An Observation on Chairman Bernanke’s Press Conference

On April 27, 2011 held his first press conference as Fed Chairman Bernanke, such press conferences will now be held quarterly.  Beginning at 53 minutes and 40 seconds, Chairman Bernanke was asked by a reporter who prefaced his question by quoting Reinhart and Rogoff’s book, “This Time is Different,” in which they found that recoveries following financial crisis tended to be slow if he thought that Americans expected too much from monetary policy. 

Bernanke praised Reinhart and Rogoff’s now classic work but correctly explained that the book did not provide a full explanation of why these recoveries were slower and offered some possibilities from his research.  These included problems in credit markets and housing sector, and inadequate fiscal and monetary response.

What constitutes and adequate or appropriate response is controversial and inspires an interesting and heated debate.  I will focus on fiscal policy and debt accumulation.  Reinhart and Rogoff write that “Arguably, the true legacy of banking cries is greater pubic indebtedness—far over and beyond the direct headline costs of big bailout packages.”  The Bush and Obama administrations have followed a traditional path of bailing out financial institutions (TARP authorized spending of $700 billion) and offering fiscal stimulus through deficit spending (ARRA authorized expenditures of $787 billion).  The recession has also reduced tax receipts.

The graph shows an index of the national debt held by the public.  The index begins at 100 at the end of August 2007 as the housing bubble bursts.  The gray area is represents the eighteen month recession that began in December 2007.  The index has increase to 190.7, meaning that debt held by the public has increased 90.7 percent.  This is an unfortunate sequence of events given the anticipated explosion of debt due to unfunded entitlements.Replace this text with...
Read more!

Wallison and Pinto on the FHA

There were many factors contributing to the housing bubble, some by the private sector and others public.  One mistake made by the federal government was encouraging loans to unqualified buyers.  The Clinton administration actively worked to lower lending standards for home loans. The administration also imposed mandates on Freddie Mac and Fannie Mae, two government sponsored enterprises, that forced them to purchased subprime loans and mortgage backed securities built from subprime loans.  The Bush administration strengthened the mandates. 

Congress also played a major role, keeping regulation of the GSEs weak and encouraging loans in their districts ignoring risks to the financial sector.  Has the bursting of the financial bubble, financial crisis, and impending fiscal crisis given incentives to lawmakers to act in a more circumspect manner?Peter J. Wallison and Edward J. Pinto offer evidence that Obama administration and lawmakers have learned little in “How the Government Is Creating Another Housing Bubble.”  In part, they write

Since the federal takeover of Fannie and Freddie in 2008, the government-sponsored enterprises’ (GSEs’) regulator has limited their purchases to higher-quality mortgages. Affordable housing requirements Congress adopted in 1992 and the Department of Housing and Urban Development (HUD) administered until 2008 have been relaxed. These had required Fannie and Freddie to buy the low-quality mortgages that ultimately drove them into insolvency and will cause enormous losses for the taxpayers.

The latest regulatory change does not reduce the total losses that taxpayers will suffer from HUD's policies; those losses, estimated at about $400 billion, are baked in the cake. But the higher lending standards now required of Fannie and Freddie should reduce future losses.

Not so for the FHA. While everyone has been watching Fannie and Freddie, the administration has quietly shifted most federal high-risk mortgage initiatives to FHA, the government's original subprime lender. Along with two other federal agencies, FHA now accounts for about 60 percent of all U.S. home purchase mortgage originations. This amounts to more than $1 trillion and is rising rapidly. The administration justifies this policy by saying it is necessary to support the mortgage market, yet borrowers are once again receiving high-risk loans…

The Dodd-Frank Act, however, exempts FHA and other government agencies from appropriate standards on mortgage quality. This will give low-quality mortgages a direct route into the market once again; it will be like putting Fannie and Freddie back in the same business, but with an explicit government guarantee.

For example, thanks to expanded government lending, 60 percent of home purchase loans now have down payments of less than 5 percent, compared to 40 percent at the height of the bubble, and the FHA projects that it will increase its insured loans total to $1.34 trillion by 2013. Indeed, the FHA just announced its intention to push almost half of its home purchase volume into subprime territory by 2014-2017, essentially a guarantee to put taxpayers at risk again.

Read more!

Rogoff Compares Japanese, U.S., and European Financial Crises

Kenneth Rogoff is one of the nation's foremost scholars on financial crisis. With Carmen Reinhart, he coauthored the popular and widely cited book "This Time is Different: Eight Centuries of Financial Folly." Rogoff has the talent of engaging in politically charged economic debate without partisan rancor.  Rogoff compares the ongoing financial crises in the United States and Europe to the crisis in Japan that evolved into the "lost decade" in "An Age of Diminished Expectations?"  The article is short and well worth the time to read highlighting similarities and many differences between the economies as they entered their financial crises.  I have focused on paragraphs that describe policies that might help the United States exit the Great Recession and resume more robust growth. 

As the United States and European economies continue to struggle, there is rising concern that they face a Japanese-style “lost decade.” Unfortunately, far too much discussion has centered on what governments can do to stimulate demand through budget deficits and monetary policy. These are key issues in the short term, but, as every economist knows, long-run economic growth is determined mainly by improving productivity...

In the short term, it is important that monetary policy in the US and Europe vigilantly fight Japanese-style deflation, which would only exacerbate debt problems by lowering incomes relative to debts. In fact, as I argued at the outset of the crisis, it would be far better to have two or three years of mildly elevated inflation, deflating debts across the board, especially if the political, legal, and regulatory systems remain somewhat paralyzed in achieving the necessary write-downs.

With credit markets impaired, further quantitative easing may still be needed. As for fiscal policy, it is already in high gear and needs gradual tightening over several years, lest already troubling government-debt levels deteriorate even faster. Those who believe – often with quasi-religious conviction – that we need even more Keynesian fiscal stimulus, and should ignore government debt, seem to me to be panicking.

Last but not least, however, it is important to try to preserve dynamism in the US and European economies through productivity-enhancing measures – for example, by being vigilant about anti-trust policy, and by streamlining and simplifying tax systems.

Read more!

The Crisis Paradox

Robert Higgs offered the "Crisis Hypothesis," that the supply of and demand for government oversight and control of a market economy increases in times of crisis, in "Crisis and Leviathan."  Rahm Emanuel turned this hypothesis into the political dictum, "Never let a crisis go to waste."  I believe that the dictum is widely accepted.  Higgs offered another hypothesis, that increased government oversight and control during the Great Depression dampened investment resulting in what he terms, "the Great Duration," in "Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War" (The Independent Review, Vol. 1, No. 4, Spring 1997).  I synthesize the two hypotheses into the Crisis Paradox: crisis is the best time politically and the worst time economically to enact fundamental economic reform.

