed.org/publications_papers/issue.cfm?id=283


David H. Romer and Christina D. Romer both teach at the University of California at Berkeley, where he is Herman Royer Professor of Political Economy and she is Class of 1957-Garff B. Wilson Professor of Economics.

The “starve-the-beast” strategy was pushed by Ronald Reagan and the supply-siders in the 1980s and by George W. Bush in the 2000s in an attempt to put a fiscal straightjacket on Congress to rein in its spending. In fairness, the resulting deficits emerging out of the strategy seemed to have no more effect on the desire of Presidents to spend than it had on Congress. In the end, it would seem government spending went merrily on its way, dragging up taxes in its wake.

Before one throws away the idea of starving the beast, however, it would be useful to know what spending would have been without this strategy. I would suspect it would be much higher than it is, and if the strategy did not lower or even restrain spending, it at least made it lower than it would have been otherwise.

The interview excerpted above with husband-and-wife team Christina Romer and David Romer covers a wide range of topics. Each received in 1985 a PhD in economics from MIT, currently teach at the same rank at the University of California-Berkeley, and have co-authored many studies. When asked to describe their working relationship, Christina Romer responded "We can be brutally frank". David Romer added "Exactly. We can be more frank in our criticism because there's plenty of time to iron out the differences."

Thanks to Larry Willmore for the Tdj.

Tax cuts to "starve-the-beast"

“David Romer: [A] major motivation that people have put forward for cutting taxes is their concern that government is too large. ....

This is something that Ronald Reagan was very explicit about. It was one of the motivations for his tax cuts, and it goes under the name of the "starve-the-beast" hypothesis. The "beast" is government and its "food" is the revenues. Despite its importance, there's been very little empirical work on this ....

In the paper ..., we go through the history of tax changes and take out the ones that are motivated by decisions that had already been made to increase spending, take out ones that are coming not from policy at all but from developments in the economy, and the like. We try to isolate changes in taxes that seem truly legitimate for testing the starve-the-beast hypothesis.

And what we find is no evidence for starve-the-beast. There's no systematic tendency for spending to fall after tax cuts relative to what it otherwise would have been.

Region: I was quite surprised by that.

Christina Romer: We didn't know what we were going to find. .... But ... we thought the results would be interesting whichever way they came out.

Region: But you did find that tax cuts were followed by something else.

Christina Romer: Right. Tax cuts led, eventually, to tax increases. Basically, something has to give; there is a government budget constraint. What we thought gave when you cut taxes was spending, but we seem to find that in postwar U.S. history what actually gives is the tax cut itself. A substantial fraction of a tax cut is typically undone in the subsequent five years.”

"Christina and David Romer Interview", The Region, Federal Reserve Bank of Minneapolis (September 2008).

http://www.minneapolisfed.org/pubs/region/08-09/romers.pdf

http://www.minneapolisfed.org/publications_papers/issue.cfm?id=283


David H. Romer and Christina D. Romer both teach at the University of California at Berkeley, where he is Herman Royer Professor of Political Economy and she is Class of 1957-Garff B. Wilson Professor of Economics.

The “starve-the-beast” strategy was pushed by Ronald Reagan and the supply-siders in the 1980s and by George W. Bush in the 2000s in an attempt to put a fiscal straightjacket on Congress to rein in its spending. In fairness, the resulting deficits emerging out of the strategy seemed to have no more effect on the desire of Presidents to spend than it had on Congress. In the end, it would seem government spending went merrily on its way, dragging up taxes in its wake.

Before one throws away the idea of starving the beast, however, it would be useful to know what spending would have been without this strategy. I would suspect it would be much higher than it is, and if the strategy did not lower or even restrain spending, it at least made it lower than it would have been otherwise.

The interview excerpted above with husband-and-wife team Christina Romer and David Romer covers a wide range of topics. Each received in 1985 a PhD in economics from MIT, currently teach at the same rank at the University of California-Berkeley, and have co-authored many studies. When asked to describe their working relationship, Christina Romer responded "We can be brutally frank". David Romer added "Exactly. We can be more frank in our criticism because there's plenty of time to iron out the differences."

Thanks to Larry Willmore for the Tdj.

OK, let's shoot the macroeconomists first, the politicians second, and then the rest of the establishment

“The Wall Street Journal reports,

‘The government's plan to buy equity in financial institutions, announced Friday by Treasury Secretary Henry Paulson, is an idea that many academic economists have championed from the start of the crisis.’

The Paulson plan was so bad that just about anything is better. But I'm ready to rip into academic economists. I've been thinking more about Joe Stiglitz's valid criticisms of what I call the Lost Generation of Macroeconomists, and I'm getting more and more steamed. If you stacked up everything written by the leading macro folks of my generation and later (actually, starting a few years earlier also), you would have nothing but an enormous baloney sandwich. Ordinarily, I don't dwell on the fact that these people who were no smarter than me back-scratched each other into the best journals, the prestigious professorships, the important conferences, etc. But sometimes, especially now, I think about how badly they have failed intellectually. They are the precise academic equivalent of Wall Street executives who enjoyed golden parachutes while bankrupting their firms.

Is bank recapitalization a good idea? Probably not, if you think that the main problem with the financial sector is that it is bloated. The best way to restore confidence in banks is to identify the ones that are insolvent and shut them down. The FDIC knows how to do this. They should roll up their sleeves and get to work.

Anyone who wants to stop mortgage foreclosures needs to have his head examined. How many of the bad loans are investor loans, where the borrower never occupied the house? 20 percent of them? 50 percent? 70 percent? We know that in the last years of the bubble more than 15 percent of mortgages were for non-owner-occupied (the true figure might actually be higher than reported, because it is common to fraudulently claim that you will be using the home as a residence when you will not). Investor loans default at a much higher rate than regular loans, somewhere between 3 and 10 times as much. If it's 4 times as much, then already we can be surmise that a majority of bad loans are investor loans. The best thing to do with those is to foreclose ASAP.

My view of the crisis is that every sector of the establishment has been discredited. The financial establishment has been discredited. Government policymakers and regulators have been discredited. And academic economics has been discredited. The fact that we now have all three on the same page about policy going forward is hardly comforting.”

Arnold Kling, “Oh, No!”, EconLog Blog (11 October 2008).

http://econlog.econlib.org/


Arnold Kling is a noted economist who has worked for the Federal government and as a professor at several universities. He holds a Ph.D. in economics from the Massachusetts Institute of Technology, and worked as an economist in the Federal Reserve System from 1980 to 1986 and at Freddie Mac from 1986 to 1994. He is a founder and co-editor of EconLog, a popular economics blog that reflects Libertarian thinking.

