Category: Economics

Anna Schwartz on the crisis

She offers a clear statement of the previous default point of view:

…this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly, as the Treasury did this week. But in doing so, he’s shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

This is almost certainly true if the number of "problem banks" is sufficiently small.  It works less well if the number of problem banks is very large.  And why might you believe the number of problem banks is large?:

1. The very actions of Bernanke and Paulson — both smart and competent people and in the case of Bernanke with libertarian sympathies — are signaling that the number of problem banks is large.

2. The credit freeze signals that the number of problem banks is large.

3. We cannot afford to take the chance that the number of problem banks is large.

4. Direct knowledge that the number of problem banks is large.

#1-3 seemed increasingly persuasive to me as the crisis went on, but it would be nice to shore up #4, which to this day remains weak.  Of course since #4 is not independent of what government is doing at any point in time, the signal extraction problem is significant.  If we see banks doing poorly, it could simply be that markets do not like the chosen remedy.  Furthermore share prices reflect what the market thinks banks are worth, but only conditional on what policies the market expects.

Will the price of risk be too high or too low?

From the comments at MR:

…we had all better hope that there will be some stupid groups in the
future, because if not, then our society will be poorer due to a
societywide excessively high price of risk. an excessively high price
of risk isn’t as spectacularly catastrophic as the excessively low
price of risk of the last 10 years, but compounded over time it can do
just as much damage…

I hold a few beliefs:

1. For a while the price of risk had been too low.

2. Currently the price of risk is too high.

3. In response to the crisis, we will regulate to prevent the particular previous manifestations of #1.  The bad news is this will be an overreaction; the good news is that because of #2 the regulatory overreaction won’t matter for some while.

4. We do not know how to regulate to prevent other, future, hitherto unexperienced manifestations of an excessively low price of risk.

5. Maybe #4 is wrong, but beware of any huff-and-puff polemic discussion that is not at least considering these points.

What caused the financial crisis?

The column is titled "Three Trends and a Train Wreck."  I attempt to explain the financial crisis in as simple and general terms as possible.  Here is one paragraph:

Over all, then, the three fundamental factors behind the crisis have
been new wealth, an added willingness to take risk and a blindness to
new forms of systematic risk. All three were needed to bring about the
scope of the current mess – so that means we’ve had some very bad luck
on top of everything else.

I have about nine hundred words to flesh this out and to discuss Fischer Black as well; Black is a neglected but insightful macroeconomic theorist who starts with ideas from finance.  Here is another paragraph:

Subprime loans collapsed first because those were the investments most
dependent on relatively poor borrowers who were the most likely to
fail. Since then, we’ve seen asset values fall throughout the economy.
Subprime borrowing was the canary in the coal mine, but it was hardly
the only problem. It now seems that a wide range of asset prices were
artificially inflated. The market for contemporary art, which depends
almost exclusively on very wealthy buyers, will probably be the last
market to plummet but that development is almost certainly on its way.

One thing to keep in mind is how international the crisis has been; any explanation should start there.  I wish in the column I had had space to discuss Spain, which has had relatively prudent banking regulation but still will have one of the biggest downturns in Europe.  It is also worth considering Norway, Canada, and some of the other countries which limited their risk exposure all along.  I mention Japan, but Brazil and Mexico also already have their banking crises behind them in the former decade and they too form other valuable points of comparison.

I am not sure I understand this Daniel Davies post, but it may have some overlap with my arguments.

Addendum: You might want to read this Jacob Weisberg column saying that the financial crisis refutes libertarianism.  His paragraph starting with "There’s enough blame to go around…" is exactly the foil I had in mind.  His overall thesis is worth pondering but he doesn’t once consider any cross-sectional variation across nations; such consideration wouldn’t help his thesis.  Am I allowed to say that the experience of Iceland refutes the small nation, social democratic model?  Probably not, nor should I be.

Second addendum: Tim Harford has a humorous piece comparing the crisis to Monopoly the board game.

Manipulation of Prediction Markets

As many people suspected someone was manipulating Intrade to boost John McCain’s stock price:

An internal investigation by the popular online market Intrade has revealed that an investor’s purchases prompted “unusual” price swings that boosted the prediction that Sen. John McCain will become president.

Over the past several weeks, the investor has pushed hundreds of thousands of dollars into one of Intrade’s predictive markets for the presidential election, the company said.

This is big news but not for the reasons that most people think.  Although some manipulation is clearly possible in the short run, the manipulation was already suspected due to differences between Intrade and other prediction markets.  As a result,

According to Intrade bulletin boards and market histories, smaller investors swept in to take advantage of what they saw as price discrepancies caused by the market shifts – quickly returning the Obama and McCain futures prices to their previous value.

This resulted in losses for the investor and profits for the small investors who followed the patterns to take maximum advantage.

This supports Robin Hanson’s and Ryan Oprea’s finding that manipulation can improve (!) prediction markets – the reason is that manipulation offers informed investors a free lunch.  In a stock market, for example, when you buy (thinking the price will rise) someone else is selling (presumably thinking the price will fall) so if you do not have inside information you should not expect an above normal profit from your trade.  But a manipulator sells and buys based on reasons other than expectations and so offers other investors a greater than normal return.  The more manipulation, therefore, the greater the expected profit from betting according to rational expectations.

