“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.
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