As is always true in the confusion of a crisis, it is difficult to see amidst the chaos where we have made progress and where everything we have done has only made the situation worse. A timeline of events and actions can briefly be described as follows:

1. A booming housing market stoked by government housing policies begins to cool in 2006, and in 2007 the sub-prime mortgage industry collapses, housing prices fall dramatically, problems spread to other types of mortgages, the Fed lowers interest rates, and the Treasury supports a fund to buy mortgage-backed securities. Nothing policy does helps turn around a deteriorating situation;

2. In 2008, problems escalate as major lenders and investors begin to fail, investment banks on Wall Street fail and are either closed or converted to more general financial institutions, and the downsizing of the financial sector begins. Congress passes legislation to address the sub-prime mortgage problem through re-financing initiative (April and July). Banking problems intensify abroad. Nothing policy does helps turn around a deteriorating situation;

3. In September 2008, all comes to a head as a liquidity crisis develops, the Feds take over Fannie and Freddie (7 Sept), and Lehman Brothers collapses and Merrill Lynch is sold to Bank of America (14 Sept), and the Fed saves AIG as financial turmoil worsens and global financial markets become embroiled (~mid Sept) . Nothing policy does helps turn around a deteriorating situation;

4. Faced with an unprecedented volatility in key capital markets and a collapse of intermediation in the banking system, the Treasury and the Fed hastily act and cobble together and submit to Congress a plan sketched on three pages to give these two institutions a wide range of extraordinary powers over the financial system, complete discretion in what they might do and full immunity from any legal challenges and suits, and purchasing power in the economy equal to 5 per cent of all goods and services produced in a year (19 Sept) . Nothing policy does helps turn around a deteriorating situation;

5. Congress substitutes its version of the initial sketch but then rejects it (29 Sept) and starts negotiations which, after much debate and acrimony, results in the Emergency Economic Stabilization Act of 2008, which, among other unrelated provisions costing $150 billion, broadly authorizes the Treasury to spend up to $700 billion to purchases distressed assets from banks and otherwise deal with the financial crisis(1 and 3 Oct) . But nothing helps turn around a deteriorating situation;

6. Since then, in its confusion over what to do, the fiscal and monetary authorities have followed (better, suggested, since they have not really had time to implement any approach) several strategies:

a. At first, following the approach used in the S&L crisis of the 1980s, the idea was to try and bail out banks and other financial institutions by buying (with taxpayers’ money) the toxic assets in the bank’s portfolios, thereby restoring the capacity of the banking system to extend new loans. Initially, in their haste to restore order to the financial system little or no consideration was given to the costs to the taxpayer or the need for the financial sector and its stakeholders to bear any of the burden of the bailout. It quickly became clear, however, that this approach, strongly criticized as unfair to the taxpayer and promoting moral hazard, is not working, as the entire economy remains in a liquidity trap. This does not mean that the approach has been entirely abandoned or will be abandoned, but is now seen as insufficient to the problem. It is also caught up in defining the details: What assets should the Treasury buy (whole mortgages, pools of mortgages, mortgage-backed securities, non-mortgage financial instruments such as commercial paper) and at what price and under what terms?

b. As Kling mentions, consideration is now being given to the direct re-capitalization of the banking system by the government taking an equity stake in banks. The Treasury gives a bank money, and the bank gives the Treasury bank stock representing in some sense partial ownership of the bank. Right now, the banking system is regulated by the Fed, the Comptroller of the Currency and other regulators and the Fed affects bank behavior indirectly through its monetary and regulatory policies. Partial ownership could, but not necessarily will, place the government in the position to affect decision-making within the bank. If this approach is followed, and the Treasury accepts preferred stock for example, it will inject equity into banks but without strongly affecting their day-to-day operation. It remains to be seen, however, whether the Treasury will follow this approach. If it does, it will be very expensive, above and beyond the $700 billion now committed, and will involve difficult issues of implementation since it must reduce the risk of a bank’s default to an insignificant level to restore a bank’s position in the market. Finally, there is no more reason to believe that this approach will be any more successful in convincing the banks to lend.

Given where we are and the prospects for the current approaches for ending the crisis, the situation is likely to deteriorate further. But let us be grateful for four things.

1. While the authorities are confused and flaying about in their policies and have followed strategies that to date have gone nowhere, we now know what doesn’t work, and we have learned what doesn’t work in only a matter of weeks. This allows us to consider other options early in the crisis.

2. In the turmoil the Fed has done a remarkable job keeping its own balance sheet in shape. By skillful manipulation of its assets and liabilities it has kept the drain on its own resources to a minimum. This means the Fed remains in a position to act without fear of its own collapse as we go forward. This is very important.

3. The real economy has held up extremely well during the worst financial storm in generations. This is remarkable, and gives hope we may yet avoid an economic catastrophe. One only wonders how long this development can last.

4. We have plenty of ideas as to what to do if the current strategy doesn’t work. Kling’s suggestion of just doing what we always did when banks failed -- close them down and move on -- is a good one. Maybe we should try it. It certainly would be cheaper for the taxpayer.

While we do not know how the crisis will all play out, we do know:

1. Our understanding of and confidence in macroeconomics and macroeconomic policy has been shaken to its core. Modern macroeconomics stresses the discretionary management of the economy by the government. Stabilizing the economy in the short- and medium-term involves adjusting aggregate demand by increasing and decreasing taxes, higher or lower government spending, and/or cutting or raising interest rates. Looking to the longer-term, macroeconomics suggests supply-side measures can encourage capital formation and economic growth and do not need to consider the interdependencies between the financial and real economies. In its view, monetary policies affecting the external sector, at least in the case of the United States, can provide access to cheap foreign goods and very cheap saving needed to finance investment without considering the impact of the exchange rate on the real economy. Regulatory policies can protect not only our health and safety and the environment, it can override the market in the pursuit of social goals of importance to us all. In sum, all these assumptions are false, at least in some circumstances, and contrary to what the macroeconomists told us, the basic workings of the economy are not predictable nor is the economy so malleable it can be orchestrated by government policy to achieve economic and social objectives inconsistent with economic rationality.

2. Our faith in the political process, never high among Americans to begin with, has also been shaken to its core. Out of the blue, the main economic authorities of the country rushed to the stage to shout that Congress must immediately pass legislation to save the economy from imminent collapse. Their plan consisted of unintelligible notes scribbled on a few sheets of paper, and was immediately seen to be unfair to the taxpayer, power grasping by the authorities, and detrimental in its long-term effects. No matter, Congress proceeded to do what Congress does: Add complications and special interest pork to any bill brought before it and proceed to pass the bill before it has a chance to think about what it has done. We are fortunate to date the bill has had no effect on the financial sector, which remains in gridlock but has not suffered a complete meltdown, and unfortunate that, equally, it has had no positive effect on the real economy, which remains in a precarious state but has yet to be helped.

3. Our confidence in the future has been shaken to its core. We have enjoyed decades of prosperity with only minor interruptions in an upward trend in incomes and employment. We consumed more than we produced, borrowed against our future, and went deeply into debt at home and abroad. In our affluence, we became lazy, careless and reckless. Now the realization has arrived that the days of living beyond our means are over, and a costly and painful adjustment is necessary. Our future is not what it was.
OK, so the macroeconomists have failed us, the politicians have failed us, and in many ways we have failed ourselves. We are left shaken. Kling is right that every segment of the American establishment has been discredited. If it wasn’t for the wisdom and strength of ordinary Americans, one might be worried.

OK, let's shoot the macroeconomists first, the politicians second, and then the rest of the establishment

“The Wall Street Journal reports,

‘The government's plan to buy equity in financial institutions, announced Friday by Treasury Secretary Henry Paulson, is an idea that many academic economists have championed from the start of the crisis.’

The Paulson plan was so bad that just about anything is better. But I'm ready to rip into academic economists. I've been thinking more about Joe Stiglitz's valid criticisms of what I call the Lost Generation of Macroeconomists, and I'm getting more and more steamed. If you stacked up everything written by the leading macro folks of my generation and later (actually, starting a few years earlier also), you would have nothing but an enormous baloney sandwich. Ordinarily, I don't dwell on the fact that these people who were no smarter than me back-scratched each other into the best journals, the prestigious professorships, the important conferences, etc. But sometimes, especially now, I think about how badly they have failed intellectually. They are the precise academic equivalent of Wall Street executives who enjoyed golden parachutes while bankrupting their firms.

Is bank recapitalization a good idea? Probably not, if you think that the main problem with the financial sector is that it is bloated. The best way to restore confidence in banks is to identify the ones that are insolvent and shut them down. The FDIC knows how to do this. They should roll up their sleeves and get to work.

