Government's Role

I'm always underwhelmed by Stiglitz. A Nobel prize doesn't seem to come with a clue.

And what about those credit rating agencies that the regulators empowered by their governments empowered as their official risk surveyors and which with their AAA ratings allowed securities backed with junk to travel all over the world… to such an extent that the first bank to default because of this was a German bank that had never given a mortgage in Germany?

Without the AAA ratings this would never have happened… and that is just a fact!

Well done.

The politicians want to have it both ways. They want to assume ownership of the housing market by declaring it to be a public good, but then avoid responsibility by blaming greedy wall street, predatory lenders, or whoever else they can find to blame, when things don't work out quite the way they had "planned". I got news for the politicians - you stole it, you own it. You - not me. You want to buy up a bunch of bad real estate? Fine, take it out of your own pockets. Come up with $700 billion worth of spending cuts and buy whatever you want.

re Stiglitz: It is incredibly frustrating to see comparisons to the Great Depression thrown around so clumsily. "We learned from the Depression that markets are not self-adjusting." How does one reach that conclusion? I think at best, one could be agnostic on the question of markets self-adjusting in the 1930s and 1940s given that the US economy was essentially command and control.

"recessions and depressions that have periodically plagued capitalist economies" Please show me the economies that do not have recessions and depressions. Oh right, in the great theoretical utopia where strong centrally dictacted regulation results in perfect resource allocation.

Here's the key part, "But the financial markets have failed laughably at both. Hundreds of billions of dollars were allocated to home loans beyond Americans’ ability to pay." Ergo, "Economic theory—and historical experience—long ago proved the need for regulation of financial markets." Because the financial markets are currently unregulated and the federal government had no role in the mortage market via Fannie and Freddie.

"To curb inflation therefore means that the price of everything else needs to fall drastically to compensate, which means that unemployment would also have to rise drastically." It's amazing that someone a winner of the Nobel Prize in economics can also disregard most of the basic insights of economics.

Re; Stiglitz: "Today everyone—even the president—accepts the need for macro-economic policy."

1. Bandwagon

2. Flat out lie - and he knows it.

My favorite part:

Beware of trying to do good with other people's money. Unfortunately, that strategy remains at the heart of the political process, and of proposed solutions to this crisis.

Do you ever wonder if you have unfalsifiable beliefs? It seems telling that you've reached your conclusion and now you are searching for data.

Well said Dr. Roberts. There are few things in the economy that have a single cause.

As for Russ' article, I think it's important to point of the federal government's involvement in contrast to the claims of no regulation, but I also think it's important not to seem to blame everything on various federal laws (not saying the article did, but I've heard others make that charge).

Markets work far too well for most people's liking. With or without Fannie and Freddie, individuals freely make poor economic decisions even with strong regulations. The problem is not so much market failure, but individual judgment failure. Many seem to think they should be protected against any negative outcome -- at everyone else's expense.

I hear a lot about the "innocent victims" in this economic "crisis," but I've been hard pressed to find a lot of them.

Russ,

That's a very good article and you bring a lot of things together.

The story is very complex and requires a lot more investigation as to why things happened the way they did. You wrote;

" Without Fannie and Freddie's implicit guarantee of government support (which turned out to be all too real), would the mortgage-backed securities market and the subprime part of it have expanded the way they did?"

Wasn't there a time that mortgage backed securities didn't exist? I understand that repeal of the Glass Steagall Act took 8 different major lobbying efforts on the part of the banking and finance industry. I don't see how this crisis could have occurred had we keep to the simple model that separated banking and investment institutions. I suspect a lot of the pushes for changes in Fannie and Freddie occurred because they were privatized. And they had powerful lobbyist working to get the rules changed.

Do you think his could have happened had we not repealed Glass Steagall and passed the Commodity Futures Modernization Act? If you haven't even commented on the effects of these deregulatory changes you really haven't been trying to look at the whole picture.

Also when you point to Fed policy of lowering interest rates and the Taxpayor Relief Act as being implicit you have to remember those are things the industry called for. Also loosening lending standards... these are all relative deregulatory pushes.

Bottom line I'm still convinced Wall Street and the policies it pushed for had a lot more to do with this then ACORN.

Muirgeo,

There's evidence on the consequences of the repeal of Glass-Steagall -- and it is simply inconsistent with your assertion that that repeal is partly responsible for today's turmoil. Indeed, this repeal likely helped to keep matters from being even worse. See, for example, http://www.marginalrevolution.com/marginalrevol...>

There are few things in the economy that have a single cause.

