Did we *really* need that bail-out?

by on September 10, 2008 at 4:27 pm in Economics | Permalink

The highly-praiseworthy-but-ever-so-occasionally-totally-wrong Bryan Caplan suggests that Paulson should have simply let the debt securities of the mortgage agencies go.  In addition to the fact that he favors The End of the World, Bryan is underestimating at least two points:

1. The current operation of the money market requires ongoing faith in a variety of assets and commitments.  Just try tracing through the consequences of a general "run" on money market funds, which "promise" a redemption ratio of $1 a share but on the other hand really don’t make such a promise.  How quickly would Merrill Lynch cry Uncle, how quickly would the Fed’s balance sheet be exhausted, and how many commitments would they have made in the meantime and how many people would have to sell stocks to find cash and make margin calls?  Or think about what would happen if FASB ruled that Frannie debt securities did not qualify as "ready cash" for accounting purposes.  (As a general tendency I find that economists vastly underrate the importance of accounting as an economic force.  I might add that many market advocates are unaware of how quickly liquidity can vanish in these markets; just look at auction-rate securities.)  And those aren’t even the biggest potential problems arising from a default.

2. In essence we already agreed to the bail out some time ago.  Have you ever spent $17,000 on a car and asked the dealer what the warranty for the car "really meant"?  Well, the Chinese spent $340 billion on agency debt and probably asked the same question at least once or twice.  They live in a world of secret agreements with leaders, not transparent democratic arrangements.  So when it comes to the U.S government decision, we’re not just starting from scratch here.  How many phone calls do you think Hank Paulson has received from the Chinese central bank since August 2007?

"Are you *sure* that paper is safe enough for us to keep on buying?"

We’ll never know exactly what kind of verbal dance Paulson concocted in response, but just look at the resulting flow of purchases and the relatively slight mark-up over Treasuries over that period of time.  The Chinese (among others) thought we were standing behind the securities, at least in any world-state short of federal government quasi-bankruptcy.  (In fact Paulson is in a total bind once that phone call comes in.  He doesn’t have much incentive to just say "tough luck" and precipitate a crisis when otherwise no crisis is on the horizon.)

So should we try this: "Oh, is that what you thought?  Guaranteed?  Did we use that word? Sorry, try reading our signals better next time.  We love you.  Great job with those Olympics.  And when it comes to those Treasury Bills, we really do still mean it.  And don’t forget to support us on Iran and North Korea."

The libertarian critique of the mortgage agencies is, in my view, very much on the mark.  But still the error has been made and we must pay up.  As Steve Chapman points out, the bailout is a necessary evil, but with emphasis on the word "evil."

Seth Burn September 10, 2008 at 4:51 pm

Look, I understand what you are saying, but then why the spread between T-Bills and Fannie and Freddy? They got the benefits of the increased rates with the guarantee of payment? It seems like Fannie and Freddy weren’t too big to fail, but the creditors were too big not to pay. That is a major problem and foretells the end of America as we know it. China now controls enough of our debt and the value of our currency that we must do their bidding. Game over boys, we are in the control of a totalitarian state.

JordanT September 10, 2008 at 5:58 pm

Have you ever spent $17,000 on a car and asked the dealer what the warranty for the car “really meant”?

No, and I would fully expect the dealer to fully renege on any verbal backroom deal and point to the signed and written warranty contract.

David Wright September 10, 2008 at 6:04 pm

Without a lot more evidence, I am very skeptical of your emphasis of the role of China in this nationalization. I don’t doubt that the Chinese expressed their opinion clearly, but that’s not the same as the administration being moved by that opinion.

The administration had plenty of purely economic reasons for fearing a GSE default. The administation has not shirked back in the past from doing what it wanted in the face of Chinese, and indeed even worldwide, opposition. The Chinese clearly had no legal recourse, and probably wouldn’t threaten military recourse. The only realistic and frightening threat they could make would be to stop buying T-bonds, but given their merchantilist growth strategy based on US consumption(not to mention what that would do to their own T-bond holdings), that’s not really a credible threat.

If you want to convince me that China is the key here, you’ll have to get Paulson in an interview saying “we were planning to let the GSEs fail, but then I got a call from W. saying the Chinese were threatening to fire ICMBs at Washington, and the Pentagon was saying they couldn’t stop them”.

David Wright September 10, 2008 at 6:11 pm

ZBicyclist:

I believe the GSEs guaranteed their paper against prepayment risk as well as default risk.

But even if I am wrong about that detail, the spread between GSE debt and treasury debt had increased by over 100 bp over the past few months, which means some new risk — default risk — must have developed over that time.

lxm September 10, 2008 at 6:19 pm

How many more rich people do we have to save before we are safe?

Nemo September 10, 2008 at 7:03 pm

“But still the error has been made and we must pay up.”

Um… *I* did not make any error, so I do not see why *I* should have to pay up.

What’s that? You say the alternative is the collapse of the global something-or-other, and it would ultimately hurt me, too? Well thank you so much for your concern, but I will gladly take my chances.

I am getting a tired of all this “we” talk. As near as I can tell, the only time people I do not know use that word is when they are trying to pick my pocket.

Simit Patel September 10, 2008 at 7:17 pm

Thanks to the policies of the Federal Reserve, we are already in no man’s land. Sadly, it seems as though the next bubble — after Nasdaq, after housing — is insanity, which is clearly through the roof.

The bailout is going to destroy the dollar and create more inflation — more than we already will be facing, which is quite a bit. I would rather suffer the financial/economic consequences of letting them die rather than death by hyperinflation. While neither option is pretty, and while both are immensely painful, I think a “let them die” approach to Fannie and Freddie is ultimately healthier for the economy and more “just” in the sense of letting those who took improper risks bear the greater portion of the calamity.

Of course, the ultimate problem is the Fed, and any real solution to our pending economic/monetary crisis begins with addressing that issue.

Bernard Yomtov September 10, 2008 at 8:48 pm

I think that those who differ with Tyler here ought to imagine themselves in Paulson’s place when he gets that phone call from the Chinese – back when things didn’t look particularly perilous for Fannie and Freddie.