Gary S. Becker, Steven J. Davis, and Kevin M. Murphy describe the motivation of "Liberal Democrats" to enact economic reform and its consequences in "Uncertainty and the Slow Recovery" in the Wall Street Journal, January 3, 2010.  Their analysis could be squeezed into the Crisis Paradox.  Their take on the motivation of the reform is that,

...Liberal Democrats won a major victory in the 2008 elections, winning the presidency and large majorities in both the House and Senate. They interpreted this as evidence that a large majority of Americans want major reforms in the economy, health-care and many other areas. So in addition to continuing and extending the Bush-initiated bailout of banks, AIG, General Motors, Chrysler and other companies, Congress and President Obama signaled their intentions to introduce major changes in taxes, government spending and regulations—changes that could radically transform the American economy...

The authors give several examples of major reforms that are one of two causes for the current prolonged recession (the other is the severe financial crisis) including large increases in marginal tax rates for higher incomes, the introduction of cap-and-trade legislation, tougher enforcement of antitrust laws, health care reform, and possibly more politicized monetary policy.  They briefly describe the state of the economy which I quote in part...

Business investment in the third quarter of 2009 is down 20% from the low levels a year earlier. Job openings are at the lowest level since the government began measuring the concept in 2000. The pace of new job creation by expanding businesses is slower than at any time in the past two decades and, though older data are not as reliable, likely slower than at any time in the past half-century. While layoffs and new claims for unemployment benefits have declined in recent months, job prospects for unemployed workers have continued to deteriorate. The exit rate from unemployment is lower now than any time on record, dating back to 1967.

According to the Michigan Survey of Consumers, 37% of households plan to postpone purchases because of uncertainty about jobs and income, a figure that has not budged since the second quarter of 2009, and one that remains higher than any previous year back to 1960.

Becker, Davis, and Murphy summarize their findings.

In terms of discouraging a rapid recovery, other government proposals created greater uncertainty and risk for businesses and investors.

These facts suggest that it was a serious economic mistake to press for a hasty, major transformation of the U.S. economy on the heels of the worst financial crisis in decades. A more effective approach would have been to concentrate first on fighting the recession and laying solid foundations for growth. They should have put plans to re-engineer the economy on the backburner, and kept them there until the economy emerged fully from the recession and returned to robust growth. By failing to adopt a measured approach to economic policy, Congress and the president may be slowing the economic recovery, and thereby prolonging the distress from the recession.

As always, I encourage you to read the complete article.  I have rearranged a couple of paragraphs to fit the "Crisis Paradox," and the squeezing may detract from their writing and analysis.
Read more!

Banks, Equity, Liquidity, and Insolvency

It was my intention to write a number of posts on bank operations and tie them into a narrative of the 2008 financial crisis.  I got no further than explaining the role of capital in protecting banks against losses (Banks and the Importance of Equity) before the exigencies of finishing my classes in the fall semester delayed my plans.  A question by an anonymous reader has placed me back on path.

Brooks,
Thanks for taking a simple example to explain a complex issue such as this. Could you please explain the following for me:

- As loans given out by banks result in profits (e.g., through interest/fees less operating costs), these get added to the equity capital and thus, the equity capital account line grows. However, to me this does not feel like a "real thing" that is available to a bank to absorb losses. It feels like "Cash" is the thing that is ultimately available to the bank to absorb losses. If that is true, then why worry about equity capital at all?

In this post, I attempt to distinguish between insolvency and liquidity.  An institution is insolvent if its liabilities are greater than its assets.  It is illiquid if it does not have sufficient cash to meet its liabilities as they come due.  In the short run, an insolvent institution can be liquid if it has sufficient cash to pay its most immediate liabilities.  Obviously, it will eventually become illiquid as more liabilities become due.  I will also demonstrate that leverage, the number of dollars of liabilities per dollar of equity, magnifies both profits and losses.  
As a quick review, a bank's balance sheet is described by the equation, Assets=Liabilities+Equity.  The owners of a bank have a goal of maximizing profits for a given level of risk.  The risks are the probability that the bank will suffer losses from operations ( expenses exceed revenues) or a decline in asset value.  I will begin with the example provided by Juliusz Jabtecki and Mateusz Machaj, "The Regulated Meltdown of 2008," Critical Review, 21(2-3): 301-328, 2009.  At the beginning of operations (Year 0), the bank's leverage ratio is $20 of liabilities (deposits) for every $1 of equity. 

Figure 1. Year 0

Assets		Liabilities
Reserves (Cash)	$10	Equity	$5
Loans	$90	Deposits	$95
Total	$100	Total	$100

To keep the math simple, assume that in the first year of operations (Year 1), the bank earns a return of $5.00, or a 100% return on equity.  The bank must decide how to distribute the profit between dividends and retained earnings (I will show retained earnings as an increase in equity.), and if the profit is retained, how it will be invested.  In Figure 2, the bank did not pay dividends, increasing equity by $5.00, and it held all new equity as reserves (cash).  As it begins its second year of operations, it has $9.50 of liabilities for every $1.00 of equity; its leverage has decreased.  

Figure 2. Year 1: The Conservative Option with Profit

Assets		Liabilities
Reserves (Cash)	$15	Equity	$10
Loans	$90	Deposits	$95
Total	$105	Total	$105

If the bank earns a return of 5% ($90*.05=$4.50), the resulting return on equity is ($10/$4.50*100=) 45%.  

Figure 3. Year 1: The Aggressive Option with Profit

Assets		Liabilities
Reserves (Cash)	$2	Equity	$7
Loans	$100	Deposits	$95
Total	$102	Total	$102

Alternatively, if the bank had taken a more aggressive, riskier position as it began is second year of operations, paying $3.00 as dividends, increasing equity by $2.00, and investing the additional $2.00 of equity and $3 of returns in new loans, its balance sheet would be depicted by Figure 3.  Its leverage is $13.57 of liabilities for every $1.00 of equity.  In this case, a 5.0% return on loans ($100*.05=) $5.00, results in a return on equity of ($5/$7*100=) 71.4%.  The additional leverage magnified the return on equity. 

Figure 4: Year 2: The Conservative Option with Losses

Assets		Liabilities
Reserves (Cash)	$9.40	Equity	$4.60
Loans	$90.00	Deposits	$95.00
Total	$99.40	Total	$99.40

Now consider the bank's financial position if it had lost 6% on loans.  Figure 4 adjusts Figure 2 for losses in operations.  The bank's return on equity is (-$5.40/$4.60) -117.4%.  The bank's equity position is weaker, but it is both liquid and solvent.  Compare that outcome to that of the more aggressive investment strategy.  Figure 5 adjusts Figure 3 for a 6% or $6.00 loss on loans after one year of operations. 

Figure 5.  Year 2: The Aggressive Option with Losses from Operations

Assets		Liabilities
Reserves (Cash)	-$4	Equity	$1
Loans	$100	Deposits	$95
Total	$96	Total	$96

The bank is still solvent (Assets-Liabilities>0), but it is illiquid, it does not have cash to meet short term depositor demands.  Its return on equity is (-$6.00/$1.00) -600%.  The higher leverage magnified the losses.  The bank might be able to secure short-term loans to meet its cash demands.  If not, it will be forced to liquidate.