I agree. Particular causes, and silly semantic disputes over the distinction between "government" and "market", are not very instructive. A more "macro" analysis seems useful in this scenario.

Why are investors exploring the tail of the risk distribution to this extent at this time, and why are they paying so much to explore it?

That mortgage lending was unusually risky recently is not news. That mortgages were increasingly unconventional was well known. The political influences and financial innovation discussed in this context was well known. I was a housing bubblist years ago, before it was fashionable. I knew about these things, and I'm not an expert.

The remarkable fact is not that politicians and financiers wanted to sell these bonds. The remarkable fact is that they did sell the bonds at prices that subsequently drove investors to flee the market for them. Why didn't bond buyers discount sufficiently for the risk?

We can't simply blame Barney Frank for their willingness. He was continually saying that government would not bail the bondholders out. Even if bond buyers didn't believe him, they accepted the risk that he wasn't lying (or self-deceiving).

Suppose our economy consists of three people, you, me and a banker. I build you a house. You borrow the price of the house from the banker and buy it from me. You build me a car every five years. I borrow the price of these cars from the banker every five years.

We also produce food, clothing and entertainment for each other while the banker accounts for credit extended, and we all accumulate account balances at the bank. We're wise enough to avoid the financial burden of raising children (or investing otherwise), so we have lots of cash to buy gold.

Eventually, all three of us retire with our account balances. What happens?

We starve to death, because we can't eat our gold. Money has no hands.

The payroll tax surplus peaked this year. While this surplus rose, the supply of rents was increasing relative to demand. Now, the supply of rents is falling relative to demand; therefore, the price of an entitlement to rent is increasing.

We'll go on paying more for entitlement to rents (and buying riskier promissory notes) for the foreseeable future, unless statesmen simply command lower prices by compelling us to sell entitlement to our labors and other resources at the price it commands.

Rising productivity doesn't solve this problem, because rent seekers aren't necessarily entitled to the value of this productivity, without the commandments.

Denying this reality doesn't change it.

I just spoke with a lawyer today who volunteered to do pro bono work for a person who is in foreclosure through a special program sponsored by our state's Supreme Court. He ended sending the first file back when he found these facts.

His "poor" client was living in a $300,000 house in the midwest (about 3,000 square feet) that was financed with a 125% undocumented loan. The client left closing two years ago with $75,000 cash and did not have to submit any proof of income. His client had not made a payment for 7 months.


I had heard that the subprime mortgages were risky, but this example seems beyond absurd to me. And this guy had the gall to sign up for a program that provide free legal representation? And who knows, when this is all done he may be able to keep his home with our taxpayer money.

Excellent article describing the significant contribution that Fannie and Freddie and CRA made to the financial crisis.

One issue that is still opaque to me is the paucity of information on the underlying assets on which the securities were based. Generally, mortgages are pooled to decrease risk through diversification -- e.g., combining loans with different maturities, from different geographical areas, at different interest rates, etc. Through such diversification, the risk can be spread.

What factors explain the fact that information was not passed up? Even now, the value of the underlying mortgages in the pools and tranches is almost impossible to assess. That is a critical issue.

Fran Smith,

I've had the same thought, but my guess is that valuation isn't all that difficult. You get out a spreadsheet and you break it down. So I'm thinking this really isn't an issue of capability, but rather of incentives. The people who know have an incentive to not tell, and the politicians who want to seize an opportunity have an incentive to not ask.

Wow, I am just a dolt with BS in Resource economics but how in the world can a guy with Nobel Prize in economics write the following:

But that would lead to more gas consumption, raise the price of gas further, increase our dependence on foreign oil, and expand our already massive trade deficit. The expanding deficit would in turn force the U.S. to continue borrowing gargantuan sums from abroad, making us even more indebted. At the same time, the higher imports of oil and petroleum-based products would lead to a weaker dollar, fueling inflationary pressures.

Does he not believe in Adam Smith’s idea if people in a country can buy a good cheaper that it can be made domestically that they should buy it. Does he not know that most of Americans fuel imports come from Canada? Does he not know that even if Adam Smith was wrong that for a little higher price Coal to liquids can substitute for petroleum and there is a lot of coal here in the USA, at a still higher price shale oil can be used to produce our fuel, and the list goes on, there is bitumen and other heavy oil around the world, so we are not dependent!

As far as the idea that some money spent on petroleum will trickle down to terrorists:

1. Terrorism does not take much money cutting off the money would require the total collapse in the price oil to about $1/barrel and with it the total collapse of Saudi and other oil producing nation’s economies.