Anyone who wants to stop mortgage foreclosures needs to have his head examined. How many of the bad loans are investor loans, where the borrower never occupied the house? 20 percent of them? 50 percent? 70 percent? We know that in the last years of the bubble more than 15 percent of mortgages were for non-owner-occupied (the true figure might actually be higher than reported, because it is common to fraudulently claim that you will be using the home as a residence when you will not). Investor loans default at a much higher rate than regular loans, somewhere between 3 and 10 times as much. If it's 4 times as much, then already we can be surmise that a majority of bad loans are investor loans. The best thing to do with those is to foreclose ASAP.

My view of the crisis is that every sector of the establishment has been discredited. The financial establishment has been discredited. Government policymakers and regulators have been discredited. And academic economics has been discredited. The fact that we now have all three on the same page about policy going forward is hardly comforting.”

Arnold Kling, “Oh, No!”, EconLog Blog (11 October 2008).

http://econlog.econlib.org/


Arnold Kling is a noted economist who has worked for the Federal government and as a professor at several universities. He holds a Ph.D. in economics from the Massachusetts Institute of Technology, and worked as an economist in the Federal Reserve System from 1980 to 1986 and at Freddie Mac from 1986 to 1994. He is a founder and co-editor of EconLog, a popular economics blog that reflects Libertarian thinking.

As is always true in the confusion of a crisis, it is difficult to see amidst the chaos where we have made progress and where everything we have done has only made the situation worse. A timeline of events and actions can briefly be described as follows:

1. A booming housing market stoked by government housing policies begins to cool in 2006, and in 2007 the sub-prime mortgage industry collapses, housing prices fall dramatically, problems spread to other types of mortgages, the Fed lowers interest rates, and the Treasury supports a fund to buy mortgage-backed securities. Nothing policy does helps turn around a deteriorating situation;

2. In 2008, problems escalate as major lenders and investors begin to fail, investment banks on Wall Street fail and are either closed or converted to more general financial institutions, and the downsizing of the financial sector begins. Congress passes legislation to address the sub-prime mortgage problem through re-financing initiative (April and July). Banking problems intensify abroad. Nothing policy does helps turn around a deteriorating situation;

3. In September 2008, all comes to a head as a liquidity crisis develops, the Feds take over Fannie and Freddie (7 Sept), and Lehman Brothers collapses and Merrill Lynch is sold to Bank of America (14 Sept), and the Fed saves AIG as financial turmoil worsens and global financial markets become embroiled (~mid Sept) . Nothing policy does helps turn around a deteriorating situation;

4. Faced with an unprecedented volatility in key capital markets and a collapse of intermediation in the banking system, the Treasury and the Fed hastily act and cobble together and submit to Congress a plan sketched on three pages to give these two institutions a wide range of extraordinary powers over the financial system, complete discretion in what they might do and full immunity from any legal challenges and suits, and purchasing power in the economy equal to 5 per cent of all goods and services produced in a year (19 Sept) . Nothing policy does helps turn around a deteriorating situation;

5. Congress substitutes its version of the initial sketch but then rejects it (29 Sept) and starts negotiations which, after much debate and acrimony, results in the Emergency Economic Stabilization Act of 2008, which, among other unrelated provisions costing $150 billion, broadly authorizes the Treasury to spend up to $700 billion to purchases distressed assets from banks and otherwise deal with the financial crisis(1 and 3 Oct) . But nothing helps turn around a deteriorating situation;

6. Since then, in its confusion over what to do, the fiscal and monetary authorities have followed (better, suggested, since they have not really had time to implement any approach) several strategies:

a. At first, following the approach used in the S&L crisis of the 1980s, the idea was to try and bail out banks and other financial institutions by buying (with taxpayers’ money) the toxic assets in the bank’s portfolios, thereby restoring the capacity of the banking system to extend new loans. Initially, in their haste to restore order to the financial system little or no consideration was given to the costs to the taxpayer or the need for the financial sector and its stakeholders to bear any of the burden of the bailout. It quickly became clear, however, that this approach, strongly criticized as unfair to the taxpayer and promoting moral hazard, is not working, as the entire economy remains in a liquidity trap. This does not mean that the approach has been entirely abandoned or will be abandoned, but is now seen as insufficient to the problem. It is also caught up in defining the details: What assets should the Treasury buy (whole mortgages, pools of mortgages, mortgage-backed securities, non-mortgage financial instruments such as commercial paper) and at what price and under what terms?

b. As Kling mentions, consideration is now being given to the direct re-capitalization of the banking system by the government taking an equity stake in banks. The Treasury gives a bank money, and the bank gives the Treasury bank stock representing in some sense partial ownership of the bank. Right now, the banking system is regulated by the Fed, the Comptroller of the Currency and other regulators and the Fed affects bank behavior indirectly through its monetary and regulatory policies. Partial ownership could, but not necessarily will, place the government in the position to affect decision-making within the bank. If this approach is followed, and the Treasury accepts preferred stock for example, it will inject equity into banks but without strongly affecting their day-to-day operation. It remains to be seen, however, whether the Treasury will follow this approach. If it does, it will be very expensive, above and beyond the $700 billion now committed, and will involve difficult issues of implementation since it must reduce the risk of a bank’s default to an insignificant level to restore a bank’s position in the market. Finally, there is no more reason to believe that this approach will be any more successful in convincing the banks to lend.

Given where we are and the prospects for the current approaches for ending the crisis, the situation is likely to deteriorate further. But let us be grateful for four things.

1. While the authorities are confused and flaying about in their policies and have followed strategies that to date have gone nowhere, we now know what doesn’t work, and we have learned what doesn’t work in only a matter of weeks. This allows us to consider other options early in the crisis.

2. In the turmoil the Fed has done a remarkable job keeping its own balance sheet in shape. By skillful manipulation of its assets and liabilities it has kept the drain on its own resources to a minimum. This means the Fed remains in a position to act without fear of its own collapse as we go forward. This is very important.

3. The real economy has held up extremely well during the worst financial storm in generations. This is remarkable, and gives hope we may yet avoid an economic catastrophe. One only wonders how long this development can last.

4. We have plenty of ideas as to what to do if the current strategy doesn’t work. Kling’s suggestion of just doing what we always did when banks failed -- close them down and move on -- is a good one. Maybe we should try it. It certainly would be cheaper for the taxpayer.

While we do not know how the crisis will all play out, we do know:

1. Our understanding of and confidence in macroeconomics and macroeconomic policy has been shaken to its core. Modern macroeconomics stresses the discretionary management of the economy by the government. Stabilizing the economy in the short- and medium-term involves adjusting aggregate demand by increasing and decreasing taxes, higher or lower government spending, and/or cutting or raising interest rates. Looking to the longer-term, macroeconomics suggests supply-side measures can encourage capital formation and economic growth and do not need to consider the interdependencies between the financial and real economies. In its view, monetary policies affecting the external sector, at least in the case of the United States, can provide access to cheap foreign goods and very cheap saving needed to finance investment without considering the impact of the exchange rate on the real economy. Regulatory policies can protect not only our health and safety and the environment, it can override the market in the pursuit of social goals of importance to us all. In sum, all these assumptions are false, at least in some circumstances, and contrary to what the macroeconomists told us, the basic workings of the economy are not predictable nor is the economy so malleable it can be orchestrated by government policy to achieve economic and social objectives inconsistent with economic rationality.