Figure 6.  Year 1: Operating losses

Assets		Liabilities
Reserves (Cash)	$4.60	Equity	-$.40
Loans	$90.00	Deposits	$95.00
Total	$94.60	Total	$94.60

Compare this outcome to a 6% loss on loans ($90*.06=$5.40) in the first year of operations (Figure 6).  If the same level of losses had occurred before implementing an aggressive investment strategy after a profitable year, the bank would have been liquid, but insolvent.  If the losses had occurred after a year of profitable operations, even with the aggressive strategy and illiquid cash position, the increase equity from the first year of operations protected it against insolvency.

My next post on banking will explain maturity mismatching (long-term assets and short-term liabilities), and how it impacts the regulation of banks. 
Read more!

Banks and the Importance of Equity

Principles of economics textbooks generally omit equity from the balance sheet equation, Assets=Liabilities+Equity, to focus on money creation. Given the financial crisis that became manifest in September 2008 and its continuing aftermath, this post reinserts equity or capital to focus on the risk of insolvency bankers take in lending. The example is provided by Juliusz Jabtecki and Mateusz Machaj, "The Regulated Meltdown of 2008," Critical Review, 21(2-3): 301-328, 2009. The article often refers to capital, a richer term than equity, the term used in class. When reading the quote, you can replace capital with equity with no loss of understanding. I added Figure 2 to the quote.

Figure 1

Assets		Liabilities
Cash	$10	Equity	$5
Loans	$90	Deposits	$95
Total	$100	Total	$100

Generally speaking, "capital" is the portion of a bank's assets that does not have to be ultimately repaid to creditors--such as depositors, who are, after all, merely loaning their funds to a bank. To see why capital should offer protection against unexpected losses, consider the following simple example of a bank's balance sheet (Figure 1).

The balance sheet consists of the bank's sources of funds (liabilities) and the uses to which those funds are put (assets). By definition, the two must be equal at all times We can see that our bank has collected $100 of funds: $95 in deposits from retail customers, representing liabilities; and $5 in "capital" which for the moment, we will assume is equity capital: income from issuing shares of common stock in the bank. Such income does not have to be repaid: Shareholders have no legal right to be paid dividends; and common shares have the lowest-priority claim on other assets in case of bankruptcy.

Of the $100 of liabilities (including the $5 in capital), 90 percent is then turned into credit by being loaned out, while 10 percent is held as cash in the bank's vault as cash reserves against potential withdrawals from depositors of a portion of the $95 they have lent to the bank. A bank's loans plus its cash reserves constitute its assets.

Figure 2

Assets		Liabilities
Cash	$10	Equity	$3
Loans	$88	Deposits	$95
Total	$98	Total	$98

Now imagine that some of those to whom the bank has loaned money unexpectedly default, rendering $2 of loaned assets worthless (Figure 2). The bank has to write off these losses, diminishing the total value of assets to $98. But while the value of the bank's assets has declined by $2, the amount that it owes depositors remains exactly the same ($95). Thus, for assets ($98) to continue to equal liabilities, capital must fall to $3. Suppose, by contrast, that the bank didn't initially have any capital, and that its assets ($90 in loans plus $10 in cash) were financed fully by the collection of $100 in deposits. Any unexpected (and unaccounted for) loss would then render the bank immediately insolvent, as the assets--all that the bank has--would not suffice to pay off all that it owes.

It is only due to the fact that a portion of its financing does not have to be repaid (e.g., the portion obtained from issuing stock) that the bank has the capacity to withstand unexpected losses on the investments that it makes with the funds entrusted to it. That is the primary reason that bank regulators believe it necessary to control the amount of capital that financial institutions hold. On the other hand, holding capital constrains risk-taking (and thus, potentially, profitability); that is the point of the capital regulations. To the extent that bank managers view regulatory capital as a tax imposed on them, they will tend to see capital regulations as obstacles to be gotten around.

Read more!

Glaeser on the Home Buyers' Tax Credit

Edward Glaeser, described the bad incentives created by the Home Buyers' Tax Credit in "Attack of the Home Buyers' Tax Credit," written for the New York Times.  Glaeser creatively applies economic tools to problems.  

One reason to fret about federal anti-recessionary fixes is that they often last long after the crisis that justified their creation.

According to Case-Shiller data, housing prices have been rising since May, yet Congress has just extended and expanded last year’s home buyers’ tax credit. They’ve made the program more regressive by upping the income limit for families from $150,000 to $225,000.

Even more problematically, the new, but definitely not improved, tax credit now offers up to $6,500 to current homeowners who have lived in their houses for at least five of the last eight years and buy new homes.

Who but a real estate agent could love this policy?...

Certainly, extending the tax credit to current owners doesn’t increase homeownership. I believe that our government bears some responsibility for the housing bubble because it encouraged Americans to leverage themselves to the hilt to buy homes. But just because I’d like to do less to encourage homeownership doesn’t lead me to favor more handouts that don’t increase homeownership.

A buyers’ credit that goes to everyone creates a strong incentive for purely mindless house swapping. If my cousin and I sell our houses this year, and then move back three years later, we can make $13,000. In some such transactions, people may decide to flout the law and continue to live in their old houses, pocketing quick money for a sham deal...

It subsidizes existing owners to trade up or down, which implicitly encourages people to pull up roots and sever their connections with their existing community. If you ever thought that encouraging civic engagement through housing policy was a good thing, then the current policy will push in exactly the opposite direction.

There is also no reason to think that a tax credit that encourages house-trading among current owners will help the overall housing market. A subsidy for existing homeowners provides an equal incentive for buying and selling. There will be no net decrease in the vacant housing inventory; basic economics suggests that any policy that provides equal incentives to buy and sell will do little to increase housing prices.

Increasing the scope of the program will also significantly increase its cost.

Recently, first-time home buyers have been accounting for close to one-half of home purchases, but before the tax credit particularly subsidized new home buyers, their share was lower. In 2006, only 36 percent of home purchases were first-time buyers, and a tax credit for existing owners will surely move us in that direction. If 40 percent of future transactions involve existing owners who can take advantage of the benefit, then giving the tax credit to existing homeowners could easily burn through $5 billion in five months.

The best thing about extending the home buyers’ tax credit is that it does at least have an expiration date; it is currently set to end in May 2010. Unfortunately, the events of the last week lead me to suspect that the tax credit will continue to exist, like a B-movie zombie, long after it should have settled in its grave.

Read more!

