…our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.
Thus my dissatisfaction with Larry White’s piece: he talks only about the impulse, while it is the propagation mechanism-the financial accelerator-that is the important part of the story. $2 trillion shocks to global wealth do, after all, happen every several years, everytime there is a recession or a big rise in the prices of natural resources. But financial distress of the magnitude we see today happens once a century. Since the Bank of England developed its lender of last resort doctrine in the 1830s, we have only had two episodes this bad: the Great Depression and today.
Here is the whole essay, interesting throughout. Brad is also blogging parts of the General Theory over at delong.typepad.com.
Addendum: Arnold comments; I think Brad’s short essay is so far the single best thing written on the crisis.
my impression is that securitization is completely shut down in the US at least because it is in among other things legal limbo, and because it is at this point the financial technology underlying fractional reserve lending, fractional reserve lending is broken.
In a world of full and honest disclosure people would point out that White recently took De Long to school for his bogus interpretation of the role of Friedrich Hayek, Austrian economics, and “liquidationist” economics during the Great Depression.
Read the article here: http://economics.sbs.ohio-state.edu/jmcb/jmcb/07056/07056.pdf
There is a deep background to the back and forth going on here, and people have a right to know about it.
How much of it is due to skewed risk assessment models that were being used? I think, fundamentally, the perception of risk or the absence of it, was skewed to unnaturally high levels and the 2 trillion impulse was the trigger that made the people come back to senses.
A deeper look at what really went wrong with the risk assessment models would be one of the things with highest priority. Maybe one of the expert would probably be good enough to do some good research, just a request.
Brad DeLong’s politics are not mine, and I don’t consider him a particularly admirable person, but his article is indeed one of the best things I have read on the current crisis. Why have credit spreads widened so, that is the question, and we have no real answer.
I’m not an economist and I don’t even really understand parts of Brad’s essay yet. So let me ask a stupid question. Is it possible that the world is just adjusting to the “unsustainability” of the American model (with a lot of debt, crappy secondary education, wages too high, etc.) and the rise of other economies that don’t have the same weaknesses (e.g. China, India)?
In this picture, the mortgage crisis is just an example of bad things to come for the US economy. Of course everyone’s stock market is tanking including China’s. But maybe that’s to be expected anyways.
In my mind, the margin, leverage, fractional reserve, whatever you want to call it is just a bungy leash that let’s things get further out of whack before violently snapping back.
10% down on a house mortgage is 10-1 leverage. 35-1 leverage by investment banks is like margin. We now have financial instruments that make staid stuff like buildings trade almost like stocks. We now say these things must be on the balance sheet at market values. And reserves must be based on the balance sheet. And now we are going to start require reserves to increase, what do you have to sell? Oh, and we might not bail you out or any of your counterparties.
I get the same impression, Bob, about Tyler’s refrain that there are market failures. Correct me if I’m mistaken, but Mises premise was that investors make mistakes, WHY do they make mistakes? So, yeah, they make mistakes…and? Maybe some people need to keep hearing that refrain, but some don’t either.
Wasn’t the complaint against the gold standard before the political primaries is that it potentially hindered growth? What’s the argument for regulation (including investment bank leverage regulation) now?
Perhaps the missing explanation is that the dramatic change to the risk discount is due to, and warranted by, the manifest failure of our risk estimation devices. With so many obscure financial instruments at work in the markets, credit ratings, and the sound judgement of the banking industry as a whole, must largely have been accepted as articles of faith.
With the betrayel of this philosophy of faith in market expertise and market forces, investment favors a comparitively myopic valuation of the known over unknown. Perhaps lack of transparency is the major impedement to global economic progress, i.e. suffering as in the tower of babil.
Funny how your two prior posts discussed dynamics of the auto industry.
Re: Krugman’s excellent slides, I’m actually a bit amazed that Krugman uses the shift in the geographical center of gravity of auto production in the U.S. as a basis for suggesting that returns to scale may not be as important as they used to be, thus putting a fence around the power of theory that just won him the Nobel. Could it be that his political proclivities now overshadow his economic ones?
I mean, wouldn’t it be far more likely, and intuitive for anyone not committed to the goodness of unions, to see the auto industry shift to the deep South as an example of labor market distortions at some point simply outweighing returns to scale? I find Krugman’s explanation as likely as an Alphabetic Theory, i.e., that auto companies are predominantly drawn to states beginning with the letters “Mi.”
