At Forbes.com, Russ and I each weigh in on today’s financial turmoil. Russ’s superb contribution is here; mine is here.
Only time will tell if my
optimism is justified. Adam Smith was correct that there’s "a great
deal of ruin in a nation" — meaning that a relatively free society can
withstand much abuse. Whether or not ours can weather the added abuse
about to be heaped on it by the hordes of political opportunists
scurrying like fanged roaches in Washington remains to be seen.
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There was no need to write these articles. President Bush has announced that he is working to calm the turmoil, and that his administration is providing information to key members of Congress. Our future prosperity seems assured.
Russ,
That was a very strange article. First, your examples have nothing to do with the current crisis. Yes, price gouging is stupid and so is ethanol and so was Fannie and Freddie. All economists generally agree with those points. But they generally have nothing to do with the failure of AIG, Lehman, Bear and the host of other banks that are teetering. Yes, it fueled the housing boom, but government involvement didn't force companies to hold risky securities. The examples you named are itsy bitsy-gouging and ag subsidies have been around forever (why not mention the biggest gov't spurring of housing, the mortgage exemption?). The cause of this meltdown is a market failure, and its a market failure that can cripple the real economy. I can tell from econtalk that you are really trying hard to get someone to tell the systemic risk story, and no one has been able to. Neither Taylor or Shiller could really form a coherent story, but you need to get some crisis experts on, because the story does exist and it's an important part of the discussion.
"By sparing some reckless investors but not others, they have signaled that risk-taking results in arbitrary rewards and prudence will be punished."
I mean, this is true, but that doesn't mean the Fed should have done nothing. The alternative could be far worse. Do no harm is a stupid rule. We certainly wouldn't want our doctors to follow it. Medicine has side effects, but that doesn't mean we shouldn't take it. If doing nothing will lead to death, it may even be better to take medicine that will probably do harm, if there is some chance that it will help us.
The Fed is making a decision now to save the real economy. It doesn't want to bail people out. It knows that it creates bad incentives, but that still may be the best option.
Also, as much as you think about the incentives around the Fed, you never seem to consider commitment. It is possible, the best of all possible worlds would be for the Fed/Treasury to commit to no bailouts, even if not doing a bailout would be devastating to the real economy. Firms might internalize risks better and create a better outcome. But the Fed can't commit to no bailouts and firms no the fed can't commit, because it won't kill the real economy just to stick it to the bankers.
Charlie
Thanks Russ and Don; I posted both of your articles on the electronic blackboard site for my students to read. Great jobs both of you.
Great articles gentlemen. I'm furious at the President and the Fed. Furious.
Charlie,
The examples of anti-gouging and ethanol are related to the housing crisis because in all three, politicians think they can steer markets to do good things and nothing else will happen other than the good things.
You're a very careful listener to EconTalk. I also tried to get Barro to elaborate on the systemic risk. He and Taylor and Shiller were elusive. I don't conclude that there isn't systemic risk. I think there probably is. I find it strange that there isn't a standard story out there to describe it. But you're right–there are people who can detail it. I'll be posting an interview with Arnold Kling in ten days which I think you'll enjoy.
If I were in Bernanke's shoes or Paulson's I wouldn't be passive, either. I just think they've intervened in arbitrary and opaque ways.
The cause of this meltdown is a market failure,
If you are talking about the meltdown, this is what the market is supposed to do.
The government is trying to prevent the market from performing its function…which is how we got here in the first place.
"The turmoil in the housing market and the resulting financial crisis is just the latest example of political failure. Politicians wanted more home ownership than the market produces on its own, especially among low-income families. To encourage this politically popular goal, Fannie Mae (nyse: FNM – news – people ) and Freddie Mac (nyse: FRE – news – people ) were allowed to privatize their profits and socialize their losses. At the same time, Housing and Urban Development (HUD) required them to expand their commitment to affordable housing. Freddie and Fannie achieved this goal by buying bundles of subprime mortgages."