2. Our faith in the political process, never high among Americans to begin with, has also been shaken to its core. Out of the blue, the main economic authorities of the country rushed to the stage to shout that Congress must immediately pass legislation to save the economy from imminent collapse. Their plan consisted of unintelligible notes scribbled on a few sheets of paper, and was immediately seen to be unfair to the taxpayer, power grasping by the authorities, and detrimental in its long-term effects. No matter, Congress proceeded to do what Congress does: Add complications and special interest pork to any bill brought before it and proceed to pass the bill before it has a chance to think about what it has done. We are fortunate to date the bill has had no effect on the financial sector, which remains in gridlock but has not suffered a complete meltdown, and unfortunate that, equally, it has had no positive effect on the real economy, which remains in a precarious state but has yet to be helped.

3. Our confidence in the future has been shaken to its core. We have enjoyed decades of prosperity with only minor interruptions in an upward trend in incomes and employment. We consumed more than we produced, borrowed against our future, and went deeply into debt at home and abroad. In our affluence, we became lazy, careless and reckless. Now the realization has arrived that the days of living beyond our means are over, and a costly and painful adjustment is necessary. Our future is not what it was.
OK, so the macroeconomists have failed us, the politicians have failed us, and in many ways we have failed ourselves. We are left shaken. Kling is right that every segment of the American establishment has been discredited. If it wasn’t for the wisdom and strength of ordinary Americans, one might be worried.

The Financial Crisis and the Future

The Macroeconomic Background

For more than three decades the American people have been living beyond their means, going deeply into debt at home and abroad to promote a lifestyle that was becoming increasingly unsustainable.

Since the early 1980s, the economy has experienced a long term boom, with average incomes increasing markedly across the entire country and among all income groups but seeds of troubles could be seen.

Here are some main trends of the past few decades:

+ When measured in 2000 prices, the per capita income of Americans has risen from $22,225 in 1980 to $38,000 in 2007, or 70 per cent in real terms;


+ While income distribution patterns became somewhat more skewed, much of this increase in inequality was due to a higher proportion of reduced income retirees in an ageing population and influx of low-income migrants into the country. Despite these trends, levels of real incomes and spending rose across the income spectrum;

+ The boom was encouraged by a rapid rise in international trade, which was both the source of cheap foreign products enhancing the purchasing power of American consumers and a source of cheap foreign saving to finance American domestic investment.

However, as the boom continued, we became increasingly reckless in our spending, with consumption outpacing production, imports racing ahead of exports, and domestic saving increasingly falling behind domestic investment, and our federal budget deficits increasingly financed by debt owed to countries notable only for their hostility to our values and our people.

Large structural deficits emerged:

+ Over the longer-term, the trade deficit has tended to steadily worsen, and in recent years has reached 6 per cent of our GDP;

+ The budget deficit has also tended to worsen and imbalances have regularly exceeded 4 per cent of the GDP.

We have been in a state of domestic overconsumption and underinvestment now for decades. Increasing dangerous and intractable imbalances distorted both the financial and real sectors of the economy, the financial sector through an extraordinary inflow of low-cost foreign saving and the real sector by a corresponding inflow of low-priced imports displacing domestic production and wiping out entire branches of American manufacturing. On the other hand, the inflow of foreign saving boosted the financial sector and investment in housing under government policies intended to promote broad-based home ownership. These developments would not have occurred had policy had been neutral and credit were not cheap.


A Housing Boom Develops and Affects and Infects the Rest of the Economy

Nowhere are the excesses clearer than in housing. Easy credit led to demand pressures on key sectors such as housing and promoted speculation by outsiders who entered the housing market as prices began to rise and increasingly Achurned@ the market toward ever higher levels. Homeownership became a means by which consumers borrowed excessively to sustain their consumption and go further in debt. Cheap credit is also associated with financial innovations, and new mortgage securities were developed to widen the sale of the growing number of mortgages entering the market. The flood of money into mortgage markets also lessened the need to maintain high borrowing standards. Easy credit, lax borrowing standards, over-trading in mortgages and other securities, growing indebtedness all create great risks to the economy.


In particular, over-trading in a market such as housing creates a bubble by stimulating both prices and volumes, and the more people trade, the more the profits accumulate, and the more profits accumulate the more insiders are paid and outsiders are attracted to the market and its offshoots. Everyone=s sense of reason is dulled by constant good news from a rising market in an expanding economy. A state of euphoria develops as people learn of easy riches and massive profits. Many who are attracted to what appear to be easy and permanent gains are foolish and greedy and do not understand that prices in any market cannot keep rising forever at a pace faster than the general price level. In their stupor, they ignore this truth.

Others, not seeking the gains themselves, are drawn in search of work and opportunity in the related industries and activities that support what seems to be a strong and growing sector of the economy. In the case of the housing bubble, real estate firms, building supply centers, home decorating and garden and landscaping services, among many other activities, are stimulated by the increased demand for their services, and they expand along with the housing finance and construction sectors. In the real sector, the interdependencies tighten with the housing core and the fate of firms far removed from housing itself become tied in ways they cannot see and cannot affect. Similarly, in the financial sector, the entire structure of financial assets in the country becomes increasing entangled with increasingly doggy mortgages as these securities are spread far and wide under the assumption that not only are they secure but, more importantly, they represent a liquid asset. The bubble in housing assets encourages a bubble in all capital assets.

Eventually, of course, it must all come to an end. Key people on the inside, seeing the inevitable, take their profits and cash out, all the time pretending optimism and promoting the cruel lie that no problems can be seen. Soon other insiders start for the door, doing their best to be unnoticed as they run to avoid the collapse. Many outsiders sense an end to the party but always assume a gentle decline in prices will not turn into a rout. Then it happens. All at once, prices start to tumble and madness sets in and panic takes over as everyone realizes it has all gone too far. Losses rapidly accumulate, contagion to other financial markets sets in, and credit everywhere dries up.

The expiring financial economy quickly undermines the real economy, and a deep recession sets in.


The Important Role of Government Policy

The boom of the past quarter century was promoted by government policies intended to promote a consumption binge and an unreasonable and unsustainable pace of domestic growth. In the case of housing, affordable housing was seen as a public good because of the stability it encouraged in neighborhoods and the contribution it made to stable family formation. Implementation of this policy focused on favorable tax considerations (most notably, the continuation of the mortgage interest deduction and its use in home-equity loans) and extending more and more mortgages to low and middle-income families with marginal credit histories. Policy also included measures to expand general consumption through higher levels of credit card and other types of consumer debt.

The effort to promote housing began in 1977 with the Community Reinvestment Act (CRA), a Federal law passed to encourage commercial banks and saving and loan associations to channel credit to low- and moderate-income neighborhoods. CRA regulations were substantially revised and strengthened over the years to promote affordable housing in previously under-served neighborhoods. Banks that failed to comply with the policy were threatened with legal action by the Justice Department and suits from community organizations supporting low- and moderate-income groups. Many other government programs fueled the housing boom, including in recent years the American Dream Down Payment Fund and the Home Investment Opportunity Program. All these initiatives led to an substantial increase in the number of bank loans going to low- and moderate income families.

Congress also pushed Fannie Mae and Freddie Mac -- government-sponsored enterprises which own or guarantee almost half of all home loans in the U.S. -- to increase their purchases of sub-prime mortgages going to families with incomes below the median average of incomes. These goals included a target to increase their purchases of mortgages of low and moderate-income borrowers to 50 per cent in 2000 and 52 per cent in 2005. Moreover, government mandates on banks and lending institutions were introduced to override standard criteria used to identify sound borrowers. In doing so, the potential for what would become sour financial assets was created.

Initially, Fannie and Freddie and the banks opposed the policy measures promoting sub-prime mortgages. But they learned that these mortgages could be profitable as long as housing prices rose and defaults remained low, and their opposition waned. Propped up by the artificial stimulus created by the government=s housing policy, the demand for housing rose and so did the price index for housing relative to the general price index.