Frank and Government Regulation

In a Real Clear Politics video of an interview of Ralph Nader and Barney Frank (Rep. MA), Frank declares, "We are trying on every front to increase the role of government in the regulatory area." There is a noun for Frank in the Spanish language, sinverguenza; roughly translated, it means shameless. For those who don't recall, Frank was deeply involved in fighting tighter regulation of Fannie Mae and Freddy Mac, the two GSE's that were deeply involved in the financial crisis.

While it may be fair to assert that the regulation was wrong, it is disingenuous to assert that financial regulations were nonexistent. The government currently has layers and layers of regulation on banks and other financial corporations. Those layers increased with the Sarbanes-Oxley Act of 2002. This act is both costly to government in establishing and maintaining a regulatory structure, and more importantly to the private sector in compliance. The international Basel accords govern financial institutions in more than 100 countries. The regulators who implemented the accords and other regulatory measures failed to recognize and stop the financial crisis. Perhaps regulators are no wiser than market participants. All regulation should be approached with caution for their unintended impact on innovation and growth as well as their direct cost. Members of Congress who are working to tighten financial regulation should read the empirical findings of Robert Barro in "Determinants of Economic Growth."

The regression (a statistical technique)...shows a significantly negative effect on growth from the ratio of government consumption (measured exclusive of spending on education and defense) to GDP...The particular measure of government spending is intended to approximate the outlays that do not improve productivity. Hence, the conclusion is that a greater volume of nonproductive government spending--and the associated taxation--reduces the growth rate for a given starting value of GDP. In this sense, big government is bad for growth.

Replace this text with...
Read more!

Good Morning American and JPMorgan Chase

I watched ten minutes of Good Morning America yesterday and was disappointed in news story about profits earned JPMorgan Chase.  It seemed a blatant case of agenda setting.  The agenda is that private corporations, particularly financial corporations, are dangerous and must be more carefully regulated by the government.  They, and I think they was Diane Sawyer, reported on profits.  It was similar to Stephen Bernard's article, "JPMorgan Earns $3.6B, but Loan Losses Remain High," which was linked to the show's web page. 

JPMorgan Chase & Co. reported strong third-quarter earnings Wednesday as its thriving investment banking business more than offset rising loan losses that the bank warned would continue for the foreseeable future.

JPMorgan, the first of the big banks to report earnings for the July-September period, reported a $3.59 billion profit but also said it roughly doubled the amount of money it set aside for failed home and credit card loans in the quarter.

Hard on the heels of the report on JPMorgan's profits, Sawyer introduced Claire Shipman's report on the dangers of high compensation to financial institutions bailed out by the government stating,

Some good news from some of the banks, but what about these other banks that had billions in profits now after all the taxpayer bailouts.

Rather than report on JPMorgan prudent actions during the housing boom that saved them from the fate of their less prudent competitors, ABC News switched focus to imprudent banks that required government bailouts.  JPMorgan was a well managed investment bank that bucked many of the practices followed by the institutions that the government rescued.  Jeffery Friedman describes JPMorgan's business strategy during the go-go years of the housing boom in Critical Review, "A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure," 21(2-3):127-183.

J. P. Morgan Chase, which single-handedly accounted for about 44 percent of the world’s derivatives exposure (Slater 2009).18 Moreover, even when it was making very low profits relative to other commercial banks, J. P. Morgan raised the pay of its risk-monitoring personnel (Tett 2009a, 115–17), and after considering the possibility of engaging in subprime securitization to boost the bank’s profits, its CEO, Jamie Dimon, decided that the risk was too great (ibid., 124–28). Earlier on, the J. P. Morgan employees who developed CDO tranching had had the opportunity to apply this technology to mortgage-backed securities.  But they realized that even though “the last time house prices had fallen significantly” across the United States as a whole “was way back in the 1930s,” a similar event might make all the losses within a mortgage-backed CDO “correlate” with each other, which “might be catastrophically dangerous.”

Therefore, "to cope with the uncertainties the team stipulated that a bigger-than normal funding cushion be raised, which made the deal less lucrative for J. P. Morgan. The bank also hedged its risk. That was the only prudent thing to do. . . . Mortgage risk was just too uncharted."

"The team at J. P. Morgan did only one more [such] deal with mortgage debt, a few months later, worth $10 billion. Then, as other banks ramped up their mortgage-backed business, J. P. Morgan largely dropped out. (Tett 2009b)"

Finally, J. P. Morgan “did not unduly leverage [its] capital, nor did [it] rely on low-quality forms of capital.” Instead of targeting a high leverage ratio, as in the examples Jablecki and Machaj use to illustrate the behavior of SIVs—of which it had none—J. P. Morgan aimed for an 8-8.5 percent “tier-1” capital ratio—twice the level required by the Basel rules (Dimon 2009, 16)—despite the higher costs of tier-1 capital.19

By taking all of these prudent actions, J. P. Morgan emerged from the crisis as the strongest of the nationwide American commercial banks.

Read more!

Sowell: Housing Boom and Bust

At the one year anniversary of the financial crisis of 2008, I am making an effort to learn more about its origins by reading several books with different perspectives.  I began by reading Posner's "A Failure of Capitalism."  Posner has extensive expertise in legal and economic aspects of regulation.  He took a Keynesian approach in his macroeconomic analysis of the crisis.  Keynesian economics is dated but anybody who studies modern macroeconomics will recognize his influence on those who followed, particularly New Keynesian economists.  As soon as it is available, I will order and read Chinn and Friden's forthcoming book.  Chinn is a careful modeler who pays close attention to empirical results.  I don't know much about Friden.  I suspect that they will use a real business cycle or New Keynesian approach.  I just ordered Thomas Sowell's "The Housing Boom and Bust."  Sowell is often described as a libertarian or sometimes a conservative.  Sowell believes that government policy designed to increase home ownership was an important cause of the financial crisis.  Chinn, Friden, and Posner dismiss this view.  Below I have included part of a book review by dostoyevsky76 that I found online.

The first half of Housing Boom and Bust is like the housing market in the first half of this decade--seemingly endless potential. While I disagree politically with some of what Sowell believes, he is a clear-thinking, thoughtful writer. His book "Basic Economics" is a five-star work. He has the ability to lucidly explain arcane subjects without talking down to readers.

But this book only begins to tell the story of the housing bust and ensuing financial crisis. It's the equivalent of watching a football game and the t.v. station only shows you the first half. It was a great two quarters, but I want to see the rest of the game.

This book does an excellent job of explaining the political origins of this crisis. The main thrust of Sowell's argument is that government action usually leads to the opposite of intended consequences. The mantra of "affordable housing" led to government interference into banking which weakened standards of due diligence for home buyers. The government's most significant act was the pressure put on Fannie Mae and Freddie Mac to buy mortgages from lenders who had lowered their standards in the pursuit of providing "affordable housing." Only banks that played along in the late 90s were allowed to offer more exotic securities, and thus increase their potential for profit.