This is unfortunate because I'm pretty sure it has no basis in fact. Barry Ritholtz from The Big Picture actually calls it "wingnuttery" and Baney Franks explains why.
I've also previously posted studies here that support exactly what Barney Franks says in the video.
The claim is further dispelled here.
I'm sorry but IMO Joseph Stiglitz gives a far better explanation of what happened that makes logical sense and is consistent with the facts.
"Politicians and policy makers ignored the essentially organic nature of market forces and assumed that one piece of the market could be altered while everything else remained unchanged."
RR
Tell me again what they altered that allowed investment banks and lending banks to conglomerate? Tell me what they altered to allow for opaque securitizations to dominate the sub-prime market? What did they alter that made the credit rating agencies fail? Where is the law that forced these firms to give greater then 100% loans???
"And they will tell us that the right regulations can be put into place to patch things up. Color me skeptical."
The period between the dots was the period where regulations where in place. I could post data showing a booming economy and NO BANK failures during the same time.
Then you go on to almost claim the bailouts caused the crisis.
Color me skeptical… this was a market failure that followed ill advised deregulation and unlimited offerings of cheap money from the Fed…. Wall Street got everything it wanted and the only thing that's prevented total collapse was them getting their way one more time…. Wall street did exactly what people do in a "free market".. they were over come by greed.
"Returning to that world, the world of markets, is the beginning of a return to stability." RR
Can you be specific and tell me when we were in the world of markets. What years were those?
It's not a market failure, and it needn't cripple anything. A market is just a place where (or a process whereby) people decide how they want to exchange the goods they produce. When lots of people end up organized to produce things that most people don't really deem "good", that's not a market failure. Maybe it's some kind of failure, but it's not a market failure.
I don't know what a "crisis expert" is, but the interview with Taleb seems relevant.
Suppose half the economy is a house of cards, so half of us are producing stuff free consumers don't really want while clueless bean counters pass dubious paper around. Yeah, that can happen. States obviously do it all the time; otherwise, they wouldn't need the taxes.
In this scenario, the other half of us are still producing things free consumers do want, so the malinvested resources can reorganize to produce the same things for each other, if nothing else, assuming that states haven't passed laws against it. Imitating success is not rocket science.
If we can't reorganize into profitable organizations, the problem isn't the market. The problem is a lot of forcible propriety inhibiting this reorganization. The problem is what we're calling "property", not the market.
The Fed only needs to make credit available. It doesn't need to conserve existing organization with all of its established entitlements. So what if AIG melts down? Why can't an independent bankruptcy court preside over the reorganization? Why must the Treasury do it? That's the issue. Why is the Fed extending all of this credit to an organization that free investors will no longer support? Why not extend credit to its competitors for capital instead? That's the question.
We don't have enough insurance companies in the U.S., so the single largest insurance company can't be allowed to fail? I'm supposed to swallow this logic? When did bankruptcy become a "disorderly" liquidation anyway? Why is it any less "orderly" than what the Fed, the Treasury and the board of AIG are concocting behind closed doors right now? Russ is right. The issue is transparency.
Stiglitz makes sense to me, but I'm not sure how his explanation clashes with Roberts here. Failed products are not evidence of "market failure". They're inevitable, and markets deal with them appropriately. We cannot and should not expect governments to guarantee that products succeed. Subprime mortgage securities sold to the People's Bank of China are no exception.
Martin, I cannot understand why Henry Paulson or the Federal Reserve hasn't published a note on what systemic risk a AIG failure would have presented. Such note can restore some much needed confidence, if there was some real objective risk.
Quote from charlie: "The cause of this meltdown is a market failure, and its a market failure that can cripple the real economy."
After citing all the ways in which the government has interfered and coerced the market, your conclusion is that it's a market failure. Then you seem to think that the market is some how separate and distinct from the "real" economy. Amazing.
Kurt:
If they published some analysis as convoluted as the entitlements AIG has been gaming, and if they put "systemic risk" in the title of their report, would that help? The Fed has lots of staff who'll do that for you.