2. To prevent any money from trickling down to terrorists would require the whole world stop using petroleum not just the USA or even the developed world.


3. Most of the money spent on petroleum that goes to the producing countries does not trickle down to terrorists but stays with those in those countries who are interested, just like us in reducing, terrorism.


4. The rise in terrorism coincided with a fall in Saudi average per capita income from 20K to 5K.

Now I am not writing this because I believe that McCain’s gas tax reduction is good. IMO the Gas tax should be enough to cover all Government automobile transportation expenditures including all roads construction and maintenance expenditures. Maybe even a little more to cover air pollution costs.

Two questions for Russ.

"Much of the rise in housing prices was the result of public policies that increased the demand for housing. Without the surge in housing prices, the subprime market would have never taken off."

The second sentence, which attributes the rise of subprime lending to the surge in housing prices, appears to be at odds with the thrust of the first sentence, which attributes "much of the rise in housing prices" to "public policies that increased the demand for housing." Please elucidate.

Second, to what extent do you think worldwide financial innovation like securitization was a factor in the disaster and would have had harmful consequences even without U.S. public policies increasing the demand for housing along the lines you describe?

The Fed's rates cuts aren't the sole cause, but they are the root cause. The rest of stuff (Fannie, Freddie, CRA, ect.) just determined where the new money would be injected into the economy.

Off topic abit:

But has anyonw seen this legislation from Sept. 27, 2008?


Is this what our TAXES pay for? I am deeply OUTRAGED! I Do not, cannot, will not support such an unabashedly socialist celebration.


View the Link to find out more concerning the new Federal Holidy now known as "New Deal Week" - http://thomas.loc.gov/cgi-bin/query/D?r110:1:./...

Even now, the value of the underlying mortgages in the pools and tranches is almost impossible to assess. That is a critical issue.

It's not impossible at all. It's just going to take a lot of work. Work that, I assure you, the government will not be doing. The banks selling to the government, I assure you, will. All bad news for taxpayers.

"It's not impossible at all. It's just going to take a lot of work. Work that, I assure you, the government will not be doing. The banks selling to the government, I assure you, will. All bad news for taxpayers.'

I'm sure that's why the press and other BS artists have suddenly latched onto the "mark to market" arguement. If the financial guys are going to be able to entertain offers on their toxic assets they can't sell anywhere else,then isn't it convenient that marking them to future cash flows rather than last trade is in fashion. So much for that phantom profit we the taxpayers will make.

Russ, good job. Keep trying to fit the pieces together. There are lots of them.

Many, I think most, disasters are a result of a chain of events. Break any link in the chain and the disaster is avoided. I learned this as a Navy Nuke studying nuclear incidents throughout history. There is rarely a single cause.

I date the beginning of the crises to August 1971, when Nixon severed the Bretton Woods system. Arnold Kling gets close to this in the EconTalk podcast about Fannie and Freddie. The savings and loan crisis began with the massive inflation resulting form Nixon's folly. In a world with a floating unit of account, free market participants create derivatives to help offset the risks they face from the rudderless currency. Such derivatives were never necessary before the end of BW.

Regarding the demand for housing, I think it helps to remember there is a socioeconomic ladder. Some folks jump up several rungs at a time, and others fall off, but many simply progress gradually. The surge in demand for more expensive homes as a result of TRA 1997 explains the high end, but why did the government need to interfere on the low end? The answer is because I cannot buy a $1million dollar home until I sell my $750k home. The guy buying my $750k home is looking to sell his $500k home, and so on. If the guy with the $50k home cannot get a buyer from the ranks of the renters, the system never gets very far. It wasn't so much social promotion at work as it was self interest. We all needed a buyer for our place if we were going to upgrade. We all had an incentive to help lower socioeconomic players buy a home, which is why we all allowed the changes at Fannie, Freddie, CRA, etc. to occur.

There's evidence on the consequences of the repeal of Glass-Steagall -- and it is simply inconsistent with your assertion that that repeal is partly responsible for today's turmoil. Indeed, this repeal likely helped to keep matters from being even worse. See, for example, http://www.marginalrevolution.com/marginalrevol...>

Posted by: Don Boudreaux

Here's the evidence I'm looking at. One can also put in the graph where Glass-Steagall was in effect ad were it was not. Also fill in the blancks on the graph of where the two great economic disruptions occured.

Free market capitalism is all about boom and bust cycles. I think it's no coincidence these bust occured after periods of republican dominance and relative deregulation. And then you have the 40 year period of increase regulation that was the most stable AND was associated with the greatest growth.