What isn't here is the extent to which lenders and investors took every advantage of this system, flooding the market with new investment tools that didn't hold up to the light of day (mostly due to the unsoundness of many of the mortgages that provided their foundation). Just like any other market or opportunity that is offering unusually high rewards, huge numbers of lenders and investors were drawn to mortgage-backed securities at the beginning of this decade. It was the dangerous extent to which major creditors were heavily leveraged with these securities and their by-products, such as credit default swaps, that has led to the severity of this crisis.

Read more!

Chinn and Frieden, and Posner on Origins of the Fall of 2008 Financial Crisis

I find substantial agreement about the origins of the fall of 2008 financial crisis between Menzie Chinn and Jeffry Frieden and Richard Posner.  I do not agree with all their conclusions, but I respect their analysis and give it serious consideration.  They find that large budget deficits during the Bush era, high leverage by firms in the financial sector, financial innovation and lax regulatory control were the culprits.  Chinn and Frieden write in "Reflections on the Causes and Consequences of the Debt Crisis of 2008," La Follette Policy Report, Vol. 19, No. 1, Fall 2009 (see also Chinn's post, "Reflections on the Causes and Consequences of the Debt Crisis of 2008" on Econbrowser) that

In late 2008, the world's financial system seized up. Billions of dollars worth of financial assets were frozen in place, the value of securities uncertain, and hence the solvency of seemingly rock solid financial institutions in question. By the end of the year, growth rates in the industrial world had gone negative, and even developing country growth had declined sharply.

This economic crisis has forced a re-evaluation of deeply held convictions regarding the proper method of managing economies, including the role of regulation and the ideal degree of openness to foreign trade and capital. It has also forced a re-assessment of economic orthodoxy that touts the self-regulating nature of free market economies.

The precise origin of this breathtaking series of events is difficult to identify. Because the crisis is such an all-encompassing and wide-ranging phenomenon, and observers tend to focus on what they know, most accounts center on one or two factors. Some reductionist arguments identify "greed" as the cause, while others obsess about the 1990s era amendments to the 1977 U.S. Community Reinvestment Act that was designed to encourage banks and other financial institutions to meet the needs of the entire market, including those of people living in poor neighborhoods. They also point to the political power of government-sponsored entities such as Fannie Mae and Freddie Mac, agencies designed to smooth the flow of credit to housing markets.

In our view, such simple, if not simplistic, arguments are wrong. Rather, we view the current episode as a replay of past debt crises, driven by profligate fiscal policies, but made much more virulent by a combination of high leverage, financial innovation, and regulatory disarmament. In this environment, speculation and outright criminal activities thrived; but those are exacerbating, rather than causal, factors.

In Posner's book, "A Failure of Capitalism," that I commented on here, he writes

So the market can be blamed for recessions, which without government intervention would often turn into depressions, as they often did before the government learned (we thought) in the aftermath of the Great Depression how to prevent that from happening.  But it doesn't let the government off the hook.  It failed to take timely and coherent measures to check the downturn.  The seeds of failure were sown in movement to reduce the regulation of banking and credit, which began in the 1970s.  They germinated during the Clinton Administration, when the housing bubble began and the deregulation of banking  culminated in the repeal of the Glass-Steagall Act (which had separated commercial banking from investment banking and it was decided not to bring the new financial instruments, in particular credit-default swaps, under regulation even to the limited extent of moving trading in swaps to exchanges, which would have given the public information about the scope, risks, and value of these investments.  Greenspan, Ruben, and Summers, the dominant figures in U.S. economic policy during the Clinton era, allowed the head of steam to build up that would eventually blow the housing and banking industry sky-high. 

But there might not have been a depression if not for the Bush Administration's mismanagement of the economy.  Bush cannot be criticized for having reappointed Greenspan as chairman of the Federal Reserve in 2004.  Greenspan had a towering reputation; it is only in hindsight that we can see that his reputation was inflated and after seventeen years in the post he had overstayed his welcome.  And Bernanke looked like a superb choice to succeed Greenspan in 2004, and probably was, though he went on to make grave mistakes...

Another mistake of the Bush Administration's management of the economy, though one the gravity of which is apparent only in hindsight, is the budget deficits of the Bush years, which so increased the size of the national debt.  So great was the national debt before the financial crisis hit that the economy will be hard-pressed to absorb the enormous expenditures that are being made in an effort to spur a recovery, without doing serious long-term damage to the U.S. economy. 

I accept the argument that the Fed's easy money policy contributed to the financial crisis.  I also accept the argument that the Bush administration's profligate spending contributed to the severity of the crisis and increased the difficulty of an effective fiscal response now.  The Bush deficits are even more egregious for those who believe that war expenditures were easily observed as unnecessary as the campaigns in Afghanistan and Iraq began.  Many liberal and libertarian economists warned of the difficulty of building democracy in those countries based on good empirical data.  It is hard to deny that high leverage contributed to greater insolvency of financial institutions as default rates increased.  I would like to read more about the role that new credit default swaps played; I simply don't understand it well.   

My largest disagreement with Chinn and Frieden, and Posner is their dismissal of active government regulation of Fannie and Freddie designed to increase home ownership.  Posner calls the government involvement, "pushing through an open door," meaning that the mortgage industry would have made these loans without government help.  They may be right but I would like to see an event study investigating changes in bank lending behavior as the Congress put pressure on the agencies to increase nontraditional lending.  I also believe that local practices authorizing building permits and building codes were at least an "exacerbating" factor in the crisis.  Many local governments limited permits and stiffened codes in ways that tended to increase the inelasticity of housing supply, setting the stage for large price increases and subsequent decreases in many of the cities that experienced the largest bubbles.

Before I draw a stronger conclusion about root causes of the financial crisis, I would like to see more evidence in several areas.  My prior beliefs make me doubt that the repeal of the Glass-Steagall Act had a negative impact.  Likewise, I would like more evidence linking weak enforcement through the SEC under the Bush administration to the financial crisis.  
Read more!

Posner, "A Failure of Capitalism"

Richard Posner has been a leading scholar of the impact of regulatory law on the economy.  In his most recent book, "A Failure of Capitalism," Posner describes the descent of the U.S. economy into depression and gives its proximate causes.  Although I do not agree with all his conclusions, he makes a valuable contribution.  The book is an easy read for principles students and tells a coherent story about our nation's current economic crisis.  As might be gathered from the title, he believes that individuals acting rationally by responding to the incentives they faced caused the depression.  He also faults policy of both the Clinton and Bush administrations; the former for excessive deregulation of the banking industry and the latter for a hands-off approach to regulation in place. 

In a chapter titled, "The Economics Profession Asleep at the Switch," he describes the interaction between political bias and empirical testing.  Economists do try to let the data form their opinions, but it is neither a painless nor perfect process.