Finally, in order to meet affordable housing goals imposed by the Department of Housing and Urban Development, Fannie and Freddie began to purchase sub-prime mortgages for their own account, in addition to the traditional kinds of securities they purchased from mortgage originators such as banks and non-bank mortgage firms. Mortgages backed by and assets from and equity in Fannie and Freddie were purchased by investment banks, and repackaged and sold to other financial institutions all over the world.


In this way, much of the increase in the demand for housing, and hence much of the increase in the price of housing, stemmed from the policies followed by the government and implemented through its quasi-official agencies. The program was successful, perhaps too successful. Homeownership rates rose to record levels B from 64% in 1994 to 69% in 2004 B but the strategy promoted risk and low-quality loans that undermined the housing market. The actions of these agencies, especially their aggressive purchase and sale of sub-prime mortgages, also spread what were to become toxic assets throughout the financial system, including commercial and investment banks, stock brokerage houses, and pension funds.


Novel Securities, an Economic Downturn and Spreading Toxic Securities

Financial booms are often associated with novel ways of providing credit and borrowing money. This boom was one of them. New and poorly understood financial instruments of pre packaged mortgages were created on Wall Street which allowed large blocks of mortgages to be purchased and sold by major financial institutions. Junk bonds, derivatives, and packages of mortgages are examples from the recent rise of financial markets. These and more traditional instruments soon became infected with what were increasingly questionable assets, and these questionable packages were spread far and wide into a financial system here and abroad that did not understand how they worked and what their implications were.

The most toxic of these assets were created early in this decade at a time when a recession began and interest rates were very, very low. Adjustable and teaser rate mortgages built on these low rates were sold to sub prime borrowers that could afford them at the time of the original borrowing but could not afford any significant upward adjustment in the initial terms.

But the Fed did raise rates as the economy recovered from the doldrums of the downturn of the early 2000s and the terms of many of these mortgages were hiked well above what the sub prime borrowers could afford. They began to fall behind in their mortgage payments and default.

Seeing the deteriorating situation, some (by no means all) regulators called for higher credit standards and quick action to stem a potentially disastrous situation. But Congress objected and insisted regulators back off. They did.

The housing market continued to weaken and when the housing price bubble burst in mid-decade, many mortgagees walked away from their houses, and a full scale financial crisis began.

Then the housing crisis spread step by step throughout the country and throughout the entire financial system as packaged mortgages sold far and wide became part of the asset base underneath almost all the country=s financial institutions. They were increasingly recognized as doggy and overpriced. Worse, the complex character of the packages and an inability to establish a price them in an uncertain housing market caused these assets to become untradeable. This problem was compounded by the mark to market rule of the regulators, which forced banks to write down the asset base of the banking system greatly as the prices of these securities fell. Given the highly leveraged nature of the American financial system and the inability to price mortgage-based assets, the entire financial system came to be gridlocked.


The Collapse and Where We Are Now

A financial system is based on trust and confidence. The inability to price assets destroyed trust and confidence. Once trust is removed, technical questions about financial instruments and financial arrangements no longer matter. The entire financial structure collapses in a state of complete confusion and distrust. This is where we are now.

The Fed and the Treasury are now trying to prop up and revive financial markets and rebuild financial intermediaries. Although details of its plans are not known, the Treasury has already announced some of the ideas it hopes to put into place to stem the decent into full financial chaos: The extension of deposit insurance to money market funds, and the full insurance of bank deposits. The new law passed by Congress allows the Treasury Secretary to increase the liquidity of the banking system by purchasing as much as $700 billion in toxic bank assets.

To implement these programs Treasury Secretary Henry Paulson named Neel Kashkari, formerly a colleague of Mr. Paulson at Goldman Sachs and now assistant Treasury secretary for international affairs, as interim assistant secretary for financial stability. Sour assets now held by the banks are of uncertain worth so there is no market for them and hence no price for them. It is reported that Mr. Kashkari intends to use a reverse auction to rebuild bank assets, where banks would offer securities at particular prices and the Treasury would decide whether to buy them or not. Other provisions in the legislation allow for the government to take an equity position in the banks. Of course, these plans may change in light of further developments.

Needless to say, it will take time to put these programs into full effect, even with experienced, if unemployed, investment bankers. These assets to be brought forward for sale by the banks are complex because they include derivatives and securitization. Moreover, it is by no means what is inside some of these packages in terms of the quality of the underlying assets, and therefore it is by no means clear what their price should be. It will take time to set up the institutional mechanisms to carry out the asset purchases and even longer to figure out how they should be priced.

They will not succeed anytime soon. The financial system will have to be rebuilt, and to rebuild it trust and confidence will have to be restored. This will take even more time. In the interim, ad hoc measures will no doubt be introduced to limit the damage.


Looking to the Future

For and foremost in the rebuilding task is restoring macroeconomic balance by matching domestic saving to domestic investment, thereby removing our dependence on foreign sources of saving to finance our national needs. The needed adjustment is large and requires reintroducing domestic economic discipline into a country that has ignored it for decades.


In the first instance, a believable statement of government policy about a future that balances the budget and limits our excessive dependence on foreign sources of oil must be announced. This statement must make clear the approach to be followed in overcoming the crisis, specifically, whether it will stress restraining government spending or focus on raising additional revenue through taxation. And it must be honest about where the burden of the adjustment to a more sustainable economy will be centered, specifically, on those groups or sectors where higher taxes or lower expenditures will fall and the industries that will be most adversely affected and what governments intends to do to mitigate the costs of the adjustment process.

No such statement or suggestion about how to approach the problems before the economy has even been hinted at. To the contrary, both Presidential candidates have avoided saying anything significant about the crisis, even denying it will have much of an impact on present policy intentions.

There is also the problem that we are in the midst of a political campaign and it will be months before whoever is elected assumes office and can set policy with regard to the bailout of the financial sector and the longer term rebuilding of the real economy. Until the policy approach of the new President is known, actions taken by the Treasury will be limited.

Were he to be elected, John McCain would no doubt follow a policy approach that emphasizes reliance on the market mechanism to restore stability and growth. It would in the first instance deal with restoring financial stability but it is increasingly recognized that the country must also eliminate the outsized structural imbalances that now describe the budget and trade deficits. In the long run a market oriented approach would lead to a more efficient outcome and a more vibrant economy than alternative ways of dealing with these problems. But market oriented approaches come with very high short term costs in terms of unemployment and loss of incomes in those areas that suffer from downsizing and a redeployment of their resources. Because of its costs, market oriented adjustment is not popular, and even if elected a President McCain would find considerable opposition to implementing his program.

Were he to be elected, Barack Obama would likely follow a more government oriented approach, in the hope that it can be more rapidly implemented and, with the exception of the financial services sectors, would not entail far reaching and painful adjustments likely to increase unemployment for any sustained period of time. He would no doubt regulate financial service firms more closely than at present and would also be more protective of those affected by change in the economy and attempt to slow down the process of structural adjustment. A President Obama would also be more protective of the environment and be more incline to allow government policy to intrude into the decisions of firms. In the long run, government oriented approaches tend to lead to a more inefficient economy and a slower pace of change but one with a lower degree of inequality and a higher degree of moral hazard. In the short term, government oriented approaches are more popular but the longer they are pursued they tend to generate greater resentments rooted in the inequities of unshared burdens and unfair subsidies to those who have made poor economic decisions and refuse to adjust.

At this time, it is by no means clear who will win the election and the policies they will actually put in place. Until this question is settled, the Treasury and the rest of the country cannot really a program for a recovery and restoration of its economy.