An even more important lesson is that prediction markets have truly arrived when people think they are worth manipulating.  Notice that the manipulator probably doesn’t care about changing the market prediction per se.  Instead, a manipulator willing to bet hundreds of thousands to change the prediction of a McCain win must think that the prediction will actually affect the outcome.  And if people think prediction markets are this important then can decision markets be far behind?

Hat tip to Paul Krugman.

Questions that are no longer rarely asked

Why would you leave your money in UBS?

I’m not a close observer of the company, but I have to wonder how they would now describe their business model to a new and eager customer.  Bernard Bauhofer had a funny way of putting it:

The big question is whether high net worth individuals are
willing to stay with an institution incapable of surviving on its
own…

Meanwhile, over at the state-owned bank:      

Clients seeking to open an account last week at ZKB’s
central branch on Bahnhofstrasse in Zurich, a block from UBS’s
headquarters, had to wait as long as an hour. "We don’t know what to do with all the money right now,”
ZKB spokesman Urs Ackermann said.    

My dream

I just had a dream about economics (NB: the word "dream" means that what follows is not real).  It turned out that Fischer Black wrote a short, secret manuscript shortly before his death and that manuscript was just dug up and published in an obscure portfolio journal.  In the piece Black expresses new yet serious reservations about the idea of arbitrage.  He built a simple model in which there are four kinds of arbitrage but each serves as a substitute for investment in human capital.  The more arbitrage an economy engages in, the worse off it is in the long run.  For various second best reasons, most of all related to the concept of superfluous assets and "spanning," the arbitrage did not bring the usual welfare gains from equalizing prices across different markets.

It is rare that my dreams are so detailed or for that matter so analytical.

Kenneth Arrow gets a sentence

There is obviously much more to the full understanding of the current
financial crisis, but the root is this conflict between the genuine social value
of increased variety and spread of risk-bearing securities and the limits
imposed by the growing difficulty of understanding the underlying risks imposed
by growing complexity.

Here is more.  Arrow, of course, has long been interested in issues of complexity and computability, even though his work is within the usual neoclassical confines.  One way of putting the point is that starting a new market creates a negative externality on other people by eroding their knowledge and understanding of context and thus limiting the general ease of economy-wide transparency.  I’m not sure this is true (we usually think of the extra market as adding knowledge), but it is an interesting way to categorize current problems.

The Playmate Indicator

The Environmental Security Hypothesis says that in tough times men will prefer women who are good at production, generally older, taller, heavier, less curvaceous women with less body fat.  In good times, they will prefer women who are good at reproduction, generally younger, shorter, lighter, more curvaceous women.  Pettijohn and and Jungeberg look at the characteristics of playboy playmates from 1960 to 2000 and find:

Consistent with Environmental Security Hypothesis predictions, when social and economic conditions were difficult, older, heavier, taller Playboy Playmates of the Year with larger waists, smaller eyes, larger waist-to-hip ratios, smaller bust-to-waist ratios, and smaller body mass index values were selected. These results suggest that environmental security may influence perceptions and preferences for women with certain body and facial features.

Econometricians who wish to investigate further may download the data here (yes really).  The 2008 Playmate of the year, Jayde Nicole. does not seem to fit the hypothesis however.

Paul Krugman summarizes Paul Krugman

The new trade theory starts with the observation that while this
[the old trade theory] explains a lot of world trade, it also misses a lot. France and Germany
sell lots of stuff to each other, even though they have similar
climates and resources; so do the United States and Canada. What’s that
about?

The answer is that there are many goods that aren’t like wheat or
bananas, but are instead like wide-bodied jet aircraft. There are only
a few places in which wide-bodied jets are produced, because of the
enormous economies of scale – you only want a couple of factories
worldwide. Those factories have to be somewhere, and those countries
that get the factories export jets, while everyone else imports them.

But who gets the aircraft factories, or the factory producing a
specialized kind of machine tool, or the plant producing a particular
model of car that selected consumers all over the world want? The
answer of new trade theory – and it was a tremendously liberating
answer – is that it doesn’t matter. There are many economies-of-scale
goods; everyone gets some of them; and the details, which may be
largely a story of historical accident, aren’t important.

Here is the whole post, which covers his work on economic geography as well and relates it to his work on trade.  As you might expect, it is a very good exposition of…Paul Krugman.

If you are wondering, one early writer who saw a link between trade, location, urban economics, and increasing returns was the 17th century British pamphleteer Nicholas Barbon; his full name was Nicholas Unless-Jesus-Christ-Had-Died-For-Thee-Thou-Hadst-Been-Damned Barbon.  Barbon was also a precursor of aggregate demand theories of macroeconomics and an influence on Adam Smith.

What are economics blogs good for?