Matt September 10, 2008 at 9:43 pm

In most areas, I’m as libertarian as they come. But there’s something to positive feedback loops of exuberance and pessimism overshooting the correct value of assets in a free market economy. In 05-06, the Chinese and others with capital backed MBS’s because everybody agreed with each other that there was no housing bubble. Subprimes and even A-1s were a small part of demand for housing and the 30-year fixed loans had always been nearly default-proof before.

It works the same the other way. What exactly would happen if Freddie had no choice but to declare Chapter 11? In a perfect world, some T. Boone Pickens would go bargain-hunting with thier billions the next second to counteract the precipitous drop in asset prices. But that doesn’t happen in the real world. In the real world, people in a downturn go 1990′s Japan and horde money, except for buying nice safes of course.

Before the FDIC and better financial regulation, booms were much higher and busts were much deeper. The crash was just the largest bust followed by the largest boom. While FDR did prolong his depression with his socialist and unionist policies, the new financial regulation helped America achieve relative stability until the late-70′s when inflationary policies came home to roost.

Similar to the 1920′s, the financial innovation and increased globalization post-2000 gave way to an unfounded rise in asset prices. But those that do hold capital must soften the landing using minor one-time inflation instead of the alternative of depression.

David R. Henderson September 10, 2008 at 10:02 pm

Dear Tyler,
Four things:
1. You’re using the word “we” incorrectly. I never made a commitment to the Chinese buyers and neither, I suspect, did you. If it happened, it was the actions of a few individuals. You can’t even argue that those individuals had the legal authority to promise full faith and credit. They didn’t. (For more on the misuse of “we,” see my “Who is We?” http://www.antiwar.com/henderson/?articleid=7889
2. You make a good point about converting our money market funds at par. But so what. If we took a haircut on those, it would be a couple of percentage haircut. So if you have $20K in a MMF, you lose $400 to $600. No catastrophe here.
3. You’re confusing a wealth loss, which, I agree, would happen, with a contraction of the money supply. To make your case, you would have to argue that the money supply would contract.
4. If your argument is that the money supply would contract, that would increase the value of the dollar, not decrease it as you said in your previous post.
Best,
David

Anonymous September 10, 2008 at 11:36 pm

It’s disturbing how many people seem to be saying, in effect, “Bring on the Argentina moment and let the chips fall where they may”. Do you really want to live in a world where essentially no one can buy a house except for cash upfront? A world where the US budget needs to be balanced more or less overnight? Maybe we’re headed there anyway, but buying time is surely a better option.

Do you seriously think that China would meekly continue buying Treasuries after a Frannie default, because they supposedly have no choice? Generally speaking, in the Chinese way of doing business, personal relationships still count for a lot more and written contracts count for considerably less. Invoking “nothing personal, it’s just business” doesn’t go over well, because it’s always personal — if it wasn’t personal, there wouldn’t have been a deal to break in the first place. Tyler is absolutely correct that as the crisis unfolded over the past year, China must have sought ironclad personal assurances from the very top and would consider that to trump the letter of any written contract. They would not have bought such high levels of GSE debt otherwise, and would react with absolute fury at what they would consider deception and a very personal betrayal. Decisions made in a state of fury often do not correspond to rational self-interest.

China has been working with the US to sustain an unsustainable status quo, because an abrupt realignment of the world’s financial tectonic plates will bring great pain for everyone when things inevitably finally snap — but this is precisely the sort of thing that will trigger the snap. Foreign central banks would consider a GSE default equivalent to a US government default (whether you or legal scholars or anyone else agrees with that is irrelevant), and would act in accordance with that belief. The myth of risk-free US government debt would be forever shattered and interest rates on Treasuries would rise sharply and permanently. US sovereign debt would follow in the footsteps of Fannie and Freddie, from unimpeachably rock-solid to shaky in a hitherto inconceivably short time. Unthinkable is not the same as impossible.

One “interesting” retaliation option for China would be to confiscate US intellectual property — trademarks, patents and copyrights. There is precedent for this: in 1994, Bayer had to pay $1 billion to buy back the US rights to its name and trademarks, which it lost during World War I.

Yancey Ward September 10, 2008 at 11:56 pm

One thing is abundantly clear, now- no amount of financial risk is too much- indeed, the bigger the bets, the less risk there actually is. If your bets win, you make billions, if your bets lose, you get bailed out. If I were running a large financial firm, I would make the “riskiest”, most profitable bets I could possibly devise. Anyone care to take a shot at where the next failures are going to show up and why?

Anonymous September 11, 2008 at 1:49 am


You’re assuming that they were currently in crisis and the choices were bailout or massive default. This is not a valid assumption. Their regulator said they met capital requirements. They had so far had been successful in rolling over their debt. The stock went to 0.7 from 7 after Paulson’s plan, not before. The GSE’s weren’t in great shape, but they weren’t in some imminent crisis either.

With all due respect, this is sheer revisionism. The writing was very much on the wall. For instance:

Aug. 20 (Bloomberg) — Fannie Mae and Freddie Mac’s success in repaying $223 billion of bonds due by the end of the quarter may determine whether they can avoid a federal bailout.
[...]

Rolling over the debt “is the single most important factor to their ability to remain liquid,” said Moshe Orenbuch, an analyst at Credit Suisse in New York. “So far, they’ve been able to do that.”

At the end of August the picture had become clearer. By September 2, Brad Setser, who follows Chinese purchases of Treasuries and Agencies more closely than just about anyone else, noted the ongoing reduction of central bank demand for Agencies, in particular drawing attention to the very bad August datapoint showing strong flight into Treasuries, and commented with understatement (via Naked Capitalism):

If these trends continue for much longer, US Treasury Secretary Paulson will be forced to show his hand. The Agencies won’t be able to rollover their debt — at least not at a spread that works for them. The US government will then either have to step or let the Agencies fail. And, well, letting the Agencies fail, in the sense of default on their debt, is probably more than the US government is willing to consider right now. Any restructuring though would likely be bad for the holders of the Agencies common equity.