I don't know what's happening with AIG, aside from vague reports of a line of credit exchanged for whatever "equity" theoretically exists in the company. What I gathered of the Bear Stearns bailout goes like this. Bear Stearns (BS) was bankrupt, because it owned too many mortgage backed securities representing too many subprime loans approaching default, and it couldn't find any suckers big enough to buy 'em.
The Fed solved this problem by swapping some BS paper for Treasury securities and cajoling J. P. Morgan into buying Bear Sterns for a song on this condition. J. P. Morgan complied, and the Creditor in Chief was satisfied. Were the Treasury securities the real quid pro quo, or did J. P. Morgan grease the skids to the discount window for its own use later? Your guess is as good as mine. Now that the Fed isn't holding these securities anymore, the Congress must actually pay interest on them to J. P. Morgan. Other Treasury paper held by the Fed is effectively interest free, so this transaction apparently imposes a cost on taxpayers.
The Treasuries are worth more than the mortgage backed securities, because Bear Stearns can't shoot people refusing to hand it money. J.P. Morgan can't shoot people refusing to hand it money either, but it can accept a handout of entitlement to tax revenue from the Fed.
I worked for a small company that had exchanged its equity for a line for credit shortly before hiring me, and I saw the line of credit vaporize before my very eyes. I'm the beneficiary in fact, because I drew a salary from the credit line, before the creditor, a larger corporation, effectively canceled the line of credit by buying the smaller company's "equity", whereupon I started drawing a salary from the larger corporation.
I later found another position and resigned, because the larger corporation apparently also had a lot of debt, and the business model seemed untenable to me. I never did much useful work for the smaller company. Maybe I earned my keep at the larger company, but I doubt it.
The smaller company was small enough that I could easily see what was happening, so I have little doubt of its description. The larger company was too large for me to see, even from within it, but I doubt that it's too large to fail. If it does fail in the next recession, I suppose my theory is correct. I'm more optimistic about my current position, but life is always a guessing game.
Muirgeo and Martin Brock,
I hope to be commenting on the Stiglitz piece soon. I also hope to post some evidence on the pressure that Fannie and Freddie were under to finance subprime mortgages.
Martin,
All you've done is re-define market failure as a normal process markets go through. That's not very helpful.
I continually ask people to point to the time and place when we had "free markets' and I never get a response.
So I'm gonna assume they mean the period post civil war up to the Great depression. That period was marked by BOOM and BUST cycles with recurring DEPRESSIONs. If you think returning to that is a good thing I think you need to read more history.
No one wants that. They want satbility and the stable strong growth period from 1940 to 1970 was an example of what good regulation can do. We repealed those regulations and now we've returned to boom and bust cycles.
What you asking for is like asking to go back to the "good old days" when markets and diseases were allowed to run their course without interference from government mandated regulations and vaccinations.
Those days weren't that good Martin. Old people starved and froze to death and there was almost no middle class to speak of.
"I just think they've intervened in arbitrary and opaque ways."
The arbitrariness may actually be a good thing. We want companies to not know if they are AIG or Lehman, and we don't want investors to know either. The arbirtariness undermines the bad incentives associated with bailouts.
""The cause of this meltdown is a market failure,"
If you are talking about the meltdown, this is what the market is supposed to do."
This isn't actually true or at least it doesn't have to be. There are lots of reasons credit markets can fail. Imperfect information, liquidity crises, sticky prices…each has a different story. That doesn't mean you have to agree that Bernanke is doing the right thing, but you should try to understand what he's thinking. If your just on the sidelines saying "market good, government bad" your not participating in the discussion you're just yelling at it.
"A market is just a place where (or a process whereby) people decide how they want to exchange the goods they produce."
The purpose of a market (in economics) is to allocate goods efficiently, when it isn't doing that it is failing. As noted above there are several relevant arguments that explain how it may be failing right now.
