What went wrong with the economy?

On Wednesday David Leonhardt posed the question, here is part of my answer:

To understand the depths of the current crisis, let’s go back to an
apparently unrelated episode in economic thought: the socialist
calculation debate. Starting in the 1920s, Ludwig von Mises, the leader
of the so-called Austrian School of Economics, charged that socialism
was unable to engage in rational economic calculation. Without market
prices, he reasoned, no one knows how much economic resources are

The subsequent poor performance of planned economies
bore out his point…The irony is that the supercharged
capital markets of the American economy are now – at least temporarily
– in a somewhat comparable position. Starting in August, many asset
markets lost their liquidity, as trading in many kinds of junk bonds,
mortgage-backed securities and auction-rate securities has virtually

Market prices have been drained of their informational
value and thus don’t much reflect the “wisdom of crowds,” as they would
under normal circumstances. Investors are instead flocking to the
safest of assets, like Treasury bills.

The absence of trading
is a big problem. Financial institutions have been stuck holding
illiquid assets, whose value cannot be easily determined. Who wants to
lend to the institutions holding them? No wonder there is a credit
crisis and a general attitude of wait and see.

And here is another problem, namely the relationship between Mises’s argument and the degree of leverage.  When leverage is high the needs for exact calculation are much greater:

This gridlock is especially harmful because leverage is so high, and
financial institutions are so interconnected through swaps and loans.
Institutions that rely so heavily on debt are precarious and need
up-to-date information about valuations. When they don’t have it,
markets freeze up. This is what has taken policymakers by surprise and
turned a real estate crash into a much bigger financial problem.

Do read the whole thing; I also consider why price declines don’t necessarily restore asset liquidity.


I'm surprised to hear you argue for more regulation. However, I'm more interested in your response to Fred Block's comment that one major problem was the reduced taxes on the rich, which lead them to invest more money in risky areas like hedge funds.

The libertarian solution is to abolish the Fed, and to arrest Greenspan and Bernanke (even before Cheney and Bush).
When the Fed expands the monetary base by lowering the discount and/or fed-funds rate or by other means, the resulting interest rates are inconsistent with the unfettered time preferences of of all market participants, including margined and cash buyers of securities and derivatives and the institutional lenders to the former. When the loan rate of interest is forced down far enough, demand for loanable funds (or investible resources as Roger Garrison would say) exceeds their supply. To the extent that more of these funds enter capital markets than would otherwise be the case, they help inflate asset prices.
The calculation problem comes into play because the discount rate used to value cash flows of these assets is lower than would be the case under free banking, which causes the bubbles to appear. When rates rise toward their market levels, the bubbles are deflated.

I have two questions for Tyler.

I'm not much of a judge, but I recall hearing that one of the reasons for the crash in the 20's was excessive leveraging making the financial institution unstable. Thus, regulations were created to restrict buying on margins and other leveraging strategies. Have we simply circumvented these regulations with a new set of leveraging strategies and thus reinvented the same instability?

It seems to me that it would be possible to create assets which can be accurately valued at first, lending themselves well to market calculation. But if these assets then are prone to becoming uncertainly valued as time passes, they would foil market calculation, right? Have we created such hot potatoes with the housing bubble and highly leveraged instruments? Or is it more simply fraud, as in Ponzi schemes? Or neither?

I liked your article. But I have two questions: (1) Aren't asset values always uncertain? Fischer Black in one of his papers argues that speculation exists only when asset values are uncertain, and speculation is always with us. (2) If speculation is always with us, aren't markets inherently unstable-- i.e. bubbles, followed by collapses, severe doubts about the value of assets: liquidity crises!

Hmm, not a word about consumer fraud. I guess that narrative franchise is defunct. Doesn't reflect well on the supposed "insights" that were produced by that franchise though.

However, this column is really pretty good. The psychologizing seems eminently sensible, rather than the previously banal and condescending ideological tone, and it admits that the set of likely outcomes is rapidly reducing, for good reasons. We do have to thank Republicans and faux libertarian collaborationists like Tyler for enabling this rather large experiment in free market exuberance, and especially to thank them for the backlash that's coming. Your time in the woods probably extends for a decade so, that will be a good time to do some thinking on other minor trifles, such as when is it right to go to war.

I find the following Hayek quote very useful here :
"before we can explain why people commit mistakes, we must first explain why they should ever be right"
Economics and knowledge (1937)

Subprime mortgages were used to trick poor people into huge loans? Greedy investors leveraged themselves to the eyeballs? A sudden epidemics of dumbness and greediness is probably not the answer. People are usually quite good at coping with these flaws in there fellow partners. There is no reason to believe that these preventions suddenly vanished.

As it turns out, both parties are losing money : the lender and the borrower. They were both unable to even roughly guess the future value of houses. And few others were, or we would have expected better informed people to jump in as contrarians. By doing so, they would have involuntarily shared their information so the rest of us could benefit. That's how people and markets can be right.

The current lack of liquidity seems to be a side-effect. If anyone knew where housing prices were headed, they could use that information to do arbitrage, and the bid-ask spreads would soon be back to normal.