The game was up: the buyers’ strike (and probably a few overseas phone calls) made it clear that the debt would not be rolled over successfully at the end of September. That is what forced Paulson’s hand. The fact that he commendably acted a few weeks before the absolute deadline is now being spun by some into the fantasy that it was not necessary for him to act at all.

It was an open secret that the common shares were going to zero. So why were Fannie common shares actually up (to $7) on the Friday before? Chalk it up to a combination of wary professional traders burned by the short squeeze triggered by the SEC’s July restrictions on shorting financial institutions and fearing a repeat intervention of some sort, and naive retail investors who probably thought that the word “bailout” actually implied good news for the common shares.

Stephane September 11, 2008 at 3:17 am

Would the result of a GSE default be so clearly negative for China? On the one hand, they would lose part or all of their agency debt investment. But on the other hand, they hold a lot of government debt. Ultimately, its value depends on how the dollar will move. A financial market meltdown would reduce significantly the money supply. And it could increase the demand for dollars if people believe that monetary expansion is coming to a halt and they start anticipating deflation. In other words, government debt would become more and more valuable. So, between these two opposite effects – GSE debt losing and govt debt gaining value – which one would affect China most?

Andrew September 11, 2008 at 4:45 am

By rescuing alpha chasers, you lock in the punishment of GNMA holders and corporate bonds. Why would anyone buy non-ginormous government associated bonds? Bad for us. We should not forget that whatever the current actions, major screw-ups happened. Just because you may not like my “chips fall where they may” after the chips are already in the air, doesn’t make the cause of the situation different.

But for me, going forward, I don’t even have to get past the utilitarian argument. I had the ironic (to me anyway) thought that while I’ve been chanting containment on these comments pages for months, all the experts are screaming contagion to justify spreading around the contamination.

The Chinese are businessmen. What are they going to do with the dollars we exchange for their exploding tires? Bury them?

Dannyboy September 11, 2008 at 6:02 am

A few technical clarifications for the sake of better arguments:
The GSEs guarantee Mortgage Paper (MBS) against default. It is considered AAA. It is not guaranteed against prepayment. Hence it has a spread to treasury (OAS). The Chinese (and every other government) bought this.

The GSE also issue debt. It has many forms/flavors. Bullet, callable, step up, flip etc. It carries a spread to treasury due to credit risk of the GSEs. Typically this was 30-40bps.

The GSE’s make money on the difference between the OAS and the debt spread. Think 100bps. They have to hedge the duration mismatch (prepayments) and that reduces their net interest margin.

World governments own both kinds. The later was perceived riskless. While the former was perceived to only have interest rate (prepayment) risk.

2nd point – the FASB has never declared that the GSE debt is “money good.” That is an unfortunate falsehood by the author. Anyone holding GSE debt that only pays 30-40bps should be marking it DOWN over the last 3 months when spreads widened to 80-90bps.

But, 40bps over 10yrs… how much off par is that?

What is very disturbing in all of this, and has not gotten much press, is that the pref shares of the GSEs were rated AA. AA?!?!?! How can something worth 0 be AA?

I understand the AAA rating on the implicitly guaranteed debt / mortgages. But the rating agencies should’ve moved much faster on AA paper that became WORTHLESS over night.

Tyler Cowen September 11, 2008 at 6:45 am

David, step one is “runs” on most financial institutions, especially those without the FDIC guarantee. We know the outcome there is very bad and even Fed liquidity has its limits, and that’s assuming that we choose to bail out MMFs, credit swaps, investment banks, etc. but not the agencies, an odd choice. Given that we know the costs of runs are very high, I’m not sure why you see the whole scenario as my extreme speculation. As for M, most likely base money goes way up, broader measures of the money supply collapse, and foreign investors stop supporting the dollar. That’s about the worst possible mix to happen with M and it would not entail a strengthening of the currency, to say the least.

J Thomas September 11, 2008 at 9:34 am

The problem is bigger than it looks.

We got through the 90′s with the dot.com bubble. A bunch of people investing in the internet because it looked like the great new thing, with no business plan. That investment spending sped up the economy with a classic accelerator effect. Then all of a sudden most of them noticed they weren’t going to get anything for their investment, and they quit.

Lacking anything better we got a real estate bubble. Buy a fixer-upper, fix it up and sell it. Take the money and buy a better house. Etc. People got tax breaks on their housing loans, and they paid the tax if they sold and didn’t buy a new house with a new loan. It didn’t have to be a ponzi scheme, but it got played like one. People who were stuck in dead-end jobs with no prospect for pay improvements to match inflation got to feel like they were making money. But they weren’t, really. What it amounted to was they got to take out loans against their paper profits.

The system required more and more people to buy homes, and when they ran out of qualified buyers they were in trouble. Meanwhile “we” built lots and lots of new energy-inefficient housing. It wasn’t cost-effective to improve insulation etc if you assumed that energy prices won’t rise over the lifetime of the building.

People who believe in markets figure that when individual people make stupid choices it isn’t a market problem. They do something stupid, they lose their money, all’s right with the world. Even when millions of people make stupid choices there’s nothing wrong with the market. What we have here is a case where the smart money got sent out of the USA before the dollars got devaluated so much. The money still invested in the USA is all stupid money. We’re all bozos on this bus.

So, let’s say the market boom is over, and somebody has to pick up the pieces and take the losses. What are we going to do to earn the money to pay back those losses? Do we just take the money from whoever has it to paper over the mortgage risks? I guess so. In the short run. But beyond that you need a plan.

Say your house burns down and it turns out your fire insurance was a swindle. Yesterday your finances were somewhat shaky but not bad. Today you owe $300,000 with no collateral. Tomorrow your house payment is due. Do you borrow money to make that payment? Probably. You don’t want all your creditors coming after you at once before you have a plan. But by next month you want to have some sort of plan. You can’t afford to take out short-term loans to pay the house loan.

Sure, it’s a catastrophe if these big institutions are allowed to fail. We have a catastrophe coming and propping them up brings it faster and bigger. What’s the plan?