Finally, the economy is going down. Nothing can stop the decline. The question is only how far down and how long the decline. That depends on political leadership that, at the moment, is entirely absent.

The Financial Crisis and the Future

The Macroeconomic Background

For more than three decades the American people have been living beyond their means, going deeply into debt at home and abroad to promote a lifestyle that was becoming increasingly unsustainable.

Since the early 1980s, the economy has experienced a long term boom, with average incomes increasing markedly across the entire country and among all income groups but seeds of troubles could be seen.

Here are some main trends of the past few decades:

+ When measured in 2000 prices, the per capita income of Americans has risen from $22,225 in 1980 to $38,000 in 2007, or 70 per cent in real terms;


+ While income distribution patterns became somewhat more skewed, much of this increase in inequality was due to a higher proportion of reduced income retirees in an ageing population and influx of low-income migrants into the country. Despite these trends, levels of real incomes and spending rose across the income spectrum;

+ The boom was encouraged by a rapid rise in international trade, which was both the source of cheap foreign products enhancing the purchasing power of American consumers and a source of cheap foreign saving to finance American domestic investment.

However, as the boom continued, we became increasingly reckless in our spending, with consumption outpacing production, imports racing ahead of exports, and domestic saving increasingly falling behind domestic investment, and our federal budget deficits increasingly financed by debt owed to countries notable only for their hostility to our values and our people.

Large structural deficits emerged:

+ Over the longer-term, the trade deficit has tended to steadily worsen, and in recent years has reached 6 per cent of our GDP;

+ The budget deficit has also tended to worsen and imbalances have regularly exceeded 4 per cent of the GDP.

We have been in a state of domestic overconsumption and underinvestment now for decades. Increasing dangerous and intractable imbalances distorted both the financial and real sectors of the economy, the financial sector through an extraordinary inflow of low-cost foreign saving and the real sector by a corresponding inflow of low-priced imports displacing domestic production and wiping out entire branches of American manufacturing. On the other hand, the inflow of foreign saving boosted the financial sector and investment in housing under government policies intended to promote broad-based home ownership. These developments would not have occurred had policy had been neutral and credit were not cheap.


A Housing Boom Develops and Affects and Infects the Rest of the Economy

Nowhere are the excesses clearer than in housing. Easy credit led to demand pressures on key sectors such as housing and promoted speculation by outsiders who entered the housing market as prices began to rise and increasingly Achurned@ the market toward ever higher levels. Homeownership became a means by which consumers borrowed excessively to sustain their consumption and go further in debt. Cheap credit is also associated with financial innovations, and new mortgage securities were developed to widen the sale of the growing number of mortgages entering the market. The flood of money into mortgage markets also lessened the need to maintain high borrowing standards. Easy credit, lax borrowing standards, over-trading in mortgages and other securities, growing indebtedness all create great risks to the economy.


In particular, over-trading in a market such as housing creates a bubble by stimulating both prices and volumes, and the more people trade, the more the profits accumulate, and the more profits accumulate the more insiders are paid and outsiders are attracted to the market and its offshoots. Everyone=s sense of reason is dulled by constant good news from a rising market in an expanding economy. A state of euphoria develops as people learn of easy riches and massive profits. Many who are attracted to what appear to be easy and permanent gains are foolish and greedy and do not understand that prices in any market cannot keep rising forever at a pace faster than the general price level. In their stupor, they ignore this truth.

Others, not seeking the gains themselves, are drawn in search of work and opportunity in the related industries and activities that support what seems to be a strong and growing sector of the economy. In the case of the housing bubble, real estate firms, building supply centers, home decorating and garden and landscaping services, among many other activities, are stimulated by the increased demand for their services, and they expand along with the housing finance and construction sectors. In the real sector, the interdependencies tighten with the housing core and the fate of firms far removed from housing itself become tied in ways they cannot see and cannot affect. Similarly, in the financial sector, the entire structure of financial assets in the country becomes increasing entangled with increasingly doggy mortgages as these securities are spread far and wide under the assumption that not only are they secure but, more importantly, they represent a liquid asset. The bubble in housing assets encourages a bubble in all capital assets.

Eventually, of course, it must all come to an end. Key people on the inside, seeing the inevitable, take their profits and cash out, all the time pretending optimism and promoting the cruel lie that no problems can be seen. Soon other insiders start for the door, doing their best to be unnoticed as they run to avoid the collapse. Many outsiders sense an end to the party but always assume a gentle decline in prices will not turn into a rout. Then it happens. All at once, prices start to tumble and madness sets in and panic takes over as everyone realizes it has all gone too far. Losses rapidly accumulate, contagion to other financial markets sets in, and credit everywhere dries up.

The expiring financial economy quickly undermines the real economy, and a deep recession sets in.


The Important Role of Government Policy

The boom of the past quarter century was promoted by government policies intended to promote a consumption binge and an unreasonable and unsustainable pace of domestic growth. In the case of housing, affordable housing was seen as a public good because of the stability it encouraged in neighborhoods and the contribution it made to stable family formation. Implementation of this policy focused on favorable tax considerations (most notably, the continuation of the mortgage interest deduction and its use in home-equity loans) and extending more and more mortgages to low and middle-income families with marginal credit histories. Policy also included measures to expand general consumption through higher levels of credit card and other types of consumer debt.

The effort to promote housing began in 1977 with the Community Reinvestment Act (CRA), a Federal law passed to encourage commercial banks and saving and loan associations to channel credit to low- and moderate-income neighborhoods. CRA regulations were substantially revised and strengthened over the years to promote affordable housing in previously under-served neighborhoods. Banks that failed to comply with the policy were threatened with legal action by the Justice Department and suits from community organizations supporting low- and moderate-income groups. Many other government programs fueled the housing boom, including in recent years the American Dream Down Payment Fund and the Home Investment Opportunity Program. All these initiatives led to an substantial increase in the number of bank loans going to low- and moderate income families.

Congress also pushed Fannie Mae and Freddie Mac -- government-sponsored enterprises which own or guarantee almost half of all home loans in the U.S. -- to increase their purchases of sub-prime mortgages going to families with incomes below the median average of incomes. These goals included a target to increase their purchases of mortgages of low and moderate-income borrowers to 50 per cent in 2000 and 52 per cent in 2005. Moreover, government mandates on banks and lending institutions were introduced to override standard criteria used to identify sound borrowers. In doing so, the potential for what would become sour financial assets was created.

Initially, Fannie and Freddie and the banks opposed the policy measures promoting sub-prime mortgages. But they learned that these mortgages could be profitable as long as housing prices rose and defaults remained low, and their opposition waned. Propped up by the artificial stimulus created by the government=s housing policy, the demand for housing rose and so did the price index for housing relative to the general price index.

Finally, in order to meet affordable housing goals imposed by the Department of Housing and Urban Development, Fannie and Freddie began to purchase sub-prime mortgages for their own account, in addition to the traditional kinds of securities they purchased from mortgage originators such as banks and non-bank mortgage firms. Mortgages backed by and assets from and equity in Fannie and Freddie were purchased by investment banks, and repackaged and sold to other financial institutions all over the world.


In this way, much of the increase in the demand for housing, and hence much of the increase in the price of housing, stemmed from the policies followed by the government and implemented through its quasi-official agencies. The program was successful, perhaps too successful. Homeownership rates rose to record levels B from 64% in 1994 to 69% in 2004 B but the strategy promoted risk and low-quality loans that undermined the housing market. The actions of these agencies, especially their aggressive purchase and sale of sub-prime mortgages, also spread what were to become toxic assets throughout the financial system, including commercial and investment banks, stock brokerage houses, and pension funds.