But the Harvard economist [Dani Rodrik] finds the blog – short for Web log – useful because it serves as a reference catalog for his ideas. “I now constantly Google my own blog for ideas that I knew I had at some point,” he says. “Previously, the ideas would have come and gone. The first good thing is that I have them a little more developed, and, secondly, I can actually recover them.”

Here is the whole story, on the rise of the econ blogosphere, which has much from yours truly.  It is in this issue from the Richmond Fed, which has much of interest on economics and the economics profession.  Here is an article on experimental vs. behavioral economics.

The prospects for credit market revitalization

Today you get more Felix Salmon, who nails it:

America’s banks — and the world’s, for that matter — have had de facto
unlimited access to very cheap Fed liquidity for many months now. That
hasn’t induced them to lend. Will this latest recapitalization do the
trick? I’m far from convinced. And what’s more, the demand for loans is drying up fast: do you
really feel like buying a bigger house right now, or taking out a car
loan? Well, businesses are in the same boat. In a recession, their ROI
falls, so they borrow less.

I am, however, a little worried about Felix’s proposal to make banks lend the money.  It’s not that I have a better idea, but I suspect any scheme of compulsion will bring either higher risk or ways to game the scheme or both.  And if bank shareholders and CEOs do not wish those loans to be made, our current system of corporate governance quickly becomes unworkable.

These days there are so many sentences to ponder

If you’re running an insolvent bank, and you get a slug of equity from
Treasury, your shareholders will thank you if you use that equity to
take some very large risks. If they pay off and you make lots of money,
then their shares are really worth something; if they fail and you lose
even more money, well, there was never really any money for them to
begin with anyway.

That’s Felix Salmon: read the whole thing.  Read this too.  Here is Megan McArdle on the pooling equilibrium.  Here is a good article on how Paulson "sold" his plan to the bankers.  And here are yet some more sentences to ponder:

So it in the end, we have what is basically an economic loan, but structured
in a way to game bank capital adequacy requirements. What strange times we live
in when Treasury and the Fed have to engineer a deal to circumvent their own
regulations.

The new Obama economic plans

The main new proposals would:

– for the next two years, give businesses a $3,000 income-tax credit for each new full-time employee they hire above the number in their current workforce;

– allow savers with tax-favored Individual Retirement Accounts and 401(k)’s to withdraw 15 percent of those retirement savings, up to a maximum of $10,000, without paying a tax penalty as the law currently requires for withdrawals before age 59 and a half;

– bar financial institutions that take advantage of the Treasury’s rescue plan from foreclosing on the mortgages of any homeowners who are making “good-faith efforts” to make payments;

– direct the Treasury and the Federal Reserve to create a temporary facility for loans to state and local governments, similar to the Fed’s new arrangement to loan corporations money by buying their commercial paper, which are the I.O.U.s that help businesses with daily operating expenses like payrolls.

Here is the article.  I doubt if the substitution effect generated by #1 is large.  I fear the precedent set by #2 and I don’t understand the enforceability of #3.  Savings withdrawals are in effect a form of fiscal policy and I don’t yet see how fiscal policy is supposed to cure us of our current mess, which is rooted in coordination problems.  Let’s hope #4 does not become necessary.  Of course it is before an election and each candidate has to propose doing something in addition to the status quo.  But a lot will happen between now and 1/20; fortunately these proposals won’t be taken very seriously.

Here are McCain’s proposals, I may discuss them soon.

Paragraphs to ponder

Via Mark Thoma, Susan Woodward has an idea:

The true values of mortgage assets are generally thought to be a mystery. But
little-mentioned among discussions … of the crisis is that the Treasury has
access to the best resources in the business for estimating the hold-to-maturity
values of mortgages and mortgage-backed securities. This team is at Fannie Mae,
which the government now effectively directs.

You might laugh, or cry, but the reality is that most proposed paths out of the crisis involve a circularity problem.  And, courtesy of Chris Masse, here is another paragraph to ponder:

Krugman’s award could bring Bush face-to-face with his
antagonist. The president typically invites Nobel Prize winners
to the White House in November or December.    

Paul Krugman on Austrian trade cycle theory

Here’s the problem: As a matter of simple arithmetic, total spending in
the economy is necessarily equal to total income (every sale is also a
purchase, and vice versa). So if people decide to spend less on
investment goods, doesn’t that mean that they must be deciding to spend
more on consumption goods–implying that an investment slump should
always be accompanied by a corresponding consumption boom? And if so
why should there be a rise in unemployment?

Here is the link once again.  But I think the point is more effective in reverse.  Why should the boom be a boom in the first place?  The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages.  In other words, the Austrian theory doesn’t generate the very high degree of comovement found in the data.  Or, in other words, there aren’t that many countercyclical assets.

One MR commentator suggests this, this, and this as responses.  They make various points against Krugman (who I might add is not as clear as usual in this piece) but they don’t solve this central problem of generating the amount of comovement found in the data.  The best shot is to relax the Austrian-favored methodological assumption of full employment; I leave it as an exercise for the reader whether that could work and what other problems for the theory it might create. 

I should add that Gordon Tullock has made much the same point, as has Bob Lucas or for that matter Piero Sraffa in 1932.