Scott Wentland September 11, 2008 at 9:39 am

If it is a “run” on the financial sector, this implies some sort of panic that is a temparary departure from fundamentals. The Fed could act as lender of last resort, provide short term liquidity to stave off this panic (lower the discount rate, expand its scope and allow more non-member banks and financial institutions to borrow, etc.). This liquidity can keep the financial sector afloat until we see a return to fundamentals. It’s not clear to me why you prefer the more intimate intervention with the GSEs over the more standard intended role of the Fed.

Also, it’s not clear what the “limit” of this liquidity is. Exactly how much money can the Fed print?

It seems like the (temporary) expansion of the base and the (temporary) contraction of the broader measures of M have conflicting effects on the dollar. News of a recent falling commodity prices could temporarily insulate the consumer, while a temporary dip in the dollar could boost exports and foreign direct investment. I, too, still underestimate your disaster scenario and the federal government’s recent actions.

floccina September 11, 2008 at 10:05 am

A little off topic but I had to think who made the big money in the makeing of this problem? The builder, net sellers of homes?

datadave September 11, 2008 at 12:17 pm

As much as Tyler might deny it, deregulation of financial markets is what is causing this finanialization crisis. When the financial sector gets so big w/o corresponding productivity gains, one has to wonder what all those financial geniuses are making so much money doing?
I know that rightwingers hate Kevin Phillips and others complaining about ‘financialization’ of the economy they are being proven now.

Remember the same clowns who wanted our Social Security payments to be entrusted with the corrupt Wall Street crowd? So what are all those Hedge Fund billionaires doing for US of late?

Henry September 11, 2008 at 12:54 pm

Even given a private guarentee to China, there is a big leap from “we privately guaranteed China’s $300B” to “we should guarantee all $7000B”.

When in a hole, stop digging.

Adam September 11, 2008 at 6:49 pm

the only thing the bailout taught me was to never again invest in companies that can be potentially bought out by the government. Look at the stock price now.

d g lesvic September 12, 2008 at 12:30 am

You’re all making this way too complicated. The simple fact is that a sub-prime mortgage is a non-free market mortgage, a creation of the “governmental” policy of providing mortgages for those who would not have qualified for them in a free market. In the free market, they would not have been sub-prime but non-existent. If sub-prime mortgages were the creation of “government,” so was the sub-prime mess, the solution to which is not more but less of what created it in the first place, not more but less “governmental” involvement in the housing market.

d g lesvic September 12, 2008 at 4:08 am

J Thomas wrote:

“D G Lesvic, history has shown that in the absence of government intervention the free market gives us a “business cycle” with more-or-less periodic depressions. That’s how it works. Just as canadian rabbits and lynx populations fit a Lotka-Volterra equation, so do unregulated economies.”

J Thomas, history has just shown the opposite of what you say. I repeat: a sub-prime mortgage is really a non-free market mortgage, created not by the market but “government,” making mortgages available to those who could not qualify for them in a free market. In the market itself, they wouldn’t have been sub-prime but non-existent, and, there could have been no “sub-prime mess.”

The solution to the problem is not more but less of what created it in the first place, not more but less “governmental” involvement in the housing market.

meter September 12, 2008 at 12:13 pm

To pin this all on poor people getting mortgages is really short-sighted even if I agree with you that government had no place getting involved. A spate of delinquencies alone wouldn’t have wrought havoc on our economy.

What has wrought havoc on our economy is the financial services sector (of which I am a part) which has created all sorts of instruments and strategies that have magnified that problem by many orders of magnitude. SIVs, MBSes, CDOs, CMBSes, risky leveraging, and the topper: accounting trickery (Level 3 assets, mark to market, mark to model).

d g lesvic September 12, 2008 at 1:17 pm

J Thomas, Give me one example of a business cycle not caused by “government,” and explain how a free market by itself could generate a business cycle.

meter, You’re stretching to blame the free market for something that you admit originated with “government.”

You say that a spate of delinquencies wouldn’t have wrought havoc on our economy, but that Wall Street’s magnification of the problem did.

How could the “magnification” of the problem have occured if there had been no problem in the first place?

And how could the machinations of Wall Street bring down a house of cards, unless there had been a house of cards to bring down, our whole dishonest, fractional reserve banking system, created by “government?”

J Thomas September 12, 2008 at 3:01 pm

D G Lesvic, since by your question you admit your utter ignorance of economics I’m not sure how much I can do for you, but I’ll try. Start with wikipedia.
http://en.wikipedia.org/wiki/Business_Cycle

Until Von Mises, no reputable economist imagined that business cycles might not be inherent to capitalist economies. There were various attempts to define particular causes.

The central problem follows from the nature of feedback loops, and you would see it easiest by taking a course in control theory. These courses are typically taught by EE departments. Here is a wikipedia link.
http://en.wikipedia.org/wiki/Control_theory

The simple example people usually start out with is a thermostat. A mercury switch on a bimetal thermometer turns off when the thermometer gets hot and bends one direction. Then when the thermometer cools off and bends the other way, the switch turns on. The switch is connected to a heater. So the heater turns on and makes the thermostat hot enough to turn the heater off, and then the thermostat cools down enough to turn the heater back on. You get a cycle of warmer and cooler temperatures.

The cycle is caused by the delay between the signal and the response. When the response is too great, it creates a large slow cycle, it quickly heats things up and turns off, and then takes a long time to cool down enough to get another big burst of heat. When the response is too small then it may not actually stabilise the temperature at all. When it’s just right then the switch might vibrate between on and off, sitting on the edge, working so fast that no cycle is seen. That’s rare. And then any external shock can throw it off.

Two vital factors. The timing of the response and the size of the response. To get good control both of those must be optimised. Why would you expect a system to optimise those when everybody is reacting to the system in his own best interest and nobody is in a position to tune the system?

Remember, if you are in a position to affect or even predict the delay in an economic feedback loop, you can profit from both sides of the cycle. Would that encourage you to tune the loop to best serve the greater economy? Is it any wonder that there are large unexplained fluctuations?