Novel Securities, an Economic Downturn and Spreading Toxic Securities

Financial booms are often associated with novel ways of providing credit and borrowing money. This boom was one of them. New and poorly understood financial instruments of pre packaged mortgages were created on Wall Street which allowed large blocks of mortgages to be purchased and sold by major financial institutions. Junk bonds, derivatives, and packages of mortgages are examples from the recent rise of financial markets. These and more traditional instruments soon became infected with what were increasingly questionable assets, and these questionable packages were spread far and wide into a financial system here and abroad that did not understand how they worked and what their implications were.

The most toxic of these assets were created early in this decade at a time when a recession began and interest rates were very, very low. Adjustable and teaser rate mortgages built on these low rates were sold to sub prime borrowers that could afford them at the time of the original borrowing but could not afford any significant upward adjustment in the initial terms.

But the Fed did raise rates as the economy recovered from the doldrums of the downturn of the early 2000s and the terms of many of these mortgages were hiked well above what the sub prime borrowers could afford. They began to fall behind in their mortgage payments and default.

Seeing the deteriorating situation, some (by no means all) regulators called for higher credit standards and quick action to stem a potentially disastrous situation. But Congress objected and insisted regulators back off. They did.

The housing market continued to weaken and when the housing price bubble burst in mid-decade, many mortgagees walked away from their houses, and a full scale financial crisis began.

Then the housing crisis spread step by step throughout the country and throughout the entire financial system as packaged mortgages sold far and wide became part of the asset base underneath almost all the country=s financial institutions. They were increasingly recognized as doggy and overpriced. Worse, the complex character of the packages and an inability to establish a price them in an uncertain housing market caused these assets to become untradeable. This problem was compounded by the mark to market rule of the regulators, which forced banks to write down the asset base of the banking system greatly as the prices of these securities fell. Given the highly leveraged nature of the American financial system and the inability to price mortgage-based assets, the entire financial system came to be gridlocked.


The Collapse and Where We Are Now

A financial system is based on trust and confidence. The inability to price assets destroyed trust and confidence. Once trust is removed, technical questions about financial instruments and financial arrangements no longer matter. The entire financial structure collapses in a state of complete confusion and distrust. This is where we are now.

The Fed and the Treasury are now trying to prop up and revive financial markets and rebuild financial intermediaries. Although details of its plans are not known, the Treasury has already announced some of the ideas it hopes to put into place to stem the decent into full financial chaos: The extension of deposit insurance to money market funds, and the full insurance of bank deposits. The new law passed by Congress allows the Treasury Secretary to increase the liquidity of the banking system by purchasing as much as $700 billion in toxic bank assets.

To implement these programs Treasury Secretary Henry Paulson named Neel Kashkari, formerly a colleague of Mr. Paulson at Goldman Sachs and now assistant Treasury secretary for international affairs, as interim assistant secretary for financial stability. Sour assets now held by the banks are of uncertain worth so there is no market for them and hence no price for them. It is reported that Mr. Kashkari intends to use a reverse auction to rebuild bank assets, where banks would offer securities at particular prices and the Treasury would decide whether to buy them or not. Other provisions in the legislation allow for the government to take an equity position in the banks. Of course, these plans may change in light of further developments.

Needless to say, it will take time to put these programs into full effect, even with experienced, if unemployed, investment bankers. These assets to be brought forward for sale by the banks are complex because they include derivatives and securitization. Moreover, it is by no means what is inside some of these packages in terms of the quality of the underlying assets, and therefore it is by no means clear what their price should be. It will take time to set up the institutional mechanisms to carry out the asset purchases and even longer to figure out how they should be priced.

They will not succeed anytime soon. The financial system will have to be rebuilt, and to rebuild it trust and confidence will have to be restored. This will take even more time. In the interim, ad hoc measures will no doubt be introduced to limit the damage.


Looking to the Future

For and foremost in the rebuilding task is restoring macroeconomic balance by matching domestic saving to domestic investment, thereby removing our dependence on foreign sources of saving to finance our national needs. The needed adjustment is large and requires reintroducing domestic economic discipline into a country that has ignored it for decades.


In the first instance, a believable statement of government policy about a future that balances the budget and limits our excessive dependence on foreign sources of oil must be announced. This statement must make clear the approach to be followed in overcoming the crisis, specifically, whether it will stress restraining government spending or focus on raising additional revenue through taxation. And it must be honest about where the burden of the adjustment to a more sustainable economy will be centered, specifically, on those groups or sectors where higher taxes or lower expenditures will fall and the industries that will be most adversely affected and what governments intends to do to mitigate the costs of the adjustment process.

No such statement or suggestion about how to approach the problems before the economy has even been hinted at. To the contrary, both Presidential candidates have avoided saying anything significant about the crisis, even denying it will have much of an impact on present policy intentions.

There is also the problem that we are in the midst of a political campaign and it will be months before whoever is elected assumes office and can set policy with regard to the bailout of the financial sector and the longer term rebuilding of the real economy. Until the policy approach of the new President is known, actions taken by the Treasury will be limited.

Were he to be elected, John McCain would no doubt follow a policy approach that emphasizes reliance on the market mechanism to restore stability and growth. It would in the first instance deal with restoring financial stability but it is increasingly recognized that the country must also eliminate the outsized structural imbalances that now describe the budget and trade deficits. In the long run a market oriented approach would lead to a more efficient outcome and a more vibrant economy than alternative ways of dealing with these problems. But market oriented approaches come with very high short term costs in terms of unemployment and loss of incomes in those areas that suffer from downsizing and a redeployment of their resources. Because of its costs, market oriented adjustment is not popular, and even if elected a President McCain would find considerable opposition to implementing his program.

Were he to be elected, Barack Obama would likely follow a more government oriented approach, in the hope that it can be more rapidly implemented and, with the exception of the financial services sectors, would not entail far reaching and painful adjustments likely to increase unemployment for any sustained period of time. He would no doubt regulate financial service firms more closely than at present and would also be more protective of those affected by change in the economy and attempt to slow down the process of structural adjustment. A President Obama would also be more protective of the environment and be more incline to allow government policy to intrude into the decisions of firms. In the long run, government oriented approaches tend to lead to a more inefficient economy and a slower pace of change but one with a lower degree of inequality and a higher degree of moral hazard. In the short term, government oriented approaches are more popular but the longer they are pursued they tend to generate greater resentments rooted in the inequities of unshared burdens and unfair subsidies to those who have made poor economic decisions and refuse to adjust.

At this time, it is by no means clear who will win the election and the policies they will actually put in place. Until this question is settled, the Treasury and the rest of the country cannot really a program for a recovery and restoration of its economy.

Finally, the economy is going down. Nothing can stop the decline. The question is only how far down and how long the decline. That depends on political leadership that, at the moment, is entirely absent.

Does the US Treasury know how to run a 'reverse auction'?

“[T]he House's "Emergency Economic Stabilization Act of 2008" [is] a bureaucratic nightmare that fails to use auction markets in a way that will minimize both taxpayer and systemic risk. The key flawed provision states "The [Treasury] Secretary is authorized to purchase, and make and fund commitments to purchase, troubled assets from any financial institution as are determined by the Secretary."

Excuse me, did I read "any?"

The Senate spelled it out more clearly: "troubled assets are not limited to mortgage related assets but could include auto loans, credit card debt, student loans or any other paper related to commercial loans."

"Any other paper?" Heaven help us! ....

Auction designers should immediately note that we are talking about a market with one buyer and many sellers of a hodge-podge of items. The mechanism that will be used is a "reverse auction" -- with sellers competitively submitting asking prices to sell Treasury a heterogeneous mix of good, some sour, apples and oranges whose content is better known to sellers than the Treasury. ....