Isn’t DeLong arguing that such small inputs–the housing bust–shouldn’t have caused such a large output of problems in the financial sector? But, isn’t this a chaotic system, and thus prone to large output changes from small inputs?
The perceived value of assets soared during the boom.
All assets, real and paper can be traded interchangeably. Together, they comprise the total amount of perceived wealth in the system.
Now, what happens when the value of assets suddenly erodes, as they have with the mortgage crisis? The total amount of wealth declines. This manifests itself as deflation.
The Federal Reserve hasn’t actually removed dollars from the world. But the effect is the same.
The most stabilizing thing the Fed can do is to support the dollar, that is, keep its value stable with respect to stable commodities.
Echoes of that inflation are still in the system and will run its course. The Fed should not be reacting to echoes, but to whats happening NOW systemwide. And that is clear only by looking at the value of the dollar in gold:
http://tinyurl.com/10yeargold
Unfortunately, the Fed just stares at the CPI when deciding whether there is inflation. As if a statistic created by the government is providing an accurate picture. As if assets don’t matter.
Larry White is correct that the excess credit went heavily into the housing market; but that is far from the only industry it went into. There were also credit-fed booms in commodities, the stock and corporate bond markets, and private equity, including the LBO market (which is unraveling now, just as the housing, mortgage, commodities, securities and derivatives markets have been doing). I’m sure he recognizes this, but his purpose was the more narrow one of focusing on the housing market. The commodities boom was led by growth in developing countries, particularly the BRICs; but it would be wrong not to recognize the role of debt in fueling the investment in mines and other assets, both agricultural and non-agricultural, that facilitated this.
Brad DeLong sees five reasons for fluctuations in the stock of global capital: (1) Savings and investment. He notes the large fall in the capital stock with no concomitant fall in savings. This is true and relevant in explaining the credit crunch and decline in markets, but it ignores the question, zeroed in on by Larry White, of why the boom in the housing market happened to begin with?
And why the roughly concurrent booms in other markets cited above–commodities, private equity, and stocks and bonds?
(2) News. This includes news about changes in political arrangements that bear on investment decisions and expected future cash flows reaped by investors in equity and debt instruments.
Has Mr. DeLong been living in a cave since August of 2007, and has he had no access to the financial press (e.g., FT, WSJ, Grant’s) since then? The financial press, not to mention other media, has been awash in reports about investor uncertainty thanks to the changing regulatory regime. To top it off, stock and bond market volatility has been at record highs since the VIX was invented in the early 1980s. The only time volatility was anywhere near current levels was during the Great Depression. But no news is good news when you ignore economic and financial reality. (Mr. DeLong also might acquaint himself with the concept of “regime uncertainty,” as discussed by Robert Higgs. It applies now as it also did during the Great Depression, mutatis mutandis.)
(3) Default discount. Not all deeds and ocntracts will be worth what they were when they were written.
(4) Liquidity discount. I gather he means the discount rate that investors use to value uncertain expected future cash flows. Cash flows vary, partly (but only partly) because of changes in discount rates, and some will fall short of expectations, driving equity and debt prices lower than when they were acquired, resulting in losses. (I find his discussion confusing because he later refers to a liquidity premium.)
He says this should be 2-4% in real terms; but no competent business school graduate would use a rate anywhere near this low; 10% is more like it.
(5) Risk discount. He means risk premium (I was scratching my head too), which is the difference between the riskless rate and the expected return on a an equity investment (risk premium) or a bond (credit spread).
He is correct that 3-5 are important; but he is incorrect to dismiss 1 and 2, which are even more relevant.
Every bust requires a boom before it; and the boom must be explained just as the bust is. There are competing explanations of booms–Keynesian, monetarist, Austrian, and ad hoc and frankly unscientific (“irrational expectations,” “greed,” etc.), to name four. I was surprised that Brad DeLong didn’t weigh in with an explanation, presumably Keynesian. Maybe he thought this would play into the hands of the Austrians too much; after all, an autonomous demand “shock,” a precipitous decline in “aggregate demand,” call it what you will–is a dollar short of an adequate explanation.
So he ducked the question, opting instead for “hand waving,” and a closing shot in the dark about
“how human psychological limits lead to bad private-sector contract design that then magnifies psychological biases.”