Give me one example of a business cycle not caused by “government,”

You might consider the long cycle from 1825 to 1843. The government was weak. The Federal Reserve did not exist. The main way the government could influence banks was by passing laws that they were supposed to abide by. The number of federal employees was very low. During this time the federal debt had gone from $90 million to zero. Van Buren was harshly criticized for doing nothing about the panic of 1837 and resulting depression, but there wasn’t really much he could have done.

While there are some people who blame the bubble and its bursting on the US government, they are fools.

meter September 12, 2008 at 4:54 pm

I know nothing about the economics of that period in American history and won’t pretend otherwise. Obviously my points are regarding the here and now. Are you disputing my claims?

J Thomas September 12, 2008 at 6:45 pm

DG Lesvic, if you want to you can argue that any time there’s a government then that government is doing things that might be influencing the economy, and so maybe that government is entirely responsible for the business cycle.

I can’t prove you’re wrong. I can’t give you any examples of business cycles under complete anarchy because we don’t seem to have any business records from such periods. Whenever the governments have collapsed completely people have stopped keeping records about how well the bartering is going.

You can say that the cycle I’m talking about was the government’s fault because it didn’t adequately regulate the banks, but that’s backward.

This will all make more sense to you if you build some control structures. See what it takes to tune them. They don’t automatically tune themselves to do what you want, if you create a self-tuning control loop you still have to set its targets.

The idea that free enterprise systems automatically optimise something in particular is just stupid. To make it work you have to take whatever results they give you and argue that this is the optimum we ought to have wanted.

To build a free enterprise system that optimises what you want it to, somebody has to carefully design it and then carefully tune it.

dg lesvic September 12, 2008 at 8:37 pm

Sorry, I inadvertently posted some of Thomas’s statements as my own, the last 3 paragraphs of my posting. That was Thomas, not me.

J Thomas September 12, 2008 at 11:56 pm

DG Lesvic, you are not qualified to have an opinion on this topic.

Your claim is first that markets provide feedback loops. This is true.

You go from there to claim that market feedback loops must optimise something, in fact everything. You further claim that they must approach an equilibrium. Both of these claims need a great deal of verification. There is strong reason to believe they are not true and no particular reason to believe in them.

In general feedback loops do not approach equilibrium.

A feedback loop might perhaps optimise something. There’s no particular reason to assume it will optimise anything in particular.

Your ideas were popular in the early 19th century. The concepts were new, and so there was the belief that evolution has adapted every possible trait of every biological organism to be perfectly adapted to its ecosystem, and each ecosystem is perfectly adapted to its physical environment, and each human economy is perfectly adapted to provide for its population.

It’s true that evolution does occur and organisms tend to become better adapted to the persistent behaviors of their ecosystems. And ecosystems do over time improve their responses to their physical environments, other things equal. And economies do occasionally and haltingly become better able to respond to the particular sorts of challenges they face repeatedly.

But to say that there is anything optimal about these processes is to go far beyond the data.

J Thomas September 13, 2008 at 9:29 am

Maybe there’s a place online where you can do javascript simulations of control systems. There ought to be. There ought to be a way for people to learn this stuff short of going after electrical engineering degrees. (Which I don’t have myself, I’m a mathematician.)

Very often feedback systems do not approach an equilibrium.

If the direction of the response is the same as the direction of the original stimulus, you get positive feedback — it just builds on itself and heads toward infinity until something else intervenes.

If the direction of the response is in the opposite direction of the original stimulus, but it’s *too strong*, then you overshoot. The response pushes things too far, and then you head back to equilibrium from the other direction but overshoot again, and you head back to equilibrium once more but overshoot etc. It’s possible for those oscillations to gradually die back toward equilibrium. It’s possible and more likely for them to approach a limit cycle, not an equilibrium.

If the response is too weak, it may not approach equilibrium at all. Outside stimuli bat the system around and the attempts toward equilibrium just don’t get very far.

The response always comes with a delay. If a series of stimuli come at the right frequency they can make the responses amplify instead of cancel out. This will usually happen on purpose since there’s no particular reason to expect an accidental set of inputs to resonate to the loop.

Why would you expect whatever equilibrium develops to be “the optimum”? In complicated situations there can easily be multiple local equilibria. All it means for it to be an equilibrium is that things balance out so they don’t tend to change in any particular direction. Sometimes an equilibrium is stable, meaning small changes from it tend to get pushed back toward the equilibrium. Some of them are unstable meaning any small change tends to get amplified. We mostly don’t notice unstable equilibria because the system passes right through them without stopping.

Is there any reason to think that just because there’s stability, it’s the best for some purpose? There have been various economies that were reasonably stable — some in medieval europe lasted for hundreds of years with only small changes, and likewise some in ancient china. We don’t usually think they were the best just because they didn’t change much. That’s what an equilibrium is, it’s something that’s stable, where the various forces of change are all balanced against each other so they don’t actually change. We could decide this has to be the best because it’s stable. Or we could decide what we mean by the best and then argue whether any particular stable system achieves it. But there’s no particular reason to assume that any particular economic system is approaching stability.

If you like technological change, you probably don’t even want stability.

J Thomas September 13, 2008 at 6:32 pm

DG Lesvic, do we want an economy with workable feedback loops?

When I tell you that free markets that develop by accident are unlikely to “optimise” what you want, I’m not saying anything controversial. No reputable economist would disagree. But when I say what we ought to do instead I’m speaking entirely for myself.

Would a centralised bureaucracy give us feedback in the amount and with the timing we want? Possibly. It depends.

Very often markets will be the approach we want. And we want to design those markets carefully to behave the ways we want them to.

There are problems with this approach, not least that we have to choose what we want.

So for example markets that do chaotic-seeming rises and falls are good for market makers. They provide excitement and bring in speculators and the more trades the more opportunities for market makers to profit. Are they good for anybody else? They’re good for gamblers who want a place to gamble their money. But do we want that for the markets where ordinary people’s retirements are invested?

Similarly, why should ordinary people’s housing be dependent on a speculative market? Somebody has to design the rules for the market, and those rules got designed wrong last time. Whoever designs the rules the next time around needs to do it better.