Treasury has no expertise in this ridiculous new venture. ....

Treasury action should focus on providing capital to individual banks and mortgage companies in return for debt, convertible bonds and equity and warrants to be negotiated. This is dangerous enough for the taxpayer, but here Mr. Paulson has previous experience.”

Vernon L. Smith, "There's No Easy Way Out of the Bubble", Wall Street Journal (8 October 2008).

http://online.wsj.com/article/SB122351051370717359.html

Vernon Smith, professor of economics and law at Chapman University (Orange, California), received the Nobel Prize in economics in 2002 "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms".

As Vernon notes, the Treasury has expertise in the regular auctioning of its own securities, which are identical in terms of content and maturity. The only unknowns are the final clearing price and which buyer among thousands is going to be the one that walks away with the security. In the case of the bailout, we have a reverse auction where one buyer, the Treasury, faces thousands of sellers bringing to the Treasury all kinds of securities, many of dubious and unknown content and value. Here the Treasury must set a price for each and every security put forward when it doesn’t have the slightest idea what it is buying. In this situation, risk of error is extremely high and, more importantly, distortion of prices in the wider market for securities possible, even likely.

It should also be noted what should be wanted is a smooth transition to a new structure of asset prices consistent with the fundamental economic circumstances of the U.S. economy as we go forward from here. We know that the upward trend in housing prices compared to the general price level was simply not sustainable over the longer-term and some downward adjustment was required. Housing prices no doubt affected prices for all other capital assets, raising them in relation to other kinds of produced goods and services in the economy. Needless to say, the distortions in the prices of capital goods also led to distortions in the payment of factor rewards for those engaged in the financial services industry, with excessive profits and absurd compensation for investment bankers and other executives.

It is not clear exactly what the new structure of prices across the entire range of goods and services should be. In addition to the distortions caused by artificially high housing prices, any new price structure should also to take into account distortions caused by a policy-induced overvaluation of the dollar-exchange rate, which lifted domestic prices in relation to prices of imports, leading to our huge balance of payments deficits and the destruction of some of our manufacturing base. Fiscal deficits also contributed to the distortions by attracting foreign saving and allowing the country to live beyond its means for so long. Were one to guess, adjustments of relative prices between sectors and products in the economy could be as large as 10 to 20 per cent (e.g., the price of housing is 20 per cent too high compared to the price of apples and all other goods and services and must come down), which would involve a wrenching adjustment to present patterns of production, expenditures and incomes and would take many years to effect.

Given that we know housing and asset prices are too high, the question can be asked as to why policy is trying to prop up these prices. It would probably be wiser to acknowledge that they have been too high and allow them to fall, even drop precipitously, at least for a while before trying to stabilize the market. When acting to calm the markets down, policy should recognize that in the overall structure of prices in the U.S., capital assets (and the prices of equities based on them) should be lower than they have been and that there is a need to weed out the most toxic of these assets before establishing any new set of relative prices.

Two questions are now before us. Smith points to the technical problems before the Treasury in actually implementing any policy. In essence, this is the question “How should we go about restoring stability to the financial system?” That is, of course, a key question. But a more important question is “What do you want policy to do, re-establish some stability in what is an unsustainable situation or create conditions which reflect long-term economic fundamentals and provide the basis for the continued prosperity of the American people?”

Via Larry Willmore and Greg Mankiw.

Does the US Treasury know how to run a 'reverse auction'?

“[T]he House's "Emergency Economic Stabilization Act of 2008" [is] a bureaucratic nightmare that fails to use auction markets in a way that will minimize both taxpayer and systemic risk. The key flawed provision states "The [Treasury] Secretary is authorized to purchase, and make and fund commitments to purchase, troubled assets from any financial institution as are determined by the Secretary."

Excuse me, did I read "any?"

The Senate spelled it out more clearly: "troubled assets are not limited to mortgage related assets but could include auto loans, credit card debt, student loans or any other paper related to commercial loans."

"Any other paper?" Heaven help us! ....

Auction designers should immediately note that we are talking about a market with one buyer and many sellers of a hodge-podge of items. The mechanism that will be used is a "reverse auction" -- with sellers competitively submitting asking prices to sell Treasury a heterogeneous mix of good, some sour, apples and oranges whose content is better known to sellers than the Treasury. ....

Treasury has no expertise in this ridiculous new venture. ....

Treasury action should focus on providing capital to individual banks and mortgage companies in return for debt, convertible bonds and equity and warrants to be negotiated. This is dangerous enough for the taxpayer, but here Mr. Paulson has previous experience.”

Vernon L. Smith, "There's No Easy Way Out of the Bubble", Wall Street Journal (8 October 2008).

http://online.wsj.com/article/SB122351051370717359.html

Vernon Smith, professor of economics and law at Chapman University (Orange, California), received the Nobel Prize in economics in 2002 "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms".

As Vernon notes, the Treasury has expertise in the regular auctioning of its own securities, which are identical in terms of content and maturity. The only unknowns are the final clearing price and which buyer among thousands is going to be the one that walks away with the security. In the case of the bailout, we have a reverse auction where one buyer, the Treasury, faces thousands of sellers bringing to the Treasury all kinds of securities, many of dubious and unknown content and value. Here the Treasury must set a price for each and every security put forward when it doesn’t have the slightest idea what it is buying. In this situation, risk of error is extremely high and, more importantly, distortion of prices in the wider market for securities possible, even likely.

It should also be noted what should be wanted is a smooth transition to a new structure of asset prices consistent with the fundamental economic circumstances of the U.S. economy as we go forward from here. We know that the upward trend in housing prices compared to the general price level was simply not sustainable over the longer-term and some downward adjustment was required. Housing prices no doubt affected prices for all other capital assets, raising them in relation to other kinds of produced goods and services in the economy. Needless to say, the distortions in the prices of capital goods also led to distortions in the payment of factor rewards for those engaged in the financial services industry, with excessive profits and absurd compensation for investment bankers and other executives.

It is not clear exactly what the new structure of prices across the entire range of goods and services should be. In addition to the distortions caused by artificially high housing prices, any new price structure should also to take into account distortions caused by a policy-induced overvaluation of the dollar-exchange rate, which lifted domestic prices in relation to prices of imports, leading to our huge balance of payments deficits and the destruction of some of our manufacturing base. Fiscal deficits also contributed to the distortions by attracting foreign saving and allowing the country to live beyond its means for so long. Were one to guess, adjustments of relative prices between sectors and products in the economy could be as large as 10 to 20 per cent (e.g., the price of housing is 20 per cent too high compared to the price of apples and all other goods and services and must come down), which would involve a wrenching adjustment to present patterns of production, expenditures and incomes and would take many years to effect.

Given that we know housing and asset prices are too high, the question can be asked as to why policy is trying to prop up these prices. It would probably be wiser to acknowledge that they have been too high and allow them to fall, even drop precipitously, at least for a while before trying to stabilize the market. When acting to calm the markets down, policy should recognize that in the overall structure of prices in the U.S., capital assets (and the prices of equities based on them) should be lower than they have been and that there is a need to weed out the most toxic of these assets before establishing any new set of relative prices.

Two questions are now before us. Smith points to the technical problems before the Treasury in actually implementing any policy. In essence, this is the question “How should we go about restoring stability to the financial system?” That is, of course, a key question. But a more important question is “What do you want policy to do, re-establish some stability in what is an unsustainable situation or create conditions which reflect long-term economic fundamentals and provide the basis for the continued prosperity of the American people?”

Via Larry Willmore and Greg Mankiw.