Economics understanding of the causes and cures of depressions has not longer influences analysis. When good arguments, and some evidence, are presented on both sides of an economic debate that engages the political passions that economists share with other people, but the debate cannot be resolved by empirical testing, preconceptions shaped by ideology with exert a mesmerizing influence on the debaters. Still, this depression, like the last, is likely to stimulate fresh thinking by economists, as well as to provide new data for empirical analysis. It has already stimulated a good deal of fresh thinking – on the part of Bernanke, for example. He is a conservative economist, and conservative economists don’t like deficit-spending programs, or at least their public-works and transfer-payment component, which expand the government’s economic footprint. Yet he supports the stimulus program, having come to doubt that a depression can be averted or cured by monetary policy alone. Many economists have been converted – virtually overnight – from being Milton Friedman monetarists to being J.M. Keynes deficit spenders, as they see monetary policy failing to deliver us from the depression. Economists are influenced by ideology, but they are not impervious to evidence. The thirteenth-century change of name of the English town of Middleton de Keynes to Milton Keynes may have been prophetic. But the speed of the profession’s conversion (not that it is complete) from Friedman to Keynes suggests that the intellectual foundations of depression economics are unstable.

Replace this text with...
Read more!

Biden on the Economic Recession

Scott Wilson, writing for the Washington Post in "Biden Acknowledges Administration 'Misread' The Economy," writes

Vice President Biden acknowledged today that the administration underestimated the depth of the economic recession months ago as it prepared a recovery package that is only now beginning to take effect.

"We misread how bad the economy was, but we are now only about 120 days into the recovery package," Biden said on ABC's "This Week." "The truth of the matter was, no one anticipated, no one expected that that recovery package would in fact be in a position at this point of having distributed the bulk of the money."

I read with incredulity. The administration underestimated the depth of the recession? Every news source from newspapers to radio and television to the blogosphere seemed full of economists stating that the economic crisis was the worst since the Great Depression. Democrats everywhere based their campaigns on the financial crisis and rising unemployment. Candidate and then President Obama said much the same. At his first press conference, which was held in the economically hard hit city Elkhart, Indiana, ("Transcript: Obama takes questions on economy," CNNPolitics.com, February 9, 2009) he said,

So what I'm trying to underscore is what the people in Elkhart already understand, that this is not your ordinary, run-of-the-mill recession. We are going through the worst economic crisis since the Great Depression.

We've lost now 3.6 million jobs, but what's perhaps even more disturbing is that almost half of that job loss has taken place over the last three months, which means that the problems are accelerating instead of getting better.

A closer reading of transcripts of President Obama's speeches indicates that his administration's big interest has been and remains reforming policies that he believes have been neglected for decades.  These policies include the environment, health care, and education.  Form the his state of the nation address (CNNPolitics.com, February 24, 2009) President Obama said,

That is why, even as it cuts back on programs we don't need, the budget I submit will invest in the three areas that are absolutely critical to our economic future: energy, health care, and education.

It begins with energy.

We know the country that harnesses the power of clean, renewable energy will lead the 21st century. And yet it is China that has launched the largest effort in history to make their economy energy efficient. We invented solar technology, but we've fallen behind countries like Germany and Japan in producing it. New plug-in hybrids roll off our assembly lines, but they will run on batteries made in Korea...

Our recovery plan will invest in electronic health records and new technology that will reduce errors, bring down costs, ensure privacy, and save lives.

It will launch a new effort to conquer a disease that has touched the life of nearly every American, including me, by seeking a cure for cancer in our time.

And -- and it makes the largest investment ever in preventive care, because that's one of the best ways to keep our people healthy and our costs under control.

This budget builds on these reforms. It includes a historic commitment to comprehensive health care reform, a down payment on the principle that we must have quality, affordable health care for every American...

Already, we've made a historic investment in education through the economic recovery plan. We've dramatically expanded early childhood education and will continue to improve its quality, because we know that the most formative learning comes in those first years of life.

We've made college affordable for nearly 7 million more students, 7 million. And we have provided the resources necessary to prevent painful cuts and teacher layoffs that would set back our children's progress.

But we know that our schools don't just need more resources; they need more reform. And that is why...

That is why this budget creates new teachers -- new incentives for teacher performance, pathways for advancement, and rewards for success. We'll invest -- we'll invest in innovative programs that are already helping schools meet high standards and close achievement gaps. And we will expand our commitment to charter schools.

Edward Lazear, a professor at Stanford University's Graduate School of Business, a Hoover Institution fellow, and President Bush's last chairman of the Council of Economic Advisers saw much of the same thing when he weighed in on the need for a second stimulus ("Do We Need a Second Stimulus?," Wall Street Journal, July 9, 2009).

With the economy weak and the labor market continuing to decline, there is now talk of a second stimulus (which is actually the third, counting President Bush's 2008 tax rebates). This would be a mistake. The truth is there hasn't been any stimulus to speak of so far this year. Moreover, what's being called stimulus is just a smoke screen for a permanent expansion of government. Let's start with some facts...

Congress and the Obama administration have used the economic downturn as an excuse to expand the size of government. Calling it a stimulus, they have instead put in place a spending agenda that will unfold over the next two years. Although a little over one-third of the American Recovery and Reinvestment Act of 2009 goes to tax relief, the rest is in the form of spending programs that will be difficult to stop once they are up and running.

Only a small share of the spending will occur in 2009, even though Keynesians would argue that stimulus spending should be frontloaded to kick-start growth. The Congressional Budget Office estimates that the largest share of the spending will occur in 2010, with the amount in 2011 being slightly larger than in 2009. Again, the timing exacerbates the problem: It will be tough to cut back on spending written into budgets as far out as 2011.

Read more!

Liebowitz on Foreclosures

Stan Liebowitz, who has investigated the impact of changing lending standards on the housing market ("Anatomy of a Train Wreck: Causes of the Mortgage Meltdown," Independent Policy Report, October 3, 2008.), has extended his research to analyze the causes of the increase in foreclosures since 2007. He reports on some of his findings for the Wall Street Journal in, "New Evidence on the Foreclosure Crisis," (July 3, 2009).

What is really behind the mushrooming rate of mortgage foreclosures since 2007? The evidence from a huge national database containing millions of individual loans strongly suggests that the single most important factor is whether the homeowner has negative equity in a house -- that is, the balance of the mortgage is greater than the value of the house. This means that most government policies being discussed to remedy woes in the housing market are misdirected...

The...data allowed me to construct a housing price index at the zip code level and then calculate the current equity position of each homeowner. I was thus able to compare the importance of negative equity to other variables related to foreclosures.

The analysis indicates that, by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home...A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.

Further, because it is difficult to account for second mortgages in this data, my measurement of negative equity and its impact on foreclosures is probably too low, making my estimates conservative...

The difference in policy implications is enormous: A significant reduction in foreclosures will happen when and only when housing prices stop falling and unemployment stops rising...

...stronger underwriting standards are needed -- especially a requirement for relatively high down payments. If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell. A further beneficial regulation would be a strengthening, or at least clarifying at a national level, of the recourse that mortgage lenders have if a borrower defaults. Many defaults could be mitigated if homeowners with financial resources know they can't just walk away.