Larry White discusses the monetary origins of the boom; but doesn’t go much into the transmission mechanism (or accelerator) of the boom and bust cycle, which presumably wasn’t his purpose.
What happened in all these markets, from the housing market to commodities to private equity and the public securities markets, was that the decline in interest rates Larry White discusses caused the loan rate of interest to fall below the natural rate, the latter being determined by the supply and demand for investible resources. This caused entrepreneurs to value prospective investments in these markets with central bank-jimmied discount rates that were too low in relation to the cash flows they would have expected in a market that was free of central bank-underwritten distortions. They made investments that turned out to be malinvestments when rates went up to reflect economic reality, and when capital markets adjusted to reflect these economic and financial realities, causing losses in all these markets–housing, commodities, private equity, and public securities markets.
What Mr. DeLong and the Keynesians don’t understand is the crucial role of interest rates in coordinating economic activity. Economics is a coordination problem, as Gerald P. O’Driscoll, Jr. put it in his book on Hayek. When rates fall below their free market level, this causes an investment boom and a structure of production that is too long for the available resources, which are called forth at the prevailing real rates of interest. The cycle is revered when rates rise toward their natural level, and the malinvestments are liquidated or restructured, causing unemployment in labor and capital markets.
This is a far more coherent explanation that one resting on “psychological biases,” “animal spirits” and other non sequiturs.
“our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.”
Clearly when we have no understanding of what led to a problem, it will be easy for our overlords to conceive of regulations to correct the market, and prevent a recurrence of the problem we don’t even understand, without creating any unforseen adverse consequences (those never happen). Everyone should just relax and let our all knowing legislature and administrative agencies enact some new regulations, which will, of course, solve everything. After all, even if the new regulations don’t work exactly as planned, it will probably be because of another market failure, and the gov. can just enact even more new regulations, over and over, until the world ends or we run out of paper.
If, as Brad DeLong says, the Bank of England “developed its lender of last resort doctrine in the 1830s,” just what was Walter Bagehot trying so hard to get it to do in the 1870s?
Why have credit spreads widened so, that is the question, and we have no real answer.
Credit spreads on bonds widened for the same reason that risk premia on stocks did: an increase in the uncertainty of the value of expected cash flows to the riskier assets (compared to the risk free ones) to investors. Hence the flight to government-issued debt and the emergence of near-single digit basis point yields in these instruments. This helped give the Fed the wherewithal to puff up its balance sheet.
Alan,
What you are saying is why I think this situation is partly good. It’s like an innoculation. Maybe the inoculation only lasts a generation, but how much more ridiculous can we get that losing money in housing? What is left to waste money on?
But the gov’t is determined to inject as much uncertainty as they can. So, on the bright side, how much worse could it get, really?
I keep looking to what the professionals say.
“Until the government stops changing the rules every single day, buy and hold is dead.”
http://finance.yahoo.com/tech-ticker/article/141683/Death-to-'Buy-and-Hold'-No-Slowing-Down-'Fast-Money's'-Macke-and-Adami?tickers=MCD,DIS,POT,X,TGT,MRK,CSCO
How ’bout this theory. The explosion of capital completely outpaced the availability of quality capital allocators, including a brain drain into hedge funds (does not follow that hedge funds are good investments for individuals). This situation lasted as long as people convinced themselves otherwise, until they couldn’t because it started showing up on the balance sheets and the men behind the curtain said “oopsie.”
People are shell shocked by this proposition. People who never bought into the elitist school were blindsided to the extent that everyone else did. All up and down we are surprised at how little everyone knows. Trust = poof!
To me, the question as to why these corrections are so bad is the question, what facilitated the differential between actual prices and rational prices to expand for so long.
Fundamentally, the economy had been deteriorating for a long time. People like me assumed that this slow growth was a good thing, but didn’t take into account that the long, slow growth, while allowing some areas to adjust in an orderly fashion, just kept eating away at the foundations of the housing market economics, while the financial innovation let the players do what a lot of builders do, bury the trash under the houses where it isn’t seen until later. Ultimately, the charade had to end.
The internet may be part of the reason for the speed that all the economic information got priced into the assets. Add in to the mix the narratives about Obama raising taxes, a secular bear market, Chindia’s coming dominance, baby boomers selling all their stocks, etc., and there was a lot of angst just under the bull market shroud ready to gush out at the slightest tear of the veil.
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