I have a lot to learn but I'm very sketical that the data supports your claims.


I will indeed review your references when I have more time. But still just from a simple logical stand point I''m guess none will explain how this could have occured without the seperation of lending from investment.

The surge in demand for more expensive homes as a result of TRA 1997 explains the high end, but why did the government need to interfere on the low end?

If the problem is confined to the low end, why did the "stimulus package" increase the conforming limit to $729,750? Or is this figure now "low"?

If the guy with the $50k home cannot get a buyer from the ranks of the renters, the system never gets very far.

I just bought a $100,000 condominium (and I'm very happy with it) without first selling my $100,000 house. Barring catastrophic events, I'm not a default risk, regardless of falling house prices, so I don't understand this logic. Next year, if plans mean anything, I'll sell my house, buy a new new house with my new wife, keep the condo and still be a very manageable default risk.

We all needed a buyer for our place if we were going to upgrade.

Upgrading is not a problem if you can afford the house you're upgrading to. The process you describe needn't inflate house prices, and the rise apparently wasn't confined to mobile homes in trailer parks.

I am not believing that Barney Frank's easy credit for buyers of $50,000 homes somehow created a chain reaction inflating the price of million dollar homes. The idea is absurd on its face. When I look around, I don't see an explosion of trailer parks or even a lot of unoccupied, moderately priced housing. I see a lot of new, quarter to half million dollar homes sitting unsold or half completed, and these homes are not "moderately priced" in my neck of the woods.

The Misean explanation makes a lot more sense to me, and his explanation has nothing to do with the Community Reinvestment Act or any similar act. TRAs and CRAs aren't irrelevant, but they aren't remotely the whole story or even the most interesting chapter.

The Misean explanation is not particularly about hard money or central banking either. A central bank can inflate, but inflation does not imply a central bank. Inflation is about excessively easy credit, and rent seekers with too much cash, for whatever reason, can create this pressure.

"One can also put in the graph where Glass-Steagall was in effect ad were it was not. Also fill in the blancks on the graph of where the two great economic disruptions occured."

Correct me if need be, but are you saying the repeal of Glass Steagall reduced the number of bank failures? Glass steagall was repealed in 1999 and your chart shows little bank failures after that point and a large amount of failures in the 80's when Glass Steagall was in effect.

Free market capitalism is all about boom and bust cycles.

Socialism is all bust and no boom.

Yes, the bank failures from 1932 to 1940 when FDR was in office was all fault of just the Republicans. LOL. From 1981-1990 was also all fault of just the Republicans. Great! Does it really matter who was in Congress?

Free market capitalism is all about boom and bust cycles.

Muirgeo,

A central bank is all about boom and bust cycles.

Rothbard on:

America's Great Depression

Economic Depressions: Their Cause and Cure

The Mystery of Banking

The Misean explanation is not particularly about hard money or central banking either. A central bank can inflate, but inflation does not imply a central bank. Inflation is about excessively easy credit, and rent seekers with too much cash, for whatever reason, can create this pressure.

Yes, the definition of inflation does not specify an agency of inflation, however, the history of government control of currency and credit issuance (either directly or indirectly) shows that governments will inflate when direct taxation becomes politically infeasible.

In a system where currency and credit is private, the market will give feedback to those who attempt to cheat. The government is about resisting such feedback.

The core of our fiscal problems is government spending.

it's more convenient to blame greedy capitalism than a distributionist politically correct government program that was created to make the "American dream " available to all. Having a fed does not make the case for free markets much easier either. Great article!

His "poor" client was living in a $300,000 house in the midwest (about 3,000 square feet) that was financed with a 125% undocumented loan. The client left closing two years ago with $75,000 cash and did not have to submit any proof of income. His client had not made a payment for 7 months.

I had heard that the subprime mortgages were risky, but this example seems beyond absurd to me.

Posted by: pauld

Do you think this lender/ mortgage broker would have made the loan if he knew he couldn't ponzi it off to some one who would securitize it? NO WAY.

Banks who have the priveledge of lending from the Treasury and being backed by the FDIC should never have been allowed to securitize loans.

What factors explain the fact that information was not passed up? Even now, the value of the underlying mortgages in the pools and tranches is almost impossible to assess. That is a critical issue.

Posted by: Fran Smith

That's a very good point.

Unregulated rating agencies and unregulated securities... look into The Commodities Futures Modernization Act of 2000... that's what allowed this degree of asymmetrical information to invade and destroy the "freed economy".