Markets don’t spring up out of nothing automaticly using the best rules that will give “optimal” results. Often somebody designs them. The NYSE started out as a cartel that made its rules to benefit itself. Cartels have the right to do that, but is there any reason to think the result will be the best for the economy as a whole or for anybody besides the cartel members?

Government is (at least in theory) responsible to the citizens. I say the government ought to be designing feedback systems like free markets, and designing them to run according to published specs. When a market doesn’t run to spec it should be tuned, and at all steps this should be an open process.

It’s a problem that most citizens lack the skills to design control systems. Over the next century or so I expect these skills will become as important as calculus etc used to be. Not just a way to solve problems but a comprehensive view of the world that was previously only available through intuition.

J Thomas September 13, 2008 at 9:04 pm

DG, you don’t get it.

If you accept a random free market then you will get random results. To get a market that actually approaches equilibrium you need to design it to do that.

To understand how it works, imagine an isolated community with one store, and that when the housewives came in to buy meat and potatoes for the evening dinner, they found more meat but not as many potatoes as they wanted.

They would bid up the price of the potatoes, and downward that of the meat, and, thereby, send a signal to the farmers: less meat and more potatoes. To maximize their sales and profit, the farmers, and all of the other producers, would have to respond to the signals and wishes of the consumers, and until there were no more relative oversupplies and undersupplies but equilibrium between the supply of and demand for meat and potatoes, and everything else.

So, when do the farmers decide to plant more potatoes and raise fewer cattle? Perhaps next spring? You have a feedback system with a period of one year.

Next spring the farmers plant more potatoes and raise fewer cattle. But let’s say next year there’s a drought, and the potatoes don’t do very well. They fail to produce more potatoes, though they do produce less meat. Potato prices stay high, but meat prices rise too.

Next spring some of the office workers, concerned that they were on short rations last winter, decide to be farmers instead. After all, last year farmers made a lot of money selling into shortages. And as a farmer at least you can’t starve. The farmers on average decide to produce more potatoes and more cattle.

But this year there’s great weather in albania, and the albanian farmers produce bumper crops of potatoes and cattle both. They have so much that they sell cheap. Prices fall. Our own farmers get the price signal that tells them to produce fewer potatoes and fewer cattle next year. The new farmers see that farming is not so easy to survive with, and they look for office jobs.

Where is your equilibrium?

Here’s one way to get an equilibrium. You get a big company that buys potatoes from farmers and sells them to everybody else. The company makes long-term contracts with farmers; it buys potatoes at a set price. That way it doesn’t have to worry about how much it will cost to buy potatoes. It sells potatoes for whatever it can get. If the farmers actually produce more potatoes than it needs, it dries the extra and stores them in its warehouses. Then if one year there’s a shortage it can sell dried potatoes at high prices. If it goes too long without a shortage it takes the surplus potatoes and makes vodka from them. It sells the vodka for whatever it can get, and if the price is too low it stores the vodka in warehouses too. It does advertising to persuade customers that vodka is better after it’s sat in a warehouse for a few years.

The result is that farmers don’t have to worry that they’ll raise a bumper crop and go broke trying to sell it. They’re spared that market problem. And consumers are also buffered from the worst of the shortages. They never have low prices but the high prices aren’t as high. They don’t starve.

Markets work better when there is somebody controlling the market, somebody who can store the product, who buys low and sells high. When there is nobody controlling the market that way, the markets don’t work well at all. It’s better when the market-controller is interested in the long-term good of the producers and consumers. If he wants to maximise his profits in the short run he can do a lot of harm. The other people can think in terms of their own greed and wind up doing the right thing for the community. Not him.

I say in general it’s better to design markets. When it takes a whole year before farmers can make the choices that respond to prices, how can you ever get an efficient response? Well, having a futures market at least gives some indication how much demand there will actually be for the products next year. You’re a lot better off taking orders for products to be delivered then than you are depending on last year’s prices.

And it’s good for farmers to get a clear view how much of each product all the other farmers are choosing to grow. Otherwise each farmer is depending on sheer statistical chance that the others aren’t responding the wrong amount to price signals. And it’s good for farmers to get a clear sense of how well everybody else’s crops are doing. If there’s going to be a shortage then it’s worth spending extra money getting your crop in. If there will be a surplus then you might as well cut corners on your costs.

People can potentially make better choices when they have more information. There’s a theory that the latest prices are all that anybody needs. I don’t know anybody who actually tries to make production schedules or even stock market picks looking at only that.

Think about it. Does the dogma you have been taught actually match anything you’ve seen or heard of in the real world?

J Thomas September 14, 2008 at 5:13 am

DG, I am at a loss.

You have not paid any attention.

I have never advocated “socialism” as an improvement over markets. But you are acting as if handling everything by direct bureaucracy versus letting them entirely self-organize are the only two choices.

You continue to quote ignorant useless drivel as if it was an answer, as if it had not been utterly discredited. Your claims are precisely equivalent to Intelligent Design as opposed to evolution, except they take the opposite stand. You argue that when there is no design of any kind we will automatically evolve a perfect economic system that will give us the best possible results, because if somehow it wasn’t the best it would change itself into the best without anybody having to think about anything at all. People could just look at prices and that would tell them everything they need to know.

I give up. Believe whatever religion you want, and call it economics if you want to. You are not paying attention. Go away. Or stay here and cut-and-paste more garbage. I don’t care.

J Thomas September 14, 2008 at 2:44 pm

DG, you still aren’t thinking.

Your co-ops and future markets are not alternatives to a free market but creations of it.

I never said anything about co-ops. Futures markets were invented by human beings. They weren’t created by market forces. It wasn’t like one day the free market looked at prices and so futures markets sprang into existence, created by supply and demand.

Every individual market was created by somebody, and created in some specific way with specific rules. Some of them work better than others.

The explanations you have accepted about how markets work are *stupid*. These people want to claim that the only information they need is price. Well, try it! Try running a business where all you know is the prices of your raw materials and the current selling prices of your products. See if you think that’s enough to make good decisions with!