So whatever caused people and bankers to be wrong about housing prices must be the answer to the post's title. This brings us back to the usual suspects : Federal deficit and inflation of the money supply.

Bear Stearns is worth more than $2.30 a share.
One reason JPM made a low-ball offer is the $5-6 billion in retention and severance pay they'd have to pay to keep Bear's more productive employees from defecting to competitors.

If there is no market for a thing, is it worth anything? Of course you are talking about a point in time. 6 months from now, everyone will be writing up those supposedly worthless assets. People like Jamie Diamond know this.

As asset price begin to fall, somewhere we will reach a market price. The sooner the better.

The banks are the openly real frauds, not homeowners.

There is nothing fraudulent about banks and the fiduciary media they issue. They are bailors performing a warehousing operation only in Rothbard's incorrect, a priori (!) history.
The development of assignable and negotiable bank instruments, bank notes and clearing facilities, proceeded in accordance with the rule of law and didn't involve fraud or coercion.

But the real problem was that Ponzi's business was not as big as a fractional reserve bank or Bear, Stearns, so the government arrested him like Al Capone instead of taking the business over and selling it like they do with strip clubs that don't pay taxes.

Strip clubs that don't pay taxes are being shaken down and robbed by the State. Al Capone was busted for income tax evasion, a natural right. Taxation of Capone or of strip clubs is theft.

People who want to pin the entire blame for the current crisis on the Fed are ignoring a pretty important fact: the yield curve was inverted for most of 2006 and 2007. The Fed influences short-term rates very heavily through open-market operations but has a much smaller and more muted influence over long-term rates. The inverted yield curve squeezed profit margins of banks which depend on long rates being higher than short rates and enticed them to seek out higher-yield, higher-risk investments.

If you want to pin blame on someone for low long-term rates, start with sovereign wealth funds and foreign central banks. There is no reason why Fed monetary policy alone would have caused the yield curve to flip.

I'll say it again, just because: I don't think it is a "fundamentalist" position to insist that contracts are honored, and that taxpayers don't bail people out for their bad investment decisions. I am shocked that Professor Cowen seems to be saying that the best thing to do now is to let government relieve investors of their mistakes, while increasing its oversight of their decisions. I would prefer a move in the other direction, where people can do whatever they want with their money, but then don't cry to the government if they lose it.


I don't believe the problem is that some people may loose a lot of money. No matter how many people default on their mortgages, no houses will be "lost". They don't disappear, they just get used by someone else. No justification for a free market I've ever heard of is dependent upon people getting to keep their wealth in times of trouble.

If you want to show that BSC's buyout was necissary, I think you need to show how the buyout would aid people in consuming desired goods and services more than it would hurt the taxpayer. It doesn't matter if the housing market crashes in areas where too many houses were built; that would be a good thing.

If BSC went under, would there be anything preventing sound mortgages from being taken out? I understand there would be temporary disruptions in the mortgage markets as firms toppled, but would there be lasting effects? I do understand that because our nations financial markets are largely centrally-planned, we are unlikely to have a significantly better system emerge from the ashes of the current one. But I still think the moral hazard of a bailout is significant.

Are we in a circumstance of privatized profits and public losses? Given the lack of any significant externalities in the mortgage industry, I wonder how this came about?

--The absence of trading is a big problem. Financial institutions have been stuck holding illiquid assets, whose value cannot be easily determined.

whose problem is this absence of trading? how have they been "Stuck"? They bought various assets, and claimed to have handled the risk for them. Their value WAS determined, they though: by the price.

Sure, there was a lack of interest in working through their risk profiles, or checking the value of the instruments. but the above statement is silly.

They don't trade now because THEY DON'T WANT TO. They don't want to find out that they aren't worth what they paid for them. they don't WANT to cut their losses and take their lumps.

"Regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions."

But there are *already* credit conversion factors for just about every conceivable off-balance-sheet commitment, to be applied in calculating the capital requirement. Isn't the problem that too many of these factors are zero or otherwise lower than they should be? Is that what you mean by "apply consistently"?

Or can this approach never work?

The similarity between 1929 and now: Facilitators.

These are people who told capitalists that prices would always go up, so they should lend their money to bad risks and told would-be capitalists to borrow money at any rate they wanted because prioces would always go up.

The facilitators skimmed money off the top and made a fortune (and, if they were smart, did not take their own advice).

The facilitators are the most sophisticated in the market. People believe they know the market best. People trust them.

When the market is good, facilitators do well when people follow their advice. When the market is bad, facilitators break even. Eventually, when he market normalizes, the facilitators figure that they can do it all again.

Until there is a downside for the facilitators, the cycle will repeat.

So what good are economists anyway?

After the fact analysis is, let us say, after the fact.

Where were you before?

I mean what good are you? Sure there are markets in everything, but so what.

If you guys got no predictive power, why pay you the comfortable bucks?

(Yeah, I know you ain't getting rich fast, but you ain't poor either.)

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