It's a sad ruse to try an explain this all away on lending practices pushed by Fannie, Freddie and the CRA when the majority of sub-prime loans were not under their regulations. Also other countries are having major housing crashes even thought they have no Fannie or Freddie lick institutions.

Finally there was a similar housing crash that prior to the Great Depression that occurred with out such regulation and in fact resulted in the regulations that worked until they were repealed.

The whole thing is just ridiculous. We have had a bubble economy based on cheap credit and debt ever since Reagan.

The speculators saw the Social security treasure a good place to raid next. Fortunately they were defeated. With working peoples wages stagnant and no extra money to spend they saw the last bit of value to exploit in the housing market. They worked for years and years to set it up for exploitation.. they succeeded.

The sub-prime crisis is simply the latest get rich quick scheme for the Wall Street Raiders.

As we sit and sort out the details they are, as we speak, looking for the next speculative bubble to create profit from and leave the rest of us picking up the pieces. I understand it will likely be in commodities (gold, oil, other energy source)

The Hedge Fund managers are retired to their 100,000 acre ranches comfortable in the fact there are plenty of academics and talking heads providing cover for them while they work on the next pyramid scheme.

They just love the concept of free markets because for them the money comes pretty much free... siphoned right out of the productive economy or what is left of it.

The whole thing is just ridiculous. We have had a bubble economy based on cheap credit and debt ever since Reagan.

You are cherry picking the date. We have had a bubble economy based on cheap credit since that fascist named Woodrow Wilson occupied the white house.

Russ,

I enjoyed your article in WSJ. But I think you are down playing the role that the Fed played in all this, by distorting price signals - interest rates.

That bailout worked out well....

And now we have a bureau of "Financial Stability" - is that what they're calling it?

We're screwed.

The Bureau of Financial Stability? Holy crap. Its like something straight out of Atlas Shrugged.

Sounds like the National Recovery Administration. Sieg Heil ...

More than home loans

"Though all eyes have been focused on faltering mortgage-backed securities, the Treasury Department last month amended its original $700 billion bailout plan to buy up a wider range of troubled assets after heavy lobbying by financial industry groups."

Told ya so.

"Last month" was three days ago.

Methinks, we've been screwed. Now we're...well a certain five letter word staring "r" comes to mind.

Yep, we're about to see something new - a run on the treasury.

Muirduck has spent eighteen-plus months telling us that Democrats are as pure as the driven snow.

I'm shocked, SHOCKED, I tell you to find out that the liberals have been bought out by those EEEEEEEEEEEVIL Wall Street-types and voted for the bailout over House Republican objections.

What's a good Commie to do? I'm waiting with bated breath for our resident socialist asswipe to tell us.

We have had a bubble economy based on cheap credit since that fascist named Woodrow Wilson occupied the white house.

Posted by: Oil Shock

Hey at least he admitted it was the biggest mistake he ever made. And it's important to understand he acted in the interest of what some of the biggest bankers of the time wanted. The Federal Reserve then as now is just an instrument of bankers to control the rest of us.

Yes, a Progressive Democrat used the coercive power of the state to create a banking cartel which has been wrecking havoc on the economy ever since. I totally agree. I honestly do.

Hey! Let's give Democrats even more power over our lives! What could go wrong?

Muirgeo says:

"The speculators saw the Social security treasure a good place to raid next. Fortunately they were defeated."

Yes, they we're defeated by government bureaucrats. These "representatives of the people" have been raiding SS largess for some time now.

It is easy to see why such an archaic & illogical program like SS exists: it's free money to the bandits in Congress.

If its any comfort, the people that are telling us that Social Security and Medicare are doing fine are the same people that told us that Fannie and Freddie were doing fine. I guess in a way they are right, if by fine they mean that if things get any worse the federal government will just nationalize all retirement funds and the healthcare industry. Isn't that a comforting thought? I know I feel comforted.

Just heard a good one, seriously, rolling on the floor funny. Watching the news and the news lady comes on with the teaser, "The bailout. It was supposed to rescue the economy, but could it have exactly the opposite effect? Stay tuned."

So what's funny about that? Well, just yesterday the same channel was pushing that we absolutely must pass the bailout or life as we know it will end. I just think its funny as hell that they didn't take the time to consider the possibility that the "plan" might not work - or that the result might be something other than what was "planned".

So, what was this all about? What was the motive? Well, how about the 700 billion dollars?

Paid for by the 'Someone better start pointing out the obvious' committee for a better planet.

From Wednesday's Pearls Before Swine by Stephan Pastis.