by Tyler Cowen
on February 7, 2009 at 9:25 pm
1. China prodigy of the day.
2. Johnny Cash and Louis Armstrong (YouTube).
3. Models of correlations among risks, by Robert Engel, and here.
4. What really caused the crisis? A good short piece.
5. Brad Delong lists the cuts in the stimulus plan.
6. Should the IMF create more SDRs?
The people who cut aid to states don’t understand basic economics. Due to the recession, states and cities are slashing programs, halting half-completed construction, and hiking taxes and fees. Of course, this only worsens the recession, but they have to do it to balance their budgets.
It’s CRAZY for the Federal gov’t to prioritize new projects and programs ahead of maintaining existing projects at the state level that already passed the cost-benefit test.
It’s a case of putting (mistaken) ideology and politics ahead of standard economics.
Streetwalker, just for a start there was Basel I not just Basel II, but mostly I think you are imagining demons in the piece, which is largely about *market* failure.
To Tyler and Streewalker,
Indeed Acharya and Richardson are referring to Basel I not to Basel II. Their argument, however, is not about “market” failure; it is about arbitraging regulation. Their argument is consistent with a point made by Peter Wallison in his article The True Origins of This Financial Crisis (the American Spectator February 2009) when writes:
“Bank regulatory policies should also shoulder some of the blame for the financial crisis. Basel I, a 1988 international protocol developed by bank regulators in most of the world’s developed countries, devised a system for ensuring that banks are adequately capitalized. Bank assets are assigned to different risk categories, and the amount of capital that a bank holds for each asset is pegged to the asset’s perceived riskiness. Under Basel I’s tiered risk-weighting system, AAA asset-backed securities are less than half as risky as residential mortgages, which are themselves half as risky as commercial loans. These rules provided an incentive for banks to hold mortgages in preference to commercial loans or to convert their portfolios of whole mortgages into an MBS portfolio rated AAA, because doing so would substantially reduce their capital requirements.
“Though the banks may have been adequately capitalized if the mortgages were of high quality or if the AAA rating correctly predicted the risk of default, the gradual decline in underwriting standards meant that the mortgages in any pool of prime mortgages often had high loan-to-value ratios, low FICO scores, or other indicators of low quality. In other words, the Basel bank capital standards, applicable throughout the world’s developed economies, encouraged commercial banks to hold only a small amount of capital against the risks associated with residential mortgages. As these risks increased because of the decline in lending standards and the ballooning of home prices, the Basel capital requirements became increasingly inadequate for the risks banks were assuming in holding both mortgages and MBS portfolios.”
You should read Wallison’s article to put those two paragraphs in the context of his explanation. His article is a truly good short piece.
“There is almost universal agreement that the fundamental cause of the crisis was the combination of a credit boom and a housing bubble.”
So, I’m not appealing to the authority of the piece. I’m pointing out that they are either right or wrong about “universal agreement” regarding a credit boom. The investment banks collapsed in rough correlation to their leverage rates.
Okay, so these highly regulated institutions didn’t have to put all the bananas on their roof, but calling banana-induced roof collapse a “market failure” sounds like it is ignoring the necessity of an accompanying government/policy failure. If the government is going to regulate the financial institutions, then I am reminded of Bastiat’s assertion that if the government claims to control the weather, then they make themselves responsible for weather problems.
These things happen because people follow the market-share leader in a pro-cyclical fashion. Calling it market-failure seems to imply that there is a government solution. However, this is perhaps the one sense in which the “we are the government” mantra is actually true. How is a democratic government going to take the punch bowl away from the party when everyone wants more punch?
I’m not an economist so I don’t understand fully but the big problem seems to be the failure of the banks to correctly assess risk. This was manifested in giving loans to people who couldn’t pay them back and then chopping them up to hide how risky they were. Now, if this is correct (and it might well not be) then government regulation could easily have prevented the crisis. Making sure the credit-rating agencies were doing their job properly could have been enforced. Making sure the quants were not allowed to dupe everyone with overly complex financial instruments could have been enforced. Lastly, setting limits on the kinds of credit risks the banks could lend to could have been enforced. I worked in mortgages when I was at university years ago and we weren’t allowed to lend over 3x income. Looser banks lent 4x income. Recently, banks were lending 7 or 8x income. It’s just crazy.
Of course it’s possible that with totally unregulated everything, markets would have performed better but that’s a) unrealistic and b)a huge and unnecessary gamble. It’s not news that people don’t always behave rationally. What’s so dangerous about some genuine oversight?
The Robert Engle piece is the one that annoys me, personally. He talks about VaR working because if you ran it every day it would show you that you were increasingly in trouble. Too bad that you were too late to unwind your positions, eh?
It’s like navigating a boat with the depth finder. Usually it will work. You can feel your way along the cost using the 200ft line … until you get to a dangerous place where you should be no where near.
They are right about the problems caused by regulatory arbitrage; but, contrary to their proffered solution, the only way to avoid this problem is to get rid of regulation, or rather, to “regulate” by the rule of law and the discipline of capital markets.
They also fail to understand that the boom and bust was caused by central banks. In the U.S. the Fed kept interest rates too low too long, and in Europe, the Bank of England and the ECB did the same. These led to housing bubbles, which spilled over into banks, then commodities, private equity, stocks, etc.
The Economist of Feb. 7 points out that when the euro started trading, euro-denominted interest rates were lower than rates denominted in defunct currencies, leading to housing bubbles.
Talk about bankers who broke the world!
Easy Al and the Helicopter Pilot ought to be on trial, and if found guilty frog marched to the nearest jail cell. We’ll let European libertarians extract their own justice.
odograph you are right, but, as a boater, there are a lot of times when you really, really want a depth finder, since a lot of sandbars like to move away from their charted position. VaR isn’t everything but CVaR is an essential piece of the toolbox.
This deserves a prize for opacity – “the ratio of debt to national income went up 100% from 3.75 to 4.75 to one”.
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