Read more!

Treasury to Bank of America: You've Got Mail

In December 2008, Merrill Lynch & Co. (ML) was on the verge of bankruptcy.  Bank of America (BA) was the Treasury's last remaining viable buyer.  As the negotiations to acquire ML proceeded, additional information about Merrill's potential losses spooked BA CEO Kenneth Lewis, who suggested to Secretary of Treasury Paulson that they were going to exercise a material adverse clause in the merger agreement to end negotiations.  Paulson and Federal Reserve Chairman Bernanke pressured Lewis to go forward with the deal and he capitulated.  Craig Torres and Scott Lanman of Bloomberg tell the story more fully in, "Fed Memo Said Aid for Bank of America Would ‘Come at a Price’" (June 11, 2009).

Jessica Pressler a New Yorker writer gives sage advise in "Fed Flamed Bank of America CEO in E-mails, Threatened to Have Him Fired" (June 11, 2009).

See, this is why we always say that if you're going to threaten someone you should do it in person, in an area that has been swept clean of recording devices. What is even the point of working for the United States government if you cannot take advantage of the CIA's infrastructure for this stuff? The full e-mails have not been released yet, but we imagine when Bernanke's whole "Don't you know who I AM? You and me, we’re f*****’ DONE professionally" rant hits the Internet he's going to be mighty embarrassed.

The Bush administration professed love for markets until the financial meltdown began in September, 2008, when President Bush proclaimed "I've abandoned free-market principles to save the free-market system."[1]  The negotiations between the Treasury and BA illustrate that the Bush administration was willing to run roughshod over private property rights to obtain its objectives. Motivation for Bernanke's actions may be found in his American Economic Review paper, "Bankruptcy, Liquidity, and Recession, (Vol. 71, No. 2, May 1981).  Bernanke begins his paper,

This paper examines the possibility that the economy-wide level of bankruptcy risk plays a structural role in the propagation of recessions.  The argument is as follows: Bankruptcy imposes net social costs, so that all agents have an interest in avoiding it.  Consumers and firms do this by being careful to retain sufficient liquid assets to meet fixed expenses; banks and other lenders, by being selective in choosing borrowers and limiting the size of loans.  The onset of recession strains the system by reducing the flow of income available to meet current obligations and by increasing uncertainty about future liquidity needs.  There is a general attempt to insure solvency which leads to a reduced demand for consumer and producer durables--which may in turn generate further income reductions. 

Bernanke's confidence in this model as Fed chairman exceeds his confidence as a researcher.  Near the end of the paper, he describes evidence supporting his model.

At present the empirical evidence relevant to the story I have told is limited and does not permit firm conclusions. 

The coerced purchase of ML by BA illustrates the sad nature of political commitment to markets.  Republicans often profess their love of markets in good times, but abandon them as soon as a crisis occurs with little or no evidence that the government will perform better.  Democrats are generally more skeptical of markets, but lack political support for increased intervention in good times.  But when a crisis comes, with religious fervor, Democrats "never let a serious crisis go to waste."  The result is that crisis often results in more government regardless of the party in power as Robert Higgs hypothesized in "Crisis and Leviathan,"   (Oxford University Press 1987).[2]

If anything, the Obama administration has less respect for private decision making than the Bush administration.

[1] Don Boudreaux of Cafe Hayek wrote the "Politicians Principles,"

I wrote the following lines in a private letter to friends back in December when George W. Bush, then still president of the executive branch of the U.S. national government, announced that he was abandoning his free-market principles.  The truth of these lines, however, transcends time and political party.

The man who never cheats on his wife because no other woman will have him is not particularly principled - but he proudly fancies himself that way. So the first bimbo he sniffs who'll do him the honor will prompt him to "abandon his principles" with as much alacrity as a hungry dog will attack a ham. Such are the principles of our "leaders."

(P.S. One cannot abandon what one never possessed.)

[2]  Beginning in the late 1970's and continuing until the 1990's economic crisis induced government officials to deregulate and privatize.  Perhaps Higgs' hypothesis should be amended to read that "crisis causes government action." 
Read more!

Christopher Dodd as Darth Vader

Holdup occurs when one party to a contract alters it to his or her advantage after the other party has taken an irreversible action called for by the contract.  Darth Vader's treatment of Lando Calrissian illustrates holdup.  Vader wants to lure Luke Skywalker into a trap using Han Solo as bait.  He must first capture Solo.  Vader makes a contract with Calrissian in which he will free Solo's and Calrissian's friends, Princess Leia and Chewbacca, once Solo is captured.  The scene portraying the holdup is brief.

Imperial Officer: Skywalker has just landed, my Lord.

Vader: Good.  See to it that he finds his way here.  Calrissian, take the princess and the Wookie to my ship.

Lando: You said they'd be left in the city under my supervision.

Vader: I am altering the deal.  Pray I don't alter it any further. 

The fear of holdup causes economic agents to forego mutually beneficial contracts.  The problem is overcome through contracts enforced by an independent third party, usually the government.
A short time ago, in the nation's capital not too far away we witnessed a similar episode of holdup--the BONUS WARS.  Christopher Dodd (Vader), wants Jake DeSantis' (Skywalker) bonus.  DeSantis has worked for AIG for $1 over the past year to remake the company and has never participated in credit default swaps or other activities that caused the company's demise.  Edward Liddy (Lando Calrissian) is the government picked CEO of AIG.  The other executives who were to receive bonuses collectively play the roles of Princess Leia and Chewbacca.  The scene portraying the holdup is brief.

Sergeant-at-Arms: DeSantis has just written the New York Times, Senator.

Dodd: Good.  See to it that he finds his way here.  Liddy, take the workers' bonuses.

Liddy: You said they'd be left to the workers under my supervision according to contract.

Dodd: I am altering the deal.  Pray I don't alter it any further.

CEO's of financial institutions and their employees will view the government with less trust and avoid contracts that may be mutually beneficial increasing the cost of the bailout and the length of time necessary to resolve the financial crisis. 

The dialogue from Star Wars and the idea to apply it to economic hold up was taken from the back cover of the Journal of Political Economy, Vol. 114, No. 2, April 2006.  I love the back cover of the JPE!
Read more!

Jonathan Jarvis and the Financial Crisis

Jonathan Jarvis is a designer based in Los Angeles. He is practicing in the Graduate Media Design Program at the Art Center College of Design. He constructed a great introduction to the financial crisis. It can be found at "The Crisis of Credit Visualized."

He omits the role of the government, which I would not, but the omission is understandable given the time frame devoted to the topic. If you make it too long, nobody will watch it.

I also find it valuable because it explains how markets can misfunction, and I believe that it comes very close to describing the origin of the financial crisis in England, Ireland, and several other European countries where the government's influence in the housing market was less significant than in the U.S.