"I don't know what a "crisis expert" is, but the interview with Taleb seems relevant."
I was speaking about someone who studies financial crises. Taleb and Shiller are both thinking about ways we could get into crises, a bubble might contribute to a crisis but neither thinker has looked into the crisis itself, and how it might be mitigated. It's the difference between studying how car wrecks happen and emergency medicine. Though, if you've listened to the Shiller or Taleb podcast you have hear market failure stories, both of there's basically revolve around myopia.
"The Fed only needs to make credit available. It doesn't need to conserve existing organization with all of its established entitlements. So what if AIG melts down? Why can't an independent bankruptcy court preside over the reorganization?"
If you really want to know this argument, you can start with a paper I just emailed Russ. "Agency Costs, Collateral, and Business Fluctuations" by Ben Bernanke. I just found it myself and plan to read it over the weekend.
"After citing all the ways in which the government has interfered and coerced the market, your conclusion is that it's a market failure."
Suppose the government restricted my car in such a way that made my steering a little let responsive. This sucks, because it's really going to slow me down, especially if I have to drive say through the mountains of Colorado. But that's all it should do, slow me down. If I don't slow down and drive off a cliff, it's still a driver failure.
"Then you seem to think that the market is some how separate and distinct from the "real" economy. Amazing."
It's a term of art in economics. The "real"
economy is things like output, productivity, employment… There are certain theorems that say under certain conditions financing or financial markets don't matter. It probably seems silly at times like these to separate the two, but it is just part of the research process. The economy is too complicated to deal with all at once, so researcher break it up into pieces.
Charlie
Failure of particular organizations is not a failure of the market. It's an inevitable, even desirable feature of market organization.
"Free market" is a slogan. Real markets are complex and don't conform to Rothbardian or Randian principles. We've never had an ideally free market by either of their standards (which aren't the same), and I don't what such a market would look like in reality. We certainly didn't have one in the U.S. for most of the nineteenth century, because most people agree that hereditary slavery violates free market principles.
This period was not ideally "free", and it also wasn't the shop of horrors you portray here. Were people poorer? Of course, they were. They had no electricity for one thing. They had no modern medicine. They had no green revolution.
I don't have a fundamental problem with booms and busts or even with DEPRESSIONs. What do you expect to happen to horse breeders and wagon wheel producers as people shift rapidly to driving cars? At best, a welfare state cushions these transitions. It does not and cannot prevent them.
Cheap, straw man argument.
So you don't think I want it then? That's reassuring.
No. I don't want stability. I want what Virginia Postrel calls "dynamism" and distinguishes from "stasis". In fact, this dynamism is essential for growth.
We all want "good" regulation definitively. No one wants "bad" regulation. Property rights themselves are market regulations.
We enacted different regulations. Our economy is hardly unregulated.
In fact, recessions have been remarkably brief and infrequent in recent decades, compared with preceding decades. It's not obvious that we're in a recession now. The official statistics don't show it yet. We probably need one, because we seem to have too many resources bound into unproductive organizations. When many factors move over a short period of time from less productive organizations into more productive organizations, output can contract for a time, because the new organizations don't become fully productive overnight.
Really? Where have I ever written "good old days" anywhere? Please quote me.
You needn't use my name when addressing your straw man. I have never anywhere claimed that any time in the nineteenth century was in any sense "better" than the present.
Right. You oppose old people starving and freezing to death, and I'm presumed to disagree with you about something, so I guess I must favor old people starving and freezing to death. Aren't you special.
A market reorganizing resources is not failing to organize resources inefficiently. "Efficiency" is not a static condition, and it's not some simple function with a single, static global maximum and no local maxima. When regulatory measures prevent this reorganization, the market fails to find a more efficient organization.
Sometimes a major upheaval is necessary to move an economy from a local maximum to a state from which it can evolve toward a higher global maximum. Economic development sometimes involves punctuated equilibrium.
The market is failing, because particular organizations are not allowed to fail.