You’re trying to frame it as two choices, capitalism versus socialism. But I’m saying you know essentially nothing about how capitalism works. All you know is the lies somebody has told you about it.

Free markets have to be designed. There’s no particular reason to design them in ways that bring great wealth to their inventors — except that’s what some inventors want.

Price information is not the only thing that entrepreneurs look at when making economic decisions. It’s necessary but not sufficient information. It’s a central part of keeping score, but it doesn’t particularly predict winning strategies.

To deny that equilibrium would be the optimum state of affairs would be to say that relative oversupplies of some things and undersupplies of others would be a more satisfying state of affairs.

Your claim is that there are market forces which tend to push things in the “right” direction. You argue that if we ever got to the point that all these market forces balanced out perfectly then the economy would be perfect, though of course that never happens.

You have no argument why you’d expect that all the market forces have the right amplitude in addition to the right direction. Think about it. Your theory is so incomplete that it’s worthless.

The same things apply to a bureaucratic approach. Even if you have a horde of bureaucrats deciding what to build and how much of everything to build instead of using designed markets, still somebody has to tell them how to do their jobs. I’m not saying that one of these is necessarily better than the other.

I’m saying that you have no idea how free markets actually work, and you’d do well to start figuring that out before you do your cheerleading about how they always do the best possible job.

J Thomas September 14, 2008 at 11:31 pm

“I never said anything about co-ops.”

Sorry, but it seemed to me that that was what you were describing. How would your structure differ from a free market co-op?

You continually reply to things I haven’t said, as if you think I said things I didn’t say. I remember I pointed out that farmers benefit by knowing what crops other farmers are planting. I suppose they could find out some of that by being in a co-op together, or they might find out by satellite photos, or whatever.

“Futures markets were invented by human beings. They weren’t created by market forces.”

What’s the difference?

If you don’t see any difference then I despair of communicating with you.

“Market forces” give people price signals for things that are being bought and sold. That doesn’t tell you how to invent a brand new product and develop a brand new market to sell it in. It doesn’t tell you anything about how to design the rules for the new market.

“Every individual market was created by somebody.”

By a lot of somebodies.

I suppose you’d say that every new invention is invented by a lot of somebodies?

Markets are special. A market matches up buyers and sellers. So the bigger the market the faster it clears, and the better it determines price. Markets do economy of scale better than anything else — the larger the market the better the market. And so markets themselves are inevitably monopolistic. The buyers and sellers in the market don’t have to be monopolies. The markets themselves are — a smaller market must have some fantastic advantage to survive in competition with a larger one. When secondary markets survive they always have some specialised niche they occupy. They can serve a different geographic area, or operate at different times, etc. Sometimes small markets survive by catering to people who have been blackballed by the larger market.

The man or small committee who makes the rules for the market has to make them *really bad* to lose out in competition with a newer market.

The details matter a whole lot. You appear never to have imagined there were any such details.

To deny that equilibrium would be the optimum state of affairs would be to say that relative oversupplies of some things and undersupplies of others would be a more satisfying state of affairs.

How do you even decide what’s an oversupply or an undersupply? The market adjusts prices so the market will clear.

So for example the last time I checked, the market price for rhodium was around $4400 per ounce. Is there an oversupply or an undersupply? Can you tell by knowing the price? If somebody thinks there’s an undersupply, will they go out and try to mine more rhodium? Probably not. They purify stuff from ores, and rhodium is only one of a dozen or more things they get. A change in the price of rhodium has to be balanced against the changes in the other twelve products.

Rhodium is usually used as a thin layer on other metals — a hard, corrosiun-resistant layer. There are other metals that can do the same thing but not as well. If the price goes up, do you just pay it, or do you substitute something cheaper? If the price goes down, do you design new products that use it instead of something cheaper, or do you keep doing the same things you were doing before? Well, it depends, right?

The very concept of oversupply and undersupply demands that you have your over-simple equilibrium concept. It’s like a christian saying “It’s far better to believe in Christ because then you get to go to Heaven when you die.” Not that the christian has to be wrong, but his conclusions are a direct result of his assumptions. People who don’t make the assumptions are unlikely to get the same conclusions.

J Thomas September 15, 2008 at 8:06 am

DG, you have no way to decide what’s an oversupply or an undersupply until after you see what the market has done. And even then it’s an interpretation.

Suppose for example that the price for a computer chip is dropping. Does that mean there’s an oversupply and they should make less of them?

Maybe. More likely, the supplier has paid off his fixed costs, and now he’s taking advantage of his convex demand curve. He can sell a lot more chips at the lower price.

But then later the price goes down more. The chip is becoming obsolescent and his primary market doesn’t want them anymore. He can sell them cheap for embedded systems etc, before he phases them out entirely.

How do you tell those apart, using only price? How do you tell the “equilibrium” with high price, versus the “equilibrium” with moderate price and high sales, versus the “equilibrium” where the chips stop being made?

Markets adjust so products clear. That isn’t enough to say whether it’s an oversupply or an undersupply or what. Just, the product eventually clears. The undersupply stuff is your interpretation.

Also, the structure of the market has a lot to do with how fast products clear and how efficiently prices adapt. Price information is very noisy. Real markets are usually designed to even out prices, to artificially reduce the variation. Often they are designed so that some individual manager — a market maker — decides what the price will be every minute, and he makes money off the volume of sales, plus he makes more by correctly predicting market demands — or creating them.

Your concepts are too simple to do what you want them to do.

You want to argue that because there is a feedback loop that you believe tends to nudge things in the right directions, that something is being optimised. But to make that work you need a circular definition.

What do random unregulated markets do? They optimise trade.

How do you tell whether trade is being optimised? Trade is optimised when it’s mediated by random unregulated markets.

J Thomas September 15, 2008 at 6:33 pm

Maybe it’s semantics. We’re arguing about what it means.

You talk about “optimising”. I look at what you call optimising and I see no reason to expect any optimums.