I give it four and a half stars out of five.

Read more!

Fixing The Financial Sector

George Bittlingmayer and Thomas Hazlett are at it again, criticizing the stimulus by looking at its impact on capital markets ("The markets do not believe the 'stimulus'," Chicago Tribune, March 8, 2009.). I will highlight two points from the article and make an additional observation.

It is sometimes difficult to interpret market swings. They are the combined reactions of thousands of thousands of buyers and sellers. With that caution in mind, forward looking markets would respond positively to policies or events that signal a resolution to the financial crisis and negatively to policies or events that signal continued turbulence.

Many factors move markets, but investors would respond enthusiastically to signs the government was solving the economic crisis. Indeed, news that the experienced, moderate Timothy Geithner would be Treasury chief lifted the Dow 6.5 percent Nov. 21 (and an additional 4.9 percent when the choice was confirmed by Obama Nov. 24). Geithner's glow has since dimmed; the Dow dropped 300 points when his Feb. 10 news conference revealed that little progress had been made in crafting a solution to the banking crisis. And today the evidence is that investors do not believe that the massive new debt will spur economic growth.

Event studies are a type of opinion pool by people who have money in the game and politicians realize their value in forecasting policy outcomes.

The point is not that economic policies should be crafted to benefit shareholders. It is that financial markets offer important evidence about the effect of different choices on the overall health of the American economy. Former President Bill Clinton harks back to the good times in the 1990s when equity valuations were booming. Last fall, conversely, House Republicans and Blue Dog Democrats blocked the banking bailout requested by Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke, only to see the Dow decline nearly 7 percent on Sept. 29. That was a signal. House opposition quickly collapsed and the bill passed.

The Obama administration has much to blame on its predecessor. But its own fiscal strategy is highly leveraged on a theory that has not scored well in previous runs. Markets are dubious that the "stimulus" will stimulate. And investors are losing patience with the federal fixes offered for the banking crisis. If the warning signs of the Dow are not heeded by policymakers, they will be by others. Ask Sen. John McCain.

Investors also respond to unexpected market driven events such as Citigroup turning a profit (Lepro, Sara and Paradis, Tim, AP Business Writers. "Dow ends up nearly 380 on Citigroup profit news," Yahoo Finance, March 10, 2009.)(HT Drudge.)

NEW YORK (AP) -- Wall Street has had its best day of the year, storming higher after some good news from Citigroup. Citigroup Inc. says it operated at a profit during the first two months of the year. That energized financial stocks and in turn, the entire stock market. Surprised investors drove the major indexes up more than 5.5 percent to their biggest one-day rally of the year. The Dow Jones industrials shot up nearly 380 points.

Read more!

Finn Kydland and the Stimulus

In a December 9, 2008, Andina article titled, "Infrastructure investment, best way to face financial crisis", says Nobel in Economics" Finn Kydland gives what sounds like guarded advice on dealing with the international financial crisis. The article reads

Infrastructure investment is one of the best ways to face the international financial crisis due to its long term positive effects on the productivity of the country, Nobel Prize in Economics for 2004, Finn Kydland, stated Tuesday.

"I do not trust too much on measures addressed to aliviate situations in the short term since, usually, these measures are likely to have negative effects in the long term, and long term is what really matters”, señaló.

For example, he said, a fiscal policy such a temporal reduction of taxes has little effect, so that infrastructure investment is better to face financial crisis.

“When the economy grows and the highways do not progress accordingly, the economy becomes ineffective, hence, investing in transport is a good idea", he stated.
He said infrastructure investment is one of the most recommended measures by the
Copenhagen Consensus (2004) for Latin America, and is also mentioned in the Consulta de San José en Costa Rica (2007).

Read more!

The WABAC Machine

Hand pained limited edition for sale (and not by me).

Mr. Peabody, AKA the Wolf of Wall Street, and Sherman are sitting in Peabody's penthouse, when Sherman asks, "Where are we going today, Mr. Peabody?"

Peabody responds, "June 1997, to Washington."

Why, Mr. Peabody?

“The Asian Financial Crisis will break out in early July, raising fears of a worldwide economic meltdown and we have to stop it.”

His curiosity aroused, Sherman demands, “Tell me more, Mr. Peabody.”

Peabody explains, (quote from Wikipedia) “The crisis started in Thailand with the financial collapse of the Thai baht [Thai currency] caused by the decision of the Thai government to float the baht, cutting its peg to the USD [U.S. dollar], after exhaustive efforts to support it in the face of a severe financial overextension that was in part real estate driven. At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt.”

“What are we going to do about it, Mr. Peabody?”

Holding a browned copy of the September 25, 1998 Wall Street Journal, and pointing to an article titled, "Would-Be-Keyneses Vie Over How to Fight Globe's Financial Woes" and Peabody reads, "President Clinton asks, ‘Is there a modern John Maynard Keynes to show us the path back to prosperity?’” Flipping to the back page to continue the article, he knowingly points to the pictures of Paul Krugman, Jeffrey Sachs, and Joseph Stilitz, and calmly declares, “Yes Sherman, and I know who they are!”

“Why didn't anyone listen to them?”

Peabody continues reading about Keynes from the WSJ, "[ Keynes], who died in 1946, fell from grace in the late 1970s and early 1980s as his followers in governments around the world couldn't easily understand or cure inflation. But the current talk of deflation, global overcapacity and irrational financial markets harks back to the Depression-era issues he confronted."

Sherman, surfing the Internet, lands on The Financial Times Economists' Forum, and eyes an article by Peter Clarke titled, "In the Long run we are all dependent on Keynes", and reads to himself, "It was US president Richard Nixon who declared: ‘We are all Keynesians now.’ Well, times change. Myths become vulnerable to debunking – and, if you wait long enough, to rebunking too. The Keynesian era came to grief in the 1970s. For about 30 years Keynes’s reputation languished. Then, in about 30 days, it has apparently been restored.’” Sherman responds, “Gee that sounds familiar Mr. Peabody.”

Peabody, glaring at Sherman, explains, “We are going to perform a natural experiment. We will try the Keynesian solution, and if they don’t work, we will try the New Classical solutions proposed by Robert Lucas, Thomas Sargent, and Edward Prescott. Doing something about a problem that has not happened yet just might work. If that doesn’t work, we’ll try New Keynesian solutions proposed by Greg Mankiw, David Romer, and Olivier Blanchard.”

“And we’ll try plans until one works?” Sherman asks innocently, and then he grasps the genius of Peabody’s plan, “Everybody will wake up and the Asian Financial Crisis will never have happened?”

“Yes, and maybe the American Financial Crisis will be history as well if policy makers learn from past success.” Peabody declares, and then thoughtfully observes, “Another possibilities exist: People might wake up and find that nothing has changed. This means that we none of the policies worked, or that policy makers did not listen to hard advice from good economists.”

Read more!