You argue that there are economic forces that tent to make things “better”. And then you argue that these forces must make things approach the best possible state. Would you make those claims for every possible hill-climbing algorithm?

J Thomas September 15, 2008 at 11:45 pm

DG, sorry about that. If you make a *circular definition*, where whatever a “free market” does is defined to be the best, then you can say that free markets always optimise whatever-it-is you want to say they optimise. Because that’s how you defined it.

Similarly you could say that monarchy is the perfect form of government because whatever a king does has to be perfect because God chose the King by Divine Right so whatever he does has to be perfect. It’s that kind of argument.

I wasn’t agreeing with you, I was telling you that you’ve accepted a stupid rationale.

Let’s take the same argument and put it into a different context. I personally believe that carefully designed democracies are on average the best governments we can get. (Although poorly designed democracies can be among the worst.)

But what would you think if I argued that democracy — every democracy — has to make people the happiest. Because we know that in democracy everybody is guaranteed life, liberty, and the pursuit of happiness. While you don’t necessarily get to be happy from pursuing happiness, still when everybody pursues happiness they’ll all be happier than if they weren’t pursuing happiness. And they’ll be happier than under any other system. Because it’s only democracy where people can pursue happiness, with every other system they’re forbidden to pursue happiness.

Wouldn’t that sound stupid?

But if we change “democracy” to “free markets” and “happiness” to “equilibrium” and make a few minor wording changes that don’t change the meaning, we’ll have your claim about free markets.

Free markets — every free market — have to bring economies closest to equilibrium. Because we know that free markets always approach equilibrium. While you don’t necessarily get to equilibrium from pursuing equilibrium, still when an economy is approaching equilibrium it will always be closer to equilibrium than if it wasn’t approaching equilibrium. And it will stay closer to equilibrium with any free market than with any other system. Because it’s only free markets that approach equilibrium. No other system approaches equilibrium.

I’m not saying that some other approach has to be better than “free markets” (whatever we mean by free markets). They might be the best. And quite likely people are happier on average living in democracies. What I’m saying is that your arguments in favor of free markets so far, have been utterly and completely bogus.

If you want to make the claim, you ought to have better arguments in favor of it because the ones you’re using are things that any reasonable person will reject if they think about them.

J Thomas September 16, 2008 at 2:45 am

DG, I’m completely lost on what you’re saying here.

Are you saying that I must have meant what I in fact did not mean, because that’s how you understand the words? If so then let me retract those words. I didn’t mean what you think I did. And I still don’t.

Are you saying “You too”?

Instead of any sort of rational argument are you saying “I know you are but what am I?”

J Thomas September 16, 2008 at 8:16 am

DG, the way people deal with that problem is that when a confusion arises, you get it cleared up.

The best way I’ve ever found to do that is you repeat back what the other guy has said in your own words and you ask if that’s what he meant. If he says no, he gets to say it again in a way that should be clearer given what you told him about what you misunderstood. Then you repeat that back in your own words and see if he says you got it.

You have found out that I was not agreeing with you. I was saying that your claims lack so much detail that they are not useful.

I will once more repeat what I see you saying. You say that markets provide their paticipants with information in the form of prices. This price information suggests to the market participants ways to change their behavior.

* You assert that this information will always suggest they change their behavior in the right direction and by the right amount.

* You assert that the sum total of the price information will lead an economy toward an equilibrium.

* And you assert that there’s something special about the equilibrium that markets encourage, that there’s something *good* about it.

I agree with your beginning. I think the three marked parts need more work.

Why do you think that the price information will always influence people in the right direction and by the right amount?

If some price signals get a response too fast or too slow, or too strongly or too weak, then the sum total of them will never approach any equilibrium. How is it that all the price signals are coordinated to get the right result?

Why do you suppose that there’s anything special about the particular equilibrium that you think markets tend to? Why isn’t it just some random equilibrium that isn’t particularly good for anything?

J Thomas September 17, 2008 at 3:42 pm

DG, that’s very poetic but it doesn’t explain anything at all.

Was there anything wrong with the way I restated your position in my own words?

Do you feel up to restating my position in your own words?

That’s how we see where we misunderstand each other, see — not by just repeating what we said before.

So anyway, a question about your claim — can there be more than one equilibrium state or is it guaranteed there can only be one?

If there’s more than one equilibrium, how do you decide which of them is better? Or do you figure that every equilibrium is as good as every other equilibrium?

If there can only be one equilibrium, why is it there can be only one?

dencard September 22, 2008 at 5:39 pm

The Bail-out, as proposed, cannot possibly work.
Why? Because the total outstanding in US mortgages is 7 trillion. However, the “wizards” on Wall Street have created a monster called “Collaterized Debt Obligations” These are the “derivitaves” only loosley based on the actual motgages and a larger synthetic component based on the supposed value of the underlying assets (mortgages).

Any guess at the total amount? Try $49 TRILLION.

No one can buy that amount back, even the US Treasury.

A better solution is for the Treasury to buy all non-performing loans from the banks servicing them, at a discount, somewhere between 20 to 50 % of face value.

The banks get to remove the bad loans from their books,this restores their liquidity.
The CDO’s start trading at pre-meltdown levels and the Treasury can form a RTC type entity and sell off the foreclosed homes or renegotiate with the current defaulter.

If the bad loans represent 10% of the total outstanding (and that is a high estimate) the 700 Bill will cover. The resulting work-outs may even turn a profit!

Then when the emergency is over, END the largely synthetic overly marginalized and dangerous CDO derivitaves forever!

GaugeBoson September 25, 2008 at 6:14 pm

I am sure bin Laden is kicking himself – all he had to do is wait a few years and Wall Street would kill the American dream for him.

I need Bailed out too September 28, 2008 at 8:52 pm

Agreed Michael Webb !
Why should I have to pay for $10 cigars and some guy that has only HIS/HER personal interest in mine?
If they bail them out heck why not just bail us all out? Whats wrong with printing a few more billion dollars that we do not have to place a band aid on a failed (was run very shotty) financial system?

The 1910 (I think) image of a german women burning a stack of bills in her cooking stove looks alittle closer to home now…

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